SIM MODULE BOOK

Diploma in Management Studies

FINANCIAL ACCOUNTING

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Module Book
FINANCIAL ACCOUNTING

Module Book Developer : Janice Lee & Sunny Wong

Production : SIM Global Education

Module Book  SIM Global Education 2019

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All rights reserved.
No part of this material may be reproduced in any form or by any means without permission in writing
from SIM Global Education

First Version @ Dec 2019

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Table of Content

Introduction 5

Session 1: Introduction to Financial Accounting 13

Session 2: Double Entry Bookkeeping 27

Session 3: Trading Account 41

Session 4 &
Session 5: The Adjusting Process 58

Session 6: Current Assets: Inventory 74

Session 7: Current Assets: Receivables 86

Session 8: Non-Current Assets 98

Session 9: Liabilities and Shareholders’ Equity 109

Session 10: Cash Flow Statement 119

Session 11 &
Session 12: Financial Statement Analysis 127

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Module Book
FINANCIAL ACCOUNTING

Content

This course is designed to provide students with an understanding of the fundamental concepts
and principles of accounting, accounting equation, double-entry concepts, assets and liabilities,
inventory, tax and auditing. Emphasis is placed on analysis of business transactions of a company
and understanding basic financial statements to support decision-making. Students will be taught
how to prepare the profit and loss statements, cash flow statements and balance sheets.

Module Aims

The aims of this module are to enable students to:

1. Understand the objectives of financial reporting and explain the fundamental accounting
concepts and principles.
2. Understand the accounting cycle, apply the principles of double-entry and prepare financial
statements.
3. Apply the matching principle and understand the basis of accrual accounting in the
preparation of financial statements.
4. Account for inventory transactions and analyse the effects of different inventory methods on
financial statements.
5. Understand the issues in managing receivables and account for receivables.
6. Account for non-current assets and their depreciation.
7. Prepare the statement of cash flows.
8. Perform basic financial statement analysis.

Learning Outcomes

On completion of this module, the student should be able to:

1. Show a detailed knowledge and understanding of:

i) The accounting equation and accounting rules.

ii) The classification of accounts.
iii) Bookkeeping and the accounting cycle.
iv) The relation between the principal financial statements.
v) The interpretation of financial statements, the analysis of profitability, of solvency and gearing.
2. Demonstrate module specific skills with respect to:

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i) Preparing a simple balance sheet from financial information.
ii) Forecasting financial statements for simple cases and adjusting financial statements for
transactions.
iii) Citing, explaining, selecting, and applying formats/models to solve numerical problems in such
areas as: analysis of financial statements and computation of depreciation.

3. Show cognitive skills with respect to:

i) Integrating and synthesizing between module topics to discuss coherent approaches to the key
issues faced in planning and controlling a business from the accounting perspective.
ii) Developing familiarity and confidence with accounting / financial arithmetic.
iii) Applying accounting models in a “real world” context.

4. Demonstrate transferable skills in:

i) Information retrieval and numerical analysis.

ii) Analytical reasoning.
iii) Communication and presentation.
iv) Accounting in context.
v) Problem formulation and decision making.
vi) Working with others.

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Delivery of Module and Lesson Plan

S/N Topics Learning Outcomes Prescribed

At the completion of this session, participants will Text,
be able to: Readings
and/or
Activities

1. Introduction 1. Define the nature and purpose of accounting. SIM

to Financial 2. Identify the users of accounting information. Financial
Accounting 3. Understand business and the types of business Accounting
organisations. Module
4. Understand accounting concepts and principles. Book
5. State the accounting equation and define each Session 1
element of the equation.
6. Describe and illustrate how business transactions
can be recorded in terms of the resulting change
in the elements of the accounting equation.
7. Describe the financial statements and explain
how they interrelate.

2. Double Entry 1. Describe the characteristics of an account and a SIM

Accounting chart of accounts. Financial
2. Describe and illustrate journalising transactions Accounting
using the double-entry accounting system. Module
3. Describe and illustrate the journalising and Book
posting of transactions to accounts. Session 2
4. Prepare an unadjusted trial balance and explain
how it can be used to discover errors.
5. Discuss the limitations of the balance sheet in
portraying financial position.

SIM
3. Trading 1. Explain the difference between a trade Financial
Account receivable and a trade payable. Accounting
2. Explain the purchases account, purchases returns Module
account, sales account and sales returns account Book
and prepare the journal entries in a periodic Session 3
inventory system.
3. Explain the difference between cash and trade
discounts.
4. Explain and compute the Cost of Goods Sold,
Gross Profit and Net Profit of a trading business.
5. Prepare financial statements with trading
account.

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4 & The Adjusting 1. Describe the nature of the adjusting process. SIM
5. process 2. Journalise entries for accounts requiring Financial
adjustment. Accounting
3. Prepare an adjusted trial balance. Module
4. Prepare financial statements from the adjusted Book
trial balance. Session 4
and 5

6. Current 1. Describe the importance of control over SIM

Assets: inventories. Financial
Inventory 2. Describe three inventory cost flow assumptions. Accounting
3. Determine the cost of inventory under the Module
perpetual and periodic inventory system. Book
4. Compare and contrast the use of the three Session 6
inventory costing methods.
5. Describe and illustrate the reporting of
merchandise inventory in the financial
statements.

7. Current 1. Describe the common classes of receivables. SIM

Assets: 2. Describe the accounting for uncollectible Financial
Receivables receivables. Accounting
3. Describe the direct write-off method of Module
accounting for uncollectible receivables. Book
4. Account for the allowance for uncollectible Session 7
receivables.

8. Non-Current 1. Define, classify, and account for the cost of fixed SIM
Assets assets. Financial
2. Compute depreciation, using the following Accounting
methods: straight-line method and reducing- Module
balance method. Book
3. Journalise entries for the disposal of fixed assets. Session 8
4. Describe intangible assets.

9. Liabilities and 1. Define and illustrate current liabilities related to SIM

Shareholders’ accounts payable and current portion of long- Financial
Equity term debt. Accounting
2. Describe the nature of the corporate form of Module
organisation. Book
3. Describe the two main sources of stockholders’ Session 9
equity.
4. Describe and illustrate the characteristics of
stock and classes of shares.

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10. Cash Flow 1. Describe the cash flow activities reported in the SIM
Statement statement of cash flows. Financial
2. Prepare cash flows from operating activities, Accounting
using the indirect method. Module
3. Prepare cash flows from investing activities. Book
4. Prepare cash flows from financing activities. Session 10
5. Prepare a statement of cash flows

11 Financial 1. Describe basic financial statement analytical SIM

& Statement methods. Financial
12. Analysis 2. Use financial statement analysis to assess the Accounting
solvency of a business. Module
3. Use financial statement analysis to assess the Book
profitability of a business. Session 11
and 12

Teaching and Learning Methods

Participants will learn through a combination of lectures and practice exercises.

Participants will be expected to learn independently by carrying out reading and directed
study beyond that available within taught classes.

Indicative Readings

Textbook required SIM Financial Accounting Module Book,

Diploma in Management Studies, SIM Global Education,
BPP Learning Media

Supplementary reading Wood, F. & Sangster, A (2015). Frank Wood’s Business

Accounting Vol. 1. 13th Edition, Harlow, Essex, Pearson,
ISBN: 9781292084664
McLaney E and Atrill, P (2012), Accounting, An Introduction,
6th Edition, FT Prentice Hall, Harlow, ISBN: 9780273771838

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Assessment/coursework

All assessments must comply with the SIM Rules and Regulations. To satisfy module
requirements, students must:
1) Satisfactorily complete and present on due dates their completed assignment. A
penalty of 20% of the total marks will be imposed for late submission. A submission
later than 1 calendar day past deadline will receive a zero mark.
2) Complete all assignments and the online examination in a satisfactory manner.
3) Reference all their work and observe SIM’s policy on plagiarism. Students found
guilty of plagiarism will be dealt with severely.
4) Adopt either the Harvard or APA (American Psychological Association) Referencing
Style.

Specific for this module are the following requirements:

Weighting between components A and B – A: 60% B: 40%

Element Description % of Assessment

Component A (Controlled Conditions)

Online Examination (120 60%

minutes)

Component B (Assignments)

CAs 40%
Total (Component A+B) 100%

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 FINANCIAL ACCOUNTING

SESSION 1

INTRODUCTION TO FINANCIAL ACCOUNTING

At the end of the lecture, students should be able to:

1. Define the nature and purpose of accounting.

2. Identify the users of accounting information.
3. Understand business and the types of business organisations.
4. Understand accounting concepts and principles.
5. State the accounting equation and define each element of the equation.
6. Describe and illustrate how business transactions can be recorded in terms of the resulting
change in the elements of the accounting equation.
7. Describe the financial statements and explain how they interrelate.

1.1 Nature and Purpose of Accounting

Accounting is the process of recording, analyzing, summarizing, interpreting and communicating

business transactions to users of the information to help them in making decisions.

There is a difference between bookkeeping and accounting. Bookkeeping is the process of recording
transactions accurately and systematically following the double entry system.

Accounting goes beyond bookkeeping or record keeping. The data recorded is summarized and
financial information is reported to management and other interested parties in the form of financial
reports. The financial reports namely the Statement of Comprehensive Income shows the financial
performance of the enterprise for a certain period of time, and the Statement of Financial Position
shows the enterprise’s financial position as at a point in time. The results of the enterprise’s business
events could be analyzed through the use of percentages and ratios and further interpreted for the
purpose of decision making.

Activity 1

Is bookkeeping part of accounting?

Bookkeeping is a part of accounting which focuses on recording of transactions accurately and

systematically. Accounting goes beyond that to include analysing, summarising, interpreting and
communicating transactions.

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1.2 Users/Stakeholders of Accounting Information

Internal users (within business organisation): Owners, managers and employees.

External users (outside biz organisation): Credit suppliers, bankers and lenders, investors, government.

Activity 2

Why are the users/stakeholders interested in the accounting information?

Internal users:
Owners: assess the returns of their investment;
Employees: want to be assured of steady employment;
Managers: concerned with the company’s performance as their performance is based on their
stewardship of the company’s resources.

External users
Creditors and lenders: assess the ability to meet payments for goods and services acquired on credit
terms and lenders such as banks are concerned with a company’s ability to service the loan.
Governments: interested in the financial data to assess taxes.

Prospective Investors: interested to invest in a business that is financially stable and solvent.

1.3 Understand Business and Types of Business Organisations

A business is a unit of whatever size or nature which exists to make a profit. The types of businesses
include trading, service and manufacturing. Profit is defined as revenue less expenses.

The three types of business organisations are:

Sole traders – refers to ownership by one person who has total control over the business operations.
A sole trader or sole proprietor can enjoy all profits made and bear all losses incurred. Sole traders can
have employees.

Partnerships – refers to ownership by two or more people working together to earn profits. The
partners will share profits and bear losses according to their profit-sharing ratio as agreed upon.

Limited liability company – refers to ownership by purchase of shares and the shareholders have
liability limited to the amount they pay for their shares. (Owners: Shareholders)

Activity 3

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Business transactions are business activities taking place in a business firm which can be on cash or
credit basis.
What are some common business transactions in a business organisation?

 Examples of transactions:
Purchase of inventory/product/stock
Sales of inventory/product/stock
Pay salaries and wages, utilities, rent etc.
Take up a bank loan
1.4 Accounting Concepts and Principles

These are the broad assumptions which underlie the financial accounts of business entities and they are
important in the construction of accounting statements.

a) Going concern
b) Accruals
c) Objectivity
d) Consistency
e) Historical cost
f) Accounting period
g) Matching
h) Business entity
i) Duality
j) Money measurement
k) Prudence

a) Going concern: the business is assumed to continue to operate indefinitely and not likely to be
liquidated in the foreseeable future. Hence business transactions are recorded at the historical cost
and not at the liquidating value.

b) Accruals: the income and expense are recognized in the accounting periods to which they relate
rather than on cash basis. This implies that income must be recorded in the accounting period in
which it is earned rather than in the period in which cash will be received. Likewise, expenses
must be recorded in the period in which it is incurred, rather than in the period in which cash will
be paid. This concept will enable proper matching of revenue and expenses so that accurate
periodic profit can be ascertained. The accruals basis results in balance day adjustments which
will be further explained in Session 4.

c) Objectivity: accounting information should be freed from bias, that is they must be supported by
objective evidence which is verifiable. Source documents are used to verify the events or
transactions. This concept supports the historical cost concept.

d) Consistency: similar items are given similar treatment within one accounting period and from
one accounting period to the next. For instance, in the inventory costing methods such as FIFO,
LIFO and WAC methods; a method chosen is to be applied consistently in each accounting

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 period. The purpose is to have effective comparison of the results of one accounting period to
another and to avoid manipulation of accounting results.
e) Historical cost: transactions are stated in the accounts at the price at which the transactions occur.
The amounts initially recorded in the accounting records are at their cost or purchase price. The
historical cost is adopted as it is objective and verifiable. (Ignore market price)

f) Accounting period: the indefinite life of a business is divided into shorter time periods known
as accounting periods of twelve months. This will enable financial reports to be prepared at the
end of each period to meet the needs of various users.

g) Matching: expenses incurred by a business entity must be matched with the revenue earned in the
same accounting period. It is a process for periodic profit determination based on the accrual
basis. The statement of comprehensive income (SCI) is prepared based on the matching
concept.

h) Business entity: a business is considered separate and distinct from its owners or managers. So
only business activities are recorded and not the personal activities of the owner. Every business
transaction is recorded from the viewpoint of the business.

i) Duality: every business transaction has a two-fold effect. This gives rise to the double-entry
bookkeeping system. DEBIT & CREDIT

j) Money measurement: only transactions that can be expressed in monetary terms be recorded. It
enables many otherwise unlike items to be added together. Some events are significant to the
business but are not recorded as they could not be quantified into dollars and cents such as
competence of employees.

k) Prudence: a business should exercise caution not to overstate assets, revenues and gains and not
to understate liabilities, expenses and losses. This concept gives rise to providing for depreciation
on fixed assets and creating the allowance for receivables for outstanding trade receivables are so
as not to overstate assets and profits.

Activity 4

Give examples of the application of the Duality concept.

When an owner contributes personal cash to commence a business, it will be

recorded as business cash and at the same time recorded as a capital contribution.

1.5 The Accounting Equation

Assets = Liabilities + Owner’s Equity

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 IMPORTANT PAGE
Assets: items of value or resources which a business owns.

Fixed Assets: Assets that can be used for more Current Assets: Assets that can be converted
than one accounting period into cash within one accounting period
Land and building (Premises)/Property Cash
Motor vehicle Stock / Inventory/Product
Office equipment Trade debtors / Accounts receivable / Credit
customers of inventory (Haven’t pay)
Furniture and fittings Prepaid expense Session 4
Plant and machinery Accrued revenue Session 4
Liabilities / Debts: Resources owing by the business or resources contributed by non-owners such as
bankers and credit suppliers.

Current Liabilities: Liabilities to be paid Non-current liabilities: Liabilities to be paid

within one accounting period from the date of beyond one accounting period from the date of
the Statement of Financial Position (SOFP) the Statement of Financial Position (SOFP)

Trade creditors / accounts payable / credit Bank loan

suppliers of inventory (Long-term loan)
Bank overdraft Mortgage loan
Short term loan Debenture bonds / bonds payable
Unearned revenue Session 4
Accrued expense /expense due / expense owing /
expense outstanding Session 4

Capital/ Owner’s equity: Resources contributed by the owner into the business.
Cash, furniture, laptop, car etc.
Drawings/ Negative capital: Resources taken out by owner from business for personal use
/ Negative OE Cash, inventory
Drawings will reduce OE

The Accounting Equation

Accounting Equation
Assets = Capital + Liabilities

Accounting Equation Expanded

Assets = (Capital introduced + Profit - Drawings) + Liabilities Losses will reduce OE

Matching Concept:
Profit = Revenue earned – Expenses incurred

Revenue: Resources earned by the business which cause owner’s equity to increase.

Expenses: Resources used up to earn revenue which cause owner’s equity to decrease.

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 Revenue Expenses Expenses
Fees revenue Salaries Sundry expense/miscellaneous
(Service company) expense
Δ Sales revenue Rental Staff welfare
Interest earned Utilities Interest on bank overdraft,
interest on loan
Rent earned Advertising Irrecoverable debts expense
Commission earned Insurance Repairs and maintenance
Discount received Carriage outwards/carriage on Entertainment
sales
Carriage inwards/ carriage on Discount allowed
purchases
Activity 5

Complete the following table:

Assets Liabilities Owner’s Equity

$ $ $
(a) 65,000 35,600 29,400
(b) 60,700 47,200 13,500
(c) 70,000 33,400 36,600

1.6 Effects of Transactions on the Accounting Equation

Activity 6
Jan 2019
1 Beatrice deposited $80,000 in a bank account in the name of Be Trading.
6 Be Trading bought equipment worth $15,900 paying by cheque.
11 Furniture of $12,440 was bought on credit.
14 Be Trading received $3,600 for commission through GIRO.
21 The following expenses were paid by cheques: wages $11,500, utilities $3,800 and insurance
$9,650.
24 Be Trading paid creditors $8,100 with a cheque.
31 Beatrice withdrew $1,330 from Nancy Trading for her personal use.

Date Assets = Liabilities + Capital

Bank Equipment Furniture Other Payable Capital / OE
1/1 +$80,000 +$80,000
6/1 -$15,900 +$15,900
11/1 +$12,440 +$12,400
14/1 +$3,600 Commercial receive +$3,600
21/1 -$24,950 wages -$11,500
utilities -$3,800
insurance -$9,650
24/1 -$8,100 -$8100

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31/1 -$1,330 Drawings -$1,330
Activity 7

Analyse the Effect of the following Transactions by using the Duality Principle

Inc./Dec. Transactions Category

A = L + OE
+ Bank a/c $10K Current Asset/CA Bank
+ Motor vehicle a/c $80K Fixed Asset/FA MV. Capital
+ John, Capital a/c OE +$90K +$90K
(Start a biz with cash and a
delivery van)
+ A = L + OE
- Office equipment a/c $4K Fixed Asset/FA Equipment+$4K
Bank a/c $4K Current Asset/CA Bank -$4K
(Buy a fixed asset paying by
cheque)
A = L + OE
Furniture a/c $3K Fixed Asset/FA Furniture OP.
Other Payable a/c $3K Current Liability +$3K +$3K
(Buy a fixed asset on credit)
A = L + OE
- Other payable a/c $3K Current Liability Bank OP.
- Bank a/c $3K Current Asset/CA -$3K -$3K
(Paying other payable by
cheque)
A = L + OE
Bank a/c $5K Current Asset/CA Bank Comm. earn
Commission earned/Rent Revenue/R/ +$5K +$5K
earned/Interest earned a/c Increase OE
$5K
(Receive a revenue by
cheque)
A = L + OE
Salaries and wages expense Expense/E/ Bank Salaries -$8K
a/c Decrease OE
$8K
Utilities expense a/c $2K E -$15K Utilities -
$2K
Advertising expense a/c $5K E Advertising -
$5K
Bank a/c $15K CA
(Paying for an expense by
cheque)
A = L + OE
Bank a/c $20K CA Bank Loan
Loan a/c $20K Non-current +$20K +$20K
liability/NCL
(Taking up a loan)

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 Inc./Dec. Transactions Category
A = L + OE
Loan a/c $5K NCL Bank Loan
Bank a/c $5K CA -$5K -$5K
(Partial repayment of loan)

A = L + OE
John, Drawing a/c $1K Drawings/- OE Bank
Drawings
Bank a/c $1K CA -$1K -$1K
(Owner John took biz money
for personal use)
A = L + OE
John, Drawings a/c $2K Drawings/ - OE Drawings -
$2K
Purchases a/c $2K E/ + OE Purchase +
$2K
(Owner John took inventory
for personal use)

1.7 Describe the financial statements and explain how they interrelate

Financial Statements:

The financial statements of a business are represented by several elements, the most basic being the
Statement of Profit or Loss/ Statement of Comprehensive Income, Statement of Owner’s Equity and
the Statement of Financial Position.
The Statement of Comprehensive Income/Statement of Profit or Loss shows the financial performance
of a business based on the matching concept. It shows how the profit or loss for the period has been
made.
Key items on the statement of profit or loss are gross profit and net profit.
Key Formulae:
Gross Profit = Net Sales less Cost of goods sold
Net Sales = Sales less Sales returns
Cost of goods sold/COGS represents the purchase or production costs of goods sold
COGS = Opening stock add Purchases less Purchases returns add Carriage inwards add Customs
duties less Closing stock
Net Profit = Gross profit add Other income less Other expenses

The Statement of Owner’s Equity shows the change in the owner’s equity.
Opening capital + New capital + Net profit – Drawings = Closing capital

The Statement of Financial Position ( SOFP ) shows the assets, liabilities and capital of the business at
the period end. It represents the accounting equation.

Review Questions

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Question 1

Which of the following statements is incorrect?

A. A business exists to make profits.

B. Financial statements provide relevant information to external users only.
C. Business activities that can be expressed in monetary terms are recorded.
D. Financial statements comprises of a Statement of Comprehensive Income and a Statement of
Financial Position to meet the needs of a number of user groups.

Question 2

Which of the following statements about the accounting equation is correct?

A. Assets + Liabilities = Owner’s equity

B. Assets – Liabilities = Owner’s equity
C. Assets + Owner’s equity = Liabilities
D. Liabilities – Assets = Owner’s equity

Question 3

Randy contributed a laptop of $3,000 worth into his business. What is the effect of the transaction on
the business’s accounting equation?

A. Increase in asset and owner’s equity

B. Decrease in an asset and decrease in another asset
C. Increase in assets and decrease in liabilities
D. Increase in assets and decrease in owner’s equity

Question 4

Eric paid trade payables of $18,000 with a personal cheque. What is the effect of the transaction on the
business’s accounting equation?

A. Increase in a liability and decrease in owner’s equity

B. Decrease in an asset and decrease in a liability
C. Increase in an asset and decrease in a liability
D. Decrease in a liability and increase in owner’s equity

Question 5

Complete the following table:

Assets Liabilities Capital

$ $ $
(i) 100,200 49,000 ?

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 (ii) 78,000 ? 33,150
(iii) ? 26,789 56,000

A. (i) Capital $101,200; (ii) Liability $39,350; (iii) Assets $67,789

B. (i) Capital $ 56,200; (ii) Liability $35,600; (iii) Assets $88,000
C. (i) Capital $ 51,200; (ii) Liability $44,850; (iii) Assets $82,789
D. (i) Capital $122,200; (ii) Liability $40,650; (iii) Assets $30,211
Question 6

During the month of March 2019, Mr Tan entered into the following transactions:

(i) Sold a machine which costs $19,200 on credit for $8,700.

(ii) Withdrew $1,000 from his business’s bank account to go on a holiday.
(iii) Bought a sofa set for office use for $1,390 on credit.
(iv) Repaid a bank loan of $30,000 with a personal cheque.

