Chapter 1

Introduction to financial
accounting
Discussion questions
1 What is the basic purpose of financial accounting?
The basic purpose of financial accounting is to produce useful information which is used
in many and varied ways. People use the information generated by financial accounting
to improve their decision-making in allocating scarce resources.

2 Distinguish between financial performance and financial position.

Financial performance means generating new resources from day-to-day operations over
a period of time. Financial position is the organisation’s set of financial resources and
obligations at a point in time.

3 What is the difference between financial and management accounting?

Managerial accounting is a branch of accounting that is oriented towards helping
managers and others inside the enterprise. Financial accounting has a more external
focus, and is often used by parties external to the enterprise, such as, shareholders,
investors, bankers, legislators and employees etc.

4 Who are the main parties that comprise the social setting of accounting?
The main parties that comprise the social setting of accounting are:
– the information users (the decision makers)
– the information preparers, who put the information together to facilitate the
users’ decision-making
– the auditors, who assist the users by enhancing the credibility of the
information, providing a professional opinion that the information is fair and
appropriate.

5 What is meant by credible periodic reporting? What prevents organisations from

making financial statements increasingly credible? (Consider cost–benefit
implications.)
Credible periodic reporting means that trustworthy and competently prepared financial
reports are provided on a regular basis. The cost involved in making the reports
absolutely accurate and perfect would be enormous, and may outweigh the benefit
obtained in achieving the highest level of credibility possible. The information has to be
worth its cost!

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6 List four important users of financial accounting and describe the use that each user
would make of the information.
The important users that could be listed are shown in the table below:
User Usage of the financial accounting information
Owner To evaluate the success of the business, and whether or not the
business is functioning well, and is achieving its financial goals.
Potential owner To gain an insight into the enterprise, and make a decision as to
whether or not to invest in the enterprise. Also to use the past
financial results as an indicator of the future functioning of the
business.
Creditors and potential To ascertain the ability of the enterprise to repay any debts or
creditors potential debts that the enterprise may have.
Managers To ascertain whether or not the business has achieved its financial
goals, and to provide a basis for development of future business
goals and business plans. Also to compare the results of their
enterprise with those of its competitors, using financial
information as a common denominator.
Employees Out of interest to gain further insight into the functioning of the
business they work for. Also to assess: whether or not the business
is able to pay wages as they fall due, the employers future demand
for the employees’ services, and to use the information in
bargaining for wage increases.
Regulators and other To check that the enterprise is functioning well, and is not carrying
government bodies and on business in any manner that may contravene any laws or
agencies regulations. Also, to provide some knowledge of businesses, which
may be used to develop new regulations, or modify existing
regulations.
Financial and market The results would be scrutinised in depth, and further analysed to
analysts provide deep insight into the enterprise. This information could
then be used by the analysts to make investment decisions, or the
information could be sold to interested parties. The financial
results of many enterprises could be analysed and compared to
gain an understanding of the market as a whole.
Competitors To allow them to compare themselves with other enterprises, to
see how they are functioning in comparison. Also to gain insight
into their operations, and to use that information to improve their
business, by gaining ideas from their competitors’ business.
Accounting researchers To evaluate how accounting is practised in the practical business
environment, and to use this information as a basis for theories,
and the development of new accounting standards.
Miscellaneous third parties Usage depends on the specific party using the information.
e.g. Journalists use the information to evaluate businesses and
compare various enterprises, so that they can write articles relating
to certain industries and/or businesses and/or economic trends
e.g. Politicians make judgements about industry efficiency or
taxation levels
e.g. Judges may evaluate the enterprise’s ability to pay if it loses a
lawsuit

7 Do all users of financial accounting have the same information needs? Why, or why
not?
Users of financial statements do not all have the same information needs. They are all
different people, with differing objectives, preferences and capabilities, so they are likely

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to need different information to meet these differences in decision-making. Probably
most users share an interest in fair, timely information, but the details of that information
depend on the decision(s) each user is making.

8 List some similarities and differences between the need for financial information
between shareholders and bankers.
Similarities
Both parties would be interested in past profits and cash flows to provide them
with the relevant information.
Differences
Shareholders are particularly interested in dividends and potential growth in
share price; bankers are more concerned with the ability of the company to repay its
debt.

9 List five situations in which judgement is required by the preparers of financial

information.
The following are some suggested situations where judgement is required by preparers
of financial information, however this list is not exhaustive!
– deciding which accounting policies to use
– deciding on the level of depth of information that is provided in financial
reports
– deciding on when to provide financial information, including how often, as
well as at what time of the year
– deciding on how to technically keep the records, for example, using computers
versus human effort, what the various records will look like, etc.
– deciding on whether or not to be ethical in reporting the financial information
– deciding in which period a transaction occurs
– deciding on how to measure a transaction, for example a property that cost
$100 000 ten years ago may be worth $500 000 today. Therefore, how do
preparers decide on the value of assets/ liabilities to be reported.

10 What does an audit achieve?

An audit enhances the credibility of an organisation’s financial statements. An auditor
provides an opinion on whether the financial statements are fairly presented.

11 Describe what is meant by accrual accounting. How does it differ from cash
accounting?
Accrual accounting includes the impact of transactions on the financial statements in the
time periods where revenues and expenses occur rather than when the cash is received or
paid. Cash accounting only accounts for revenues and expenses when cash is paid or
received by the enterprise.

12 Who uses accrual accounting?

Most businesses and organisations use accrual accounting.

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13 Which of the following terms would you see in financial statements prepared under
(a) accrual accounting and (b) cash accounting: accounts payable, accounts
receivable, cash and inventory?
Term a) Accrual accounting b) Cash accounting
Accounts payable Yes No
Accounts receivable Yes No
Cash Yes Yes
Inventory Yes Yes

14 What are the three key financial statements, and what relevant information do they
provide to users of accounting reports?
The key financial statements and the information they provide are:
i a balance sheet which shows the financial position at a point in time;
ii an income statement which measures financial performance over a defined
period (such as a month or a year) by deducting expenses from revenues
during the period to obtain profit for the period;
iii a statement of cash flows which shows the sources and uses of cash during the
period. Operating, financing and investing activities are included in this
statement.

