CHAPTER 1 – INTRODUCTION TO ACCOUNTING

ANSWERS TO QUESTIONS

3. Advantages of company structure are limited liability (shareholders not being

personally liable for corporate debts), indefinite life, easy transferability of ownership
(through selling shares), and greater ability to raise funds. Disadvantages of a
company are the establishment costs and ongoing fees and increased government
regulations.

5. (a) Statement of profit or loss.

(b) Statement of financial position.
(c) Statement of financial position.
(d) Statement of profit or loss.
(e) Statement of financial position.
(f) Statement of financial position.

7. It is important to determine if a business is a reporting entity as it is only reporting

entities that are required to prepare general purpose financial reports in accordance
with the accounting standards.

Three main indicators determine which of the forms of business organisation fall into
the category of a reporting entity. That is, an entity is more likely to be classified as a
reporting entity if it is (1) managed by individuals who are not owners of the entity, (2)
politically or economically important, and (3) sizable in any of the following ways —
sales, assets, borrowings, customers or employees.

9. Retained earnings is the profit retained in a company. Retained earnings is increased

by profit and is decreased by dividends and by losses.

(a) BRIEF EXERCISE 1.1

(a) P Shared control, increased skills and resources.
(b) SP Simple to set up and maintain control with founder.
(c) C Easier to transfer ownership and raise funds, no personal
liability.

BRIEF EXERCISE 1.2

(a) False
(b) True
(c) False

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BRIEF EXERCISE 1.3
1. Trying to determine whether the company complied with the Corporations Act.

2. Trying to determine whether the entity can pay its obligations.

3. Trying to determine whether a major investment proposal will be cost effective.

4. Trying to determine whether the company’s profit will result in a share price increase.

5. Trying to determine whether the entity should use debt or equity financing.

(a) 3 Executive directors

(b) 2 Bank managers
(c) 4 Shareholders
(d) 5 Chief Financial Officer
(e) 1 ASIC

EXERCISE 1.4
Black Ltd

(a) Eq Retained earnings $2,000

E Cost of sales 24,600
E Wages expense 18,300
A Cash 11,200
L Current payables 14,500
E Interest expense 6,200
E Other expense 1,100
E Depreciation expense 1,800
L Non-current borrowings 22,000
A Inventories 4,500
R Sales revenue 66,000
A Accounts Receivable 12,000
Eq Reserves 8,000
E Income tax expense 4,200
Eq Contributed equity 30,000
A Property and Equipment 20,000

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(b) Calculation of profit for Black Ltd
for the year ended 30 June 2015

$ $
Sales revenue 66,000
Expenses:
Cost of sales 24,600
Wages expense 18,300
Interest expense 6,200
Other expense 1,100
Depreciation expense 1,800
Income tax expense 4,200
Total expenses 56,200
Profit $9,800

EXERCISE 1.5
Road Ltd

Note to solve the missing amounts the student needs to decide the order to solve the
missing amounts
1. The Statement of changes in equity shows the ending retained earnings as $45,000 which
then can be substituted into the Statement of financial position so that (b) equals $45,000.

2. Now (a) Contributed equity can be calculated.

Accounts payable + Contributed equity + Retained earnings = Total liabilities and equity.

$26,000 + (a) + $45,000 = $106,000

(a) = $106,000 – $45,000 – $26,000
(a) = $35,000

3. Items (d) and (e) are the same figure. Therefore solve (e) first in the Statement of changes
in equity
Beginning retained earnings+ Profit – Dividends = Ending retained earnings

$12,000 + (e) – $8,000 = $45,000

(e) = $45,000 –$12,000 + $8,000
(e) = $41,000
and also (d) equals $41,000

4. Lastly now item (c) can be calculated

Revenue – Cost of sales – Administrative expenses = Profit

$200,000 – (c) – $14,000 = $41,000

$200,000 – $14,000 – $41,000 = (c)
(c) = $145,000

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EXERCISE 1.6
Cheong Pty Ltd

(a) This is a violation of the cost principle. The inventory was written up to its market
value when it should have remained at cost.

(b) This is a violation of the accounting entity concept. The treatment of the transaction
treats Cheong Kong and Cheong Pty Ltd as one entity when they are two separate
entities. The computer should not have been charged to the expense account. If paid
for by the business, it should have been treated as a loan from the business to
Cheong Kong.