Question 7

Below is the information of Mr Pang, a sole proprietor for the year ended 31 July 2019:

$
Capital 61,000
Motor van 33,400
Cash at bank 11,700
Furniture and fixtures 18,290
Service revenue 13,850
Transportation expenses 1,250
Interest expense 400
Salaries & wages 7,000
Commission received 6,000
Utilities 4,000
Rental expense 9,300
Receivables 9,710
Payables 2,200
Loan 15,000
Drawings 3,000
Required:

Compute the total amount of:

(i) Fixed assets

(ii) Current assets
(iii) Current liabilities
(iv) Non-current liabilities
(v) Revenues
(vi) Expenses

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Question 8

The following balances were extracted from the accounting records of Peter Khoo:

$
Plant and machinery 88,000
Bank loans 100,000
Premises 355,000
Trade receivable 45,000
Trade payable 23,000
Inventory 18,000
Bank overdraft 13,300
Fixtures and fittings 11,500
Repairs and maintenance 800
Drawings 3,200
Mortgage loan 250,000
Other payable 3,100
Other receivable 4,990

Required:

Compute the total amount of:

(i) Fixed assets

(ii) Current assets
(iii) Current liabilities
(iv) Non-current liabilities
(v) Capital

Homework Questions (with answers)

Question 1

Which of the following statements is correct?

A. Assets include trade receivable, inventory and bank overdraft.

B. Liabilities include trade payable, bank loan and accrued revenue.
C. Drawings cause owner’s equity to decrease.
D. Expenses include interest on loan, commission received and insurance.

Question 2

Employees are interested in financial information because they need to

A. assess the business’s ability to meet loan and interest payments.

B. decide whether to buy shares in the company.
C. assess the business’ ability to make payments for goods bought on credit.
D. be assured of steady employment.

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Question 3

Leslie contributed a sofa set of $2,000 worth into his business. What is the effect of the transaction on
the business’s accounting equation?

A. Increase in asset and owner’s equity

B. Decrease in an asset and decrease in another asset
C. Increase in assets and decrease in liabilities
D. Increase in assets and decrease in owner’s equity

Question 4

A cheque of $1,600 paid to Lee Co. by a customer was used by Mr Lee, the owner to pay for his home
utility bill. What is the effect of the transaction on the business’s accounting equation?

A. Decrease in accounts receivable and drawings

B. Decrease in accounts receivable and increase in drawings
C. Increase in accounts receivable and drawings
D. Increase in accounts receivable and decrease in drawings

MCQ Answers: C, D, A, B

Question 5

During the month of May 2019, James entered into the following transactions:

(i) Bought a van which costs $80,000 on credit.

(ii) Deposited $11,000 from his personal bank account to pay for a laptop for office use.
(iii) Received a cheque of $490 from a trade debtor.
(iv) Took up a bank loan of $50,000.

Show how the accounting equation is affected with the above transactions.

Answer:
(i) Asset (Bank) + $80,000; Liability (Other payable) + $80,000.
(ii) Asset (Equipment) + $11,000; Equity (Capital) + $11,000.
(iii) Asset (Bank) + $490; Asset (Trade receivable) - $490.
(iv) Asset (Bank) + $50,000; Liability (Bank Loan) + $50,000.

Question 6

Complete the following table:

Assets Liabilities Capital

$ $ $
(a) 99,000 41,000 ?

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 (b) 78,400 ? 32,500
(c) ? 63,789 100,000

Answer: Assets Liabilities Capital

$ $ $
(a) 99,000 41,000 58,000
(b) 78,400 45,900 32,500
(c) 163,789 63,789 100,000
Question 7

The following balances were extracted from Debbie’s accounting books:

$
Trade receivable 44,000
Trade payable 37,650
Equipment 24,950
Salaries and wages 33,456
Utilities 12,110
Loan 40,000
Freight outwards 4,456
Inventory 15,320
Sales 68,468
Rent expense 12,600
Interest received 5,400
Bank overdraft 15,120
Furniture 19,800

Required:

Compute the total amount of:

(i) Fixed assets

(ii) Current assets
(iii) Current liabilities
(iv) Non-current liabilities
(v) Expenses
(vi) Revenues

Answer:
The total amount of:

(i) Fixed assets = $24,950 + $19,800 = $44,750

(ii) Current assets = $44,000 + $15,320 = $59,320
(iii) Current liabilities = $37,650 + $15,120 = $52,770
(iv) Non-current liabilities = $40,000
(v) Expenses = $33,456 + $12,110 + $4,456 + $12,600 = $62,622
(vi) Revenues = $68,468 + $5,400 = $73,868

23
24
Question 8

Raymond has the following items in his statement of financial position on 30 November 2019:

Trade payable $29,345; motor vehicles $50,800; office equipment $19,500; trade receivable $25,220;
bank overdraft $18,300; bank loan $30,000, inventory $20,660, furniture and fittings $18,755.

Required:

Compute the total amount of:

(i) Capital
(ii) Fixed assets
(iii) Current assets
(iv)Current liabilities
(v) Non-current liabilities

Answer:
(i) Capital = Assets – Liabilities
= 50,800 + 19,500 + 25,220 + 20,660 + 18,755 – 29,345 – 18,300 – 30,000
= $57,290
(ii) Fixed assets = $50,800 + $19,500 + 18,755 = $89,055
(iii) Current assets = $25,220 + $20,660 = $45,880
(iv)Current liabilities = $29,345 + $18,300 = $47,645
(v) Non-current liabilities = $30,000

25
 FINANCIAL ACCOUNTING

SESSION 2

DOUBLE ENTRY BOOKKEEPING

At the end of the lecture, students should be able to:

1. State the dual aspect rule.

2. Describe the double-entry accounting system and the basic accounting rules.
3. Describe and illustrate journalizing transactions using the double-entry accounting system.
4. Describe the general ledger account and the balancing of the ledger accounts process.
5. Prepare an unadjusted trial balance and explain how it can be used to discover errors.
6. Discuss the limitations of the balance sheet in portraying financial position.

2.1 Dual Aspect Rule

The dual aspect rule states that every business event will always have a twofold effect. The
recognition of the twofold effect of all transactions gave rise to the double-entry bookkeeping system.

2.2 Double Entry Bookkeeping System and the Basic Accounting Rules

Double entry bookkeeping is a financial accounting system used to record financial transactions.
Every accounting transaction has two equal but opposite effects.

Every transaction is recorded in the accounting system as a debit (Dr.) and an equal but opposite credit
(Cr.)

The basic accounting rules are as follows:

When Increase, When Decrease,

Item record as a … record as a …
Asset Dr Cr
Expense Dr Cr
Drawings Dr Cr

Liability Cr Dr
Capital Cr Dr
Revenue Cr Dr

• Asset, Expense and Drawings have normal Debit balances.

• Liability, Capital and Revenue have normal Credit balances.

26
2.3 Journalising Transactions Using the Double-Entry Bookkeeping System

The General Journal

Journals are used to record source information that is not contained within the other books of prime
entry such as balance day adjustments, correction of errors, large/unusual transactions and purchases
and sales of fixed assets on credit.

Format of General Journal

Date Debit Credit

$ $
DEBIT A/c to be debited x
CREDIT A/c to be credited x
Narrative to explain transaction

A transaction is initially entered in a record called a journal.

The process of recording a transaction in the journal is called journalising.

Double-entry rule: Whenever there is a debit, there must be a corresponding credit.

Activity 1 Asset Expense Drawings Liabilities Capital Revenue

Inc DR Inc CR
Dec CR Dec DR

CA: Current asset FA: Fixed asset CL: Current Liability NCL: Non current Liability
OE: Owner’s Equity R: Revenue E: Expenses

Date Transactions Accounts Categor +/- Journal Entries

y
1/10 Abel contributed
$90,000 by cheque
and brought in his
car $60,000 to
commence his
business Able
Company.

8/10 Able Company

bought a fax
machine worth
$2,300 paying by
cheque.

10/1 Furniture of $7,200

0 was bought on
credit.

27
Date Transactions Accounts Categor +/- Journal Entries
y

Asset Expense Drawings Liabilities Capital Revenue

Inc DR Inc CR
Dec CR Dec DR

Date Transactions Accounts Cate. +/- Journal Entries

16/10 Able Company
received $3,900 for
rental from tenant by
cheque.

20/10 The following

expenses were paid
by cheques: salaries
and wages $10,500,
utilities $1,950 and
insurance $6,620.

24/10 Able Company paid

trade creditors $4,900
with a cheque.

30/10 Abel took a bank loan

of $15,000 from
OCBC.

31/10 Abel withdrew

$1,600 from Abel
Company for his
personal use.

28
 Abel Company
General Journal
Date Particulars Dr Cr
$ $
1/10 Bank a/c 90,000
Motor vehicle a/c 60,000
Abel, Capital a/c 150,000

8/10 Office equipment a/c 2,300

Bank a/c 2,300

10/10 Furniture a/c 7,200

Other Payable a/c 7,200

16/10 Bank a/c 3,900

Rent Earned a/c 3,900

20/10 Salaries and wages expense a/c 10,500

Utilities expense a/c 1,950
Insurance expense a/c 6,620
Bank a/c 19,070

24/10 Other payable a/c 4,900

Bank a/c 4,900

30/10 Bank a/c 15,000

Loan a/c 15,000

31/10 Abel, Drawing a/c 1,600

Bank a/c 1,600

29
2.4 The General Ledger and Balancing the Ledger Accounts

The General Ledger

Ledger (T) accounting is the system by which a business keeps a record of its transactions in
chronological order and built up in cumulative totals.

The general ledger is an accounting record which summarises the financial affairs of a business.

Name of Account

Debit side Credit side

Balancing ledger accounts

At the end of an accounting period ledger accounts are totalled up and balanced.
If the total debits exceed the total credits there is a debit balance on the account.
If the total credits exceed the total debits then the account has a credit balance.

2.5 The Trial Balance

A trial balance is a list of ledger balances shown in debit and credit columns. It is a device to ensure
the mathematical accuracy of transactions posted from the general journal to the general ledger. The
Dr and Cr balances after the balancing process form the trial balance as at the end of the period.

A sample of a Trial Balance

Abel
Trial Balance as at 31 October
Dr Cr
$ $
Bank 81,030
Capital 150,000
Motor vehicle 60,000
Office equipment 2,300
Furniture 7,200
Rent earned 3,900
Other payable 2,300
Salaries and wages 10,500
Utilities 1,950
Insurance 6,620
Loan 15,000
Drawings 1,600
171,200 171,200

30
Activity 2

The following Trial Balance has a number of errors. Prepare a corrected trial balance.

Trial Balance as at December 2019

Dr. Cr.
$ $
Capital 60,000
Cash at bank 25,800
Loan 40,000
Premises 120,000
Consultation Revenue 74,000
Other debtors 12,000
Other creditors 27,000
Repairs expense 4,000
Wages and salaries 25,000
Utilities 13,500
Drawings 700
Total

Activity 3

Record the following transactions for February 2020 in the General Journal of Bernard Lim and
prepare a Trial Balance as at 28 February 2020.

202
0
Feb 1 Started business with $12,000 cash.
2 Paid $11,700 of the opening cash into a bank account for the business.

5 Bought furniture on credit from Wood Ltd for $1,900.

8 Bought a van paying by cheque $5,250.

12 Bought equipment from EE Ltd on credit $2,300.

15 Returned faulty office furniture costing $120 to Wood Ltd.

19 Received $2,400 by cheque for rental of office space to tenant.

21 Paid amount owing to Wood Ltd $1,780 by cheque.

25 Paid $1,090 for office utilities by cheque.

30 Fanny lent us $4,000 – giving us the money by cheque.

31
 Bernard Lim
General Journal
Date Particulars Dr Cr
2020 $ $

32
 Bernard Lim
Trial Balance as at 28 February 2020
Dr Cr
$ $
Bank a/c (11,700 – 5,250 + 2,400 – 1,780 – 1,090 9,980
+ 4,000)

Cash a/c (12,000 – 11,700) 300

Furniture a/c (1,900 – 120) 1,780

Capital a/c 12,000

Other payable EE Ltd a/c 2,300

Motor vehicle a/c 5,250

Equipment a/c a/c 2,300

Rent received a/c 2,400

Utilities expense a/c 1,090

Loan a/c 4,000

$20,700 $20,700

Activity 4 Journal Entries related to Activity 7 (Topic 1) on page 17 (Summary)

Business Name
General Journal
Date Particulars Dr Cr
$ $
2019
+ Bank a/c 80,000
+ Motor vehicle a/c 60,000
+ John, Capital a/c 140,000
(Start a biz with cash and a delivery van)

+ Office equipment a/c 2,500

- Bank a/c 2,500
(Buy a fixed asset paying by cheque)

+ Furniture a/c 5,200

+ Other Payable a/c 5,200

33
 Date Particulars Dr Cr
$ $

- Other payable a/c 3,400

- Bank a/c 3,400
(Paying partially other payable by cheque)

+ Bank a/c 3,500

+ Commission earned/Rent earned/Interest earned a/c 3,500
(Receive a revenue by cheque)

+ Salaries and wages expense a/c 8,500

+ Utilities expense a/c 1,350
+ Advertising expense a/c 2,450
- Bank a/c 12,300
(Paying for an expense by cheque)

+ Bank a/c 10,000

+ Loan a/c 10,000
(Taking up a loan)

- Loan a/c 8,000

- Bank a/c 8,000
(Partial repayment of loan)

+ John, Drawing a/c 7,500

- Bank a/c 7,500
(Owner John took biz money for personal use)

+ John, Drawings a/c 800

- Purchases a/c 800
(Owner John took inventory for personal use)

Review Questions

Question 1

Janessa received 5,000 of commission income. What is the double entry for this transaction?

A. Dr Cash $5,000 and Cr Capital $5,000

B. Dr Cash $5,000 and Cr Loan $5,000
C. Dr Cash $5,000 and Cr Commission earned $5,000
D. Dr Cash $5,000 and Cr Commission expense $5,000

34
Question 2

George repaid his loan of $14,000 by cheque. What is the double entry for this transaction?

A. Dr Cash $14,000 and Cr Loan $14,000

B. Dr Bank $14,000 and Cr Loan $14,000
C. Dr Loan $14,000 and Cr Cash $14,000
D. Dr Loan $14,000 and Cr Bank $14,000

Question 3

A debit entry is recorded when

A. asset decreases and liability decreases CR DR

B. asset increases and equity increases DR CR
C. equity decreases and liability increases DR CR
D. expense increases and revenue decreases DR DR

Question 4

A credit entry is recorded when

A. asset decreases and liability increases CR CR

B. asset increases and capital decreases DR DR
C. expense decreases and liability decreases CR DR
D. drawings increase and revenue decreases DR DR

Question 5

Jeremy bought a cabinet that cost $2,000 paying by a personal cheque. What is the effect of the
transaction on the business’s accounting equation?

A. Increase in furniture and increase in capital

B. Increase in furniture and decrease in bank
C. Increase in furniture and increase in other payable
D. Increase in bank and increase in revenue

Question 6

When a photocopier is sold on credit, the accounting entries are

Debit Credit
A. Office equipment Other payable
B. Other payable Office equipment
C. Office equipment Other receivable
D. Other receivable Office equipment

35
Question 7

A trade debtor paid Sally $3,000 by cash. What is the correct double entry to record this transaction in
the books of Sally?

A. Dr Cash account Cr Capital account

B. Dr Cash account Cr Sales account
C. Dr Cash account Cr Trade debtor account
D. Dr Cash account Cr Trade creditor account

Question 8

Lionel paid $2,400 by cheque for repairing a machine. What is the correct double entry?

A. Dr Machine account Cr Bank account

B. Dr Repairs account Cr Bank account
C. Dr Bank account Cr Repairs account
D. Dr Bank account Cr Machine account

Question 9
Consider the following transactions of Agnes who owns a business selling cameras. You are required
to analyse each transaction and write down the double entries to record the transactions.

Transaction Accounts Cat. +/- Double Entries

1 Agnes contributed
$50,000 cash to start her
business and the money
was deposited into the
business’ bank account.

2 Bought a laptop from

Simon, $2,800 on
account.

3 Paid $4,800 for rental of

shop space by cheque.

4 Withdrew $1,200 from

the bank account to pay
for her personal
insurance.

36
 Transaction Accounts Cat. +/- Double Entries

5 Took a loan of $20,000,

receiving a cheque for it.

6 Paid amount owing to

Simon with a cheque.

7 A debtor, Jackie, paid

$500 by cheque.

8 Agnes put $3,000

personal cash into the
business.

Question 10

Samson has a business selling equipment. You are required to journalise the following transactions:

Journal Entries
a) Samson brought in $80,000 cash and his car that costs
$70,000 to start his business.

b) Bought a cabinet from Tan, $800 paying by cheque.

c) Bought a computer from Best Ltd, $3,300 on account.

d) Paid Best Ltd the full amount owing by cheque.

37
 Journal Entries

e) Received interest income of $380 in cash.

f) Issued a business cheque of $440 to pay Samson’s

home utility bill.

g) Paid employees $8,900 by cheque for their salaries and

wages.

h) Took a loan of $10,000 from a bank, receiving the

amount by cheque.

i) Paid the loan interest amount of $110 by cheque.

j) Samson paid for advertising $6,800 with his personal

cheque.

k) Samson brought in $8,000 personal money into the

business, depositing the money in the bank account.

l) Bought an equipment $7,200 from SS Ltd, paying

$5,000 by cheque and the remaining amount one month
later.

38
Homework Questions (with solutions)

Question 1

Thomas Lam received $800 of interest revenue. What is the double entry for this transaction?

A. Dr Cash $800 and Cr Interest revenue $800

B. Dr Cash $800 and Cr Loan $800
C. Dr Cash $800 and Cr Capital $800
D. Dr Cash $800 and Cr Interest expense $800

Question 2

Gracia Lee paid trade creditor $8,000 with a personal cheque. What is the double entry for this
transaction?

A. Dr Trade creditor $8,000 and Cr Bank $8,000

B. Dr Trade creditor $8,000 and Cr Cash $8,000
C. Dr Trade creditor $8,000 and Cr Capital $8,000
D. Dr Trade creditor $8,000 and Cr Gracia $8,000

Question 3

Which of the following requires a debit entry?

1. Furniture increases and trade payable increases

2. Equipment increases and drawings increases
3. Interest revenue decreases and loan increases
4. Interest expense increases and rent revenue decreases

A. 1 and 2
B. 2 and 4
C. 2 and 3
D. 3 and 4

Question 4

A credit entry is recorded when

A. Bank decreases and loan increases

B. Machinery increases and capital decreases
C. Salaries decreases and trade payable decreases
D. Drawings increases and commission earned decreases

39
Question 5

Noah Tan sold a laptop that cost $2,400 for $1,300 receiving the amount by cheque. What is the effect
of the transaction on the business’s accounting equation?

A. Increase in asset $1,100 and increase in capital $1,100

B. Decrease in asset $1,100 and increase in capital $1,100
C. Increase in asset $1,100 and decrease in capital $1,100
D. Decrease in asset $1,100 and decrease in capital $1,100

Question 6

When a rack for placing the files in the office is bought on credit, the accounting entries are

Debit Credit
A. Furniture Other payable
B. Other payable Furniture
C. Furniture Other receivable
D. Other receivable Furniture

Question 7

Pamela paid other creditor Tammy $3,000 by cash. What is the correct double entry to record this
transaction in the books of Tammy?

A. Dr Cash account Cr Capital account

B. Dr Cash account Cr Sales account
C. Dr Cash account Cr Trade debtor account
D. Dr Cash account Cr Trade creditor account

Question 8

Bella paid $1,010 by cheque for her daughter’s tuition fees from the business bank account. What is
the correct double entry?

A. Dr Tuition fees account Cr Bank account

B. Dr Tuition fees account Cr Capital account
C. Dr Drawings account Cr Tuition fees account
D. Dr Drawings account Cr Bank account

MCQ Answers: A, C, B, A, D, A, C, D

40
Question 9

Complete the following table for Benny who has started a retail business dealing in stationery:

Debit Credit
a) Benny started his business by depositing $20,000
into the business bank account.

b) Bought a cabinet of $1,100 from Jelly Ltd on credit.

c) Returned cabinet to Jelly Ltd.

d) Paid $5,600 for advertising by cheque.

e) Benny paid his home utility bill of $360 from the

business bank account.

f) A debtor, Eugene, paid Benny $4,800 and the

money was used to pay the office rent.

Answer:
Debit Credit
a) Benny started his business by depositing Bank a/c $20,000 Capital a/c $20,000
$20,000 into the business bank account.

b) Bought a cabinet of $1,100 from Jelly Ltd Furniture a/c $1,100 Other payable Jelly
on credit. Ltd’s a/c $1,100

c) Returned cabinet to Jelly Ltd. Other payable Jelly Furniture a/c $1,100
Ltd’s a/c $1,100

d) Paid $5,600 for advertising by cheque. Advertising a/c Bank a/c $5,600
$5,600

e) Benny paid his home utility bill of $360 Drawings a/c $360 Bank a/c $360
from the business bank account.

f) A debtor, Eugene, paid Benny $4,800 and Rent expense a/c Trade receivable
the money was used to pay the office rent. $4,800 Eugene/s a/c $4,800

41
Question 10

Record the following transactions for January 2020 in the General Journal of Benson Soh and prepare
a Trial Balance as at 31 January 2020.

2020
January 1 Started business with $50,000 cash at bank and a computer $3,400.
2 Took a bank loan of $30,000.
5 Bought a delivery van on credit from Vee Ltd for $60,000 paying $20,000 by
cheque and the remainder in two months’ time.
9 Bought a sofa set for office use that costs $3,300 from Yan Ltd on credit.
11 Bought a laptop from Deluxe Ltd on credit $4,000.
13 Returned faulty laptop costing to Deluxe Ltd.
18 Received $900 commission by cheque.
21 Paid insurance of $600 by cheque.
25 Paid $1,400 to Yan Ltd by cheque.
31 Benson took $2,000 for personal use by cheque.