15 Explain, in simple terms, each of the following financial accounting assumptions:

a accounting entity
b accounting period
c monetary
d historical cost
e going concern
f materiality.
a. Accounting entity: under this concept the accounting entity is separate and
distinguishable from its owners. For example, the accounting entity of a sole trader is
differentiated from the financial affairs of the owner. Similarly, a company is a separate
entity from its shareholders. If either the sole trader or a shareholder of a company goes
out and buys a new set of golf clubs, it may affect their personal finances but does not
affect the accounting entity. Accounting entities do not necessarily correspond to legal
entities. For example, as noted above, the personal financial affairs of the sole trader can
be separated from the finances of the business, even though there is no legal distinction.
This concept puts a boundary on what transactions are to be recorded for any particular
accounting entity. It also allows the owner to evaluate the performance of the business.
b. Accounting period: the life of a business needs to be divided into discrete periods to
evaluate performance for that period. Dividing the life of an organisation into equal
periods to determine profit or loss for that period is known as the accounting period
concept. The time periods are arbitrary but most organisations report at least annually,
with large companies preparing half-yearly and quarterly financial statements for outside
purposes and at least monthly (sometimes more frequently) for management purposes.
c. Monetary: accounting transactions need to be measured in a common denominator
that in Australia is, not surprisingly, the Australian dollar. This allows comparisons
across periods and across different companies. Transactions that cannot be reasonably
assigned a dollar value are not included in the accounts. This concept also assumes that
the value of the monetary unit is constant over time, which ignores inflation.

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d. Historical cost: under this concept, assets are initially recorded at cost. As you will
see in later chapters many assets such as inventory will still be recorded at cost in the
Balance Sheet in subsequent periods even though their value has increased. Some other
assets such as property, plant and equipment can be revalued periodically. Thus, in
reading a Balance Sheet it is important to note at what valuation the assets are being
recorded.
e. Going concern: financial statements are prepared on the premise that the organisation
will continue operations in the foreseeable future. If this is not the case then it is
necessary to report the liquidation values of an organisation’s assets.
f. Materiality: under this concept, all transactions are recorded, but items that have a
small dollar value are expensed rather than included as an asset on the Balance Sheet.
For example, a box of pens that costs $13 and has a useful life of two years would be
treated as a stationery expense rather than as an asset.

16 Do you think lecturers should have the right to use their own judgement in
determining subject grades, or should those grades be based on objectively set
exams administered by someone other than lecturers? Why? Do you think
companies’ management should have the right to choose the accounting policies and
methods by which their performance is measured? Why? How do these two cases
differ, if at all?
At this point, students have little ‘accounting’ knowledge, having read only the
introductory ideas of Chapter 1. The purpose of this question is to have the students think
about information and control over it in a context they can relate to and, in the process,
suggest to the students that they may have more to say about accounting issues than they
thought because accounting is basically just a kind of information. Instructors should
encourage wide discussion of the questions raised and might try to draw out of the
students some of the fundamental issues the book will deal with.
Some points in favour of lecturers’ setting grades or management choosing
accounting policies:
i Being in charge of the course/company, the lecturer/manager has the expertise
to set grades/choose policies competently.
ii Being close to the situation, the lecturer/manager will appreciate the practical
issues and nuances behind a coherent and fair result.
iii It is to the lecturer’s/manager’s advantage to do the job well so as to avoid
getting into trouble with students/shareholders, being sued, etc.
iv Society gives professionals (educators or managers) some rights over others
because there are advantages to society (e.g. motivating good people to enter
professions, encouragement of expertise) and professionals agree to be ethical
in return.
v Having someone else do it may produce bureaucracy, red tape and general
insensitivity to the needs of each subject/company.
vi The lecturer’s/manager’s actions can be monitored or reviewed (‘audited’) and
penalties assessed for improper behaviour.
Some points against lecturers’ setting grades or management choosing
accounting policies:
i As the result reflects on the lecturer’s/manager’s performance, she/he may try
to ‘look good’ instead of letting the measures be objective.
ii The lecturer/manager may be influenced by incentives or constraints beyond
the grades or accounting figures (e.g. a wish to do research instead in order to

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 get tenure or an eye on the possibility of being hired by another company) and
so the results may improperly reflect those incentives or constraints.
iii Even with the best will, the lecturer/manager does not have the same
perspective on the matter as do the students/shareholders and so may not
produce the results they would have preferred.
iv Lots of damage from inappropriate behaviour can result before that behaviour
is detected and curtailed.
v Being a good lecturer/manager is a different task from being a good
grader/accountant, so the lecturer/manager may not in fact have great expertise
in setting grades/accounting policies.
vi The lecturer/manager may have unconscious (or conscious) decision-making
biases or prejudices that may produce results that are on average fair but may
help or hurt individual students/shareholders.
As the above presentation of points has suggested, students should be
encouraged to see the similarities in the two cases. As their knowledge develops,
students may see more differences, but many points remain fundamentally similar
because they concern basic information issues such as the following (to be examined
in the book):
– fitting the information to the problem
– serving the user’s needs
– motives of the information producer
– expertise of the information producer
– monitoring (auditing) information production
– performance evaluation
– rules and standards to control the process
– ethics and professionalism.

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Problems
Problem 1.1

Calculate accrual accounting profit

John Smith set up his own catering business on 1 July 2015. During the 12 months up
to 30 June 2016 the following transactions occurred:
1 John put $10 000 of his own money into the business.
2 He borrowed $20 000 from the bank for one year at 5 per cent per annum, with
interest to be paid at the end of the loan.
3 He paid $10 400 in wages and owed $3000 in wages for work done.
4 He bought catering equipment for $6000, which has an expected useful life of
three years.
5 He paid other expenses of $12 300.
6 John sent bills for $60 000 to customers for work performed between 1 July 2015
and 30 June 2016. By 30 June he had received $45 000 and expected the other
$15 000 by August.
Using the concepts of accrual accounting, calculate John’s profit for the year ended 30
June 2016.

Answer 1.1
Revenue 60 000
Expenses
Interest (20 000 x 0.05) (1 000)
Wages (10 400 + 3000) (13 400)
Depreciation (6,000 ÷ 3) (2 000)
Other (12 300)
Profit $31 300

Problem 1.2

Prepare a balance sheet and calculate profit

1 Given the following balances, prepare a balance sheet as at 30 June 2016 for
Palm Tree Limited.
$
Bank loan 40 000
Share capital 160 000
Wages payable 60 000
Accounts payable 80 000
Inventory 140 000
Cash at bank 50 000
Buildings 200 000
Retained profits 90 000
Accounts receivable 40 000

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2 The company did not declare any dividends during the year. Its balance in
retained profits at the start of the year was $60 000. What is the profit for the
year?

