Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.

WCN 02-200-202
 AC
TYLER
GODWIN
ALDERMAN

CT
3RD
ASIA–PACIFIC
EDITION
3
FINANCIAL

¢
¢ $
$
$ ¢
¢

$
¢

$ $ ¢

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ACCT3 Financial © 219 Cengage Learning Australia Pty Limited
3rd Edition
Jonathan Tyler Copyright Notice
Norman Godwin This Work is copyright. No part of this Work may be reproduced, stored in a
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Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
 BRIEF
CONTENTS

1 Financial accounting 1

2 Financial statements 18

3 Recording accounting transactions 40

4 Accrual accounting and adjusting entries 60

5 Cash and internal controls 81

6 Receivables 97

7 Inventory 112

8 Non-current assets and intangible assets 130

9 Liabilities 152

10 Partnerships 175

11 Shareholders’ equity 191

12 Statement of cash flows 212

13 Financial statement analysis 234

A Appendix A: Time value of money 257

B Appendix B: CSL Limited, annual report 2017 266

Endnotes 289

Index 291

Tear-out review cards

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
iii
 CONTENTS

The statement of changes in equity 29

1 Financial accounting 1 Information beyond the financial statements 30
Notes to the financial statements 30
Beginning assumptions 2 Auditor’s report 31
Economic entity assumption 2 Directors‘ report 31
Accounting period assumption 2 Other information 31
Monetary unit assumption 2 Sustainability reporting 32
Going concern assumption 2 Governance information 33
Reporting profitability: the income statement 3 Exercises 34
Revenues 3
Expenses 4
Problems 37
The income statement 4 Cases 39
Reporting financial position: the balance sheet 5
Assets 5 3 Recording accounting transactions 40
Liabilities 5
Equity 6 The accounting information system 40
The balance sheet 6
Accounting transactions and
Reporting equity: the statement of changes in equity 7 the accounting equation 42
Linking the income statement and the balance sheet 7 Transaction analysis 42
Reporting cash flows: the cash flow statement 8 The dual-entry accounting system 46
Financing activities 8 The T-account 46
Investing activities 8 Debit and credit rules 46
Operating activities 8 Summary of debit and credit rules 48
The cash flow statement 8
Recording transactions in the accounting system 48
The objectives of financial reporting 9 The journal 48
Relevance and materiality 9 The ledger 48
Faithful representation 10 The trial balance 49
Comparability 10
Comprehensive example: journal entries to
Verifiability 10
financial statements 50
Timeliness 10
Recording transactions in the journal and posting
Understandability 10
to the ledger 50
The language of accounting 11 Preparing a trial balance 54
Exercises 13 Preparing financial statements 54

Problems 15 Exercises 55
Cases 17 Problems 58
Cases 59
2 Financial statements 18
4 Accrual accounting and
Business forms 18 adjusting entries 60
Generally accepted accounting principles (GAAP) 19
Accrual and cash bases of accounting 60
The balance sheet 20
Reporting accrual- and cash-based income 61
The income statement 22
Adjusting journal entries 62
Profits before income tax expense 25
Scenario 1: Deferred revenue 62
Other comprehensive income 25
Scenario 2: Accrued revenue 64
Horizontal and vertical analyses 25 Scenario 3: Deferred expense 65
Horizontal analysis 25 Scenario 4: Accrued expense 67
Vertical analysis 26 Summary of adjusting journal entries 69

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iv
Comprehensive example: adjusting journal entries 69 Inventory costing methods 114
Journalising and posting adjusting entries 70 Specific identification 115
Preparing an adjusted trial balance 71 First-in, first-out (FIFO) 115
Preparing financial statements 71 Last-in, first-out (LIFO) 117
Closing process 72 Moving average 117

The accounting cycle: a summary 74 Comparing inventory costing methods 118

Exercises 75 Estimating ending inventory 119

Problems 77 Lower-of-cost-and-net realisable value 120

Cases 79 Evaluating a business’ management of inventory 121

Horizontal and vertical analyses 121
Inventory turnover ratio 122
5 Cash and internal controls 81
Appendix: periodic inventory system 123
Recording inventory 123
Internal control 81 Inventory costing methods 123
Components of internal control 82 Exercises 126
Control environment 82
Risk assessment 83 Problems 128
Control activities 83 Cases 129
Information and communication 84
Monitoring 84
Limitations of internal control 84 8 Non-current assets and
intangible assets 130
Cash controls 84
Bank reconciliations 85
Recording, expensing and reporting
Bank reconciliation example 86
non-current assets 130
Petty cash funds 87
Recording non-current assets 130
Reporting cash and cash equivalents 88 Expensing non-current assets 131
Analysing cash 89 Reporting non-current assets 132
Horizontal and vertical analyses 89 Calculating depreciation expense 132
Free cash flow 90 Straight-line method 133
Exercises 93 Reducing-balance method 134
Units-of-activity method 135
Problems 95 Comparing depreciation methods 135
Cases 96 Adjustments made during a non-current
asset’s useful life 137
6 Receivables 97 Changes in depreciation estimates 137
Expenditures after acquisition 138
Recording and reporting accounts receivable 97 Asset impairment 139
Recording accounts receivable 97 Asset revaluations 139
Reporting accounts receivable 98 Disposing of non-current assets 140
Uncollectible receivables 99 Loss example 140
Direct write-off method 99 Gain example 141
Allowance method 100 Evaluating a company’s management of
Estimating bad debt expense 102 non-current assets 142
Percentage-of-sales approach 102 Horizontal and vertical analyses 142
Percentage-of-receivables approach 102 Non-current asset turnover ratio 143
Average life and age of non-current assets 144
Analysing accounts receivable 104
Horizontal and vertical analyses 104 Non-current assets and cash flows 144
Receivables turnover ratio 104 Intangible assets 145
Allowance ratio 105 Recording intangible assets 145
Notes receivable 106 Amortising and impairing intangible assets 146
Recording the note 106 Exercises 148
Recording interest 106
Problems 149
Collecting the note 107
Cases 151
Exercises 108
Problems 110
9 Liabilities 152
Cases 111
Current liabilities 152
7 Inventory 112 Taxes payable 153
Current liabilities with payroll 153
Recording, expensing and reporting inventory 112 Notes payable 154
Recording inventory 112 Current portion of non-current debt 154
Expensing inventory 114 Reporting current liabilities 155
Reporting inventory and cost of sales 114 Non-current liabilities 155

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Contents v
 Bonds 155 Dividend imputation 192
Bonds issued at face value 157 Regulation 193
Bonds issued at a discount 158 Ordinary shares 193
Bonds issued at a premium 160 Shareholder rights 193
Redeeming a bond before maturity 162 Recording ordinary shares 194
Issuing shares by instalment 194
Additional liabilities 163
Oversubscription 195
Lease liabilities 163
Forfeiture 196
Contingent liabilities 164
Evaluating a company’s management of liabilities 165 Dividends 196
Cash dividends 196
Horizontal and vertical analyses 165
Share dividends 198
Current ratio 166
Dividend Reinvestment Plans in Australia 198
Debt to assets ratio 166
Share splits 199
Appendix: determining a bond’s Issue price 167
Preference shares 200
Appendix: effective interest method of amortisation 168 Recording preference shares 200
Discount example 169 Cash dividends on preference shares 200
Premium example 169
Share buybacks 201
Exercises 171 Recording share buybacks 201
Problems 173 Evaluating a company’s management of equity 203
Cases 174 Horizontal and vertical analyses 204
Earnings per share 204
Return on equity 205
10 Partnerships 175 Dividend payout ratio 205
Dividend yield 206
The partnership form of business 175 Shareholders’ equity and cash flows 207
Ease of formation 176
Partnership agreement 176 Exercises 208
Mutual agency and co-ownership of property 176 Problems 210
Unlimited liability of owners 176 Cases 211
Transferability of ownership 177
No partnership taxation 177
Capital accounts for each partner 177 12 Statement of cash flows 212
Commencing a partnership 177
Capital account for each partner 178
The statement of cash flows 212
Cash flows from operating activities 213
Allocate profits and losses 179 Cash flows from investing activities 213
Sharing profits based on a set percentage 179 Cash flows from financing activities 213
Sharing profits based on capital balances and on service 179 Net increase (decrease) in cash 214
Admission and withdrawal of a partner 180 Additional disclosures 215
Purchasing a current partner’s interest 180 Preparing the statement of cash flows 216
Investing in the partnership 181 Direct and indirect methods for operating cash flows 217
Investing in the partnership: bonus to new partner 181 Example data 217
Investing in the partnership: bonus to existing partners 182
Withdrawal of a partner 182
Reporting cash flows from operating activities:
direct method 218
Revaluation of assets before withdrawal of a partner 183
Cash received from customers 218
Withdrawal of a partner at carrying amount 183
Cash paid for inventory 218
Withdrawal of a partner at more
Cash paid for operating expenses 219
than the carrying amount 184
Cash paid for taxes 220
Withdrawal of a partner at less
Other revenues and expenses 220
than the carrying amount 184
Net operating cash flows 220
Liquidation 184
Reporting cash flows from operating activities:
Sale of assets 184
indirect method 221
Paying the liabilities 185
Adjustments for non-cash items 221
Partners receive remaining cash 185
Adjustments for gains and losses from investing and
Partnership financial statements 186 financing activities 221
Exercises 187 Adjustments for current assets and current liabilities 222
Net operating cash flows 223
Problems 188
Calculating cash flows from investing activities 223
Cases 189 Investments 223
Equipment 223
11 Shareholders’ equity 191 Accumulated depreciation 224
Summary of investing cash flows 224
The corporate form of business 191 Calculating cash flows from financing activities 224
Separate legal entity 191 Non-current liabilities 224
Ability to raise capital 191 Contributed equity 224
Limited liability of owners 192 Retained earnings 225
Transferability of ownership 192

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
vi Contents
 Net financing cash flows 225 Liquidity analysis 245
Complete statement of cash flows: indirect method 225 Current ratio 245
Analysing a company’s statement of cash flows 226 Quick ratio 246
Free cash flow 226 Receivables turnover ratio 246
Cash flow adequacy ratio 226 Inventory turnover ratio 246
Summary of liquidity analysis 247
Exercises 228
Solvency analysis 247
Problems 231 Debt to assets ratio 248
Cases 232 Debt to equity ratio 248
Times interest earned 248
Summary of solvency 249
13 Financial statement analysis 234
DuPont analysis 249
Financial statement analysis 234 Exercises 251
Financial information 235
Problems 254
Standards of comparison 235
Analysis tools 236 Cases 256
Horizontal and vertical analyses 236
Horizontal analysis 236 Appendix A: Time value of money 257
Vertical analysis 238
Appendix B: CSL Limited, annual report 2017 266
Profitability analysis 242
Endnotes 289
Profit margin 242
Return on equity 242 Index 291
Return on assets 243 Tear-out review cards
Earnings per share 243
Price to earnings ratio 244
Summary of profitability 244

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Contents vii
 Guide to the text
PROFITS BEFORE INCOME TAX EXPENSE • Samsung collects record profits
Gross profit less Operating expenses yields the second • Samsung predicts record profits for third quarter
subtotal, Operating profits. Net finance costs (Finance as memory business booms.
Aerial Filming
Cash flow statement costs LO6minus THE OBJECTIVES
Finance income) and Gain OFon acquisition are
for the months of December, January and February
FINANCIAL then deducted REPORTING
to give profits before
As you read this text you will find a number of features in every
profits before income
Operating activities
tax expense The profit income tax expense, sometimes also
Cash received from customers $10 000 that a company generates
The objective of general purpose financial reporting is to
called ‘earnings before income taxes’
Cash paid for supplies chapter to enhance your study of financial accounting and help you
(1 100)
when considering both
cost of the inventorythat
the financial
provide
and
andis useful to
information about the reporting entity
other
existing andsimilar
potentialtitles. This
investors, represents
lenders
the normal expenses
understand how the theory is applied in the real world.
Cash paid for interest (50) and other creditors in making
the profit decisions
that about providing
a company generates
incurred to operate resources
the to the entity. Those decisions involve buying,
1
Imagine for a moment that you are on summer holidays
Net cash provided by operating activities $8business.
850 when
selling or holding equityconsidering revenues
and debt instruments, and and and decide to turn your hobby into a business which you
name Aerial Filming. With $1000 of your own money and

Investing activities expenses

providing or settling except
loans and otherfor income
forms tax.
of credit.3 a $2000
a $2600
language. It does
microenterprise
statements
drone (with
sofrom
loan
of gimbal,
the aerial
by the
creating
bank you
filming
camera
the summer financial
purchase
and business,
rechargeableAerial Filming,
such as a month, a quarter, but no longer
than a year. This is known as the
battery), $350 of spare propellers, disposable batteries,
Even though accountingAfteris a reporting
very its profit
quantitative before
process and tax, described above. At the end of the chapter, you should be accounting period assumption – the

CHAPTER OPENING FEATURES

Cash paid for drone $ (2 600) income tax
SIM cards and other supplies. During December, January
familiar with the four main financial statements – income
and February, you had 28 aerial filming jobs at an average assumption made by accountants that

Net cash used by investing activities expense

(2 600) the
The financial
amount of CSL
statements reports Income
introduced so tax
far expense
are full of of pay
statement,
statement
the bank $50 of
balance
change
interest. At
sheet,
in
theequity.
end
statement
of $400 each job, you buy $750 additional supplies and
of Further,
February,
of
you
you
cash flow,
should also
economic information can be meaningfully
captured and communicated over short
income tax expense
numbers,for a accounting
over information
$350 million must to possess
yield a certain
Net profit Financial accounting havethea bank
still have
$100 expanded
working
of supplies and
accounting
loan, you
and refined
vocabulary
also have $1940
$1200 owingin thetofollowing
in cash, that will be
you from chapters.
three
periods of time. Although the measurement
Financing activities given period.qualitative characteristics to be considered useful. customers. involves numbers, it usually requires
for the period (profit after tax) of Given this information, can you tell what happened to judgements and estimates not simply

Learning
Cash received fromobjectives
borrowing at the start
2 000 of each Information
chapter inidentify the .4 key
financial
$1337 concepts
reports
million. is often based on
your business over summer? Did you make enough
money to make it worth continuing or would it have been
calculations.
Publicly traded companies such as C
Cash received from owner 1 000
financially more rewarding working at the local IGA store?
LO1 BEGINNING ASSUMPTIONS
that will be covered, and Learning objective icons appear throughout
estimates, judgements, and at times the choice of one LEARNING How can you tell? Getting answers to such questions required to file financial statements wit
OBJECTIVES requires accounting, because ultimately you are filming
P THIS Exchange (ASX) at least twice
LYSecurities
accounting method rather than an alternative. It is also P
OTHER COMPREHENSIVE INCOME
to makeThe purpose of accounting is to identify, measure and
money, no longer for the simple pleasure of flying
Drawings (dividend) (7 310) Aerial Filming business example, the tim

A
theNetchapter to identify where each objective is discussed.
and filming
communicate with a drone or to provide
economic a community
information about a particular three months of summer.
important to note that financial reports cannot provide all interested users. Review this content with the e-lecture
service. Working for yourself has certain advantages, but
entity to To being
do this, accountants make the
cash used by financing activities (4 310) After studying the material in this chapter, you
should be able to:
also hassles,
following
which may not come
four
with
basic assumptions:
an employee,
economic entity, MONETARY UNIT ASSUMPTION
Note
the in the top section
information on theusers
that different Income maystatement
want. the term 1 Explain the four assumptions made when
and these
YT
success
need to be balanced
PPL HIS of the business. All of us need money
against the financial
a c ctoo eat,
u n tpaying period,
Net increase in cash $1 940 The monetary unit assumption

A
for accommodation, the phone, fortravel,monetary
buy clothes,
If financial
‘profit’ information
is used (gross, is to bebefore
operating, useful,income
it musttax,
be net communicating accounting information. Check out the video
entertainment,
summary
Chapter 1and hopefully, at some stage save.
concern.
unit and going
assumes that the dollar is the most
2 Describe the purpose and structure of an Accounting is the process of
Cash balance, 1 December 0 effective means to communicate economic
forrelevant and faithfully represent what it is reporting on. income statement and the terms and accounting The
the period). Comprehensive income items include identifying, measuring and communicating process of identifying,

HORIZONTAL AND
principles used to create it. activity – it is the ‘attribute of interest’. The
ECONOMIC ENTITY ASSUMPTION
LO5
economic information to permit informed measuring and

Cash balance, 28 February $1 940 Financial information is more useful if it is comparable, 3 Describe the purpose and structure of a judgements and decisions. Put more communicating economic drone has many attributes: manufacturer,
movements in equity that are not part of the realised gains balance sheet and the terms and principles simply, accounting is the The economic
language of
information to permit
entity
informed assumption
judgements and model, range, flying time, colour; but the att

VERTICAL ANALYSES
economic entity
verifiable, timely and understandable. used to create it. business. When you want states
assumption The to knowthat aboutthe decisions.
financial activities of a in accounting is the cost in dollars. If an e
EXHIBIT Cash flow statement for Aerial Filming or losses in profits. These can include movement in 4 Describe the purpose of a statement of
the financial
assumption made results
must understand
accountants
by of a business, you
business can
that the and speak accounting. The purpose
be separated from the cannot be expressed in dollars, then it is no
1.5 changes in equity and how it links the financial
of thisactivities of to
a help you financial
learn, activities
write andofspeak
the business’ owner(s) accounting system. For Aerial Filming,
translation of foreign operations (due to changes in
book is this

RELEVANCE AND MATERIALITY

income statement and the balance sheet. business
language can besoseparated
that you canand make from other
socially business
responsible andactivities. This advertisement in the local paper would be
from the financial activities
5 Describe the purpose and structure of a
The previous sections demonstrate that financial
financially sound businessassumption decisions. allows a user to examine a expense, while a favourable story would no
exchange rates between the Australian dollar currencies statement of cash flow and the terms and
of theWith
business’ owner(s).
this overall purpose in mind, this chapter
company’s (sole trader’s or partnership’s) accounting as no money was exchanged. T
Note that the ending cash balance on the statement Relevant financial information can principles used to create it.
statements communicate economic information about a
introduces
accounting
the basic terms,
information
principles and
withoutofconcern
rules that
that the information
of other countries in which CSL operates) and gains and
FEATURES WITHIN CHAPTERS
comprise the ‘spelling’ and ‘grammar’ the accounting limitations (and strengths) of accounting. It
relevance The capacity 6 Appreciate the objectives of financial includes the personal affairs of the owner(s) or other business
agrees with the cash balance shown on the balance sheet influence the decisions made by users reporting and qualitative characteristics that
of accounting information make accounting information useful.
that the dollar is a reasonably stable meas

losses in ‘cash flow hedges’. AASB 101 Presentation of company to interested parties; for example, investors and activities. For the Aerial Filming example in the introduction, inflation and deflation can be ignored).
in Exhibit 1.2. Since $2600 of the $3000 of cash generated because it has predictive value (allows the to make a difference in 7 Review the language of accounting. this means that the business is the reporting entity and your

Financial Statements requires the disclosure of decisions. creditors learnt from CSL’s income statement that the personal activities (such as the cost of your Saturday evening GOING CONCERN ASSUMPTION
from financing activities was invested into the drone, the user to better determine what the future out) should not be included with business activities (such as

comprehensive incomevalue
items either feedback
after theonprofit
past and
company earned just under $2 billion (Australian) of total buying batteries for the drone). The definition of the ‘reporting
The going concern assumption takes

CSL Analysis boxes link to the CSL

majority of the $1940 of cash on hand was generated
Making it Real boxes present
may be), confirmatory (provides real-life Important
comprehensive key terms
income
Express
for the are 2017marked in This is
financial year.
entity’ can be complex and is covered in detail in the
as a given that a business will continue to
operate into the foreseeable future.
through operations. This, of course, is a good sign and loss section, or
predictions) asboth.
CSL does, or in a separate statement. In Throughout this
YT
PPL HIS (Australian) Financial Reporting Handbook (the big book of
Unless there is evidence to the contrary,

annual report
are likelyextract provided inand to financial accounting scenarios to bold
usefulininformation
the text and defined in the that the

A
chapter apply this rules for accountants preparing financial statements)
indicates you to be able to repay the bank summary, CSL’sthat
Information income statement
can help confirm provides
may also helpapredict.
picture of because
icons indicate
an opportunity
it demonstrates Statement of Accounting Concept SAC 1.
most businesses are assumed to be going
concerns. This is important because it a
for online
keep or spend some cash on yourself. company was profitable during the year. However, the
Appendix B of the textbook, and demonstrate
For the
example,
the
information
chapter
about the
concepts
revenueforAerial year. in
theFilming margin when they are used in the text
amount recorded with respect to the v
how company generated its profits This self-study through
CourseMate Express, ACCOUNTING PERIOD ASSUMPTION
Accounting as the language of business, would assets. Because Aerial Filming will conti
You might also consider the situation if all customers
linking you to revision quizzes,
earned overtosummer
translates can be
earnings percompared
share with the revenue
of almost $3US, information can be even more useful if it is compared to
e-lectures, animations and describe Business
this picture as owners
a person and
using other
an interested parties usually do not summer, it is a going concern and we va

provides
waited threean opportunity toprofit
apply practice. for the firstelse.time.
asset (the drone) to generate revenue (the
more. money shewantwill beto wait too long before they receive information about
paid) what it is worth to the business, not what
months to pay you. Your in summer predicted at the commencement of the business to determine something For example, is $1.5104 billion (US) better how a business is doing. They want periodic measurements
YT
PPL HIS unsurprising given the of the business’ financial success or failure. For many
1 at the end of summer.
would have been the same, but your cash flow very how accurate those predictions were, and in turn may be
financial accounting concepts to a or worse than last year? Is it high enough given sales for
A

Check out the animated summary share price is around activities, be it a diet or sports training, it is useful to measure
different. There would have been no spare cash to draw out onused to help
Financial predict revenue
Statements: Part 2 in autumn with greater accuracy.
BK-CLA-ACCT3_FINANCIAL-180086-Chp01.indd 1 your performance at regular intervals to determine if you
30/05/18 5:18 PM

$100US. the period? How does it compare to competitors? Such In Appendix B CSL Annual

real-world business.
should change your strategy. In business, performance is
Report 2 017, you can find CSL’s income st
and you would have needed to borrow more money just to Information is considered material if measured primarily in financial terms. Accountants therefore
materiality The
comparisons provide the necessary context for a richer assume that economic information can be meaningfully
the following three descriptions:

buy most of the supplies and interest. it has the capacity to affect decisions threshold at which a captured and communicated over short periods of time,
1 Consolidated Statement of Comprehe
2 US$m
when omitted or misstated. For a student understanding of a company’s financial activities. Such
financial item begins to account; for the equation even if those to stay in balance,
accounting periods thearetransaction
somewhat artificial, 3 For the year ended 30 June 2 017.
language. It does so by creating the summer affect decision-making.
financial such
ANALYSISas a month,
musta also
quarter,
eitherbut no longer
decrease another asset account,period
or
the difference between an exam MAKING
mark
Look of balance
at CSL’s IT REAL
sheet in context can be easily generated through two techniques
accounting
a year. increase
This aisliability
2or equity account. This means that every
ANALYSIS statements of the aerial filming business,
Appendix Aerial Filming,
B and determine how many accountsthan
it uses to known as the assumption The
ACCT3 Financial

Look at CSL’s cash flow statement 49described

and 50 isabove.
material since a 49
At the end of means
the its the
chapter, student
you should fails called
beAlso, consider the
horizontal
accountingand vertical
transaction mustanalyses.
affect at least two accounts.
assumption made by
in Appendix B. How much cash did CSL generate or
HANDS
but one additional
familiar
UP,
with themark
WHO four means
LIKES
report
PROFITS?
assets, liabilities
he
main financial or she
scenario
and equity.
whenpasses;
statements however,
one shareholder
accounting period
of CSL sells her shares to
–anincome
assumption – the accountants that economic
For every transaction there is a source and dual nature of
BK-CLA-ACCT3_FINANCIAL-180086-Chp01.indd 2

economic eventassumption made

a use. by accountants that information can beEvery
aYou maydifference, be forgiven forbetween
thinkinganotherprofits
shareholder.(orIs this
total relating to Money comes from somewhere accounting
use for operating, investing and financing activities larger
statement,
comprehensive income, to be
balance say sheet, CSL? 90
statement and 95,
of may
cash
Is it an accounting transaction?
technically correct)
not
flow,
is
HORIZONTAL
economic and it goes
information ANALYSIS
can somewhere. This is known as
be meaningfully
accountingcaptured
meaningfully transactionand
must affect at least two
during 2017? influence
statement decisions.
of change An in example
equity. ofFurther,
Analysis:materiality you in practice
should also the dual nature of accounting. communicated
accounts. over short
the only information reported in a public company’s captured and communicated
Horizontal analysis is a method of horizontalover short periods of time.
Analysis: is havehow CSL a working report results accounting CSL’s
to thecomprised
balance
closest
vocabulary sheet
tenth
reports
of
26
a million
that different accounts,
will 12beliability accounts
annual report, as from a quick scan itof seems ‘profits’
11 asset accounts, periods of time.aTRANSACTION
and
analysing Although
company’s the measurement
ANALYSIS
account balances analysis A method of
• Operating activities: generated $1246.6 million ofexpanded
dollars (see and refined in
Appendix B).the
Thefollowing
numbers
3 equity chapters.
being reported
accounts.
are often the only or at least the Whenfirst
CSL’sthing
shares reported
are sold on the Australian involves
Securities numbers, it usually requires analysing
the a company’s
• Investing activities: used $862.9 million are so large that giving more exact amounts isis an
unlikely toevent of interestover time.ToItillustrate
is normally how accounting
conducted transactions
on affect account balances over
by the media, and not just in Australia, as seen by the Exchange, the sale economic to CSL
judgements and estimates
accounting equation, not
consider simply mathematical
the following 10 transactions
• Financing activities: used $103.5 million. make a difference
following selection of headlines to decision-making. (it needs to note the change
fromdividend
the UK: 3
in shareholding so it canboth pay the balance sheet and the income
in the first month of operations of Video time
Memories, bya calculating
the correct calculations.
and record the correct shareholder
absolute and percentage
Measurement uncertainty will also impact
information relevance.
– for voting If communications,
at meetings, statement. Thecompanies
business analysis
that documents calculates
graduations, bothweddings, birthdays
• Samsung makes record profit of $109m a day as Publicly traded such as CSL Limited are
changes a in each account.
YT
PPL HIS estimates LO1
chip demand BEGINNING
are difficult to makeetc.).
soars ASSUMPTIONS
or the
exchange
range
However, is large
because CSL is the
not involved in the
of resources, no money is received required theoutabsolute
or paid
and
to filesmall
other
and
financial
significant
percentage
life events.
business, change
statements
hypothetical
Although
with
the
the
the in
example
Australian
transactions would be
is
A

Download the Enrichment Modules

for further practice • Samsung predicts record profits for second
by CSL; it is not an accounting transaction.
each account
Securities treated
Exchange balance
in(ASX) on
the same a financial
way
at least by twice statement.
a large company. We
a year. For the As a result,
start by

Apply this icons in the text link you to ACCT3 The straight online
purpose of content,
quarter accounting isincluding to identify, measure interactive and it isFilming
Aerial
recording the transactions in a spreadsheet and later in the
very usefulbusiness in identifying
example, the
chapter use the more
promising
time period or troubling
is thePLY THIStrends
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communicate economic information about a particular threein months of summer.

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quizzes, videos and more. • Samsung record profits mask crisis without a company. formal The analysisCheck
accounting is out
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the animated
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summary because
entityand within to interested users. To do this,
LO2 accountants
ACCOUNTING make the journal and ledger.
CHAPTER 1 Financial accounting 9
following four basic assumptions: TRANSACTIONS
economic entity, ANDMONETARY THE UNIT ASSUMPTION
Alamy

YT
PPL HIS a c c oACCOUNTING
unting period EQUATION
, monetary unit
The monetary unit assumption assumption An
A

Check out the video summary for monetary unit and going assumption made by
BK-CLA-ACCT3_FINANCIAL-180086-Chp01.indd 9 Chapter 1 All accounting transactions must 30/05/18 be5:19 assumes
PM
recorded in the that the dollar is the most CHAPTER 2 Financial statements 25
concern.
accounting information system. To understand the nature
accountants that the dollar
effective means to communicate economic is the most effective
END-OF-CHAPTER FEATURES ECONOMIC ENTITY ASSUMPTION
of recording transactions, it is best to start with the
fundamental accounting equation: activity – it is the ‘attribute of interest’. The means to communicate
economic activity.
Assets = Liabilities + Equity drone has many attributes: manufacturer,
BK-CLA-ACCT3_FINANCIAL-180086-Chp02.indd 25 30/05/18 5:29 PM
The economic entity assumption model, range, flying time, colour; but the attribute of interest
economic entity The equation states that a business entity’s assets
At the end of each assumption The states that must theChapter
financial activities tear-out
of its liabilities cards
of a in equity.
accounting is the cost in dollars. If an economic activity
always equal the sum and This REVIEW
assumption made by business can bethat separated from theof the equation KEY DEFINITIONS LEARNING OBJECTIVES

ofcannot be expressed in dollars, then it is not recorded in the

means any change to one part must
chapter you will accountants that the found ata second
the back the
LO2, 3
5 Adjusting journal entry – revenue accounting income statement
Explain the four assumptions made when communicating

a charges a flat feefinancial activities of the business’ owner(s)

be accompanied by change to another part. For
The process of identifying, The financial statement that LO1

EXERCISES Leopard Legal agrees to prepare and represent Ali in court

accounting system. For Aerial Filming, placing a paid
measuring and communicating reports a company’s revenues accounting information.
financialfor aactivities offirm
speeding fine. The of $250 per economic information to permit
informed judgements and
and expenses over a specific
period of time. Describe the purpose and structure of an income
example, suppose that a transaction increases an asset
LO2

Videoing a customer’s wedding

find several tools book provide a portable
hour and always completes the service before billing the
business can be separated
decisions.

and from other business activities. This

balance sheet statement and the terms and principles used to create it.

advertisement in the local paper would be recorded as an

client. The firm completes the service on 16 April and bills economic entity A financial statement that
assumption reports a business’ assets, Describe the purpose and structure of a balance sheet and
Ali on 1 March, with the bill amounting to 20 hours. Leopard LO3

from the Legalfinancial activities

prepares financial statements at the end of each
The assumption made by liabilities and equity at a specific the terms and principles used to create it.

assumption allows a user to examine a

accountants that the financial point in time.

expense, while a favourable story would not be recorded in

activities of a business can be
month. Describe the purpose of a statement of changes in
of the business’ owner(s).
asset

(solestudy tool,
LO4

to help you to
LO1
1 Cash and accrual basis separated from the financial
activities of the business’
An economic resource that is equity and how it links the income statement and the
objectively measurable, results balance sheet.
REQUIRED owner(s).

company’s trader’s or partnership’s)

During 2017, Supreme Media Company earned $77 500 in from a prior transaction and will

accounting as no money was exchanged. This is one of the

provide future economic benefit.
revenue. At year-end, only $58 500 of that revenue had been a Prepare any adjusting journal entry necessary for accounting period LO5 Describe the purpose and structure of a cash flow

TRANSACTION ANALYSIS
assumption cost principle statement and the terms and principles used to create it.
collected. Not only this, Supreme Media incurred $39 600 of Leopard Legal on 30 April. The assumption made by The principle that assets should

review, practice accounting information without concern that the information

summarising each limitations (and strengths) of accounting. It assumes further
accountants that economic
expenses of which only $35 000 had been paid. b Explain if this situation is a deferred or accrued revenue. information can be meaningfully
be recorded and reported at LO6 Appreciate the objectives of financial reporting and the
the cost paid to acquire them.
captured and communicated qualitative characteristics that make accounting
REQUIRED c Show the T-accounts with the adjusting journal entry over short periods of time.
Sometimes referred to as the
information useful.
‘historical cost principle’.
Determine profit or loss (total comprehensive income) for posted
includes
to them.
the personal affairs of Transaction
the owner(s) #1or other business monetary unit liability

that the dollardeposited

is a reasonably
$15 000 intostable measure (the effect
Becauseof
assumption An obligation of a business that
LO7 Review the language of accounting.
the year under (a) the cash basis of accounting and (b) the

and extend your chapter for class

After registering the business name, Video Memories, the owners the business’ bank account.
An assumption made by results from a past transaction
LO2, 3
accrual basis of accounting. 6 Adjusting journal entry – expense accountants that the dollar is
KEY FORMULAS and will require the sacrifice of

activities. For the Aerial FilmingVideo example in receives

the introduction,
the most effective means to economic resources at a future

2 Adjusting journal entries

On 1 March, Mustafa borrows $62 000 from Northern Lights
LO2, 3
Bank on a short-term loan. Interest is paid after three
Memories cash of $15 000, assetsinflation and
increase. Its deflation
equity canbecause
also increases be ignored).
investors have contributed cash for
communicate economic activity.
going concern
date.
equity KEY FORMULA 1.1 INCOME STATEMENT

an ownership interest in the business. More specifically, Video Memories’ contributed equity (or contributed capital) increases.
assumption The difference between a
months and annual interest rates are 6 per cent.
this means that the business is the reporting entity and your
knowledge of the preparation and
Consider the following incomplete adjusting journal entries: The assumption made by business’ assets and liabilities, Revenues – Expenses = Net Profit or Net Loss
accountants that a company representing the share of assets (or Income, more formally, Total Comprehensive Income)
REQUIRED will continue to operate into the that is claimed by the business’
1 (a) 5 600 foreseeable future. owner(s).

GOING CONCERN ASSUMPTION

a Record the adjusting journal entry necessary on 1 May.
b personal activities
entry to the relevant(such as the cost of your Saturday evening
Accumulated Depreciation 5 600 Post the 1 May journal ledger
Assets = Liabilities + Equity
income statement
(profit and loss
contributed capital
The resources that investors KEY FORMULA 1.2 THE RELATIONSHIP BETWEEN ASSETS,

key learning revision.

statement) contribute to a business in LIABILITIES AND EQUITY
2 Interest Expense 8 500 T-accounts.
Cash = + Contributed Equity
The income statement reports exchange for ownership

(b) 8 500 out) should not be included with business LO2, 3 activities
$ 0
(such as a company’s revenues and
going concern
expenses and the resulting
interest.
dividends
Assets = Liabilities + Equity

going concern assumption

7 Adjusting journal entry errors
Prior bal. The $ takes0
profit or loss. Profits that are distributed
3 Accounts Receivable 17 000
assumption Theto owners (usually called

thatbuying batteries for entries.

theShedrone). The definition+ of $15the000 ‘reporting
revenue KEY FORMULA 1.3 STATEMENT OF CHANGES IN EQUITY

objectives.
Natalie, a first-year intern at an investment bank, believes An increase in resources drawings if the business is not
(c) 17 000 (THE RETAINED EARNINGS PART)

assumption made by
a company).
she may have made errors in her adjusting resulting from the sale of goods

4 (d) 6 750 has asked you for advice and reveals the following #1 as a given that a business will continue + $15 000 to
or the provision of services. retained earnings
Profits that are kept in the
Retained Earnings, Beginning Balance

entity’ can be complex and is Newcovered in

$15detail in the
revenue recognition

accountants that a
+/– Net Profit/Loss
accounting records: business.
500
principle
Subscription Revenue 6 750
bal. $15 000
The principle that revenue – Dividends
statement of changes

operate into the foreseeable future. company will continue to

a Depreciation expense on a car was not recorded. should be recorded when in equity = Retained Earnings, Ending Balance

(Australian)
will be completed next year.Financial Reporting Handbook (the big book $15 of
a resource has been earned A financial statement that
REQUIRED b Revenue was recorded for the current year when the job
000
and not just when the cash is
$ 0 $15 500
reports the change in a
= +
Unless there is evidence to the contrary, operate into the
received. business’ equity (contributed
Identify the likely account(s) that would complete each equity, reserves and retained
KEY FORMULA 1.4 THE CASH FLOW STATEMENT
expense
adjusting journal entry (a) to (d). c Commission from customer service operators has been
rules for accountants preparing financial statements)
A decrease in resources earnings) over a specific period Cash Flows Provided (Used) by Operating Activities

foreseeable future.
of time.
overlooked. resulting from the operation of
a business. cash flow statement +/– Cash Flows Provided (Used) by Investing Activities

most businesses are assumed to be going

LO2
3 Adjusting journal entries REQUIRED matching principle A financial statement that +/– Cash Flows Provided (Used) by Financing Activities

Statement of Accounting Concept SAC 1.

The principle that expenses reports a business’ sources and
Consider the four entries in the preceding exercise. Determine the likely accounts that are affected by each error should be recorded in the period uses of cash over a specific = Net Increase (Decrease) in Cash

EXHIBIT Transaction summary for Video Memories (Continued)

resources are used to generate period of time.

concerns. This is important because it affects the dollar

and whether those accounts are understated or overstated + Cash at the beginning
REQUIRED revenues.
as a result of the error.
Identify each entry as an accrued expense, an accrued 3.2 = Cash at the end

amount recorded with respect to the value of certain

revenue, a deferred expense or a deferred revenue.

ACCOUNTING PERIOD42ASSUMPTION
LO2, 3
8 Calculate expenses and revenues
4 Adjusting journal entry – expense The current and prior-year balance sheet of NCA show the
LO2, 3
ACCT3 Financial
Muscle Man Ltd pays its one-year insurance policy of
following account balances:
assets. Because AerialFINANCIAL Filming will continue beyond the
$29 000 on 1 October. The insurance policy covers all claims Current year Prior year
1
in the next 12 months. The company is preparing its financial
statements on 31 December.
Business
Supplies owners
$4 000 and $6 500 other interested parties usually do not
summer, it is a going concern ACCOUNTING
and we value the drone at
Unearned Revenue 8 400 8 000
REQUIRED
a Determine whether the expense is deferred or accrued
want
During the to
current year,wait
NCA too
purchased $13 long
300 of before
supplies they receive information
BK-CLA-ACCT3_FINANCIAL-180086-Chp03.indd 42
about what it is worth to the business, not what it can be sold for 30/05/18 2:22 PM
BK-CLA-ACCT3_FINANCIAL-180086-Review_Cards.indd 1 23/05/18 8:02 PM

expense and explain why. and received $8700 of cash for services to be performed later.
b Prepare the journal entries that Muscle Man would make how a business is doing. They want periodic measurements
REQUIRED
at the end of summer.
during October (receipt of cash) and on 31 December. Using ledger accounts, determine NCA’s supplies expense
of the business’ financial success or failure. For many
and service revenue for the current year.

activities, be it a diet or sports training, it is useful to measure

your performance at regular intervals to determine if you ANALYSIS
Copyright 2019 Cengage Learning. All Rights Reserved. May not beIncopied, In Appendix B CSL Annual
business,scanned, orisduplicated, in whole or in part. WCN 02-200-202
CHAPTER 4 Accrual accounting and adjusting entries 75

viii should change your strategy. performance

Report 2 017, you can find CSL’s income statement with
BK-CLA-ACCT3_FINANCIAL-180086-Chp04.indd 75
measured primarily in financial terms. Accountants therefore 30/05/18 2:42 PM

the following three descriptions:

assume that economic information can be meaningfully 1 Consolidated Statement of Comprehensive Income
 Guide to the online resources
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your lectures and assessments. These teaching tools are accessible via cengage.com.au/
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Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
ix
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
 1
Imagine for a moment that you are on summer holidays
and decide to turn your hobby into a business which you
name Aerial Filming. With $1000 of your own money and
a $2000 microenterprise loan from the bank you purchase
a $2600 drone (with gimbal, camera and rechargeable
battery), $350 of spare propellers, disposable batteries,
SIM cards and other supplies. During December, January
and February, you had 28 aerial filming jobs at an average
of $400 each job, you buy $750 additional supplies and
pay the bank $50 interest. At the end of February, you

Financial accounting still have the bank loan, you also have $1940 in cash,
$100 of supplies and $1200 owing to you from three
customers.
Given this information, can you tell what happened to
your business over summer? Did you make enough
money to make it worth continuing or would it have been
financially more rewarding working at the local IGA store?
LEARNING How can you tell? Getting answers to such questions
OBJECTIVES requires accounting, because ultimately you are filming
to make money, no longer for the simple pleasure of flying
and filming with a drone or to provide a community
service. Working for yourself has certain advantages, but
After studying the material in this chapter, you also hassles, which may not come with being an employee,
should be able to: and these need to be balanced against the financial
1 Explain the four assumptions made when success of the business. All of us need money to eat, pay
communicating accounting information. for accommodation, the phone, travel, buy clothes,
entertainment, and hopefully, at some stage save.
2 Describe the purpose and structure of an Accounting is the process of
income statement and the terms and accounting  The
identifying, measuring and communicating process of identifying,
principles used to create it. economic information to permit informed measuring and
judgements and decisions. Put more communicating economic
3 Describe the purpose and structure of a information to permit
balance sheet and the terms and principles simply, accounting is the language of informed judgements and
used to create it. business. When you want to know about decisions.
the financial results of a business, you
4 Describe the purpose of a statement of must understand and speak accounting. The purpose
changes in equity and how it links the of this book is to help you learn, write and speak this
income statement and the balance sheet. language so that you can make socially responsible and
5 Describe the purpose and structure of a financially sound business decisions.
statement of cash flow and the terms and With this overall purpose in mind, this chapter
principles used to create it. introduces the basic terms, principles and rules that
comprise the ‘spelling’ and ‘grammar’ of the accounting
6 Appreciate the objectives of financial
reporting and qualitative characteristics that

Alamy Stock Photo/ITAR-TASS News Agency

make accounting information useful.
7 Review the language of accounting.