(c) This is a violation of the period concept. This concept states that the economic life of
an entity can be divided into artificial time periods (months, quarters or a year). By
adding two more days to the year, Cheong Pty Ltd would be misleading financial
statement users. In addition, 2015 results would not be comparable to previous
years’ results, and the problem would recur in 2016. The period should have been 52
weeks or 53 at the most. Retailers often use a complete number of weeks rather than
an exact year. As a 365-day year consists of 52 weeks plus one day, many retailers
use 52-week periods and then, approximately every 5 years, use a 53-week year.
However, this is fully disclosed for comparative purposes. For example Woolworths
Limited.

EXERCISE 1.9
(a)
Christchurch Flooring Pty Ltd
Statement of Profit or Loss
for the year ended 31 July 2015

$ $
Revenues:
Sales revenue 62,000
Less: Cost of sales 30,000
Gross profit 32,000
Other revenue
Rent revenue 30,000
Expenses:
Salaries expense 25,000
Depreciation expense 4,000
Other expenses 18,000
Total expense (47,000)
Profit $15,000

Calculation of Retained Earnings

for the year ended 31 July 2015

$
Retained earnings, 1 August 2014 2,000
Add: Profit 15,000
Retained earnings, 31 July 2015 $17,000

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(b)
Christchurch Flooring Pty Ltd
Statement of financial position
as at 31 July 2015

$ $
Current assets:
Cash 33,000
Inventory 26,000
Total current assets 59,000

Non-current assets:
Land 80 000
Building 70,000
Less: Accumulated depreciation (12,000) 58,000
Total non-current assets 138,000

Total Assets 197,000

Current liabilities:
Accounts payable 8,000
Rent received in advance 2,000
Total current liabilities 10,000

Non-current liabilities
Bank loan 80 000
Total non-current liabilities 80,000
Total liabilities 90 000
Net Assets $107 000

Equity
Share capital 90,000
Retained earnings 17,000
Total equity $107,000

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SOLUTIONS TO PROBLEM SET A

PROBLEM SET A 1.1

(a) The concern over legal liability would make the limited liability company form a better
choice over a partnership. Also, the corporate form will allow the business to raise
cash more easily which may be of importance in a rapidly growing industry.

(b) Sarah and Andrew should adopt the partnership form because it facilitates bringing
together the contribution of skills and resources. Also there does not appear to be
any expected needs for further fund in the near future.

(c) The fact that the combined business expects that it will need to raise significant funds
in the near future makes the company form more desirable in this case.

(d) It is likely that this business would form as a partnership. Its needs for additional
funds would probably be minimal in the foreseeable future. Also, the three know each
other well and would appear to be contributing equally to the firm. Service firms, like
consulting businesses, are frequently formed as partnerships.
Alternatively, they may prefer the company form to simplify subsequent expansion
and take advantage of limited liability, but they would need to consider the additional
regulation that it would involve.

(e) One way to ensure control would be for Anthony to form a sole proprietorship.
However in order for this business to thrive, it will need a substantial investment of
funds early. This would suggest the company form of business. In order for Anthony
to maintain control over the business, he would need to own more than 50 percent of
the voting power. In order for the business to grow, he may have to be willing to give
up some control.

PROBLEM SET A 1.2

(a) In deciding whether to extend credit for 30 days you would be most interested in the
Statement of financial position because it shows the assets on hand that would be
available for settlement of the debt in the near-term.

(b) In purchasing an investment that will be held for an extended period, the investor
must try to predict the future performance of Domino’s. The statement of profit or loss
provides the most useful information for predicting future performance.

(c) In extending a loan for a relatively long period of time, the bank is most interested in
the probability that the company will generate sufficient income to meet its interest
payments and repay its principal. The bank would therefore be interested in
predicting future profit using the statement of profit or loss.
It should be noted, however, that the lender would also be very interested in both the
Statement of financial position and the Statement of cash flows — the Statement of
financial position would show the amount of debt the company has already incurred,
as well as assets that could be liquidated to repay the loan. And the bank would be
interested in the Statement of cash flows because it would provide useful information
for predicting the company’s ability to generate cash to repay its obligations.

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(d) The finance director would be most interested in the Statement of cash flows since it
shows how much cash the company generates and how that cash is used. The
Statement of cash flows can be used to predict the company’s future cash-generating
ability.