Answer 1.2
1
Palm Tree Limited
Balance sheet
as at 30 June 2016
$
Assets
Cash at bank 50 000
Accounts receivable 40 000
Inventory 140 000
Buildings 200 000
Total assets 430 000

Liabilities and shareholders’ equity

Liabilities
Bank loan 40 000
Wages payable 60 000
Accounts payable 80 000
Total liabilities 180 000

Shareholders’ equity
Share capital 160 000
Retained profits 90 000
Total shareholders’ equity 250 000
Total liabilities and shareholders’ equity 430 000

2 Profit for year ended 30 June 2016 = Retained profits at end of year – Retained
profits at start of year
= 90 000 – 60 000
= $30 000

Problem 1.3

Content of financial statements

Consider the list of accounts given and categorise them as an asset, liability or
shareholders’ equity item that would appear on the balance sheet or a revenue or
expense that would appear on the income statement by ticking the appropriate
column.
Asset Liability Stockholders’ Revenue Expense
Equity
Buildings
Accounts payable
Rent expense
Retained profits
Sales
Accounts receivable

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Equipment
Cost of goods sold
Inventory
Share capital
Provision for employee
entitlements

Answer 1.3
Asset Liability Stockholders’ Revenue Expense
Equity
Buildings 
Accounts payable 
Rent expense 
Retained profits 
Sales 
Accounts receivable 
Equipment 
Cost of goods sold expense 
Inventory 
Share capital 
Provision for employee 
entitlements

Problem 1.4

What are various people’s interests in financial accounting?

Briefly describe what each of the following people would likely want to learn from
the financial statements of BrandX Ltd, and how each might be affected if the
statements showed good or bad financial performance or financial position.
1 The chief executive officer (CEO) of the company
2 The company’s chief accountant
3 The chairperson of the company’s board of directors (the board evaluates the
president’s performance on behalf of the shareholders)
4 The partner of auditing firm Dimbleby & Co, for whom BrandX is a client
5 The local manager of tax collections for the Australian Taxation Office
6 John Flatstone, who owns 100 shares of BrandX
7 Mildred Evans, who is thinking of buying some shares of the company
8 The local manager of Big Bank, which has made a large loan to BrandX

Answer 1.4
Person Information wanted How affected
1 CEO Profitability Salary, bonus and tenure
Financial stability or growth
2 Chief Accountant Profitability Salary
Liquidity Continuity of employment
3 Chairperson of Adequacy of capital, profitability, Recommend dividend
Board of Directors growth, market share Recommend share issue
Recommend borrowing of funds

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4 Partner of auditing Whether financial statements are Provide: unqualified opinion
firm fairly presented except for opinion
adverse opinion
inability to form opinion
5 Local manager of tax Taxable income Whether calculated in
collections accordance with legislation
6 Shareholder Profitability Sell shares or buy additional
Dividends proposed shares
Market price of shares
Prospects of bonus issue
7 Potential shareholder As for shareholder Purchase shares
8 Local bank manager Liquidity Require payment of loan
Profitability Seize assets given as security
Regular payment of interest

Problem 1.5

What are various people’s interests in financial accounting?

Briefly describe what each of the following groups would like to know from the
financial statements of the Swans Football Club.
1 The CEO
2 The players
3 The supporters
4 The suppliers of meat pies and beer for home games

Answer 1.5
1 – The profit for the period which is revenue minus expenses. Profit will be
one of the performance indicators for the CEO. If the club is making a loss
there will be issues about the financial viability of the club.
– Financial position: as provided by the balance sheet. A strong balance sheet
will make it easier for the CEO to carry out their strategic initiatives, e.g.
new training facilities.

2 – Cash flow is critical as the players’ payments depend on it.

– The higher the profit the more likely the players can argue for pay
increases.

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

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

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Problem 1.6

Users and their needs

Accounting information is demanded by a wide range of users, including

shareholders, company management, suppliers, bankers, trade unions, the Australian
Securities and Investments Commission (ASIC) and the Australian Taxation Office
(ATO). Which user is likely to seek each of the following types of information?
1 The likelihood of the company meeting its interest payments on time
2 The profitability of each division in the company
3 The financial position and performance of a company issuing shares to the public
for the first time
4 The prospects for future dividend payments
5 The probability that the company will be able to pay for its purchases on time
6 The profitability of the company based on the tax law
7 The profitability of the company since the last contract with employees was
signed

Answer 1.6
User Type of Information
Bankers The likelihood of the company meeting its interest payment on time
Company Management The profitability of each division of the company
ASIC Financial position and performance of a company issuing shares to
the public for the first time
Shareholders Prospects for future dividend payments
Suppliers Probability that the company will be able to pay for its purchases
on time
Australian Tax Office Profitability of company based on tax law
Trade Unions Profitability of company since last contract with employees was
signed

Problem 1.7

Accrual profit

Brick Limited made cash sales of $550 000 and credit sales of $370 000 ($220 000 of
which had been collected by year-end). It also paid $410 000 in expenses and owed
$230 000 at year-end. What was the accrual profit?

Answer 1.7
Sales
Cash sales 550 000
Credit sales 370 000
Total sales 920 000

Expenses
Total expenses (410 000 + 230 000) 640 000

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 Accrual profit = Total sales – Total expenses
= 920 000 – 640 000
= 280 000

Problem 1.8

Accrual profit
1 During the year that ended 30 June 2016, French Horn Ltd made cash sales of
$100 000, credit sales of $200 000 ($50 000 of which were still to be collected at
year-end), and received $25 000 owing from credit sales, which occurred in May
2015. What is French Horn’s sales revenue for the year ended 30 June 2016?
2 Also during the year ended 30 June 2016, French Horn paid $60 000 and owed
$10 000 in employee wages. Of the $60 000 paid, $5000 related to wages payable
as at 30 June 2015. What is the total of French Horn’s accrual accounting
expenses?
3 What is French Horn’s accrual accounting profit for the year ended 30 June
2016?

Answer 1.8
1 Sales revenue for the year ended 30/06/16
= $100 000 + $200 000
= $300 000
2 Accrual accounting expenses for the year ended 30/06/16
= $60 000 + $10 000 – $5000
= $65 000
3 Accrual accounting profit for the year ended 30/06/16
= Revenue – accrued expenses
= $300 000 – $65 000
= $235 000

Problem 1.9

Calculate accrual accounting profit

Fred Jones started a consulting business on 1 March 2016. During the period up to 30
June 2016, the following transactions occurred.
1 Fred put $10 000 of his own money into the business.
2 He borrowed $30 000 from the bank at 10 per cent per annum for one year with
interest to be repaid at the end of the loan.
3 He sent bills for $35 000 to customers for work performed. By 30 June he had
received $30 000 and expected the other $5000 in July.
4 He bought a computer for $8100 that has an expected useful life of three years.
5 He paid $12 000 in wages.
6 He paid other expenses of $20 000.
7 He received a $500 bill for advertising (appeared in newspapers in May; will be
paid in July).
Using the concepts of accrual accounting, calculate Fred’s profit for the four months
ending 30 June 2016.