Express
YT
Throughout this PPL HIS
A

chapter apply this

icons indicate
an opportunity
for online
self-study through
CourseMate Express,
linking you to revision Accounting as the language of business, would
quizzes, e-lectures, describe this picture as a person using an
asset (the drone) to generate revenue (the
animations and more. money she will be paid)
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
1
 language. It does so by creating the summer financial such as a month, a quarter, but no longer accounting period
statements of the aerial filming business, Aerial Filming, than a year. This is known as the assumption  The
described above. At the end of the chapter, you should be accounting period assumption – the assumption made by
accountants that economic
familiar with the four main financial statements – income assumption made by accountants that information can be
statement, balance sheet, statement of cash flow, economic information can be meaningfully meaningfully captured and
statement of change in equity. Further, you should also communicated over short
captured and communicated over short periods of time.
have a working accounting vocabulary that will be
periods of time. Although the measurement
expanded and refined in the following chapters.
involves numbers, it usually requires
judgements and estimates not simply mathematical
calculations.
Publicly traded companies such as CSL Limited are
LO1 BEGINNING ASSUMPTIONS required to file financial statements with the Australian
Securities Exchange (ASX) at least twice a year. For the
The purpose of accounting is to identify, measure and Aerial Filming business example, the time period is the
communicate economic information about a particular three months of summer.
entity to interested users. To do this, accountants make the
following four basic assumptions: economic entity, MONETARY UNIT ASSUMPTION
PPLY THIS accounting period, monetary unit
The monetary unit assumption assumption  An
A

Check out the video summary monetary unit and going

for Chapter 1 assumes that the dollar is the most assumption made by
concern. accountants that the dollar
effective means to communicate economic is the most effective
activity – it is the ‘attribute of interest’. The means to communicate
ECONOMIC ENTITY ASSUMPTION economic activity.
drone has many attributes: manufacturer,
The economic entity assumption model, range, flying time, colour; but the attribute of interest
economic entity
assumption  The states that the financial activities of a in accounting is the cost in dollars. If an economic activity
assumption made by business can be separated from the
accountants that the cannot be expressed in dollars, then it is not recorded in the
financial activities of a financial activities of the business’ owner(s) accounting system. For Aerial Filming, placing a paid
business can be separated and from other business activities. This advertisement in the local paper would be recorded as an
from the financial activities
of the business’ owner(s). assumption allows a user to examine a expense, while a favourable story would not be recorded in
company’s (sole trader’s or partnership’s) accounting as no money was exchanged. This is one of the
accounting information without concern that the information limitations (and strengths) of accounting. It assumes further
includes the personal affairs of the owner(s) or other business that the dollar is a reasonably stable measure (the effect of
activities. For the Aerial Filming example in the introduction, inflation and deflation can be ignored).
this means that the business is the reporting entity and your
personal activities (such as the cost of your Saturday evening GOING CONCERN ASSUMPTION
out) should not be included with business activities (such as going concern
The going concern assumption takes assumption  The
buying batteries for the drone). The definition of the ‘reporting
as a given that a business will continue to assumption made by
entity’ can be complex and is covered in detail in the accountants that a
operate into the foreseeable future. company will continue to
(Australian) Financial Reporting Handbook (the big book of
Unless there is evidence to the contrary, operate into the
rules for accountants preparing financial statements) foreseeable future.
most businesses are assumed to be going
Statement of Accounting Concept SAC 1.
concerns. This is important because it affects the dollar
amount recorded with respect to the value of certain
ACCOUNTING PERIOD ASSUMPTION
assets. Because Aerial Filming will continue beyond the
Business owners and other interested parties usually do not summer, it is a going concern and we value the drone at
want to wait too long before they receive information about what it is worth to the business, not what it can be sold for
how a business is doing. They want periodic measurements at the end of summer.
of the business’ financial success or failure. For many
activities, be it a diet or sports training, it is useful to measure
your performance at regular intervals to determine if you ANALYSIS
In Appendix B CSL Annual
should change your strategy. In business, performance is
Report 2 017, you can find CSL’s income statement with
measured primarily in financial terms. Accountants therefore the following three descriptions:
assume that economic information can be meaningfully 1 Consolidated Statement of Comprehensive Income
captured and communicated over short periods of time, 2 US$m
even if those accounting periods are somewhat artificial, 3 For the year ended 30 June 2 017.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
2 ACCT3 Financial
 This reports a company’s revenues and expenses and the
Which assumption does each description best relate to? resulting profit or loss (net income or total comprehensive
Analysis: income). When a company releases its annual report, the
1 economic entity news headline is almost always the profit or loss number; for
2 monetary unit (for comparison with other biotech example, ‘Commonwealth Bank Reports $9.9 Billion Profits’.
companies CSL reports in US dollars, it does not affect
the assumptions here)
REVENUES
3 time period.

Royal Australian Mint

MAKING IT REAL

IS THE BUSINESS A GOING CONCERN?

The Auditing Standard ASA 570 Going Concern
suggests the following wording for the Auditor’s
report when a business has been unable to find
sufficient financing:
Basis for qualified opinion
‘As discussed in Note yy, the Company’s financing
arrangements expire and amounts outstanding are
payable on 19 August 20X2. The Company has been
unable to conclude renegotiations or obtain
replacement financing. This situation indicates that a Revenues and expenses are measured in dollars
material uncertainty exists that may cast significant
doubt on the Company’s ability to continue as a A revenue is an increase in resources
revenue  An increase in
going concern. The financial report does not resulting from the sale of goods (sales resources resulting from
adequately disclose this matter.’1 revenue) or the provision of services (service the sale of goods or the
provision of services.
revenue). Receiving $400 for filming a
Shutterstock.com/Dmitry Kalinovsky

surfing competition is an example of revenue. You have $400

that you didn’t have before you provided the service.
Revenues are recorded according to the revenue
recognition principle. The revenue
revenue recognition
recognition principle states that revenue principle  The principle
should be recorded when a resource has that revenue should be
recorded when a resource
been earned, regardless of when the cash has been earned and not
is received. That is, you may ask for just when the cash is
advance payment prior to filming the surf received.
contest or decide not to bill the surfers
until after they have received their prize money. Regardless
YT of when cash is received, revenue is earned when you do
PPL HIS
the filming. The provision of the service is substantially
A

Review this content with the e-lecture

complete, and collection is reasonably assured. This is
known as a­ ccrual-based accounting and is distinguished
from cash-based accounting. The Australian Accounting
LO2  EPORTING PROFITABILITY:
R Standard: AASB 15 Revenue from Contracts with
THE INCOME STATEMENT Customers provides much more detail on calculating the
amount and timing of revenue recognition.
The first question usually asked of a business is whether it Given these definitions, total revenue for summer for
is making any money. In accounting we would ask: Is the Aerial Filming is as follows: you have only one source of
business profitable? Does it generate more resources than revenue – airborne filming. Assuming that your customers will
it uses? Accounting provides answers to pay, your filming business earns revenue each time a filming
income statement
(profit and loss these questions with a financial statement job is undertaken. So, if you filmed 28 occasions at $400 each,
statement)  The called the income statement
income statement reports revenues total $11 200 for the summer. Of those revenues,
a company’s revenues and (sometimes called the profit and loss you have received cash for all except three ($1200). The $1200
expenses and the resulting statement) or, to be technically correct, has been earned (you have carried out the service and expect
profit or loss.
the statement of comprehensive income. to be paid), although it has not been received in cash.
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 1 Financial accounting 3
 EXPENSES THE INCOME STATEMENT
expense  A decrease in An expense is a decrease in resources Once a company’s revenues and expenses are calculated,
resources resulting from resulting from the operation of a they are reported on the income income
the operation of a
business.
business. The replacement propellers, statement. This is the financial statement statement  The
disposable batteries and other supplies that shows a business’ revenues and financial statement that
reports a company’s
consumed (used up) while filming are examples of expenses over a specific period of time. revenues and expenses
expenses. Other expenses common to businesses are Its purpose is to demonstrate the financial over a specific period of
time.
wages, taxes, advertising, rent, interest and utilities (i.e. success or failure of the business over
electricity, water and gas). that specific period. When revenues exceed expenses, a
Expenses are recorded in the period they are incurred. company generates a profit. When expenses exceed
matching principle  The matching principle states that revenues, a company incurs a loss. The basic structure of
The principle that expenses should be recorded in the the statement is as follows:
expenses should be
recorded in the period
period resources are used to generate
resources are used to revenues. For example, in summer the KEY FORMULA 1.1 INCOME STATEMENT
generate revenues. disposable batteries are used and should
Revenues – Expenses = Net Profit or Net Loss
therefore be included in summer’s (or Income, more formally, Total Comprehensive Income)
expenses. The recording of revenues and expenses in the
period they are earned and incurred should result in accurate
Given the revenues and expenses determined
matching and the calculation of a ‘true and fair’ profit or loss.
previously, Aerial Filming’s summer income statement
Given these definitions, total summer expenses for the
would appear as shown in Exhibit 1.1. It contains the
filming business are as follows. While the business has
business name, the statement name (that is, ‘Income
only one source of revenue, the filming business has three
statement’) and the time period, which for this example is
sources of expenses. The first is supplies. From the given
the summer – the months of December, January and
information, the amount of supplies used during summer
February. It also shows that the filming business generated
can be calculated as follows:
$9650 of profits during summer. This part of the statement
Amount on hand at the beginning of summer $  350 is often called the ‘profit and loss’ section.
Plus amount purchased during summer 750
Aerial Filming
Less amount on hand at the end of summer (100) Income statement
Amount used during summer $1 000 for the three months ending 28 February
Revenues $11 200
Therefore, supplies expense in this period is $1000. Expenses:
The second expense relates to your borrowing. You paid  Supplies $1 000
the bank $50 at the end of summer to compensate them
 Interest     50
for loaning you $2000. Paying for the use of someone else’s
money is called interest. Therefore, interest expense is $50.  Depreciation    650
The third expense relates to your equipment – the   Total expenses $  1 700
drone. Unlike supplies, which are used up and need to be Profit $  9 500
refilled, equipment includes things like tools and furniture EXHIBIT Income statement for Aerial Filming
that is used on an ongoing basis (although it will eventually 1.1

deteriorate and be of no economic value to the business).

Because this equipment was used in summer to generate
revenues, the matching principle requires that some portion ANALYSIS
of the equipment’s cost be expensed in summer. This is Look at CSL’s income statement
(consolidated statement of comprehensive income) in
called depreciation expense. Chapter 8 will discuss the
Appendix B. The statement contains six revenues
various methods for calculating depreciation expense, but (including ‘finance income’ and ‘gain on acquisition’ in the
for now we will keep things simple. Assuming that the middle of the statement) and six expenses (including ‘cost
equipment will be used for another three seasons and then of sales’, ‘finance costs’ and ‘income tax expense’).
thrown away, it is reasonable to expense one-quarter of the 1 Can you identify the others?
equipment’s cost each season. This equals $650 for the 2 What was the company’s ‘net profit for the
drone ($2600 cost divided by four seasons). Therefore, period’ (after tax) for 2017?
depreciation expense for summer is $650.

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4 ACCT3 Financial
 ASSETS
Analysis:
At this stage do not become too concerned over the An asset is a resource of a business.
asset  An economic
particular profit figure used. CSL’s financial statements in More formally, it is an economic resource resource that is objectively
the appendix are an extract from its annual report as that is objectively measurable, that results measurable, results from a
required by Corporations Law and are complex, especially prior transaction and will
from a prior transaction, and that will provide future economic
for the first-time viewer.
provide future economic benefit. Cash is benefit.
• Revenues: sales revenue; Pandemic Facility
a good example of an asset: it can be
Reservation fees; royalties and licence revenue; other
income. counted, it is received through a transaction with someone
• Expenses: research and development expenses; else and it can be used to buy things in the future. Other
selling and marketing expense; general and common assets include inventories, receivables, property,
administration expense. plant and equipment, and intangible assets (assets that
• Net profit for the period (after income tax expense) have no physical form, such as trademarks and copyright).
for 2017: $1337.4 million. This was over $95 million Money owed to the business is often called a receivable,
more than 2016 ($1337m – $1242m)! it is an asset because you expect to exchange it for cash
when you are paid.
Assets are recorded and reported according to the
historical cost principle, which is often shortened to the
MAKING IT REAL
cost principle. The cost principle states cost principle  The
WHY DO WE HAVE that assets should be recorded and principle that assets
FINANCIAL STATEMENTS? reported at the cost paid to acquire them. should be recorded and
reported at the cost paid to
Dun & Bradstreet2 Given these definitions, Aerial Filming acquire them. Sometimes
D&B is the world’s leading source of commercial has several assets at the end of February: referred to as the
information and insight on businesses, and the ‘historical cost principle’.
● $1940 of cash
need of financial statements. This need shows that
● $100 of remaining supplies
financial statements are not only important for
students beginning their study of business, but also ● $1200 of receivables from customers.
for use in a billion-dollar company, both inside and You also have a used drone, but the value of this asset
outside the company. is calculated a little differently because it will continue to
Before we start our review of financial statements, be used beyond this summer. The drone originally cost
it is important to understand why they are put
$2600, but (as explained above) the matching principle
together in the first place. Management of any
business requires a flow of information to make allows us to expense $650 of that cost in summer. This is
informed, intelligent decisions affecting the success called depreciation expense. As a result, the drone’s
or failure of its operations. Investors need statements remaining value to the business is $1950 ($2600 – $650).
to analyse investment potential. Banks require Again, Chapter 8 will discuss in much more detail the
financial statements to decide whether or not to loan accounting for equipment and the related depreciation
money, and many companies need statements to
expense calculations.
ascertain the risk involved in doing business with
their customers and suppliers.
LIABILITIES
A liability is an obligation of a business.
liability  An obligation
More formally, it is a present obligation of of a business that results
LO3  EPORTING FINANCIAL
R a business that results from a past from a past transaction
and will require the
POSITION: THE transaction and will require the sacrifice of sacrifice of economic
BALANCE SHEET economic resources at a future date. resources at a future date.
Examples of liabilities common to
Another important issue for any business is its current businesses include accounts payable to suppliers, salaries
financial position. What does the business own? What payable to employees and taxes payable to governments.
does it owe? Accounting provides answers to these The only liability of Aerial Filming at the end of summer is
questions with a financial statement the $2000 borrowed from the bank which is considered a
balance sheet  A called the balance sheet (sometimes creditor. A creditor is a person or business who you owe
financial statement that money to. As will be explained below, the business does not
reports a business’ assets, called the statement of financial position),
liabilities and equity at a which reports a business’ assets, have a liability for the $1000 of your own money that was
specific point in time. contributed to the business. You are the owner, not a creditor.
liabilities and equity at a point in time.

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CHAPTER 1 Financial accounting 5
 EQUITY time. Its purpose is to show a business’ resources and the
claims against those resources. Because a balance sheet
equity  The difference Equity is the difference between a is reported at a moment in time, it is often referred to as a
between a business’ business’ assets and liabilities and
assets and liabilities, still photograph or snapshot of a business. The basic
represents the share of assets that are
representing the share of structure of the statement is as follows:
assets that is claimed by claimed by the business’ owner(s). An
the business’ owner(s). example of equity with which you may KEY FORMULA 1.2  THE RELATIONSHIP BETWEEN ASSETS,
be familiar is home equity. A homeowner’s equity refers to LIABILITIES AND EQUITY
the difference between the value of the home and the
amount owed to the bank. Equity in accounting is the same Assets = Liabilities + Equity
principle except that it usually refers to the difference
between the cost of the business’ assets and its liabilities. Given the assets, liabilities and equity determined
A business (company) can generate equity in two ways. previously, Aerial Filming’s balance sheet would appear as
The first is through contributed (or issued) capital. shown in Exhibit 1.2. It contains the business name, the
contributed capital 
Contributed capital is defined as the statement name and the time reference, which for this
The resources that resources that investors put into a example is 28 February.
investors contribute to a business in exchange for an ownership
business in exchange for
interest. The $1000 that you, the owner, Aerial Filming
ownership interest.
Balance sheet
put into Aerial Filming is contributed at 28 February
capital. Note here that contributed capital is not revenue. Cash $1 940
The increase of $1000 did not result from the filming
Accounts receivable   1 200
business providing a service or selling a product. It came (money customers owe)
by contributing an ownership interest. The most common Supplies    100
method that companies use to generate contributed capital
Drone   1 950
is the issue (sale) of shares to investors. (Note that this is
different to the daily buying and selling of shares on the Total assets $5 190
securities exchange where existing owners sell to new Loan from bank $2 000
owners.) Total liabilities $2 000
The second way a business generates equity is through
Contributed capital $1 000
profitable operations. When a business generates profits,
it can either distribute them to owner(s) or retain them to Retained earnings   2 190
grow the business. Profits that are distributed to a Total equity $3 190
company’s owners (shareholders) are called dividends or Total liabilities and equity $5 190
drawings for a non-company business
dividends  Profits that EXHIBIT Balance sheet for Aerial Filming
are distributed to owners (sole trader or partnership). Note here 1.2
(usually called drawings if that dividends are not an expense of a
the business is not a
company). company: they are simply a distribution
Notice that total assets equal total liabilities plus total
retained earnings  of company assets to owners. Profits
equity (or assets minus liabilities equals net assets, which
Profits that are kept in the that are retained in the business are
business. is equity). This will always be the case for any business. An
called retained earnings. A company’s
entity’s assets are always claimed by someone. Either they
retained earnings therefore represent the equity generated
are owed to someone (in the filming business’ case, the
from profitable operations that is kept in the company.
bank) or claimed by an owner (you). No asset of any
Since Aerial Filming at the end of summer has less assets
business is ever unclaimed. This relationship between
than the combined liabilities and contributed equity plus
assets, liabilities and equity is represented by the following
profits, there must have been some assets distributed to
equation, known as the accounting equation or balance
you. You obviously needed some ‘spending money’ over
sheet equation: Assets = Liabilities + Equity. During
summer.
summer you must have withdrawn $7310 ($9500 – $7310 =
$2190), because even if you were not a good record keeper
THE BALANCE SHEET we could calculate the amount of retained earnings simply
The balance sheet is the financial statement that shows a by inserting the retained earnings dollar amount to make
business’ assets, liabilities and equity at a specific point in the accounting equation balance.

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6 ACCT3 Financial
 Aerial Filming
ANALYSIS Statement of changes in retained earnings
Look at CSL’s balance sheet in from 1 December to 28 February
Appendix B. Write out in numbers the company’s Retained earnings, 1 December $    0
accounting equation (A = L + E) as at 30 June 2 017. How + Net income (or Net profits) 9 500
many different assets does the company disclose?
– Drawings (Dividends) 7 310
Analysis:
A=L+E Retained earnings, 28 February $ 2 190
9123 = 5989 + 3164
EXHIBIT Statement of changes in retained earnings for Aerial
(rounded to the nearest million) 1.3 Filming
Ten different assets are listed on CSL’s balance sheet.
Your business started with no retained earnings but
YT
PPL HIS generated profits of $9500 over summer. Since $7310 was
A

Review this content with the e-lecture distributed in dividends (or drawings) the business retained
some of that money. Therefore, retained earnings increased
from $0 to $2190.
LO4  EPORTING EQUITY: THE
R
STATEMENT OF CHANGES LINKING THE INCOME STATEMENT AND THE
IN EQUITY BALANCE SHEET
In addition to showing the change in retained earnings, the
Business owners are usually interested in how their equity changes in retained earnings part of the statement of
is growing as a result of profitable operations. They are also changes in equity links the income statement and the
interested in how that equity is distributed in the form of balance sheet. A business cannot calculate its retained
dividends. Such information is reported on earnings balance at the end of the period without factoring
statement of
changes in equity  A the statement of changes in equity. It in the profit earned during the period. The changes in
financial statement that shows the change in a business’ equity, retained earnings provide this link by including net profit or
reports the change in a
business’ equity but most importantly, the changes in loss in the calculation of retained earnings, which is then
(contributed equity, retained earnings over a specific period of reported on the balance sheet. This means that when
reserves and retained
earnings) over a specific time. The basic structure of the statement preparing financial statements for any business, the income
period of time. is as follows: statement must be prepared first, followed by the
statement of changes in equity and then the balance sheet.
KEY FORMULA 1.3  STATEMENT OF CHANGES IN EQUITY A depiction of these links is included in Exhibit 1.4.
(THE RETAINED EARNINGS PART)
Aerial Filming
Retained Earnings, Beginning Balance
Income statement
+/– Net Profit/Loss
– Dividends Revenue $11 200
= Retained Earnings, Ending Balance – Expenses   1 700
Net income (or Profit) $ 9 500
Statement of changes in equity
Getty Images/Hugh Peterswald

(retained earnings)
Retained earnings, 1 December $    0
+ Net income (from above) 9 500
– Drawings   7 310
Retained earnings, 28 February $ 2 190
Balance sheet
Total assets $ 5 190
The drone is the asset, which is being used by the business to
earn revenue Liabilities 2 000
Contributed capital 1 000
Aerial Filming’s statement of changes in equity (retained
Retained earnings (from above)   2 190
earnings) would appear as shown in Exhibit 1.3. It contains
the name of the business, the statement name and the Total liabilities and equity $ 5 190
time period, which for this example is the summer. Note EXHIBIT Relationship between the financial statements
1.4
there are a number of acceptable ways to express the time
or timing in financial statements.
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 1 Financial accounting 7
 selling of such assets are considered investing activities.
ANALYSIS In the filming business, you paid $2600 for the drone.
Look at CSL’s statement of Therefore, the cash flows from investing activities were
changes in equity in Appendix B.
negative $2600. In other words, Aerial Filming experienced
1 Which column of the statement contains the changes
a cash outflow of $2600 in summer from investing
in retained earnings?
activities.
2 For 2017, is the amount of profit after income tax
expense for the period the same as profit after tax on
the income statement? OPERATING ACTIVITIES
3 Is the balance in retained earnings the same as the After the proper equipment is acquired, a business can
balance on the balance sheet? (Hint: look at the
begin operations. Operating a business may include the
numbers in bold, they are for 2017.)
purchase of supplies, the payment of employees and the
Analysis:
sale of products. These transactions are considered
The statement of changes in equity has five columns of
numerical data. The fourth column (headed ‘Retained operating activities. For Aerial Filming, cash flows from
Earnings’) is CSL’s statement of changes in retained operations over summer included $10 000 received from
earnings. In 2017, the amount of profit after tax for the customers for filming, $1100 paid for supplies and $50 paid
period is $1377.4 million, which is the number shown on the to the bank in interest. As a result, the net cash inflow from
income statement; and the total retained earnings at the
operating activities for the month was $8850 ($10 000
end of the period is $7403.9 million in retained earnings,
which is the same balance shown on the balance sheet. minus $1100 minus $50). Note: this is not the same as
profits, because revenue included the $1200 you are owed;
expenses included depreciation but not the cost of unused
supplies.
LO5  EPORTING CASH FLOWS:
R
THE CASH FLOW STATEMENT
THE CASH FLOW
The details of cash inflows and outflows for a business
STATEMENT are reported on a cash flow statement. cash flow
The cash flow statement is a financial statement  A financial
Another important issue for any business is the
statement that shows a business’ statement that reports a
business’ sources and
management of cash. Where does a company get its cash?
sources and uses of cash over a specific uses of cash over a
Where does its cash go? Will there be enough cash to pay
period of time. Its purpose is to inform specific period of time.
the employees? Accounting provides answers to these
users about how and why a business’
questions with a financial statement called a cash flow
cash changed during the period. The basic structure of the
statement. A cash flow statement reports a business’ cash
statement is as follows:
inflows and outflows from its operating, investing and
financing activities.
KEY FORMULA 1.4  THE CASH FLOW STATEMENT

FINANCING ACTIVITIES Cash Flows Provided (Used) by Operating Activities

+/– Cash Flows Provided (Used) by Investing Activities
Most businesses must raise funds to begin. Borrowing
+/– Cash Flows Provided (Used) by Financing Activities
money from creditors and receiving contributions from
investors are both ways to finance a business’ operations. = Net Increase (Decrease) in Cash
Therefore, generating and repaying cash from creditors and + Cash at the beginning
investors are considered financing activities. In the filming = Cash at the end
business, you contributed $1000 of your own money and
borrowed $2000. Both of these inflows are from financing
Given the cash inflows and outflows described
activities. Therefore, the cash inflow in summer from
previously, Aerial Filming‘s summer cash flow statement
financing activities is $3000. You withdrew $7310 – this is
would appear as shown in Exhibit 1.5. It contains the
a cash outflow from financing activities.
business name, the statement name and the time period
covered, which for this example is the three months to the
INVESTING ACTIVITIES end of February. It also shows a net change in cash from
Once a company has raised sufficient capital from creditors 1 December to 28 February of $1940. Again, note the three
and investors, it usually acquires the ­revenue-generating months is expressed differently but clearly and
assets that it needs for operations. The buying and communicates the time period covered.

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8 ACCT3 Financial
 Aerial Filming
Cash flow statement LO6  HE OBJECTIVES OF
T
for the months of December, January and February
FINANCIAL REPORTING
Operating activities
Cash received from customers $10 000 The objective of general purpose financial reporting is to
provide financial information about the reporting entity
Cash paid for supplies   (1 100)
that is useful to existing and potential investors, lenders
Cash paid for interest      (50) and other creditors in making decisions about providing
resources to the entity. Those decisions involve buying,
Net cash provided by operating activities $8 850 selling or holding equity and debt instruments, and
Investing activities providing or settling loans and other forms of credit.3

Cash paid for drone $ (2 600) Even though accounting is a very quantitative process and
Net cash used by investing activities (2 600) the financial statements introduced so far are full of
numbers, accounting information must possess certain
Financing activities
qualitative characteristics to be considered useful.
Cash received from borrowing 2 000 Information in the financial reports is often based on
Cash received from owner   1 000 estimates, judgements, and at times the choice of one
Drawings (dividend)   (7 310) accounting method rather than an alternative. It is also
important to note that financial reports cannot provide all
Net cash used by financing activities (4 310)
the information that different users may want.
Net increase in cash $1 940 If financial information is to be useful, it must be
Cash balance, 1 December    0 relevant and faithfully represent what it is reporting on.
Cash balance, 28 February $1 940 Financial information is more useful if it is comparable,
verifiable, timely and understandable.
EXHIBIT Cash flow statement for Aerial Filming
1.5
RELEVANCE AND MATERIALITY
Note that the ending cash balance on the statement Relevant financial information can
relevance  The capacity
agrees with the cash balance shown on the balance sheet influence the decisions made by users of accounting information
in Exhibit 1.2. Since $2600 of the $3000 of cash generated because it has predictive value (allows the to make a difference in
decisions.
from financing activities was invested into the drone, the user to better determine what the future
majority of the $1940 of cash on hand was generated may be), confirmatory value (provides feedback on past
through operations. This, of course, is a good sign and predictions) or both.
indicates you are likely to be able to repay the bank and to Information that can help confirm may also help predict.
keep or spend some cash on yourself. For example, information about the revenue Aerial Filming
You might also consider the situation if all customers earned over summer can be compared with the revenue
waited three months to pay you. Your profit in summer predicted at the commencement of the business to determine
would have been the same, but your cash flow very how accurate those predictions were, and in turn may be
different. There would have been no spare cash to draw out used to help predict revenue in autumn with greater accuracy.
and you would have needed to borrow more money just to Information is considered material if materiality  The
buy most of the supplies and interest. it has the capacity to affect decisions threshold at which a
when omitted or misstated. For a student financial item begins to
affect decision-making.
the difference between an exam mark of
ANALYSIS
Look at CSL’s cash flow statement 49 and 50 is material since a 49 means the student fails
in Appendix B. How much cash did CSL generate or but one additional mark means he or she passes; however,
use for operating, investing and financing activities a larger difference, say between 90 and 95, may not
during 2017? influence decisions. An example of materiality in practice
Analysis: is how CSL report results to the closest tenth of a million
•  Operating activities: generated $1246.6 million of dollars (see Appendix B). The numbers being reported
•  Investing activities: used $862.9 million are so large that giving more exact amounts is unlikely to
•  Financing activities: used $103.5 million. make a difference to decision-making.
Measurement uncertainty will also impact relevance. If
YT
PPL HIS estimates are difficult to make or the range is large the
A

Download the Enrichment Modules

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CHAPTER 1 Financial accounting 9
 information will be less useful; for example, forecasts of

Getty Images/Paper Boat Creative

tomorrow’s temperature are usually given in whole degrees
since they are estimates, while reporting of yesterday’s
temperature can be given to two decimal places since the
exact temperature is known.

FAITHFUL REPRESENTATION
Financial statements summarise economic events in
words and numbers. To be useful it must faithfully represent
the business activities by providing information about the
substance of the activity not just its legal form. Information
faithful faithfully represents the financial
representation  position and performance if it is complete,
Financial information that Comparability is an activity with which many are familiar
is presented in a way that neutral and free from error (which does
is complete, neutral and not mean accurate in all respects as
free from error. VERIFIABILITY
estimates and judgements need to be
made). In an attempt to provide complete information, Verifiability allows users to accept that verifiability  When
companies provide additional notes (for example, see CSL’s the financial statements faithfully information allows
‘Notes to the financial statements’ in Appendix B). represent the business activity they claim different independent
observers to arrive at the
Neutrality is supported by the exercise of prudence, which to represent. Verifiability means that same or similar
is caution when making judgements under conditions of different knowledgeable and independent outcomes.
uncertainty. The exercise of prudence means that assets and observers would have prepared financial
income are not overstated and liabilities and expenses are not statements that are not materially different. Verifiable
understated. The term ‘conservatism’ is no longer used. information does not need to only have one possible
Information must be both relevant and faithfully outcome to be verifiable. For Aerial Filming the drone may
represented if it is to be useful. Comparability, verifiability, only last eleven months. A range of possible amounts and
timeliness and understandability are qualitative the related probabilities can also be verified.
characteristics that enhance the usefulness of information
that is relevant and faithfully represented. TIMELINESS
In addition to having feedback or predictive value,
COMPARABILITY accounting information must be timely to timeliness  When
Comparability refers to the ability to use be useful. Information that helps you information is provided
comparability  The
ability to use accounting accounting information to be weighed forecast March revenues is relevant when quickly enough that the
user can take action.
information to be weighed it is received in February, not when it is
against or contrasted to against or contrasted to the financial
the financial activities ofactivities of different businesses. Being able received in April. Generally, the older the information the
different businesses. to compare information across businesses less useful.
allows an entity to assess its market
position within an industry, to gauge its success against a UNDERSTANDABILITY
competitor and to set future goals based on industry standards. Accounting information should first and foremost be
Comparability does not imply uniformity. Accounting understandable. Understandability understandability 
rules allow for some discretion in the manner in which refers to the ability of accounting The ability of accounting
accounting is applied to economic phenomena. As a result, information to be comprehensible to those information to be
comprehensible to those
two businesses with the same economic phenomena could who have a ‘reasonable understanding of who have a ‘reasonable
have different accounting information because they use business and economic activities and understanding of business
and economic activities
different acceptable accounting methods (such as different accounting and a willingness to study the and accounting and a
ways to calculate the depreciation) or make different information with reasonable diligence’.4 willingness to study the
estimates (such as how long the drone will last). Because information with
Notice that this definition puts much of the reasonable diligence’.
such differences in accounting methods are a challenge to responsibility on the user of accounting
comparability, accounting rules require that entities disclose information. Users must be willing to spend a reasonable
the accounting methods that they use so that information amount of time studying the information. No specifics are
can be more easily compared across entities. Usually, such given on what is a ‘reasonable amount of time’, but it is
methods are disclosed in the notes to the financial obvious that the more time you spend studying accounting
statements, which are discussed in Chapter 2. information, the more you will understand.

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10 ACCT3 Financial
 The following tables summarise the elements of this
LO7  HE LANGUAGE OF
T conceptual framework and also serve to review this chapter.
ACCOUNTING They will provide a good reference for you as you proceed
through the remaining chapters. As you tackle more
This chapter introduced many of the terms, principles, complex accounting methods and procedures, keep in
assumptions, objectives and qualitative characteristics that are mind that they are simply extensions of the basic grammar
necessary to communicate the financial activities and position presented in the tables. So, with a good understanding of
of a business. While they were initially the conceptual framework, you have the grammar
Conceptual described as the grammar of accounting, necessar y to YT
PPL HIS
Framework for

A
Financial Reporting  they are more formally known as begin your study Test your understanding with the
The objectives, online revision quizzes for this chapter
components of the Conceptual of accounting.
characteristics and
concepts that guide the Framework for Financial Reporting,
manner in which the collection of concepts that guide the
accounting is practised.
manner in which accounting is practised.

Term Definition Reported on the

Asset A resource of a business Balance sheet
Liability An obligation of a business Balance sheet
Equity The difference between assets and liabilities Balance sheet
Contributed equity (capital) Equity resulting from contributions from owners Balance sheet
(often from issuing shares)
Retained earnings Equity resulting from profitable operations Balance sheet and statement of changes in equity
(change in retained earnings)
Revenue An increase in assets resulting from selling a good Income statement
or providing a service

Expense A decrease in assets resulting from selling a good Income statement

or providing a service
Dividend (Drawings) A distribution of profits to owners Statement of changes in equity
Terms used to identify and describe financial information

Principle Definition Ramification

Revenue recognition Revenues are recorded when they are earned The receipt of cash is not required to record a revenue. If you
sell to a customer who will definitely pay you next week,
the revenue is earned when the sale is made, not when you
receive the cash
Matching Expenses are recorded in the time period when For many assets, the cost of the asset must be spread over
they are incurred to generate revenues the periods when it is used – we call this depreciation
Cost Assets are recorded at their historical costs Except in a few cases, market values are not used for reporting
asset values
Principles used to measure financial information

Assumption Definition Ramification

Economic entity The financial activities of a business can be accounted We do not have to worry that the financial information of the
for separately from the business’ owners owner is mixed with the financial information of the business
Monetary unit The dollar, unadjusted for inflation, is the best means All transactions need to have a specific dollar value to be
of communicating accounting information recorded
Accounting period Accounting information needs to be communicated Most businesses prepare half-yearly and annual financial
effectively over short periods of time statements
Going concern The company for which we are accounting will continue If an entity is not selling its assets, then assets (like the drone)
its operations indefinitely are recorded at the value to the business (cost less depreciation)
Assumptions made when communicating financial information

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CHAPTER 1 Financial accounting 11
 Term Definition Ramification
Relevance Accounting information should have the capacity to Information should have predictive or feedback
affect decisions value and should be timely
Materiality The threshold over which an item could begin to affect When an amount is small enough, normal
decisions accounting procedures are not always followed.
Note CSL reports to the nearest $0.1 million
Faithful representation Faithfully represent the phenomena that it purports to Financial reports represent economic phenomena
represent in words and numbers
Prudence (Conservatism) When uncertainty exists, accounting information should An entity should choose accounting techniques
present the least optimistic alternative that guard against overstating revenues or assets
Comparability Accounting information should be comparable across different Entities must disclose the accounting methods
businesses. This is aided by consistency where use of the that they use so that comparisons across
same accounting method aids comparability companies can be made
Verifiability Verifiability helps assure users that information is Different knowledgeable and independent
faithfully represented observers could reach consensus
Timeliness Information available to decision-makers before they The older the information generally the less
make decisions useful it is
Understandability Accounting information should be comprehensible by Users must spend a reasonable amount of time
those willing to spend a reasonable amount of time studying accounting information for it to be
studying it understood
Qualitative characteristics that make financial reports useful

Statement Purpose Structure Links to other statements

Income statement Shows a company’s revenues and Revenue – Expenses = Net Profit/ Net profit goes to the statement of changes in
expenses over a specific period of time Loss equity to calculate retained earnings
Balance sheet Shows a company’s assets, liabilities Assets = Liabilities + Equity The balance in retained earnings comes from
and equity at a specific point in time the statement of changes in equity
The balance in cash should agree with the
ending cash balance on the cash flow statement
Statement of changes Shows the changes in a company’s Beginning Retained Earnings + Ending retained earnings goes to the balance
in equity (retained retained earnings over a specific Profits (or – Losses) – Dividends = sheet
earnings section) period of time Ending Retained Earnings
Cash flow statement Shows a company’s inflows and Operating Cash Flows +/– Investing The ending cash balance on the cash flow
outflows of cash over a specific Cash Flows +/– Financing Cash statement should agree with the balance in
period of time Flows = Net Change in Cash cash on the balance sheet
Financial statements used to communicate economic information

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12 ACCT3 Financial
 LO1, 6
6 Identify accounting assumptions and
qualitative characteristics
EXERCISES
Consider the following independent scenarios:
i Peter’s Pizza has been in business for 25 years. All of
its operations are profitable, and the accountants
believe that the company will continue to operate
into the foreseeable future.
LO2 ii A bank used the information presented in Fiona’s
1 Calculate profit or loss
financial statements to determine if it should extend
Sarah’s Science Service generated $14 000 in revenue in the
a $300 000 loan to Fiona. The information in the
month of January. Salaries were $3500 for the month and
financial statements made a difference in the bank’s
supplies used were $2000. Additionally, Sarah incurred $500
lending decision.
for advertising during the month.
iii The manager of Martha’s Antiques does not like to
REQUIRED change accounting procedures because it hinders her
Calculate Sarah’s profit or loss for the month of January. ability to make year-to-year comparisons.
iv Sarah, owner of Abbotsford Animal Accommodation,
LO3 informs her accountant that she does not want to
2 Calculate equity
review any accounting issue that is smaller than
A company reports assets of $100 000 and liabilities of
1 per cent of profits.
$60 000.
v Matthew paid $10 000 for inventory which could now
REQUIRED sell for only $6000, he recognises this decrease
Calculate the company’s equity. while not recognising the increase in land from
$200 000 to $300 000.
LO2, 3 vi Sue has two businesses, she keeps separate records
3 Identify accounting principles
for both businesses and does not combine them
Each of the following statements is an application of the
with her personal financial matters.
revenue recognition principle, the matching principle or the
cost principle. REQUIRED
i A company records Equipment for the purchase price Identify the accounting assumption or qualitative
of $10 000 although the suggested retail price was characteristic that relates to each scenario.
$13 000.
ii A company receives $2000 for a service to be 7 Accounting terms LO2, 3

performed but records only $1000 as Service

Consider the following information:
Revenue because it earned only half in the current
period. Item Appears on Classified as
iii A company pays $6000 for insurance but uses only Salaries expense
$4000 during the period. Therefore, it records only
$4000 as Insurance Expense. Equipment

REQUIRED Cash
Identify which principle relates to each statement. Accounts payable

LO4
Accounts receivable
4 Calculate retained earnings
Buildings
At the beginning of the year, a company has retained
earnings of $175 000. During the year, the company earns Contributed capital
$110 000 of profits and distributes $30 000 in dividends. Retained earnings
REQUIRED Interest revenue
Calculate the company’s retained earnings at year end.
Advertising expense

5 Calculate cash flows LO5 Sales

A company starts the year with $15 000 in cash. During the Unearned revenue
year, the company generates $80 000 from operations, uses
$56 000 in investing activities and uses $38 000 in financing REQUIRED
activities. Classify each of the items above according to:
REQUIRED a whether it appears on the income statement (Y/S) or
balance sheet (B/S)
Calculate the company’s cash at year end using a basic cash
flow format. b whether it is classified as a revenue, expense, asset,
liability or equity.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 1 Financial accounting 13
 LO5
REQUIRED
8 Classify cash flows
Fill in the blanks with the financial statement(s) (i.e. income
A company entered into the following cash transactions: statement, balance sheet, statement of retained earnings
i Cash paid to suppliers and/or cash flow statement) the user would most likely use
ii Cash received from issuing new shares to find this information.
iii Cash paid to purchase a new office building
LO2, 4
iv Cash paid in dividends to owners 11 Profit or loss and retained earnings
v Cash received from customers Hazelwood reports the following as of 30 June:
vi Repaying a bank loan
vii Cash received from the sale of land Revenues $99 000
viii Company income tax paid. Beginning retained earnings 22 000
REQUIRED Expenses 88 000
Indicate the section of the cash flow statement in which Dividends 1 000
each item would appear: operating activities (O), investing
activities (I) or financing activities (F). REQUIRED
Calculate profit or loss and ending retained earnings for the
9 Accounting terms LO2, 3, 4, 5 financial year ending 30 June.
Consider the following information: LO3
i Revenues during the period 12 Balance sheet equation
ii Supplies on hand at the end of the year Consider the following independent situations:
iii Cash received from borrowings during the year i Kelly contributes $80 000 to the business and the
iv Total liabilities at the end of the period business has total assets of $200 000. How much
are liabilities?
v Dividends paid during the year
ii Tran starts the year with $50 000 in assets and
vi Cash paid for a building
$40 000 in liabilities. Profit for the year is $12 500 and
vii Cost of buildings owned at year end
no dividends are paid. How much is Tran’s equity at
viii Profits for the period (on two statements) the end of the year?
ix Closing balance of retained earnings (on two iii Evan doubles the amount of her assets from the
statements). beginning to the end of the year. At the end of the
REQUIRED year, liabilities are $50 000 and equity is $30 000.
Indicate whether you would find each of the above items on What is the amount of Evan’s assets at the beginning
the income statement (Y/S), the balance sheet (B/S), the of the year?
statement of retained earnings (SRE) or the cash flow iv During the year the liabilities of Hudson Company
statement (CFS). triple. At the beginning of the year, assets were
$40 000 and equity was $20 000. What is the amount
LO2, 3, 4, 5 of liabilities at the end of the year?
10 Financial statements
Listed below are questions posed by various users of a REQUIRED
company’s financial statements: Use the accounting equation to answer each of the
independent questions above.
User Questions Financial
statement LO4
13 Statement of retained earnings
Shareholder How did this year’s sales
figures compare with last Chan Company’s retained earnings on 1 July is $245 800.
year’s sales figures? The following information is available for the first two
months of the financial year:
Banker How much in borrowings
does the company currently July August
owe?
Revenues $80 000 $102 000
Supplier How much does the company
owe its suppliers in total? Expenses   85 000   80 000

Shareholder Did the company pay any Dividends      0    7 000

dividends during the year?
REQUIRED
Advertising How much advertising did
Prepare the retained earnings section of the Statement of
Agent the company incur in order to
generate sales? Changes in Equity for the month ending 30 August.

Banker What was the company’s

total interest cost last year?

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
14 ACCT3 Financial
 LO2, 3, 4
f The way in which accountants deal with uncertainty.
14 Links between financial statements
g The ability to determine similarities and differences.
Below are incomplete financial statements for Jasmine:
LO1, 2, 3
Balance sheet 16 Assumptions and principles
Assets The Harbour Group had the following situations during the
year:
Cash $ 8 000
i Inventory with a cost of $186 400 is reported at its
Inventory 22 000 market value of $235 600.
Total assets $70 000 ii Harbour added four additional weeks to its fiscal year so
that it could make its income look stronger. Past
Liabilities
financial years were 52 or 53 weeks (in a leap year), this
Accounts payable $  7 000 financial ‘year’ is 56 weeks and it is not even a leap year.
Equity iii Harbour’s CEO purchased a yacht for personal use
and charged it to the company.
Contributed capital    (a)
iv Revenues of $25 000 earned in the prior year were
Retained earnings    (b) recorded in the current year.
Total liabilities & equity $70 000 v Harbour will be paid in the next financial year for
Income statement work carried out in this financial year; the decision
was made to include the revenue in the next financial
Service revenue $90 000
year.
Salaries expense (c) vi In an attempt to show exactly how much profits are
Electricity expense   20 000 earned Harbour reports $9 876 543.21 of profits for
the financial year.
Profit $    (d)
REQUIRED
In each situation, identify the assumption or principle that
Statement of retained earnings
has been violated and discuss how Harbour should have
Retained earnings, beginning balance $20 000 handled the situation.
Profit (e)
Dividends   10 000
Retained earnings, ending balance $60 000

REQUIRED
PROBLEMS
Calculate the missing amounts (not necessarily in alphabetic
order).