PROBLEM SET A 1.6

Ultra Pty Ltd
Statement of profit or loss
for the month ended 31 May 2016
$ $
Revenues:
Service revenue 42 800

Expenses:
Advertising expense 800
Fuel expense 3 600
Insurance expense 2 600
Rent expense 12 500
Repair expense 1 800
Total expenses 21 300
Profit $21 500

Ultra Pty Ltd

Calculation of Retained Earnings
for the month ended 31 May 2016
$
Retained earnings, 1 May 0
Add: Profit 21 500
21 500
Less: Dividends (2 000)
Retained earnings, 31 May $19 500

Ultra Pty Ltd

Statement of financial position
as at 31 May 2016
$ $
Assets:
Current Assets
Cash 30 500
Accounts receivable 25 400
55 900
Non-Current Assets
Equipment 87 000
Total assets 142 900

Liabilities:
Current Liabilities
Accounts payable 8 400

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Non-Current Liabilities
Bank loan 40 000
Total liabilities 48 400
Net Assets $94 500

Equity:
Share capital 75 000
Retained earnings 19 500
Total equity $94 500

CHAPTER 13 – ANALYSING AND INTEGRATING GAAP

23. The 2 basic common recognition criteria that are applied to assets, liabilities,
revenues and expenses are:

[1] Increase or decrease in economic benefits is probable, and

[2]The amount of assets, liabilities, revenues or expenses can be measured reliably.

EXERCISE 13.4

(a) A violation of revenue recognition criteria has occurred. AASB 118 and NZ IAS 18
‘Revenue’ prescribe principles for the recognition of revenue for the sale of goods. As
explained in chapter 3, IAS 18 Revenue prescribes five principles for the recognition
of revenue from the sale of goods and four principles for the recognition of revenue
from the provision of services.
In the context of revenue recognition (income), AASB 118 and NZ IAS 18 ‘Revenue’
prescribes principles for the recognition of revenue for the sale of goods. Revenue is
recognised on the sale of goods when all of the following conditions are satisfied: the
revenue and the associated costs must be able to be reliably measured and it is
probable the economic benefits, usually in the form of cash inflows, will accrue to the
seller. The seller must have transferred to the buyer the effective control over the
goods and not have any continuing managerial involvement, thereby transferring the
significant risks and rewards of ownership.

Basically, for merchandising organisations revenue is recognised when the goods

are delivered. For service organisations revenue is recognised when the services
have been provided.

In this case no sale has occurred however, revenue has been recognised. Normally,
the transfer of significant risks and rewards of ownership occurs when legal title
passes to the buyer. Further, as outlined in the Conceptual Framework, income
(which includes revenues and gains) is recognised in the statement of profit or loss
‘when an increase in future
economic benefits related to an increase in an asset or a decrease of a liability has

8
 arisen that can be measured reliably’. in the question we are also told that the
amount cannot be reliably measured at this stage – a further violation of the
recognition criteria.

(b) A violation of Accounting Period Concept has occurred. The accounting period
concept states that the life of a business entity can be divided into artificial periods
and that useful reports covering those periods can be prepared for the entity. In this
case no reports have been prepared.

(c) In this case no violation is evident as the inventory is being carried at the lower of
cost or net realisable value. Although the cost principle states that assets are to be
recorded at their cost, AASB 102 Inventories mandates that ‘inventories shall be
measured at the lower of cost and net realisable value’ (para.9). Furthermore, the
Conceptual Framework also provides expense recognition criteria. Expenses should
be recognised when ‘a decrease in future economic benefits related to a decrease in
an asset or an increase of a liability has arisen that can be measured reliably’
(paragraph 94). In this case the net realisable value is lower than the cost of
inventory so there has been a decrease in an asset (inventory) and an increase in an
expense (inventory write-down expense).

(d) A violation of going concern principle is evident in this case. The going concern
principle states that financial statements are prepared on a going basis unless
management either intends to or must liquidate the business or cease trading. In this
case, liquidation is unlikely, so property plant and equipment should not be reported
at the amount for which it could be sold at short notice, but either cost or revalued
basis. In addition, property, plant and equipment and bills payable also need to be
classified as non-current assets and liabilities respectively.

(e) A violation of cost principle in this case. The cost principle states that all assets are
initially recorded in the accounts at their purchase price or cost. This is applied not
only at the time the asset is purchased, but also over the time the asset is held. If the
net realisable value is lower than cost, then Surf’s Up Ltd should report the inventory
at net realisable value.

(f) A violation of accounting entity concept is evident in this case. This concept states
that every entity can be separately identified and accounted for. In other words,
owner’s personal transactions must be clearly separated from the entity’s
transactions. Hence a computer that is purchased for personal use should not be
included in the company records.

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EXERCISE 13.10

Assets are defined in the Conceptual Framework as a resource controlled by the entity as a
result of past events and from which future economic benefits are expected to flow to the
entity. Assets that satisfy the recognition criteria should be incorporated in the statement of
financial position when [1] it is probable that the future economic benefits will flow to the
entity and [2] the asset has a cost or value that can be measured with reliability.

(a) Saleable inventory is an asset (as opposed to old and obsolete inventory which has
no expected future economic benefit). It is it is probable that the future economic
benefits will flow to the entity through the sale of inventory in the form of receivables
and then cash and this can be measured with reliability (i.e. known selling price and
cost price).