Answer:
Benson Soh
General Journal
Date Particulars Dr Cr
$ $
2020
1/1 Bank 50,000
Office equipment 3,400
Capital 53,400

2/1 Bank 30,000

Loan 30,000

5/1 Motor vehicle 60,000

Bank 20,000
Other payable: Vee Ltd 40,000

9/1 Furniture 3,300

Other payable: Yan Ltd 3,300

11/1 Office equipment 4,000

Other payable: Deluxe Ltd 4,000

13/1 Other payable: Deluxe Ltd 4,000

Office equipment 4,000

18/1 Bank 900

Commission earned 900

42
Date Particulars Dr Cr
$ $
21/1 Insurance 600
Bank 600

25/1 Other payable: Yan Ltd 1,400

Bank 1,400

31/1 Drawings 2,000

Bank 2,000

Benson Soh
Trial Balance as at 31 January 2020
Dr Cr
$ $
Bank a/c (50,000 + 30,000 – 20,000 + 900 – 600 – 56,900
1,400 – 2,000)

Office equipment a/c (3,400 + 4,000 – 4,000) 3,400

Motor vehicle a/c 60,000

Furniture a/c 3,300

Capital a/c 53,400

Loan a/c 30,000

Other payable Vee Ltd a/c 40,000

Other payable Yan Ltd a/c (3,300 – 1,400) 1,900

Commission earned a/c 900

Insurance a/c 600

Drawings a/c 2,000

$126,200 $126,200

43
 FINANCIAL ACCOUNTING

SESSION 3

TRADING ACCOUNT

At the end of the lecture, students should be able to:

1. Explain the difference between a trade receivable and a trade payable.

2. Explain the purchase account, purchase returns account, sales account and a sales returns
account and prepare the journal entries in a periodic inventory system.
3. Explain the difference between cash and trade discounts.
4. Explain and computation the Cost of Goods Sold, Gross Profit and Net Profit of a trading
business.
5. Prepare financial statements with Trading account.

3.1 Trade Receivables and Trade Payables

Trade Receivable

A trade receivable is a person to whom the business has sold items and by whom the business is owed
money. It is also known as an accounts receivable and classified as a current asset of a business.

Trade Payable

A trade payable is a person from whom a business has purchased items and to whom a business owes
money. It is also known as an accounts payable and classified as a current liability of the business.

3.2 Purchases, Purchases Returns, Sales and Sales Returns Accounts

Purchases: Purchase of goods with the intention of resale.

Purchases returns/ Returns outwards: Return of goods to supplier due to damage, wrong brand or
model, wrong size or quantity.

Sales: Sale of goods that the business deals with.

Sales returns/Returns inwards: Return of goods by customer due to damage, wrong brand or model,
wrong size or quantity.

Activity 1 Applying the Double Entry Rules

Jonas is a sole proprietor dealing in electronic products. Below are the transactions for his business.

44
 Transaction Accounts Category Inc./ Double Entries
Dec.
1 Jonas bought $5,000 Purchases Expense Inc.
inventory paying by
cheque. Bank Asset Dec.

2 Bought more goods for Purchases Expense Inc.

resale $10,000 on
account from Ace Ltd. Trade Liability Inc.
payable

3 Returned faulty goods Trade Liability Dec.

$1,000 to Ace Ltd. payable
Purchases Contra Inc.
returns (reduces
purchases)

4 Jonas drew a cheque to Trade Liability Dec.

pay Ace Ltd. payable
Bank Asset Dec.

5 Jonas sold $3,000 Bank Asset Inc.

inventory collecting a
cheque for it. Sales Revenue Inc.

6 Sold some electronic Trade Asset Inc.

goods $8,000 on credit receivable
to Bee Ltd. Sales Revenue Inc.

7 Bee Ltd returned Sales Contra Inc.

defective goods $2,000 returns (reduces
to Jonas. Trade sales)
receivable Asset Dec.

8 Bee Ltd paid Jonas by Bank Asset Inc.

cheque.
Trade Asset Dec.
receivable

3.3 Cash Discounts and Trade Discounts

Discounts
A discount is a reduction in the price of goods below the amount at which those goods would normally
be sold to other customers of the supplier.

There are two types of discount: Trade discount and Cash discount.
A trade discount is a reduction in price given to a customer or given by a supplier when goods are
bought in bulk or in large quantities. The amount of trade discount is not to be recorded.

45
 A cash discount is a reduction in amount to be paid to supplier or to be received from customer when
payment is made within discount period. It is given to encourage prompt payment. When the discount
is granted to a customer, it is known as discount allowed and when received from a supplier, it is
known as discount received.

Activity 2

Iris Tung is a sole proprietor dealing in computer accessories. Below are the transactions for
her business.

Transaction Accounts Category Inc./ Double Entries

Dec.
1 Iris purchased $12,000 Purchases Expense Inc.
computer accessories
paying by cheque. Bank Asset Dec.

2 Bought inventories Purchases Expense Inc.

$22,000 on account
from Texas Trading, Trade Liability Inc.
receiving a trade payable
discount of 10%.

3 Returned faulty goods Trade Liability Dec.

$1,200 to Texas payable
Trading. Purchases Contra Inc.
returns (reduces
purchases)

4 Iris gave a cheque of Trade Liability Dec.

$18,000 to Texas payable
Trading in full Discount Revenue Inc.
settlement of its debts. received
Bank Asset Dec.

5 Iris sold $4,000 worth Bank Asset Inc.

of inventory. receiving
a cheque for it. Sales Revenue Inc.

6 Sold some computer Trade Asset Inc.

accessories $10,000 on receivable
credit to Tip Ltd. Sales Revenue Inc.

7 Tip Ltd returned Sales Contra Inc.

defective goods $900 returns (reduces
to Iris. sales)
Trade Asset Dec.
receivable

46
 Transaction Accounts Category Inc./ Double Entries
Dec.
8 Tip Ltd paid Iris Bank Asset Inc.
$8,500 after discount
by cheque. Discount Expense Inc.
allowed
Trade Asset Dec.
receivable

Activity 3 (Summary of Common Journal Entries for a Trading Company )

Date Particulars Dr Cr
$ $
+A Cash a/c 12,000
+R Sales a/c 12,000
Cash sales $12,000

+A Trade Receivable a/c 50,000

+R Sales a/c 50,000
Credit Sales $50,000

+ (-R) Sales returns a/c 8,000

-A Trade receivable a/c 8,000
Stock returned by debtors $8,000

+A Cash a/c 42,000

-A Trade receivable a/c 42,000
Cash received from Debtors with no discount

+A Cash a/c 41,500

+E Discount allowed a/c 500
-A Trade receivable a/c 42,000
Cash received from debtors with discount of $500
given to debtors

+E Purchases a/c 30,000

-A Cash a/c 30,000
Cash Purchases $30,000

+E Purchases a/c 70,000

+L Trade Payable a/c 70,000
Credit Purchases $70,000

-L Trade payable a/c 10,000

+ (-E) Returns outwards a/c 10,000
Stock returned to creditors $10,000

47
 Date Particulars Dr Cr
$ $
-L Trade payable a/c 60,000
-A Cash a/c 60,000
Paid cash with no discount from creditors

-L Trade payable a/c 60,000

+R Discount received a/c 1,200
-A Cash a/c 58,800
Paid cash to creditors receiving
a discount of $1,200 from creditors

+E Carriage outwards a/c 700

-A Cash a/c 700
Paid cash $700 for delivery of goods to customers

+E Carriage inwards a/c 1,000

-A Cash a/c 1,000
Paid cash $1,000 for bringing goods in from suppliers

3.4 Cost of Goods Sold/COGS, Gross Profit and Net Profit.

The cost of goods sold is the cost price of the inventory sold to customers.

Formula:
Opening inventory + Purchases – Purchases + Carriage + Customs – Closing inventory
returns inwards duties

Opening inventory is the amount of inventory the business has at the start of an accounting period
brought forward form the previous accounting period.
Closing inventory is the amount of unsold inventory the business has at the end of an accounting
period.

Carriage inwards: Cost paid by purchaser of having goods delivered to his business. It is added to the
cost of purchases. It is also known as freight inwards or carriage on purchases.

Carriage outwards: Cost to the seller, paid by the seller, of having goods delivered to customer. It is a
selling and distribution expense. It is also known as freight outwards or carriage on sales.

Gross Profit = Net Sales less Cost of goods sold

Net Sales = Sales less Sales returns

Cost of goods sold/COGS represents the purchase or production costs of goods sold

COGS = Opening stock add Purchases less Purchases returns add Carriage inwards add Customs
duties less Closing stock

48
Net Profit = Gross profit add Other income less Other expenses

Other income: Rent received, Interest revenue, Commission received, Discount received

Activity 4

The following balances were extracted from Alice’s accounting records for 2019:

$
Sales 29,000
Sales returns 5,125
Purchases 14,950
Purchases returns 3,169
Carriage inwards 1,058
Carriage outwards 1,346
Inventory 1.1.2019 3,900
Inventory 31.12.2019 5,678

Required:

Calculate the cost of goods sold/COGS and gross profit/GP for the year to 31 December 2019.

COGS =
Opening inventory + Purchases – Purchases returns + Carriage inwards – Closing inventory

Gross Profit = Net Sales – COGS

Activity 5
Shown below is a list of balances for Aziz for the year ended 31 August 2019:

$
Gross Profit 59,500
Carriage Outwards 4,138
Interest earned 3,456
Advertising 4,849
Salaries and Wages 18,245
Commission Received 2,468
Repairs 1,130
Discount Received 1,790

Required:
Calculate the net profit for the year to 31 August 2019.

Net Profit = Gross Profit + Other income – expenses

49
3.5 Statement of Comprehensive Income

The Statement of Comprehensive Income/Statement of Profit or Loss shows the financial performance
of a business based on the matching concept. It shows how the profit or loss for the period has been
made.

Format:
Excel Company
Statement of Comprehensive Income for the year ended 30 April 2019
$ $ $
Sales 100,000
Less: Return Inwards (9,000)
Net Sales 91,000

Less: Cost of Goods Sold

Opening Stock 12,000
Purchases 56,000
Less: Return outwards (11,000)
Carriage inwards 2,500
Customs duties 1,800
Less: Closing Stock (20,000)
Cost of Goods Sold (41,300)
Gross Profit 49,700
Add: Other income
Commission received 2,600
Discount received 1,600
Interest received 3,400
Rent received 10,800
Total revenues 68,100
Less: Expenses
Insurance 7,500
Irrecoverable debts expense 3,700
Increase in allowance for receivables 5,700
Depreciation 4,500
Carriage outwards 2,450
Salaries and wages 12,800
Interest expense 1,500
Rent expense 6,500
Utilities expense 6,900
Discount allowed 1,060 (52,610)
Net Profit 15,490

50
Activity 6

The following balances have been extracted from the books of Aaron.

Dr Cr
$ $
Rent Received 2,100
Furniture and fittings 15,100
Bank 67,960
Trade receivable 24,600
Office Wages 12,000
Advertising 595
Sales Commission 8,720
Returns Outwards 3,000
Capital 67,000
Interest revenue 2,450
Drawings 2,080
Office equipment 19,600
Carriage Outwards 680
Carriage Inwards 1,845
Stock, 1 August 2018 3,200
Returns Inwards 3,400
Purchases 49,900
Sales 100,000
Trade payable 16,780
Loan 20,000
Other receivable 1,650

The closing stock was valued at $4,700.

Based on the above balances, prepare the Statement of Comprehensive Income for the year ended 31
July 2019 and a Statement of financial Position as at the same date.

Solutions:

Statement of Comprehensive Income for the year ended 31 July 2019

$ $

51
Statement of Financial Position as at 31 July 2019
$ $

52
Review Questions

Question 1

What is the double entry to record goods returned by a credit customer?

Debit Credit
A. Trade receivable Sales
B. Sales returns Trade payable
C. Sales returns Trade receivable
D. Sales Trade receivable

Question 2

What is the double entry to record goods returned to a credit supplier?

Debit Credit
A. Purchases Trade payable
B. Sales returns Trade payable
C. Purchases returns Trade receivable
D. Trade payable Purchases returns

Question 3

Credit purchase of inventory of $20,000 was recorded as $22,000 on both sides of the accounts. What
is the journal entry to correct the error?

A. Dr Trade payable $22,000 Cr Purchases $22,000

B. Dr Trade payable $2,000 Cr Purchases $2,000
C. Dr Trade payable $20,000 Cr Purchases $20,000
D. Dr Trade payable $20,000 Cr Purchases returns $20,000

Question 4

The bookkeeper of Lee Trading recorded the returns inwards of $4,000 as $400. What is the corrected
net profit amount given the draft net profit of $92,000?

A. $88,400
B. $92,000
C. $95,600
D. $96,000

Question 5

A cash purchase of $15,000 was recorded as a credit purchase of inventory by mistake. What is the
journal entry to correct the error?

53
A. Dr Cash $15,000 Cr Trade payable $15,000
B. Dr Cash $15,000 Cr Trade receivable $15,000
C. Dr Purchases $15,000 Cr Cash $15,000
D. Dr Trade payable $15,000 Cr Cash $15,000

Question 6

The following balances were extracted from Tracy’s accounting records for 2019:

$
Sales 89,000
Carriage inwards 9,230
Carriage outwards 11,456
Opening inventory 24,390
Sales returns 19,560
Purchases 48,321
Purchases returns 10,456
Customs duties 3,468
Closing inventory 21,330

Required:

Calculate the cost of goods sold and gross profit for the year to 31 December 2019.

54
Question 7

Below is the information of Tansy, a sole proprietor for the year ended 31 July 2019:

$
Stock, 1 August 2018 12,000
Stock, 31 July 2019 9,600
Sales 60,000
Purchases 27,450
Returns Inwards 1,180
Carriage Inwards 950
Custom duties 348
Carriage Outwards 480
Returns Outwards 1,280
Salaries & Wages 12,000
Interest received 5,220
Discount received 3,240
Heating and lighting 1,768
Rental expense 6,600

Required:

Prepare a Statement of Comprehensive Income for the year ended 31 July 2019.

Question 8

Sam Tan provided the following information as at 30 June 2019:

$
Plant and machinery 152,000
Motor vehicle 78,500
Premises 280,000
Trade receivable 45,080
Trade payable 92,340
Inventory 54,000
Office equipment 26,000
Bank loan 150,000
Bank overdraft 12,600
Mortgage loan 120,000

Required:

Based on the information above, prepare a statement of financial position as at 30 June 2019 and
compute the missing Capital amount.

55
Question 9

The following trial balance was extracted from the books of Adrian Cheng on 31 March 2019.

Dr Cr
$ $
Sales 28,000
Purchases 14,556
Stock 1 April 2018 3,776
Carriage outwards 2,226
Carriage inwards 234
Returns 440 1,355
Salaries and wages 7,447
Motor expenses 664
Rental expense 576
Sundry expenses 1,202
Motor vehicles 2,400
Office equipment 3,600
Trade receivables 8,077
Trade payables 3,045
Cash at bank 4,996
Drawings 2,050
Capital 19,844
52,244 52,244

Stock at 31 March 2019 was $4,998.

Required:

(i) Prepare a Statement of Comprehensive Income for the year ended 31 March 2019.
(ii) Prepare a Statement of Financial Position as at 31 March 2019.

56
Question 10

The following is the trial balance of Darrell as at 30 September 2019.

Dr Cr
$ $
Stock 1 October 2018 18,160
Sales 102,340
Purchases 69,185
Carriage inwards 420
Carriage outwards 1,570
Returns outwards 640
Wages and salaries 10,240
Rent and rates 3,639
Commissions 216
Insurance 405
Miscellaneous expenses 318
Motor vehicle 50,000
Trade receivables 14,320
Trade payables 9,180
Furniture 3,985
Cash at bank 2,970
Loan 10,000
Drawings 7,620
Capital 60,888
183,048 183,048

Stock at 30 September 2019 was $22,390.

Required:

(i) Prepare a Statement of Comprehensive Income for the year ended 30 September 2019.
(ii) Prepare a Statement of Financial Position as at 30 September 2019.

57
Homework Questions (with solutions)

Question 1

What is the double entry to record inventory sold to a customer on credit?

Debit Credit
A. Trade receivable Sales
B. Sales returns Trade payable
C. Trade receivable Inventory
D. Sales Trade receivable

Question 2

What is the double entry to record inventory bought on credit from a supplier?

Debit Credit
A. Inventory Trade payable
B. Sales returns Trade payable
C. Purchases Trade payable
D. Trade payable Purchases returns

Question 3

Credit sales of inventory of $35,000 was recorded as $29,000 on both sides of the accounts. What is
the journal entry to correct the error?

A. Dr Trade receivable $35,000 Cr Sales $35,000

B. Dr Trade receivable $29,000 Cr Sales $29,000
C. Dr Sales $6,000 Cr Trade receivable $6,000
D. Dr Trade receivable $6,000 Cr Sales $6,000

Question 4

The bookkeeper of Lee Trading recorded the returns outwards of $6,000 as $6,300. What is the
corrected net profit amount given the draft net profit of $112,000?

A. $111,000
B. $111,700
C. $112,300
D. $112,600

58
Question 5

A credit sales of $19,000 was recorded as a cash sales by mistake. What is the journal entry to correct
the error?

A. Dr Cash $19,000 Cr Trade receivable $19,000

B. Dr Cash $19,000 Cr Trade payable $19,000
C. Dr Trade receivable $19,000 Cr Cash $19,000
D. Dr Trade payable $19,000 Cr Cash $19,000

MCQ Answers: A, C, D, B, C

Question 6

The following balances were extracted from Monica’s accounting records for 2019:

$
Sales 44,000
Returns inwards 7,650
Purchases 14,950
Returns outwards 3,456
Freight inwards 2,110
Freight outwards 4,456
Inventory 1.1.2019 5,320
Inventory 31.12.2019 8,468

Required:

Calculate the cost of goods sold and gross profit for the year to 31 December 2018.

Answer:
Cost of goods sold = Opening inventory + Purchases – Returns outwards + Freight inwards
– Closing inventory
= $5,320 +14,950 – 3,456 +2,110 – 8,468 = $10,456

Net sales = Sales – returns inwards = $44,000 – 7,650 = $36,350

Gross profit = Net Sales – COGS = $36,350 - $10,456 = $25,894

59
Question 7

Shown below is a list of balances for Linda for the year ended 31 July 2019:

$
Gross Profit 71,300
Utilities 4,989
Rent earned 6,360
Insurance 3,100
Salaries and wages 23,568
Discount received 2,056
Vehicle expenses 4,244
Commission received 852

Required:

Calculate the net profit for the year to 31 July 2019.

Answer:
Total revenue = Gross profit + Rent earned + Discount received + Commission received
= $71,300 + 6,360 + 2,056 + 852 = $80,568

Total expenses = $4,989 + 3,100 + 23,568 + 4,244 = $35,901

Net profit = Total revenues – total expenses = $80,568 - $35,901 = $44,667

Question 8

Below is the information of Heather Tan, a sole proprietor for the year ended 31 August 2019:

$
Stock, 1 September 2018 14,000
Stock, 31 August 2019 8,600
Sales 40,000
Purchases 23,450
Returns Inwards 380
Carriage Inwards 250
Carriage Outwards 400
Returns Outwards 280
Salaries & Wages 7,000
Interest received 5,000
Commission received 1,000
Utilities 2,000
Rental expense 5,300

Required:

Prepare a Statement of Comprehensive Income for the year ended 31 August 2019.

60
Answer:
Heather Tan
Statement of Comprehensive Income for the year ended 31 August 2019

$ $ $
Sales 40,000
Less: Returns Inwards 380 39,620

Cost of goods sold

Opening stock 14,000
Purchase 23,450
Returns Outwards (280)
Carriage Inwards 250 23,420
Less: Closing stock (8,600) 28,820

Gross profit 10,800

Interest received 5,000
Commission received 1,000
16,800
Less: Expenses
Carriage Outwards 400
Salaries & Wages 7,000
Utilities 2,000
Rental expense 5,300 14,700
Net profit 2,100

Question 9

Peter has the following items in his statement of financial position on 30 June 2019:

Trade payable $21,345; motor vehicles $89,800; office equipment $39,500; trade receivable $55,220;
bank overdraft $18,300; cash in hand $1,100; bank loan $30,000, inventory $19,560, furniture and
fittings 8,755.

Based on the information above, compute the missing capital amount and prepare a statement of
financial position as at 30 June 2019.

Answer:
Capital = Assets – Liabilities
= 89,800 + 39,500 + 55,220 + 1,100 + 19,560 + 8,755 – 21,345 – 18,300 – 30,000
= $144,290

61
 Peter
Statement of Financial Position as at 30 June 2019
$ $ $
Current Asssets
Inventory 19,560
Trade receivable/Accounts receivable 55,220
Cash 1,100 75,880

Fixed Assets
Motor vehicles 89,800
Office equipment 39,500
Furniture and fittings 8,755
138,055
213,935

Current Liabilities
Trade payables/Accounts payable 21,345
Bank overdraft 18,300 39,645

Non Current Liabilities

Bank loan 30,000

Owner’s Equity
Capital, Peter 144,290
213,935

62
 FINANCIAL ACCOUNTING

SESSION 4 & 5

THE ADJUSTING PROCESS

At the end of the lecture, students should be able to:

1. Describe the nature of the adjusting process.

2. Journalise entries for accounts requiring adjustment.
3. Prepare an adjusted trial balance.
4. Prepare financial statements from the adjusted trial balance.

4.1 The Adjusting Process

Cash Basis of Accounting: revenue is recognised when cash is received and expense is recognised
when cash is paid.

Accrual Basis of Accounting: revenue is recognised only when it is earned in an accounting period
and expenses only when incurred. This is to ensure that there is proper matching of revenue and
expenses to determine profit. This is regardless if payment is received or made in the same accounting
period.

The accounting concept that supports the reporting of revenues and related expenses in the same
period is called the matching concept.

The accrual basis of accounting therefore results in typical balance-day adjustments.

Prepaid Expense
These are items paid for before they are used; expenses paid in advance. It is shown as a Current Asset
in the Statement of Financial Position.

Accrued Expense
These are expenses incurred/used up in the current period but have not been paid. It is also known as
an expense owing, expense payable, expense due, expense outstanding, expense in arrears. It is shown
as a Current Liability in the Statement of Financial Position.
.
Accrued Revenue
This refers to revenue earned but money has not been received. Trade receivable is an accrued revenue
but the Trade receivable account is used for Credit Sales of inventory only. Examples of accrued
revenues are accrued interest revenue, accrued rent revenue and accrued commission revenue. It is
shown as a Current Asset in the Statement of Financial Position.

Unearned Revenue
This refers to money that has been received but revenue has not been earned yet. It is also known as
Prepaid Revenue. It is shown as a Current Liability in Balance Sheet.

63
Activity 1

The following transactions were extracted from the accounting records of Ali whose financial year end
falls on 31 August 2019. Identify the type of balance-day adjustments.

(a) The office utility bill of August 2019 was paid in September 2019.

(b) Advertising of $2,400 has been paid for September 2019 to February 2020.

(c) A deposit of $5,000 has been collected from Eunice a customer, but the inventory was sent
to her on 3 September 2019.

(d) Ali has rented out his warehouse to Tham Co. at a monthly rental of $4,000. The rental for
August 2019 has not been received as at 31 August 2019.

There are three more Balance Day Adjustments to consider: Depreciation of non-current assets,
Irrecoverable debts and Allowance receivables. The latter 2 will be discussed in Session 6.

Depreciation
Depreciation is a non-cash charge made to the statement of comprehensive income to reflect the
wearing out of a non-current asset over its useful life. There are various depreciation methods to
compute the amount of depreciation expense. We will look at only two methods; the Straight-line
depreciation (same charge each year) and the Reducing balance method (charge is higher in first few
years).