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Answer 1.9
$ $
Revenue 35 000
Less expenses
Interest (30 000 x 10/100 x 4/12) 1000
Depreciation (8,100 x 4/36) 900
Wages 12 000
Advertising 500
Other expenses 20 000 34 400
Net profit 600

Problem 1.10

Comparing net profits and cash flow

Kingsford Customs was founded on 1 July 2016. At the end of first year’s operations,
the following summary of its activities has been prepared by the owner.
1 Borrowed cash of $60 000 from CAA Bank.
2 Employees earned $96 800 of wages, of which $40 000 is to be paid in the next
accounting period.
3 Performed customised services that generated sales revenue of $243 300, of
which $100 000 remained uncollected at the end of the year.
4 Other operating expenses, including phone bills and electricity that amounted to
$26 800, were incurred during the year. Of this amount, $10 000 remained unpaid
at the end of the year.
Show the effect on net profit and cash of each of the above transactions for this
accounting period.

Answer 1.10
Net Profit Cash
1 - +60 000
2 -96 800 -56 800
3 +243 300 +143 300
4 -26 800 -16 800

Problem 1.11

Contents of financial statements

Match each item with the financial statement it would appear in by ticking the
appropriate column.
Item Balance Sheet Income Statement of
Statement Cash Flows
Wages expense
Cash paid for equipment
Cash at bank
Equipment
Cash flow from customers
Accounts payable
Cash paid to employees
Sales revenue

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Answer 1.11
Item Balance Sheet Income Statement of
Statement Cash Flows
Wages expense 
Cash paid for equipment 
Cash at bank  
Equipment 
Cash flow from customers 
Accounts payable 
Cash paid to employees 
Sales revenue 

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

Problem 1.12

Contents of financial statements

Match each item with the financial statement that it would appear in by ticking the
appropriate column.
Item Asset Liability Shareholders’ Revenue Expense
Equity
Administrative expenses
Cash at bank
Marketing expenses
Buildings
Income taxes payable
Loans from banks
Accounts payable
Retained profits
Accounts receivable
Income tax expense
Cost of goods sold
Sales Revenue
Inventories

Answer 1.12
Item Asset Liability Shareholders’ Revenue Expense
Equity
Administrative expenses 
Cash at bank 
Marketing expenses 
Buildings 
Income taxes payable 
Loans from banks 
Accounts payable 
Retained profits 
Accounts receivable 
Income tax expense 

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 Cost of goods sold 
Sales Revenue 
Inventories 

Problem 1.13

Classification of items
Listed below are balances for 2016.

$
Accounts receivable 80 000
Sales 250 000
Electricity 30 000
Retained profits 50 000
Loan 200 000
Transportation costs 10 000

1 Classify each account as an asset, liability, revenue, expense or equity.

2 Prepare an income statement for the period ending 31 December 2016.

Answer 1.13
1
Account Classification
Accounts receivable Asset
Sales Revenue
Electricity Expense
Retained profits Equity
Loan Liability
Transportation costs Expense

2
Income Statement
For the year ending 31 December 2016
$ $
Sales 250 000
Electricity 30 000
Transportation costs 10 000 40 000
Net profit 210 000

Problem 1.14

Matching financial statement items to statement categories

Raindrop Holdings Ltd is a public company. Below are items taken from its recent
consolidated balance sheet and consolidated income statement. Note that different
companies use slightly different titles for the same item. Mark each item in the
following list as an asset (A), liability (L) or shareholders’ equity (SE) that would
appear on the balance sheet, or revenue (R) or expense (E) that would appear on the
income statement.

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1 Property plant and equipment
2 Sales revenue
3 Trade and other payables
4 Advertising costs
5 Provisions
6 Inventories
7 Prepayments
8 Revenue received in advance
9 Reserves
10 Cash and cash equivalents
11 Depreciation
12 Cost of sales

Answer 1.14
1 A
2 R
3 L
4 E
5 L
6 A
7 A
8 L
9 SE
10 A
11 E
12 E

Problem 1.15

Matching cash flow statement items to categories

The following items were taken from a recent cash flow statement. Note that different
companies use slightly different titles for the same item. Mark each item in the list as
a cash flow from operating activities (O), investing activities (I) or financing activities
(F).
1 Cash paid to employees
2 Cash borrowed from the bank
3 Cash proceeds received from sale of investment in another company
4 Income taxes paid
5 Repayment of loan principal
6 Cash received in return for issue of share capital
7 Cash received from customers
8 Purchases of property, plant and equipment
9 Cash paid to suppliers
10 Cash paid for dividends to shareholders
11 Repayment of loan interest

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Answer 1.15
1 O
2 F
3 I
4 O
5 F
6 F
7 O
8 I
9 O
10 F
11 O

Problem 1.16

Accounting equation
Mr Smiles opened his fruit shop at the beginning of last year. By the end of that year
he had the following assets and liabilities:

$000
Assets
Cash 350
Fruit 600
Total Assets 950
Liabilities
Supplies Payable 280
Wages Payable 128
Total Liabilities 408

1 What is Mr Smiles’ shareholders’ equity in his fruit shop at the end of the year?
2 If Mr Smiles’ initial investment was $500 000, what was his profit for the year?

Answer 1.16
1 Shareholders’ equity = Assets – Liabilities
= $950 000 – $ 408,000
= $542,000
2 Closing balance of shareholders’ equity = Opening balance of shareholders’ equity
+ Profits – distributions
Therefore, Profit = c/b shareholders’ equity – o/b shareholders’ equity +
distributions
Mr Smiles’ profit = $542,000 – $500 000
= $42,000

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Problem 1.17

The accounting equation

Cardigan Ltd has total assets of $150 000 and liabilities that add up to $70 000 as at
30 June 2015.
1 What is Cardigan’s shareholders’ equity as at 30 June 2015?
2 During the year to 30 June 2016, Cardigan’s total assets increase by $63 000
while total liabilities increase by $25 000. What is the amount of Cardigan’s
shareholders’ equity on 30 June 2016?
3 Now assume that in the year to 30 June 2016, Cardigan’s total liabilities increase
by $20 000 and its shareholders’ equity decreases by $12 000. On 30 June 2016,
what is the level of Cardigan’s total assets?
4 Assume that in the year to 30 June 2016, Cardigan’s total assets double while its
shareholders’ equity remains unchanged. What are its total liabilities as at 30 June
2016?