LO6
15 Qualitative characteristics
The following qualitative characteristics of accounting were
LO2, 3, 4
discussed in the chapter: 17 Prepare financial statements
i consistency The following items are available from the financial records
ii relevance of Innovators Incorporated at the financial year ending
iii understandability 30 June, 2018:
iv comparability
Accounts payable $27 000
v prudence (conservatism)
vi materiality Accounts receivable 21 000
vii faithful representation. Advertising expense 6 000
REQUIRED Buildings 76 000
Match the descriptions with the appropriate characteristic. Contributed capital 30 000
a The ability of accounting information to be Cash 6 320
comprehensible to those who have a reasonable
Notes payable 70 000
knowledge of business and are willing to study the
information with reasonable diligence. Salaries expense 9 500
b The capacity to affect business decisions. Service revenue 16 820
c The dependability of accounting information. Equipment 25 000
d The ability to compare and contrast the financial
activities of the same company over a period of time.
e The threshold over which an item begins to affect
decision-making.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 1 Financial accounting 15
 REQUIRED LO1, 2, 3
20 Errors in accounting
Prepare Innovators Incorporated’s income statement and
statement of retained earnings for the year and its balance The Nguyen Company was incorporated on 1 July. At 30
sheet at the end of the year. June the following year Ms Ly Nguyen, the CEO and sole
owner, prepared the company’s balance sheet as follows:
LO2
18 Identify and correct income statement
Nguyen Company Balance Sheet
errors 30 June
Sivabalan Group was started on 1 July. At the end of the
Assets
financial year the company used an accounting intern to
prepare the following financial statement: Cash $25 000
Accounts receivable 40 000
Sivabalan Group income sheet
at 30 June Inventory 35 000
Income from services $170 000 Building 20 000
Accounts receivable   40 000 Liabilities and Equity
Total revenue $210 000 Accounts payable $40 000
Less: Expenses Building loan 15 000
Salaries $  57 000 Retained earnings 37 000
Advertising (14 000) Ly is not an accountant by trade and she believes there may
Dividends 10 000 be some mistakes. She has provided you with the following
additional information:
Electricity   22 000
i The building is Ly’s personal beach house. However,
Total expenses $  75 000 she plans on using it for company retreats and for
Total income $135 000 hosting some large clients. She decided to list the
asset and the corresponding liability for this reason.
REQUIRED ii The inventory was originally purchased at $12 000,
List all of the deficiencies that you can identify in this but due to a recent increase in demand she believes
income statement and prepare an income statement with she could sell it for at least $35 000. She thought that
correct information and proper format. $35 000 would best portray the economic reality of
her inventory.
19 Identify and correct balance sheet errors LO3 iii Ly included $5000 in accounts receivable and
retained earnings for a service that she will provide
Hildebrand House Haunting (HHH) commenced business on next year. Since she is honest and will provide the
1 July. It was a good year as Hildebrand believes she has service, she decided to record the amount in this
over $100 000 of assets. At the end of the financial year the year’s balance sheet.
following financial statement was quickly prepared by a
student intern: REQUIRED
Comment on what accounting assumptions or principles
HHH Balance Statement for the have been violated; briefly describe how each item should
year ending 30 June be accounted for and prepare a correct balance sheet.
Resources:
LO2, 3, 4
Cash $ 30
21 Preparing financial statements
On 1 July you begin a whale watching business for the winter
Things we sell 40
whale migration season by contributing $60 000 of capital
Land 53 and borrowing $80 000 from your parents. With the money
Retained earnings   17 you pay $48 000 in July to rent a boat with all the equipment
needed. You also purchase advertising on the hotel TV channel
Grand total $146
for $25 000 and during the month fuel for $155 000. You also
Debts: pay your parents $800 for monthly interest.
Money we owe $ 43 You decide to charge $90 per passenger. At the end of
the month of July, you have taken 2400 guests aboard the
Contributed capital   63 boat. Included in those 2400 guests were tour groups from
Grand total $106 China who always pay seven days after whale watching. The
tour group at the end of July owes you $1080.
REQUIRED REQUIRED
List all of the deficiencies that you can identify in this Prepare an income statement and a statement of retained
financial statement and prepare a proper balance sheet. earnings for the month ending 31 July and a balance sheet
at 31 July. How might the financial statements influence
your plans next year?

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
16 ACCT3 Financial
 LO1, 2, 6
23 Ethics in accounting
CASES As the chief accountant at an education college which is listed
on the Australian Securities Exchange you discover that profits
in each of the previous five years have been understated due
to an error in accounting. After much thought, you decide to
approach the CEO. Her response is: ‘What the public doesn’t
know won’t hurt them. We’ll just adjust this year’s profits to
LO1, 2, 5 make up for the mistakes. We are having a bad year and this
22 Read, locate and compare financial
comes as a great relief, it will certainly get us out of a hole’.
statements
Access the latest financial statements for CSL (Google ‘CSL REQUIRED
Annual Report’). Identify the ethical dilemma of this situation; outline the
ways that you could respond and explain the possible
REQUIRED consequences of your responses.
a For CSL Limited’s (ASX: CSL) last financial year, identify
the amounts reported for revenues, total comprehensive 24 Written communication skills LO2, 3, 4, 5
income, total assets and cash flows from operating
activities. Also, identify the date on which the financial Your wonderful brother has just won lotto. He is trying to find
statements are prepared. companies in which to invest his winnings; however, he is having
trouble reading the financial statements because he has no idea
b Locate Cochlear Limited’s (ASX: COH) financial
what they are saying. Knowing you are in an accounting class,
statements for the same year. Identify the same
your brother is willing to pay you $10 a word to write to him
information as in the previous requirement.
about financial statements (maximum 400 words).
c Compare both companies. Identify which company is:
(i) the largest, (note how you define largest) (ii) the most REQUIRED
profitable (be careful how you define most profitable) Prepare a written response to your brother explaining what
and (iii) the best able to generate cash from its information is contained in each financial statement and how
operations. it is relevant to investors.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 1 Financial accounting 17
 2
Chapter 1 introduced the terms, assumptions, principles
and statements that accounting uses to capture and
communicate a company’s economic activities. This
chapter takes a more detailed look at the accounting
information provided by businesses, particularly public
corporations (companies) such as CSL. Specifically, this
chapter introduces the (classified) balance sheet, the
(multi-step) income statement and the statement of
changes in equity. Each of these three financial statements
represents a more detailed version of the statements

Financial statements covered in Chapter 1. This chapter also introduces two

analysis techniques: horizontal and vertical analyses,
which are simple but powerful tools for generating a more
in-depth understanding of a company’s financial position
and performance. By the end of this chapter, you should
be comfortable reading through, using and being able to
explain the financial statements of most companies.
LEARNING

Courtesy CSL
OBJECTIVES

After studying the material in this chapter, you

should be able to:
1 Explore the three major forms of business.
2 Define Generally Accepted Accounting
Principles (GAAP) and their origins.
3 Describe the main classifications of assets,
liabilities and equity in a balance sheet.
4 Discuss the main subtotals of income on an
income statement.
5 Analyse the balance sheet and the income
statement using horizontal and vertical
analyses.
6 Describe the structure of a statement of
changes in equity.
7 Look at the types of information usually
disclosed along with financial statements.

LO1 BUSINESS FORMS

One of the first decisions that any new business faces is
the form that it will take. Businesses have the following
Express three basic options:
YT ● sole proprietorship
Throughout this PPL HIS
● partnership
A

chapter apply this

icons indicate ● company.
an opportunity A sole proprietorship is a business sole proprietorship
for online owned by one person and is the most (sole trader) 
self-study through A business owned by
CourseMate Express,
common type of business in Australia. In one person.
linking you to revision a sole proprietorship (sometimes known
quizzes, e-lectures, as a sole trader), the owner maintains complete control
animations and more.
of the business, bears all the risk of failure and reaps all
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18
 the rewards of success. For accounting purposes, a There are two main types of companies in Australia,
sole proprietorship is accounted for separately from the proprietary (private) and public companies. The most
proprietor’s (owner’s) personal affairs (and possibly separate common type of company in Australia is the proprietary
from other businesses they may own). This is an application company (often indicated by the ‘Pty’ at the end of
of the economic entity assumption. For tax purposes, the company name). A public company public company 
though, a sole proprietor’s business is not separated from is one in which ownership is available to A separate legal entity
in which ownership is
the proprietor. The income from the business is reported the general public. The shares of a public available to the
on the owner’s personal tax return, along with other income company may be bought and sold on an general public.
like wages. open market such as the Australian
partnership  A partnership is a business that is Securities Exchange (ASX). To have a company’s shares
A business that is formed formed when two or more proprietors traded on the ASX, a company needs to be ‘listed’ on the
when two or more
proprietors join together
join together to own a business. Exchange, a much more expensive process than just
to own a business. Partnerships can be established by either registering a company. Such companies are said to be
a written or verbal agreement and can ‘publicly listed’. Examples of publicly listed companies are
include many partners. Partnerships are formed for various BHP, Commonwealth Bank, Telstra, Woolworths and, of
reasons, such as joining proprietors with different skills, course, CSL. From this point forward, we will focus on the
combining resources and spreading the financial risk of the accounting for publicly listed companies. This will allow us
business among several people. Like sole proprietorships, to see accounting issues in companies with which you may
a partnership is considered a separate accounting be familiar and that usually have their financial reports
entity, separate from the individual partners (owners). publicly available on their website.
However, like sole proprietorships, a partner’s share of Alamy Stock Photo/Pulsar Imagens
partnership income is reported on the partner’s individual
tax return. Partnerships are covered in detail in Chapter 10.
company (or
A company or corporation is a
corporation)  separate legal entity that is established
A separate legal entity that by registering the company with the
is established by registering
with ASIC. Australian Securities and
Australian Securities Investments Commission (ASIC).
and Investments Once a company is formed, it sells shares
Commission
(ASIC)  The agency to individuals who want to own part of
charged with protecting the company. This is one of the main
investors and maintaining Inventory is one of the biggest assets for a company like CSL.
the integrity of securities reasons that companies are formed – the Because of its importance, it is reported separately on the
markets. company’s balance sheet
ability to raise equity (capital) through the
sale of ownership interests (issue of PLY THIS
AP
shares). It is also why company owners are called
Review this content with the e-lecture
shareholders (or stockholders). Like a sole proprietorship
and a partnership, a company is accounted for separately
from its owners; however, it is also taxed separately. LO2  ENERALLY ACCEPTED
G
Income generated by a company is taxed on a company ACCOUNTING PRINCIPLES
tax return, not on the shareholders’ individual tax returns. (GAAP)
One of the advantages of a company in Australia is that
dividends are not ‘double taxed’ as in many other countries.
When accounting for their economic Generally Accepted
Companies are covered in more detail in Chapter 11. Accounting
activities, public companies must follow
Principles
Generally Accepted Accounting (GAAP)  The accounting
ANALYSIS Principles (GAAP). These GAAP are the standards, rules, principles
Look at the full company name and procedures that
accounting standards plus the rules, comprise authoritative
on the front cover of CSL’s annual principles and procedures that comprise practice for financial
report in Appendix B. Can you tell from the name accounting.
authoritative practice for financial
what form of business CSL is? Australian
accounting. The formal part of these Accounting
Analysis:
The full company name is ‘CSL Limited’. The ‘limited’ principles, the accounting standards, have Standards Board
been developed over time by the (AASB)  The standard-
stands for the limited liability a company enjoys – the setting body whose mission
owners (shareholders) are not personally liable for the Australian Accounting Standards is ‘to develop and maintain
debts of the company. Board (AASB) and enforced by ASIC. high-quality financial
reporting standards’.
High-quality accounting standards should
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 2 Financial statements 19
 lead to financial statements that are ‘presented fairly’ or
provide a ‘true and fair view’. It is interesting to note the ANALYSIS
Look at the Independent Auditor’s
objective is not to produce ‘accurate’ or ‘correct’ financial
Report in Appendix B. According
statements, because, although accounting is based to the auditor, is CSL’s financial report in accordance
on numbers, there are many judgements and some with the standards and the law?
choices that are needed, which means financial statements Analysis:
do not have the mathematical precision many think they Yes. The Report on the Audit of the Financial Report states
possess. ‘In our opinion, the accompanying financial report of the
In the Australian Accounting Standard AASB 101, the Group is in accordance with the Corporations Act 2001’, and
goes on to add that this includes ‘giving a true and fair view’,
achievement of ‘fair presentation’ is laid out in paragraph 17,
and that it is ‘complying with the Australian Accounting
which states: Standards and the Corporations Regulations 2001’.2
In virtually all circumstances, an entity achieves a fair
presentation by compliance with Australian Accounting
Standards. A fair presentation also requires an entity:
a to select and apply accounting policies in
accordance with AASB 108 Accounting Policies, LO3 THE BALANCE SHEET
Changes in Accounting Estimates and Errors. AASB
108 sets out a hierarchy of authoritative guidance
that management considers in the absence of an
Chapter 1 introduced the balance sheet. A balance sheet
Australian Accounting Standard that specifically is a financial statement that summarises a company’s
applies to an item; assets, liabilities and equity at a given point in time. Your
b to present information, including accounting balance sheet shown in Chapter 1 reported every account
policies, in a manner that provides relevant, reliable,
of your Aerial Filming business. However, most public
comparable and understandable information; and
c to provide additional disclosures when compliance companies are much too large to report every account. For
with the specific requirements in Australian ease of presentation, accounts of similar nature are placed
Accounting Standards is insufficient to enable users under one heading: e.g. Property, Plant and Equipment
to understand the impact of particular transactions,
includes all CSL land, buildings, laboratories, scientific
other events and conditions on the entity’s financial
position and financial performance.1 equipment, etc. The consolidated consolidated
balance sheet groups together all the balance sheet  A type
The accounting standards are part of the Corporations of balance sheet that
companies controlled by CSL into one groups together the parent
Act 2001 (as amended).
economic (reporting) entity. The process company and its
Australian accounting standards are
of ‘consolidation’ would not be necessary subsidiaries as one
based on the International Financial reporting entity.
International if all operations were carried out by a
Financial Reporting Reporting Standards (IFRS), and as
Standards single company, but this is often not feasible because of
(IFRS)  Standards
such the rules we follow in Australia
legal, historical, geographic or other reasons. The
issued by the are the same as much of the rest of
International Accounting consolidation process is covered in later years of accounting
the world (except the US). The IFRS
Standards Board. study and is not important at this stage to your understanding
International are developed by the International
of the financial statements; it is sufficient to know that
Accounting Accounting Standards Board (IASB)
Standards Board consolidation treats the whole business as one accounting
whose mission is to have a single set of
(IASB)  A board, similar entity ignoring the legal boundaries of each individual
to the AASB, whose high-quality standards requiring
mission is to develop a
company in the ‘group’.
transparent and comparable information.
single set of high-quality The following sections discuss the various asset,
standards requiring Because adoption of IFRS is voluntary,
liability and equity classifications commonly used on a
transparent and the effectiveness of the IASB at
comparable information. balance sheet. The 30 June 2017 balance sheet of CSL in
accomplishing its mission has been
Exhibit 2.1 will be used as an illustration. As you review
limited because the US (and some other
the statement, note that all numbers except per share data
countries) have retained their own GAAP. However, the
are in millions of dollars (to one decimal place, meaning
IASB and the US Financial Accounting Standards Board
that the number after the decimal point is a hundred
have agreed to a commitment to the convergence of US
thousand dollars (e.g. 20.3 is $20 300 000). Note also that
and international standards. At some time in the future, the
two years of data are presented, with the most recent year
world may very well use one set of global accounting
listed first. This is the normal format for most company’s
standards set by a global board.
financial statements. CSL reports in United States dollars.
This is not relevant to most of our analysis and only

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20 ACCT3 Financial
becomes critical when comparisons are made to companies Assets
reporting in Australian dollars. At the time of the financial
An asset is a resource of a business. Assets are generally
report $1US = $1.3Aust.
grouped into two main categories on a balance sheet:
● current assets
Notes 2017 2016 ● non-current assets (including intangible assets).
US$m US$m
CURRENT ASSETS
Current assets
A current asset is any asset that is current asset  Any
Cash and cash equivalents 14 844.5 556.6
reasonably expected to be converted to asset that is reasonably
Trade and other receivables 15 1 170.4 1 107.2 cash or consumed within one year of the expected to be converted
to cash or consumed
Inventories 4 2 575.8 2 152.0 balance sheet date. Common examples within one year of the
Current tax assets 6.2 1.6 include cash, investments that will mature balance sheet date.
Other financial assets 5.2 0.6 or be sold within a year, accounts
Total current assets 4 602.1 3 818.0 receivable from customers, inventories and other assets
such as prepaid insurance. Current assets are listed in order
NON-CURRENT ASSETS
of their liquidity, which refers to the speed with which a
Other receivables 15 16.5 15.6
resource can be converted to cash. Cash is listed first,
Other financial assets 3.9 2.9 followed by short-term investments, receivables,
Property, plant and equipment 8 2 942.7 2 389.6 inventories and then finally other assets.
Deferred tax assets 3 496.5 389.0 CSL reports five current assets totalling over $4.6 billion
Intangible assets 7 1 055.4 942.6 on its 30 June 2017 balance sheet. As you might expect
from a biotechnology company, the majority of those
Retirement benefit assets 18 5.6 5.0
assets (almost $2.6 billion) is in inventories, trade and other
Total non-current assets 4 520.6 3 744.7
receivables and cash and cash equivalents making up the
TOTAL ASSETS 9 122.7 7 562.7 majority of the other current assets.
CURRENT LIABILITIES
Non-current assets
Trade and other payables 15 1 155.8 996.1 Non-current assets are the resources non-current asset 
Interest-bearing liabilities 11 122.5 62.3 that are used in a company’s operations A resource that is used in a
company’s operations for
Current tax liabilities 202.5 207.3 for more than one year and are not more than one year and is
Provisions 16 134.1 99.6 intended for resale. Examples include not intended for resale.
Deferred government grants 9 3.2 3.1 property, plant and equipment, intangible
assets and deferred tax assets.
Derivative financial instruments – 6.0
CSL reports over $4.5 billion of non-current assets
TOTAL CURRENT LIABILITIES 1 618.1 1 374.4
on its 30 June 2017 balance sheet, with almost $3 billion
NON-CURRENT LIABILITIES of property, plant and equipment, making them the largest
Other non-current liabilities 15 25.8 18.8 asset.
Interest-bearing liabilities 11 3 852.7 3 081.0
KEY FORMULA 2.1 ASSETS
Deferred tax liabilities 3 138.2 119.2
Provisions 16 32.9 40.5 Current Assets
Deferred government grants 9 35.9 35.0 + Non-current Assets
Retirement benefit liabilities 18 255.3 326.6 = Total Assets
Total non-current liabilities 4 340.8 3 621.1
TOTAL LIABILITIES 5 958.9 4 995.5 Intangible assets
NET ASSETS 3 163.8 2 567.2 An intangible asset is a type of non- intangible asset 
EQUITY current asset that has no physical A resource that is used in
Contributed equity 12 (4 534.3) (4 213.0) substance. Examples include trademarks, operation for more than
one year, is not intended
patents, franchise rights, copyrights and for resale and has no
Reserves 12 294.2 187.9
goodwill. Like other non-current assets, physical substance.
Retained earnings 19 7 403.9 6 592.3
intangible assets are subject to
TOTAL EQUITY 3 163.8 2 567.2 depreciation (although it is actually called amortisation
EXHIBIT CSL Limited’s Consolidated Balance Sheet as at
2.1 30 June 2017
Source: CSL Limited, Annual Report 2017, p. 82.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 2 Financial statements 21
 instead of depreciation) and are reported net of amortisation amount of equity a company generates through the sale
or impairment. Intangible assets, which Note 7 of CSL’s (issue) of shares to investors (equity contributed by the
annual report 2017 shows is predominantly goodwill, is the shareholders). Such equity is often referred to as share or
second largest non-current asset that CSL reports in its issued capital. Like most publicly traded companies, CSL
balance sheet. At this stage a detailed knowledge of reports its equity accounts in one general section called
goodwill is not important. For now, it can be understood (Shareholders’) Equity. There is just over $4.5 billion in
simply as the excess CSL paid when acquiring other Contributed Equity and almost $7.5 billion in Retained
businesses for assets that are not separately identifiable: Earnings, indicating a lot of profits in previous years that have
things like brand recognition, distribution network, research not been distributed as dividends, but retained and used in
teams etc. (not intellectual property, which is recognised the business to buy assets. Reserves are like Retained
separately). Earnings but a little
YT
more complex and PPL HIS
Liabilities

A
will be discussed in Check out the animated summary on
Financial Statements: Part 1
A liability is an obligation of a business, which is generally depth in Chapter 11.
classified into two main categories on a balance sheet:
● current liabilities
● non-current liabilities.
LO4 THE INCOME STATEMENT
Current liabilities
current liability  A current liability is an obligation that Chapter 1 also introduced the income statement. The
An obligation that is is reasonably expected to be satisfied income statement is a financial statement that summarises
reasonably expected to be within one year. Examples include
satisfied within one year. a company’s revenues and expenses over a period of time.
accounts payable to suppliers, salaries Companies generally use one of two forms for their income
payable to employees and taxes payable statements – a single-step statement or a multi-step
to the government. Even long-term debt, if maturing within statement.
one year, is classified as a current liability. A single-step income statement, as seen in Exhibit 2.2,
CSL reports six current liabilities totalling over calculates total revenues and total expenses and then
$1.6 billion on its 30 June 2017 balance sheet. The largest determines net income in one step by subtracting all
is over $1.1 billion in Trade and other payables, which is expenses from the revenues. The income statement
basically the amount owed to suppliers. The company also prepared in Chapter 1 was a single-step income statement.
reports over $200 million in current tax liabilities. The major advantage of a single-step statement is its
Non-current liabilities simplicity. For a service organisation such as Chartered
non-current A non-current liability is an obligation Accountants Australia and New Zealand, a single-step
liability  An obligation that is not expected to be satisfied within income statement presents its income clearly.
that is not expected to be A multi-step income statement multi-step income
satisfied within one year. one year. Examples include interest-
bearing liabilities, which for CSL, make calculates income by grouping certain statement  Calculates
up the majority of its non-current liabilities. In Note 11, as revenues and expenses together and income by grouping certain
revenues and expenses
part of its risk management CSL discusses the interest- calculating several subtotals of income. together and calculating
bearing liabilities. CSL has over $4 billion of non-current These subtotals provide information on several subtotals of
income.
liabilities at 30 June 2017. the profitability of various aspects of the
company’s operations. While most companies prepare
Equity multi-step statements, there is some slight variation in
Equity is the difference between a company’s assets and how they are prepared. However, most include some or all
its liabilities. It is generated from the following two main of the following subtotals of income:
sources: ● total revenue
● retained earnings (including reserves) ● cost of sales
● contributed equity. ● gross profit other
Retained earnings is the amount of ● expenses comprehensive
contributed income  Includes gains
equity  The amount of equity a company generates by being ● profits before income tax expense and losses not included in
equity a company profitable and retaining those profits in the ● profits after income tax expense traditional revenue and
generates through the expense items.
sale of shares to investors business (earnings retained by the ● other comprehensive income
(shareholders). business). Contributed equity is the ● total comprehensive income.
The following sections discuss these subtotals that
are commonly used by companies. For illustration

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22 ACCT3 Financial
 Consolidated statement of profit or loss and other comprehensive income
For the year ended 30 June 2017

Notes 2017 2016

$’000 $’000
Revenue 127 882 121 624
Other income 2 534 2 900
Total revenue and other income 3(a) 130 416 124 524
Service expenses (31 282) (29 683)
Occupancy expenses (8 828) (8 914)
Administration expenses (71 000) (69 765)
Information technology expenses (18 159) (16 326)
Other expenses (7 917) (8 014)
Total expenses (137 186) (132 702)
(Deficit) before tax (6 770) (8 178)
Income tax expense 4 – –
(Deficit) after tax (6 770) (8 178)
Other comprehensive income
Items that may be reclassified subsequently to surplus or deficit:
Exchange differences on translation of foreign operations (15) 120
Fair value increment of freehold property 7 4 994 3 370
Total other comprehensive income 4 979 3 490
Total comprehensive (deficit) for the year, net of tax (1 791) (4 688)
EXHIBIT Consolidated statement of profit or loss and other comprehensive income
2.2

This consolidated statement of profit or loss and other comprehensive income should be read with the accompanying notes.
Source: JT Chartered Accountants Australia and New Zealand, Annual Report 2017, p. 80.

CSL Limited
Consolidated statement of comprehensive income

Notes 2017 2016

 
US$M US$M
Continuing operations    
Sales revenue 6 615.8 5 909.5
Pandemic Facility Reservation fees 94.0 68.7
Royalties and licence revenue 203.3 122.7
Other income 9.7 14.4
Total operating revenue 6 922.8 6 115.3
Cost of sales (3 326.8) (3 052.8)
Gross profit 3 596.0 3 062.5
Research and development expenses 6 (645.3) (613.8)
Selling and marketing expenses (697.0) (620.9)
General and administration expenses (484.8) (390.3)
Operating profit 1 768.9 1 437.5
Finance costs 2 (90.0) (71.6)
Finance income 10.9 13.9
Gain on acquisition 1b – 176.1
Profit before income tax expense 1 689.8 1 555.9
Income tax expense 3 (352.4) (313.5)

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 2 Financial statements 23
 Net profit for the period 1 337.4 1 242.4
Total of other comprehensive income/(expenses) 173.0 (198.8)
Total comprehensive income for the period 1 510.4 1 043.6
Earnings per share (based on net profit for the period)    
Basic earnings per share 10 2.937 2.689
EXHIBIT CSL’s consolidated income statement
2.3

Source: Adapted from CSL Limited, Annual Report 2017, p. 82.

purposes, Exhibit 2.3 contains CSL’s income statement Operating (other) expenses
for the financial year ended 29 June 2014. Note that the
After gross profit is reported, operating expenses are listed.
company uses the title Consolidated statement of
Operating expenses are the expenses operating
comprehensive income because it includes the revenues
that a company incurs during normal expenses  Recurring
and expenses of the parent entity as well as all of the expenses that a company
operations. Such expenses are recurring, incurs during normal
subsidiaries. Note also that, as with the balance sheet,
meaning that they are incurred year after operations.
the numbers are in millions of (US) dollars (shown to one
year as the company runs its business.
decimal point) except earnings per share.
CSL reports these expenses in three categories:
Gross profit Research and development, Selling and marketing, and
sales revenue  The
resources that a company General and administration. There is no requirement to
In a multi-step statement, revenue is
generates during a period report particular categories or details, but you may note
from selling its inventory. listed first. Sales revenue, which
Research and development has ‘Note 6’ which provides
is revenue from sale of goods, is
information on how the expense is calculated but not what
the resources that a company generates during a period
it was spent on or what kind of expenses made up the total,
from selling its inventory. CSL reports three other revenues,
while the other two expenses simply have the total. A
which it lists as ‘Pandemic Facility Reservation fees’,
business might believe providing too much information to
‘royalties and licence revenue’, and ‘other income’, (note
competitors would harm future profits.
the use of other common terms used for revenue),
contributing to a total operating revenue of $6922.8.
Courtesy CSL

(Finance income is reported in the middle of the statement

as this is seen to offset Finance cost reported just above.)
cost of sales  The cost Listed next is cost of sales ,
of the inventory sold sometimes called cost of goods sold,
during a period.
which represents the cost (to CSL) of
gross profit (gross
margin)  The profit that the inventory that was sold during a
a company generates period. Subtracting cost of sales from
when considering only the
sale price and the cost of total operating revenue yields the first
the product sold. subtotal of income, gross profit. Gross
profit (sometimes called gross
Part of CSL research and development
margin) represents the profit that a company generates expenses are the wages paid to scientists
when considering only the sales price and the cost of the who develop the new medicines

product sold. It therefore represents the gross dollar

‘mark-up’ that a company is able to achieve when selling
ANALYSIS
its inventory. Look at CSL’s income statement in
With cost of sales of over $3.3 billion, CSL generated Appendix B. What form of income
a gross profit of almost $3.6 billion for the year. This statement does the company use?
gives an average mark-up on inventory of a little over Analysis:
100 per cent. Note this is not ‘bottom line profit’ (total CSL uses a multi-step income statement. It shows several
comprehensive income); out of gross profit CSL pays for subtotals of income, including gross profit, operating
profit, profit before income tax expense, net profits
research and development, rent, wages, advertising,
for the period and total comprehensive income for
electricity, etc. the period.

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24 ACCT3 Financial
 PROFITS BEFORE INCOME TAX EXPENSE • Samsung collects record profits
Gross profit less Operating expenses yields the second • Samsung predicts record profits for third quarter
subtotal, Operating profits. Net finance costs (Finance as memory business booms.
costs minus Finance income) and Gain on acquisition are

Alamy Stock Photo/tony french

profits before income then deducted to give profits before
tax expense  The profit income tax expense, sometimes also
that a company generates
when considering both the called ‘earnings before income taxes’
cost of the inventory and and other similar titles. This represents
the normal expenses the profit that a company generates
incurred to operate the
business. when considering revenues and
expenses except for income tax.
After reporting its profit before tax,
income tax
expense  The amount of CSL reports Income tax expense of
income tax expense for a over $350 million to yield a Net profit
given period.
for the period (profit after tax) of
$1337.4 million.
YT
PPL HIS
OTHER COMPREHENSIVE INCOME

A
Review this content with the e-lecture
Note in the top section on the Income statement the term
‘profit’ is used (gross, operating, before income tax, net
for the period). Comprehensive income items include
movements in equity that are not part of the realised gains
LO5 HORIZONTAL AND
or losses in profits. These can include movement in VERTICAL ANALYSES
translation of foreign operations (due to changes in
exchange rates between the Australian dollar currencies The previous sections demonstrate that financial
of other countries in which CSL operates) and gains and statements communicate economic information about a
losses in ‘cash flow hedges’. AASB 101 Presentation of company to interested parties; for example, investors and
Financial Statements requires the disclosure of creditors learnt from CSL’s income statement that the
comprehensive income items either after the profit and company earned just under $2 billion (Australian) of total
loss section, as CSL does, or in a separate statement. In comprehensive income for the 2017 financial year. This is
summary, CSL’s income statement provides a picture of useful information because it demonstrates that the
how the company generated its profits for the year. This company was profitable during the year. However, the
translates to earnings per share of almost $3US, information can be even more useful if it is compared to
YT unsurprising given the something else. For example, is $1.5104 billion (US) better
PPL HIS
or worse than last year? Is it high enough given sales for
A

Check out the animated summary share price is around

on Financial Statements: Part 2
$100US. the period? How does it compare to competitors? Such
comparisons provide the necessary context for a richer
understanding of a company’s financial activities. Such
MAKING IT REAL context can be easily generated through two techniques
called horizontal and vertical analyses.
HANDS UP, WHO LIKES PROFITS?
You may be forgiven for thinking profits (or total
comprehensive income, to be technically correct) is
HORIZONTAL ANALYSIS
the only information reported in a public company’s Horizontal analysis is a method of horizontal
annual report, as from a quick scan it seems ‘profits’ analysing a company’s account balances analysis  A method of
are often the only or at least the first thing reported
over time. It is normally conducted on analysing a company’s
by the media, and not just in Australia, as seen by the account balances over
following selection of headlines from the UK:3 both the balance sheet and the income time by calculating
statement. The analysis calculates both absolute and percentage
• Samsung makes record profit of $109m a day as changes in each account.
chip demand soars the absolute and percentage change in
• Samsung predicts record profits for second each account balance on a financial statement. As a result,
straight quarter it is very useful in identifying promising or troubling trends
• Samsung record profits mask crisis without in a company. The analysis is called ‘horizontal’ because
and within

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CHAPTER 2 Financial statements 25
 the calculation compares an account’s balance across the required. A minor complication may be the change in the
columns of yearly data – that is, horizontally across price of the products sold by CSL. While the Consumer
the financial statement. Price Index in Australia rose around 2 per cent in the 2017
Horizontal analysis is calculated as follows. First, the financial year, if CSL’s medicines rose by a similar amount
dollar change in an account is determined. This is defined (which is unlikely given the global nature of CSL’s sales)
as the current year balance less the prior year balance. The then selling the same quantity would account for
dollar change is then divided by the prior year balance to 2 per cent rise in sales.
yield a percentage change. These two calculations are In summary, horizontal analysis of the balance sheet
shown below: and the income statement shows that CSL had another
growth year. Horizontal analysis (as seen in Exhibit 2.4)
KEY FORMULA 2.2 HORIZONTAL ANALYSIS has provided the context for a more thorough
understanding of the financial statements. The five-year
Dollar Change in Current Year Balance – summary information for CSL is an extension of the
=
Account Balance Prior Year Balance
horizontal analysis undertaken above, showing total
Percentage Change Dollar Change operating revenue rose from A$5.1 to A$7.0 billion
=
in Account Balance Prior Year Balance between 2013 and 2017, or 37.3 per cent, while profits
after tax rose from A$1.21 to A$1.43 billion, a more
To illustrate, consider the inventories balance from modest 17.8 per cent.4
CSL’s balance sheet in Exhibit 2.1; the company’s
inventory increased $424 million over the year, from VERTICAL ANALYSIS
$2152 in 2016. Dividing that increase by the 2016 balance Vertical analysis is a method of vertical analysis 
yields a percentage change of almost 20 per cent. These comparing a company’s account balances A method of comparing a
calculations are easily done on a spreadsheet where the company’s account
within one year. It also is normally balances within one year
financial information can be directly downloaded. Such an conducted on both the balance sheet and by dividing each account
analysis of the income statement in Exhibit 2.3 would the income statement. The analysis is balance by a base amount
to yield a percentage.
show a 10.9 per cent increase (3596 – 3062.5)/3062.5 in calculated by dividing each account
gross profits and a 23.1 per cent increase (1768.9 – 1437.5) balance by a base account, yielding a percentage. The
1437.5 in operating profits. For a full horizontal analysis, base account is total assets for balance sheet accounts
both dollar and percentage changes are calculated for and sales or total revenues for income statement accounts.
each account on both the balance sheet and the income These two calculations are shown below.
statement.
Further analysis of the balance sheet shows significant KEY FORMULA 2.3 VERTICAL ANALYSIS
growth. Total assets in the most recent year were 21 per
cent higher than the prior year. Since total liabilities For the For the income
balance sheet statement
increased 19 per cent, the company’s asset growth was
not only generated by borrowing money. Rather, the Account Balance Account Balance
Percentage
company grew by being profitable and not paying out all Total Assets Net Sales or Revenue
profits in dividends (12 per cent increase in retained
earnings). The negative contributed equity is due to share The product of a vertical analysis is
buybacks at prices higher than they were originally issued sometimes called a common-size common-size
(see CSL’s Note 12 to the financial statements). Share financial statement 
financial statement , which is a A statement in which all
buybacks are discussed in Chapter 11 ‘Shareholders’ statement in which all accounts have been accounts have been
equity’. An examination of the income statement may standardised by the overall
standardised by the overall size of the size of the company.
appear to be complicated by the presentation in $US. In company. Common-size statements are
vertical and horizontal analysis the percentages and very useful because they allow financial statement users
percentage changes are exactly the same as they would to determine the importance of each account to the overall
have been had the financial statements been in $A, company and to compare that importance to other
because we are comparing within and between figures companies, even those of vastly different sizes (and even
in one currency. Only when comparing actual dollar companies reporting in different currencies).
amounts or dollar changes between CSL and financial
statements in $A, would a currency conversion be

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26 ACCT3 Financial
 A B C D E
CSL Limited
1
Consolidated balance sheet

2 2017 US$m 2016 US$m $ Change % Change

3 CURRENT ASSETS        
4 Cash and cash equivalents 844.5 556.6 287.9 0.52
5 Trade and other receivables 1 170.4 1 107.2 63.2 0.06
6 Inventories 2 575.8 2 152.0 423.8 0.20
7 Current tax assets 6.2 1.6 4.6 2.88
8 Other financial assets 5.2 0.6 4.6 7.67
9 Total current assets 4 602.1 3 818.0 784.1 0.21
10 NON-CURRENT ASSETS        
11 Other receivables 16.5 15.6 0.9 0.06
12 Other financial assets 3.9 2.9 1.0 0.34
13 Property, plant and equipment 2 942.7 2 389.6 553.1 0.23
14 Deferred tax assets 496.5 389.0 107.5 0.28
15 Intangible assets 1 055.4 942.6 112.8 0.12
16 Retirement benefit assets 5.6 5.0 0.6 0.12
17 Total non-current assets 4 520.6 3 744.7 775.9 0.21
18 TOTAL ASSETS 9 122.7 7 562.7 1 560.0 0.21
19 CURRENT LIABILITIES        
20 Trade and other payables 1 155.8 996.1 159.7 0.16
21 Interest-bearing liabilities 122.5 62.3 60.2 0.97
22 Current tax liabilities 202.5 207.3 (4.8) −0.02
23 Provisions 134.1 99.6 34.5 0.35
24 Deferred government grants 3.2 3.1 0.1 0.03
25 Derivative financial instruments – 6.0 (6.0) −1.00
26 Total current liabilities 1 618.1 1 374.4 243.7 0.18
27 NON-CURRENT LIABILITIES        
28 Other non-current liabilities 25.8 18.8 7.0 0.37
29 Interest-bearing liabilities 3 852.7 3 081.0 771.7 0.25
30 Deferred tax liabilities 138.2 119.2 19.0 0.16
31 Provisions 32.9 40.5 (7.6) −0.19
32 Deferred government grants 35.9 35.0 0.9 0.03
33 Retirement benefit liabilities 255.3 326.6 (71.3) −0.22
34 Total non-current liabilities 4 340.8 3 621.1 719.7 0.20
35 TOTAL LIABILITIES 5 958.9 4 995.5 963.4 0.19
36 NET ASSETS 3 163.8 2 567.2 596.6 0.23
37 EQUITY        
38 Contributed equity (4 534.3) (4 213.0) (321.3) 0.08
39 Reserves 294.2 187.9 106.3 0.57
40 Retained earnings 7 403.9 6 592.3 811.6 0.12
41 TOTAL EQUITY 3 163.8 2 567.2 596.6 0.23
EXHIBIT Horizontal analysis of CSL’s consolidated balance sheet
2.4

Source: Adapted from CSL Ltd, Annual Report 2017, p. 82.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 2 Financial statements 27
 In vertical analysis we divide each inventory balance by For a full vertical analysis, percentages are calculated
total assets for that year. These calculations are shown in for every account on each financial statement. Exhibit 2.5
the following table. Also shown are similar calculations that contains a vertical analysis of CSL’s income statement.
would be made for a vertical analysis of total comprehensive Of course, sales revenue is 100 per cent (1.00) of itself.
income from the company’s income statement in Cost of sales is 50.3 per cent of sales revenue in 2017
Exhibit 2.3. The only difference is that total comprehensive (51.7 per cent in 2016), which indicates, on average, CSL
income is divided by sales, not total assets. manufactures (or buys) medicines for about 51c and sells
them for $1.00. At the bottom of the income statement in
2017 2016 Exhibit 2.5 we can see CSL makes well over 20c from
Inventory balance $2 575.8 $2 152.0 every $1 of sales in 2017 and well under 20c in 2016. The
Total assets $9 122.7 $7 562.7 vertical analysis shows excellent improvement in financial
= Percentage of total assets = 28.2% = 28.5% performance in 2017.
A more advanced examination of the balance sheet
would show the single largest asset for CSL is property,
Total comprehensive income $1 510.4 $1 043.6
plant and equipment (PPE). PPE increased by 23 per cent
Total operating revenue* $6 922.8 $6 115.3 during the year (we know this from the horizontal analysis).
= Percentage of net sales = 21.8% = 4.217.1% In 2016 it was 31.6 per cent of total assets (2389.6/7562.7)
*In Exhibit 2.5 Sales revenue is used rather than Total operating revenue. There may be reasons for using one and 32.3 per cent of total assets (2942.7/9122.7) in 2017.
rather than the other in analysing a particular company; here it is more about ease of understanding.
This is due to total assets increasing by 21 per cent (again

A B C D E F
CSL Limited
1
Consolidated statement of comprehensive income

Notes 2017 As % of 2016 As % of

2 US$M Total revenue US$M Total revenue
3 Continuing operations          
4 Sales revenue   6 615.8 1.000 5 909.5 1.000
5 Pandemic Facility Reservation fees   94.0 0.014 68.7 0.012
6 Royalties and licence revenue   203.3 0.031 122.7 0.021
7 Other income   9.7 0.001 14.4 0.002
8 Total operating revenue   6 922.8 1.046 6 115.3 1.035
9 Cost of sales   (3 326.8) (0.503) (3 052.8) (0.517)
10 Gross profit   3 596.0 0.544 3 062.5 0.518
11 Research and development expenses 6 (645.3) (0.098) (613.8) (0.104)
12 Selling and marking expenses   (697.0) (0.105) (620.9) (0.105)
13 General and administration expenses   (484.8) (0.073) (390.3) (0.066)
14 Operating profit   1 768.9 0.267 1 437.5 0.243
15 Finance costs 2 (90.0) (0.014) (71.6) (0.012)
16 Finance income   10.9 0.002 13.9 0.002
17 Gain on acquisition 1b – – 176.1 0.030
18 Profit before income tax expense   1 689.8 0.255 1 555.9 0.263
19 Income tax expense 3 (352.4) (0.053) (313.5) (0.053)
20 Net profit for the period   1 337.4 0.202 1 242.4 0.210
21 Total of other comprehensive income/(expenses)   173.0 0.026 (198.8) (0.034)
22 Total comprehensive income for the period   1 510.4 0.228 1 043.6 0.177
EXHIBIT Vertical analysis of CSL’s consolidated income statement
2.5

Source: Adapted from CSL Limited, Annual Report 2017, p. 81.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
28 ACCT3 Financial
from the horizontal analysis). Inventories increased 20 per company’s balance sheet changed from one year to the
cent (again from the horizontal analysis) while in 2016 it next. It therefore focuses not only on retained earnings,
was 28.5 per cent (2152.0/7562.7) of total assets and in but also on other equity accounts relating to a company’s
2017 it was 28.2 per cent (2575.8/9122.7). This may appear total equity.
to be incorrect, but simply shows inventories grew For illustration purposes, Exhibit 2.6 contains CSL’s
substantially, but not quite as much as the average Consolidated statement of changes in equity for the year
other assets. ended 30 June 2017. Like the other financial statements,
The analysis also reveals CSL’s capital structure. Capital changes in equity reports two years of data. However,
structure refers to the degree to which a company’s assets unlike the income statement, each column reflects the
are generated from liabilities versus equity. In general, a activity in a specific equity account rather than a period of
capital structure more heavily weighted towards liabilities time. The five columns of the statement refer to the five
is riskier. According to the vertical analysis, CSL financed equity accounts, four are shown in the balance sheet,
over 65 per cent of total assets from total liabilities (debt) (Foreign currency translation reserve and Share-based
and therefore less than 35 per cent from total payment reserve are combined and shown as one line
(shareholders’) equity in the most recent year. Total ‘Reserves’ in the balance sheet).
liabilities increased substantially over the year (19 per cent The first column ‘Contributed equity’, as discussed
from the horizontal analysis) and there was a small previously, is negative. This is complex, and at the
reduction in debt as a percentage of total assets (2017: introductory stage not important, but if you are interested
65.3% [5958.9/9122.7]; 2016: 66.1% [4995.5/7562.7]). a simple example may be helpful. Assume a company sold
(issued) 100 shares for $1 each – it would have contributed
equity of $100. After a number of years the company was
LO6 THE STATEMENT OF very financially successful and the shares were selling for
$25 each. If the company wanted to buyback say 10 shares
CHANGES IN EQUITY it would need to pay $250 ($25 x 10), which would leave a
negative contributed equity of $150 (original $100 minus
Chapter 1 introduced the statement of changes in equity.
$250 buyback). Reasons for buybacks are discussed in
The retained earnings section of the statement of changes
Chapter 11.
in equity links a company’s income statement and balance
The fourth column, Retained earnings, represents the
sheet by showing how profits or losses and dividends
equity that has been generated through profitable
change the company’s retained earnings balance. All
operations and retained in the business. The Retained
companies show changes in retained earnings, but most
earnings column is CSL’s statement of changes in equity.
show it as a component of a more complete statement of
Profit for the period (and some of the comprehensive
changes in equity.
income) is added to the beginning retained earnings
A statement of changes in equity is a financial statement
balance, and dividends are subtracted. As we can calculate,
that shows how and why each equity account in the

A B C D E F
1 CSL Limited Consolidated Statement of Changes in Equity

Contributed Foreign Share based Retained Total

equity currency payment earnings US$m
2   US$m translation reserve US$m
reserve US$m
US$m
3 At the beginning of the year (4 213.0) 28.5 159.4 6 592.3 2567.2
4 Total comprehensive income for the full year – 97.5 – 1 412.9 1510.4
5 Share based payments – – 8.8 – 88
6 Dividends – – – (601.3) 6 013
7 Share buyback (334.0) – – – 3 340
8 Share issues - Employee share scheme 12.7 – – – 127
9 As at the end of the year (4 534.3) 126.0 168.2 7 403.9 3163.8
EXHIBIT CSL’s consolidated statement of changes in equity
2.6

Source: Adapted from CSL Limited, Annual Report 2017, p. 83.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 2 Financial statements 29
 CSL paid out around 43 per cent of its profits (and some
MAKING IT REAL
comprehensive income) in 2017 in dividends (601.3/1412.9).
The last row of the statement and bottom line of the
WHICH RETAILER IS WHICH?5 statement of changes in equity, ‘As at the end of the year’,
A company’s balance sheet often reflects its business has (of course) the same numbers that appear in the
model, and a vertical analysis can help you distinguish
balance sheet $3163.8.
one model from another. For example, take the YT
PPL HIS
following vertical analyses of selected assets from the

A
Download the Enrichment Modules
2017 balance sheets of two well-known retailers – for further practice
Myer and JB Hi-Fi. Can you tell which company is
which? Although Myer has more than double JB
Hi-Fi’s total assets, vertical analysis facilitates the
comparison (figures as a percentage of total assets).
LO7 I NFORMATION BEYOND
Company A Company B THE FINANCIAL
Inventories 19.8% 35.1% STATEMENTS
Plant, property and equipment     21.66% 8.5%
A company’s financial statements contain a significant
Both Myer and JB Hi-Fi are in the business of selling amount of information about the financial activities and
inventory, but their models are different. Myer is a position of the company. However, they are not exhaustive,
traditional ‘bricks and mortar’ company that sells its
and much information that is useful to users of annual
inventory in stores, some of which it owns, while JB
Hi-Fi is a relatively new retailer that stocks and sells reports is not included directly in the financial statements.
large quantities of inventory for the space it occupies. As a result, companies like CSL prepare and report
Therefore, Myer should have a greater percentage of additional information beyond the financial statements.
its total assets in plant, property and equipment (PPE) These items are normally included in a company’s annual
and JB Hi-Fi a greater percentage in inventory. report that is distributed to all shareholders. Four items of
Company A has 21.6 per cent of its assets in PPE and
Company B 35.1 per cent of its total assets in inventory.
interest are:
Therefore, Company A is Myer and B is JB Hi-Fi. ● notes to the financial statements
● auditor’s report
Alamy Stock Photo/Takatoshi Kurikawa; Alamy Stock Photo/KC Hunter

● directors’ report
● other information, which often includes: information
about the business operations, future prospects,
shareholder information and a sustainability report
● governance information.