4.2 Journal Entries for the Balance-day Adjustments

Adjusting Journal Entry for Prepaid Expense

Illustration 4.1

During the financial year ended 31 December 2019, Felix paid office rent of $26,000. The monthly
rent is $2,000. What is the adjusting entry for the rent?

General Journal
Date Particulars Dr. Cr.
2019 $ $
31/12 Prepaid Expense a/c
Rent a/c
Being rent prepaid in 2019 for 2020

For the financial year ended 31 December 2019, Felix will report the following items on the financial
statements:
Rent expense incurred of in the Statement of Comprehensive Income and
Prepaid expense of shown as a current asset in the Statement of Financial Position.

64
Adjusting Journal Entry for Accrued Expense

Illustration 4.2

During the financial year ended 31 August 2019, Tony has paid utility of $10,000. The records showed
that he has yet to receive the electricity bills for July and August 2019. Tony assumes that electricity
costs are constant throughout the year. What is the adjusting entry for the utility expense?

General Journal
Date Particulars Dr. Cr.
2019 $ $
31/8 Utilities a/c
Accrued Expense a/c
Being utility unpaid for July and August 2019

For the financial year ended 31 August 2019, Tony will report the following items on the financial
statements:
Utilities expense incurred of in the Statement of Comprehensive Income and
Accrued expense of shown as a current liability in the Statement of Financial
Position.

Adjusting Journal Entry for Accrued Revenue

Illustration 4.3

During the financial year ended 30 November 2019, Jill received rental income of $33,000 from the
office space that she has sublet to a tenant. The monthly rent is $3,000. What is the adjusting entry for
the rent revenue?

General Journal
Date Particulars Dr. Cr.
2019 $ $
30/11 Accrued Revenue a/c
Rent Received a/c
Being rent not received for November 2019

For the financial year ended 30 November 2019, Jill will report the following items on the financial
statements:
Rent revenue earned of in the Statement of Comprehensive Income and
Accrued revenue of shown as a current asset in the Statement of Financial Position.

Adjusting Journal Entry for Unearned Revenue

Illustration 4.4

During the financial year ended 31 December 2019, Jerry received fees of $24,000 in cash for a
maintenance contract for work to be done from August 2019 to January 2020. What is the adjusting
journal entry for the service revenue?

65
 General Journal
Date Particulars Dr. Cr.
2019 $ $
31/12 Service revenue a/c
Unearned revenue a/c
Being fees received in advance for January 2020.

For the financial year ended 31 December 2019, Jerry will report the following items on the financial
statements:
Service revenue earned of in the Statement of Comprehensive Income and
Unearned revenue of shown as a current liability in the Statement of Financial
Position.

Adjusting Journal Entry for Depreciation

Illustration 4.5

The accountant of Kings Ltd has computed the depreciation expense of $12,000 on the motor vehicles
for the year ended 31 October 2019. What is the adjusting entry for the depreciation expense?

General Journal
Date Particulars Dr. Cr.
2019 $ $
31/10 Depreciation expense a/c 12,000
Accumulated depreciation a/c 12,000
Being depreciation expense for motor vehicles.

4.3 Adjusting the Trial Balance

Illustration 4.6

Cheryl Ting has been in business as a retailer and the following balances were extracted from her
books on 30 June 2019.

$
Capital 1 July 2018 7,000
Stock 1 July 2018 2,644
Freehold premises (at cost) 6,400
Carriage inwards 590
Trade receivable 3,500
Trade payable 2,300
Irrecoverable debts 896
Purchases 27,000
Sales 39,592
Returns inwards 415
Returns outwards 614

66
 $
Discount received 412
Wages 6,200
Motor vehicle 1,000
Utilities 114
Insurance 452
Cash in hand 63
Bank overdraft 841
Discount allowed 1,485

The following adjustments are to be considered:

(i) The closing stock was valued at $2,089;
(ii) It was estimated that $38 was owing for the utility in June 2019;
(iii) An amount of $400 of insurance was for July 2019.
(iv) Cheryl had withdrawn stock of $200 for personal use and no entries had been made in the books.
(v) Part of the building was sublet on 1 October 2018 at an annual rent of $1,600; the rental has not
been collected yet.
(vi) Depreciation was charged at $300 on the motor vehicle.
(vii) Sales in the trial balance included an amount of $2,300 worth of stock to be delivered to
customers in July 2019.

Required:

(a) Prepare general journal entries to record the above balance-day adjustments.
(b) Prepare the Statement of Comprehensive Income for the year ended 30 June 2019.
(c) Prepare a Statement of Financial Position as at 30 June 2019.

Cheryl
General Journal
Dr ($) Cr ($)
(ii)

(iii)

(iv)

(v)

(vi)

(vii)

67
Answer:
Cheryl
Statement of Comprehensive Income for the year ended 30 June 2019
$ $ $

68
 Cheryl
Statement of Financial Position as at 30 June 2019
$ $ $

69
Review Questions

Question 1

Ronald is preparing his statement of financial position at 31 January 2020. The last electricity invoice
he received was for $4,800. This was for the four months to 30 November 2019. Ronald assumes that
electricity costs are constant throughout the year.

How should the accrual for electricity be reported in Ronald’s statement of financial position at 31
January 2020?

A. as a current liability of $1,200

B. as a current liability of $2,400
C. as a current asset of $1,200
D. as a current asset of $2,400

Question 2

An amount of $25,000 of advertising expense for the period 1 November 2019 to 31 March 2020 was
paid on 1 November. What is the amount to be reported for the year ended 31 January 2020 in the
Statement of Comprehensive Income and Statement of Financial Position?

A. $15,000 in the Statement of Comprehensive Income and $10,000 Prepaid amount in the Statement
of Financial Position.
B. $10,000 in the Statement of Comprehensive Income and $15,000 Prepaid amount in the
Statement of Financial Position.
C. $10,000 in the Statement of Comprehensive Income and $15,000 Accrued amount in the
Statement of Financial Position.
D. $15,000 in the Statement of Comprehensive Income and $10,000 Accrued amount in the
Statement of Financial Position.

Question 3

Deposit of $20,000 was received before the financial year ended 31 January 2020 but the maintenance
work was only done on 1 February 2020. How should the amount of $20,000 be recorded in the
Statement of Financial Position?

A. Accrued revenue; Current Asset

B. Accrued expense; Current Liability
C. Unearned revenue; Current Liability
D. Unearned revenue; Current Asset

70
Question 4

Insurance of $5,400 for the financial year ending 31 October 2019 was paid in November 2019.
The adjusting entry for the insurance was not made. What would be the corrected net profit given a
draft net profit of $108,000?

A. $118,800
B. $113,400
C. $102,600
D. $97,200

Question 5

The following trial balance has been extracted from the books of Norman as at 31 May 2019:

Debit Credit
$ $
Bank 17,090
Trade receivables 12,800
Inventory as at 1 Jun 2018 21,000
Furniture and fittings 45,000
Accumulated depreciation- F & F, 1 Jun 2018 12,270
Office equipment 83,300
Accumulated depreciation- O.E., 1 Jun 2018 38,650
Trade payables 35,460
Loan repayable six years later 20,000
Capital at 1 Jun 2018 80,985
Drawings 5,400
Sales 246,000
Purchases 106,820
Carriage inwards 3,800
Carriage outwards 11,200
Office expenses 28,575
Salaries 45,000
Advertising 20,190
Utilities 11,450
Insurance 19,200
Returns 8,540 6,000
439,365 439,365

Inventory as at 31 May 2019 is $38,000.

Additional information:

a. Commission revenue of $2,700 for May 2019 has not been received nor recorded.

71
b. Salary of $4,200 for a temporary staff will only be paid on 6 June 2019.

c. A payment of $16,000, recorded as advertising expense, is for advertisements for four months
commencing 1 April 2019.

d. A customer has paid a deposit of $2,500 for goods to be delivered on 2 June 2019. The bookkeeper
recorded it in the sales account.

e. An invoice to a credit customer for sales of $2,000 was recorded wrongly as $2,200.

f. A cabinet which costs $1,400 was recorded wrongly into the office equipment account.

g. Norman bought a laptop for the business at $3,100, with his personal funds. This transaction has
been omitted from the accounts.

h. Cash drawings of $7,000 by Norman was still unrecorded at year-end.

i. Annual depreciation on fixed assets is to be recorded as follows:

Furniture & fittings - $7,345
Office equipment - $12,689

Required:

(a) Show journal entries for adjustments (a) to (i). Narrations are not required.
(Hint: For some transactions, you will need to create new accounts which are not shown on the
trial balance.)

(b) Prepare the following financial statements for Norman:

(i) Statement of Comprehensive Income for the year ended 31 May 2019;
(ii) Statement of Financial Position as at 31 May 2019.

Question 6

The following unadjusted trial balance is for AED Co. as at 31 May 2019.

Dr Cr
Cash $24,150
Trade receivable 18,900
Rent revenue 500
Opening inventory 8,900
Insurance 6,300
Purchases 82,500
Office Equipment 43,000
Accumulated depreciation -- Equipment 17,570
Furniture and fittings 8,200
Customs duties 480
Returns inwards 15,020
Returns outwards 4,150
Trade payables 28,060

72
 Dr Cr
Loan (repayable in 2025) 30,000
Capital, Benny 40,000
Carriage on sales 7,554
Depreciation 8,226
Drawings 14,220
Sales 175,600
Commission revenue 8,900
Salaries and wages expense 40,860
Interest expense 600
Advertising expense 13,200
Carriage on purchases 2,810
Utilities expense 8,600
Discount allowed 5,040 3,780
Totals 308,560 308,560

Stock at 31 May 2019 is $18,100.

Additional information:

a. The rent receivable as at balance day is $3,200.

b. Interest of 5% on the loan from HSBC has not been accounted for.

c. The insurance of $4,000 included above is for 4 months commencing 1 May 2019.

d. Depreciation for equipment for the year has been accounted for. It is now decided to depreciate
also Furniture and fittings by $760.

e. Credit sales of $3,100 has been entered as cash sales.

f. Salaries and wages of $1,980 for May 2019 was paid in June 2019.

g. Discount allowed of $230 granted to a customer for prompt payment and discount received of
$220 from a credit supplier were not yet recorded.

h. Damaged stock of $2,190 was returned to supplier but this transaction has not been recorded.

Required:

(a) Prepare the necessary general journal entries to record transactions (a) to (h).
Narrations are not required.
(Hint: For some transactions, you will need to create new accounts which are not shown on the
trial balance.)

(b) Prepare the following financial statements for AED Co:

(i) Statement of Comprehensive Income for the year ended 31 May 2019
(ii) Statement of Financial Position as at 31 May 2019

Question 7

73
Good Enterprise was started by Glenn and trades in frozen food products. Its unadjusted trial balance as at
31 March 2019 is given as follows:

Unadjusted Trial Balance as at 31 March 2019

Accounts Dr ($) Cr ($)
Capital – Glenn 151,605
Drawings – Glenn 2,400
Sales 1,029,410
Purchases 812,065
Carriage inwards 18,410
Returns inwards 19,280
Returns outwards 21,420
Commission income 44,800
Management fee income 19,500
Utilities expenses 48,230
Advertising expense 36,900
Rent expense 67,900
Salaries expense 62,700
Miscellaneous expenses 18,910
Interest expense 4,000
5% Bank Loan, due in 2024 80,000
Trade payables 65,370
Equipment 135,000
Accumulated depreciation-Equipment 60,750
Furniture & Fittings 96,000
Accumulated depreciation-Furniture & Fittings 28,800
Inventory, 1 April 2018 65,680
Trade receivables 85,780
Cash at Bank 28,400
1,501,655 1,501,655

The following additional information was made available before the year-end closing.

1. On 28 March 2019, Good Enterprise settled a personal loan that was taken up by Glenn one
year ago. The loan amount was $15,000 and annual interest charged at 8% was also paid on the
same day. This transaction had been omitted in the accounts.

2. Commission income included amount received for April and May 2019. Monthly income
amounted to $3,200.

3. Salaries expense was paid for the period from April 2018 to February 2019 only. Monthly
salaries expense had remained constant throughout this period.

4. Rent expenses included $16,800 paid for the period March to May 2019.

74
5. Management fee income has been accounted for the period up to February 2019 only. Income for
March amounting to $8,100 has yet to be received.

6. A customer who owed $24,000 settled the amount early and was given a 3% cash discount.
The accounts clerk recorded the net cash received but omitted the discount.

7. Carriage inwards included $7,500 which was incurred for delivery of goods to customers during
March 2019.

8. Annual depreciation on fixed assets were as follows:

Equipment - $20,250
Furniture & Fittings - $9,600

9. A physical count on 31 March 2019 revealed stocks on hand to be $52,100.

Required:

(a) Prepare the necessary general journal entries to record transactions (1) to (8).
Narrations are not required.
(Hint: For some transactions, you will need to create new accounts which are not shown on the
trial balance.)

(b) Prepare the following financial statements for Good Enterprise:

(i) Statement of Comprehensive Income for the year ended 31 March 2019
(ii) Statement of Financial Position as at 31 March 2019

Question 8

Sony Trading Company was started in 2015. It trades in wooden furniture. Its unadjusted trial balance as
at 31 May 2019 is given as follows:

Unadjusted Trial Balance as at 31 May 2019

Accounts Titles Dr ($) Cr ($)
Capital – Sandy 210,000
Drawings – Sandy 28,230
Inventory, 1 June 2018 74,400
Purchases 615,230
Returns 5,960 11,060
Carriage inwards 18,455
Carriage outwards 27,680
Rent income 15,270
Advertising expense 20,560
Utilities expense 70,316
Insurance expense 47,751
Repairs expense 31,720
Salaries and wages expense 319,080
Miscellaneous expenses 30,000

75
 Accounts Titles Dr ($) Cr ($)
Discount 4,100 858
Equipment 270,360
Accumulated depreciation-Equipment 87,100
Motor Vehicles 384,100
Accumulated depreciation-Motor Vehicles 198,400
Trade receivables 281,250
6% Bank Loan, due in 2027 200,000
Trade payables 105,840
Cash at Bank 65,148
Sales 1,465,812
2,294,340 2,294,340

The following additional information was made available before the end of the financial year.

1. Purchases of a computer of $2,100 was debited to the Purchases account in error.

2. On 29 May 2019, Sony Trading Company received a cheque of $98,000 from a credit customer
who was given a 2% cash discount for early payment. This transaction was not recorded at all.

3. A cheque of $5,090 was made as payment for Sandy’s home utilities bill. This transaction has
not been recorded.

4. Sandy withdrew inventory of $15,700 for his personal use.

5. A discount of the amount of $700 received from a credit supplier has been recorded as a
discount granted to a credit customer.

6. Advertising expense was paid for the period of 10 months commencing on 1 March 2017.

7. The 6% bank loan was taken on 1 June 2016. The interest expense has yet to be accounted for.

8. Annual depreciation on fixed assets were as follows:

Equipment - $21,300
Motor Vehicles - $39,890

9. A physical count on 31 May 2019 revealed stocks on hand to be $121,000.

Required:

(a) Prepare the necessary general journal entries to record transactions (1) to (8).
Narrations are not required.
(Hint: For some transactions, you will need to create new accounts which are not shown on the
trial balance.)

(b) Prepare the following financial statements for Sony Trading Company:
(i) Statement of Comprehensive Income for the year ended 31 May 2019
(ii) Statement of Financial Position as at 31 May 2019

76
Homework Questions (with solutions)

Question 1

Lisa’s financial year ends on 31 October 2019. She took a business loan of $20,000 at the interest rate
of 5% per annum on 1 August 2019. Interest is payable on 1 January and 1 July. How should the
interest on the loan be reported in her financial statements?

A. $250 interest expense in the Statement of Comprehensive Income and $250 Prepaid amount in the
Statement of Financial Position.
B. $1,000 interest expense in the Statement of Comprehensive Income and $1,000 Prepaid amount in
the Statement of Financial Position.
C. $250 interest expense in the Statement of Comprehensive Income and $250 Accrued amount in
the Statement of Financial Position.
D. $1,000 interest expense in the Statement of Comprehensive Income and $1,000 Accrued amount
in the Statement of Financial Position.

Question 2

Rent of $28,000 has been paid for March to September 2019. The financial year ends on 31 August
2019. The adjusting entry for the rent expense was not made. What would be the effect of the error
made on the draft net profit of $144,000?

A. Net profit overstated by $4,000.

B. Net profit understated by $4,000.
C. Net profit overstated by $8,000.
D. Net profit understated by $8,000.

Question 3

Vanessa rented out her warehouse at $48,000 per year on 1 February 2019. $40,000 was received for
the financial year ended 31 January 2020. What is the adjusting journal entry required on 31 January
2020?

A. Dr Accrued revenue $8,000; Cr Rent revenue $8,000

B. Dr Unearned revenue $8,000; Cr Rent revenue $8,000
C. Dr Rent revenue $8,000; Cr Accrued revenue $8,000
D. Dr Rent revenue $8,000; Cr Unearned revenue $8,000

Question 4

Depreciation expense of $16,000 has not been charged on the machinery in Brenda’s Company.
What are the effects of the error on the amount of net profit and the amount of the fixed assets?
A. Net profit overstated by $16,000 and Fixed assets overstated by $16,000.
B. Net profit understated by $16,000 and Fixed assets understated by $16,000.
C. Net profit understated by $16,000 and Fixed assets overstated by $16,000.

77
D. Net profit understated by $16,000 and Fixed assets overstated by $16,000.

MCQ Answers: C, B, A, A

Question 5

Jolene, the owner of J Trading, started her business in 2015. Her accountant has prepared the unadjusted
trial balance as at 31 August 2019.

Unadjusted Trial Balance as at 31 August 2019

Accounts Titles Dr ($) Cr ($)
Land 500,000
Equipment 620,000
Accumulated depreciation – Equipment 310,280
Motor Vehicles 242,600
Accumulated depreciation – Motor Vehicles 97,140
Trade receivables 271,550
8% Bank Loan, due in 2027 240,000
Trade payables 140,000
Cash at Bank 81,000
Sales 2,258,600
Capital – Jolene 264,800
Drawings – Jolene 17,500
Inventory, 1 September 2018 85,800
Purchases 955,160
Returns 160,000 148,720
Freight outwards 32,580
Freight inwards 29,470
Commission income 51,200
Advertising expense 28,650
Utilities expense 96,500
Insurance expense 41,200
Salaries and wages expense 300,000
Sundries expense 34,730
Interest expense 8,000
Discount allowed 6,000
3,510,740 3,510,740
The following additional information was made available before the end of the financial year.

1. Sale of a printer of $1,900 was credited to the Sales account in error.

2. On 28 August 2019, Jolene paid a cheque of $28,500 to a credit supplier who gave a 5% cash
discount for early payment. This transaction was not recorded.

3. Rental income of $4,800 per month was outstanding for July and August 2019.

78
4. Inventory of $8,100 returned to a credit supplier was recorded as inventory returned by a
customer.

5. The 8% bank loan was taken on 1 November 2018. The remaining interest expense has yet to
be accounted for.

6. Annual depreciation on fixed assets were as follows:

Equipment - $27,300
Motor Vehicles - $35,980

7. Credit sales of $25,000 were recorded in the correct accounts but on the opposite sides.

8. A physical count on 31 August 2019 revealed stocks on hand to be $98,200.

Required:

(a) Prepare the necessary general journal entries to record transactions (1) to (7).
Narrations are not required.
(Hint: For some transactions, you will need to create new accounts which are not shown on the
trial balance.)

(b) Prepare the following financial statements for J Trading:

(i) Statement of Comprehensive Income for the year ended 31 August 2019
(ii) Statement of Financial Position as at 31 August 2019

Solutions:
(a)
Accounts DR ($) CR ($)
1) Sales 1,900
Equipment 1,900

2) Trade Payable 30,000

Discount received 1,500
Bank 28,500

3) Accrued revenue 9,600

Rent income 9,600

4) Trade receivable 8,100

Returns inwards 8,100

Trade payable 8,100

Returns outwards 8,100

5) Interest expense {(0.08 x 240,000) / 12 x 10 - 8,000} 8,000

Accrued expense 8,000

79
 Accounts DR ($) CR ($)
6)(i) Depreciation Exp - Equipment 27,300
Accumulated Depn - Equipment 27,300

6)(ii) Depreciation Exp - MV 35,980

Accumulated Depn - MV 35,980

(7) Trade receivable 50,000

Sales 50,000

80
(b)(i)
Jolene
J Trading
Statement of Comprehensive Income for the year ended 31 August 2019
$ $
Sales (2,258,600 – 1,900 + 50,000) 2,306,700
Less: Returns inwards (160,000 – 8,100) (151,900)
2,154,800
Less: Cost of goods sold:-
Inventory, 1 September 2018 85,800
Purchases 955,160
Less: Returns outwards (148,720 + 8,100) (156,820)
Add: Freight inwards 29,470
913,610
Less: Inventory, 31 August 2019 (98,200) (815,410)
Gross Profit 1,339,390
Commission Income 51,200
Rent income 9,600
Discount received 1,500 62,300
Total revenue 1,401,690

Less Operating expenses:-

Freight outwards 32,580
Advertising expense 28,650
Utilities expense 96,500
Insurance expense 41,200
Salaries and wages expense 300,000
Sundry expense 34,730
Interest expense (8,000 + 8,000) 16,000
Discount allowed 6,000
Depreciation Exp – Equipment 27,300
Depreciation Exp – MV 35,980 (618,940)
Net profit $782,750

81
(b)(ii)
Statement of Financial Position as at 31 August 2019
$ $
Fixed assets
Land 500,000
Equipment (620,000 – 1,900) 618,100
Less: Acc. Depn. (310,280 + 27,300) (337,580)
280,520
Motor vehicles 242,600
Less: Acc. Depn. (97,140 + 35,980) (133,120) 109,480
890,000

Current assets
Cash at bank (81,000 – 28,500) 52,500
Trade receivables (271,550 + 8,100 + 50,000) 329,650
Accrued Revenue 9,600
Inventory, 31 August 2019 98,200
489,950
Total assets 1,379,950

Current liabilities
Trade payables (140,000 – 30,000 – 8,100) 101,900
Accrued Expenses 8,000
Total current liabilities 109,900

Long-term liabilities
8% Bank Loan, due in 2027 240,000
Total liabilities 349,900

Owner's equity
Capital – Jolene 264,800
Add: Net Profit 782,750
Less: Drawings (17,500)
Closing capital 1,030,050
Total liabilities & OE 1,379,950

82
Question 6

Helene started a business dealing in branded watches. The following trial balance has been extracted
from her general ledger book at 31 October 2019:

Debit Credit
$ $
Cash at bank 120,500
Trade receivables 85,674
Office equipment 101,628
Motor vehicle 132,900
Accumulated depreciation at 1 Nov 2018
- Office equipment 29,070
- Motor vehicle 78,664
Sales commission expense 62,430
Trade payables 54,421
Capital at 1 November 2018 323,563
Returns 20,456 15,655
Carriage on purchases 9,026
Carriage on sales 11,698
Rent expense 65,890
Salaries expense 65,370
Interest expense 4,000
Utilities 63,230
Insurance premiums 38,400
Purchases 748,600
Sales 1,014,420
Inventory at 1 November 2018 77,350
10% loans repayable 2022 80,000
Discount Allowed 9,879
Discount Received 9,018
Commission income 28,000
Drawings 15,780
1,632,811 1,632,811

The following additional information was made available before balance day.