Answer 1.17
1 Cardigan’s shareholders’ equity as at 30/06/15 = Assets – Liabilities
= $150 000 – $ 70 000
= $80 000
2 Cardigan’s assets as at 30/06/16 = $150 000 + $63,000 = $213 000
Cardigan’s liabilities as at 30/06/16 = $ 70 000 + $25,000 = $ 95,000
Cardigan’s shareholders’ equity as at 30/06/16 = Assets – Liabilities
= $213,000 – $ 95,000
= $118,000
3 Cardigan’s shareholders’ equity as at 30/06/16 = $80 000 – $12,000 = $68,000
Cardigan’s liabilities as at 30/06/16 = $70 000 + $20 000 = $90 000
Cardigan’s assets as at 30/06/16 = Shareholders’ equity + Liabilities
= $68,000 + $90 000
= $158,000
4 Cardigan’s assets as at 30/06/16 = $150 000 x 2 = $300 000
Cardigan’s shareholders’ equity as at 30/06/16 = $80 000
Cardigan’s liabilities as at 30/06/16 = Assets – Shareholders’ equity
= $300 000 – $80 000
= $220 000

Problem 1.18

The accounting equation

Use the accounting equation to answer the following questions.
1 Pillow Ltd halved its liabilities during the year. At the beginning of the year, the
amount of total assets was $80 000 and owners’ equity was $50 000. What is the
amount of Pillow’s total liabilities at the end of the year?
2 Buffalo Ltd began the year with assets of $60 000 and liabilities of $25 000. Net
profit for the year was $43 000. What is the amount of owners’ equity at the end
of the year?

©2016 Cengage Learning Australia Pty Limited 18

3 During the last financial year, Sparkle Industries tripled the amount of its assets.
At the end of the year, total liabilities amounted to $57 000 while owners’ equity
was $15 000. What was the amount of total assets at the beginning of the year?

Answer 1.18
1 Liabilities = Assets – Owners’ equity
Pillow’s opening balance of liabilities = $80 000 – $50 000 = $30 000
Pillow’s closing balance of liabilities = $30 000 / 2 = $15 000
2 Closing balance of Owners’ equity = Opening balance of Owners’ equity +
Net profit
= (O/b assets – O/b liabilities) + Net profit
Buffalo Ltd’s closing bal. of Owners’ equity = ($60 000 – $25 000) + $43 000
= $78 000
3 Assets = Liabilities + Owners’ equity
Sparkle Industries closing balance of assets = $57 000 + $15 000 = $72 000
Sparkle Industries opening balance of assets = $72 000 ÷ 3 = $24 000

Problem 1.19

Income statement

Given the following information, prepare an income statement for Gerke Ltd for the
year ended 30 June 2016.
$
Rent expense 30 000
Cost of goods sold 100 000
Sales 250 000
Wages 75 000
Advertising 25 000
Training expense 8000

Answer 1.19
Gerke Ltd
Income Statement for the year ended 30 June 2016
$
Sales revenue 250 000
Less cost of goods sold 100 000
Gross profit 150 000
Less operating expenses
– wages 75 000
– rent 30 000
– advertising 25 000
– training 8 000 138 000
Net profit 12 000

©2016 Cengage Learning Australia Pty Limited 19

Problem 1.20

Income statement

Given the following balances, prepare an income statement for the year ended 30 June
2016 for Bush Traders.
$
Sales 48 000
Cost of goods sold 21 000
Wages 8000
Electricity 4000
Travel 2000
Advertising 1000

Answer 1.20
Bush Traders
Income Statement for the year ended 30 June 2016
$
Sales revenue 48 000
Less cost of goods sold 21 000
Gross profit 27 000
Less operating expenses
– wages 8 000
– electricity 4 000
– travel 2 000
– advertising 1 000 15 000
Net profit 12 000

Problem 1.21

Prepare a balance sheet and calculate profit

1 Given the following balances, prepare a balance sheet as at 30 June 2016 for
Bricks Ltd.
$
Bank loan 100 000
Share capital 400 000
Accounts payable 60 000
Taxes payable 40 000
Inventory 150 000
Cash 50 000
Land and buildings 500 000
Retained profits 200 000
Accounts receivable 100 000

2 The company did not declare any dividends during the year. Its balance in
retained profits at the start of the year was $120 000. What is the profit figure for
the year?

©2016 Cengage Learning Australia Pty Limited 20

Answer 1.21
1 Bricks Ltd
Balance Sheet as at 30 June 2016
Assets $
Cash 50 000
Accounts receivable 100 000
Inventory 150 000
Land and buildings 500 000
Total assets 800 000
Liabilities and shareholders’ equity $
Liabilities
Accounts payable 60 000
Taxes payable 40 000
Bank loan 100 000
Total liabilities 200 000

Net assets 600 000

Shareholders’ equity
Share capital 400 000
Retained profits 200 000
Total shareholders’ equity 600 000

2 $200 000 – $120 000 = $80 000

Problem 1.22

Analysing revenues and expenses and preparing an income statement

Assume you are the owner of Double Cafe, a coffee shop in Sydney’s CBD. At the
end of June 2016, you find (for June only) this information:
1 Sales, as per cash register records, of $47 000, plus sales on credit (two birthday
parties) of $750.
2 The cost of goods sold during June had cost $16 000, consisting of coffee, cups
and cakes.
3 During the month, according to the cheque book, you paid $14 000 for salaries,
rent, advertising and other expenses; however, you have not yet paid the $680
monthly bill for electricity for June.
On the basis of the data given (disregard income taxes), what was the amount of net
profit for June? Show computations.

Answer 1.22
Revenue (47 000 + 750) 47 750
Cost of Goods Sold (16 000)
Gross profit 31 750
Expenses (14 000 + 680) (14 680)
Net profit 17 070

©2016 Cengage Learning Australia Pty Limited 21

Problem 1.23

Calculate shareholders’ equity

Gomez Limited has the following assets and liabilities.

$
Loan 180 000
Cash 90 000
Accounts Payable 110 000
Accounts receivable 170 000
Equipment 200 000

1 Classify each balance as an asset or a liability.

2 Calculate shareholders’ equity.

Answer 1.23
1
Assets $ Liabilities $
Cash 90 000 Loan 180 000
Accounts receivable 170 000 Accounts payable 110 000
Equipment 200 000

Total assets 460 000 Total liabilities 290 000

2 Shareholders’ equity = Assets – Liabilities

= $460 000 – $290 000
= $170 000

Problem 1.24

Calculate shareholders’ equity

Given the following information relating to Stripes Ltd, what is the balance of
shareholders’ equity?
$
Land and buildings 2 800 000
Accounts payable 250 000
Cash and cash equivalents 340 000
Inventoy 410 000
Bank loan 600 000
Taxes payable 104 000

Answer 1.24
Shareholders’ equity = Assets – Liabilities
= ($2 800 000 + $340 000 + $410 000)
- ($250 000 + $600 000 + $104 000)
= $3 550 000 - $954 000
= $2 596 000

©2016 Cengage Learning Australia Pty Limited 22

Problem 1.25

Identify some accounting concepts and principles

Identify the accounting concepts or principles that relate to each of the following
sentences and explain what effect the concepts or principles have on financial
statements:
1 Users of financial statements should be able to believe that the numbers represent
real events.
2 Financial statements should avoid undue optimism about the future.
3 It is hard to say absolutely if a company is performing well or badly, but you can
evaluate its relative performance.
4 Financial accounting should be helpful both in understanding the past and looking
ahead to the future.
5 The content of financial statements should not depend on who prepares them.