NOTES TO THE FINANCIAL STATEMENTS

At the bottom of each of CSL’s financial statements is the
following quote: ‘The consolidated statement … should
be read in conjunction with the accompanying notes’.
In addition, next to many of the accounts in the ‘Note’
column is a number that refers to a specific note following
the financial statements. For CSL there are 24 notes in
2017, taking up 35 pages of the annual report.
A company’s financial statements cannot communicate
or disclose to users all the information necessary to
adequately understand the financial activities and condition
of an entity. Additional information, both quantitative and
qualitative, is necessary and can be found in the notes to
the financial statements.
The notes to the financial notes to the
statements are the textual and financial
statements  The
numerical information immediately additional textual and
following the financial statements that: numerical information
immediately following the
(1) disclose the accounting methods financial statements.
used to prepare the financial statements,

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
30 ACCT3 Financial
(2) disclose additional detail and explanation of account Since most of us don’t have access to the financial and
balances and (3) provide information not recognised in the other records, nor the ability to determine whether the
financial statements. Financial statements should not be reported numbers are reliable, we trust a third party
examined without considering the notes to the financial to provide assurance that the information is reliable. This
statements. is why all annual reports contain an independent
The content of the notes to the financial statements auditor’s report.
varies by company, but there are some similarities across An independent auditor’s report independent
companies. Initially, the first note of most companies is a report, prepared by a registered auditor’s report 
summarises the significant accounting policies used to company auditor for the shareholders, A report, prepared by a
registered company auditor
prepare the financial statements. For example, CSL stating an opinion on whether the for the shareholders,
commences by stating the financial report is prepared in financial statements give a true and fair stating an opinion on
whether the financial
accordance with Australian Accounting Standards. It goes view and comply with Australian statements present fairly,
on to explain ‘significant accounting policies that summarise Accounting St andards and the in conformity with
Australian Accounting
the measurement basis used and are relevant to an Corporations Regulations. Exhibit 2.8 Standards, the company’s
understanding of the financial statements are provided contains an extract from CSL’s 2017 financial condition and
results of operations and
throughout the notes to the financial statements’.6 These auditor’s report. cash flows.
explanations are especially useful in determining the As you can see in the report, EY, one
comparability of financial statements across companies. of the ‘big four’ accounting firms, performed the audit.
Second, most companies include a note for each of their The auditor’s opinion is that the financial reports of CSL
significant accounts. These notes can vary depending on give a true and fair view and comply with Australian
the type of business, but most companies have notes for Accounting Standards and the Corporations Regulations
significant items such as property, plant and equipment, 2001. This type of opinion, which is known as an
income taxes and employee benefit plans, among other unqualified opinion, is what all companies hope to
things. Exhibit 2.7 is an extract from CSL’s balance sheet receive. With this assurance from EY, users can consider
with the corresponding note. the financial statements reliable.

Note DIRECTORS’ REPORT

Current assets In addition to financial statements, notes and the auditor’s
Cash and cash equivalents 14 report, all annual reports contain a section called
Trade and other receivables 15 directors’ report. The directors’ report directors’
Inventories 4 forms part of the financial report and report  Forms part of the
covers matters which are the Board of financial report and covers
Current tax assets matters which are the
Directors’ responsibility, including: who Board of Directors’
Non-current assets are the directors, how many meetings responsibility.
Other receivables 15 they attended, risk management – and
Other financial assets over the last ten years increasing in importance – how
Property, plant and equipment 8 much and why senior managers are paid (remunerated).
Intangible assets 7
Equity
OTHER INFORMATION
Contributed equity 12 Sometimes referred to as management’s discussion and
Reserves 12
analysis, CSL commences the annual report by telling the
reader about the business, including the major business
Retained earnings 19
sectors, reviewing the year and highlighting certain aspects.
EXHIBIT Extract from CSL’s balance sheet with the Some of the information may be considered informative or
2.7 corresponding note to the financial statements
some may cynically see it as public relations. Other
Source: Adapted from CSL Limited, Annual Report 2017, p. 82.
information, such as major shareholders and corporate
governance, may be required by the Australian Securities
AUDITOR’S REPORT Exchange as part of a listed company’s obligations. This
How do you know if a financial report can be trusted to other information normally precedes the financial report
fairly present CSL’s financial position and performance?

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 2 Financial statements 31
 EXHIBIT Extract from CSL’s independent auditor’s report
2.8

Source: CSL Ltd, Annual Report 2017, p. 121 & 126. ©2017 CSL Limited.

and, for CSL’s 2017 annual report, takes up the first SUSTAINABILITY REPORTING
fifty pages. Many companies report information that is broader than the
I would encourage you to look at more detail of this financial and operating activities. Some reporting areas and
report in Appendix B and on the internet. An excerpt of this frameworks have been developed over recent decades
is presented in Exhibit 2.8. which consider a more comprehensive set of stakeholders.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
32 ACCT3 Financial
 • ensuring our therapies are safe and of the highest
Driven by our promise, CSL is a global biotechnology quality by maintaining the highest standards
throughout all stages of the product life cycle
company that develops and delivers innovative
• operating responsibly in the marketplace by
medicines that save lives, protect public health and marketing our medicines in an ethical manner,
help people with life-threatening medical conditions working with others to improve equity of access and
live full lives. Our Values guide us in creating sharing our financial success
• providing a positive working environment for our people
sustainable value for our stakeholders.
by engendering a culture of mutual trust and respect,
Delivering on promises is what we do at CSL. enabling them to do their jobs safely and effectively,
Starting a century ago in Melbourne, Australia, we and rewarding and recognising their contributions
made a promise to save lives and protect the health of • supporting our patient, biomedical and local
people who were stricken with a broad range of serious communities by improving access to our therapies
and enhancing the quality of life for patients,
medical conditions. Today, that same promise has advancing scientific knowledge and supporting
never been stronger. As a leading global biotechnology future medical researchers, and engaging our staff
company, CSL delivers medicines to patients in more in the support of local communities.7
than 60 countries and employs nearly 20 000 people … While there is no requirement to provide any information
CSL focuses its world-class research and on sustainability, many businesses see providing such
development (R&D), high-quality manufacturing, and information as useful for stakeholders.
patient-centred management to develop and deliver
innovative biotherapies, influenza vaccines and GOVERNANCE INFORMATION
support programs … CSL devotes 12 pages in the annual report to Corporate
Governance. The Australian Securities Exchange (ASX) requires
EXHIBIT Excerpt from ‘About CSL’
2.9 listed companies to report on corporate governance principles
Source: CSL Ltd, Annual Report 2017, p. 2. ©2017 CSL Limited. Reproduced with permission.
and recommends that companies ‘lay solid foundations for
management and oversight’ to ‘make timely and balanced
disclosures’ and ‘remunerate fairly and responsibly’.8
Integrated reporting combines financial, corporate social
The board of directors is the governing group of a
responsibility and other non-financial information into a
company; the board selects and appoints the senior
single report. Integrated reporting is encouraged in India and
managers and makes the major strategic decision. The
China and required in South Africa, but voluntary in Australia.
recognition and management of risk is a major function of
CSL lists the following corporate responsibility priority
boards today. CSL reports on the directors’ knowledge, skills
areas:
• innovation by focussing on product research and and experience, their length of service on the board and,
YT
development and operational excellence importantly, if they PPL HIS

A
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CHAPTER 2 Financial statements 33
 LO4
4 Calculating profit after tax
EXERCISES Brancatisano Clothing Supercentre generated a gross profit
of $3 875 000 during the year. Also, during the year,
Brancatisano incurred advertising expense of $750 000,
salaries expense of $1 050 000 and income tax expense of
$1 000 000.
REQUIRED
LO1, 7
1 Miscellaneous terms Calculate the company’s profit or loss after tax for the year.
The following definitions were discussed in the chapter:
LO5
a A form of business in which two or more people 5 Horizontal and vertical analyses
combine their capital and talents. The following information (in millions) was taken from a
b Information following the financial statements that recent income statement of Lucy-Rose and Sarah Company:
provides additional information and disclosures.
c A form of business that is a separate legal entity, Current year Prior year
established by filing proper forms with ASIC. Net sales $32 235 $26 306
d A report that attests to the fair presentation of a
Cost of sales    19 726     17 920
company’s financial statements.
Gross profit $12 509 $8 386
e The most common form of business.
f Information on role of the board and how it provides REQUIRED
responsible leadership. Conduct horizontal and vertical analyses of gross profit.
REQUIRED Was the company more or less profitable in the current
Match each definition with one of the following terms: sole year? Do both horizontal and vertical analyses indicate that?
proprietorship; governance information; notes to the For your calculations, round percentages to one decimal
financial statements; partnership; auditor’s report; company point (e.g. 10.1%).
or corporation.
LO4, 5
6 Horizontal analysis
LO3
2 Classified balance sheet The horizontal analysis of a company’s sales shows a
The following is a list of accounts taken from Jann’s Jeans: $34.2 million increase, which equated to a percentage
change of 22.8 per cent.
Accounts receivable $  2 400 REQUIRED
Sales 36 000 Interpret the dollar change and percentage change and
Inventory 6 300 identify which item(s) from the following list would
potentially explain the results of the analysis:
Contributed equity 52 000
a A sales promotion was highly successful.
Accounts payable 9 240 b A major supplier was unable to deliver goods on time.
Cash 14 660 c The company opened several new stores.
Prepaid insurance 5 600 d The company lost market share to Amazon.
Equipment 27 000 e The company’s contributed equity increased by
$1.5 million from the issue of shares.
Short-term investments 1 600
f Additional optional question: what were sales in the
REQUIRED previous year?
Prepare the current asset section of Jann’s balance sheet.
LO6
Attempt to list the accounts in the proper sequence 7 Statement of changes in equity
(liquidity). A company provides the following account balances for the
current year:
LO4
3 Calculating gross profit
During the month, a retailer generates $45 000 of sales, Contributed equity, beginning of year $  20 600
$9500 of operating expenses, and $34 500 in cost of sales. Retained earnings, beginning of year 62 496
At the end of the month, the company had $3000 of
Additional contributed equity 100 000
inventory (goods) on hand.
Dividends 9 500
REQUIRED
Profits (comprehensive income) 22 133
Calculate the company’s gross profit for the month.
REQUIRED
Prepare a statement of changes in equity at year-end in a
single column to give the closing balance of total equity.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
34 ACCT3 Financial
 LO3 LO3
8 Classified balance sheet 10 Balance sheet
The following is a list of accounts:
Balance sheet
●● Mortgage payable, due in 15 years
●● Short-term investments Pauline’s Barnaby’s Sue’s
Fish & Bar & Surf
●● Cash Chips Grill and Turf
●● Prepaid rent
ASSETS
●● Patents
●● Contributed equity Current assets $  48 500 $  35 000 $  64 500
●● Accounts payable Non-current assets 125 750 100 000 150 000
●● Buildings Intangible assets 32 250 55 250 15 000
●● Notes payable, due in six months. Other assets (a) 35 500 6 500
REQUIRED Total assets 220 000 225 750 (g)
Identify each account as a current asset, non-current asset, LIABILITIES
intangible asset, current liability, non-current liability,
Current liabilities $  15 500 $  7 000 (h)
contributed equity, or retained earnings.
Non-current liabilities 45 000 (d) 65 500
LO3
9 Classified balance sheet terms Total liabilities (b) 75 000 69 000
The following is a list of balance sheet classifications and EQUITY
descriptions:
Contributed equity $  55 000 (e) $  67 500
a Current asset
Retained earnings (c) 105 000 (i)
b Long-term investment
Total liabilities and equity 220 000 (f) (j)
c Non-current asset
d Contributed equity REQUIRED
e Intangible asset Fill in the 10 missing numbers (a)-(j) for the independent
f Current liability businesses.
g Non-current liability
LO3
h Retained earnings 11 Classified balance sheet
i An obligation that is reasonably expected to be The following items were taken from the 30 June balance
satisfied within the coming financial year. sheet of Samantha Solarium:
ii An investment in the shares or bonds of another
entity that the company does not intend to sell Buildings, net $120 400
within one year. Accounts receivable 29 040
iii An obligation that is not expected to be satisfied Prepaid insurance 9 360
within one year.
Cash 41 680
iv The portion of equity contributed by shareholders
through the purchase of shares. Equipment (net) 127 360
v Resources that are reasonably expected to be Land 123 600
converted to cash or consumed during the
Mortgage payable 206 080
coming financial year.
vi Tangible resources that are used in the company’s Contributed equity 132 000
operations for more than one year and are not Retained earnings 80 000
intended for resale.
Interest payable 7 200
vii The profits that a company earns over time and is not
paid out in dividends. Accounts payable 24 960
viii Resources to be used in the company’s operations REQUIRED
for more than one year that have no physical
Recreate the company’s classified balance sheet, assuming
substance.
that $27 200 of the mortgage payable balance will be paid
REQUIRED within three months of the balance sheet date.
Match the classification to the description.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 2 Financial statements 35
 LO4 LO4, 5
12 Multi-step income statement 15 Horizontal and vertical analyses,
These items were taken from the financial records of Tran income
Nguyen Pty Ltd: Comparative statements of comprehensive income are
available for Fiona’s Fine Fruit (all figures in millions):
Electricity expense $  17 650
Interest expense 50 2020 2019

Selling expense 14 600 Sales $850 $800

Administrative expense 15 230 Cost of sales 325 275
Interest revenue 500 Gross profit 525 525
Cost of sales 75 620 Other expenses    175    121
Net sales 154 900 Profits before tax 350 404
Income tax expense    105    121
REQUIRED
Prepare a multi-step income statement assuming Tran Total comprehensive income $245 $283
Nguyen pays the 25 per cent company rate and has a
REQUIRED
30 June financial year end (you can assume in this case
accounting profit equals taxable income). a Perform horizontal and vertical analyses on each of the
items in the above comparative income statements.
LO4 Round percentages to one decimal point (e.g. 10.1%).
13 Multi-step income statement
b Briefly comment on the performance and suggest areas
The following income statement items are taken from where management need to devote attention if they
the records of Matthew Music Mania for the year ending wish to reverse the decline in profits.
30 June:
LO3, 5
Advertising expense $  6 210 16 Horizontal and vertical analyses,
balance sheet
Cost of sales 83 910
The following comparative balance sheet data is available for
Income tax expense 2 250
Elizabeth Enterprises:
Insurance expense 3 960
Interest expense 4 115 2020 2019

Interest revenue 6 055 Total assets $850 000 $700 000

Rent expense 11 410 Total liabilities   240 000   280 000
Salaries expense 28 525 Total equity   610 000   420 000
Sales 153 100 REQUIRED
Electricity expense 5 600 Perform horizontal and vertical analyses on each of the
items above. Round percentages to one decimal point
REQUIRED (e.g. 10.1%). If generating assets through debt is considered
Prepare a multi-step income statement for the year ending riskier than generating assets through equity, is Elizabeth
30 June. more or less risky in 2020?

LO3, 4, 6 LO5
14 Financial statement accounts 17 Horizontal and vertical analyses
The following is a list of accounts: A company provides the following information:

Accounts receivable Interest payable Current year Prior year

Interest revenue Contributed equity Net sales $121 345 $119 872
Inventory Pandemic reservation fees Accounts receivable   30 192   12 676
Buildings Cost of sales Total assets   246 933   250 361
Dividends Administrative expense
REQUIRED
Mortgage Sales
Should the company be concerned about its performance?
Accounts payable Retained earnings Use horizontal and/or vertical analyses to ‘prove’ it should or
Supplies Cash should not be concerned. Round percentages to one
decimal point (e.g. 10.1%). What other information may be
Reserves Finance costs considered more relevant to a question about
‘performance’? Why?
REQUIRED
Identify if each account would appear on the balance sheet,
income statement and/or statement of changes in equity.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
36 ACCT3 Financial
 LO5, 7
account balances, and information not recognised in the
18 Financial accounting terms financial statements.
The following are various terms and definitions from iii A statement in which all accounts have been
financial accounting: standardised by the overall size of the company.
a Common size financial statement iv A discussion and analysis of strategic and risk
b Notes to the financial statements management by the board of directors.
c Governance report v A report, prepared by a specialist accountant for the
d Auditor’s report stakeholders stating the company’s financial
performance and position are fairly stated.
e Vertical analysis
vi A technique that calculates the change in an account
f Horizontal analysis.
balance from one period to the next and expresses that
i A technique that compares account balances within one change in both dollar and percentage terms.
year by stating each account balance as a percentage of
a base amount. REQUIRED
ii Textual and numerical information immediately following a Match each term with the appropriate definition.
the financial statement’s disclosing information such as b Rewrite two of the definitions in your own words
accounting methods used, detail and explanation of explaining to a group of 16-year-old students what the
two terms mean. You may use examples.

PROBLEMS

LO3
19 Prepare a classified balance sheet
Bay Company thinks there may be a problem with its balance sheet:

Bay Company
Classified balance sheet
For the year ending 30 June

Assets Liabilities and shareholders’ equity

Current assets Current liabilities
Buildings $70 000 Accounts payable $16 000
Interest revenue 11 000 Interest expense 39 000
Equipment 41 000 Total current liabilities $  55 000
Cash 8 000 Shareholders’ equity
Other current assets 4 000 Retained earnings $50 000
Total current assets $134 000 Contributed equity 35 000
Accounts receivable $12 000 Bonds payable 40 000
Land 20 000 Total shareholders’ equity 125 000
Interest payable 14 000
Total non-current assets 46 000
Total assets $180 000 Total liabilities and shareholders’ equity $180 000

REQUIRED
Prepare a correctly classified balance sheet.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 2 Financial statements 37
 LO4
REQUIRED
20 Prepare a multi-step income statement
a Prepare a comparative, classified balance sheet for
The auditor for Chan Corporation noticed that its income Lim Limited.
statement was incorrect b Perform horizontal and vertical analyses and interpret
the results. Round percentages to one decimal point
Chan Corporation income statement 30 June
(e.g. 10.1%).
Sales $130 000 c Assume the same information above except that in
Cost of sales 80 000 2021, Bonds payable is $0 while Retained earnings is
$271 295. Does this new information change any
Accounts receivable    19 500 interpretations previously made?

LO3, 4
Gross profit 30 500 22 Multi-step income statement and
Interest expense $15 000 classified balance sheet
The following items were taken from the financial
Selling and administration expense 13 000
statements of Wells Company for 2018:
Dividends 1 000
Total other expenses    (29 000) Accounts payable $15 780
Interest revenue 16 500 Accounts receivable 8 470
Accounts payable 4 000    8 500 Advertising expense 4 200
Income before taxes 10 000 Cash 16 080
Income tax expense    (12 850) Contributed equity 15 400
Loss $     (850) Cost of sales 41 250
Dividends 2 310
REQUIRED
Equipment, net 45 420
Prepare a corrected multi-step income statement.
Income tax expense 3 260
LO3, 5
21 Prepare and analyse the balance sheet Insurance expense 4 680
The following comparative balance sheet items are available Non-current liabilities 9 920
from Lim Limited as of 30 June 2021:
Prepaid insurance 5 970
2021 2020 Retained earnings, 1 Jan. 28 450

Accounts payable $  75 500 $  35 035 Salaries expense 17 420

Accounts receivable 50 000 85 065 Salaries payable 5 210

Bonds payable, due 30/06/2028 125 000 25 000 Sales 78 480

Buildings, net 240 000 300 000 Electricity expense 4 180

Contributed equity 100 000 80 000 REQUIRED

Cash 15 000 25 635 Prepare a multi-step income statement for the year ending
31 December 2018, and a classified balance sheet at
Equipment, net 24 000 24 000
31 December 2018. Hint: you must calculate ending retained
Income taxes payable 12 250 16 465 earnings.
Interest payable 13 755 7 550
LO4, 5
Inventory 25 650 27 270 23 Prepare and analyse an income
statement
Land 300 000 200 000
The following income statement items are available from
Long-term investments 125 000 100 000 Bugeja Limited for the years ending 31 December:
Notes payable, due 31/12/2021 100 000 100 000
2019 2018
Supplies 12 500 13 500
Additional equity 200 000 190 000 Advertising expense $  7 765 $  9 789

Patents 6 000 6 000 Commissions expense 4 879 6 010

Prepaid rent 10 150 12 275 Cost of sales 48 596 58 896

Retained earnings 146 295 306 135 Income tax expense 2 217 2 684

Salaries payable 35 500 33 560 Insurance expense 4 897 5 236

Interest expense 2 584 2 695

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
38 ACCT3 Financial
 Interest revenue 4 287 4 189 REQUIRED
a Identify the company’s current-year and prior-year
Sales 95 950 106 569
balances in total current assets; property, plant and
Supplies expense 1 654 2 106 equipment; total current liabilities; interest-bearing
Salaries expense 19 320 21 012 liabilities; and total shareholders’ equity. Conduct vertical
analysis on each account balance. What broad trend
Rent expense 7 634 7 856 (if any) is indicated by the calculations? Round
percentages to one decimal point (e.g. 10.1%).
REQUIRED
b Identify the company’s current-year and prior-year total
a Prepare a comparative, multi-step income statement for
operating revenue, gross profit, operating profits and
Bugeja.
total comprehensive income for the period. Conduct
b Perform horizontal and vertical analyses and interpret horizontal analysis on each account balance. What broad
the results. Round percentages to one decimal point trend (if any) is indicated by the calculations? Round
(e.g. 10.1%). percentages to one decimal point.
c Assume the following changes: Cost of sales in 2019, c Look up CSL’s share price. How has it changed over the
$62 470 and in 2018, $45 670. Does this new information period covered by the income statement? Calculate the
change previously made interpretations? percentage change in the share price. Of the change in
the four accounts in (b) above, which is it closest to?
LO5
24 Using horizontal and vertical analyses
LO4, 5
The president of Wakefield Investments is disappointed that 26 Research and analysis
the company was less profitable this year than last. Access the latest annual report for Cochlear by searching the
Comparative income statements for Wakefield are: internet for ‘Cochlear limited annual report’.
Current year Prior year REQUIRED
a Conduct horizontal analysis of Cochlear’s sales, gross
Sales $800 000 $500 000
profit and total comprehensive income, and vertical
Cost of sales 300 000 200 000 analysis for the same accounts for both the current and
Gross profit 500 000 300 000 prior year. Round percentages to one decimal point
(e.g. 10.1%). What conclusions can you draw about the
Operating expenses 167 000 130 000
company’s ability to earn a profit from its sales?
Profits after tax 333 000 170 000 b Conduct horizontal analysis of the company’s inventory,
Gain on hedge transaction 0 180 000 total liabilities and total equity for the current year and
(net of tax) vertical analysis for the same accounts for both the
Profit 333 000 350 000 current and prior year. Round percentages to one
decimal point (e.g. 10.1%). What conclusions can you
REQUIRED draw about the company’s changing business model?
Why was Wakefield’s profit lower in the current year? Use c Look up Cochlear’s share price. How has it changed over
horizontal and vertical analyses to show the ways in which the period covered by the income statement? Calculate
Wakefield was more profitable in the current year. Round the percentage change in the share price. Of the change
percentages to one decimal point (e.g. 10.1%). in the three accounts in (a) above, which is it closest to?

CASES

LO3, 4, 5
25 Reading and analysing financial
statements
Access the latest copy of CSL’s Annual Report by searching
the internet for ‘CSL Annual Report’ (the annual report is
released in September or October each year).

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 2 Financial statements 39
 3
The first two chapters of this book focused on how
economic information is communicated to users through
financial statements, including:
● balance sheets (statement of financial position)
● income statements (statement of comprehensive
income)
● statements of changes in equity
● cash flow statements.

Recording accounting This chapter and Chapter 4 focus on how the activities
of a business are captured by the accounting system so

transactions that these financial statements can be prepared. More

specifically, they describe the accounting cycle. Because
financial statements must be prepared periodically, the
process of capturing and reporting information is a
repetitive process, or cycle. This chapter explores the first
three steps in the accounting cycle. The next chapter
LEARNING explores the remaining steps.
OBJECTIVES

After studying the material in this chapter, you

LO1 THE ACCOUNTING
should be able to: INFORMATION SYSTEM
1 Describe the purpose of an accounting
An o r g a n i s a t i o n’s a c c o u n t i n g accounting
information system.
information system is the system that information
2 Analyse the effect of accounting identifies, records, summarises and system  The system
that identifies, records,
transactions on the accounting equation. communicates the various transactions summarises and
3 Understand how T-accounts and debits and of a business entity. Accounting communicates the various
transactions of a business.
credits are used in a dual-entry information systems var y widely,
accounting system. ranging from manual, pencil-and-paper systems in
4 Explain the purpose of the journal, ledger some micro businesses to highly complex electronic
and trial balance. systems in other organisations. However different
their forms, all accounting systems are built to capture
5 Record and post accounting transactions, and report the effects of a business’ accounting
prepare a trial balance, income statement,
transactions.
the changes in equity and balance sheet.
An accounting transaction is any accounting
Any
economic event that affects a business’ transaction  economic event that
assets, liabilities or equity at the time of affects a business’ assets,
the event. Examples include the liabilities and/or equity at
the time of the event.
purchase of equipment, the consumption
of supplies in operations and the issuance of debt or
shares. In each example, the event increases or decreases
a specific asset, liability and/or equity account of the
business. Accounting transactions between a business
and an external party (for example, an equipment purchase
Express or the issuance of shares) are external transactions, while
YT
PPL HIS transactions within a business (the consumption of
Throughout this
A

chapter apply this supplies) are internal transactions.

icons indicate To record accounting transactions
account  An accounting
an opportunity and summarise the resulting record that accumulates
for online
self-study through information, companies use accounts. the activity of a specific
item and yields the item’s
CourseMate Express, An account is an accounting record balance.
linking you to revision
quizzes, e-lectures,
animations and more.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
40
 that accumulates the activity of a specific item and

iStock.com/David Hills
yields the item’s balance. For example, a business’ cash
account is increased and decreased as cash is received
and paid, and it shows the amount of cash held at any
point in time. The various accounts that a business uses
to capture its business activities are often
chart of listed in a c h a r t o f a c c o u n t s .
accounts  The list of
accounts that a business An example, complete with
uses to capture its numerical references for each account, is
business activities.
found in Exhibit 3.1.
Much like a video camera, an
Charts of accounts will vary across accounting information system
businesses. For example, a bank will have accounts captures business activity so that
others can view it
relating to customer deposits, while a biotech company
like CSL will have accounts relating to research and
development. Of course, there certainly will be many
commonalities across charts of accounts, for example, MAKING IT REAL

practically every business will have an account for CHART OF ACCOUNTS

cash, but there will be differences depending on the Even for a relatively small organisation like a university
business’ activities. As a result, you can tell a lot about with turnover of around $1 billion, it would have
YT
PPL HIS what a business does if thousands of accounts to allow it to keep track of where
A

Check out the video summary the money is spent and where the money comes from.
for Chapter 3
you have its chart of
The chart of accounts is also used to ensure if money
accounts.
has been allocated to a particular project, like the
development of a student learning activity, and that no
more is spent on the project than the funds set aside.
100–199 ASSETS Although the account numbers and account
100 Cash description are almost meaningless to an outsider,
the first two numbers ‘90’ probably represent
101 Accounts Receivable revenue accounts, the next two numbers may be a
110 Supplies unit or activity within the organisation, and so the
120 Equipment account numbers take on meaning for those using
the chart of accounts regularly. Below are just a few
200–299 LIABILITIES of more than 18 000 accounts used by a university.
210 Accounts Payable
Lacoste + Stevenson Architects

211 Unearned Revenues

230 Notes Payable
300–399 EQUITY
300 Contributed Equity
350 Retained Earnings
400–499 REVENUES
400 Service Revenue
410 Sales Revenue
500–599 EXPENSES
501 Administrative Expense
502 Advertising Expense
Account
Account description
600–699 DIVIDENDS number
906420 COHTLE Library Collection
EXHIBIT An example of a chart of accounts 906500 COHTLE Library
3.1
906610 COHWPS Widening Participation Funding
906620 COHWPS Partnership Funding
906630 COHWPS Bridges to Higher Education
906640 COHWPS Additional Partnership Funding
907010 COHRES – COH – CSU Managed

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 3 Recording accounting transactions 41
 account; for the equation to stay in balance, the transaction
ANALYSIS must also either decrease another asset account, or
Look at CSL’s balance sheet in
increase a liability or equity account. This means that every
Appendix B and determine how many accounts it uses to
report its assets, liabilities and equity. Also, consider the accounting transaction must affect at least two accounts.
scenario when one shareholder of CSL sells her shares to For every transaction there is a source and dual nature of
another shareholder. Is this an economic event relating to a use. Money comes from somewhere accounting  Every
CSL? Is it an accounting transaction? and it goes somewhere. This is known as accounting transaction
must affect at least two
Analysis: the dual nature of accounting. accounts.
CSL’s balance sheet reports 26 different accounts,
comprised of 11 asset accounts, 12 liability accounts and
3 equity accounts.
TRANSACTION ANALYSIS
When CSL’s shares are sold on the Australian Securities To illustrate how accounting transactions affect the
Exchange, the sale is an economic event of interest to CSL accounting equation, consider the following 10 transactions
(it needs to note the change in shareholding so it can pay
in the first month of operations of Video Memories, a
the correct dividend and record the correct shareholder
information – for voting at meetings, communications, business that documents graduations, weddings, birthdays
etc.). However, because CSL is not involved in the and other significant life events. Although the example is a
exchange of resources, no money is received or paid out small hypothetical business, the transactions would be
by CSL; it is not an accounting transaction. treated in the same way by a large company. We start by
recording the transactions in a spreadsheet and later in the
chapter use the more YT
PPL HIS

A
formal accounting Check out the animated summary
on Transaction Analysis
LO2  CCOUNTING
A journal and ledger.
TRANSACTIONS AND THE
Alamy Stock Photo

ACCOUNTING EQUATION
All accounting transactions must be recorded in the
accounting information system. To understand the nature
of recording transactions, it is best to start with the
fundamental accounting equation:
Assets = Liabilities + Equity

The equation states that a business entity’s assets

must always equal the sum of its liabilities and equity. This
means that any change to one part of the equation must
be accompanied by a second change to another part. For
example, suppose that a transaction increases an asset Videoing a customer’s wedding

TRANSACTION ANALYSIS
Transaction #1
After registering the business name, Video Memories, the owners deposited $15 000 into the business’ bank account. Because
Video Memories receives cash of $15 000, assets increase. Its equity also increases because investors have contributed cash for
an ownership interest in the business. More specifically, Video Memories’ contributed equity (or contributed capital) increases.

Assets = Liabilities + Equity

Cash = + Contributed Equity
Prior bal. $   0 $  0
#1 + $15 000 + $15 000
New bal. $15 500 $15 000
$15 000 = $ 0 +    $15 500

EXHIBIT Transaction summary for Video Memories (Continued)

3.2

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
42 ACCT3 Financial
 Transaction #2
Video Memories purchases an HD digital video camera for $9000 and supplies (memory cards, USBs, paper, pens etc.)
for $1000. In this transaction, the business is exchanging one asset (cash) for other assets (equipment and supplies).
Therefore, assets both increase and decrease by $10 000. The net effect is no change in total assets.

Assets = Liabilities + Equity

Cash Supplies Equipment = + Contributed Equity
Prior bal. $15 000 $    0 $    0 $15 000
#2 – $10 000 + $1 000  + $ 9 000
New bal. $ 5 000 $1 000 $ 9 000 $15 000
$15 000 = $ 0 +    $15 000

Transaction #3
Video Memories receives a $1500 payment immediately after videoing a customer’s wedding. Since Video Memories is
receiving cash, assets increase. But unlike the previous transaction in which assets were exchanged, the increase in
assets in this transaction results from videoing the wedding. Recall from Chapter 1 that an inflow of assets from
providing a service is a revenue. Revenues increase profits and therefore retained earnings. As a result, Video
Memories’ equity increases. At this stage we record the revenue as an increase in retained earnings, for simplicity and
to emphasise that revenues increase the value of the business to the owner.

Assets = Liabilities + Equity

Cash Supplies Equipment = + Contributed Equity Retained Earnings
Prior bal. $5 000 $1 000 $9 000 $15 000 $  0
#3 + $1 500     + $1 500
New bal. $6 500 $1 000 $9 000 $15 000 $1 500
$16 500 = $ 0 +    $16 500

Transaction #4
Video Memories receives a $2000 deposit from a customer to video her parents’ 25th wedding anniversary. In this
transaction, Video Memories again receives cash from a customer, so assets increase. However, it has not yet provided
the service, so it has an obligation to the customer (it needs to video the anniversary or return the deposit). As a result,
Video Memories’ liabilities increase for the amount of cash received. We call the liability Unearned Revenue as it is the
result of receiving future revenue that at this stage is unearned.

Assets = Liabilities + Equity

Cash Supplies Equipment = Unearned Revenue + Contributed Equity Retained Earnings
Prior bal. $6 500 $1 000 $9 000 $  0 $15 000 $1 500
#4 + $2 000     +$2 000
New bal. $8 500 $1 000 $9 000 $2 000 $15 000 $1 500
$18 500 = $2 000 +    $16 500

Transaction #5
Video Memories paid $250 cash to have the business appear on Google Maps for the month. Because Video Memories
paid cash, assets decrease. The decrease in assets results from advertising its business. Recall from Chapter 1 that a
decrease in resource (in this case an asset) from operating a business is an expense. Expenses decrease profits and
therefore retained earnings. As a result, Video Memories’ equity decreases. At this stage we record the expense as a
decrease in retained earnings, for simplicity and to emphasise that expenses decrease the value of the business to the
owner.

EXHIBIT Transaction summary for Video Memories (Continued)

3.2

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 3 Recording accounting transactions 43
 Assets = Liabilities + Equity
Unearned
Cash Supplies Equipment = + Contributed Equity Retained Earnings
Revenue
Prior bal. $8 500 $1 000 $9 000 $2 000 $15 000 $1 500
#5 − $  250     − $ 250
New bal. $8 250 $1 000 $9 000 $2 000 $15 000 $1 250
$18 250 = $2 000 +    $16 250

Transaction #6
Video Memories videos a dance competition, leaving a $3500 invoice (bill) with the customer. Because Video Memories
receives no cash at the time of the competition, it is tempting to conclude that there is no accounting transaction and
therefore no effect on the accounting equation. However, not all accounting transactions affect cash. By completing
the job and leaving an invoice with the customer, Video Memories now has a receivable from the customer. Therefore,
assets increase. And because the receivable is generated by providing a service, the business entity has additional
revenues and therefore more equity. So, equity increases as well. Note that this transaction is very similar to
Transaction #3, with the only difference being the type of asset that increases.

Assets = Liabilities + Equity

Accounts Unearned Contributed Retained
Cash Supplies Equipment = +
Receivable Revenue Equity Earnings
Prior bal. $8 250 $  0 $1 000 $9 000 $2 000 $15 000 $1 250
#6 + $3 500  + $3 500 
New bal. $8 250 $3 500 $1 000 $9 000 $2 000 $15 000 $4 750
$21 750 = $2 000 +    $19 750

Transaction #7
Video Memories purchases another video camera for $9000 by signing a nine-month promissory note requiring the
payment of principal and interest at maturity. Interest is charged at a 6 per cent annual rate. Like Transaction #2, Video
Memories receives equipment, so assets increase like Transaction #2, but unlike this Video Memories promises to pay
cash and interest in nine months instead of paying cash now. Therefore, the liabilities increase.

Assets = Liabilities + Equity

Accounts Unearned Notes Contributed Retained
Cash Supplies Equipment = +
Receivable Revenue Payable Equity Earnings
Prior bal. $8 250 $3 500 $1 000 $9 000 $2 000 $ 0 $15 000 $4 750
#7 + $9 000 + $9 000
New bal. $8 250 $3 500 $1 000 $18 000 $2 000 $9 000 $15 000 $4 750
$30 750 = $11 000 +    $19 750

Transaction #8
Video Memories receives $3500 from the customer in payment of the invoice from Transaction #6. In this transaction,
Video Memories exchanges one asset for another. It receives cash in satisfaction of the receivable that was created
when the service was performed. As a result, cash increases while receivables decrease. There is no change in total
assets and this is not the earning of revenue (the revenue was earned in Transaction #6).

Assets = Liabilities + Equity

Accounts Unearned Notes Contributed Retained
Cash Supplies Equipment = +
Receivable Revenue Payable Equity Earnings
Prior bal. $8 250 $3 500 $1 000 $18 000 $2 000 $9 000 $15 000 $4 750
#8 + $3 500 − $3 500
New bal. $11 750 $ 0 $1 000 $18 000 $2 000 $9 000 $15 000 $4 750
$30 750 = $11 000 +    $19 750

EXHIBIT Transaction summary for Video Memories (Continued)

3.2

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
44 ACCT3 Financial
 Transaction #9
Video Memories pays wages of $2000 to its employee. In this case, its cash decreases by $2000, so its assets decrease.
Since the payments are an outflow of assets from operating the business, the payments are an expense, which reduces
profits, a reduction to equity. Therefore, equity (retained earnings) decreases.

Assets = Liabilities + Equity

Accounts Unearned Notes Contributed Retained
Cash Supplies Equipment = +
Receivable Revenue Payable Equity Earnings
Prior bal. $11 750 $ 0 $1 000 $18 000 $2 000 $9 000 $15 000 $4 750
#9 − $  2 000 − $2 000
New bal. $  9 750 $ 0 $1 000 $18 000 $2 000 $9 000 $15 000 $2 750
$28 750 = $11 000 +    $17 750

Transaction #10
At the end of the month, the owners of Video Memories withdraw $1500 for personal use. In this transaction the asset
cash decreases. Payments to business’ owners are drawings or dividends (if the business was a company), they are not
an expense. Recall from Chapter 1 that dividends decrease retained earnings, so equity decreases as well.