1. Inventory at 31 October 2019 was ascertained at $120,750.

2. Helene owed trade creditors $9,000 and managed to settle the amount early and was given a
discount of 5%. The net cash paid was recorded but not the discount.

3. Rent income of $48,000 for October 2019 had not been received nor recorded.

4. Cash discount of $750 given to a credit customer was recorded wrongly as $75 in the accounting
records.

83
5. During the financial year, Helene paid $1,015 for personal insurance and it was included in the
insurance account in the trial balance shown above.

6. On 30 October 2019, damaged goods of $2,050 of which Helene has not paid for were returned
to trade suppliers. The transaction has not been recorded.

7. Interest on the bank loans are payable semi-annually on 1 May and 1 November. Interest for
period November 2018 to April 2019 was paid on 1 May 2019 and recorded. No other entries
were recorded.

8. Depreciation for the year to 31 October 2019 has been calculated as:
Office equipment $10,400
Motor Vehicle $13,700

Required:

The accountant has required you to perform the following tasks:

(a) Except for (a), show journal entries for adjustments (2) to (8). Narrations are not required.
(Hint: For some transactions, you will need to create new accounts which are not shown on the
trial balance.)

(b) Prepare the following financial statements for Helene:

(i) a statement of comprehensive income for the year ended 31 October 2019
(ii) a statement of financial position as at 31 October 2019

Solutions:
(a)
Accounts DR ($) CR ($)
2) Trade payable (5% X 9,000) 450
Discount received 450

3) Accrued income 48,000

Rent income 48,000

4) Discount allowed (750 -75) 675

Trade receivable 675

5) Drawings 1,015
Insurance 1,015

6) Trade payable 2,050

Returns outwards 2,050

7) Interest expense {(10% x 80,000) – 4,000} 4,000

Accrued expense 4,000

84
 Accounts DR ($) CR ($)
8) Depreciation Exp - Equipment 10,400
Accumulated Depn - Equipment 10,400

Depreciation Exp - MV 13,700

Accumulated Depn - MV 13,700
.

(b)(i)
Helene
Statement of Comprehensive Income for the year ended 31 Oct 2019
$ $ $
Sales 1,014,420
Less: Returns inwards (20,456)
993,964
Less: Cost of goods sold:-
Inventory, 1 November 2018 77,350
Purchases 748,600
Less: Returns outwards (15,655 + 2,050) (17,705) 730,895
Add: Carriage on purchases 9,026
817,271
Less: Inventory, 31 October 2015 (120,750)
(696,521)
Gross Profit 297,443
Commission Income 28,000
Rent income 48,000
Discount received (9,018 + 450) 9,468 85,468
Total revenue 382,911

Less Operating expenses:-

Sales commission expense 62,430
Carriage on sales 11,698
Rent expense 65,890
Salaries expense 65,370
Interest expense (4,000 + 4,000) 8,000
Utilities 63,230
Insurance (38,400 – 1,015) 37,385
Discount allowed (9,879 + 675) 10,554
Depreciation Exp – Office Equipment 10,400
Depreciation Exp - MV 13,700
(348,657)
Net profit $34,254

(b)(ii)
Statement of Financial Position as at 31 October 2019

85
 $ $
Fixed assets
Office Equipment 101,628
Less: Acc. Depn. (29,070 + 10,400) (39,470)
62,158
Motor vehicles 132,900
Less: Acc. Depn. (78,664 + 13,700) (92,364) 40,536
102,694

Current assets
Cash at bank 120,500
Trade receivables (85,674 - 675) 84,999
Accrued Revenue 48,000
Inventory, 31 October 2019 120,750
374,249
Total assets 476,943

Current liabilities
Trade payables (54,421 – 450 – 2,050) 51,921
Accrued Expense 4,000
Total current liabilities 55,921

Long-term liabilities
10% Bank Loan, due in 2022 80,000
Total liabilities 135,921

Owner's equity
Capital – Helene 323,563
Add: Net Profit 34,254
Less: Drawings (15,780 + 1,015) (16,795)
Closing capital 341,022
Total liabilities & OE 476,943

FINANCIAL ACCOUNTING

86
 SESSION 6

CURRENT ASSETS: INVENTORY

At the end of the lecture, students should be able to:

1. Describe the importance of control over inventories.

2. Describe three inventory cost flow assumptions.
3. Determine the cost of inventory under the perpetual and periodic inventory system.
4. Compare and contrast the use of the three inventory costing methods.
5. Describe and illustrate the reporting of merchandise inventory in the financial statements.

1 Definition
Inventories are assets that are:

- held for sale in the ordinary course of business;

- in the process of production for such sale; or
- in the form of materials or supplies to be consumed in the production process or in the rendering of
services

These include raw materials, work-in-progress as well as finished goods.

1.1 Inventory Control

A business should account for its inventories appropriately, covering the following:

Physical control
Inventory should be safeguarded through security measures to prevent damage and theft. These will
include storing goods in areas with restricted access, deploying security personnel and using
technological tools to monitor the movement of inventory.

Proper reporting
The amount presented in the financial statements should reflect the correct quantity and appropriate
value. This can be achieved by ensuring a proper paper trail with adequate documentation (e.g.
purchase orders, invoices and delivery orders) as well as conducting a physical inventory count.

2 Inventory Costing Systems

There are two main inventory costing system: perpetual and periodic.

2.1 Perpetual Inventory System

Perpetual system requires a continuous record of all inventory movements. When goods or materials
are purchased, the inventory (asset) account is increased along with an increase in liability (e.g. trade
payables) or decrease in asset (e.g. cash). Conversely, the inventory account is decreased when goods
are sold or materials used during production coupled with an increase in costs (e.g. cost of goods sold
or cost of good manufactured). Stock counts are conducted periodically to ensure the accuracy of the
company’s records.

87
The perpetual system provides accurate records for inventory control, e.g. in detecting inventory
shortages. However, there are usually high costs involved in the implementation and maintenance of a
perpetual system and thus usually appropriate for high value items.

2.2 Periodic Inventory System

Under the periodic system, no detailed records for inventory movements is required. No updating is
done for inventory movement after every purchase or sale. All inventory purchases are recorded in the
purchases account. Stock count is conducted (at least) annually to ascertain value of closing inventory
at the end of the financial year, i.e. inventory account records only opening and closing stock balances.

The periodic system is less costly to administer and appropriate for firms that carry low unit items with
high turnover. However, the lack of detailed and accurate records causes challenges in planning and
control and over-reliance on stock count which may be disruptive to operations.

3 Inventory Costing Methods

Commonly used inventory costing methods include First-In-First-Out (FIFO), Last-In-First-Out
(LIFO) and Weighted Average Cost. Each assumes a particular pattern of how cost flow through
inventory:

- FIFO assumes that the first units purchased are sold first. Thus, ending inventory is made up of the
most recent purchases.
- LIFO assumes that the last units purchased sold first and that the ending inventory is made up of
the first units purchased.
- Weighted Average Cost assumes costs flow at the average of the costs available, i.e. the cost of the
units sold and in ending inventory is an average of the purchase costs.

It should be noted that physical flow of inventory and cost flow need not be the same.

3.1 Inventory Costing Methods under Perpetual System

Activity 1: Perpetual System

On 1 September 2019, Andrew Inc has 420 units of inventory that cost $5 each. The transactions for
September as provided below:

Date Transaction Units Unit cost Unit selling price

8 Sep Purchase 180 $6
14 Sep Sale 310 $9
18 Sep Sale 250 $10
23 Sep Purchase 560 $8
28 Sep Sale 270 $11

The business uses the perpetual system for inventory costing.

Required:

88
 Compute Andrew Inc’s ending inventory, cost of goods sold and gross profit for September 2019
using the (a) First-In-First-Out (FIFO), Last-In-First-Out (LIFO) and Weighted Average Cost
inventory costing methods.

Activity 1 [ANSWERS]

a) First-In-First-Out (FIFO)
2019 Purchases COGS Balance
Sep Quantity Unit Total Quantit Unit Total Quantit Unit Total
Cost Cost y Cost Cost y Cost Cost
1
8

14

18

23

28

Purchases COGS End Inv

Gross profit = Sales – COGS
=
b) Last-In-First-Out (LIFO)
2019 Purchases COGS Balance
Sep Quantity Unit Total Quantit Unit Total Quantit Unit Total
Cost Cost y Cost Cost y Cost Cost
1
8

14

18
23

28

Purchases COGS End Inv

Gross profit =
c) Weighted Average Cost

89
 2019 Purchases COGS Balance
Sep Quantity Unit Total Quantit Unit Total Quantit Unit Total
Cost Cost y Cost Cost y Cost Cost
1
8
14
18
23
28
Purchases COGS End Inv
Gross profit = $8,260 – $5,079 = $3,181

3.2 Inventory Costing Methods under Periodic System

Activity 2: Periodic System

Information as per Activity 1, but Andrew Inc uses periodic inventory system.

Required:

Compute Andrew Inc’s ending inventory, cost of goods sold and gross profit for September 2019
using the (a) First-In-First-Out (FIFO), Last-In-First-Out (LIFO) and Weighted Average Cost
inventory costing methods.

Activity 2 [ANSWERS]

Ending inventory quantity =

Ending inventory value computation:

First-In-First-Out (FIFO): Sell old goods first; new goods remain in closing inventory

Ending inventory ($) =

Last-In-First-Out (LIFO): Sell new goods first; old goods remain in closing inventory

Ending inventory ($) =

Weighted Average:

Opening Inventory ($) + Purchases ($)

Cost per unit =
Opening Inventory (units) + Purchases (units)

Ending inventory ($) =

COGS computation

90
 FIFO LIFO WAC
Opening inventory
Purchases

(less): Closing inventory

COGS

Gross Profit computation

FIFO LIFO WAC

Sales
Less: COGS
Gross Profit

Sales =

3.3 Comparing Inventory Costing Methods

In a period of rising prices,

- FIFO gives the highest ending inventory value with the lowest Cost of Goods Sold (COGS) and
hence highest gross profit.
- LIFO gives the lowest ending inventory value with highest COGS and lowest gross profit
- Weighted Average Cost method gives an intermediate amount of ending inventory value, COGS
and gross profit.

Note: The opposite is true for periods of reducing prices for inventory purchases.

4 Reporting Inventory in Financial Statements

When inventory is reported on the statement of financial position, it should be valued at lower of cost
and net realisable value (NRV).

Cost is measured using one of the above-mentioned inventory costing methods while NRV is the
estimated selling price in the ordinary course of business less the estimated costs of completion and
the estimated costs necessary to make the sale.
The rule can be applied separately to each individual item or to major categories of assets.
Activity 3: Reporting Inventory

91
Median Co is a seller of three products: A, B and C. The following is available at the end of the
current financial year:

Cost ($) Selling Price ($)

A 10,200 9,600
B 15,400 18,100
C 23,600 29,300

Commission of 8% on the selling price is payable to the company’s sales staff in order to make the
product sales.

Required:

Compute the total value of inventory to be reported in Median Co’s financial statements?
[Round off your answers to the nearest whole number if necessary.]

Activity 3 [ANSWERS]

Cost ($) NRV ($) Lower of Cost and NRV ($)

A
B
C
Total value of inventory

5 Effect of Inventory Errors on Financial Statements

Errors in recording inventory lead to misstatements in various items within the financial statements of
a business, including current assets, cost of goods sold, profit cost of goods sold and equity. In
addition, errors in ending inventory will be carried forward to the next period as opening inventory and
thus cause misstatements in the following year’s financial statements as well. Besides understating or
overstating inventory itself, a summary of the other major impacts of inventory errors are as follows:

Current Year Following Year

Error
COGS Net Profit Equity COGS Net Profit Equity
Ending
inventory
- Understated Overstated Understated Understated Understated Overstated Overstated
- Overstated Understated Overstated Overstated Overstated Understated Understated

92
Review Questions

Question 1

Which of the following inventory costing methods will report the least current prices in the ending
inventory of a business?

A. First-In-First-Out
B. Specific Identification
C. Last-In-First-Out
D. Weighted Average Cost

Question 2

Which of the following is true with regards to a product’s net realisable value (NRV)?

A. NRV is derived after subtracting estimated costs to complete and sell the product.
B. It is equivalent to a product’s purchase price.
C. Businesses should all inventories at NRV.
D. It only reflects the product’s current market price.

Question 3

Which of the following inventory valuation methods will result in the highest profit during a period of
inflation?

A. Weighted Average Cost

B. Last-In-First-Out
C. Specific Identification
D. First-In-First-Out

Question 4

Marie Inc commenced operations on 1 October. Its inventory-related transactions for the month of
October were:

1 Oct purchased 510 units for $16 each

13 Oct sold 370 units for $24 each
20 Oct purchased 420 units for $18 each
28 Oct sold 460 units for $32 each

If Marie Inc values closing inventory using the periodic weighted average cost method, what is the
value of its closing inventory at 31 October (to the nearest dollar)?

A. $1,600
B. $1,690
C. $1,740
D. $1,800

93
Question 5

If the ending inventory is reported erroneously, it can cause a misstatement in all of the following
except:

A. Net profit
B. Total equity
C. Net sales
D. Total assets

Homework Questions (with answers)

Question 1

On 1 May, Paul Inc had 240 units of inventory at a cost of $10 each on June 1. It purchased 180 units
at $13 each on 15 May and sold 370 units on 28 May for $16. Using the FIFO perpetual inventory
method, calculate the cost of goods sold for the month of May.

A. $4,810
B. $4,090
C. $3,700
D. $5,920

Question 2

An organization uses the periodic inventory system and its inventory as at 1 June comprises 40 units at
$3 each. The following movements occur:

7 June 8 units sold at $4 each

16 June 15 units bought at $3.50 each
28 June 23 units sold at $4.50 each

Closing inventory at 30 June, using the LIFO method of inventory valuation, would be:

A. $79.50
B. $82
C. $84.50
D. $72

Question 3

A business usually sells its product for $24 per unit, though the selling price has recently dropped to
$20 per unit. This company's current inventory consists of 360 units purchased at $12 per unit and has
a net realisable value of $17 per unit. Calculate the value of this company's inventory that should be
presented in the statement of financial position.

A. $7,200
B. $8,640
C. $6,120
D. $4,320

94
 Question 4

Which of the following inventory valuation methods will result in the highest cost of goods sold
during a period of falling prices?

A. First-In-First-Out
B. Specific Identification
C. Weighted Average Cost
D. Last-In-First-Out

MCQ Answers: B, D, C, A

Question 5

Edge Co started business on April 1 and uses a weighted average cost method under a perpetual
inventory system. During the month of April, the following inventory-related transactions took place:

April 6 30 units were purchased at $18 per unit.

April 13 22 units were purchased at $14 per unit.
April 24 37 units were sold for $25 per unit.
April 30 25 units were purchased at $12 per unit.

What is the value of ending inventory on April 30? Round off unit costs to 2 decimal places and total
costs to the nearest whole number if necessary.

Answers:

Purchases COGS Balance

Apr Quantity Unit Total Quantit Unit Total Quantit Unit Total
Cost Cost y Cost Cost y Cost Cost
6
13
24
30
Purchases COGS End Inv

95
 FINANCIAL ACCOUNTING

SESSION 7

CURRENT ASSETS: RECEIVABLES

At the end of the lecture, students should be able to:

1. Describe the common classes of receivables.

2. Describe the accounting for uncollectible receivables.
3. Describe the direct write-off method of accounting for uncollectible receivables.
4. Account for the allowance for uncollectible receivables.

1 Introduction
Receivables recorded in the financial statements of a business include all money claims against other
entities, including individuals, firms and other organisations. Since they represent resources from
which the business can derive future economic benefits., receivables are classified as assets in the
statement of financial position.

2 Classes of Receivables
There are various types of receivables, depending on the nature of the underlying transaction and due
date of the outstanding amount.

2.1 Trade Receivable

These are amounts owed by customers from sale of goods and services on credit and also known as
accounts receivables. The journal entry to record a credit sale is as follows:

Dr Trade (or accounts) receivable

Cr Sales

The outstanding amount is typically expected to be collected within a relatively short period, such as
30 or 60 days. Thus, trade receivables is classified as current assets in the statement of financial
position.

2.2 Notes Receivable

These are formal written promises made by customers to pay a specified amount of money, with
interest, either on demand or at a definite future date. Typically, businesses require such notes in lieu
of trade receivable when a customer needs more time to pay a past-due account or has demonstrated a
history of tardy payments. Notes may also be preferred if the amount owed is large and credit period is
long.

2.3 Other Receivables

These are other amounts expected to be collected such as interest receivable and rent receivable.

96
3 Accounting for Uncollectible Receivables
When a business makes a credit sale, it takes on the risk that the customer will not pay the amount due.
Despite the best efforts of a business, some trade receivables will be uncollectible or irrecoverable.
This maybe attributed to customers’ inability pay due to financial difficulties, bankruptcy or lack of
good faith.

3.1 Write-off of Uncollectible Debts

An asset should only be presented if there is a probability of receiving economic benefits. A receivable
should therefore only be recorded as an asset if the amount due is collectible.

Any amount deemed to be uncollectible is accounted for as an irrecoverable or bad debt and charged
to the income statement as an operating expense in the relevant accounting period. The journal entry to
record an irrecoverable debt when it is deemed to be uncollectible is:

Dr Irrecoverable debts expense

Cr Trade (or accounts) receivable

When a debt that was previously written off is subsequently recovered, the business shall record the
following journal entry:

Dr Cash or Bank
Cr Irrecoverable debts expense

3.2 Allowance for Uncollectible Receivables

In order to present its trade receivables at the most relevant and reliable amount, businesses often
conduct a review of their trade receivables balance at the end of each financial year. There may be
some debts which the business thinks might not be paid (i.e. doubtful debts) due to reasons such as
customers’ financial difficulties and disputes over particular invoices.

In line with prudence concept, the business estimates amount uncollectible at the end of each
accounting period and records it with an adjusting entry via an allowance account. The allowance for
receivables is often computed as a percentage of the outstanding receivables balance at year-end and
commonly based on an aging analysis of year-end receivables balance.

The allowance for receivables account is contra-asset account that is offset against the trade
receivables balance in the statement of financial position, as shown below:

Statement of Financial Position (extract)

$ $
Current Assets
Trade receivables X
(less): Allowance for receivables (X)
X

Upon review at year-end, the business will determine if the allowance for receivables account is to be
increased or decreased.

97
The journal entry to record an increase in allowance account is as follows:

Dr Irrecoverable debts expense

Cr Allowance for receivables

Should the allowance be decreased, the entry is as follows:

Dr Allowance for receivables

Cr Irrecoverable debts expense

Note: that the allowance account is a contra-asset and thus has a ‘credit’ nature.

Activity

Mills Ltd commenced trading on 1 April 2018. During the year ended 31 March 2019, the company
had the following transactions:

- Total sales of $970,900 (including cash sales of $390,200)

- Payments made by credit customers amounted to $415,000
- $120,800 of debt was written off as irrecoverable
- A credit customer returned $82,500 worth of goods as they were faulty

At the year-end, Mills Ltd decided to make an allowance for 2% of outstanding receivables.

Required:

a) Record the journal entries to record the above transactions realting to trade receivables.

b) With respect to trade receivables, prepare the following for the year ended 31 March 2019 for
Mills Ltd:
(i) An extract of Income Statement for the year ended 31 March 2019.
(ii) An extract of the Statement of Financial Position as at 31 March 2019.
Activity [ANSWERS]

a)
Date Account Dr ($) Cr ($)

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 Date Account Dr ($) Cr ($)

b)
Workings
Trade receivables
$
Beginning balance

Ending balance

Allowance for receivables

$
Beginning balance

Ending balance

Irrecoverable debts expense

$

99
Income Statement for the year ended 31 March 2019 (extract)
$ $
Operating expenses
Irrecoverable expense

Statement of Financial Position as at 31 March 2019 (extract)

$ $
Current assets
Trade receivables
(less): Allowance for receivables

Review Questions

Question 1

At 31 December 2018, Wendy Co was owed $285,300 by its customers. The business has estimated
that 96% of its customers are able to pay their outstanding debts. What is the correct amount to be
reported on Wendy Co’s statement of financial position as at 31 December 2018?

A. $285,300
B. $11,412
C. $34,720
D. $273,888

Question 2

What is the impact on the financial statements of a business if it overstates the irrecoverable debts at
the end of the financial year?

A. Net trade receivables is understated.

B. Revenue for the year is overstated.
C. Profit for the year is overstated.
D. Allowance for receivables is understated.

Question 3

At the end of the year, the unadjusted trial balance of a business shows an outstanding Accounts
Receivable of $128,800 and a balance of $5,350 in its Allowance for Receivables account. What is the
charge to the income statement if 3% of accounts receivable is estimated to be uncollectible?

A. $3,864 credit
B. $1,486 debit
C. $1,486 credit
D. $3,864 debit

100
Question 4

The opening balances of the accounts receivable and allowance for receivables accounts as at 1
January 2019 were $72,000 and $5,600 respectively.

During the year ended 31 December 2019, the following transactions took place:

Transaction $
Credit sales 310,000
Cash sales 180,000
Collections from credit customers 240,000
Irrecoverable debts written off 4,500
Carriage outwards to customers 6,300

If the allowance for receivables as at 31 December 2019 has been set at 5% of outstanding receivables
balance, what is the net amount shown on the Statement of Financial Position as at 31 December 2013
with regards to accounts receivable?

A. $124,640
B. $130,625
C. $240,885
D. $301,625

Question 5

The following has been extracted from the records of Francis Trading as at 30 September 2018:

$ $
Trade receivables 425,800
Allowance for receivables (33,700)
392,100

During the year ended 30 September 2019, Francis Trading made cash sales of $1,720,500 and credit
sales of $2,590,000. Despite its best efforts, the business was unable to collect an overdue amount of
$85,600 from its customers and wrote it off during the year. Francis Trading received $2,030,600 from
its credit customers and estimated that the allowance for receivable should be set at 2% of outstanding
trade receivables.

Required:

a) Record the journal entries to record the above transactions that relate to trade receivables.

b) With respect to trade receivables, prepare the following for the year ended 30 September 2019 for
Francis Trading:

(i) An extract of Income Statement for the year ended 30 September 2019.
(ii) An extract of the Statement of Financial Position as at 30 September 2019.