Answer 1.25
Here are some ideas in response to the sentences. You may well think of several other
concepts/principles and probably will make additional points about some of them.

1 The concept/principle related to this is reliability. Some effects on financial

statements of this are: accountants are careful that all cash transactions and
day-to-day events such as credit sales and purchases are reflected in the
financial statements; considerable care is taken to minimise errors and
omissions in the accounting system that underlies the financial statements; and
auditors ensure that important financial statement data can be traced back to
underlying events and evidence.
2 Three concepts/principles related to this are conservatism, reliability and
matching. Conservatism results (or should result) in financial statements that
contain prudent, not overly optimistic estimates of future cash inflows and
outflows regarding present assets and liabilities. Reliability has the effect of
keeping conservatism in check so that the financial statements are not
pessimistic (which would be unfair to present owners and managers).
Matching says that estimates affecting revenues should be done on comparable
bases to those affecting expenses so that the net profit makes sense, so it puts
some bounds on conservatism too.
3 Three concepts/principles related to this are conformance with GAAP,
consistency and comparability. Conformance with GAAP ensures that the
company’s information is prepared in ways the user might expect, to permit
meaningful analyses of its performance. The objective of consistency over
time results in highlighting inconsistencies so that the user can consider their
effects on the information. The goal of comparability refers directly to the idea
of ‘relative performance’ because if the previous two principles are met, the
company can be evaluated by comparison to others like it, or to others the user
might consider investing in or lending to.
4 Three concepts/principles related to this are disclosure, decision relevance and
understandability. Disclosure has the effect of helping users understand how
the accounting numbers were computed. This helps to make estimates of
future effects. Decision relevance is a reminder that the financial statements
should be useful both in past-oriented decisions (such as evaluating
management’s performance or calculating bonuses) and in future-oriented
decisions (such as whether to invest in or lend to the company).

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 Understandability requires that reports be prepared so they are comprehensible
to the recipients.

5 Two concepts/principles related to this are reliability, and conformance with

GAAP. The goal of both is partly to minimise the effects of human error,
biases and wishes on the information by promoting objective, careful methods
of preparing it and making it possible (in principle) for anyone else who
prepares it to come up with, and agree with, the same information.

Problem 1.26

Accounting assumptions
Consider the following statements relating to how we might account for certain
transactions or events. What accounting assumption or principle underlies each?
1 ‘Inventory is recorded at cost unless the net realisable value of inventory is below
cost. In that case, inventory is written down to the net realisable value.’
2 ‘Accounting financial statements are primarily based on historical costs. They
should, however, be primarily about the contemporary cash value of a company’s
net assets.’
3 ‘At the end of each period, a company has to calculate any salaries that have
accrued, and recognise an expense and a liability for that amount.’
4 ‘If a company changes its depreciation policy, it needs to disclose (in the notes to
the financial statements) the nature of the change, and its financial effects.’
5 ‘Many businesses do not record “freight in” as part of the acquisition cost of
inventory, but any freight charges of the period, which are normally small
amounts, are expensed in the gross profit section of the income statement.’

Answer 1.26
1 Conservatism
2 Historical cost (see chapter 1)
3 Accounting period (see chapter 1)
4 Consistency
5 Materiality

Problem 1.27

Qualitative characteristics

The Framework for the Preparation and Presentation of Financial Statements

examines the characteristics of accounting information that make this information
useful for decision-making. It also points out that various limitations, which are
inherent in the measurement and reporting process, may necessitate trade-offs
between these limitations and the positive characteristics of useful information.
1 Briefly describe the following characteristics of useful accounting information:
a relevance
b reliability
c understandability
d comparability.

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2 For each of the following pairs of information characteristics, give an example of
a situation in which one of the characteristics may be sacrificed in return for a
gain in the other:
a relevance and reliability
b relevance and comparability
c relevance and understandability.

3 What criterion should be used to evaluate trade-offs between information

characteristics?

Answer 1.27
1 a Relevance is one of the two primary decision-specific characteristics of useful
accounting information. Relevant information is capable of making a difference
in a decision. Relevant information helps users to make predictions about the
outcomes of past, present, and future events, or to confirm or correct prior
expectations. Information must also be timely in order to be considered relevant.
b Reliability is one of the two primary decision-specific characteristics of useful
accounting information. Reliable information can be depended upon to
represent the conditions and events that it is intended to represent. Reliability
stems from representational faithfulness and verifiability. Representational
faithfulness is correspondence or agreement between accounting information
and the economic phenomena it is intended to represent. Verifiability provides
assurance that the information is free from bias.
c Understandability is a user-specific characteristic of information. Information
is understandable when it permits reasonably informed users to perceive its
significance. Understandability is a link between users, who vary widely in
their capacity to comprehend or utilise the information, and the decision-
specific qualities of information.
d Comparability means that information about enterprises has been prepared and
presented in a similar manner. Comparability enhances comparisons between
information about two different enterprises at a particular point in time.
2 There are a multitude of answers possible here. The suggestions below are intended
to serve as examples.
a Forecasts of future operating results and projections of future cash flows may
be highly relevant to some decision-makers. However, they would not be as
reliable as historical cost information about past transactions.
b Proposed new accounting methods may be more relevant to many decision-
makers than existing methods. However, if adopted, they would impair
consistency and make trend comparisons of an enterprise’s results over time
difficult or impossible.
c Occasionally, relevant information is exceedingly complex. Judgement is
required in determining the optimum trade-off between relevance and
understandability. Information about the impact of general and specific price
changes may be highly relevant but not understandable by all users.
3 Although trade-offs result in the sacrifice of some desirable quality of information,
the overall result should be information that is more useful for decision-making.

©2016 Cengage Learning Australia Pty Limited 25

Problem 1.28

Primary assumptions made in preparing financial statements

Kelly opened a photography business in a small shop that she rented from a large
retailer, Eastfield Limited. She paid the first month’s rent of $400 by writing a cheque
from her personal account. Kelly took some of her own photography equipment and
materials (worth $5000) into the shop, and also bought some new cameras so that she
could take pictures of her customers with the best available technology. The cameras
had a recommended retail price of $2500 but she was able to buy them on sale for
$2200, charging them to her personal credit card. Kelly’s first customer paid her $900
for a set of portraits, so she opened a bank account for the company. Her other
customers have not yet paid her, owing a total of $3100. At the end of the first month
of business, Kelly prepared the following financial statements.