Assets = Liabilities + Equity

Accounts Unearned Notes Contributed Retained
Cash Supplies Equipment = +
Receivable Revenue Payable Equity Earnings
Prior bal. $9 750 $ 0 $1 000 $18 000 $2 000 $9 000 $15 000 $2 750
#10 − $1 500 − $1 500
New bal. $8 250 $ 0 $1 000 $18 000 $2 000 $9 000 $15 000 $1 250
$27 250 = $11 000 +    $16 250

SUMMARY OF TRANSACTIONS
The 10 transactions of Video Memories are summarised transaction affected at least two specific accounts.
in Exhibit 3.2. The business entity started the month with Sometimes the transaction affected two asset accounts
nothing but an idea and ended the month with $27 250 in (#2 and #8), sometimes an asset and a liability account
assets, $11 000 in liabilities and $16 250 in equity. As you (#4 and #7), and sometimes an asset and an equity
review the exhibit, note that changes to the left side of account (#1, #3, #5, #6, #9 and #10). Any combination
the equation equal the changes to the right side of the affecting assets, liabilities and equity can occur, as long as
equation for all transactions. As a result, the accounting the equation stays in balance.
equation was always in balance. Note also that every

Assets = Liabilities + Equity

Accounts Unearned Notes Contributed Retained
Cash Supplies Equipment = +
Receivable Revenue Payable Equity Earnings
#1 + $15 000 = + + $15 000
#2 –10 000 + $1 000 + $9 000 = +
#3 +1 500 = + + $1 500
#4 +2 000 = + $2 000 +
#5 –250 = + – 250
#6 + 3 500 = + + 3 500
#7 + 9 000 = + 9 000 +
#8 + 3 500 – 3 500 = +
#9 – 2 000 = + – 2 000
#10 – 1 500 = + – 1 500
$ 8 250 $ 0 $1 000 $18 000 = $2 000 $9 000 + $15 000 $1 250
$27 250 = $11 000 +    $16 250

EXHIBIT Transaction summary for Video Memories

3.2

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 3 Recording accounting transactions 45
 Asset: Cash
LO3 THE DUAL-ENTRY
15 000
ACCOUNTING SYSTEM 10 000

While the preceding analysis is an excellent way to 1 500

understand and visualise the effect of accounting 2 000
transactions, accounting information systems do not record 250
transactions using pluses and minuses in a spreadsheet 3 500
format, because although it is accurate, it is very
2 000
cumbersome. Instead a dual-entry
dual-entry 1 500
accounting system is used, which
accounting 8 250
system  A system of traces its origins back to a mathematical
accounting in which every treatise written in the 15th century by a
accounting transaction The areas between the horizontal lines contain the
affects at least two Franciscan monk, Luca Pacioli. The dual-
activity in each account, with the account balance below.
accounts. entry system is based on the dual nature
The asset account has four debit entries totalling $22 000
of accounting demonstrated in the
and four credit entries totalling $13 750, leaving a debit
preceding transaction analyses. That is, every accounting
balance of $8250.
transaction affects at least two accounts, so accounting
It is no coincidence that in this example the asset
systems record those transactions with a ‘dual’ or ‘double’
account has a debit balance. In a dual-entry system, asset
entry. The following sections explain the mechanics of this
accounts should normally have debit balances while liability
dual-entry system, starting with the T-account.
and equity accounts should normally have credit balances.
Such ‘normal’ balances mirror the accounting equation,
THE T-ACCOUNT where assets are on the left side of the equal sign, and
All accounts can be characterised or represented in the liabilities and equity are on the right side.
following form known as a T-account due to its resemblance
Normal account balances
to an upper-case letter T.
Asset Liability Equity
Account name accounts accounts accounts
Debit side Credit side Normal Normal Normal
balance balance balance
The name of the account is listed at the top with two
columns appearing below. The left column is the debit side Accounting equation
while the right column is the credit side. Assets = Liabilities + Equity
debit  A use of funds, The word debit comes from the Latin
recorded on the left-hand word debitum, meaning ‘what is due’, and This arrangement of normal balances is the key to how
side of a T-account. a dual-entry system works. To keep the accounting equation
credit comes from creditum, something
credit  A source of
funds, recorded on the entrusted to another or a loan. Recall that balanced, a dual-entry system must keep debit balances
right-hand side of a a list of all the different asset, liability and equal to credit balances. This means that every accounting
T-account.
equity accounts is called a chart of transaction must be recorded with equal changes to debit
accounts. and credit balances. That, again, is why the system is ‘dual-
T-accounts work as follows. When a transaction affects entry’. How debits and credits are used to change account
an account balance, the amount of the transaction is balances is discussed next.
entered on the account’s debit side or credit side, depending
on the transaction. You will see how transactions are DEBIT AND CREDIT RULES
recorded shortly. Once all entries are made, the balance in In a dual-entry system, changes in account balances are
an account is determined by separately adding up all debits recorded according to the following basic rules:
and all credits and subtracting the smaller total from the ● To increase an account balance: record the transaction
larger, leaving the difference as the account balance on the on the same side as the normal balance.
side that is larger. The following example illustrates this ● To decrease an account balance: record the transaction
process: on the opposite side of the normal balance.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
46 ACCT3 Financial
 These two rules seem simple enough, but their application Accounts Payable
can be confusing at first because different accounts have
850 2 500
different normal balances. The following sections demonstrate
 150
how these rules are applied to asset, liability and equity
1 800
accounts. Also demonstrated is how these rules are applied
to the three types of accounts that affect equity: revenues, To illustrate an equity account, suppose that a company
expenses and dividends (drawings). Once you have mastered has $34 000 of contributed equity. The company then
the mechanics of these six types of accounts, you should be issues additional shares for $10 000 and later buys back
able to record any accounting transaction correctly. $6000 of shares. The original $34 000 balance appears on
the credit side of the Contributed Equity T-account.
Asset accounts Since the Contributed Equity account has a normal credit
Asset accounts have normal debit balances. Therefore, balance, the $10 000 increase is recorded on the credit side
increases to assets are recorded on the debit side while while the $6000 decrease is recorded on the opposite or
decreases are recorded on the credit side. debit side of the account. Netting the debit and credit sides
Asset accounts gives a credit balance of $38 000.
Record increases Record decreases Contributed Equity
on debit side on credit side
6 000 34 000
Balance
10 000
To illustrate, suppose that a business starts the day with 38 000
$5000 in cash, receives $300 from a customer and pays
$250 to a supplier. The beginning balance of $5000 is Revenue accounts
recorded on the debit side of the cash T-account. The When a business earns revenue, it is increasing its equity.
increase of $300 is also recorded on the debit side, but the As demonstrated previously, increasing an equity account
$250 decrease in cash is recorded on the side opposite of requires a credit entry. Therefore, revenue accounts are set
the normal balance – the credit side. Netting the debit and up so that they also are increased with a credit entry. That
credit sides gives a debit balance of $5050. (Remember, if is, revenue accounts have normal credit balances and are
we were recording these transactions there would be a increased with credit entries and decreased with debit
corresponding $300 credit to revenue and a $250 debit to entries.
accounts payable.)
Revenue Accounts
Cash Record decreases Record increases
5 000 250 on debit side on credit side
300 Balance
5 050
To illustrate, suppose that a business has $115 000 in
existing service revenue. The business then earns an
Liability and equity accounts additional $13 000 in revenue. Since the Service Revenue
Liability and equity accounts have normal credit balances. account has a normal credit balance, both the existing
Therefore, increases are recorded on the credit side, while $115 000 balance and the $13 000 increase are shown on
decreases are recorded on the debit side. the credit side, resulting in a balance of $128 000.

Liability and Equity Accounts Service Revenue

Record decreases Record increases 115 000
on debit side on credit side
13 000
Balance
128 000
To illustrate a liability account, suppose that a business
owes $2500 to a supplier, then buys an additional $150 of Expense and dividend accounts
inventory on account and then pays $850 of its obligation. When a business incurs expenses or pays dividends, it is
The beginning balance of $2500 is recorded on the credit decreasing its equity. As demonstrated previously,
side of the accounts payable T-account. The additional decreasing equity requires a debit entry. Therefore, for
payable of $150 is also recorded on the credit side. In expense and dividend accounts to effectively reduce equity,
contrast, the $850 payment, which is a reduction to the they have normal debit balances. Expense and dividend
payable, is recorded on the debit side. Netting the debit accounts are therefore increased with debit entries and
and credit sides yields a credit balance of $1800. decreased with credit entries. Although expenses and

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CHAPTER 3 Recording accounting transactions 47
 dividends both reduce equity they are very different: accounting transactions are first recorded in a journal. Once
expenses reduce profits while dividends are voluntary recorded, the information is transferred or posted to a
distributions out of retained earnings. ledger. Information in the ledger is then summarised in a
worksheet known as a trial balance. Financial statements
Expense and dividend accounts
are then prepared from the information in the trial balance.
Record increases on Record decreases on
debit side credit side
THE JOURNAL
Balance
A journal is a chronological (in time order) journal  A chronological
To illustrate an expense, suppose that a business has record of transactions. Entries recorded record of transactions.
$66 000 in salaries expense when it incurs an additional in the journal are called journal entries. A
$6000 in salaries expense. Since the Salaries Expense business can have various types of journals in which it
account has a normal debit balance, both the $66 000 in records transactions, but since the mechanics of all journals
existing expense and the $6000 increase should be recorded are the same, we will focus on the most basic of journals,
on the debit side of the account, giving a balance of $72 000. the general journal. The general journal and an example
Salaries Expense journal entry take the form shown in Exhibit 3.4.
66 000
General journal
6 000
Account and
72 000 Date explanation Debit Credit
Date of transaction Account(s) debited Amount
SUMMARY OF DEBIT AND CREDIT RULES   Account(s) credited Amount
You have now seen each major type of account and how the   
(Explanation of
debit and credit columns are used to increase or decrease transaction)
those accounts. For asset, expense and dividend accounts, General journal form
EXHIBIT
increases are recorded in the debit column and decreases 3.4

are recorded in the credit column. For liability, equity and

revenue accounts, increases are recorded in the credit At the far left of the journal is a column for the transaction
column and decreases are recorded in the debit column. A date. To the right of the date is a column to record the
summary of these rules is presented in Exhibit 3.3. names of the accounts affected by the transaction and an
explanation. The account(s) receiving debit entries are listed
Type of Normal Increase Decrease first, followed by the account(s) receiving credit entries,
account balance with a with a
which are slightly indented. To the right of the account
Asset Debit Debit Credit names are debit and credit columns to record the monetary
Liability Credit Credit Debit amounts of the transaction. As explained previously, the
Equity Credit Credit Debit totals in the debit and credit columns should be the same
Revenue Credit Credit Debit for each transaction. When an accounting transaction is
Expense Debit Debit Credit recorded in the general journal, we often say that the
transaction has been journalised.
Dividend Debit Debit Credit
The general journal is useful in that it contains in one
EXHIBIT Summary of debit and credit rules place a record in time order of all the accounting transactions
3.3
of a business. However, the general journal is not very
YT
PPL HIS useful if a business is trying to determine the balance in a
A

Review this content with the e-lecture particular account. To get an account balance, one would
have to find all journal entries affecting that account and
then calculate a balance. To avoid such a time-consuming
task, the information recorded in the general journal is
LO4  ECORDING
R transferred (posted) to a ledger.
TRANSACTIONS IN THE
ACCOUNTING SYSTEM THE LEDGER
A ledger is a collection of accounts and ledger  A collection of
This section examines the actual process of recording their balances. While most businesses accounts and their
balances.
accounting transactions in a dual-entry system. Accounting have various types of ledgers containing
transactions are not recorded directly in T-accounts. Instead, different accounts, we will focus on the

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48 ACCT3 Financial
 most basic type of ledger, the general ledger. The general
ledger is nothing more than a collection of all the T-accounts three accounts at the top of the income statement would
for a business, which means that the general ledger be increased with a credit entry, as would Finance Income
and Gain on Acquisition in the middle of the income
contains both the activity and balances of all the business’
statement. These seven accounts are revenue accounts.
accounts. The other six accounts (Cost of sales, Finance costs and
Account balances in the general ledger are updated as the four ‘expenses’) are expense accounts and are
follows. When an accounting transaction is recorded in the increased with a debit entry.
general journal, the amounts recorded in the debit and

iStock.com/Yuri Arcurs
credit columns are transferred to the debit and credit
columns of the respective T-accounts in the ledger. This
process of copying or transferring the information from the
journal to the ledger is called posting and results in up-to-
date account balances.

THE TRIAL BALANCE

After accounting transactions are recorded in the journal
and posted to the ledger, companies prepare a
trial balance, which is a listing of all the
trial balance  A listing
of accounts and their accounts and their balances at a specific Mistakes in trial balances are often made when we add up the
balances at a specific columns incorrectly – the auto ‘add’ feature on electronic spread
point in time. In a trial balance, all accounts sheets solves this source of errors. In a spreadsheet the rows
point in time.
in the ledger are listed in a column on the correspond to the journal and the columns correspond to the ledger
left. Asset accounts are usually listed first, followed by
liability accounts, equity accounts and then revenue,
A trial balance serves several functions. First, it proves
expense and dividend accounts. Each account’s balance
that total debit balances equal total credit balances. If they
from the ledger is listed in the appropriate debit or credit
are unequal, then the accounting equation is out of balance
column. At the bottom of each column, a total is calculated.
and a correction is needed. Second, it summarises in one
The debit and credit totals should be the same. A trial
place all accounts of an entity and their respective balances.
balance is shown in Exhibit 3.5.
Financial statements are then prepared from those
balances. Finally, a trial balance may be helpful in making
A listing of accounts and their balances at a specific any necessary adjustments to account balances at the end
point in time.
of an accounting period. We will see this function in
Debit Credit Chapter 4.
Asset account(s) Amount
Liability account(s) Amount
MAKING IT REAL
Equity account(s) Amount
Revenue account(s) Amount ACCOUNTING IN THE CLOUD
Although this text primarily discusses a manual
Expense account(s) Amount
accounting system, there are several popular
Dividends Amount computerised accounting information systems
Totals Total debits Total credits utilised by small businesses. Three of the most
popular are QuickBooks, MYOB and Xero.
EXHIBIT Trial balance form Accounting systems provide banking, general
3.5
ledger, accounts payable, accounts receivable,
payroll and inventory features and can keep track
of income and expenses by customer, job and
department. Many reports can be created by both
ANALYSIS
systems to analyse business performance. They also
Look at CSL’s income statement
provide security features to ensure only authorised
in Appendix B. Which of the
users are accessing the business’ accounting
accounts would be increased with a credit entry? Would
information.
the remaining accounts be increased with a debit entry?
Analysis:
CSL’s income statement lists twelve different accounts.
Of those accounts, Sales Revenue and the other

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CHAPTER 3 Recording accounting transactions 49
 STEP 3 Record the journal entry
Overall, such computerised systems are a great tool
for businesses because they help ensure that the #1 Cash 15 000
accounting information is captured and
  Contributed Equity 15 000
communicated effectively and efficiently, and with the
cloud available on any device anywhere.    (Owners invest cash in business)
Assets = Liabilities + Equity
T
PPLY HIS +15 000 +15 000
A

Download the Enrichment Modules for further practice

STEP 4 Post the information to the ledger

Cash Contributed Equity

15 000 15 000
LO5  OMPREHENSIVE EXAMPLE:
C
15 000 15 000
JOURNAL ENTRIES TO
FINANCIAL STATEMENTS
Transaction #2
The following section uses the Video Memories Video Memories buys a $9000 camera and $1000 of
transactions recorded earlier in the spreadsheet to supplies with $10 000 cash.
demonstrate how to record transactions in the journal, STEP 1 What accounts are affected and how?
post information to the ledger, prepare a trial balance and Video Memories receives equipment and supplies, so both
prepare financial statements. We will now assume the the Equipment and the Supplies accounts increase. Cash
business entity is a company and will record the revenues, is paid, so cash decreases.
expenses and dividends rather than simply changes in STEP 2 What debit and credit entries are required?
retained earnings. Equipment and supplies are assets, so the Equipment and
Supplies accounts are debited to increase them. Cash is
RECORDING TRANSACTIONS IN THE JOURNAL also an asset, so the Cash account is credited to decrease  it.
AND POSTING TO THE LEDGER STEP 3 Record the journal entry
Video Memories entered into 10 transactions. A four-step
process will be used to demonstrate how to properly #2 Equipment 9 000
record each transaction and post it to the ledger. First, the Supplies 1 000
accounts affected by the transaction will be identified. Cash 10 000
Second, the relevant debit/credit rules for those accounts   (Purchase cameras and supplies)
will be identified. Third, the transaction will be recorded
Assets = Liabilities   + Equity
in the journal. Fourth, the transaction will be posted to the
ledger. This four-step process can be followed when +9 000
recording and posting any accounting transaction. +1 000
–10 000
Transaction #1
Video Memories issued shares for $15 000.
STEP 4 Post the information to the ledger
STEP 1 What accounts are affected and how?
Video Memories receives cash, so the Cash account Cash Supplies Equipment
increases. Shares are issued, so the Contributed Equity 15 000 10 000 1 000 9 000
account also increases. 5 000 1 000 9 000
STEP 2 What debit and credit entries are required?
Cash is an asset, so the Cash account needs to be debited Transaction #3
to increase it. Contributed equity is an equity account, so
Video Memories videos a wedding, for which it receives
the Contributed Equity account need to be credited to
$1500 cash.
increase it.
STEP 1 What accounts are affected and how?
Cash has been received, so the Cash account increases.
The increase in cash has resulted from a service being
provided, so the Service Revenue account increases.

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50 ACCT3 Financial
STEP 2 What debit and credit entries are required? Transaction #5
Cash is an asset, so the Cash account needs to be debited
Video Memories pays $250 cash for advertising.
to increase it. Revenues increase equity, so the Service
Revenue account needs to be credited to increase it. STEP 1 What accounts are affected and how?
Cash is paid, so the Cash account decreases. The decrease
STEP 3 Record the journal entry in cash results from Video Memories advertising its service,
#3 Cash 15 000 so Advertising Expense increases.
Service Revenue 15 000 STEP 2 What debit and credit entries are required?
   (Provide service to customer) Cash is an asset, so the Cash account needs to be credited
to decrease it. Expenses decrease equity, so debit the
Assets   =  Liabilities  + Equity
Advertising Expense account to increase it.
+15 000 +15 000
STEP 3 Record the journal entry
STEP 4 Post the information to the ledger #5 Advertising Expense 250

Service Revenue Cash 250

Cash
15 000 10 000 1 500    (Paid for advertising)

1 500 Assets = Liabilities + Equity

6 500 1 500 –250 –250

STEP 4 Post the information to the ledger

Transaction #4
Video Memories receives $2000 to video a reception at a Cash Advertising Expense
future date. 15 000 10 000 250
STEP 1 What accounts are affected and how? 1 500 250
We receive cash, so the Cash account increases. Because 2 000
Video Memories has not yet performed the required 8 250 250
service, there is a new liability to the customer called
Unearned revenue.
Transaction #6
STEP 2 What debit and credit entries are required?
Video Memories videos an event for $3500 and leaves an
Cash is an asset, so debit the Cash account to increase it.
invoice with the customer.
Unearned revenue is a liability, so credit the Unearned
Revenue account to increase it. STEP 1 What accounts are affected and how?
Video Memories performed a service for a customer, so
STEP 3 Record the journal entry
its Service Revenue account increases. Payment has not
#4 Cash 2 000 been received from the customer, but they have promised
Unearned Revenue 2 000 to pay, so the Accounts Receivable account also increases.
  (Cash received in advance of providing STEP 2 What debit and credit entries are required?
service to customer) Accounts receivable is an asset, so the Accounts Receivable
Assets = Liabilities + Equity account needs to be debited to increase it. Revenues
+2 000 +2 000 increase equity, so the Service Revenue account needs to
be credited to increase it.
STEP 4 Post the information to the ledger STEP 3 Record the journal entry

Cash Unearned Revenue #6 Accounts Receivable 3 500

15 000 10 000 2 000 Service Revenue 3 500
1 500  (Provide service to customer
on account)
2 000
Assets = Liabilities + Equity
8 500 2 000
+3 500 +3 500

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CHAPTER 3 Recording accounting transactions 51
 STEP 4 Post the information to the ledger STEP 3 Record the journal entry

Accounts Receivable Service Revenue #8 Cash 3 500

3 500 1 500 Accounts Receivable 3 500
3 500   (Receive payment from customer)
3 500 5 000 Assets = Liabilities + Equity
-3 500 +3 500
Transaction #7
Video Memories buys another camera by signing a $9000 STEP 4 Post the information to the ledger
note payable.
Cash Accounts Receivable
STEP 1 What accounts are affected and how? 15 000 10 000 3 500 3 500
The camera has been received, so the Equipment account
1 500 250
increases. A note has been signed for payment, so the
2 000
Notes Payable account increases.
3 500
STEP 2 What debit and credit entries are required?
11 750 0
Equipment is an asset, so the Equipment account needs
to be debited to increase it. Notes payable is a liability,
so the Notes Payable account needs to be credited to Transaction #9
increase it. Video Memories pays $2000 in salaries to an employee.
STEP 3 Record the journal entry STEP 1 What accounts are affected and how?
Cash is paid, so the Cash account decreases. This reduction
#7 Equipment 9 000
in cash results from salaries paid to employees, so the
Notes Payable 9 000
Salaries Expense account increases.
 (Purchase of a video camera
with a note payable) STEP 2 What debit and credit entries are required?
Cash is an asset, so the Cash account needs to be credited
Assets = Liabilities + Equity
to decrease it. Expenses decrease equity, so the Salaries
+9 000 +9 000
Expense account needs to be debited to increase it.
STEP 3 Record the journal entry
STEP 4 Post the information to the ledger
#9 Salaries Expense 2 000
Equipment Notes Payable
Cash 2 000
9 000 9 000
  (Pay salaries to employees)
9 000
Assets = Liabilities + Equity
18 000 9 000
-2 000 -2 000

Transaction #8 STEP 4 Post the information to the ledger

Video Memories receives $3500 from a customer in
payment of services provided in Transaction #6. (This is the Cash Salaries Expense
exchange of one asset for another, not the earning of 15 000 10 000 2 000
revenue: the revenue was earned in Transaction #6.) 1 500 250
STEP 1 What accounts are affected and how? 2 000 2 000
Cash has been received, so the Cash account increases. A 3 500
receivable has been collected from a customer, so the
9 750 2 000
Accounts Receivable account decreases.
STEP 2 What debit and credit entries are required?
Transaction #10
Cash is an asset, so the Cash account is debited to increase
Video Memories pays $1500 in dividends to the owners.
it. Accounts receivable is also an asset account, so the
Accounts Receivable account is credited to decrease it. STEP 1 What accounts are affected and how?
Cash is paid, so the Cash account decreases. The cash
payment is a distribution of company assets to the owners,
so the Dividends account increases.

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52 ACCT3 Financial
 STEP 2 What debit and credit entries are required? # 8 Cash 3 500
Cash is an asset, so the Cash account needs to be credited Accounts Receivable 3 500
to decrease it. Dividends decrease equity, so the Dividends # 9 Salaries Expense 2 000
account needs to be debited to increase it (or simply, if you Cash 2 000
debit Cash the other account must be credited). #10 Dividends 1 500
STEP 3 Record the journal entry Cash 1 500

#10 Dividends 1 500

Cash 1 500 Let’s assume May was the first month of operation.
  (Pay dividends to owners)
Assets = Liabilities + Equity General ledger

-1 500 -1 500 Accounts

Cash Receivable Supplies

STEP 4 Post the information to the ledger 15 000 10 000 3 500 3 500 1 000
1 500 250
Cash Dividends
2 000 2 000 0 1 000
15 000 10 000 1 500 3 500 1 500
1 500 250 8 250
2 000 2 000
3 500 1 500 Unearned
8 250 1 500 Equipment Revenue Notes Payable
9 000 2 000 9 000
Shutterstock.com/Kharidehal Abhirama Ashwin

9 000
18 000 2 000 9 000

Contributed Service Advertising

Equity Revenue Expense
15 000 1 500 250
3 500
15 000 5 000 250
Not all transactions involve cash

Salaries
Summary Expense Dividends
After recording and posting the 10 transactions,Video Memories’ 2 000 1 500
complete journal and ledger would appear as follows:
2 000 1 500
General journal
Transaction Account Debit Credit Video Memories
Trial balance
# 1 Cash 15 000
31 May
Contributed Equity 15 000
Debit Credit
# 2 Equipment 9 000
Cash $8 250
Supplies 1 000
Supplies 1 000
Cash 10 000
# 3 Cash 1 500 Equipment 18 000
Service Revenue 1 500 Unearned Revenue $2 000
# 4 Cash 2 000 Notes Payable 9 000
Unearned Revenue 2 000 Contributed Equity 15 000
# 5 Advertising Expense 250 Service Revenue 5 000
Cash 250 250
Advertising Expense
# 6 Accounts Receivable 3 500
Salaries Expense 2 000
Service Revenue 3 500
Dividends 1 500    
# 7 Equipment 9 000
Notes Payable 9 000 Total $31 000 $31 000

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CHAPTER 3 Recording accounting transactions 53
 PREPARING A TRIAL BALANCE With net profit calculated, Video Memories’ retained
earnings section of the statement of changes in equity
Once all transactions are recorded in the journal and posted
can be prepared. Recall from Chapter 1 that the
to the ledger, a trial balance can be prepared. Recall that a
statement takes the beginning balance in retained
trial balance is a listing of all accounts and their balances at
earnings, adds profits and subtracts dividends to yield
a specific point in time. Therefore, it is a summary of the
the current balance in Retained Earnings. Its 31 May trial
balances in the ledger. You can confirm that the trial balance
balance shows no balance in beginning retained earnings
includes only the balances from the general ledger by
because the business had just started. It also shows a
reviewing again Video Memories’ ledger. As expected, total
$1500 balance in dividends. Combining these two
debit balances of $31 000 equal total credit balances of
balances with profits yields the following retained
$31 000 in the trial balance.
earnings section of the statement of changes in equity
for the month of May:
PREPARING FINANCIAL STATEMENTS
Video Memories
Once the trial balance is completed, the final product of the Statement of changes in equity
accounting system can be prepared – the financial (retained earnings section)
for the month ending 31 May
statements. As demonstrated in Chapter 1, the income
Retained earnings, 1 May $  0
statement must be prepared first, followed by the
statement of changes in equity and then the balance sheet. + Profits 2 750
The income statement shows a company’s revenues – Dividends 1 500
and expenses. Video Memories’ 31 May trial balance Retained earnings, 31 May $1 250
contains only one revenue account and two expense
accounts. Therefore, its income statement for the month With retained earnings calculated, the company’s
of May would appear as follows: balance sheet can be prepared. This shows a company’s
assets, liabilities and equity at a point in time. Video
Video Memories Memories’ 31 May trial balance shows four asset accounts,
Income statement
two liability accounts and one equity account (Contributed
for the month ending 31 May
Equity). These seven accounts, along with the amount of
Service Revenue $5 000
retained earnings from the May statement of changes in
Advertising Expense $ 250 retained earnings, should be included on the balance sheet.
Salaries Expense 2 000 Therefore, its 31 May balance sheet would appear as
Total Expenses 2 250 follows:
Profit $2 750 Video Memories
Balance sheet
at 31 May
Getty Images/Chad Baker/Jason Reed/Ryan McVay

Cash $8 250
Supplies 1 000
Equipment 18 000
  Total assets $27 250
Unearned Revenue $2 000
Notes Payable 9 000
Contributed Equity 15 000
Retained Earnings 1 250
  Total liabilities and equity $27 250
Accounting software automatically prepares financial
statements once all journal entries are completed
YT
PPL HIS
A

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54 ACCT3 Financial
 Account #1 Account #2 Account #3
1 000 6 000 8 400 3 250 4 280 3 600
EXERCISES
4 000 3 000 2 120 1 660 1 120

REQUIRED
Determine the balance in each account and identify whether
each account would most likely be an asset or a liability
LO1 account.
1 Chart of accounts
Compare Aerial Filming (drone business) in Chapter 1 to LO3
6 Posting transactions
Video Memories in this chapter. Which account/s would be
used for Aerial Filming that were not used for Video Greg’s company records the following transactions during
Memories? November:

LO1
Date Account title Debit Credit
2 Chart of accounts
1 Nov. Accounts Receivable 3 200
Which of the following accounts are liabilities?
Service Revenue 3 200
Accounts Receivable, Accounts Payable, Unearned
Revenue, Service Revenue, Notes Payable, Notes 6 Nov. Cash 1 900
Receivable, Loan, Retained Earnings, Wages Payable, Rent Accounts Receivable 1 900
Expense.
15 Nov. Telephone Expense 250
3 Accounting transactions LO1 Cash 250
The Howard company entered into the following economic 26 Nov. Inventory 2 340
events: Accounts Payable 2 340
i hired a new researcher
REQUIRED
ii billed customers for services performed
Post the transactions to appropriate T-accounts and prepare
iii announced the signing of a contract that should
a trial balance.
produce $100 000 of new revenue
iv paid for insurance that will not be used until next year LO2, 3, 5
7 Recording transactions
v owned land that was rezoned allowing higher density
accommodation to be built on it Matthew received a payment from a customer and recorded
vi purchased and paid for supplies on the internet that the following journal entry:
are never delivered.
Date Account title Debit Credit
REQUIRED 1 Mar. Cash 1 000
Indicate whether each economic event would be considered
Accounts Payable 1 000
an accounting transaction.
REQUIRED
LO2
4 Analyse transactions Is this entry correct or not? Explain your answer.
Sue’s Services entered into the following transactions during
the month of August: LO4
8 Trial balance
i received $6350 for services performed during August Hildebrand Consulting provides the following incomplete
ii purchased $1200 of supplies on account (on credit) trial balance:
iii paid employee salaries of $3280 for the first week of
August Hildebrand Consulting Trial Balance 30 September
iv paid $900 towards the previous purchase of supplies Debit Credit
v received $2460 for services performed in July. (a) $  8 640
REQUIRED Accounts Receivable (b)
a Indicate whether each transaction increases, decreases Supplies 1 230
or has no effect on assets, liabilities and equity. If a Notes Payable $3 000
transaction affects equity, indicate whether the
Contributed Equity 10 000
transaction affects revenues or expenses.
Retained Earnings (c)
b Prepare journal entries for each transaction (omitting
explanations). Service Revenue 15 000
Salaries Expense 10 560
5 T-accounts LO3 Electricity Expense 2 340
Brancatisano reports the following asset and liability Totals $33 333 $  (d)
T-accounts:

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CHAPTER 3 Recording accounting transactions 55
 REQUIRED v provided services of $15 325, receiving $12 200 in
Determine the missing values at (a), (b), (c) and (d). cash
vi paid $1000 for advertising for January
9 Prepare financial statements LO4 vii received payment of $3125 from customers in
transaction (v)
Review the Hildebrand Consulting information in the
viii paid $4000 on the account from transaction (iv)
preceding exercise.
ix paid dividends of $1000 to shareholders
REQUIRED x paid employee salaries of $4000 for January
Using the given information and your answers for (a) to (d), xi billed customers $3500 for services provided during
prepare Hildebrand’s income statement and statement of January
retained earnings for September and its balance sheet at 30
xii paid $100 interest on the notes payable.
September.
REQUIRED
10 Transaction analysis LO2 a Show the effects of each transaction on the accounting
equation by preparing a spreadsheet using the following
The following transactions occurred in summer:
column headings: Cash, Accounts Receivable, Supplies,
i issued shares for cash Property and Equipment, Accounts Payable, Notes
ii purchased inventory on account Payable, Contributed Equity, Retained Earnings.
iii received cash payment from client for services b Calculate Handywoman’s profit for the month of January.
iv billed customers for services
v paid rent in cash 13 Normal balances LO3

vi received a bill for electricity used

The following is a list of possible accounts found in a trial
vii bought equipment for cash
balance:
viii received cash from customer previously billed in
i Accounts Receivable
transaction (iv)
ii Contributed Equity
ix paid electricity bill received in transaction (vi)
iii Cash
x paid dividends at the end of the year.
iv Retained Earnings
REQUIRED v Accounts Payable
a Indicate the accounts that would be affected by each vi Salaries Expense
transaction. vii Long-term Investments
b Indicate whether each transaction increases, decreases viii Service Revenue
or has no effect on assets, liabilities and shareholders’ ix Dividends
equity.
x Unearned Revenue.

11 Transaction analysis LO2 REQUIRED

Indicate each account’s normal balance and the effect of a
The following are a few possible ways in which the
debit and a credit to the account.
accounting equation can be affected by a transaction:
LO3
Assets Liabilities Equity 14 T-account mechanics
i Increase Increase The general ledger for MRT Company contains the following
ii Decrease Decrease accounts:
iii Increase Increase
Cash Notes Payable
iv Increase/Decrease
v Decrease Decrease 2 000 3 000 10 000 5 500
vi Increase Decrease 8 000 (a) 18 100
4 000   (b)
REQUIRED
Salaries Expense Accounts Payable
Describe at least two transactions that could result in each
13 500 23 850 43 500
of the six scenarios listed.
      (c)       (d) 12 775
12 Transaction analysis LO2 15 900 17 300
Handywoman Services commenced business on 1 January Service Revenue Accounts Receivable
and entered into the following transactions during January:       (e)       (f) 3 500
i issued shares (contributed equity) for $300 000 cash 33 210 2 500 9 570
ii purchased an old warehouse for $250 000 by 88 690 7 660
borrowing from the bank with a mortgage
iii purchased a van for $35 000 cash REQUIRED
iv purchased supplies for $5000 on account Determine the missing values at (a) to (f).

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56 ACCT3 Financial
 LO3, 4, 5
c The system that identifies economic events to be
15 Recording transactions recorded, measures and records those events, and then
The following information pertains to Avon Challenge Rafting processes the resulting information so that financial
Company in January: statements can be prepared.
  2nd Issued shares to investors for $25 000. d An accumulation of the activity and balance for a specific
  3rd Purchased $3500 of supplies on account. item.
  4th Paid rent for January $1200. e Any economic event that affects specific asset, liability,
  9th Invoiced a customer $7000 for services provided. or equity accounts at the time of the event.
16th Paid $1500 cash to supplier for the purchase on the 3rd. f The right side of an account.
24th Borrowed $10 000 from local bank. g The left side of an account.
26th Received payment for billing made on the 9th. h A collection of accounts and their balances.
REQUIRED i A listing of all accounts and their balances at a specific
point in time.
a Prepare journal entries for each transaction (omitting
explanations). j A chronological record in which transactions are first
recorded.
b Post the journal entries to their appropriate ledger (T)
accounts and prepare a trial balance at 31 January.
LO4, 5
18 Errors in recording transactions
LO3, 4, 5 Sarah’s Scientists recently hired a new accountant, who
16 Recording transactions
made the following errors:
In the month of March, Peter Wells Consulting entered into
the following transactions: i recorded a $200 cash purchase of inventory as a
debit to inventory and a credit to accounts payable
  2nd Purchased a new building for $935 000.
ii failed to record the payment of $300 for advertising
  3rd Paid $860 for January’s electricity bill which was
for the period
received in February.
iii debited supplies for $150 and credited cash for
11th Issued shares to investors in return for $50 000 cash.
invoice amount of $510
13th Hired a new administrative assistant for an annual
iv recorded $100 cash received for services but forgot
salary of $85 000.
to record the service revenue.
19th Received payment in the amount of $750 for service
billed in February. REQUIRED
23rd Sent an invoice (bill) to a customer for the week’s a Prepare each entry that should have been made.
work just completed $6800. b Which of the four errors would result in the trial balance
31st Paid dividends of $1000. being out of balance?
REQUIRED
LO4, 5
Prepare all necessary journal entries for March (omitting 19 Posting information
explanations). The following is the general journal of Chan for the month of
November:
LO1, 2, 3,4
17 Accounting terms
Date Account Titles Debit Credit
The following is a list of various terms and definitions
1 Cash $15 000
associated with accounting information systems:
Nov.
i Accounting information system
Contributed Equity $15 000
ii Accounting transaction
iii Account 8 Equipment 5 000
iv Dual-entry accounting Accounts Payable 3 000
v Chart of accounts
Cash 2 000
vi Debit
vii Credit 11 Accounts Receivable 7 500
viii Journal Service Revenue 7 500
ix Ledger 18 Accounts Payable 1 700
x Trial balance.
Cash 1 700
REQUIRED
21 Cash 5 000
Match terms (i) to (x) with their matching definition in the list
that follows: Notes Payable 5 000
a A listing containing a name and a numerical reference for 24 Dividends 1 500
all the accounts that a business entity uses to record Cash 1 500
accounting information.
25 Cash 3 500
b A recording system in which at least two accounts will
be affected when recording every accounting Accounts Receivable 3 500
transaction.
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 3 Recording accounting transactions 57
 REQUIRED v billed customers $14 680 for services
a Post the journal entries to the appropriate T-accounts, vi paid salaries of $8015
assuming Chan starts its business in November. vii received payment of $6023 from customers for bills
b Prepare a trial balance for the month ending 30 in transaction (v)
November. viii received $5000 cash for services to be performed in
March
ix paid $6000 to suppliers for purchase in transaction (iii)
x received bill for January electricity, $975
xi paid dividends of $900 to shareholders
xii borrowed $100 000 from bank on a mortgage
PROBLEMS xiii paid $400 interest on the bank loan.
REQUIRED
a Show the effects of each transaction on the accounting
equation by preparing a spreadsheet using the following
LO3, 4, 5 column headings: Cash, Accounts receivable, Supplies,
20 Recording transactions Property and equipment, Accounts payable, Unearned
On 1 November, Geoff Howard started a small amusement revenue, Mortgage, Contributed equity, and Retained
park. The park experienced the following transactions during earnings.
the first month of operations: b Record the transactions in the journal.
  1st Shareholders contributed $350 000 in exchange for c Post to the ledger (T) accounts.
shares.
d Extract a trial balance.
  2nd Hired six employees to staff the park.
e Prepare an income statement for the month of January.
  3rd Purchased go-carts for $87 500 on account (on
credit). f Prepare the retained earnings section of a statement of
  3rd Borrowed $90 000 from the bank. changes in equity for the month of January.
  3rd Purchased arcade games for $72 000. g Prepare a balance sheet at 31 January.
  4th Paid $3000 to advertise the opening on various
LO3, 4, 5
websites. 22 Recording transactions
  7th Purchased ‘bumper-boats’ for $35 250 on account. Madden Consulting was established on 1 March, and during
10th Billed Le Ma $3300 for her son’s birthday party on March it entered into the following transactions:
the 10th.   1st Issued $10 000 shares in exchange for cash.
11th Received cash of $6600 for entry fees into the park.   3rd Purchased $300 of supplies on account.
15th Paid $45 000 towards the go-cart bill (purchase on   7th Prepaid $1500 total for April, May and June rent.
3rd).   8th Paid $175 towards the 3 March purchase of supplies.
20th Received $10 200 for entry fees into the park. 11th Billed customers $5780 for services rendered.
25th Received full payment from Le Ma. 12th Paid $700 for March advertising.
28th Paid electricity, $7680. 25th Received $4500 from customers billed on 11 March.
30th Paid $900 interest on loan. 28th Paid $200 in dividends to shareholders.
REQUIRED 29th Paid $1200 for March salaries.
Prepare journal entries for each transaction, including 29th Paid $760 for March water usage.
explanations. REQUIRED
a Prepare journal entries for each transaction (omitting
21 Transaction analysis, journal, ledger, explanations).
LO2,3, 4
trial balance, financial statements b Post the journal to the appropriate ledger (T-accounts).
Megan and Sinclair was established on 1 January and c Prepare a trial balance at 31 March.
entered into the following transactions during its first month d Prepare Madden’s income statement for the month of
of business: March
i issued shares of $50 000 in exchange for cash
e Prepare the retained earnings section of the statement
ii purchased equipment for $24 000 cash of changes in equity for the month of March.
iii purchased supplies of $6000 on account f Prepare Madden’s balance sheet at the end of March.
iv received $235 bill for January advertising

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58 ACCT3 Financial
 LO3, 4, 5
REQUIRED
23 Recording transactions
a Identify the dollar change in the following subtotals in
The trial balance for Geoff Howard Limited at 31 January is the balance sheet: total current assets, total non-current
shown as follows: assets, total current liabilities, total non-current liabilities
and total shareholders’ equity.
Geoff Howard Limited b Identify whether the accounting system would debit or
Trial balance
31 January credit each subtotal to achieve the change. Treat each
subtotal description as if it were an account (e.g. an
Debit Credit increase of $XYZ in total current assets would be
Cash $  5 600 accomplished with a debit to that account).
Accounts Receivable 12 890 c Prepare one journal entry that records the changes in all
subtotals. Again, use the subtotal descriptions as if they
Supplies 9 235
were actual accounts.
Prepaid Rent 1 500 d Does the answer to question c balance? Should it?
Property, Plant & Equipment 30 500 Explain why or why not.
Accounts Payable $ 7 625
LO3, 4, 5
6 400 25 Ethics in accounting
Unearned Revenue
You are a junior accountant at a large construction company.
Notes Payable 15 000
Your company is under tremendous pressure to meet
Contributed Equity 25 000 earnings targets so that the company share price can
Sales Revenue 9 650 continue to grow. For the current year, it appears that the
company will miss its earnings targets simply because heavy
Salaries Expense 2 300 rain prevented work being carried out towards the end of the
Electricity Expense 650 financial year. Your boss, who has been a mentor to you,
Dividends 1 000 asks you to prepare a journal entry to record $280 million of
revenue for work that will be done in the first two weeks of
Totals $63 675 $63 675 the next financial year. He provides a fabricated invoice as
documentation. He states that without the rain the work
During February the following transactions occurred: would have been completed before year end and it is extra
  1st Billed customers for orders shipped, $2500. work the business will be doing in the next financial year
  2nd Paid $150 interest on note from bank. anyway. He asks you to do this as a personal favour to him.
  4th Received payment from customers billed in January, REQUIRED
$4500. a Identify the ethical issues associated with this scenario.
  6th Bought office supplies on account, $560.
b What factors other than accounting are at play here?
  7th Completed an order for which payment had
c What are your alternatives?
previously been received in January, $3500.
  8th Paid creditors for purchase of supplies in January, $1895. LO3, 4
26 Written communication
24th Paid dividends to shareholders, $1000.
28th Paid salaries of $2100; paid electricity of $775. As the only accountant on the company board, explain to
your fellow directors why the balance sheet may not show
REQUIRED assets at current market value.
a Prepare opening T-accounts for the month of February.
LO3, 4
b Prepare journal entries for transactions in the month of 27 Written communication
February. Since you are enrolled in an introductory accounting class, a
c Post journal entries to appropriate T-accounts. friend asks you the following: ‘I’ve never understood debits
d Prepare a trial balance at 28 February. and credits. All I know is that debit means bad and credit
means good’.
REQUIRED
Write a brief explanation of the terms debit and credit and
how they are used in an accounting information system.
Explain why debit and credit cannot mean good and/or bad.
CASES

LO3, 4, 5
24 Read and interpret financial statements
Access Woolworth’s (or another company as instructed)
latest annual report (e.g. conduct an internet search of
‘Woolworth annual report’)

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 3 Recording accounting transactions 59
 4
1
Chapter 3 introduced the first three steps in the accounting
cycle: recording transactions, posting information to the
ledger and preparing a trial balance from which financial
statements are prepared. This chapter explores the
remaining steps in the cycle.
This includes the adjusting process that leads to accrual-
based financial statements and the closing process that
prepares the accounting system for the next period. Both

Accrual accounting and

the adjusting and closing processes occur at the end of
each accounting period.

adjusting entries
LO1 ACCRUAL AND CASH BASES
OF ACCOUNTING

LEARNING One of the main functions of the accounting information

OBJECTIVES system is to record the revenues and expenses that a
business generates. In accounting, there are two possible
YT
bases for recording revenues and PPL HIS

A
Check out the video
expenses: the cash basis and the summary for Chapter 4
After studying the material in this chapter, you accrual basis. The main difference
should be able to: between the two is the timing of when revenues and
1 Explain how profit is measured and expenses are recorded.
reported under the accrual and cash bases The cash basis of accounting records cash basis of
of accounting. revenues when cash is received and records accounting  Records
revenues when cash is
2 Identify the four major circumstances in expenses when cash is paid. The best received and records
which adjusting journal entries are example of a cash basis accounting system expenses when cash is
paid.
necessary. is your personal bank account. Revenues
such as wages are recorded only when you are paid.
3 Record and post adjusting journal entries as
Expenses such as paying your credit card are recorded
well as prepare an adjusted trial balance
only when you transfer the money.
and financial statements.
In contrast, the accrual basis of accounting accrual basis of
4 Understand the purpose of the closing records revenues when they are earned and accounting  Records
process and prepare closing entries. revenues when they are
records expenses when they are incurred. This is earned and records
5 Describe the steps of the accounting cycle. an application of the revenue recognition and expenses when they are
incurred.
matching principles discussed in Chapter 1. In an
accrual accounting system, revenues such as your wages would
be recorded when you earn them, regardless of when payment
is received. Likewise, expenses such as event tickets are
recorded when you attend the event, regardless of when
payment is made. A summary of each basis is as follows:

Cash basis Accrual basis

Record revenues Cash is received Revenue is earned

when:
Express
Record expenses Cash is paid Expense is incurred
YT
Throughout this PPL HIS when:
A

chapter apply this

icons indicate To illustrate the difference between the cash and
an opportunity
accrual bases, suppose that a neighbour leaves town for
for online
self-study through the months of December and January and asks you to
CourseMate Express, collect her mail and newspapers. Before she leaves, she
linking you to revision pays you $100. Suppose further that you agree to pay a
quizzes, e-lectures,
animations and more. friend $40 to do the work, but you pay him at the end of
January after the work is completed. Income for December
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60
Alamy Stock Photo/Sam Stephenson REPORTING ACCRUAL- AND
CASH-BASED INCOME
Because GAAP require the accrual basis, income
statements report accrual-based profits or losses. However,
cash basis information is also useful in understanding the
financial condition of a company. A company that generates
accrual income but never generates cash is a company that
will soon fail. As a result, cash-based income is reported
on the cash from operations section of a cash flow
When a retailer like Bunnings sells a gift card, statement. Recall from Chapter 1 that the operating
it records an increase in cash and an increase
in a liability. It records revenue (and reduces activities section calculates and reports the cash generated
the liability) when the customer uses the card from operating the business. Cash generated from
operations is the same as cash-based income.
and January under each basis would be calculated as
outlined in the following.
Under the cash basis, December revenues are $100 ANALYSIS
In Appendix B, in CSL’s Notes to
because you received $100 during the month. Likewise,
the Financial Statements, look at
December expenses are $0 because you paid nothing Note 2: Revenue and Expenses. How can you tell from
during the month. As a result, December profit is $100. For this note that CSL uses the accrual basis of accounting?
January, you received no money but paid your friend $40, Analysis:
so revenues are $0, and expenses are $40. Therefore, Under the heading ‘Recognition and measurement of
January’s loss is $40. revenue’ the note states: ’The Group recognises revenue
Under the accrual basis, revenue for December is $50 when the amount of revenue can be reliably measured
and it is probable that the future economic benefits will
because you earned half of the $100 during December. flow to the group’. Further, ‘Sales are recognised when
And, even though you don’t pay your friend until January, the significant risks and rewards of ownership of the
he provided half of the agreed labour in December, so goods have passed to the buyer’. More specifically,
December expenses are $20. As a result, December profit ‘Finance revenue: Income from cash deposits is
is $30. Because the exact same circumstances occur in recognised as it accrues’.1
January, profit for January is also $30.
To illustrate, consider the reconciliation of profits after
Cash basis Accrual basis
tax to cash flow from operations for CSL. It uses the direct
December January Total December January Total
method of reporting operating cash flows in the cash flow
Revenues $100 $ 0 $100 $50 $50 $100 statement (see the CSL 2017 Annual Report in Appendix
– Expense 0    40 40  20  20    40 B) while in the reconciliation the difference between net
Profit (Loss) $100 $(40) $ 60 $30 $30 $ 60 cash from operating activities (cash profits of $1246.6
million) and profits after income tax (accrual profits of
The comparative income statements (or statements of $1337.4 million) is almost $91 million. In the previous year
comprehensive income) show that although each basis the figure was almost $64 million. Cash basis income is
results in the same $60 of cumulative profit, monthly profit less than accrual basis income due primarily to increases
or loss varies considerably. The cash-based statement in inventory of $389 million and increases in net tax assets
reports that you generated a $100 profit one month and a (unimportant at this stage) of $111 million.The reconciliation
$40 loss the next, while the accrual-based statement of Profits After Tax to Cash Flow from Operations in CSL’s
reports that you generated $30 in profits each month. Given 2017 Annual Report (see Appendix B or download full
that your activities were exactly the same each month, report online) also shows depreciation of $279 million and
accrual-based income of $30 each month makes more increases trade and other payables of $154 million,
sense than a $100 profit and a $40 loss. Even though both offsetting the increases in inventory and tax assets. There
bases result in the same total $60 profit over the two are a number of other smaller items that contribute to
months, the accrual basis provides a better representation cash from operations being less than profit after tax.
of income for each month. As a result, the accrual basis is
required by Generally Accepted Accounting Principles
(GAAP) and specifically by the Accounting Standard AASB
15 Revenue from Contracts with Customers.