101
Question 5 [ANSWERS]

a)
Date Account Dr ($) Cr ($)

b)
Workings
Trade receivables
$
Beginning balance

Ending balance

Allowance for receivables

$
Beginning balance

Ending balance

Irrecoverable debts expense

102
 $

Income Statement for the year ended 30 September 2019 (extract)

$ $
Operating expenses
Irrecoverable expense

Statement of Financial Position as at 30 September 2019 (extract)

$ $
Current assets
Trade receivables
(less): Allowance for receivables

Homework Questions (with answers)

Question 1

Which of the following is a difference between trade receivables and note receivables?

A. Only trade receivables relate to credit customers of a firm.

B. Note receivables involve the payment of interest over a specified period.
C. Trade receivables are classified as current asset while note receivables are recorded as non-
current assets.
D. Only trade receivables require prompt payment of any outstanding amount.

Question 2

At 31 December 2019, Parker Co was owed $264,500 by its customers. Upon review, the business
feels that 7% of the amount owed may not be recoverable.
How should receivables be reported in Parker Co’s statement of financial position as at 31 December
2019?

A. Current asset of $264,500 and current liability of $18,515

B. Current asset of $264,500
C. Current asset of $245,985 and non-current asset of $18,515
D. Current asset of $245,985
Question 3

103
Which of the following best describes the possible consequence of a firm omitting the allowance for
receivables account at the end of its first year of operations?

A. Net trade receivables may be understated.

B. Total liabilities may be understated.
C. Net profit may be overstated.
D. Total revenue may be overstated.

Question 4

At the end of the current financial year, the unadjusted balance on Anthony’s receivables account was
$365,200. Discount allowed of $9,700 and irrecoverable debts written off amounting to $8,400 had not
been recorded. Anthony also estimated that his receivables allowance to be 4% of the outstanding
receivables balance.

If Anthony’s receivables allowance at the beginning of the financial year was $12,400, what is the
amount of irrecoverable debts charged to the income statement for this year?

A. $22,284
B. $14,608
C. $13,884
D. $23,008

MCQ Answers: B, D, C, A

Question 5

During the year ended 30 June 2019, Max Co had the following transactions:

- Total sales of $846,000, 75% of which were made on credit.

- Credit customers paid him $425,100 after deducting cash discount of $10,500.
- Goods sold for $12,800 were returned by credit customers.
- $97,800 of debt was written off as irrecoverable.

On 1 July 2018, the company had the following balances:

$
Trade receivables 285,600
Allowance for receivables 17,800

At year-end, Max Co decided to make an allowance for 5% of outstanding receivables.

Required:

What amounts are shown on Max Co’s Statement of Financial Position in respect of receivables, and
what are the charges to the Income Statement for irrecoverable debt expense?
Question 5 [ANSWERS]

104
Income Statement for the year ended 30 September 2019 (extract)
$
Operating expenses
Irrecoverable expense 98,695

Statement of Financial Position as at 30 September 2019 (extract)

$ $
Current assets
Trade receivables 373,900
(less): Allowance for receivables (18,695)
355,205

FINANCIAL ACCOUNTING

105
 SESSION 8

NON-CURRENT ASSETS

At the end of the lecture, students should be able to:

1. Define, classify, and account for the cost of fixed assets.

2. Compute depreciation, using the following methods: straight-line method and reducing-balance
method.
3. Journalize entries for the disposal of fixed assets.
4. Describe intangible assets.

1 Definition

A non-current asset is one which is acquired and retained in the business with a view to earning
profits. It is expected to be used for more than one accounting period.

Asset: Resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity.

Non-current assets are also known as long-term assets and include tangible (or fixed) and intangible
assets as well as long-term investments made by the entity.

1.1 Tangible (Fixed) Assets

Tangible (or fixed) assets items with physical existence that are owned and used by the business in its
normal operations, i.e. they are not offered for sale as part of normal operations. These include land,
building, equipment, vehicles etc.

Fixed assets are to be distinguished from inventories which we buy or make in order to sell.
Inventories are current assets, along with cash and receivables. For example, computers bought for
business’ use are accounted for as fixed assets while those bought for trading purpose should be
accounted for as inventories.

1.2 Intangible Assets

Intangible assets are assets which do not have any physical form and often represent legal rights
possessed & paid for by the business entity, such as patents and copyrights.

1.3 Long-term Investments

These are funds invested by the company (including idle funds) on a long-term basis such as
investment in a subsidiary.

2 Accounting for Tangible (Fixed) Assets

106
When accounting for fixed assets, it is crucial to distinguish between capital and revenue expenditure.

Capital expenditure results in the acquisition of fixed assets, or an increase in their earning capacity. It
is recorded as cost of fixed assets is the Statement of Financial Position.

Revenue expenditure is incurred for the purpose to maintain the existing earning capacity of the fixed
assets. It is recorded as an expense in the Statement of Comprehensive Income.

2.1 Initial Cost Measurement

Non-current assets are initially recorded at its cost, i.e. the amount spent to acquire the assets.
Components of cost include capital expenditure such as the following:

- Purchase price (incl. import duties, excl. trade discount, recoverable sales tax)
- Directly attributable costs, e.g. site preparation, delivery and handling costs installation, assembly
costs, testing and professional fees
- Initial estimate of dismantling and restoration costs

Activity 1

Virgil Inc acquired a piece of freehold land for $1.8 million, paying $800,000 in cash and financing
the remaining amount with a bank loan. Legal fees of $25,600 and inspection costs of $14,200 were
also paid to get the land ready for use. The business commenced work to construct an office building
on the land and has paid an architect $75,300 to design building. $490,500 was also paid to a main
contractor for construction services.

Required:

a) Determine the following costs to be reported on the Statement of Financial Position for (i)
Freehold land and (ii) Office building.
Activity 1 [ANSWERS]

a)(i) Freehold land

$
Purchase price
Directly attributable costs

b) Office building
$
Purchase price
Directly attributable costs

b) Prepare journal entries to record the acquisition costs of (i) Land and (ii) Warehouse.

107
 Item Account Dr ($) Cr ($)
(i) Freehold land

(ii) Office building

2.2 Subsequent Expenditure

These relate to amounts spent on fixed assets subsequent to their acquisition. Expenditures that
improve the asset or extend its useful life are capital expenditure and added to the cost of the asset in
the Statement of Financial Position. On the other hand, expenditures that maintain the performance
level of the asset and benefit only current period are revenue expenditure. These will then be charged
to the Statement of Comprehensive Income as operating expenses.

Activity 2

a) State whether each of the following items should be accounted for as capital expenditure or
revenue expenditure:

Item Capital or Revenue Expenditure

i) Annual servicing fee of $8,900
ii) Installation costs of $7,500 for fixtures
iii Major overhaul of delivery van: $12,500
)
iv) Insurance premium for one year: $3,200

b) Prepare journal entries to record the expenditure items (i) to (iv):

Item Account Dr ($) Cr ($)

(i)

(ii)

108
 Item Account Dr ($) Cr ($)
(iii)

(iv)

3 Depreciation
Depreciation is a process of spreading the cost of a fixed asset over its useful life during which the
benefit is expected from its use. During the asset’s useful life, the carrying amount of the asset is
gradually reduced until it is equal to the residual value at the end of the useful life. In other words, the
asset is depreciated over time due to usage as well as wear and tear.

Depreciation expense is charged to the Statement of Comprehensive Income at the end of the
accounting period. It matches the expense incurred against revenue generated using the asset, thus
ensuring compliance with matching concept. A contra-asset account (accumulated depreciation) is
deducted from the asset cost to reflect the carrying amount of the fixed asset at the end of every year in
the Statement of Financial Position.

The journal entry to record annual depreciation is as follows:

Dr Depreciation expense
Cr Accumulated depreciation

3.1 Methods of Depreciation

Two commonly used methods of computing depreciation are straight-line and reducing balance
depreciation.

3.1.1 Straight-line Method

Straight-line depreciation should be used when the pattern of benefits from the non-current asset is
expected to be consistent and unchanging over time. The total cost of using the asset (the difference
between its original cost and its estimated residual value) is spread evenly over the asset’s useful life.

Cost - Residual Value

Annual depreciation = or Cost × Depreciation Rate
Useful Life

3.1.2 Reducing Balance Method

109
Reducing balance method be used when the asset is expected to produce more benefits in the earlier
years of its useful life. Higher annual depreciation is charged initially and gets lower annually until the
residual value is reached. Reducing balance depreciation is always expressed as a percentage rate.

Depreciation expense = Net Book Value * × Depreciation Rate

*Net Book Value (NBV) = Cost – Accumulated Depreciation

Activity 3

On 1 January 2016, a business acquired a motor vehicle for $48,000. It has a useful life of 4 years and
an estimated residual value of $6,000. The financial year for the business ends on 31 December each
year.

Compute depreciation for the business using (i) straight-line and (ii) reducing balance methods.

(i) Straight-line method

Annual depreciation =

Year ended Depreciation Ending Accumulated Ending

31 Dec Depreciation Net Book Value

$ $ $
2016
2017
2018
2019

(ii) Reducing balance method

Depreciation is charged at 40% per annum.

Year ended Depreciation Ending Accumulated Ending

31 Dec Depreciation Net Book Value

$ $ $
2016
2017
2018
2019

3.2 Acquisition of asset during the year

110
If the fixed asset is acquired during the financial year, depreciation is charged proportionately based
on usage of the asset unless otherwise stated in the accounting policy of the business.

Activity 2

Information as per Activity 1 except that equipment is acquired on 1 April 2016.

Required:

Compute depreciation for the business using (i) straight-line and (ii) reducing balance methods.

(i) Straight-line method

Annual depreciation =

Year ended Depreciation Exp Ending Accumulated Ending

31 Dec for the year Depreciation Net Book Value

$ $ $
2016
2017
2018
2019
2020

Note:
- Only 9 months of depreciation is charged in the accounting year 2016.
- Depreciable cost is allocated based on 4 years of use and over 5 accounting periods.

(ii) Reducing balance method

Depreciation is charged at 40% per annum.

Year ended Depreciation Ending Accumulated Ending

31 Dec Depreciation Net Book Value

$ $ $
2016
2017
2018
2019
Note:
- Only 9 months of depreciation is charged in the accounting year 2016.

111
- Depreciation ends in accounting year 2019 when net book value reaches the residual value.

4 Disposal of Fixed Assets

Fixed assets may be disposed or sold off at some stage during its useful life. The sale may result in
either a gain or loss depending on whether disposal proceeds are greater or less than the net book value
of the asset.

Gain/(Loss) on disposal = Sales proceeds – Net book value

- When sales price > NBV  gain

- When sales price < NBV  loss
- When sales price = NBV  no gain/loss

4.1 Procedures to record disposal of fixed asset

The following steps are to be taken when accounting for disposal of fixed asset:

1) Record depreciation up to date of disposal (unless stated otherwise).

2) Determine NBV [ Cost – Accumulated Depreciation] as at disposal date.
3) Compute & record gain/loss on disposal [ Gain/(Loss) = Proceeds# – NBV]
4) Record proceeds and remove balances from asset and accumulated depreciation accounts.
#
Proceeds = $0 if asset is discarded/scrapped.

Journal entries to record disposal of fixed asset:

If proceeds < NBV

Dr Cash/Asset
Dr Accumulated depreciation
Dr Loss on disposal
Cr Non-current asset

If proceeds > NBV

Dr Cash/Asset
Dr Accumulated depreciation
Cr Gain on disposal
Cr Non-current asset

Activity 3

The following information has been extracted from Bob Trading’s financial statements for the year
ended 31 December 2018:

$ $
Non-current Assets
Equipment, at cost 30,000
(less): Accumulated depreciation (25,000) 5,000
The equipment has a useful life of 4 years and an estimated residual value of $2,000. Bob Trading uses
the straight-line method to depreciate its fixed assets.

112
Required:

Prepare the journal entries for asset disposal for the following scenarios:

(i) Equipment was sold on 1 April 2019 for $4,800.

Depreciation expense for year ended 31 December 2019

=

Net book value as at disposal date

=

Gain/(Loss) on disposal
=

Date Account Dr ($) Cr ($)

(ii) Equipment was sold on 1 July 2019 for $1,200.

Depreciation expense for year ended 31 December 2019

=

Net book value as at disposal date

=

Gain/(Loss) on disposal
=

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 Date Account Dr ($) Cr ($)

Notes:
- Partial year depreciation is charged when asset is purchased/disposed during the year unless
otherwise stated in question.
- Disposal account may be used in the recording of journal entries.

5 Intangible Assets

These are assets which do not have any physical form and are used to generate economic benefits for
the business. Intangible assets typically include legal rights possessed by the business such as
trademarks, patents and copyrights.

- A trademark is a unique name, term, or symbol used to identify a business and its products. They
can typically be registered for 10 years and can be renewed every 10-year period thereafter.

- A patent is the exclusive right to manufacturers to produce and sell goods with one or more unique
features is a patent. These rights tend to be in effect for 20 years.

- A copyright is the exclusive right to publish and sell a literary, artistic, or musical composition is a
copyright. A copyright usually extends for 70 years beyond the author’s death.

5.1 Accounting treatment for intangible assets

Intangible assets with a finite useful life should be amortised over their useful life in a systematic
manner. Those with an indefinite useful life are not amortised but tested for impairment annually,
together with a review of the useful life assumption. Once a finite useful life is estimated, amortisation
of the assets will commence.

114
Review Questions

Question 1

Steven has prepared his draft financial statements for the year ended 31 May 2011. He discovers that
he has capitalised repairs to the delivery van amounting to $245. Ignoring depreciation, what is the
effect of this error?

A. Net assets and net current assets are $245 too high.
B. Profit and capital are $245 too high.
C. Net assets and capital are $245 too low.
D. Ownership can be easily transferred. Profit is $235 too low and net current assets are $245 too
high.

Question 2

An asset costs $15,000. If the reducing balance method of depreciation is used at 40% per annum,
what will be the income statement charge for depreciation in the second year?

A. $3,600
B. $6,000
C. $2,400
D. $5,600

Question 3

In the year to 30 November 2011, Jake accounted for $7,000 of expenditure on machinery repairs as
the cost of a new machine. Jake depreciates machinery on a straight-line basis over 10 years and
charges depreciation for a full year in the year an asset is acquired. What is the effect of the error on
Jake’s profit for the year to 30 November 2011?

A. understated by $6,300
B. understated by $7,700
C. overstated by $6,300
D. overstated by $7,700

Question 4

A car was purchased by Tyre for $14,000 on 1 April 20X1 and has been depreciated at 20% each year
straight line, assuming no residual value. The accounting policy is to charge a full year’s depreciation
in the year of purchase and no depreciation in the year of sale. The car was traded in for a replacement
vehicle on 1 August 20X4 for an agreed figure of $5,800.

What was the profit or loss on the disposal of the vehicle for the year ended 31 December 20X4?

A. Loss of $2,600
B. Profit of $3,000
C. Loss of $200
D. Profit $200

115
Question 5

At 30 June 2018, the following balances existed in the records of Decker Co (“Decker”):

Equipment: Cost $680,000

Accumulated depreciation $350,000

During the year ended 30 June 2019, a used equipment with a net book value of $46,000 was sold for
$59,000. The equipment had originally cost $90,000.

As part of its expansion plans, Decker bought a new equipment during the year. The equipment cost
$120,000, with additional $8,000 paid for delivery and $4,000 for testing. A one-year maintenance
contract was also taken out at a cost of $1,000.

It is the company’s policy to charge a full year’s depreciation in the year of acquisition of an asset and
none in the year of sale, using a rate of 10% on the straight-line basis.

Required:

a) Record the journal entries to record the above transactions for the year ended 30 June 2019.

b) What is the net book value of equipment that should appear on Decker’s Statement of Financial
Position at 30 June 2019?

c) What are the figures, relating to plant and equipment, that would appear on Decker’s Income
Statement for the year ended 30 June 2019?

Question 5 [ANSWERS]

a)
Sale of used equipment

Gain/(Loss) on disposal =

Accumulated depreciation =

Date Account Dr ($) Cr ($)

116
Acquisition of new equipment

Costs to capitalise (i.e. capital expenditure)

=

Costs to expense off (i.e. revenue expenditure) =

Date Account Dr ($) Cr ($)

Depreciation for the year

Depreciation expense =

Date Account Dr ($) Cr ($)

b)

Workings
Plant & equipment
$
Beginning balance

Ending balance

Accumulated depreciation
$
Beginning balance

Ending balance

Statement of Financial Position as at 30 June 2019 (extract)

117
 $ $
Non-current assets
Equipment
(less): Accumulated depreciation
Net book value

c)
Statement of Comprehensive Income for year ended 30 June 2019 (extract)
$
Other income

Operating expenses

Homework Questions (with answers)

Question 1

When a business incurs capital expenditure, its financial records will involve a debit to:

A. a capital account.
B. an expense account.
C. an asset account.
D. a liability account.

Question 2

A new equipment was purchased for $80,000 on 1 April 2011. It has a useful life of 10 years, at the
end of which it can be sold as scrap for $10,000. What is the depreciation expense for the year ended
31 December 2011 assuming that the straight-line method is used?

A. $6,000
B. $8,530
C. $7,000
D. $5,250

Question 3

118
An asset was purchased for $120,000 and originally estimated to have a useful life of 10 years with a
residual value of $10,000. After two years of straight-line depreciation, it was determined that the
remaining useful life of the asset was only 4 years with a residual value of $2,000. Calculate this
year’s depreciation using the revised amounts and straight-line method.

A. $24,000.
B. $11,000.
C. $24,500.
D. $25,000.

Question 4

In the financial year ended 30 September 2019, Martin sold her car for $5,600. The car had been
bought on 1 October 2017 for $14,000 with depreciation calculated proportionately based on number
of months of ownership.

If Martin depreciates motor vehicles on the straight-line basis at a rate of 20% per annum, w hat is the
profit or loss on disposal of the car (to the nearest $1)?

A. $5,600 profit.
B. $2,800 loss.
C. $5,600 loss.
D. $2,800 profit.

MCQ Answers: C, D, A, B

Question 5

At 31 May 2018, the following balances existed in the records of Hargrave Ltd (“Hargrave”):

Motor vehicles: Cost $930,000

Accumulated depreciation $560,000

During the year ended 31 May 2019, the following transactions took place:

(1) A delivery van of $85,000 was purchased on 1 June 2018 for delivering goods to the company’s
customers. Additional $5,000 was paid for testing and installation. Insurance coverage for a year
was also purchased for $3,000.

(2) An old vehicle with net book value of $73,000 was sold for $58,000. The vehicle had originally
cost Hargrave $120,000.

It is the company’s policy to depreciate its plant and equipment on a straight-line basis at 10% of cost.
A full year’s depreciation is charged in the year of acquisition of an asset and none in the year of sale.

Required:

119
(a) Prepare journal entries for transactions (1) and (2).

(b) Show the cost and accumulated depreciation of motor vehicles that should appear in the
Statement of Financial Position of Hargrave Ltd as at 31 May 2019.

(c) Show the figures (including depreciation). Relating to motor vehicles, that would appear on the
Statement of Comprehensive Income for the year ended 31 May 2019.

Answers:
a)
Item Account Dr ($) Cr ($)
(1) Motor vehicles [85k + 5k] 90,000
Insurance expense 3,000
Cash 93,000

(2) Cash 58,000

Accumulated depreciation [120k – 73k] 47,000
Loss on disposal 15,000
Motor vehicles 120,000

b)
Statement of Financial Position as at 31 May 2019 (extract)
$ $
Non-current assets
Motor vehicles [930k + 90k – 120k] 900,000
(less): Accumulated depreciation [560k + 90k # – 47k] (603,000)
297,000
#
Depreciation for the year = $900k × 10% = $90k

c)
Statement of Comprehensive Income for year ended 31 May 2019 (extract)
$
Operating expenses
Insurance 3,000
Loss on disposal 15,000
Depreciation 90,000

FINANCIAL ACCOUNTING

120
 SESSION 9

LIABILITIES & SHAREHOLDERS’ EQUITY

At the end of the lecture, students should be able to:

1. Describe the nature of the corporate form of organization.

2. Describe the two main sources of stockholders’ equity.
3. Describe and illustrate the characteristics of stock and classes of shares.
4. Define and illustrate current liabilities related to accounts payable and current portion of long-
term debt.

1 Introduction
A company is a business structure whereby the business issues shares to its owners who become
shareholders upon payment for the shares. It is a legal entity which is distinct and separate from its
shareholders.

Shareholders do not typically run the business. Rather, they appoint directors to operate the company
on their behalf. Profits earned by the company can be distributed to shareholders in the form of
dividends.

1.2 Characteristics of Companies

Features of a company include the following:

- A company has a separate existence from its owners and thus can own property and sue (and be
sued) in its own name.
- The liability of owners is limited to the amount that they have invested in the company.
- Ownership can be transferred easily through the purchase and sale of shares.
- Governed by national legislation and subject to More stringent accounting requirements.

2 Types of share capital

When company is incorporated, it raises funds through issuing shares. The face value of the shares is
called ‘par’ or nominal value. Price at which shares are issued may exceed the par value, with the
excess amount recorded as a reserve named “share premium”. [Note: Shares in Singapore do not carry
any par/nominal value.]

There are generally two types of shares: ordinary shares and preference shares.

2.1 Ordinary shares

These shares carry the right to vote (e.g. during the annual general meeting) and thus participate in the
growth of the firm. Ordinary shareholders are not entitled to fixed dividends and Ranks below
preference shareholders in receiving dividends and claiming assets should the company be wound up.
Since they are entitled to all profits remaining after payment of preference share dividends, ordinary
shareholders are often viewed as the effective owners of the firm.

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2.2 Preference shares
Preference shares carry a right to a fixed dividend that is usually expressed as a percentage of their par
values. They do not usually carry rights to vote during meetings. Other characteristics of preference
shares include the following:

- Right to fixed dividend with priority over ordinary shares

- Priority over ordinary shareholders in in distribution of assets on winding-up
- Shareholders have no voting rights

Preference shares may be cumulative/non-cumulative and redeemable/irredeemable in nature.

2.1.1 Cumulative Preference shares

Should the profit of any particular year be insufficient to pay a dividend, the right to receive a dividend
is carried forward to following years. Any dividend due to preference shareholders is to be distributed
before the ordinary shareholders receive anything.

For non-cumulative preference shares, any shortage in dividends paid is lost to the shareholders.

2.1.2 Redeemable Preference shares

Company is committed to repay nominal value of shares at a later date after series of fixed dividend
payout. The shares will then be cancelled and no further dividends are to be paid.

Redeemable preference shares are treated as loans and classified as non-current liabilities in Statement
of Financial Position (note: current liability if redemption date is within 1 months). Dividends paid are
recorded as interest expense in the Statement of Comprehensive Income.

On the other hand, irredeemable preference shares are treated like any other preference share and
classified as equity in the company’s financial statements.