KELLY’S PROFESSIONAL PHOTOGRAPHY

BALANCE SHEET AS AT 31 MAY 2016
$ $
Cash 900
Equipment 2500 Shareholders’ Equity 3400
3400 3400

KELLY’S PROFESSIONAL PHOTOGRAPHY

INCOME STATEMENT FOR THE MONTH ENDED 31 MAY 2016
Sales 4000
Rent 400
Equipment 2500 2900
Net profit 1100
Identify the assumptions that Kelly has violated, and explain how each event should
have been handled. Prepare a corrected balance sheet and income statement.

Answer 1.28

Assumptions violated:
1 Accounting entity is separate and distinguishable from its owners. The photography
equipment and materials worth $5000 should be shown as a business asset and
included in Kelly’s capital.
2 Historical cost – assets are initially recorded at cost. The cameras should be recorded
at their cost to Kelly, $2200, not their recommended retail price.
3 Accounting period. Cameras have been shown as both an asset and an expense. As
their life is longer than one month they should not be expensed.
4 Accounts receivable have been omitted from the balance sheet.
5 Share capital comprises: $
Rent paid 400
Equipment & materials 5000
Cameras 2200
7600

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 Kelly’s Professional Photography
Balance Sheet as at 31 May 2016
$ $
Assets Shareholders’ equity
Cash 900 Share capital 7 600
Equipment 7 200 Retained profits 3 600
Accounts receivable 3 100

Total assets 11 200 Total shareholders’ 11 200

equity

Kelly’s Professional Photography

Income Statement for the month ended 31 May 2016
$
Sales revenue 4 000
Less operating expenses
Rent 400
Net profit 3 600

Problem 1.29

Discuss ethical problems

Discuss the examples of ethical problems given at the end of section 1.4. What ethical
issues do you see? What do you think the chief accountant, the auditor and the general
manager should do?

Answer 1.29
Employee lawsuit and chief accountant
Ethical issue: The chief accountant has a responsibility to the users of the financial
statements and to the company.
• Users of financial statements need information that is useful for decision-making.
The question that arises here is whether the potential effects of the lawsuit will affect
the decisions of users of the financial statements.
• The chief accountant also has a responsibility to the company. Will disclosure of the
lawsuit in financial statements affect the outcome of the lawsuit? Will disclosure
result in other lawsuits by previously dismissed employees?
• The chief accountant may also fear that disagreement with the general manager may
jeopardise his own employment with the firm.
What should the chief accountant do?
• Ensure that all of the facts are known.
Why does the general manager deny any impropriety?
• The general manager may have been advised by the enterprise’s lawyers that the
lawsuit was unlikely to be successful.
Why does the chief accountant personally feel the claim is justified? What is the
amount of the potential claim? Is it large enough to make a difference to the users of
the financial statements?

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• Once the chief accountant has all of the facts, it may be desirable to discuss the issue
with the general manager again. He/she may also want to make the general manager
aware of the accounting rules governing disclosure of potential losses.
• During the course of the audit, bring the matter to the attention of the enterprise’s
auditors.
• Also note that the enterprise’s auditors are required to communicate with the
enterprise’s lawyers to determine whether there are any existing or potential lawsuits.
The information provided by the lawyers would include the amount and likelihood of
any gains or losses.

External auditor and possible cheating

Ethical issue: The auditor cannot apprise the other client that that client may be being
cheated because this would violate the first client’s confidentiality.
• If the enterprise is cheating one customer, it may be cheating others and may in
general be dishonest. Since auditors performing an audit rely in part on
representations of management, the potential dishonesty may jeopardise the effective
conduct of the audit.
• Being associated with an enterprise whose management is dishonest may harm the
reputation of the auditor.
• On the other hand, if the auditor ends the involvement with the enterprise, this will
result in a loss of audit fees.
What should the auditor do?
• Get all of the facts.
• Determine whether the enterprise is actually cheating the customer.
• If the enterprise is actually cheating the customer, determine whether the cheating is
the result of an inadvertent error. If the enterprise is not purposely cheating the
customer, the auditor can bring the error to the attention of management and the
problem will be solved.
• If the enterprise is purposely cheating the customer, determine what level of
management is involved. If top management is not involved and is unaware of the
circumstances the auditor can bring the matter to the attention of top management. At
this point, top management would (hopefully) do something to rectify the situation.
• If the enterprise is purposely cheating the customer and top management is involved,
the situation becomes more difficult. The auditor should do a number of things at this
time, including seeking advice and discussing the situation with top management.
Further action by the auditor is dependent on the response of management and
whether the incident is isolated or not.
• If discussions with management result in the feeling that management is dishonest,
the auditor should resign, by addressing a letter of resignation to the Board of
Directors setting out the reasons for resignation.

The general manager’s bonus

Ethical issue: The general manager’s performance is evaluated based on performance of
the company.
• The proposed change will not change the total amount of depreciation expense
charged to income over the life of the relevant assets; it will only change the timing
of the recognition of those expenses. As a result, it will not change the amount of
cash generated from operations of the enterprise before considering the amount of

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 the general manager’s bonus. The proposed change will increase the amount of cash
paid out to the general manager by way of bonus. Should the general manager get a
higher bonus, if nothing has really changed?
• On the other hand, the proposed change to the depreciation method may result in
providing the users of financial statements with information which is useful. Perhaps
the new depreciation method results in better matching of expenses with revenues.
Or, perhaps the new depreciation method is similar to depreciation methods used by
other enterprises in the same industry. This would result in enhanced comparability
between enterprises and may be more useful to users of the financial statements.
What should the general manager do?
• The general manager should determine whether the proposed change results in
information which is more useful to users of the financial statements. If this is the
case, the accounting change should be implemented. If not, the change should not be
implemented.
• If the change is implemented, the general manager must decide whether to request
that the bonus calculation ignore the change. It may be the case that some aspect of
the general manager’s performance has resulted in the possibility of decreasing
depreciation expense. For example, if the general manager ensured that the relevant
assets were well maintained to the point that the useful life of the assets was
extended, the general manager should be rewarded for this performance and the
bonus calculation should not ignore the change. If the change in depreciation is
unrelated to the general manager’s performance, the general manager should request
that the bonus calculation should ignore the change.
• It is often the case that bonus plan parameters are such that changes of this nature are
taken into account in determining bonus amounts. If this is the case, the amount of
the general manager’s bonus won’t change with the implementation of new policy.