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CHAPTER 4 Accrual accounting and adjusting entries 61
 you fly. When a company receives cash before it provides
LO2 ADJUSTING JOURNAL the service, it has a deferred revenue (sometimes known
ENTRIES as revenue received in advance or unearned revenue). The
term deferred is used because at the time of cash receipt,
To ensure that revenues and expenses are properly the company has not yet provided the promised service
recorded under an accrual basis, accounting information and therefore cannot record a revenue in its accounting
adjusting journal systems use adjusting journal entries. system. Instead, it must record a liability. Recording the
entries  Entries made in These are entries made in the general revenue must be deferred until the revenue is earned.
the general journal to
journal to record revenues that have been
record revenues that have
been earned but not earned but not recorded, and expenses
Subscription revenue
recorded and expenses that have been incurred but not recorded To illustrate a deferred revenue adjustment, suppose that
that have been incurred
but not recorded. (and the corresponding updating of a company sells 12-month subscriptions to its monthly
assets and liabilities). The process of magazine. On 1 October, the company receives a total of
recording and posting adjusting entries is the fourth step $120 for 12 subscriptions. To record this transaction, the
in the accounting cycle and occurs at the end of each company would record the following entry in its general
accounting period after the trial balance is prepared. After journal:
adjusting entries are journalised and posted, an ‘adjusted’ 1 Oct. Cash 120
trial balance is then prepared, from which financial
 Unearned Subscription Revenue 120
statements are generated.
While adjusting entries can vary significantly across   (To record cash received for future magazines)
companies, they all arise because the exchange of cash Assets = Liabilities + Equity
does not always coincide with the earning of a revenue or +120 +120
incurrence of an expense. For example, sometimes cash
is received before a revenue is earned while at other times This entry first increases the Cash account by the
cash is received after a revenue is earned. Likewise, amount received. And, because the company now has an
sometimes cash is paid before an expense is incurred obligation to its customers to deliver the magazines, the
while at other times cash is paid after an expense is entry also increases a liability account called Unearned
incurred. These four basic scenarios are the reasons that Subscription Revenue. As a result, both assets and liabilities
adjusting journal entries are necessary. Each scenario is are increasing. The entry would then be posted to the
listed in the following table and is discussed further in the relevant T-accounts as follows:
following sections.
Unearned
Subscription Subscription
Classification of scenario Adjusting entry Cash Revenue Revenue
1 Cash is received before Deferred revenue is earned 120 120 0
revenue. (An insurance 120 120 0
company receives the cash at
the beginning of the policy)
Suppose further, that the company prepares financial
2 Cash is received after Accrued revenue is earned statements at the end of each month. As of 31 October,
revenue. (The phone company
the company has provided one month of magazines and
receives cash after the
customer has made calls and has therefore earned one month of revenue, or $10
accessed the internet) ($120/12 months). Because the accounting system does
3 Cash is paid before expense. Deferred expense is incurred not yet reflect this earned revenue, the following adjusting
(The tenant pays rent to the journal entry should be made on 31 October:
property owner for the coming
month’s rent) 31 Oct. Unearned Subscription 10
Revenue
4 Cash is paid after expense. Accrued expense is incurred
(Electricity may be used for  Subscription Revenue 10
three months before the bill is   (To record revenue earned during October)
received and then paid)
Assets = Liabilities + Equity
–10 +10
SCENARIO 1: DEFERRED REVENUE
Companies sometimes receive cash before they earn the
revenue; for example, airlines receive your money before

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
62 ACCT3 Financial
 This entry increases the Subscription Revenue account desirable way to record the transaction, however it is
by the amount earned during the month and decreases the important to your understanding of adjusting entries).
liability account Unearned Subscription Revenue by the To record this transaction (the other way), the company
same amount. As a result, liabilities are decreasing and would record the following entry in its general journal:
equity is increasing. The entry would be posted to the
1 Oct. Cash 120
relevant T-accounts as follows:
 Subscription Revenue 120
Unearned
Subscription Subscription
  (To record cash received for future magazines)
Cash Revenue Revenue Assets = Liabilities + Equity
120 120 0 +120 +120
10 10
This entry first increases the Cash account by the
120 110 10
amount received (as before). Because the company
After posting, the Subscription Revenue T-account recorded it as a revenue (it may have believed the revenue
reflects the $10 earned in the current period while the would be soon earned), the entry has also increased the
Unearned Subscription Revenue T-account reflects the revenue account called Subscription Revenue. As a result,
remaining $110 to be earned over the next 11 months. both Assets and Revenue (Equity) are increasing. The
These two accounts have been adjusted so that they entry would then be posted to the relevant T-accounts as
properly reflect revenues earned during October and follows:
liabilities owed on 31 October. The Cash account is not
Unearned
affected by the adjusting journal entry. Cash was exchanged Subscription Subscription
and recorded on 1 October. Cash Revenue Revenue
120 120
General rule 120 120
When a company receives cash before it provides a service,
the company should always increase a liability account The company prepares financial statements at the end
for the amount received. As the company provides the of each month. As of 31 October, the company has
service, the liability account is adjusted down (decreased) provided only one magazine and has therefore earned
and the related revenue account is adjusted up (increased). only 1/12 of the revenue, or $10 ($120/12 months), as
So, the adjusting journal entry for this scenario should before. Because the accounting system reflects all the
always be a reduction to a liability account and an increase revenue being earned in the month of October, the
to a revenue account, as shown in Exhibit 4.1. revenue needs to be decreased and the liability increased,
and the following adjusting journal entry should be made
Exception to the general rule on 31 October:
What if the money received was, for some reason, credited
to Revenue rather than the liability Unearned Revenue? The 31 Oct. Subscription Revenue 110
necessary adjustment at the end of the period would need  Unearned Subscription Revenue 110
to be totally different, but the balances after adjustment in   (To record revenue earned during October)
both the revenue account and the liability account would Assets = Liabilities + Equity
be exactly the same as above.
+110 −110
To illustrate the same situation, accept that the credit
was made to the revenue account (this may not be the
iStock.com/hidesy

Receipt End of DECEMBER

of cash period
Provide service

Cash $$ Liability $$
Liability $$ Revenue $$

EXHIBIT Entries in a deferred revenue scenario

4.1

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CHAPTER 4 Accrual accounting and adjusting entries 63
 This entry decreases the Subscription Revenue account The entry increases the Accounts Receivable account
by the amount not yet earned ($110) and increases the for the amount that the client owes the firm and increases
liability account Unearned Subscription Revenue by the the Service Revenue account for the amount that the firm
same amount. As a result, liabilities are increasing and has earned. As a result, both assets and equity are
revenue is decreasing. The entry would be posted to the increasing. The preceding entry would be posted to the
relevant T-accounts as follows: relevant T-accounts as follows:

Unearned Accounts Service

Subscription Subscription Cash Receivable Revenue
Cash Revenue Revenue
0 1 000 1 000
120 120
0 1 000 1 000
110 110
120 110 10 After posting, the Service Revenue T-account reflects
the $1000 earned in the current period while the Accounts
After posting, the Subscription Revenue T-account Receivable T-account reflects the $1000 of expected cash
reflects the $10 earned in the current period while the receipts from the client. These two accounts have been
Unearned Subscription Revenue T-account reflects the adjusted so that they properly reflect revenues earned
remaining $110 to be earned in the future (or to be returned during September and receivables held on 30 September.
to the customer if the magazines are not provided). These
two accounts have been adjusted so that they properly
reflect revenues earned during October and liabilities owed MAKING IT REAL
on 31 October. Again, the Cash account is not affected by
the adjusting journal entry. Note that we end up with the GIFT CARDS
Although gift cards have existed for many years, their
same balances in the accounts regardless of how the ever-growing popularity in recent times is causing
transaction was originally recorded, the adjusting entries some accounting issues for retailers due to the need
‘fix them up’. to estimate when a customer’s card is ‘no longer
expected to be redeemed’ (i.e. when the revenue can
SCENARIO 2: ACCRUED REVENUE be recognised because the card is unlikely to be used
to purchase goods).
Companies often provide a service and then collect the Many people would assume that retailers record
cash. When a company earns a revenue before it receives revenue with each gift card purchased. However, the
cash, it has an accrued revenue. The term ‘accrue’ means transfer of goods (inventory) is required for revenue
to be recognised. Therefore, gift card sales represent
to accumulate or increase. An accrued revenue is another
a deferred revenue, which is a liability. Revenue is not
name for a receivable. generated until the gift card is redeemed. For retail
companies like Bunnings (Wesfarmers), it states in its
Service revenue Notes to the Financial Statements in Recognition and
To illustrate an accrued revenue adjustment, suppose that Measurement of Revenue:
an accounting firm agrees to provide a service to a client Revenue from the sale of gift cards is recognised
for a $1000 fee. The firm completes its work on 23 when the card is redeemed and the customers
purchase goods by using the card, or when the
September, bills the client on 10 October and receives customer card is no longer expected to be
payment on 21 October. redeemed. At 30 June 2017, $217 million of
Suppose further that the accounting firm prepares its revenue is deferred in relation to gift cards.2

own financial statements at the end of each month, which

in this case is 30 September.
Because the accrual basis requires that revenues be
recorded in the period in which they are earned, the
accounting firm must record the $1000 of revenue on 30
September with the following adjusting journal entry:

30 Sept. Accounts Receivable 1 000

  Service Revenue 1 000
   (To record revenue earned during September)
Assets = Liabilities + Equity Gift cards are not only good when you have no
idea what to buy someone, but they are also
+1 000 +1 000 great for the company issuing them

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64 ACCT3 Financial
 When the customer pays cash on 21 October, the example is rent. You pay rent for a period (possibly a
following entry is made: month or only a week) in advance and are then able to
occupy the accommodation.
21 Sept. Cash 1 000
When a company pays for a resource before it uses or
  Accounts Receivable 1 000 consumes it, the company has a deferred expense. We use
   (To record receipt of cash) the term deferred because at the time of cash payment for
Assets = Liabilities + Equity the resource, the company has yet to use or consume the
+1 000 resource it is acquiring and therefore cannot record an
expense in the accounting system. Instead, it records an
−1 000
asset. Recording of the expense must be deferred until the
expense is incurred. You should note that a deferred expense
This entry increases the Cash account and decreases
is nothing more than an asset – a resource to be used.
the Accounts Receivable account for the amount collected.
As a result, although specific asset accounts are changing, Insurance expense
total assets remain unchanged. No revenue is recorded
To illustrate a deferred expense adjustment, suppose that
because it was recorded in the prior period when it was
on 1 March, a company purchases a 12-month insurance
earned. The entry would be posted to the relevant
policy for $3600. To record this transaction, the company
T-accounts as follows:
would record the following entry in its general journal:
Cash Accounts Receivable
1 Mar. Prepaid Insurance 3 600
0 1 000
 Cash 3 600
1 000 1 000    (To record purchase of insurance)
1 000 0 Assets = Liabilities + Equity
+3 600
General rule −3 600
When a company earns a revenue before it receives cash,
the company should increase a receivable account (asset) This entry increases the asset account Prepaid Insurance
and a revenue account for the amount earned. In other to reflect the amount of insurance bought and decreases
words, the receivable account should be adjusted up the Cash account for the same. Since both of these
(increased) and the revenue account should also be accounts are assets, this entry does not change total
adjusted up (increased). When the company collects the assets. The entry would then be posted to the relevant
receivable, the receivable account is decreased and T-accounts as follows. For illustration purposes, assume that
the cash account is increased. So, the adjusting journal the Cash account has a $10 000 balance prior to the entry:
entry for this scenario will be an increase to an asset
Prepaid Insurance
account and an increase to a revenue account, as shown Cash Insurance Expense
in Exhibit 4.2.
10 000 0

SCENARIO 3: DEFERRED EXPENSE 3 600 3 600

6 400 3 600 0
Companies often pay cash before they incur an
expense. You need look no further than your own Suppose further that the company prepares financial
personal expenses to find numerous examples of statements at the end of April. As of 30 April, the company
payments made before you use the service. One has been covered for two months and has therefore
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End of DECEMBER Receipt

period of cash
Provide service

Receivable $$ Cash $$
Revenue $$ Receivable $$

EXHIBIT Entries in an accrued revenue scenario

4.2

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CHAPTER 4 Accrual accounting and adjusting entries 65
 consumed two months of insurance, or $600 ([$3600 ÷ 12] 1 July Equipment 40 000
x 2 months). Because the accounting system does not yet
 Cash 40 000
reflect this expense, the following adjusting journal entry
   (To record purchase of film studio equipment)
should be made on 30 April:
Assets = Liabilities + Equity
30 Apr. Insurance Expense 600
–40 000
  Prepaid Insurance 600
+40 000
   (To record expense incurred during March)
Assets = Liabilities + Equity This entry increases the asset account Equipment to
−600 –600 reflect the cost of the equipment and decreases the Cash
account for the same. Since both of these accounts are
This entry increases the Insurance Expense account by assets, this entry does not change total assets. The entry
the amount consumed during the two months and would then be posted to the relevant T-accounts as follows.
decreases the asset account Prepaid Insurance by the We will assume that the Cash account has a $70 000
same amount. As a result, both assets and equity are balance prior to the entry:
decreasing. The entry would be posted to the relevant
Depreciation
T-accounts as follows: Cash Equipment Expense
Prepaid Insurance 70 000 0
Cash Insurance Expense
40 000 40 000
10 000 0
30 000 40 000 0
3 600 3 600 600 600
6 400 3 000 600
Suppose further that the company prepares financial
statements at the end of the financial year, 30 June the
After posting, the Insurance Expense T-account reflects following year. As of 30 June, the company has used the
the $600 of insurance that was consumed in the current equipment for one year and should therefore record some
period while the Prepaid Insurance T-account reflects the amount of expense associated with the use of the studio
remaining $3000 of insurance to be consumed over the equipment. If we assume for simplicity that the amount of
next 10 months. These two accounts have been adjusted expense to be recognised in the financial year is $10 000, the
so that they properly reflect expenses incurred during following adjusting journal entry should be made on 30 June:
March and April and unexpired assets on 30 April. The Cash
30 June Depreciation Expense 10 000
account is not affected by the adjusting journal entry. Cash
 Accumulated Depreciation 10 000
was exchanged and recorded on 1 March.
If the purchase of insurance was originally (incorrectly)    (To record expense incurred the financial year)
recorded as an expense, then the adjusting entry would be Assets = Liabilities + Equity
needed to increase the asset Prepaid Insurance by $3000 –10 000 –10 000
and reduce the expense Insurance Expense by $3000.
Such an adjustment would result in the same outcome, This entry increases the Depreciation Expense account
with Insurance Expense for the months of March and April by the amount of expense allocated to the current year.
of $600 and an asset Prepaid Insurance at the end of April However, instead of decreasing the Equipment account
of $3000. Again, no cash is involved in the adjustment. directly, the entry increases Accumulated Depreciation. We
discuss accumulated depreciation in detail in Chapter 8,
Depreciation expense but for now you should know that the account is a contra-
Another example of an expense where cash is paid before asset account that accumulates depreciation expense to
the expense is incurred, is depreciation. Depreciation is the date and is subtracted from the Equipment account to yield
process of spreading over their useful lives the cost of non- the net balance of the asset. As a result of the entry, both
current assets such as equipment and buildings. For assets and equity are decreasing. Equity is decreasing
example, suppose that on 1 July, a company purchases film because the company recorded an expense. Assets are
studio equipment for $40 000. This transaction would be decreasing because the net balance of Equipment and
recorded into the accounting system as follows: Accumulated Depreciation at the end of June is now
$30 000 ($40 000 – $10 000). The entry would be posted to
the relevant T-accounts as follows:

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66 ACCT3 Financial
 Accumulated Depreciation 30 Nov. Salaries Expense 5 000
Equipment Depreciation Expense
 Salaries Payable 5 000
40 000 0 0 0
   (To record salaries incurred during April)
10 000 10 000
Assets = Liabilities + Equity
40 000 10 000 10 000
+5 000 –5 000
The Depreciation Expense and Accumulated
Depreciation accounts have been adjusted so that they The preceding entry increases the Salaries Expense
properly reflect the $10 000 of expenses incurred during account for the $5000 of salaries incurred for the week and
the financial year and the $30 000 of net unexpired balance increases the Salaries Payable account for the same since
of Equipment on 30 June. it owes the employees those salaries. As a result, liabilities
are increasing and equity is decreasing. The preceding
General rule entry would be posted to the relevant T-accounts as follows:
When a company pays cash before it incurs an expense,
Cash Salary Payable Salaries Expense
the company should always increase an asset account for
8 000
the amount paid. As the company consumes the asset, the
asset account is adjusted down (decreased) and the related 5 000 5 000
expense account is adjusted up (increased). Depending on 8 000 5 000 5 000
the type of asset, either the actual asset account will be
decreased or a related contra-asset account will be After posting, the Salaries Expense T-account reflects
increased (which is a decrease in total assets). So, the the $5000 incurred in the current period while the Salaries
adjusting journal entry for this scenario will always be a Payable T-account reflects the $5000 owed to employees
reduction to an asset account and an increase to an on 30 November. These two accounts have been adjusted
expense account, as shown in Exhibit 4.3. so that they properly reflect expenses incurred during
November and the payable owed on 30 November.
SCENARIO 4: ACCRUED EXPENSE The Cash account is not affected by the adjusting
journal entry. Cash, which has an $8000 balance for
Companies often incur expenses and pay for them later. A illustrative purposes, will be paid on Saturday 1 December.
good example is employee salaries. Most companies pay When the company pays its employees, the following entry
their employees after the employees have provided labour would be made:
for the company. When this occurs, the company has an
accrued expense. An accrued expense is another name for 1 Dec. Salaries Payable 5 000
a liability.  Cash 5 000
   (To record payment of cash)
Salaries expense
Assets = Liabilities + Equity
To illustrate an accrued expense adjustment, suppose that
a company’s daily payroll is $1000. The company pays its −5 000 −5 000
employees via direct deposit every Saturday for the work
The entry decreases the Cash account for the $5000
the employees have provided to the end of Friday. Suppose
paid to employees and decreases the Salaries Payable
further that the company prepares its financial statements
account by the same $5000. No expense is recorded
on 30 November, which is a Friday.
because it was recorded in the prior period when the
Because the accrual basis requires that expenses be
expense was incurred. As a result, both assets and liabilities
recorded in the period in which they are incurred, the
are decreasing. The entry would be posted to the relevant
company must record the $5000 of expense on 30
T-accounts as follows:
November with the following adjusting journal entry:
iStock.com/hidesy

Payment End of DECEMBER

of cash period
Use resource

Asset $$ Expense $$
Cash $$ Asset $$

EXHIBIT Entries for a deferred expense scenario

4.3

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 4 Accrual accounting and adjusting entries 67
 Cash Salaries Payable After posting, the Interest Expense T-account reflects
the $500 incurred in the current period and the Interest
8 000 5 000
Payable T-account reflects the $500 owed to the bank on
5 000 5 000 30 November. These two accounts have been adjusted so
3 000 0 that they properly reflect expenses incurred during
November and the payables owed on 30 November.
Interest expense The Cash account is not affected by the adjusting
journal entry. Cash, which has a $1100 balance for illustrative
Interest is another example of incurring an expense before
purposes, will be paid on 1 December. On that date, the
cash is paid. For example, suppose that a company borrows
following entry would be made:
$100 000 on 1 November. The annual interest rate on the
loan is 6 per cent and interest is payable on the first day of 1 Dec. Interest Payable 500
each month. Suppose further that the company prepares  Cash 500
its financial statements on 30 November.
   (To record payment of cash)
As of 30 November, the company has used the
borrowed money for one month, so it has incurred one Assets = Liabilities + Equity
month’s worth of interest. To calculate the amount of –500 –500
interest, we simply multiply the principal amount ($100 000)
by the annual interest rate (6 per cent) and by the relevant The preceding entry decreases the Cash account for
number of periods (1 month out of 12, or 1/12). So, interest the $500 paid to the bank and decreases the Interest
for the month of November is: Payable account by the same $500. As a result, both assets
and liabilities are decreasing. The entry would be posted to
Principal × annual rate × time = $100 000 × 0.06 × 1/12 = $500
the relevant T-accounts as follows:
Therefore, the following adjusting journal entry should
Cash Interest Payable
be made on 30 November:
1 100 500
30 Nov. Interest Expense 500
500 500
  Interest Payable 500
600 0
   (To record interest incurred during November)
Assets = Liabilities + Equity
General rule
+500 –500
When a company incurs an expense before it pays cash,
the company should always increase a payable account
The preceding entry increases the Interest Expense
and an expense account for the amount incurred. In other
account for the $500 of interest for November and
words, the payable account should be adjusted up
increases the Interest Payable account for the same. As a
(increased) and the expense account should also be
result, liabilities are increasing and equity is decreasing. The
adjusted up (increased). When the company pays the
preceding entry would be posted to the relevant T-accounts
liability, the liability account is reduced and the cash
as follows:
account is decreased. So, the adjusting journal entry for
Cash Interest Payable Interest Expense this scenario will always be an increase to a liability
1 100 account and an increase YT
PPL HIS
A

to an expense account, Check out the animated

500 500 summary on Adjusting Entries
as shown in Exhibit 4.4.
1 100 500 500
iStock.com/hidesy

End of DECEMBER
Payment
period of cash
Use resource

Expense $$ Liability $$
Liability $$ Cash $$

EXHIBIT Entries in an accrued expense scenario

4.4

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68 ACCT3 Financial
 Entry before end of Adjusting entry at end Entry after end of
Scenario Classification
period of period period
Cash is received before Deferred revenue Cash $$ Liability $$
revenue is earned Liability $$ Revenue $$
Cash is received after Accrued revenue Receivable $$ Cash $$
revenue is earned Revenue $$ Receivable $$
Cash is paid before Deferred expense Prepaid Asset $$ Expense $$
expense is incurred Cash $$ Prepaid Asset $$
Cash is paid after expense Accrued expense Expense $$ Payable $$
is incurred Payable $$ Cash $$
EXHIBIT Summary of adjusting journal entry scenarios
4.5

SUMMARY OF ADJUSTING JOURNAL ENTRIES Video Memories

Unadjusted trial balance
Exhibit 4.5 summarises the four scenarios that give rise 31 May
to adjusting journal entries and the characteristics of the Debit Credit
relevant entries. As you review this exhibit, consider the Cash $ 8 250
following generalisations of all adjusting entries: Supplies 1 000
● The purpose of adjusting entries is to record revenues Equipment 18 000
that have been earned but not recorded and expenses Unearned Revenue $ 2 000
that have been incurred but not recorded.
Notes Payable 9 000
● Every adjusting journal entry will affect at least one
Ordinary Shares 15 000
revenue or one expense account. In addition, every
adjusting journal entry will affect at least one asset or Service Revenue 5 000
liability account. This means that every adjusting entry Advertising Expense 250
will affect at least one account from the income Salaries Expense 2 000
statement and one account from the balance sheet. Dividends     1 500    
● Adjusting journal entries arise because the timing of
Totals $31 000 $31 000
revenue and expense recognition differs from the
exchange of cash. Therefore, cash will never be In addition to these accounts and balances, the
increased or decreased in an adjusting entry. following information was available on 31 May:
YT 1 On 31 May, Video Memories filmed the retirement
PPL HIS
reception for the customer who paid $2000 on 10 May
A

Review this content with the e-lecture

(see Transaction #4 in Chapter 3).
2 On 31 May, Video Memories filmed the first night of a
two-night local play. The second night will be filmed on
1 June, at which time Video Memories will bill the
LO3  OMPREHENSIVE
C customer.
EXAMPLE: ADJUSTING 3 The local play customer has agreed to pay Video
JOURNAL ENTRIES Memories $1500 for each night.
4 After a physical count, Video Memories determined that
To illustrate the process of making adjusting journal entries it had $650 of supplies remaining.
from a trial balance and then preparing an adjusted trial 5 The interest rate for the note payable is 6 per cent (per
balance, the Video Memories example from Chapter 3 will annum).
be continued. As a result of the transactions entered into 6 Video Memories estimates that depreciation for May
by Video Memories during its first month of operations, on its two cameras totals $600.
the following unadjusted trial balance was prepared at Given this information, the adjusting entries that follow
31 May (this is taken from Chapter 3). Notice that it is an can be prepared.
unadjusted trial balance because adjusting entries have not
yet been made.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 4 Accrual accounting and adjusting entries 69
 JOURNALISING AND POSTING The entry would be posted to the relevant T-accounts
ADJUSTING ENTRIES as follows:

Adjustment 1: Deferred revenue Accounts Receivable Service Revenue

Video Memories has now filmed the retirement reception, 0 5 000
so it no longer has a liability to the customer; it has a 2 000
revenue instead. However, the trial balance still shows the 1 500 1 500
$2000 liability. Thus, the adjusting entry required to adjust
1 500 8 500
the liability down and the revenue up is as follows:

31 May Unearned Revenue 2 000 Adjustment 3: Deferred expense

  Service Revenue 2 000 Video Memories has $650 in supplies on hand. However,
   (To record revenue earned) the trial balance shows $1000 in the Supplies account,
Assets = Liabilities + Equity which is the amount that Video Memories originally
–2 000 +2 000 purchased. Therefore, Video Memories must have used
$350 of supplies ($1000 – $650). To adjust the Supplies
The entry would be posted to the relevant T-accounts account down from $1000 to $650 and to record the $350
as follows: in expense, the following adjusting journal entry is required.

Unearned Revenue Service Revenue 31 May Supplies Expense 350

2 000 5 000  Supplies 350
2 000 2 000    (To record expense incurred)
0 7 000 Assets = Liabilities + Equity
–350 –350

Adjustment 2: Accrued revenue The entry would be posted to the relevant T-accounts
Video Memories filmed one night of a local play. Therefore, as follows:
it has earned revenue for one night, $1500. The trial balance
does not reflect this because Video Memories has not Supplies Supplies Expense
issued a bill, so the adjusting journal entry to adjust 1 000 0
receivables and revenues up is as follows: 350 350
31 May Accounts Receivable 1 500 650 350
  Service Revenue 1 500
   (To record revenue earned) Adjustment 4: Accrued expense
Assets = Liabilities + Equity Video Memories must pay interest on the notes payable at
+1 500 +1 500 a 6 per cent annual rate (we have assumed the loan was
obtained at the beginning of May). Therefore, after one
month, Video Memories has incurred $45 of interest
Getty Images/AFP/LEON NEAL

expense ($9000 × 6% × 1/12). This expense and the related

obligation are not reflected in the trial balance because they
have not yet been recorded. To record them, the following
adjusting entry is required:

31 May Interest Expense 45

  Interest Payable 45
   (To record expense incurred)
Assets = Liabilities + Equity
+45 –45

Earning revenue is not always a burden

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
70 ACCT3 Financial
 The entry would be posted to the relevant T-accounts Interest Payable 45
as follows:
Notes Payable 9 000
Interest Payable Interest Expense Contributed Equity 15 000
0 0 Service Revenue 8 500
45 45 Supplies Expense 350
45 45 Interest Expense 45
Depreciation Expense 600
Adjustment 5: Deferred expense Advertising Expense 250
Video Memories determines that depreciation on its Salaries Expense 2 000
cameras should be $600 for the month of May. To record Dividends   1 500    
this depreciation, the following adjusting entry is required. Totals $33 145 $33 145
31 May Depreciation Expense 600
  Accumulated Depreciation 600 PREPARING FINANCIAL STATEMENTS
   (To record expense incurred) Once all revenues and expenses are recorded and an
Assets = Liabilities + Equity adjusted trial balance is prepared, financial statements can
–600 –600 be generated. Recall from Chapter 1 that the income
statement should be prepared first. Using the adjusted
The entry would be posted to the relevant T-accounts revenue and expense account balances from the adjusted
as follows: trial balance, Video Memories’ income statement for the
month of May would appear as follows:
Depreciation Accumulated
Equipment Expense Depreciation
Video Memories
18 000 0 0 Income statement
for the month ending 31 May
600 600
Revenues $8 500
18 000 600 600
Expenses
Supplies Expense $  350
PREPARING AN ADJUSTED TRIAL BALANCE Interest Expense 45
Once all of the preceding adjusting entries are journalised Depreciation Expense 600
and posted to the ledger, an adjusted trial balance can be Advertising Expense 250
prepared. Like the previous trial balance, the adjusted trial Salaries Expense 2 000
balance simply lists all balances from the ledger. Since the Total Expenses 3 245
ledger now reflects several adjustments, so does the
Profit $5 255
adjusted trial balance.
The following is the adjusted trial balance for Video Note the profit figure is $2505 higher than shown in
Memories on 31 May. The accounts that were either Chapter 3. This is due entirely to the adjusting entries
created or adjusted by the adjusting entries are highlighted. updating the revenue and expense figures.
The other accounts, such as cash, have not changed from With profits calculated, Video Memories’ retained
the unadjusted trial balance presented earlier. earnings part of the statement of changes in equity (or the
statement of changes in retained earnings) can be prepared.
Video Memories
Adjusted trial balance Recall that the statement of retained earnings takes the
31 May beginning balance in Retained Earnings, adds profits and
Debit Credit subtracts dividends to yield the current balance in Retained
Cash $ 8 250 Earnings. Video Memories’ 31 May adjusted trial balance
Accounts Receivable 1 500 shows no balance in beginning Retained Earnings and a
Supplies 650 $1500 balance in Dividends. Therefore, Video Memories’
18 000
statement of retained earnings for the month of May would
Equipment
appear as follows:
Accumulated Depreciation $  600
Unearned Revenue 0

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 4 Accrual accounting and adjusting entries 71
 Video Memories
Statement of changes in retained earnings In 2008 CSL reported net profit after tax of
for the month ending 31 May $701, increasing to $1311 in 2013 and $1739 in 2017
(all in millions of Australian dollars) CSL had flat
Retained Earnings, 1 May $    0
profits after the Global Financial Crisis but increased
Add: Profits 5 255 after 2010. We can judge the success of its strategy
Less: Dividends (1 500) by looking at profits (measured as accurately as the
judgements associated with adjusting entries permit).
Retained Earnings, 31 May $  3 755 Of course we have no way of knowing what would
have happened if a different strategy was
With retained earnings calculated, Video Memories’ implemented, but from the Excel graph below it
balance sheet can be prepared. Video Memories’ 31 May appears investors (shareholders) see similar
adjusted trial balance shows several balance sheet improvement since 2010. However, the share price is
accounts, starting with Cash and continuing through only part of the story, it does not show the $11.23 of
dividends paid out over the 10 years.
Ordinary Shares. These accounts, along with the amount
of retained earnings from the May statement of retained CSL Share Price 2008 to 2018
160
earnings, should be included on the balance sheet.
Therefore, Video Memories’ 31 May balance sheet would 140

appear as follows: 120

100
Video Memories
Balance sheet 80
at 31 May 60
Cash $  8 250 40
Accounts Receivable 1 500 20
Supplies 650 0
YT
Equipment $18 000 PPL HIS

A
Download the Enrichment
Less: Accumulated Depreciation     600 17 400 Modules for further practice
Total Assets $27 800
Interest Payable $   45
LO4 CLOSING PROCESS
Notes Payable 9 000
Total Liabilities $  9 045 After financial statements are prepared, companies
conduct the closing process. The closing
Contributed Equity $ 15 000 closing process  The
process is when all revenue, expense process of transferring all
Retained Earnings   3 755
and dividend account balances are revenue, expense and
Total Shareholders’ Equity 18 755 dividend account balances
transferred to the Retained Earnings to the Retained Earnings
Total Liabilities and $27 800 account. This transfer is necessary for account.
Shareholders’ Equity
three reasons.
First, revenue, expense and dividend accounts are
temporary accounts, meaning that they temporary
MAKING IT REAL accumulate balances only for the current accounts  Accounts that
accounting period. After the period ends accumulate balances only
EVALUATING STRATEGY for the current period.
To determine if any strategy is successful or not it is
and financial statements are prepared, all
necessary to be able to accurately measure temporary accounts must be reset to zero for the start of
performance after the implementation of the the next period.
strategy, consistent with the measure before. For Second, the transfer updates the Retained Earnings
example, after an athlete has undertaken a training account to its correct end-of-period balance. In the preceding
regime can he or she swim/run faster, jump higher or
example, the balance in Retained Earnings is generated from
lift greater weights? For someone on a diet, has he or
she lost or put on weight according to their plan? the statement of retained earnings, not the adjusted trial
There is no point measuring weight when holding balance. The closing process is the mechanism that updates
onto something or with weights in your pockets, the actual Retained Earnings account balance in the ledger.
when you originally weighed yourself under Third, the closing entries leave the revenue, expense and
different circumstances. Adjusting entries allow the dividend accounts with zero balances to commence the next
‘financial weight’ of a business to be measured as
accurately as possible.
accounting period and any amount now entered in these
temporary accounts relates to the new accounting period.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
72 ACCT3 Financial
closing entries  Entries The closing process is accomplished total expenses. In the second entry, the dividends account
made in the journal and with several entries. Closing entries, is eliminated and the Retained Earnings account is
posted to the ledger that
eliminate the balances in all
which are made in the journal and posted decreased by the same amount.
temporary accounts and to the ledger, eliminate the balances in all All three closing entries would be posted to the
transfer those balances to temporary accounts and transfer those appropriate T-accounts as follows:
the Retained Earnings
account. balances to the Retained Earnings
account. Usually, one entry is made for Retained Supplies Interest
Earnings Expense Expense
revenues, one for all the expenses and a final entry for
dividends. To illustrate, the temporary accounts from Video 8 500 350 45
Memories’ adjusted trial balance are shown in the following 3 245 350 45
partial adjusted trial balance: 1 500
3 755 0 0
Video Memories
Partial adjusted trial balance
31 May
Depreciation Advertising Salaries
Debit Credit Expense Expense Expense
Service Revenue $8 500 600 250 2 000
Supplies Expense $  350 600 250 2 000
Interest Expense 45 0 0 0
Depreciation Expense 600
Advertising Expense 250 Service
Revenue Dividends
Salaries Expense 2 000
8 500 1 500
Dividends 1 500
8 500 1 500
Video Memories has one revenue account with an 0 0
$8500 credit balance. To eliminate that balance and transfer
Notice that after the closing entries are posted, all
it to the Retained Earnings account, the following closing
revenue, expense and dividend accounts have zero
entry is required:
balances as desired. They are now ready to begin the next
31 May Service Revenue 8 500 reporting period. Also, Retained Earnings has a $3755
 Retained Earnings 8 500 credit balance. This is the balance reported on Video
  (To close revenue account) Memories’ statement of retained earnings and balance
sheet. In other words, the Retained Earnings account now
In this entry, the revenue balance is eliminated while has the correct balance at the end of the period.
the Retained Earnings account is increased. As a final check that all accounts have been properly
Expense and dividend accounts are closed in a similar closed, a new trial balance is prepared. Appropriately called
fashion. To eliminate those balances and transfer them to a post-closing trial balance, it contains all account balances
Retained Earnings, the following closing entries for the beginning of the next accounting period. Video
are required: Memories’ post-closing trial balance is as follows:

31 May Retained Earnings 3 245 Video Memories

Post-closing trial balance
 Supplies Expense 350 31 May
  Interest Expense 45 Cash $  8 250
  Depreciation Expense 600 Accounts Receivable 1 500
  Advertising Expense 250 Supplies 650
  Salaries Expense 2 000 Equipment 18 000
  (To close the expense Accumulated Depreciation $  600
accounts) Interest Payable 45
31 May Retained Earnings 1 500 Notes Payable 9 000
 Dividends 1 500 Ordinary Shares 15 000
(To close the dividends account) Retained Earnings 3 755
Totals $28 400 $28 400
In the first entry, all expense accounts are eliminated
and the Retained Earnings account is decreased by the

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CHAPTER 4 Accrual accounting and adjusting entries 73
 prepare a trial balance. This chapter demonstrated the two
Getty Images/AFP/Peter Parks

major processes that occur at the end of the period:

adjusting and closing. The adjusting process includes the
recording and posting of adjusting entries, and the
preparation of an adjusted trial balance, from which financial
statements are prepared. The closing process includes the
recording and posting of closing entries, and the preparation
of a post-closing trial balance. Once closing is completed,
the accounting information system is prepared to begin the
next period. Exhibit 4.6 summarises these steps.
Closing entries and preparing a
post-closing trial balance are the
last things accountants do before 1 Journalise and post accounting transactions
celebrating the new financial year
2 Prepare a trial balance
3 Journalise and post adjusting entries
4 Prepare an adjusted trial balance
LO5 THE ACCOUNTING CYCLE: 5 Prepare financial statements
A SUMMARY 6 Journalise and post closing entries
7 Prepare a post-closing trial balance
This and the previous chapter covered the accounting cycle.
accounting The accounting cycle is the sequence
EXHIBIT The accounting cycle
cycle  The sequence of of steps in which an accounting 4.6
steps in which an information system captures, processes
accounting information
system captures, and reports a company’s accounting YT
PPL HIS

A
processes and reports a transactions during a period. Chapter 3 Test your understanding with the
company’s accounting online revision quizzes for this chapter
transactions during a demonstrated the first three steps: how
period. to record journal entries in the journal,
post the information to the ledger and

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74 ACCT3 Financial
 LO2, 3
5 Adjusting journal entry – revenue
EXERCISES Leopard Legal agrees to prepare and represent Ali in court
for a speeding fine. The firm charges a flat fee of $250 per
hour and always completes the service before billing the
client. The firm completes the service on 16 April and bills
Ali on 1 March, with the bill amounting to 20 hours. Leopard
Legal prepares financial statements at the end of each
LO1 month.
1 Cash and accrual basis
During 2017, Supreme Media Company earned $77 500 in REQUIRED
revenue. At year-end, only $58 500 of that revenue had been a Prepare any adjusting journal entry necessary for
collected. Not only this, Supreme Media incurred $39 600 of Leopard Legal on 30 April.
expenses of which only $35 000 had been paid. b Explain if this situation is a deferred or accrued revenue.
REQUIRED c Show the T-accounts with the adjusting journal entry
Determine profit or loss (total comprehensive income) for posted to them.
the year under (a) the cash basis of accounting and (b) the
LO2, 3
accrual basis of accounting. 6 Adjusting journal entry – expense
On 1 March, Mustafa borrows $62 000 from Northern Lights
LO2, 3
2 Adjusting journal entries Bank on a short-term loan. Interest is paid after three
Consider the following incomplete adjusting journal entries: months and annual interest rates are 6 per cent.
REQUIRED
1 (a) 5 600
a Record the adjusting journal entry necessary on 1 May.
Accumulated Depreciation 5 600 b Post the 1 May journal entry to the relevant ledger
2 Interest Expense 8 500 T-accounts.
(b) 8 500
LO2, 3
7 Adjusting journal entry errors
3 Accounts Receivable 17 000
Natalie, a first-year intern at an investment bank, believes
(c) 17 000 that she may have made errors in her adjusting entries. She
4 (d) 6 750 has asked you for advice and reveals the following
accounting records:
Subscription Revenue 6 750
a Depreciation expense on a car was not recorded.
REQUIRED b Revenue was recorded for the current year when the job
Identify the likely account(s) that would complete each will be completed next year.
adjusting journal entry (a) to (d). c Commission from customer service operators has been
overlooked.
LO2
3 Adjusting journal entries REQUIRED
Consider the four entries in the preceding exercise. Determine the likely accounts that are affected by each error
and whether those accounts are understated or overstated
REQUIRED
as a result of the error.
Identify each entry as an accrued expense, an accrued
revenue, a deferred expense or a deferred revenue. LO2, 3
8 Calculate expenses and revenues
4 Adjusting journal entry – expense LO2, 3 The current and prior-year balance sheet of NCA show the
following account balances:
Muscle Man Ltd pays its one-year insurance policy of
$29 000 on 1 October. The insurance policy covers all claims Current year Prior year
in the next 12 months. The company is preparing its financial Supplies $4 000 $6 500
statements on 31 December.
Unearned Revenue 8 400 8 000
REQUIRED
a Determine whether the expense is deferred or accrued During the current year, NCA purchased $13 300 of supplies
expense and explain why. and received $8700 of cash for services to be performed later.
b Prepare the journal entries that Muscle Man would make REQUIRED
during October (receipt of cash) and on 31 December. Using ledger accounts, determine NCA’s supplies expense
and service revenue for the current year.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 4 Accrual accounting and adjusting entries 75
 LO2, 3 LO3, 4, 5
9 Adjusting journal entries 12 Adjusting and closing process
Christina Industries provides the following selected Consider the following accounts: Cash, Accounts
information from its trial balance and adjusted trial balance Receivable, Accounts Payable, Retained Earnings, Service
at 31 October: Revenue, and Supplies Expense.
REQUIRED
Christina Industries
trial balance Determine which accounts fall into the following categories:
31 October a Accounts that can be adjusted and closed.
Unadjusted Adjusted b Accounts that can be adjusted but not closed.
Debit Credit Debit Credit c Accounts that are not normally adjusted or closed.
Accounts $6 910 $9 240
Receivable 13 Adjusting journal entries LO2, 3

Supplies 3 400 2 200 In its first year of operations, Savina Sweeties entered into
Service Revenue $17 480 $19 810 the following transactions, among others:
Supplies Expense 5 320 6 520 i 1 January: Bought equipment, $90 000.
ii 31 February: Prepaid one year’s rent, $30 000.
REQUIRED iii 1 June: Took out a one-year loan from the bank at an
Prepare the adjusting journal entries that Christina Industries annual interest rate of 5 per cent, $25 000.
must have made at 31 October. iv 1 August: Received payment for goods not yet
rendered, $15 000.
10 Prepare financial statements from LO3 v 1 September: Paid for salaries expense, $3000.
trial balance On 31 December, Savina has earned $5000 of the
The adjusted trial balance for Mark Boxing Bros is as $15 000 in transaction (iv) and has incurred but not recorded
follows: $800 of electricity and $500 of salaries expense. Savina
prepares adjusting entries on an annual basis.
Mark Boxing Bros adjusted REQUIRED
trial balance
30 June Prepare journal entries for transactions (i) to (v) and any
adjusting journal entries needed at 31 December. Assume
Debit Credit that the equipment depreciates $10 000 annually.
Cash $3 500
LO2, 3
Accounts Receivable 400 14 Adjusting journal entries
Supplies 1 500 Marshall Company’s annual accounting period ends on 30
$ 650 June 2019. Marshall makes adjusting journal entries semi-
Accounts Payable
annually, and the following information applies to all
Salaries Payable 1 900 necessary adjusting journal entries at 30 June 2019:
Retained Earnings 1 600 a Marshall carries the following two insurance policies:
Service Revenue 5 450
Policy Purchase Policy Cost at purchase
Salaries Expense 3 700 date length date
Supplies Expense  500 i 1 July 2017 5 years $50 000
Total $9 600 $9 600 ii 1 July 2018 2 years $20 000
b At 1 January 2019, office supplies totalled $1800. In the
REQUIRED past six months, additional supplies of $2700 were
Prepare Mark’s income statement and statement of retained purchased, and a count revealed $2150 available supplies
earnings for the month of June and his balance sheet at 30 at 30 June 2019.
June.
c Marshall owns one building:
LO4 Cost Useful life Annual depreciation
11 Closing entries
Patrick Lawn and Order generates and records $45 000 of $150 000 25 $6 000
revenues and $36 000 of expenses during the month. It also d Marshall decides to rent out a portion of its building. On
pays and records $1500 in dividends for the month. 1 June 2019, Marshall received a prepayment of $5700
REQUIRED for rent for the months of June, July and August.
Prepare Patrick’s closing entries for the month and
determine the net change in retained earnings because of
those entries.