3 Reserves
Besides share capital, the equity section of a company’s statement of financial position (i.e.
shareholders’ equity) also includes its reserves. These include retained earnings and other reserves that
are usually classified and presented here as prescribed by accounting standards. Reserves can be
separated into revenue and capital reserves.

3.1 Revenue Reserves

Revenue reserves are amounts set aside from the profits earned by the business and can be distributed
as dividends. They are also known as non-statutory reserves and include retained earnings and
dividend reserves.

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3.1.1 Retained Earnings
Retained earnings consist of profits earned by company and not appropriated by dividends, tax or
transferred to another reserve account. The reserve represents the accumulated profits/losses of the
business since its incorporation and has a credit nature for double entry purposes. It can be distributed
as dividends to shareholders or transferred to other reserves.

The balance of the retained earnings account can be computed using the following equation:

Opening Balance + Net Profit after Tax – Dividends = Ending Balance

3.1.2 Dividends
Dividends appropriation of profits after tax to a company’s shareholders, typically in the form of cash.
They may be paid in two stages in a financial year: interim dividends and final dividends and are
reported in the Statement of Changes in Equity.

3.2 Capital Reserves

Capital reserves arise from capital transactions or are unrelated to a company’s profit & loss and thus
not available for dividend payment. They are known as statutory reserves and include share premium
and revaluation reserve.

4 Liabilities
Besides the issue of shares, a company can also raise funding from debtholders (i.e. liabilities). This
includes taking up bank loans and issuance of debt securities such as debentures and bonds.

Liabilities that are to be paid out of current assets and are due within one year should be classified as
current liabilities. This includes short-term notes payable and the current portion of long-term debt.

Debt financing that is due for payment more than one year after year-end date should be presented as
non-current liabilities, e.g. bank loan and loan notes/bonds.

5 Financial Statements of Limited Liability Companies

A complete set of financial reports for a company comprises:

- Statement of Comprehensive Income

- Statement of Financial Position
- Statement of Changes in Equity
- Statement of Cash Flows (to be covered in a subsequent chapter)
- Notes to Financial Statements (not in the syllabus)

5.1 Statement of Changes in Equity

This statement shows the movement in equity account ts for the past financial year and also provides a
reconciliation between the account balances at the beginning and end of the year. An example of the
statement is provided below:

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Statement of changes in equity for year ended 30 September 2019
Ordinary share Retained Total
capital earnings
$’000 $’000 $’000
Balance as at 1 October 2018 X X X
Add: Profit after tax X X
(Less): Dividends (X) (X)
Balance as at 30 September 2019 X X X

Activity

The following trial balance has been extracted from the books of Docks Ltd as at 30 June 2019:

Dr ($) Cr ($)
Sales 1,240,500
Inventory, 30 Jun 2018 93,400
Administrative expenses 28,700
Wages and salaries 185,600
Utilities 37,300
Advertising 19,200
Bank 27,900
Purchases 742,800
Irrecoverable debts 5,600
Allowance for receivables, 30 Jun 2018 2,700
Trade payables 77,100
Share capital (600,000 shares) 300,000
Buildings, at cost 560,200
Accumulated depreciation: Buildings, 30 Jun 2018 97,500
Machinery, at cost 250,600
Accumulated depreciation: Machinery, 30 Jun 2018 82,300
Trade receivables 88,500
Retained earnings, 30 Jun 2018 239,700
2,039,800 2,039,800
Additional information:

(i) Inventory at 30 June 2019 amounted to $86,200.

(ii) Utility bills that are unpaid as at year-end amounted to $2,900.
(iii) Advertising expenses included $1,800 paid for advertising to be run in August 2019.
(iv) At the end of the financial year, Docks Ltd is of the opinion that the allowance for receivables
should be increased to $3,600.
(v) $20,000 of dividends were paid in 2019 but omitted in the accounts of Docks Ltd.
(vi) Depreciation is to be charged on buildings at 5% per annum on cost and machinery at the rate of
10% per annum on net book value.

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Required:

a) Prepare adjusting entries for items (ii) to (vi) above.

b) Prepare the following financial statements using the worksheets provided:

(i) Statement of Comprehensive Income for the year ended 30 June 2019.
(ii) Statement of Changes in Equity for the year ended 30 June 2019.
(iii) Statement of Financial Position as at 30 June 2019.
Activity [ANSWERS]

a)
Date Account Dr ($) Cr ($)
30/6/19

b)(i)

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Docks Ltd
Statement of Comprehensive Income for the year ended 30 June 2019
$ $
Sales
(less): Cost of Goods Sold
Opening inventory
add: Purchases
(less): Ending inventory

Gross profit
(less): Operating expenses
Administrative expenses
Wages & salaries
Utilities
Advertising
Irrecoverable debts

Net profit

b)(ii)
Docks Ltd
Statement of Changes in Equity for the year ended 30 June 2019
Share capital Retained earnings Total
$ $ $
Balance as at 1 July 2018
add: Profit after tax
(less): Dividends
Balance as at 30 June 2019

b)(iii)

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Docks Ltd
Statement of Financial Position as at 30 June 2019
$ $ $
Non-current Assets
Buildings, at cost
(less): Accumulated depreciation

Machinery, at cost
(less): Accumulated depreciation

Current Assets
Inventory
Trade receivables
(less): Allowance for receivables

Total assets

Shareholders’ equity
Share capital
Retained earnings
Total shareholders' equity

Current liabilities
Trade payables

Total liabilities
Total equity and liabilities

Review Questions

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Question 1

Which of the following is not true of the corporate form of organization?

A. Company can sue other entities in its own name.

B. Owners have unlimited liability.
C. Ability to raise more capital.
D. Ownership can be easily transferred.

Question 2

Which of the following statements are correct?

(i) Preference shares promise a fixed dividend payout.

(ii) Preference shareholders have voting rights.
(iii) Both issues of ordinary and preference shares will increase share capital
(iv) Ordinary shares can be cumulative or non-cumulative in nature.

A. Items (i) & (iii) only

B. Items (i) & (iv) only
C. Items (ii) & (iii) only
D. Items (iii) & (iv) only

Question 3

All of the following are found in a company’s shareholders’ equity section except:

A. retained earnings
B. share premium
C. ordinary shares
D. dividends payable

Question 4

On 30 September 2019, Stung Limited recorded a net loss of $200,000 for the financial year ended on
the same date as well as declared dividends of $30,000 to be paid on 5 November 2019. What is the
retained earnings balance as at 30 September 2019 if the retained earnings balance as at 1 October
2018 amounted to $520,000?

A. $720,000
B. $320,000
C. $690,000
D. $290,000

Question 5

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The unadjusted trial balance of Jensen Inc as at 31 December 2019 are as follows:

Dr Cr
($’000) ($’000)
Ordinary shares 4,500
Retained earnings as at 31 Dec 2018 884
Sales 11,680
Carriage inwards 410
Equipment
- at cost 2,150
- accumulated depreciation, 31 Dec 2018 860
Land, at cost 3,700
Vehicles
- at cost 1,620
- accumulated depreciation, 31 Dec 2018 750
Bank 286
Inventory as at 31 Dec 2018 870
5% Loan notes 600
Trade payables 543
Discount received 231
Trade receivables 720
Interest expense 20
Sales returns 310
Irrecoverable debts 130
Purchases 6,930
Salaries 780
Insurance 240
Dividends paid 80
Utilities 540
Rent 650
Carriage outwards 380
Discount allowed 290
Allowance for receivables, 31 Dec 2018 58
20,106 20,106
Additional information:

(i) Inventory as at 31 December 2019 amounted to $920,000.

(ii) $114,000 was received from a credit customer in settlement of an outstanding debt after
deducting 5% cash discount. This has not been recorded in the books of Jensen Inc.
(iii) The last utilities bill received was for the quarter ended 30 September 2019 and paid for on the
same date. Monthly utilities cost is constant throughout the year.
(iv) Insurance expenses include $28,000 paid for the period November 2019 to May 2020.
(v) The allowance for receivables is assessed to be 7% of outstanding trade receivables.
(vi) Equipment is depreciated at 10% per annum based on the straight-line method.
(vii) Vehicles are depreciated at 20% per annum using the reducing balance method.
(viii) Carriage inwards paid of $98,000 was treated as carriage outwards.
(ix) The outstanding interest on loan notes has not been paid nor recorded.

Required:

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a) Prepare adjusting entries for items (ii) to (viii) above. Narrations are not required. (Hint: For some
transactions, you will need to create new accounts which are not shown on the trial balance.)

b) Prepare the following financial statements for Jensen Inc:

(i) Statement of Comprehensive Income for the year ended 31 December 2019.
(ii) Statement of Changes in Equity for the year ended 31 December 2019.
(iii) Statement of Financial Position as at 31 December 2019.

Question 5 [ANSWERS]

a)
Date Account Dr ($’000) Cr ($’000)
31/12/19

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 Date Account Dr ($’000) Cr ($’000)

b)(i)
Jensen Inc
Statement of Comprehensive Income for the year ended 31 December 2019
$ $
Sales
(less): Sales returns

(less): Cost of Sales

Opening inventory
add: Purchases
add: Carriage inwards
(less): Ending inventory

Gross profit
add: Discount received

(less): Operating expenses

Interest expense
Salaries
Insurance
Utilities
Rent
Carriage outwards
Discount allowed
Irrecoverable debts
Depreciation

Net profit

b)(ii)
Jensen Inc
Statement of Changes in Equity for the year ended 31 December 2019

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 Ordinary Retained Total
shares earnings
$ $ $
Balance as at 1 Jan 2019
Add: Profit after tax
(Less): Dividends
Balance as at 31 Dec 2019

b)(iii)
Jensen Inc
Statement of Financial Position as at 31 December 2019
$ $ $
Non-current Assets
Land
Equipment, at cost
(less): Accumulated depreciation

Vehicles, at cost
(less): Accumulated depreciation

Current Assets
Inventory
Trade receivables
(less): Allowance for receivables

Prepaid expenses
Bank

Total assets

Shareholders’ equity
Ordinary shares
Retained earnings
Total shareholders' equity

Non-current liabilities
5% Loan notes

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 Current liabilities
Trade payables
Accrued expenses

Total liabilities
Total equity and liabilities

Homework Questions (with answers)

Question 1

Shareholders’ equity

A. includes retained earnings and paid-up capital.

B. is shown on the income statement.
C. is usually equal to cash at hand.
D. includes share capital and liabilities.

Question 2

Which of the following statements are true of limited liability companies?

(i) The company exists indefinitely.

(ii) The company’s exposure to financial loss is limited.
(iii) The company exists separately from its owners

A. Items (i) & (ii) only

B. Items (ii) & (iii) only
C. Items (i) & (iv) only
D. Items (i) & (iii) only

Question 3

Which of the following does not accurately describe a difference between ordinary shares and
preference shares?

A. Preference shareholders receive a fixed dividend whereas ordinary shareholders receive a

variable dividend.
B. Preference shareholders are given one vote per share, whereas ordinary shareholders usually
have unlimited voting rights.
C. Preference shares are considered less risky than ordinary shares.
D. Preference shareholders receive assets before ordinary shareholders in the event of corporate
liquidation.

Question 4

Which of the following is not true of a loan note holder?

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A. A loan note holder is given interest throughout the tenure of the loan note.
B. At maturity of the loan note, holders will receive the principal amount from the issuer.
C. In the event of the liquidation of the company, the debenture-holder is paid after preference
shareholders.
D. A loan note holder is a creditor of the company.

MCQ Answers: A, D, B, C

Question 5

The following information was extracted from the records of Shine Co as at 30 June 2019:

Dr Cr
($’000) ($’000)
Inventory as at 1 Jul 2018 230
Sales 1,820
Returns 15 20
Rent income 72
Share capital 650
Advertising 96
Utilities 178
Plant and machinery
- at cost 445
- accumulated depreciation, 1 Jul 2018 115
Building
- at cost 600
- accumulated depreciation, 1 Jul 2018 202
Land, at cost 940
Salaries 217
Insurance 32
Cash 95
Retained earnings at 1 Jul 2018 729
Bank loan 200
Allowance for receivables, at 1 Jul 2018 20
Purchases 941
Trade payables 250
Trade receivables 295
Loan interest paid 2
Discounts 26 34
4,112 4,112

Additional information:

(i) A stock count conducted on 30 June 2019 ascertained inventory to be $196,000.

(ii) Utilities expense of $15,000 for June 2019 have not been billed nor recorded.
(iii) Insurance expense consists of payment made for the period January to August 2019.
(iv) Plant and machinery are depreciated at 20% per annum on net book value.
(v) Buildings are depreciated at 4% per annum on their original cost.

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(vi) The allowance for receivables is to be increased by 15%.
(vii) Rent income includes $24,000 received for June to September 2019.
(viii) The bank loan was taken up on 1 April 2019 and carries an annual interest rate of 6%. Any
outstanding loan interest is yet to be recorded nor paid.
(ix) An invoice received from a credit supplier amounting to $52,000 was wrongly recorded as
$25,000. Payment has not been made as at year-end.

Required:

a) Prepare adjusting entries for items (ii) to (ix) above. Narrations are not required. (Hint: For some
transactions, you will need to create new accounts which are not shown on the trial balance.)

b) Prepare the following financial statements for Shine Co:

(i) Statement of Comprehensive Income for the year ended 30 June 2019.
(ii) Statement of Changes in Equity for the year ended 30 June 2019.
(iii) Statement of Financial Position as at 30 June 2019.

Key Answers:

Statement of Comprehensive Income: Net profit = $259,000

Statement of Financial Position: Total Assets = $2,149,000; Total Liabilities = $511,000;
Total Equity = $1,638,000

FINANCIAL ACCOUNTING

SESSION 10

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 STATEMENT OF CASH FLOWS

At the end of the lecture, students should be able to:

1. Describe the cash flow activities reported in the statement of cash flows.
2. Prepare cash flows from operating activities, using the indirect method.
3. Prepare cash flows from investing activities.
4. Prepare cash flows from financing activities.
5. Prepare a statement of cash flows.

960.1 Nature and Purpose

The Statement of Cash Flows shows a firm’s cash inflows and cash outflows for a period. It explains
the change in the firm’s cash position from one financial year to the next. The statement provides
information about a firm’s ability to generate the cash it needs to operate successfully by assessing its
ability to:

- Generate cash from operations

- Maintain and expand its operating capacity
- Meet its financial obligations
- Pay dividends

1.2 Benefits of Cash Flow Information

When use in conjunction with the rest of the financial statements, users can:

- Gain appreciation of the company’s liquidity and solvency position.

- Better compare company performance without the use of differing accounting policies.
- Forecast future cash flows for better management of operations.
- Evaluate the strategic decisions made by management.
-

960 Key Components of the Statement of Cash Flows

The statement reports cash flows from or used in three categories of activities:

a) Operating activities are activities that affect net income, including receipts from customers for
products/services provided and payments to suppliers for purchase of goods.
b) Investing activities are activities related to transactions that affect the investments in non-current
assets of the company, including the acquisition and disposal of new assets.
c) Financing activities are activities that affect the equity and non-current liabilities of a firm,
including receipts from borrowings and issuance of shares as well as repayment of loans.
Activity 1

Classify the following cash flows as inflows/outflows in Operating, Investing or Financing activities:

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 Activity Inflow/(Outflow)
1. Payment for goods bought on credit
2. Proceeds from issuance of bonds
3. Receipts from disposal of equipment
4. Repayment of bank loan
5. Cash received from customers
6. Distribution of dividends
7. Payment for purchase of vehicle
8. Proceeds from share issuance

2.1 Cash Flows from Operating Activities

These cash flows show a firm’s ability to generate cash from its operations from its principal revenue-
producing activities. Most of these will include items that impact the profit or loss of the firm, such as:

- Cash received from sale of goods/services, interest income, dividends received

- Cash paid for goods purchased, interest on loans, taxes and other expenses (e.g. salaries)

Though these cash flows are short-term in nature, a firm’s performance form its operating activities
will affects its long-term viability.

2.1.1 Reporting Cash Flows from Operating Activities

There are two methods to present the cash generated from operating activities:

a) Direct method
- discloses net cash flows by displaying the gross receipts and payments.
Illustrative example: Direct Method
$’000 $’000
Cash receipts from customers 22,600
Cash paid to suppliers and employees (17,400)
Cash generated from operations 5,200
Interest paid (380)
Income taxes paid (960)
Net cash from operating activities 3,860

b) Indirect method
- derives the net cash flow from operating activities by adjusting net profit with non-cash items as
well as changes in net working assets.

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 Illustrative example: Indirect Method
$’000 $’000
Profit before tax 4,750
Adjustments for:
Depreciation 320
(Gain)/Loss on disposal of non-current assets (140)
Investment income (80)
Interest expense 70
Operating profit before working capital changes 4,920
Increase in trade and other receivables (500)
Decrease in inventories 1,620
Decrease in trade payables (840)
Cash generated from operations 5,200
Interest paid (380)
Income taxes paid (960)
Net cash from operating activities 3,860

Note that both methods will give the same amount of net cash flows from operating activities.
Though the direct method of presentation is encouraged, the indirect method is more commonly used
as it is less time-consuming and also reconciles a firm’s accounting profit with cash flows from
operations.

2.2 Cash Flows from Investing Activities

This category shows a firm’s ability to maintain and expand its operating capability through the
investment in non-current assets. These activities indicate the extent of new investment in assets which
will generate future profit and cash flows and include the following:

- Cash received from sale of non-current assets and collection of loans made to other parties
- Cash paid for non-current assets acquired, investments in other companies and loans made to other
parties

Illustrative example
$’000 $’000
Purchase of property, plant and equipment (1,280)
Proceeds from sale of equipment 410
Interest received 130
Dividends received 70
Net cash used in investing activities (670)

2.3 Cash Flows from Financing Activities

This section shows the amount of cash which firm’s finance providers have provided or claimed
during the period, as evidenced by the changes in non-current liabilities and owner’s equity of the

138
firm. It indicates the firm’s possible future interest and dividend payments. The activities will include
the following:

- Cash received from issuing shares and bonds, notes as well as proceeds from loans
- Cash paid for repayment of loans, dividends and share redemption

Illustrative example
$’000 $’000
Proceeds from issuance of share capital 500
Proceeds from long-term borrowings 240
Dividends paid* (150)
Net cash from financing activities 590

*This may also be shown as an operating cash flow

2.4 Reconciliation of Cash & Cash Equivalents Balances

The aggregate of the three core categories of cash flows provides an analysis of the movement in a
firm’s cash and cash equivalents from the one period to the next.

Cash and cash equivalents can be found in the statement of financial position and include:
- Cash: cash on hand and demand deposits
- Cash equivalents: short-term, highly liquid investments

Illustrative example
$’000
Net increase in cash and cash equivalents 3,780#
Cash and cash equivalents at beginning of period 12,960
Cash and cash equivalents at end of period 16,740

#
Sum total of net cash flows from the three types of activities
(3,860 – 670 + 590)

3 Importance of Cash Flow Reporting

Since cash is critical to a firm’s survival, it is crucial that attention is paid onto how cash can be
generated. Focusing on the profits earned is insufficient since finance statements are prepared using
the accrual basis, i.e. income is recognised when it is earned (not received) and expenses recorded
when incurred (not paid).

The Statement of Cash Flows provides information that is not available in the Statement of
Comprehensive Income and Statement of Financial Position which is independent on the accounting
policies adopted by the firm. Users can assess how liquid the firm is and predict future cash flows,
which are often needed to value a business.

Activity 2

The statement of financial position for Coates Ltd as at 30 June 2019 is provided below together with
comparative figures for the previous year.

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Coates Ltd
Statement of Financial Position as at 30 June
2019 2018
$’000 $’000 $’000 $’000
Non-current Assets
Fixed assets, at cost 3,200 2,900
(less): Accumulated depreciation (1,740) (1,130)
1,460 1,770

Current Assets
Inventory 740 625
Trade receivables 375 492
Bank 52 36
1,167 1,153
Total assets 2,627 2,923

Share capital and reserves

Ordinary share capital 1,240 1,140
Retained earnings 344 298
1,584 1,438

Non-current Liabilities
8% Loan notes 600 1,100

Current liabilities
Trade payables 443 385
Total equity and liabilities 2,627 2,923

Additional information for the year ended 31 May 2019:

1) Tax expense for the year is $25,000. The same amount has been paid during the financial year.

2) The increase in the retained earnings account is made up of:

$’000 $’000
Opening balance 298
Profit after tax 173
Dividends paid (127)
Retained profit for the year 46
Ending balance 344
3) Non-current assets that had cost $320,000 and with net book value of $240,000 were sold for
$170,000 during the year.
4) Depreciation is $690,000.

Required:
Prepare a Statement of Cash Flows for Coates Ltd for the year ended 30 June 2019.

140
Activity 2 [ANSWERS]

Coates Ltd
Statement of Cash Flows for the year ended 30 June 2019
$’000 $’000
Cash flows from operating activities
Profit tax ( )
Adjustments for:
Depreciation
on disposal of fixed assets (1)
in inventories
in trade receivables
in trade payables
Cash generated from operations
Tax paid
Net cash operating activities

Cash flows from investing activities

Proceeds from sale of fixed assets
Payment for purchase of fixed assets (2)
Net cash investing activities

Cash flows from financing activities

Proceeds from issue of shares
of long-term notes
Dividends paid
Net cash financing activities
Net increase/(decrease) in cash
Cash at beginning of period
Cash at end of period

(1) Gain/(Loss) on disposal = Proceeds – NBV of assets sold

(2) Analysis of Non-current (fixed) assets a/c:
Opening balance + Addition – Disposal (cost) = Ending balance

141
Review Questions

Question 1

Which of the following should be added to net income in calculating net cash flow from operating
activities using the indirect method?

A. Increase in inventories
B. Decrease in receivables
C. Gain on sale of equipment
D. Dividends paid

Question 2

Which of the following items is subtracted from net income when computing cash flows from
operating activities using the indirect method?

A. Loss on disposal of assets.

B. Depreciation expense.
C. Interest income.
D. Sales revenue.

Question 3

Which of the following cash flows are financing activities in the cash flow statement?

(i) Issue of new shares

(ii) Payment for new equipment
(iii) Repayment of bank loan
(iv) Dividends received

A. (ii) and (iii).

B. (i) and (iv).
C. (i) and (iii).
D. (iii) and (iv)

Question 4

Which of the following items will result in cash flow(s)?

(i) Depreciation of fixed assets

(ii) Proceeds from sale of debentures
(iii) Gain on disposal of non-current assets
(iv) Dividends paid

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A. (i) and (iv).
B. (ii) and (iii).
C. (iii) and (iv).
D. (ii) and (iv)

Question 5

The following information has been extracted form the financial statements of Potter Inc as at
31 December 2019:

Potter Inc
Statement of Financial Position as at 31 December
2019 2018
$’000 $’000 $’000 $’000
Non-current assets
Fixed assets, at cost 1,720 1,410
(less): Accumulated depreciation (845) (764)
875 646

Current assets
Inventories 452 378
Trade receivables 283 314
Bank 65 83
800 775
Total assets 1,675 1,421

Share capital and reserves

Ordinary share capital 760 630
Retained earnings 372 175
1,132 805

Non-current Liabilities
5% Loan notes 340 290

Current liabilities
Trade payables 203 326
Total equity and liabilities 1,675 1,421

Additional information for the year ended 31 December 2019:

- Depreciation was $132,000.