(b) Not an asset. While the antique boot is an interesting talking point and meets some
of the elements in the definition and recognition criteria of an asset (e.g. it is
controlled by the entity), we are told that it has no commercial value (cannot provide
future economic benefits in the form of sale). An asset needs to provide a future
economic benefit and a cost or value that can be measured with reliability.

(c) Consignment stock is not an asset of Shiny Shoes (the consignee); it is an asset of
the consignor. Although Shiny Shoes has possession of the consigned shoes, it does
not have control of the shoes as the ownership still belongs to the consignor.

(d) While in colloquial terms we often hear ‘employees are the greatest assets of a
company’, in terms of the definition of an asset in accounting, staff members are not
the company’s assets. Shiny Shoes does not have control of the three staff
members, which is essential to the definition of an asset. While staff members may
provide future economic benefits to the company, they are not controlled by the
company as they are able to resign anytime and work elsewhere.

(e) Shelving to display shoes is an asset. It is controlled by the entity as a result of past
events (i.e. purchase transaction). It provides a probable future economic benefit in
that displaying shoes is likely to result in shoe sales or the shelves themselves can
be sold for cash. Shelves also have costs that can be measured with reliability (i.e.
purchase price), and therefore should be recognised in the financial statements.

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EXERCISE 13.11

Liability is defined in the Conceptual Framework as a present obligation of the entity arising
from past events, the settlement of which is expected to result in an outflow from the entity of
resources embodying economic benefits. A liability is recognised in the statement of financial
position when [1] it is probable that an outflow of resources embodying economic benefit will
result from the settlement of a present obligation, and [2] the amount at which the settlement
will take place can be measured reliably.
(a) The purchase of tyres, glass and steel on account should be recognised as a liability.
Once the goods are received, a present obligation of a-Forden and a-Holden Custom
Cars (i.e. obligation to pay for the materials) arising from past events (i.e. purchase
transaction) exists, the settlement of which is expected to result in an outflow from
the entity of resources embodying economic benefits e.g. the payment of cash.

It is probable that an outflow of resources embodying economic benefit will result

from the settlement of the obligation, and the amount of the settlement can be
measured reliably through the purchase price.

The journal entry to recognise the liability is:

Manufacturing Materials X
Accounts Payable X

(b) The receipt of $100,000 as a deposit for cars to be built is recognised as a liability.
The deposit received, cannot be recorded as Revenue as the work to manufacture
the car has not been completed. Once the deposit is received, a present obligation of
the company to build homes for its clients has risen from a past event (i.e. receipt of
the deposit). The settlement of the obligation is expected to result in an outflow from
the company of resources embodying economic benefits e.g. resources used to build
cars or the repayment of the deposit.

The journal entry to recognise the liability is:

Cash 100,000
Revenue Received in Advance 100,000

It is probable that an outflow of resources embodying economic benefit will result

from the settlement of the obligation to build homes, and the amount of the
settlement can be measured reliably through the amount of deposit received.

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(c) An agreement to employ new staff is not recorded as liability as no present obligation
exists and there is no transaction from past event (the new staffs have not
commenced working). Once the new staff members start working, a present
obligation to pay them will exist. The journal entry to recognise the liability after the
work has been completed will be:
Wages Expense X
Wages payable X

(d) No liability should be recorded, however in this case there may be a contingent
liability. Contingent liabilities are liabilities for which the amount of the future sacrifice
is so uncertain that it cannot be measured reliably, that do not satisfy the probability
criterion, or are dependent upon the occurrence of an uncertain future event outside
the control of the entity.

Although the amount of the lawsuit can be measured reliably ($13,000), whether or
not an outflow of resources embodying economic benefit resulting from the
settlement of the lawsuit occurs would depend on the court’s decision, which is
outside the control of a-Forden and a-Holden Custom Cars. While the company
believes that it might lose the case, the result cannot be determined until court
decisions are made. Given that the lawsuit does not satisfy the probability criterion
and are dependent upon the court’s decision, it should be disclosed in the notes to
the financial statements as a contingent liability.

(e) No liability recorded as the amount of damages cannot be measured reliably.

However, given that the company has been ordered by the court to pay damages
even though the amount is uncertain, it must be disclosed in the notes of the financial
statement as a contingent liability. Contingent liabilities are liabilities for which the
amount of the future sacrifice is so uncertain that it cannot be measured reliably, that
do not satisfy the probability criterion, or are dependent upon the occurrence of an
uncertain future event outside the control of the entity. In this case there is an
obligation but the amount is uncertain.

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