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76 ACCT3 Financial
e The Marshall staff consists of seven employees. Each
LO1, 2, 3, 4
employee earns a total of $1200 a week and is paid each 17 Match terms and definitions
Monday for the previous week’s work. 30 June 2019, The following is a list of various accounting terms and
falls on Thursday. definitions:
REQUIRED i Accrued expense
Prepare all necessary adjusting entries at 30 June 2019. ii Accrued revenue
iii Deferred revenue
15 Adjusting journal entries LO2, 3 iv Adjusting journal entries
v Cash basis of accounting
Tammy, a first-year accountant at Violinda, has asked you to
vi Deferred expense
review the following items for potential errors. Violinda has a
31 December year-end. vii Accrual basis of accounting
i Did not adjust the Prepaid Insurance account for the viii Closing process
$7700 of insurance that expired during the year. ix The final step in the accounting cycle whereby all
ii Recorded a full year of accrued interest on a $20 000, revenue, expense and dividend account balances are
10 per cent note payable that was entered into on 1 transferred to the Retained Earnings account.
July (6 months ago). Interest is payable each 1 July. REQUIRED
iii Did not record $10 000 of depreciation on an office Match accounting terms (i) to (ix) with the appropriate
building. definition below:
iv Recorded revenues of $16 500 when payment was a Cash is received before revenue is earned.
received for a job that will be completed next year.
b Cash is paid before expense is incurred.
v Recorded $900 of electricity expense for December
even though Violinda will not pay the bill until January c Expense is incurred before cash is paid.
of next year. d Revenues are recorded only when cash is received, and
vi Fees due from customers amounting to $4050 are expenses are recorded only when cash is paid.
not included in the accounts. e Entries made into the general journal at the end of an
accounting period that record previously unrecorded
REQUIRED
revenues or expenses.
Determine if Tammy made any errors in the six items. For
f Revenues are recorded only when they are earned, and
those in which an error was made, prepare the entry that
expenses are recorded only when they are incurred.
Tammy should have made. What was the net effect of
Tammy’s errors on the income of Violinda? g Revenue is earned before cash is received.

LO4
16 Closing process
A partial adjusted trial balance for Sebastian Empanadas is
shown as follows:
PROBLEMS
Sebastian Empanadas
Partial adjusted trial balance
30 June
Debit Credit
Retained Earnings $17 150 LO1, 2
18 Cash and accrual income
Sales Revenue 30 500
Golden Gloria Time Ltd keeps records under the cash basis
Advertising Expense $  1 200 of accounting rather than the accrual basis. Gloria’s 2020
Depreciation Expense 10 750 income statement and additional data from 2019 and 2020
are as follows:
Interest Expense 560
Salaries Expense 5 000 Golden Gloria Time Ltd Cash-Basis
Supplies Expense 2 500 Income statement
for the year ending 31 December 2020
Utilities Expense 2 080
Revenues $54 000
Dividends 1 000
Expenses 35 000
REQUIRED Profit $19 000
a Prepare Sebastian Empanadas’ income statement and
statement of retained earnings for the month of June.
b Prepare the appropriate closing entries at 30 June.
c What is the purpose of ‘closing the books’ at the end of
an accounting period?

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 4 Accrual accounting and adjusting entries 77
 Additional information: REQUIRED
Prepare all necessary adjusting entries for the month of
31 December 31 December
September and prepare an adjusted trial balance as of 30
2019 2020
August.
Accrued Revenues 6 000 8 000
Deferred Revenues 13 000 4 500 LO2, 3, 4
20 Adjusting entries and closing entries
Accrued Expenses 5 000 4 000 The unadjusted and adjusted trial balances of Lee
Deferred Expenses 10 000 9 500 Enterprises are as follows:

All accrued revenues and expenses as of 31 December Lee Enterprises

Trial balance
2019 were collected and paid, in 2020. All deferred revenues 30 June
and expenses as of 31 December 2019 were earned and
used, in 2020. Unadjusted Adjusted
Debit Credit Debit Credit
REQUIRED
Cash $ 3 500 $ 3 500
Convert revenues and expenses from the cash basis to the
accrual basis and recalculate income. Briefly explain why Accounts 8 250 10 750
each adjustment is made. Receivable
Prepaid Insurance 4 600 3 400
LO2, 3
19 Adjusting entries and trial balance Supplies 600 200
The unadjusted trial balance of Amy Tran Spa is shown as Buildings 165 000 165 000
follows:
Land 75 000 75 000
Amy Tran Spa Accumulated $ 15 000 $ 31 500
Unadjusted trial balance Depreciation
30 August
Accounts Payable 9 950 11 000
Debit Credit
Salaries Payable 0 1 800
Cash $  4 300
Unearned 12 050 10 050
Supplies 2 250 Revenue
Equipment 18 000 Notes Payable 50 000 50 000
Accumulated Depreciation 2 400 Contributed 100 000 100 000
Unearned Revenue $ 1 500 Capital
Notes Payable 10 000 Retained 34 600 34 600
Contributed Capital 10 000 Earnings

4 000 Service Revenue 48 550 53 050

Service Revenue
Advertising Expense 650 Advertising 5 600 5 600
Expense
Depreciation Expense 1 200
Depreciation 16 500
Interest Expense 400 Expense
Salaries Expense 600 Insurance 1 200
Dividends 500 Expense

 Totals $27 900 $27 900 Salaries Expense 7 600 9 400

Supplies Expense 400
Additional information: Electricity 1 050
i on 30 August, Amy completed a service for which it Expense
had received payment in August, $1500
Totals $270 150 $270 150 $292 000 $292 000
ii on 30 August, Amy determined that she had earned
but not yet billed (invoiced) revenues of $500 REQUIRED
iii monthly depreciation on Amy’s equipment is $150 a Compare the two trial balances and recreate all adjusting
iv the interest rate on the promissory note is 6 per cent journal entries that were made at 30 June.
v a count of the supplies revealed $500 of supplies b What is the net effect of the adjusting journal entries on
remaining on 30 August total income (profit or loss)?
vi received an advertising bill to be paid next month of
$400
vii assume the trial balance was last adjusted on 31 July.

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78 ACCT3 Financial
 LO2, 3 LO2, 3, 4, 5
21 Adjusting entries and financial 22 The accounting cycle
statements Johnvo Photography was founded on 1 April and entered
The 30 June unadjusted trial balance of Ly & Thai Tutoring into the following transactions:
appears as follows:   1st Issued shares to shareholders in exchange for
$100 000 cash.
Ly & Thai Tutoring   1st Purchased a camera (equipment) for $65 000.
Unadjusted trial balance
30 June   1st Purchased supplies for $2000.
Debit Credit   1st Purchased a one-year insurance policy to be
consumed evenly over the next period, to be paid
Cash $  6 900
next month – $3700
Accounts Receivable 4 500   1st Took out a loan from First Bank for $100 000.
Prepaid Rent 6 300   6th Hired two new employees on salary of $4000 a
Supplies 2 250 month each.
Equipment 18 000   6th Received prepayment for a contracted job to be
$ 900 performed in May – $22 500.
Accumulated Depreciation
  8th Billed customers for services provided – $42 000.
Unearned Revenue 1 500
12th Paid to have an ad placed on website during
Notes Payable 10 000 April – $7000.
Contributed Capital 8 000 18th Billed customers for services provided – $34 000.
Retained Earnings, 1 April 12 200 24th Paid dividends to shareholders – $5000.
Service Revenue 11 200 30th Prepaid the next six months of rent starting with
May – $18 000.
Advertising Expense 650
Additional information:
Depreciation Expense 900
i April depreciation for the delivery van is $1085
Interest Expense 150 ii Interest on the loan from the bank is paid annually at
Rent Expense 2 100 a rate of 6 per cent
1 700 iii Prepaid insurance has expired
Salaries Expense
iv Employees’ salaries earned during April but to be
Dividends  350
paid in May.
Totals $43 800 $43 800
REQUIRED
Additional Information: a Journalise the transactions for the month of April.
i rent expires (is used up) at a rate of $800 per month b Post the journal entries to the general ledger using
T-accounts.
ii monthly depreciation on equipment is $600
iii interest on the 6 per cent promissory note is paid c Prepare a trial balance as of 30 April.
biannually on 1 July and 1 January d Prepare all necessary adjusting journal entries and post
iv performed services for which payment was received the entries to the appropriate T-accounts.
in April of $800 e Prepare an adjusted trial balance as of 30 April.
v received electricity bill for $600 to be paid next month f Prepare an income statement and a statement of
vi services to customers earned $2000 during June but retained earnings for the month of April. Also prepare a
was unrecorded at 30 June classified balance sheet as of 30 April.
vii supplies on hand totalled $1000 at 30 June g Prepare all closing entries for the temporary accounts
viii owed employees for salaries totalling $900 for the and post the entries to the appropriate T-accounts.
last week of June to be paid in July h Prepare a post-closing trial balance as of 30 April.
ix Ly & Thai Tutoring prepares adjusting entries each
quarter. Adjustments were last made on 31 March.
REQUIRED
a Prepare all adjusting journal entries for the quarter
ending 30 June. CASES
b Post journal entries to T-accounts using totals on the
unadjusted trial balance as the opening balances.
c Prepare an adjusted trial balance as of 30 June.
d Prepare an income statement and a statement of
retained earnings for the three months ending 30 June.
23 Locate and understand accounting information
e Prepare a classified balance sheet as at 30 June.
Access the latest annual report for Qantas (perform an
internet search for ‘Qantas Annual Report’)

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CHAPTER 4 Accrual accounting and adjusting entries 79
 REQUIRED a product recall of Mohammad Kebab’s Kebab line. Richard
Review the first note to the financial statements and answer Yalda the CEO recently approached Sadek Ahmed the chief
the following questions: accountant, about the inevitable losses next year and asked
Sadek to defer all possible revenue until next year and to
a When does Qantas recognise expenses from frequent
accrue all possible expenses to the current year. ‘We have
flyer points? Where does it report ‘redemption revenue’?
so much revenue to spare this year,’ Richard said, ‘but next
Is this an example of a deferred or accrued revenue?
year, we will need all the help we can get’.
b When does Qantas recognise passenger and freight
revenues? REQUIRED
c When does Qantas recognise revenues from members’ a What ethical issues are involved in this scenario?
fees? b If Richard gets his way, what accounting principles
d How does Qantas recognise employee benefits? would be violated?
c Some may say that Richard is simply managing his
24 Communication activity earnings like he manages all other aspects of the
business. What is your opinion of ‘earnings
You are the chief financial officer of a top-tier firm and the
management’ of this kind?
date is 30 June. You recently asked the new accountant to
prepare the initial draft of the financial statements for your
review. However, when you received the draft, you quickly 27 Ethics and adjusting entries
noticed that no adjusting journal entries were made. You are the service manager with a major company. When
you sell a service, the customer pays cash and you provide
REQUIRED
the service. At the end of each year, you are required to
Write a short memo explaining the importance of adjusting estimate how much of each outstanding service contract
entries and the potential misstatements that can result from has been earned. At year-end, you have $1 million of
their exclusion. outstanding contracts. You estimate that you have earned
somewhere between 45 per cent and 55 per cent of those
25 Communication activity contracts.
You are studying for your mid-term accounting exam with REQUIRED
your friend, Andrew. He is struggling and says, ‘I can never
Under the following independent conditions, identify the
understand why adjusting entries are so important; you just
amount of outstanding contracts that you would report
debit/credit cash, right?’
earned. Explain why you would report those amounts.
REQUIRED a Your compensation is based on performance and you are
Explain the importance of adjusting entries using accounting $550 000 short of your quota before your estimate.
concepts and address why the cash account is never b Your compensation is based on performance and you are
involved in any adjusting journal entries. $450 000 short of your quota before your estimate.
c Your compensation is based on your group’s
26 Ethics and adjusting entries performance, and while you have met your quota before
Mohammad’s Kebabs is a leading server of halal food. your estimate, the group needs $600 000 to meet the
During the current year, it was on target to have record group quota.
increased revenues and profits. However, towards the end
of the current year, it was found that a quantity of the food
was not halal certified, which resulted in some lawsuits and

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80 ACCT3 Financial
 5
1
This chapter examines the concepts of internal control and
how those concepts affect the accounting for cash. Internal
control is a company-wide process that seeks to improve
a company’s operations and financial reporting and to
protect its assets.There are few assets that are more prone
to theft than cash, so internal control is extremely relevant
and important to the accounting for cash.
This chapter begins with the role and overall concepts
of internal control and then examines two control activities

Cash and internal relating to cash: bank reconciliations and petty cash funds.
The chapter concludes with how cash is reported and how

controls a company’s cash position can be analysed.

LO1 INTERNAL CONTROL

LEARNING
OBJECTIVES A report prepared by forensic accounting firm Warfield &
Associates, Employee fraud in Australian financial
institutions, found Australian bank workers have taken from
the employer over $200 million in the past decade, with
After studying the material in this chapter, you gambling addiction being given as the primary reason.1
should be able to: Other cases, like the nearly $20 million taken over a two-year
1 Identify the role of internal control period by an accountant at (former) retailer Clive Peters,
in a business. illustrate the importance of good controls over the asset
2 Describe five components of cash. The accountant was sentenced to eight years in prison.
internal control. In recent years, there have been numerous widely
publicised accounting frauds. Major corporations such as
3 Understand two methods of internal control HIH Insurance in Australia and Enron in the US failed as a
over cash – bank reconciliations and petty
result of fraudulent activity. Many began to question the
cash funds.
reliability and integrity of financial reporting of publicly listed
4 Appreciate the reporting of cash and cash companies.
equivalents. Faced with this crisis, the Australian Government
5 Analyse cash through the calculation and passed the Corporate Law Economic Reform Program
interpretation of horizontal, vertical and (Audit Reform and Corporate Disclosure) Act (CLERP 9) in
ratio analyses and free cash flow. July 2004. The act sought to restore public confidence in
financial reporting by strengthening auditor independence
and enhancing financial reporting. At the heart of auditing
and financial reporting is internal control.
In its broadest sense, internal internal control  The
control is the process that a company’s system of policies and
management uses to help the company procedures used in a
company to promote
meet its operational and financial efficient and effective
reporting objectives. More specifically, operations, reliable financial
reporting and compliance
internal control is the system of policies with laws and regulations.
and procedures that a business
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Throughout this PPL HIS reasonable assurances Check out the video summary
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chapter apply this for Chapter 5

that:
icons indicate
an opportunity ● the company’s operations are effective and efficient
for online ● the company’s financial reporting is reliable
self-study through ● the company is complying with applicable laws and
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regulations.
linking you to revision
quizzes, e-lectures, All companies have systems of internal control. The only
animations and more. question is how strong or weak those systems are.
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81
 In 1992 the Committee of Sponsoring Organizations
Getty Images/Ulrich Baumgarten

(COSO) of the Treadway Commission released a report

called Internal control – integrated framework. The report
was the culmination of the committee’s exhaustive
research and deliberation on the elements of sound internal
control. The committee’s objective was to provide a
common understanding of internal control – a framework
for implementing good internal control practices. Its
success is clear. The framework has become the standard
for understanding what good internal control looks like
For CSL, selling medicines is easily seen as the way a biotechnical in an organisation, and it is the YT
PPL HIS
company earns revenue, but equally important are internal control

A
processes, especially the physical protection of its products basis for the discussion in this Review this content
chapter. with the e-lecture

Recognising that internal control affects a company’s

success or failure, the Sarbanes-Oxley Act of 2002 in the
United States contained several new requirements for
LO2 COMPONENTS OF
publicly traded companies regarding internal control. One INTERNAL CONTROL
of the most important requirements was that corporations
include in their annual reports to shareholders an internal The broad purpose of internal control is to help management
control report. To illustrate management’s responsibility for achieve effective and efficient operations, reliable financial
internal control, Exhibit 5.1 contains an excerpt from the reporting and compliance with laws and regulations.
Institute of Chartered Accountants in Australia Limited Internal control – integrated framework states that good
(now known as Chartered Accountants Australia and New internal control consists of the following five interrelated
Zealand) non-financial information assurance report. A components:
similar statement is also contained in the independent ● control environment
auditor’s report on the financial information. You can see ● risk assessment
from the audit report that the Institute’s management is ● control activities
responsible for its internal control. ● information and communication
● monitoring.

CONTROL ENVIRONMENT
The control environment is the control environment 
The Responsibility of Management
for the Report
foundation for all other components of The atmosphere in which
internal control. It is the atmosphere in the members of an
The management of the Institute is responsible for the organisation conduct their
preparation and presentation of the non-financial information which the members of an organisation activities and carry out their
in accordance with the subject matter and criteria set out in conduct their activities and carry out their responsibilities.
the basis of preparation on page 43 of the annual report. This
responsibilities. The control environment
responsibility includes establishing and maintaining internal
controls relevant to the preparation and presentation of the is often called the ‘tone at the top’ because it reflects the
non-financial information in the annual report that is free from overall control consciousness of an organisation.
material misstatement, whether due to fraud or error; selecting Many factors affect an organisation’s control
and applying specific principles, methodologies, policies and
data sources used to prepare and present the information; and environment. One of the most important is the overall
reporting targets that are reasonable, when appropriate. integrity and ethical values of personnel. These attributes
Ernst & Young translate into standards of behaviour that can permeate
Meredith Scott throughout an organisation’s operations. Other factors
Partner include management’s philosophy and operating style, the
Sydney 30 August 2011 assignment of authority and responsibility, and the general
structure of an organisation. Each of these factors
EXHIBIT Limited assurance report ICAA contributes to the overall corporate culture within which
5.1
internal control operates. Without a sound control
This information was sourced from the Institute of Chartered Accountants in Australia. Copyright © The Institute environment the remaining elements of internal control
of Chartered Accountants Australia 2014. All rights reserved. We encourage you to check the ICAA website for
any updates to this information, http://www.charteredaccountants.com.au. suffer.

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82 ACCT3 Financial
 CONTROL ACTIVITIES
ANALYSIS
Look at the report of the Control activities are the policies and control activities  The
independent auditor accompanying CSL’s financial procedures that management establishes policies and procedures
statements in Appendix B. What was the auditor’s opinion to address the risks that might prevent established to address the
risks that threaten the
regarding the effectiveness of CSL’s internal control?
the organisation from achieving its achievement of
Analysis: objectives. Although specific control organisational objectives.
In Australia, unlike the United States, the auditor does
not express an opinion on the adequacy of the internal activities vary widely across organisations,
control system. The auditor only states: they generally fall into one of several categories:
The directors of the company are responsible for the ● establishing responsibility
preparation of the financial report … and for such ● maintaining adequate documentation
internal control as the directors determine is necessary
● segregation of duties
to enable the preparation of the financial report that
gives a true and fair view and is free of material ● physical security
misstatement, whether due to fraud or error.2 ● independent verification.

Establishing responsibility
RISK ASSESSMENT A critical factor in good internal control is establishing
All organisations face a variety of risks that threaten the responsibility for the performance of a given task. When
achievement of the objectives. Risk responsibility is clear, two benefits arise. First, the employee
risk assessment  knows that they will be held accountable for completion of
The identification and assessment refers to the identification
analysis of the risks that and analysis of these risks, with the goal the task. Second, management knows who to consult if
threaten the achievement the task is not completed satisfactorily.
of organisational objectives. of effectively managing them. Because
business conditions change over time, A good example is a retailer’s cashiers. Each cashier is
risk assessment is an ongoing activity for any organisation. assigned sole responsibility over a specific cash drawer.
Risks in any organisation can arise from both external No other cashier has access to or responsibility for that
and internal sources. External sources might include new drawer. If a drawer is returned to the office short of cash,
competitors, changing customer expectations or even management knows exactly which cashier to speak to. As
natural catastrophes. Internal sources might include a result, cashiers are motivated to perform their tasks well,
inadequate workforce training, errors in financial reporting and the risk of theft or error is reduced.
of activities or theft of assets by employees.
Maintaining adequate documentation
Once an organisation identifies its risks they can be
Accounting information is useful only when it is reliable,
analysed with the following general process:
which means that it must be free from error. Control
1 Estimate the significance of a risk.
activities are necessary in all organisations to promote
2 Assess the likelihood of the risk occurring.
error-free accounting records. Consider the sale of a
3 Consider what actions should be taken to manage
company’s inventory as an example. Good control practices
the risk.
would require that the sale be documented on a sales
In CSL’s 2017 Annual Report ten risks are listed (e.g.
invoice, preferably sequentially numbered so that the sale
healthcare industry risk, manufacturing and supply risk,
will neither be lost nor recorded twice. The invoice might
market practice risk, to name a few) along with Key risk
also require the employee’s password (or card swipe) to
management for each.3
establish responsibility for the sale, and it will have multiple
Minor risks are those with a lower likelihood of
copies to be sent electronically throughout the organisation
occurrence that generally do not warrant serious concern.
for proper fulfilment and recording of the sale.
For example, the risk of a meteorite destroying a company’s
warehouse can likely be ignored. In contrast, significant Segregation of duties
risks with higher likelihood demand considerable attention. Segregation of duties is a technique that limits one person’s
For example, the risk of an employee stealing cash requires control over a particular task or area of a company. Often
more attention. That attention comes in the form of control called separation of duties, it is accomplished by spreading
activities.
responsibility among multiple employees so that one
employee’s work can serve as a check against another’s
work. For example, consider the process of ordering,
receiving and paying for inventory. If one employee handles
all three tasks, there is greater risk of error and possibly
theft of assets. However, if these three tasks are handled

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CHAPTER 5 Cash and internal controls 83
 by different employees, errors by one employee can be daily responsibilities, supervisors can check for evidence
caught by another employee. Moreover, unless the that a control activity is functioning properly. They can also
employees work unethically together (collude), company ask employees if they understand the controls in place and
assets are more protected against theft. if those controls are being completed. The second is
through a separate evaluation. In both ways, the purpose
Physical security of monitoring is to continuously improve internal control.
Good internal control includes an effort to safeguard
company assets and records. Most of these safeguarding LIMITATIONS OF INTERNAL CONTROL
controls are meant to prevent the loss of assets. Examples
Regardless of how well internal control is designed within
include secured facilities, fire and alarm systems, computer
an organisation, it can provide only reasonable assurances
passwords and encryption, video monitors and door
that a company is meeting its objectives. Internal control
sensors that signal when product is inappropriately taken
systems are limited in their effectiveness because of the
from a store. This is particularly important for a biotechnical
human element and cost–benefit analysis.
company where the product often has restrictions on
The human element refers to the fact that internal
availability to the general public. Other controls are meant
controls are often based on human judgement and action.
to detect the loss of assets. An example is the periodic
Despite our best efforts, we all make mistakes at times
counting of inventory for comparison to accounting records.
and internal control cannot eliminate them all. Furthermore,
Significant discrepancies can then be investigated.
employees can deliberately circumvent controls for
Independent verification personal gain. Sometimes this will be a manager who
Independent verification is the process of reviewing and overrides the control activities in place. Other times this
reconciling information within an organisation. This is will be multiple employees working together to circumvent
particularly useful when reconciling an asset balance with (get around) existing controls. Such collusion among
the accounting records for that asset. An example would employees can be very effective at defeating a company’s
be a bank reconciliation, where the bank’s cash balance internal controls.
and the company’s cash balance are reconciled. Often, the Cost–benefit analysis refers to the cost of implementing
most effective verifications are conducted on a surprise a control activity versus the benefit that the control
basis and are conducted by individuals who have no provides. For example, a company could install retina-
connection to the process or the employee being verified. scanning security systems for its warehouses to decrease
Internal audit divisions of organisations commonly perform the risk of theft. However, the cost of the installation may
such verifications. far outweigh the marginal advantage that retina-scanning
security provides over normal lock-and-key security. Further,
INFORMATION AND COMMUNICATION retina-scanning may be seen as too personally intrusive,
and a non-biotechnical physical access system such as a
Information and communication is another element of
staff card may be the compromise. A record of each card
sound internal control. Information and communication
tapped is recorded but without the added security of
refers to the need for the open flow of
knowing a lost or borrowed card is being used.
information and relevant information throughout an
communication 
Required for the open organisation. Information must be
flow of relevant captured and communicated in a form
information throughout an
and a timeframe that enables employees
LO3 CASH CONTROLS
organisation.
to complete their responsibilities. This
requires information systems that produce relevant and The best asset to use in demonstrating internal control is
reliable reports. It also requires both upward and downward cash. Cash is a highly desired asset. It is easily concealed,
lines of communication. Management must communicate taken and converted into other assets with only a small
with employees, and employees with management. chance of detection. As a result, companies normally
institute many controls to safeguard their cash and to
MONITORING report it properly. Electronic transfer of cash, either
physically by cards or online have their own controls:
monitoring  Monitoring refers to the assessment of passwords, PIN, SMS authorisation code, security
The assessment of the the quality of an organisation’s internal questions, etc.Two of these controls are bank reconciliations
quality of an control. Monitoring can be accomplished
organisation’s internal and petty cash funds. Each is discussed in the following
control. in two ways. The first is through ongoing sections.
activities. For example, in their recurring

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84 ACCT3 Financial
 BANK RECONCILIATIONS The first reason relates to deposits and payments made
by the business that are not reflected on the bank
Most businesses keep the majority of their cash in a bank.
statement. For example, a deposit in deposit in transit
This in itself is a good control procedure because it limits
transit is a deposit that has been made A deposit that has been
opportunities for theft – it is clearly more difficult to steal
by the company but does not appear on made by the business but
has not cleared the bank
cash when it is locked up in the bank. The use of a bank
the bank statement because it had not as of the statement date.
also provides two sources of opposing record keeping; the
cleared the bank as of the statement
liability the bank has to the customer and the asset the
date. Because the cash is now in the bank, deposits in
customer has at the bank. That is, both the business and
transit should be added to the bank’s cash balance. An
the bank keep a record of all cash transactions between
outstanding cheque is one that has outstanding cheque
them. As a result, a business (company) can compare
been distributed by the business but does A cheque that has been
these records to verify its cash balance. This comparison distributed by the business
not appear on the bank statement but has not cleared the
is called a bank reconciliation.
because it had not cleared the bank as of bank as of the statement
A bank reconciliation is the process
bank reconciliation the statement date, often because it has date.
The process of of recognising and noting the differences
not been deposited by the recipient.
reconciling the differences between the cash balance on a bank
between the cash balance Because the cash is no longer in the bank, outstanding
on a bank statement and statement and the cash balance in a
cheques should be subtracted from the bank cash balance.
the cash balance in a business’ records (at its simplest the
business’ records. As we move to a ‘cashless’ society these are becoming
‘cash’ ledger T-account). The purpose of a
less common.
bank reconciliation is twofold. First, it
confirms the accuracy of both the bank’s and the business’
cash records and updates the business’ records. Second,
it determines the actual cash balance to be reported on the
business’ balance sheet. A bank reconciliation is prepared
as follows:
1 Reconcile the bank balance to the actual cash balance. A cheque is an order to a bank to pay a stated sum from the
2 Reconcile the business’ book balance to the actual cash drawer’s account, written on a printed form as above
balance.
3 Adjust the business’ book balance to the actual cash
The second reason relates to errors made by the bank.
balance.
Although bank errors are rare, they do occur and must
Reconciling the bank balance also be reconciled. An error can result in the need to add
to or subtract from the bank balance. For example,
The first step in a bank reconciliation is to adjust the cash
suppose that the bank erroneously records a $1450
balance reported on the bank statement to the business’
deposit as $1540; the bank balance is overstated by $90
actual cash balance. The bank balance will differ from the
and should therefore be reduced by $90. In contrast,
actual cash balance and will therefore need adjustment for
suppose that the bank records a $100 cheque as $10; in
two main reasons.
that case, the bank balance is understated by $90 and
should be increased $90.
AAP Image/Tom Compagnoni

Once all adjustments to the bank balance are made, the

adjusted bank balance should equal the actual cash balance
to be reported on the statement of financial position.

Reconciling the business book

(ledger account) balance
The second step in a bank reconciliation is to adjust the
cash balance reported on the business’ books to the actual
cash balance. The business book balance is likely to differ
from the actual cash balance and therefore needs
adjustment. There are two main reasons for this. The first
reason relates to bank activities that change a business’
cash balance but have not been recorded by the business.
The bank may notify the business of an addition to the cash
Records of cash are kept by both the business and the bank balance on the bank statement. Conveniently called credit

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CHAPTER 5 Cash and internal controls 85
 memoranda, they arise when the bank collects cash on 3 The 31 March bank statement shows the collection of
behalf of the business – often through the collection of a a $550 receivable from one of Chapman’s customers
business receivable or interest on a note. (Most deposits and a $50 monthly service fee. Chapman had not
in the business’ bank accounts have an Electronic Funds recorded either of these two items.
Transfer [EFS] Code and these deposits are regularly Resolution: The collection is a credit memorandum.
supplied to the business by the bank and automatically Add it to Chapman’s cash balance. The fee is a debit
update the business’ accounting records for both the memorandum. Subtract it from Chapman’s cash
amount and the entity paying. It is only deposits not balance.
covered by the standard EFS that are included in the bank 4 The 31 March bank statement shows that a $220
reconciliation.) These should be added to the business’ customer cheque was returned to the bank for
book balance. A debit memorandum is notification of a non-sufficient funds (NSF). This is commonly known as
subtraction from the cash balance on the bank statement. a ‘bounced’ cheque. Chapman had not recorded
Common examples are fees charged for banking services this item.
and customer cheques returned for insufficient funds. Both Resolution: The NSF cheque is a debit memorandum
of these examples reflect cash that the business no longer because no cash was received from the customer’s
has, so they should be subtracted from the business’ book cheque that Chapman deposited earlier. Subtract it from
balance. With online banking, bank account balances are Chapman’s cash balance.
available at any time. The second reason relates to errors 5 A cheque clearing the bank for $400 was erroneously
made in the business’ cash records. For example, suppose recorded in Chapman’s records at $450. The cheque
that during the reconciliation a business discovers that it was written to pay off an open account payable.
erroneously recorded a cheque it had written for $1000 as Resolution: Chapman recorded $50 too much for the
only $100. The business’ balance is overstated by $900 and cheque. Therefore, Chapman’s cash is understated by
should be reduced by $900. $50. Add the $50 to Chapman’s cash balance.
Chapman’s resulting bank reconciliation is shown as
Adjusting the cash balance follows. The top half shows the reconciliation of the bank
Once the bank balance and the business’ book balance are balance while the bottom half shows the reconciliation of
reconciled, the business’ cash balance must be adjusted the business’ book balance:
to the actual cash balance determined by the reconciliations.
Therefore, the third step in a bank reconciliation is to record Chapman
Bank reconciliation
the journal entries necessary to adjust the business’ book 31 March
balance to the actual cash balance. The journal entries Balance per bank statement $49 880
are based on the credit and debit memoranda, and Add deposits in transit:
YT errors identified during
PPL HIS
30 March $6 450
A

Check out the animated summary the reconciliation of the

on Bank Reconciliation 31 March   1 236 7 686
business’ balance.
Deduct outstanding cheques:
BANK RECONCILIATION EXAMPLE No. 1987 $  589
No. 1991   2 080   2 669
To illustrate a bank reconciliation, suppose that Chapman
Enterprises maintains an account with Murray River Bank. Actual cash balance $54 897
At the end of March, Chapman shows a cash balance of Balance per business records $54 567
$54 567 while Murray River shows a balance of $49 880. Add:
The differences result from the following: Collection of receivable $ 550
1 Deposits of $6450 on 30 March and $1236 on 31 March Error by Chapman   50 600
do not appear on the 31 March bank statement since Deduct:
they had not cleared the bank as of 31 March.
Monthly service charge $  50
Resolution: These are deposits in transit. Add them to
NSF check   220     270
the bank balance.
Actual cash balance $54 897
2 Cheques written in late March for $589 (Cheque #1987)
and $2080 (#1991) do not appear on the 31 March bank Both reconciliations correctly show an actual cash
statement since they had not cleared the bank as of 31 balance of $54 897. To adjust the business’ cash balance to
March (probably yet to be deposited by the recipient). that actual balance, the following entries must be made.
Resolution: These are outstanding cheques. Subtract Note that each of the four entries comes from the four
them from the bank balance. adjustments made in the reconciliation of the book balance
to the actual balance.
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86 ACCT3 Financial
Entry #1: Collection of the receivable After these four entries are recorded, the business’
cash balance is updated to the actual cash balance.
Chapman updates its cash balance to reflect the bank’s
collection of the receivable.
PETTY CASH FUNDS
31 Mar. Cash 550
Most companies require that all disbursements of cash be
  Accounts Receivable 550 made with an authorised electronic transfer or double-
  (To record the collection of a receivable by the bank) signed cheque. This is a basic control activity that allows a
Assets = Liabilities + Equity business to better monitor its cash outflows. However,
+550 there are many instances when only a minor amount of
cash is needed and the process of writing a cheque is
–550
burdensome or a cheque is not accepted. Examples would
include postage for small mailings and the purchase of
Entry #2: Correction of error miscellaneous office supplies. To handle such cases, a
Chapman corrects the error made when the $400 cheque business may establish a petty cash fund.
was recorded for $450. This requires Chapman to add back A petty cash fund is an amount of petty cash fund
to both cash and accounts payable. cash kept on hand to pay for minor An amount of cash kept
expenditures. While the size and scope of on hand to pay for minor
expenditures.
31 Mar. Cash 50 a petty cash fund will vary across
  Accounts Payable 50 businesses, its operation will involve the
   (To correct error)
following three activities:
● establishing the fund
Assets = Liabilities + Equity
● making payments from the fund
+50 +50 ● replenishing the fund.

Entry #3: Monthly service charge Establishing the fund

Chapman records the monthly service charge as an A petty cash fund is established by writing a cheque for the
expense. As a result, both assets and equity decrease. amount of the fund, cashing the cheque and placing the
cash under the care of an employee designated as
31 Mar. Service Charge Expense 50 custodian. A journal entry is then made to record the
 Cash 50 establishment of the fund.
  (To record monthly expense for bank account) To illustrate, suppose that on 1 May, The Valley School
(Valley) cashes a $100 cheque to establish a petty cash fund
Assets = Liabilities + Equity
and gives the cash to the custodian Thu Tran. On this date,
–50 –50
Valley would record the following entry.

Entry #4: Non-sufficient funds cheque 1 May Petty Cash 100

Chapman records the effect of a cheque returned for NSF  Cash 100
by reinstating the receivable (the customer still owes the    (To establish $100 petty cash fund)
money) and reducing its cash balance. Since the cheque Assets = Liabilities + Equity
was not valid, the receivable has not yet been collected. +100
Chapman must now try to collect again.
–100
31 Mar. Accounts Receivable 220
 Cash 220 The entry increases Petty Cash and decreases Cash.
Notice that there is no change in total assets. Valley has
   (To reinstate customer receivable)
simply designated $100 to be used in a petty cash fund.
Assets = Liabilities + Equity
Valley still has its cash. It has not yet disbursed any cash
+220 outside of the business.
–220
Making payments from the fund
After the fund is established, the cash is used to pay for
qualifying expenditures. Payments are usually made in one
of two ways: cash can be taken from the fund to make
payment or employees can seek reimbursement from the

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CHAPTER 5 Cash and internal controls 87
 fund for payments they have personally made. In either 31 May Postage Expense 25
case, the custodian should collect receipts and
Supplies Expense 47
authorisations for the use of any cash. As payments are
Miscellaneous Expense 13
made from petty cash, no journal entries are made. Journal
entries are recorded only when the fund is replenished.  Cash 85
  (To replenish petty cash fund and record
various expenses)
iStock.com/hidesy

Assets = Liabilities + Equity

–85 –25
–47
–13

The entry increases the three expense accounts related

to the expenditures and decreases the Cash account for
the amount of the cheque. Because Valley is recording the
expenses resulting from fund use, the entry reduces both
assets and equity. This same type of entry would be
repeated each time the fund is replenished.