©2016 Cengage Learning Australia Pty Limited 29

Cases
CASE 1A Woolworths Limited

Refer to the extracts of the 2014 annual report of Woolworths Limited in the
Financial Accounting book’s appendix. All questions relate to the consolidated
accounts.
1 Provide indicators that Woolworths uses accrual accounting.
2 What were total assets at 29 June 2014?
3 What were total liabilities at 29 June 2014?
4 What was shareholders’ equity at 29 June 2014?
5 State the accounting equation in dollar figures at 29 June 2014.
6 What was the net profit before tax?
7 What was the net profit after tax?
8 What were the largest cash inflow and outflow relating to operating activities?
9 Give two reasons why the cash flow from operations is a different figure from
operating profit after tax.
10 Did its total assets increase or decrease over the last year?
11 How much inventory (in dollars) did Woolworths have as at 29 June 2014?
12 On what date does Woolworths’ most recent reporting year end?
13 For how many years does it present complete:
a balance sheets?
b income statements?
c cash flow statements?
14 Are its financial statements audited by an independent firm? Who is the auditor
for the company?

Answer 1A
1 Indicators that Woolworths use accrual accounting:
Trade and Other Receivables
Trade and Other Payables
Provisions
Depreciation
Amortisation
Prepayments
Accruals
Unearned Revenue
Note 1
2 Total assets at 29 June 2014 = 24 205.2m
3 Total Liabilities at 29 June 2014 = 13 679.8m
4 Shareholders’ equity at 29 June 2014 = 10 525.4m
5 Accounting equation in dollar figures at 29 June 2014
A = L + OE
24 205.2m 13 679.8m + 10 525.4m

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6 Net profit before tax = 3 515.1 m
7 Net profit after tax = 2 458.4 m

8 Largest cash inflow = Receipts from customers = 65 851.8 m

Largest cash outflow = Payments to suppliers and employees = 60 918.3 m
9 Cash flow from operations is a different figure to operating profit after tax because
the latter is calculated on an accrual basis and includes a number of items omitted
from the cash flow from operations including:
– revenue earned but received in other periods
– expenses incurred but paid for in other periods
– expenses not involving cash outlays including depreciation and bad debts.
In addition the cash flow from operations includes revenues and expenses relating to
prior or subsequent periods.
10 Total assets increased to 24 205.2m in 2014 from 22 250.2m in 2013.
11 Woolworth Limited had $4 693.2 million worth of inventory as at 29 June 2014.
12 29 June 2014
13 a two years
b two years
c two years
14 Yes, they are. There is auditor’s declaration (by Deloitte) in the report.

CASE 1B Accrual and cash profit in measuring performance

Wings Ltd is an airline services company with a plant near Sydney Airport and
service centres in several states. It provides meals, serviettes and other food-related
items, cleaning, interior maintenance and several other services to various airlines.
The company has been fairly successful, though recessions and the deregulation of air
services have put significant pressure on its operations. When the company began in
the late 1970s, it had a relatively weak financial position (mainly because of
borrowing to get set up) and its financial performance, while satisfactory, has not
enabled it to reduce its debt load very much. It seems that every time the company
gets a little ahead, new equipment must be purchased or new product lines developed,
and the company finds itself borrowing again.
A recent year provides a good example. The company’s accrual profit was
$188 000 and its cash profit was $241 000. (The difference resulted because of a
depreciation expense of $96 000 and uncollected revenue being $43 000 higher at the
end of the year than at the beginning. In the company’s financial statements, the
phrase ‘net profit for the year’ was used to describe the accrual profit and ‘cash
generated by operations’ described the cash profit.) The general manager had looked
forward to using some of the cash to pay debts, but late in the year the company had
to buy new food-handling and wrapping equipment for $206 000 to meet revised
standards announced by its airline customers. Therefore, the company ended up only a
few thousand dollars ahead in cash, not enough to make much of a dent in its debts.
The general manager has a regular half-yearly meeting with the company’s
external auditor to discuss accounting and auditing issues. After the above results
were known, the general manager phoned the auditor and made the following
comments: ‘I thought I’d ask you to think about a few things before our meeting next
week. When it comes to our accounting, I think the company has too many masters

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and too many measures. What I mean is first that too many people are concerned with
what our financial statements say. Why can’t we just prepare financial statements that
meet my needs as general manager? Why do we have to worry about all the other
people outside the company? Sometimes I’m not even sure who all those other people
are, since you accountants and auditors often just talk about “users” without being too
clear what you mean. Also, I’m confused by the existence of both a “net profit” figure
and a “cash generated by operations” figure in our financial statements. Why can’t we
just have one or the other to measure our performance?’
The general manager raised issues that will be addressed frequently as this
book develops your understanding. But for now, what would you say to the general
manager?

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

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• Net profit versus Cash from operations
– In accrual accounting, attempts are made to measure the value of incomplete
transactions. Accrual accounting is used to determine net profit. (You may
want to provide examples here: e.g. uncollected revenue at year-end increased
by $43 000.)
– Discuss why it is valuable to provide information about completed
transactions. In doing this, refer to users of financial statements. For example,
owners and potential owners may want to predict future performance of the
firm on the basis of past performance in making investment decisions. Another
example is assessment of management performance.
– Cash from operations measures the amount of cash generated from the day to
day activities of the company over a period in time.
– Why would any of the users noted above find this information useful?
– Example: creditors may use this information to assess the ability of the
company to pay interest and principal on debt.

CASE 1C Audit and ethics issues

Read the following extract.

The overall objective of the financial statement audit is to add credibility to

management’s financial reports…

Essential Component
Every financial market, and subsequently all financial regulators, relies on the
existence of meaningful and reliable financial statements. The external audit
provides the essential component of independent assurance, which is necessary for
the provision of reliable financial statements…
The high quality audit delivered in 2009 is a totally different service than the
audit that would have been offered as little as 10 years ago. What has remained
constant over this time is the value of the independent assurance provided by the
audit process…

Expectation Gap
There is a segment of the market that sees an external audit as the guarantee
against poor management behaviour, questionable business decisions and,
ultimately, against corporate failure… We are all well aware that a corporate
failure does not always equate to an audit failure.
Source: Richard Deutsch, ‘Audits add Credibility’, Charter, September 2009.

1 What is meant by independent assurance?

2 Give some examples of lack of independence.
3 Comment on the statements in the paragraph headed ‘Expectation Gap’.
4 How do management’s and auditors’ responsibilities differ?
5 Why is the integrity of management important to the financial reporting process?

©2016 Cengage Learning Australia Pty Limited 33

Answer 1C
1 The person giving the assurance is independent of those preparing the financial
statements. This would include having no conflict of interest: e.g. owning shares
in the company, lending/borrowing money for the company, having a spouse or
other family member in a key executive role.

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

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

4 Management prepare the financial statements while auditors express an opinion

on the financial report.

5 Management need to make judgments in the preparation of financial statements.

It is important that they have integrity and that those judgments are not biased
towards their self-interests.

©2016 Cengage Learning Australia Pty Limited 34