- Non-current assets with cost of $165,000 and net book value of $114,000 were sold for $127,000.
- Tax expense for the year is $37,000 with the same amount paid during the financial year.
- Profit after tax was $265,000.
- Dividends of $68,000 were paid.

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Required:
a) Prepare a Statement of Cash Flows of Potter Inc for the year ended 31 December 2019.

b) Using your answers in (a), provide four comments on the cash flow position of Potter Inc.

Question 5 [ANSWERS]

a)
Potter Inc
Statement of Cash Flows for the year ended 31 December 2019
$’000 $’000
Cash flows from operating activities
Profit tax
Adjustments for:
Depreciation
on disposal of fixed assets
in inventories
in trade receivables
in trade payables
Cash generated from operations
Tax paid
Net cash operating activities

Cash flows from investing activities

Payment for purchase of fixed assets
Proceeds from sale of fixed assets
Net cash investing activities

Cash flows from financing activities

Proceeds from issue of shares
Proceeds from issuance of loan notes
Dividends paid
Net cash financing activities
Net increase/(decrease) in cash
Cash at beginning of period
Cash at end of period

b)

Homework Questions (with answers)

144
Question 1

When drawing up a cashflow statement using the indirect method, which of the following groups of
items will be deducted from operating profit when calculating the net cash flow from operating
activities?

A. An increase in inventory and a decrease in accounts receivables.

B. A decrease in inventory and a decrease in accounts receivables.
C. A decrease in inventory and a decrease in accounts payables.
D. An increase in inventory and a decrease in accounts payables.

Question 2

Which of the following items are classified as operating activities cash flows?

(i) Payments for expenses

(ii) Income tax payments
(iii) Loan repayments
(iv) Receipts from sale of goods

A. Items (i) & (iv) only

B. Items (i), (ii) & (iv) only
C. Items (i), (ii) & (iii) only
D. All of the above

Question 3

Which of the following are classified as financing activities in the cash flow statement?

(i) Loan repayments

(ii) Dividends paid
(iii) Sale of fixed assets
(iv) Interest received

A. Only (i) and (ii)

B. Only (i) and (iii)
C. Only (i), (ii) and (iv)
D. All of the above.

Question 4

Which of the following items can be classified a cash flow from investing activities?

A. Interest expense.
B. Issue of debentures.
C. Dividends received.
D. Loss on disposal of assets.

Question 5

145
Which of the following statements about the cash flow statement is true?

A. Cash flows from financing activities include repayment of loans and receipts from the issuance
of shares.
B. Cash flows from investing activities include payments for the purchase of non- current
assets and inventories.
C. Cash flows from operating activities include depreciation and loss on disposal.
D. Cash flows from operating activities include receipts from customers and sales proceeds
from the disposal of non-current assets.

MCQ Answers: D, B, A, C, A

Question 6

The statement of financial position and selected information of Kristen Co as at 30 September 2019 is
provided below together with comparative figures for the previous year.

Kristen Co
Statement of Financial Position as at 30 September
2019 2018
$’000 $’000 $’000 $’000
Non-current Assets
Fixed assets, at cost 1,560 970
(less): Accumulated depreciation (640) (310)
920 660

Current Assets
Inventory 230 185
Trade receivables 94 66
Bank 27 41
351 292
Total assets 1,271 952

Share capital and reserves

Ordinary share capital 840 560
Retained earnings 306 212
1,146 772

Non-current Liabilities
10% Loan notes 80 120

Current liabilities
Trade payables 45 60
Total equity and liabilities 1,271 952

Additional information for the year ended 30 September 2019:

146
1) Profit after tax was $130,000.

2) Depreciation was $387,000.

3) Tax expense for the year is $15,000. The same amount has been paid during the financial year.

4) Non-current assets with cost of $92,000 and accumulated depreciation of $57,000 were sold at a
profit of $8,000.

5) Dividends of $36,000 were paid.

Required:

a) Prepare a Statement of Cash Flows of Kristen Co for the year ended 30 September 2019.

b) Based on your answers above, comment on and evaluate Kristen Co’s cash flows position.

Answers:

Net cash flow from operating activities: $421,000

Net cash flow used in investing activities: $639,000
Net cash flow from financing activities: $204,000
Net decrease in cash and cash equivalents: $14,000

FINANCIAL ACCOUNTING

147
 SESSIONS 11 & 12

FINANCIAL STATEMENT ANALYSIS

At the end of the lecture, students should be able to:

1. Describe basic financial statement analytical methods.

2. Use financial statement analysis to assess the solvency of a business.
3. Use financial statement analysis to assess the profitability of a business.

1.1 Introduction

Financial statement analysis involves the application of analytical tools to general-purpose financial
statements and related data for making business decisions. These tools enable users to interpret the
financial statements prepared in order to assess the organisations’ past performance as well as plan
future actions.

1.2 Need for Financial Statement Analysis

Though financial statements are prepared to enable users to make decisions, individual figures and
absolute amounts found in the statements are not very informative. When analysing financial
statements, it is usual to also observe the relationship between the numbers, their magnitude as well as
the changes over time.

In addition, there are also a variety of users requiring different information for a diverse range of
purposes, such as:

a)Management wish to interpret their organisation’s past performance in order to make

improvements for the future.

b)Employees will like to know the profitability of the organisation and its ability to provide
remuneration and other benefits.

c)Suppliers and lenders are concerned if the company is able to pay them on time.

d)Customers want to assess the long-term stability of the company, especially if they have
purchased products or service that include a continuing involvement with the firm.

e)Governments are interested in assessing if companies are in compliance with regulatory and tax
requirements.

f) Interested parties outside the business may seek to know more about the company’s performance
and financial position (e.g. potential investors).

The lack of detailed information on the face of financial statements may thus not address the concerns
of the various parties reading the reports.
2 Ratio Analysis

148
Ratio analysis is the calculation and interpretation of financial ratios to draw conclusions or highlight
issues of concern about the financial position and performance of a business.

A financial ratio is a relative measure of a relationship between one figure appearing in the financial
statements and another. Ratios are used to comment on the financial position and performance of a
business in relation to its past performance (over time), expected performance (such as budgets) and
competitors’ performance (such as industry averages).

In general, financial ratios can be classified into those that measure profitability and solvency.

3 Profitability ratios

Profitability ratios reflect the ability of the business to generate profit or sales relative to its sales and
resources available. They allow users to evaluate the extent to which resources and invested funds are
being used efficiently.

3.1 Gross Profit Margin

- Percentage of each sales dollar remaining after the firm has paid for its goods.
Gross Profit
Gross Profit Margin =
Sales

3.2 Net Profit Margin

- Percentage of each sales dollar that is earned as net income.
- Indicates the relative profitability of the business after deducting all costs and expenses (excluding
interest and tax).
-
Net Profit after Tax
Net Profit Margin =
Sales

3.3 Return on Capital Employed [ROCE]

- Measures overall efficiency of company in employing resources available to earn profit.

Profit before Interest and Tax

Return on Equity =
Capital Employed #
#
Capital Employed = Non-Current Liabilities + Equity or Total assets – Current Liabilities

3.4 Return on Equity

- Measures the return earned on the ordinary shareholders’ investment in the firm.
- More restrictive view of capital than ROCE.

Net Profit after Tax and Preference Dividends

Return on Equity =
Ordinary Share Capital + Reserves
3.5 Asset Turnover

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- Measures efficiency of use of assets to earn sales revenue.
Sales
Asset Turnover =
Total Assets

4 Solvency ratios
Solvency ratios measure the ability of the firm to meet its current and non-current obligations as well
as the extent which the firm’s activities are financed by borrowing externally and the firm’s ability to
service the debt. They are classified as liquidity/working capital and debt/gearing ratios.

4.1 Liquidity and Working Capital ratios

Liquidity refers to the amount of cash that a business has in hand to pay its short-term debts and meet
any unforeseen needs for cash. Thus, these ratios measure the ability of the firm to meet its current
obligations and its short-term solvency. Examples of liquidity ratios include:

4.1.1 Current ratio

- Measures the ability of business to pay its current liabilities.

Current Assets
Current Ratio =
Current Liabilities

4.1.2 Quick (Acid-Test) ratio

- Measures a firm’s ability to settle immediate or short-term debts by disregarding illiquid and
subjectively valued inventory in the analysis.

Current Assets - Inventory

Quick (Acid-Test) Ratio =
Current Liabilities

Working capital refers to cash tied-up in the day-to-day operations of the business and involves the
management elements such as inventory, trade receivables and trade payables. Examples of working
capital ratios include:

4.1.3 Inventory Turnover Period

- Shows how long inventory is held before sale and thus indicates the frequency of inventory sale
and replacement during the year.

Inventory
Inventory Turnover Period = × 365
Cost of Sales

- A lower inventory turnover period is preferred, though certain factors need to be considered
include, such as:

150
 o Lead times
o Seasonal fluctuations in orders
o Alternative uses of warehouse space
o Bulk buying discounts
o Likelihood of inventory perishing or becoming obsolete

4.1.4 Accounts Receivable Collection Period

- Shows how many days it takes to collect amount due to business from credit customers and thus
how many days’ sales remain uncollected in accounts receivable.
Accounts Receivable
Accounts Receivable Collection Period = × 365
Credit Sales

4.1.5 Accounts Payable Payment Period

- Shows how many days it takes the company to pay amount due to creditors after purchases were
made. May indicate credit terms offered by suppliers or negotiation skills of company.
Accounts Payable
Accounts Payable Payment Period = × 365
Credit Purchases

4.2 Debt and Gearing ratios

These ratios show the amount of money that a company owes relative to its size and how reliant it is
on external debt financing. High amount of gearing increases the financial risk of a business, and there
is a greater chance of business failure in the future.

4.2.1 Debt ratio

- Shows the ratio of a company’s total debts to its total assets, i.e measures proportion of company's
assets that is financed by borrowings.
- The higher the ratio, the higher the financial risk the company faces.
Total Debts
Debt Ratio =
Total Assets

4.2.2 Gearing ratio

- Indicates the long-term capital structure of the company and the proportion of its long-term funds
that is raised from debt holders as compared to equity holders.

Total Non-Current Liabilities

Gearing Ratio =
Shareholders' Equity + Total Non-Current Liabilities
4.2.3 Interest Cover

151
- Measures the firm's ability to make interest payments from profits earned.

Profit before Interest & Tax

Interest Cover =
Interest Expense

5 Limitations of Ratio Analysis

Despite the usefulness of financial ratios, there are several issues with ratio analysis including:

- As companies need time to prepare their financial statements, information in the reports provided
is often outdated and thus may affect the usefulness of the ratios computed.
- Historical cost information may not be the most relevant for decision making. This is especially so
for businesses which operate in economies with significant inflation.
- Validity of analysis depends on the accounting policies adopted by the company. Comparison of
ratios over time is affected if the business changed its accounting policies, or the nature of its
activities, during that time. When comparing company data to competitors, different companies
may apply different accounting policies, which will then affect the figures reported in their
financial statements and impact the analysis conducted.
- Comparative information is not always available for meaningful analysis.
- Lack of detailed or specific information in published financial statements may make ration analysis
difficult.

Activity

Tech-Line Ltd
Statement of Comprehensive Income for the year ended 31 December

20X8 20X7
$’000 $’000
Sales 4,520 2,890
Cost of goods sold (2,570) (1,670)
Gross profit 1,950 1,220
Operating expenses (620) (410)
Operating income 1,330 810
Interest expense (50) (20)
Profit before tax 1,280 790
Income tax expense (60) (40)
Profit after tax 1,220 750

Statement of Financial Position as at 31 December

20X8 20X7
$’000 $’000 $’000 $’000

152
 Non-current Assets
Fixed assets, net 2,396 1,376

Current Assets
Inventory 585 247
Trade receivables 408 243
Other receivables and prepayments 215 62
Cash 106 114
1,314 666
3,710 2,042

Current Liabilities
Trade payables 526 315
Other payables 104 97
630 412

Non-current Liabilities
10% Loan notes 400 220

Shareholders’ Equity
Ordinary share capital 400 350
Retained earnings 2,280 1060
2680 1410
3,710 2,042

Required:
Compute ratios to analyse Tech-Line Ltd's profitability and solvency for 20X8 as compared to 20X7.

Activity [ANSWERS]

Ratio Formula 20X8 20X7

$’000 $’000
Profitability ratios
(1) Gross profit margin Gross Profit 1,220
Sales 2,890
¿ = 0.4314
¿ or 43.14%

- Gross profit margin has __________________________ from 20X7 to 20X8, mainly due
to the increased sales.
- _________ in the rate means _________ sales dollars are available to cover operating
expenses in 20X8 compared to 20X7.

(2) Net profit margin Net Profit after Tax 750

Sales 2,890
¿= 0.2595
¿ or 25.95%

153
Ratio Formula 20X8 20X7
$’000 $’000
- Net profit margin has __________________________ from 20X7 to 20X8.
- _________ in the rate means _________ sales dollars are providing profit and _________
sales dollars are absorbed by expense in 20X8 compared to 20X7.

(3) Return on capital Profit before Income & Tax 810

Employed [ROCE] Capital Employed (220 + 1,410)
¿= 0.4969
¿ or 49.69%

- ROCE has ___________ from 20X7 to 20X8.

- ___________ in ROCE suggests __________________ in utilising available funds to earn
profits in 20X8 compared to 20X7.
- May be compared with current borrowing rate of the firm to assess adequacy of return.

(4) Return on equity Profit after Tax and Preference Dividends 750
[ROE] Ordinary Share Capital + Reserves 1,410
¿ = 0.5319
¿ or 53.19%

- ROE has _________________________ from 20X7 to 20X8, suggesting ____________

return earned for shareholders in 20X8 compared to 20X7.
- The change in ratio may be attributed to ______________________________ despite
higher debt financing through the issue of loan notes.

(5) Asset turnover Sales 2,890

Total Assets 2,042
¿ = 1.42

- There has been __________________ in asset turnover from 20X7 to 20X8, suggesting
__________________ use of assets to earn sales revenue in 20X8 compared to 20X7.
- Change in ratio may be attributed to _________________________________ in 20X8.

Liquidity and working capital ratios

(6) Current ratio Current Assets 666
Current Liabilities 412
¿ = 1.62

- Current ratio has _____________ from 20X7 to 20X8, suggesting _____________ ability
to pay its debts in 20X8 compared to 20X7 when they fall due
- The change in ratio is probably due to _______________________________________.

154
Ratio Formula 20X8 20X7
$’000 $’000
(7) Quick ratio Current Assets - Inventory (666 - 247)
Current Liabilities 412
¿ = 1.02

- __________________ in quick ratio from 20X7 to 20X8 suggests ____________ liquidity

and _____________ ability to pay its debts at very short notice in 20X8
- Though commendable, the increase is mainly due to ______________________________
__________________________.

(8) Inventory Inventory 247

× 365 ×365
Turnover Period Cost of Sales 1,670
¿ = 53.99

- There has been ___________________________ in inventory turnover period, attributable

to the ________________________________________ held by the firm in 20X8.
- This suggests __________ inventory management, which may adversely affect the
company's liquidity position.

(9) Accounts Accounts Receivable 243

× 365 ×365
Receivable Credit Sales * 2,890
Collection Period ¿ = 30.69

(*Assume all sales are on credit)

- The ratio has __________ from 20X7 to 20X8, suggesting __________ in collection of
debts from customers after sales have been made.
- This may suggest that the company is __________________ in collecting debt or has
offered a ____________________________ to its customers.
- This may affect the company's liquidity position adversely.

(10) Accounts Payable Accounts Payable 315

× 365 ×365
Payment Period Credit Purchases * 1,670
¿ = 68.85

(*Assume same as COGS)

- Payment period has __________ in 20X8 compared to 20X7 suggesting that the company
has taken a __________ time to pay its suppliers
- This may be due to ____________________ offered by suppliers or _________________
__________ of the company. On the other hand, the company may have made prompt
payments in order to ______________________________.
- The company’s liquidity has deteriorated from 20X7 to 20X8.

Debt and Gearing ratios

155
Ratio Formula 20X8 20X7
$’000 $’000
(11) Debt ratio Total Debts (412+220)
Total Assets 2,042
¿= 0.3095
¿ or 30.95%

- ___________ in the ratio suggests ____________ debt position and lower financial risk in
20X8, mainly attributed to a higher asset base despite an increase in loan notes issued.

(12) Gearing ratio Total Non-Current Liabilities 220

Shareholders' Equity (220+1,410)
+ Total Non-Current Liabilities ¿= 0.135
¿ or 13.5%

- ___________ in the ratio suggests ______________ gearing & __________ financial risk
in 20X8 compared to 20X7.
- This can be attributed to the ____________________________ , particularly the issue of
more shares, which offsets the increase in loan notes issued by the company.

(13) Interest Cover Profit before Interest & Tax 810

Interest Expense 20
¿ = 40.50
- Interest cover has ____________________________ from 20X7 to 20X8, mainly due to
the ____________________________ issued by the company.
- This increased the financial risk faced by the company due to higher future interest
payments and greater risk of default.

156
Review Questions

Question 1

Which of the following can explain a change in asset turnover from 0.05 to 0.09 if there was no
change in total assets?

A. Decrease in sales volume

B. Increase in revenue
C. Decrease in administrative expenses
D. None of the above

Question 2

Which of the following statements is true if a company observes an increase in its accounts receivable
collection period?

A. Inventory turnover period has increased.

B. Sales of inventory has decreased.
C. Collection from credit customers has been made at a slower pace.
D. Credit customers have paid the company sooner than before.

Question 3

Which of the following would most likely account for a lower inventory turnover period for a
merchandising company?

A. More frequent sale of inventory.

B. Slower sales of inventory.
C. Prompt payment by credit customers.
D. Increase in inventory purchases.

Question 4

Which one of the following groups of ratios help to evaluate a company’s solvency?

A. Net profit margin and Interest cover

B. Return on equity and Gearing ratio
C. Current ratio and Return on capital employed
D. Debt ratio and Quick ratio

Question 5

Which of the following groups of ratios are used to evaluate the liquidity of a company?

A. Return on capital employed and Debt ratio

B. Gross profit margin and Return on equity
C. Current ratio and Accounts receivable collection period
D. Quick ratio and Asset turnover

157
Question 6

Cider Ltd
Statement of Comprehensive Income for the year ended 31 December
2019 2018
$’000 $’000
Sales 840 950
Cost of goods sold (480) (530)
Gross profit 360 420
Operating expenses (210) (260)
Profit before tax 150 160
Income tax expense (40) (30)
Profit after tax 110 130

Statement of Financial Position as at 31 December

2019 2018
$’000 $’000 $’000 $’000
Non-current Assets
Tangible assets, net 510 450

Current Assets
Inventory 118 72
Trade receivables 76 68
Cash and cash equivalents 53 45
247 185
757 635
Current Liabilities
Trade payables 95 78

Non-current Liabilities
Bank loan 200 180

Shareholders’ Equity
Ordinary share capital 200 200
Retained earnings 262 177
462 377
757 635

Required:
Calculate the following ratios for Cider Ltd for the year ended 31 December 2019 and 2018 and
comment on the company’s financial performance. (Show all workings clearly and round off your
answers to two decimal places.)
i) Quick ratio
ii) Inventory turnover period
iii) Interest cover
iv) Asset turnover
v) Return on equity

158
Homework Questions (with answers)

Question 1

Which of these are possible reasons for firms having poor liquidity ratios?

(i) Inability to collect debts from customers

(ii) Capital contribution by owner
(iii) Long inventory turnover period

A. Only (i) and (ii).

B. Only (ii) and (iii).
C. Only (i) and (iii).
D. All of the listed items.

Question 2

Which of the following may account for a decrease in asset turnover ratio?

A. Increased sales to credit customers.

B. Acquisition of non-current assets.
C. Reduction in operating expenses.
D. Lower inventory turnover period.

Question 3

How can a company decrease its gearing?

(i) Pay out dividends

(ii) Issue new shares
(iii) Issue new bonds
(iv) Redeem debentures

A. Only (ii) and (iv)

B. Only (i) and (ii)
C. Only (i) and (iv)
D. Only (ii) and (iii)

Question 4

Which of the following ratios are used to evaluate a company’s solvency?

(i) Gross profit margin

(ii) Interest cover
(iii) Inventory turnover period

A. Items (i) & (iii) only

B. Items (i) & (ii) only
C. Items (ii) & (iii) only
D. All of the above

159
Question 5

Which of these statement(s) is/are FALSE?

(i) Current ratio measures the instant debt-paying ability of the business
(ii) Profitability ratios measure a company’s liquidity position.
(iii) Solvency ratios measure the ability of the firm to meet its liabilities.

A. Only (i)
B. Only (ii) and (iii)
D. Only (ii)
D. Only (i) and (ii)

MCQ Answers: C, B, A, C, D

Question 6

The following financial information has been extracted for two competing companies in the same
industry, Surf and Turf:

Statement of Comprehensive Income for the year ended 30 September 2019

Surf Turf
$’000 $’000
Sales 18,250 15,400
Cost of goods sold (11,600) (9,630)
Gross profit 6,650 5,770
Operating expenses (4,830) (3,910)
Operating income 1,820 1,860
Interest expense (150) (370)
Profit before tax 1,670 1,490
Income tax expense (290) (240)
Profit after tax 1,380 1,250

Statement of Financial Position as at 30 September 2019

Surf Turf
$’000 $’000 $’000 $’000
Non-current Assets
Tangible assets, net 5,420 4760

Current Assets
Inventory 1960 1240
Trade receivables 2670 2530
Cash and cash equivalents 1520 1160
6150 4930
Total assets 11,570 9,690

160
 Current Liabilities
Trade payables 2,090 2,180

Non-Current Liabilities
Long-term loans 1,400 3,200

Shareholders’ Equity
Ordinary share capital 5,800 3,100
Retained earnings 2,280 1,210
8,080 4,310
Total equity and liabilities 11,570 9,690

Required:
a) Calculate the following ratios for Surf and Turf. Based on the ratios computed, comment on the
liquidity position of both companies.

i) Current ratio
ii) Inventory turnover period
iii) Debt ratio

b) Calculate the following ratios for Surf and Turf. Comment on the ability of both companies to
generate profit based on the ratios computed.

i) Net profit margin

ii) Return on capital employed
iii) Return on equity

Key Answers:
Surf Turf
(a) (i) 2.94 2.26
(ii) 61.67 47.00
(iii) 30.16% 55.52%

(b) (i) 7.56% 8.12%

(ii) 19.20% 24.77%
(iii) 17.08% 29.00%

161