Cash, petty or otherwise, is a vulnerable asset of any business and

needs protecting
Cash over and short
When a petty cash fund is replenished, the amount of cash
needed for replenishment should equal the total amount of
Replenishing the fund receipts. However, this will not always be the case.
As the cash in the fund decreases, the fund must be Sometimes, the custodian will not obtain all receipts or will
replenished. To do so, the remaining cash in the fund is give incorrect change, resulting in a discrepancy between the
counted and the business cashes a cheque for the amount cash needed for replenishment and the amount of receipts.
that brings the total cash in the fund back to the original In such cases, the discrepancy is charged to an account called
balance. The receipts in the fund are then used as Cash Over and Short. Cash Over and Short is a temporary
documentation for recording expenses. account that can have either a debit or credit balance,
To illustrate, suppose that on 31 May, Tran examines depending on the situation. A debit balance increases
the petty cash fund and prepares the following report. expenses while a credit balance decreases expenses.
Many businesses have done away with petty cash and
The Valley School
require employees to spend their own money and seek
Petty cash fund replenishment report
electronic reimbursement. In some cases employees are
Petty cash fund $100 issued with a business credit card and are required to
Less: cash remaining in the fund   15 justify and receive authorisation for any purchases after
Cash requested to replenish fund $ 85 they are made. Business credit cards cannot prevent
Receipts in the fund: unauthorised expenditure, but YT
PPL HIS
A

it can easily be detected and the Review this content

Postage $ 25 with the e-lecture
employee held to account.
Office supplies 47
Miscellaneous   13
Total receipts $ 85
LO4 REPORTING CASH AND
The report shows that the fund needs $85 to be fully CASH EQUIVALENTS
replenished. It also shows that there are receipts totalling
$85. As a result, Tran would cash a cheque for $85 to At its most basic level, cash is a medium cash  A medium of
replenish the fund and record expenses as follows: of exchange. A general rule is that exchange.
something is cash if you can deposit it into
a bank and readily use it to pay someone. A credit card is
not cash although you can use it to buy goods and services;
it is access to a pre-arranged loan. A debit card is a means
of accessing cash and along with EFT has almost
completely replaced cheques.
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88 ACCT3 Financial
 In addition to these forms of cash, companies often cash position of CSL. The examination will require the cash
hold investments that are so much like cash that they are balance from the company’s balance sheet and various
deemed to be equivalent to cash. A cash equivalent is items from its cash flow statement.
any investment that is readily convertible
cash equivalent
Any investment that is into a known amount of cash and may be HORIZONTAL AND VERTICAL ANALYSES
readily convertible into limited to investments that have a
cash. A good place to start the analysis of any asset account is
maturity of a few months. Cash
horizontal and vertical analyses. Recall from Chapter 2 that
equivalents are so much like cash that they are combined
horizontal analysis calculates the dollar change in an
with cash for reporting purposes. In its annual report CSL
account balance, defined as the current-year balance less
states:
the prior-year balance, and divides that change by the prior-
Cash and cash equivalents are held for the purpose of year balance to yield the percentage change. Vertical
meeting short term cash commitments rather than for
analysis divides each account balance by a base account,
investment or other purposes. They are made up of:
• Cash on hand. yielding a percentage. The base account for an analysis of
• At call deposits with banks or financial institutions. cash is total assets. These calculations are summarised as
• Investments in money market instruments with follows:
original maturities of six months or less that are
readily convertible to known amounts of cash and KEY FORMULA 5.1 HORIZONTAL ANALYSIS
subject to insignificant risk of changes in value.4

Cash and cash equivalents are reported on the balance Dollar Change in = Current Year Balance −
sheet usually as the first current asset. Account Balance Prior Year Balance
Percentage Change = Dollar Change
in Account Balance Prior Year Balance
ANALYSIS
CSL’s balance sheet in Appendix B
reports Cash and Cash Equivalents
of $844.5 million in 2017. What has happened to the KEY FORMULA 5.2 VERTICAL ANALYSIS
balance over the previous 52 weeks?
Analysis: Cash
Percentage =
CSL’s Cash and Cash Equivalents have increased from Total Assets
$556.6 million in 2016 to $884.5 million in 2017; a
substantial increase of almost $328 million or almost
60 per cent. Given CSL’s information in Appendix B, horizontal and
vertical analyses of cash result in the following:
Alamy Stock Photo/CB_AusMoney

Horizontal analysis
Cash and Cash Equivalents increase $328m or 59% increase
2016 to 2017
Vertical analysis
2017 2016
Cash and Cash Equivalents 9.7% 7.4%

The horizontal analysis shows that CSL’s cash increased

significantly, by over $328 million in 2016–17, which equals
a 59 per cent increase over the prior year. The vertical
analysis shows that cash made up less than 10 per cent of
Most cash is held in bank deposits, not notes and coins
total assets in 2017. This was a smaller increase than the
YT
PPL HIS percentage increase from the prior year, because total
A

Download the Enrichment assets increased over 20 per cent for the year.
Modules for further practice While the preceding analysis shows that CSL’s cash
increased during 2017, it does not indicate how cash
increased. To find this out, investors and creditors can look
LO5 ANALYSING CASH at the information on the company’s cash flow statement.
Recall from Chapter 1 that the cash flow statement
A company’s management of cash is critical to its success. classifies a company’s cash inflows and outflows into three
If a company does not have enough cash, it can quickly run main categories: operating activities, investing activities
into major problems. The following sections examine the and financing activities.

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CHAPTER 5 Cash and internal controls 89
 Operating activities include those transactions property, plant and equipment (CSL would include
necessary to run the business. This would include selling intangible assets as the business is based as much on
a product, paying employees and advertising. According to intellectual property as buildings and equipment) during the
Exhibit 5.2, CSL generated almost $1250 million in cash year, or for a large diverse business such as CSL the net
from operations during 2017, which is over five per cent cash flow from investing activity. Dividends are payments
more than in 2016. to shareholders during the year. For CSL this also includes
Investing activities include the buying and selling of payments for share buy-backs (these are discussed in
revenue-generating assets. CSL reports a net cash outflow Chapter 11). Each of these items is found on the cash flow
of over $860 billion from investing activities in 2017. The statement.
majority of that outflow was to pay for property, plant and
equipment.
ANALYSIS
Financing activities include the raising and repayment
Using CSL’s financial statements in
of capital through debt and equity. During 2017, CSL both Appendix B, explain why Cash and
repaid loans ($581m) and borrowed ($1381m) for an Cash Equivalents as reported in the balance sheet is the
$800 million increase in borrowings. The majority of the net same as the closing figure reported in the cash flow
outflow from financing activities was to pay dividends (over statement.
$600m). From the bottom of the cash flow statement you Analysis:
can see cash over the period increased by $280 million. The cash figure in the balance sheet is obtained from the
balance in the Cash ledger account. The cash figure in the
CSL does not tell us why it increased its cash holdings, it
cash flow statement comes from the same information
even states that ‘liquidity and refinancing risks are not used to record the journal entries that were posted to the
significant’5, this may be due to the large cash holdings. Cash ledger account. Cash received from customers
would have been the result of (mostly) cash collected
FREE CASH FLOW from debtors (accounts receivable). The payments to
creditors (accounts payable), employees etc., are
A company needs to generate enough cash to pay its bills. recorded as a credit to cash. The cash flow statement
It also needs to generate enough to maintain its operating shows the detail of the transactions involving cash and
assets and to reward its shareholders with dividends. If a concludes with the closing balance. The balance sheet
shows only the final cash balance.
company can generate more cash than it needs for these
commitments, it is generating free cash flow.
Free cash flow is the excess cash a From the information in Exhibit 5.2, CSL’s free cash
free cash flow  The
excess cash a company company generates beyond what it flow for 2017 and 2016 is calculated as follows (rounded to
generates beyond what it needs to invest in productive capacity the closest $ million):
needs to invest in
productive capacity and and pay dividends to shareholders. That
Free cash flow
pay dividends to is, free cash flow is a measure of a
shareholders. 2017 2016
company’s ability to generate cash for
expansion, for other forms of improved Cash Flows from Operating Activities $ 1 247 $ 1 179
operations or for increased returns to shareholders. While Less: Capital Expenditure (863) (810)
free cash flow can be defined in many ways, the most (investing activities)
straightforward definition is as follows: Less: Dividends and share buy-backs (916) (1 227)
KEY FORMULA 5.3 FREE CASH FLOW Equals: Free Cash Flow ($      532) $     (858)

Cash Flows from Operating Activities As a growing business CSL may be expected to
– Capital Expenditures increase its cash. The balance sheet shows an increase of
– Dividends almost $287.7 million during the year ($555.3m to $843.0m),
= Free Cash Flow yet there is negative free cash flow. From the cash flow
statement (financing activities) it can be seen proceeds
from borrowings (debt) was greater than repayment of
The analysis starts with cash flows from operating
borrowings by about $800m ($1381m – $581m),
activities, which is a measure of a company’s ability to
$847 million in 2017. The cash flow statement shows the
generate cash from its current operations. Capital
shortfall in free cash flows and the increase in cash came
expenditures refers to the amount a company spends on
from borrowings.

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90 ACCT3 Financial
 CSL Limited
Consolidated statement of cash flows
for the year ended 30 June 2017

2017 2018
US$m US$m
Cash flows from Operating Activities
Receipts from customers (inclusive of GST) 6 749.2 5 982.7
Payments to suppliers and employees (inclusive of GST) (4 946.9) (4 417.0)
1 802.3 1 565.7
Income taxes paid (468.3) (326.2)
Interest received 6.7 14.1
Borrowing costs (94.1) (75.0)
Net cash inflow from operating activities 1 246.6 1 178.6
Cash flows from Investing Activities
Proceeds from sale of property, plant and equipment 0.1 0.1
Payments for property, plant and equipment (689.1) (495.1)
Payments for intangible assets (171.5) (70.6)
Payments for business acquisitions (Net of cash acquired) – (244.6)
(Payments)/receipts from other financial assets (2.4) 0.1
Net cash outflow from investing activities (862.9) (810.1)
Cash flows from Financing Activities
Proceeds from issue of shares 12.7 17.4
Dividends paid (601.4) (579.0)
Proceeds from borrowings 1 381.4 1 564.3
Repayments of borrowings (581.3) (716.9)
Payment for shares bought back (314.9) (648.2)
Net cash outflow from financing activities (103.5) (362.4)
Net increase in cash and cash equivalents 280.2 6.1
Cash and cash equivalents at the beginning of the financial year 555.3 555.5
Exchange rate variations on foreign cash and cash equivalent balances 7.5 (6.3)
Cash and cash equivalents at the end of the financial year 843.0 555.3
EXHIBIT CSL’s 2017 consolidated statement of cash flows
5.2

The consolidated statement of cash flows should be read in conjunction with the accompanying notes.
CSL, Annual Report 2017, p. 84. ©2017 CSL Limited. Reproduced with permission.

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CHAPTER 5 Cash and internal controls 91
 MAKING IT REAL time, these large companies may require payment
from their customers in a timely manner or the
CASH ON HAND (OR IN THE SHOE BOX customers may face collection litigation. This
UNDER THE BED) appearance of a double standard is possible because
Cash on hand is critical to any successful business. of the wide-reaching resources and market
Without available cash, a company cannot pay its bills dominance some large companies possess.
and obligations. Most retail companies buy on credit and sell for
Companies may hold onto their cash as long as cash. A comparison of their accounts receivable and
possible. These companies need their cash to finance their accounts payable emphasises this.
their day-to-day operations and many are more

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focused on arranging to pay their obligations as late
as possible (just like individuals who will usually wait
to pay their credit card until it is due).
Large companies are in the prime position to take
advantage of smaller businesses to maximise their
cash on hand. Large companies often represent a
large percentage of sales for smaller businesses,
therefore these small businesses may be forced to
accept delayed payment to maintain a supplier
relationship with their large customers. At the same
Cash is critical to any successful business

YT
PPL HIS

A
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92 ACCT3 Financial
 LO3
4 Bank reconciliation items
EXERCISES The following items may or may not be relevant to a
company’s bank reconciliation:
i The company recorded a deposit as $400, but it
correctly cleared the bank for $350.
ii A cheque recorded for $800 is shown on the
bank statement as an $800 reduction to the cash
1 Internal control LO2 balance.
Consider the following independent scenarios: iii The bank statement shows a $20 monthly service
fee.
i A company installs electronic sensors and camera
surveillance to mitigate the risk of theft. iv A $2750 deposit made by the company is not
reflected on the bank statement.
ii A company creates customer invoices to be used for
verification. v Payment received from a customer is reflected on
the bank statement but not on the company’s books.
REQUIRED
REQUIRED
Which element of internal control does each of the above
scenarios best relate to? Identify whether each item is (a) an addition to or
subtraction from the book balance, (b) an addition to or
LO2
subtraction from the bank balance or (c) not included on a
2 Match terms and definitions bank reconciliation.
The following is a list of the components of internal controls:
i Control environment 5 Petty cash LO3

ii Risk assessment On 1 June, JEA Rosario Branch established a petty cash

iii Control activities fund for $300. On 30 June, the fund’s custodian prepares a
iv Information and communication report showing $96.20 in cash remaining and receipts of
v Monitoring. $46.55 for postage, $86.50 for office supplies and $70.75 for
miscellaneous items. The custodian presents the report to
REQUIRED
the head office accountant, who replenishes the fund.
Match each internal control at (i) to (v) with the appropriate
definition below: REQUIRED
a The policies and procedures established to address the Prepare all necessary journal entries for the month of June.
risks that threaten the achievement of organisational
LO5
objectives. 6 Calculate free cash flow
b The assessment of the quality of an organisation’s During the year, a company had cash flow from operations
internal control. of $240 000. During the year the company also bought a
c The atmosphere in which the members of an new piece of equipment for $70 000, and $30 000 of
organisation conduct their activities and carry out their dividends were paid.
responsibility.
REQUIRED
d The identification and analysis of the risks that threaten
What is the company’s free cash flow for the year?
the achievement of organisational objectives.
e A requirement for the open flow of relevant information LO5
7 Evaluate cash
throughout an organisation.
Estay Engineering strives to keep a ‘consistent’ amount of
LO1, 2 cash on hand. Its latest balance sheet provides the following
3 Internal control activities
information:
Garcia Company has the following internal control
procedures: Cash and cash equivalents, current year $ 4 965
i An internal auditor reconciles the bank statement Cash and cash equivalents, prior year    5 012
each month.
Total assets, current year    70 350
ii The manager is required to authorise purchases
before they are made by employees. Total assets, prior year    67 864
iii A pre-numbered shipping document is used for each
REQUIRED
shipment to customers.
Using horizontal and vertical analyses, determine whether
iv The employee who writes cheques cannot make
Estay is maintaining a ‘consistent’ amount of cash. Round
entries in the general ledger.
percentages to one decimal point (i.e. 9.4%).
v The company stores inventory in a room that is
monitored by cameras.
REQUIRED
For each item, identify the internal control principle that is
being followed.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 5 Cash and internal controls 93
 LO4
REQUIRED
8 Reporting cash and cash equivalents
Identify whether each item is (a) an addition to the book
The following is a list of items that may or may not be balance, (b) a deduction from the book balance, (c) an
included in the cash and cash equivalents total on the addition to the bank balance or (d) a deduction from the
balance sheet: bank balance.
i undeposited cheque from a customer
ii petty cash on hand LO3
11 Bank reconciliation items
iii ordinary shares of BHP Consider the following two independent situations:
iv interest collected from savings at Westpac Bank i A company’s 30 April bank reconciliation shows
v one-month Commonwealth Government Bonds deposits in transit of $4000. The company’s books
vi certificate of deposit maturing in 45 days indicate deposits of $24 200 for the month of May,
vii certificate of deposit that matures in 120 days but the bank statement indicates deposits of
viii cash in cheque account $22 250 for May.
ix a customer’s cheque returned by the bank and ii A company’s 30 April bank reconciliation indicates
marked non-sufficient funds. outstanding cheques of $4500. The company’s
books indicate disbursements of $18 450 for the
REQUIRED month of May, but the bank statement shows
For each of the stated items, indicate whether the item $20 400 of disbursements for May.
should be included or excluded from the cash and cash
equivalents total. REQUIRED
a For situation (i), determine deposits in transit at 28 May
9 Internal control activities LO1, 2 b For situation (ii), determine outstanding cheques at
28 May.
Maria’s Boutique uses the following control procedures:
i The employee who works the register reconciles LO3
cash to receipts at the end of the day.
12 Prepare bank reconciliation
ii Employees know that the internal auditor will Juan Company’s 30 June bank statement shows a balance
perform a bank reconciliation at the end of each of $19 250. Juan’s books show a 30 June cash balance of
month. $18 100. Juan also has the following information:
iii Cheques are not pre-numbered because the i deposits in transit as of 30 June, $2500
purchasing manager must approve payments ii outstanding cheques as of 30 June, $3900
before cheques are signed. iii $150 service charge reported on the bank statement
iv A cashier lets another employee work his assigned iv non-sufficient funds cheque returned with bank
register while he helps a customer. statement, $2500
v Petty cash is kept in a back room but is not v interest on note receivable collected by the bank,
monitored during the day. $1800.
vi The company’s accountant records the receipt of REQUIRED
cash and cheques and makes deposits at the bank.
Prepare Juan’s bank reconciliation as of 30 June and prepare
REQUIRED any necessary journal entries resulting from the
Identify the problem with each internal control procedure. reconciliation. What is the actual cash balance that should be
reported on the 30 June balance sheet?
LO2
10 Bank reconciliation items
LO3
Araya’s Wraps is preparing a bank reconciliation for the
13 Prepare bank reconciliation
month of March and needs help with the following items: Noemi Company’s 30 September bank statement shows a
i A customer’s $95 cheque was deposited on 31 balance of $53 810. Noemi’s 30 September cash balance is
March but does not appear on the bank statement. $45 800. Noemi also has the following information:
ii A cheque clearing for $60 was recorded by Araya’s i deposits made but not appearing on the September
Wraps for $84. bank statement, $5500
iii The bank statement shows a $50 non-sufficient ii cheque written but not appearing on the September
funds cheque. bank statement, $12 200
iv A service charge of $45 was reported on the bank iii one cheque written for the purchase of supplies was
statement. erroneously recorded for $890 but appears on the
v The bank statement shows that the bank collected bank statement as $980
$105 of interest on Araya’s Wraps’ behalf. iv monthly service charges listed on the bank
vi A charge of $25 for internet banking was reported on statement are $230. Noemi had already recorded the
the bank statement. effect of $130 of those charges
vii A $75 cheque written on 31 March does not appear v a customer payment for a $1500 receivable was
on the bank statement. collected by the bank but not yet recorded by
Noemi.

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94 ACCT3 Financial
REQUIRED REQUIRED
Prepare Noemi’s bank reconciliation as of 30 September and a Prepare horizontal and vertical analyses of Nicole’s
also prepare any necessary journal entries resulting from the Nursery’s cash balance. Round percentages to one
reconciliation. decimal point (e.g. 8.2%).
b Calculate free cash flow.
LO3
14 Bank reconciliation items c Interpret the results of your calculations.
A company makes the following journal entries after
preparing a bank reconciliation:

i Cash 920
  Accounts Payable 920
ii Cash 900
PROBLEMS
  Accounts Receivable 900
iii Service Charge Expense 20
 Cash 20
18 Prepare bank reconciliation
REQUIRED
Rolo Hardware Company’s bank statement for the month of
Explain the likely circumstance behind each of the entries. April and its general ledger cash account at the end of April
are as follows:
LO3
15 Petty cash
Bank Statement
On 1 September, Saul’s Consultants establishes a petty
cash fund for $350. On 30 September, the fund’s Date Disbursements Deposits Other Balance
custodian prepares a report showing $180 in cash
1 April $8 250
remaining and receipts of $54.75 for miscellaneous items,
$56.25 for postage and $61 for supplies. The custodian 3 # 300 $1 220 7 030
presents the report to the company accountant, who 4 $2 100 9 130
replenishes the fund.
6 # 303 365 8 765
REQUIRED
9 # 304 840 7 925
Prepare all necessary journal entries for the month of
September. 15 # 302 900 7 025
16 # 307 1 400 5 625
LO3
16 Petty cash 18 # 305 2 000 3 625
On 1 January, Melissa Co. establishes a petty cash fund in 18 3 500 7 125
the amount of $750. On 31 January, the fund is replenished.
19 # 308 1 620 5 505
Before replenishment, there was $278.25 remaining in the
petty cash drawer and the following receipts: 22 # 309 150 5 355
i parking fees – $125.25 25 2 220 7 575
ii postage – $71 26 # 311 355 7 220
iii office supplies – $222
27 # 312 3 650 3 570
iv miscellaneous expenses – $52.
28 5 100 8 670
REQUIRED
30 $100 8 770
Prepare all journal entries necessary to record the
establishment and replenishment of the fund. 30 130 8 640

LO5
17 Evaluate cash
In a recent annual report, Nicole’s Nursery reported the
following account balances (in millions):

Cash and cash equivalents, current year $ 1 753

Cash and cash equivalents, prior year 957
Total assets, current year 71 253
Cash flows from operating activities 8 653
Capital expenditures 1 834
Dividends 1 588

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 5 Cash and internal controls 95
 Cash
1 April Balance 9 130 5 April # 301 790
17 April 3 500 6 April # 302 900
24 April 2 220 6 April # 303 365 CASES
27 April 5 100 8 April # 304 840
30 April 1 750 11 April # 305 2 000
15 April # 306 1 180
16 April # 307 1 400 20 Research and analysis
18 April # 308 1 260 Access the latest copy of CSL’s annual report by doing an
20 April # 309 150 internet search for ‘CSL Annual Report’ (annual reports are
made public around the beginning of October each year).
22 April # 310 560
23 April # 311 355 REQUIRED
a Conduct horizontal and vertical analyses of CSL Limited’s
26 April # 312 3 650
(ASX: CSL) cash balance. Round percentages to one
decimal point (e.g. 8.2%).
Other information: Rolo had one deposit in transit of
$2100 and one outstanding cheque (#300) of $1220 at 31 b Examine the company’s statement of cash flows and
March. All cancelled cheque amounts agree with the bank determine the major ways in which the company has
statement. been using its cash in the past two years.
c Based on your answers above, write a paragraph
REQUIRED explaining your opinion of CSL Limited’s (ASX: CSL) cash
a Identify all deposits in transit and outstanding cheques at position. Use your answers as supporting facts.
30 April.
b Prepare a bank reconciliation for the month of April. 21 Written communication
c Prepare all journal entries required by Rolo at 30 April. You partner with a friend of yours, Vladimir, start up a
Assume any debit memorandum is a service charge, any cosplaying clothing retailer business. You plan on
credit memorandum is a collection of an account implementing the internal controls that you have learnt from
receivable, and any error relates to an account payable. university, but your friend is worried about its effectiveness.
Vladimir wonders what internal controls there are and what
19 Evaluate cash happens if they do not work.
In their recent annual reports, Jasmine and Daniela reported REQUIRED
the following account balances:
Explain the types of internal control that can be used and
Jasmine Daniela address the issue of the limitation of internal control.
Cash and cash equivalents, 30/06/17 $ 1 880 1 427
22 Written communication
Cash and cash equivalents, 30/06/16 2 087 1 086
You are the owner of Simple Vintage, an indie retail business
Total assets 26 275 62 169
close to the university. You have a store manager who
Cash flows from operating activities 3 744 4 779 supervises employees. Most employees are part-time
Capital expenditures 1 014 2 005 university students and your manager is having a difficult
time getting the employees to follow internal control
Dividends 541 479
procedures. Most of the employees think that the
REQUIRED procedures are a waste of time and that they don’t relate to
the main purpose of the business, which is to ‘sell stuff’.
For both companies, calculate and interpret (a) horizontal
and vertical analyses of cash balance and (b) free cash flow. REQUIRED
How do the cash positions compare? Round percentages to Prepare a memo that can be given to incoming employees
one decimal point (e.g. 8.2%). explaining to them the importance of the control
environment in general and control activities specifically.

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96 ACCT3 Financial
 6
This chapter examines the accounting for receivables.
Specifically, the chapter focuses on how companies
account for the recording, the collection and the non-
collection of accounts receivable. After a discussion of
how to analyse a company’s receivable position, the
chapter concludes with the accounting for a second type
of receivable – a note receivable.

Receivables LO1  ECORDING AND

R
REPORTING ACCOUNTS
RECEIVABLE
A receivable represents a company’s claim on the
assets of another entity. The most common type of
LEARNING
OBJECTIVES receivable is an account receivable. An
account receivable is an amount account receivable 
owed by a customer who has purchased An amount owed by a
customer who has
the company’s product or service. purchased the company’s
After studying the material in this chapter, you Sometimes these receivables are product or service.
should be able to: referred to as debtors or
YT
trade receivables PPL HIS
1 Describe the recording and

A
because they arise from Check out the video summary
reporting of receivables. for Chapter 6
the trade of the company.
2 Compare the methods used to account for
uncollectible receivables.
RECORDING ACCOUNTS RECEIVABLE
3 Contrast the methods for estimating bad
debt expense. Receivables are recorded at the time of the sale. To
illustrate, suppose that on 4 June, Howard Limited sells
4 Evaluate accounts receivable through the $1000 of product to a customer on account. Howard would
calculation and interpretation of horizontal,
record the revenue and receivable arising from the sale
vertical and ratio analyses.
with the following entry. Note that this example ignores
5 Understand the accounting the effects on Howard’s inventory and cost of goods sold.
for notes receivable. These will be covered in Chapter 7.

4 Jun. Accounts Receivable 1 000

 Sales 1 000
  (To record sale on account)
Assets = Liabilities + Equity
+1 000 +1 000

Both assets and equity (revenue) increase because of

this sale. When Howard collects the receivable, it will
increase its cash and eliminate the receivable.
In some cases, a customer will return a product instead
Express of paying for it, and this affects the Accounts Receivable
YT
PPL HIS balance. To illustrate, suppose that on 6 June the customer
Throughout this
A

chapter apply this returns a $150 product because it is faulty. Howard would
icons indicate record the return with the following entry.
an opportunity
for online 6 Jun. Sales Returns and Allowances 150
self-study through   Accounts Receivable 150
CourseMate Express,
linking you to revision    (To record sales return)
quizzes, e-lectures, Assets = Liabilities + Equity
animations and more. –150 –150
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97
 payment, goes into the Sales Discounts account. Like
Sanitarium Health & Wellbeing. Reprinted with permission

Sales Returns and Allowances, the Sales Discounts account

is a contra-revenue account that is subtracted from sales
when calculating net sales. Companies use this account to
maintain a record of discounts each period. It is a temporary
account whose balance is closed at the end of each period.
Some may treat sales discount as a ‘financial expense’ as
it might be seen as a way of receiving cash earlier than
would happen if there was no incentive for customers to
pay quickly.

Companies like Sanitarium (the manufacturer of Weet-Bix and Up & Go)

REPORTING ACCOUNTS RECEIVABLE
commonly sell their products on account. Unfortunately, the receivables Because accounts receivables are expected to be collected
that are created are not always collected
within a month (or two), they are classified and reported as
current assets. However, companies do not normally
Again, the example focuses only on the effect on collect all their receivables because customers do not
receivables and ignores the effects on inventory and cost always pay their bills. Among other reasons, customers
of goods sold. have financial hardships, relocate without paying or simply
The entry decreases Accounts Receivable for the sales refuse to pay. As a result, companies must follow the
price of the product. However, instead of decreasing the principle of prudence and report their accounts receivable
Sales account directly, the entry increases Sales Returns at net realisable value.
and Allowances. Sales Returns and Allowances is a contra- Net realisable value is the amount of net realisable
revenue account, meaning that its balance is subtracted cash that a company expects to collect from value  The amount of
from Sales when calculating a company’s net sales. its total or gross accounts receivable balance. cash that a company
expects to collect from
Companies use this account to maintain a record of returns It is calculated by subtracting from gross its total accounts
each period. Like the Sales account, Sales Returns and receivables the amount that a company does receivable.
Allowances is a temporary account, the balance is closed not expect to collect. For example, a company
(zeroed out) at the end of each period (see ‘LO4 Closing that has $2000 of gross receivables but does not expect to
process’, Chapter 4.) collect $50 of them has receivables with a net realisable value
In addition to returns, companies sometimes provide of $1950. The amount that a company does not expect to
discounts to customers if they pay within a certain time collect goes by many names: provision for impairment loss,
period. For example, sales are commonly made with terms allowance for bad debts, allowance for doubtful debts, and
2/70, n/30, meaning that customers can receive a 2 per provision for bad and doubtful debts. Here we use an
cent discount if they pay within 7 days of the invoice. To ‘Allowance’ account as ‘Provisions’ may be confused with
illustrate, suppose that Howard grants terms of 2/7, n/30. ‘Equity’ accounts. How companies estimate and record the
On 10 June the customer pays the remaining $850 bill. By allowance will be examined later in the chapter.
qualifying for a 2 per cent discount, the customer saves
$17 ($850 × 2%) and pays only $833. Howard would record
the receipt of payment as follows: ANALYSIS
Look at CSL’s balance sheet in
10 Jun. Cash 833 Appendix B. Can you tell whether
the company’s receivables are reported at net realisable
Sales Discounts 17 value?
  Accounts Receivable 850 Analysis:
   (To record payment) CSL’s simply reports: ‘Trade and other receivables’. The
Accounts Receivable paragraph in Note 15 states:
Assets = Liabilities + Equity
Trade and other receivables are initially recorded at fair
+833 –17 value and are generally due for settlement within 30 to
60 days from date of invoice. Collectability is regularly
–850
reviewed at an operating unit level. Debts which are

The entry increases Cash for the $833 payment and

decreases Accounts Receivable for the full $850 balance.
The difference, which equals the discount of $17 for timely

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98 ACCT3 Financial
 known to be uncollectible are written off when MAKING IT REAL
identified. A provision for impairment loss is recognised
when there is objective evidence that all amounts due COLLECTING RECEIVABLES
may not be fully recovered.1 Businesses often need to offer credit to compete, but
Note 15 shows in 2017 Trade receivables were $978.6 they then need to collect their receivables without
million Less: Provision for impairment loss $22.6 million. (In alienating customers and obtaining a reputation for
2016 the figures were $958.8 million and $31.1 million). being a difficult supplier.
Therefore, receivables are stated at net realisable value Waster (waster.com.au) bills around $80 000 per
with an improvement (lowering) in the Provision in 2017. month, with each bill averaging $150. Co-founder
Aodhan MacCath-mhaoil explains their strategy for
combatting the possible negative effects of collecting
To illustrate the reporting of receivables, consider the receivables: ‘Throughout this process we seek to be
following receivables balances from CPA Australia’s Annual friendly and helpful as we want the customer to
Report 2016:2 continue with us. This process is effective, though we
have had incidences [sic] where we have not been paid’
2016 2015 … ‘We offer an ongoing service, so if a debt builds up
$’000s $’000s for a few months, it can really start to snowball. Cash
Current flow and collecting payments is vital for us’.5
Trade and other receivables 2 425 7 804
Less allowance for doubtful debts (24) (102) profit and loss statement. Thus, you will rarely find a
2 401 7 702 company’s bad debt expense listed separately. If you do, it
The consolidated entity has recognised an allowance for doubtful debts of 100 per cent against all receivables is likely bad news because the amount was large enough
over 90 days except for those debtors/members who at balance date have committed to pay. Historical experience
has been that receivables that are past due beyond 90 days are difficult to recover.
to warrant individual reporting.
There are two methods to account for bad debt expense:
In contrast, Chartered Accountants Australia and New
the direct write-off method and the allowance method. Each
Zealand, in its Financial Report 2017, ‘Trade and other
method is discussed in the following sections.
receivables’, lists:3
2017 2016 DIRECT WRITE-OFF METHOD
$’000s $’000s
Current Under the direct write-off method, bad direct write-off
debt expense is recorded when a method
Trade receivables (a) 12 363 14 253 Method in which bad debt
company determines that a receivable is expense is recorded when
Allowance for impairment loss (622) (658)
uncollectible and removes it from its a company determines
11 741 13 595 that a receivable is
records. The receivable is eliminated or uncollectible and removes
Trade receivables are recognised and carried at the original invoice amount less an allowance for impairment. We ‘written off’ the company’s accounting it from its records.
regularly review the collectability of trade receivables, and apply an impairment provision when there is evidence
that the Group won’t be able to collect. When we identify individual debts that are uncollectible, we write them off. records, and bad debt expense is recorded
(a) Trade receivables are non-interest bearing and are generally on 30-day terms. A provision for impairment of
$622 000 (2016: $658 000) has been raised to cover expected uncollectible debtors. The Group does not hold any
for the amount of the receivable.
collateral over these balances. To illustrate, suppose that Chan makes a $4000 credit
YT
PPL HIS sale during October 2019 to Baron. In April 2020, Chan
A

Check out the animated summary determines that it will be unable to collect from Baron.
on Accounts Receivable
Chan would make the following entries to reflect this
activity:

Oct. 2019 Accounts Receivable 4 000

LO2 UNCOLLECTIBLE
 Sales 4 000
RECEIVABLES
   (To record sale on account)
As stated in the previous section, most companies are Assets = Liabilities + Equity
unable to collect all their accounts receivable. Losses from +4 000 –4 000
the inability to collect accounts receivable Apr. 2020 Bad Debt Expense 4 000
bad debt expense are recorded in the accounting system as
The expense resulting from   Accounts Receivable 4 000
bad debt expense.
the inability to collect all
accounts receivable. Because uncollectible accounts are a   (To record bad debt expense and
normal part of any business, bad debt write off receivable)
expense is considered a normal operating expense. It is Assets = Liabilities + Equity
included in the calculation of net profits or losses but is +4 000 –4 000
usually combined with other operating expenses on the

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CHAPTER 6 Receivables 99
 The first entry records the account receivable created That is, instead of writing off specific receivables at year-end,
from the sale. Both assets and equity increase as a a company increases a contra-asset account called Allowance
result. The second entry increases Bad Debt Expense to for Doubtful (Bad) Debts or Allowance for
reflect the loss incurred from the inability to collect from Impairment Loss. The allowance for allowance for
Baron. It also decreases Accounts Receivable to remove doubtful debts represents the dollar amount doubtful debts
The dollar amount
the receivable from Chan’s records. As a result of this of receivables that a company believes will of receivables that
write-off, both assets and equity decrease. All write-offs ultimately be uncollectible. As described a company believes
will ultimately be
under the direct method will result in the same basic earlier, its balance is subtracted from gross uncollectible.
entry. The only difference will be the dollar amount. receivables to yield the receivables’ net
The major advantage of the direct write-off method is realisable value.
its simplicity. When an account is deemed uncollectible, it To illustrate, suppose that Duncan Sports makes credit
is written off and an expense is recorded. The major sales of $800 000 during 2019. Based on experience,
disadvantage is that it can violate the matching principle. Duncan estimates that $16 000 of these sales will not be
The matching principle requires that expenses be matched collected. Duncan would therefore make the following
as closely as possible to the period in which the related entries to record this activity:
revenues are recognised. In the preceding example, the
During Accounts Receivable 800 000
revenue is recorded in 2019, but the expense is recorded 2019
in 2020. Assuming that Chan prepares financial statements
 Sales 800 000
at the end of December, the expense is not recorded in the
   (To record sales on account)
same year as the revenue.
Because the direct method violates the matching Assets = Liabilities + Equity
principle, generally accepted accounting principles prohibit +800 000 +800 000
its use. The only exception to this prohibition is when bad
debt expense is immaterial to the company. For most
End of Bad Debt Expense 16 000
companies, though, bad debt expense is material, so they 2019
must use the allowance method.
  Allowance for Doubtful Debts 16 000
Using the direct method would have also overvalued
   (To record bad debt expense)
Chan’s asset. Accounts receivable at 31 December 2019 is
in breach of the prudence concept; another reason for Assets = Liabilities + Equity
using the allowance method. –16 000 –16 000

ALLOWANCE METHOD The first entry increases Accounts Receivable and Sales
for the credit sales during the year. This increases both
While the direct write-off method accounts for
assets and equity. The second entry increases both Bad
uncollectible receivables with one entry, the allowance
Debt Expense and Allowance for Doubtful Debts by
allowance method method splits the accounting into two $16 000. This effectively matches the expense of future
Method in which entries – one to record an estimate of
companies use two uncollectible receivables to 2019 sales. It also reduces
bad debt expense and another to write
entries to account for Duncan’s net realisable value of receivables by $16 000
bad debt expense – one off receivables when they become
because it is now allowing for $16 000 of those receivables
to estimate the expense uncollectible. Both entries are
and a second to write off to be uncollectible. As a result, both assets and equity
receivables. described in the following sections.
decrease.
The same basic entry will be recorded each time bad
debt expense is estimated under the allowance method.
Recording bad debt expense
The only difference will be the amount of the estimate,
The purpose of the allowance method is to match the
which will depend on circumstances and the estimation
expense from uncollectible receivables to the period in
method a company uses. Methods of estimating bad debt
which those receivables were created. To achieve this
expense are covered later in the chapter.
purpose, a company must record bad debt expense at the
end of each accounting period. However, at the end of the Recording a write-off
period, the company does not yet know which receivables Regardless of the method used to account for uncollectible
will be uncollectible. receivables, a company must write off a receivable when
Because of this inability to know which specific it is deemed to be uncollectible. Under the direct write-off
receivables will turn out to be uncollectible, the allowance method, the company records bad debt expense at the
method requires a company to set up an ‘allowance’ for time of the write-off. However, under the allowance
uncollectible receivables when recording bad debt expense. method, bad debt expense has already been estimated and
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100 ACCT3 Financial
recorded and an allowance balance created for uncollectible
receivables. Therefore, instead of increasing bad debt MAKING IT REAL
expense at the time of the write-off, the company reduces
COLLECTING DEBTS
the balance in the allowance account. Most companies have a good idea of how long it
To illustrate, suppose that Duncan Sports determines takes them to collect their receivables. However,
in 2020 that a $5000 receivable from William Johnson is sometimes shocks to the economy can cause
uncollectible and decides to write it off the books. Duncan significant delays in collections. Take the Global
would make the following entry: Financial Crisis during which customer payments
slowed significantly. This reduced cash flow is
2020 Allowance for Doubtful Debts 5 000 especially damaging to small businesses that might
not have sufficient cash on hand to pay their own
  Accounts Receivable 5 000
suppliers. This turns into a never-ending cycle where
   (To record write-off) buyers and sellers are both past due on their bills and
Assets = Liabilities + Equity reduces the cash flow to the entire economy.
To combat this, companies are forced to alter
–5 000 their collections policies. Traditionally, buyers with
+5 000 delinquent accounts would have their credit slashed
or cancelled. Now, companies are considering
The entry decreases Accounts Receivable and alternative approaches which do not place undue
pressure on the customer in the hope of maintaining
decreases an equal amount of Allowance for Doubtful
an agreeable relationship. The bottom line is that
Debts. Note that the entry has no effect on total assets or delayed collection of accounts receivable affects both
profit or loss. More specifically, the entry has no effect on the business and the customer. Longer collection
Duncan’s net realisable value of receivables. This is because cycles mean that businesses have a diminished cash
both the asset account and the contra-asset account are flow and have to struggle to make do with less cash
decreasing by the same amount, thereby offsetting one on hand. Without timely collections, many businesses
are put in a situation where they might face
another. Duncan now knows that Johnson will not pay, but
delinquency with their own vendors or even
Duncan had already allowed for that possibility. Therefore, bankruptcy from lack of liquidity.
Duncan’s expected cash receipts are unchanged. This will You can get a copy of your credit report for free
be the case for all write-offs under the allowance method. from a credit reporting body (CRB) in all of the
following circumstances:
Recording the recovery of a write-off • if you have applied for, and been refused credit,
Occasionally, a company will collect a receivable that it had within the past 90 days
previously written off. For example, suppose that Johnson • where your request for access relates to a
pays his bill in full later during 2020. When this payment decision by a CRB or a credit provider to correct
information included in your credit report, and
occurs, the following two entries are made:
• once a year (not counting the above
2020 Accounts Receivable 5 000 circumstances).5
  Allowance for Doubtful Debts 5 000
   (To reverse the original write-off)
Cash 5 000
  Accounts Receivable 5 000
   (To collect the receivable)
Assets = Liabilities + Equity
+5 000
–5 000

The first entry simply reverses the original entry writing

off the receivable. The second entry records the collection
of cash and the reduction of the receivable. Notice that One of the more challenging aspects of business is pursuing bad debts,
the option to imprison slow payers is no longer available
once again there is no effect on total assets by either of
these two entries.
YT
PPL HIS
A

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CHAPTER 6 Receivables 101
 should be. This is accomplished by multiplying accounts
LO3 ESTIMATING BAD receivable by a percentage set by the company. The
DEBT EXPENSE second step is to adjust the allowance account to that
calculated balance. The amount of the adjustment is bad
The previous section demonstrated how to record bad debt debt expense for the period.
expense under the allowance method. This section To illustrate, suppose that a company has a
demonstrates how to estimate the amount of bad debt receivables balance of $24 000 at the end of 2019. Based
expense to be recorded. on past experience, the company expects that 2 per cent
When estimating bad debt expense, companies may of its receivables balance will be uncollectible. As a
use one of two different approaches: result, the balance in the allowance account at year-end
● percentage-of-sales approach should be 2 per cent of receivables, or a $480 credit
● percentage-of-receivables approach. balance ($24 000 × 2%). The next step is to make the
Both approaches use information such as past adjustment.
experience, industry norms or trends and current customer Since the allowance method for bad debts relies on
credit ratings to make the estimate as accurate as possible. estimates, a company’s allowance balance prior to
Each approach is discussed in the following sections. adjustment can have either a debit or credit balance. A
debit balance means that the company has experienced
PERCENTAGE-OF-SALES APPROACH greater write-offs during the year than expected. A credit
balance indicates that write-offs have been less than
percentage-of-sales Under the percentage-of-sales
expected. Whether the balance is a debit or credit does not
approach approach , bad debt expense is a
Method that estimates require a company to correct its bad debt expense from
bad debt expense as a function of a company’s sales. It is
the prior year. However, it does affect the adjustment for
percentage of sales. calculated by multiplying sales for the
the current year.
period by some percentage set by the
To illustrate, assume that the allowance account has a
company. For example, suppose a company with $250 000
$100 credit balance prior to adjustment. To get the balance
of sales in 2019 estimates that it will not collect 4 per cent
to a $480 credit requires a $380 credit entry. Therefore, bad
of those sales. The estimate for bad debt expense at the
debt expense for the period is $380. This is illustrated as
end of 2019 would be $10 000 ($250 000 × 4%). The entry
follows:
to record the estimate is shown below.
Allowance for
End of Bad Debt Expense 10 000 Bad Debts
2019
100 Existing balance
  Allowance for Doubtful Debts 10 000
380 Adjustment required = Bad Debt Expense
   (To record bad debt expense)
480 Desired balance ($24 000 × 2%)
Assets = Liabilities + Equity
–10 000 –10 000
End of Bad Debt Expense 380
2019
The advantages of this approach are its simplicity and the
  Allowance for Doubtful Debts 380
fact that it results in very good matching. Bad debt expense
   (To record bad debt expense)
for a period is primarily a function of sales for that period. The
main disadvantage is that no consideration is given to the Assets = Liabilities + Equity
resulting balance in the Allowance for Doubtful Debts –380 –380
account. It is simply the existing balance plus the current
estimate. Since the allowance account is used to calculate In contrast, assume that the allowance account has a
net realisable value, the percentage-of-sales approach results $50 debit balance prior to adjustment. In that case, the
in a less meaningful net realisable value of receivables. necessary adjustment is a $530 credit entry. Therefore, bad
debt expense for the period is $530. This is illustrated as
PERCENTAGE-OF-RECEIVABLES APPROACH follows:

Under the percentage-of-receivables Allowance for

percentage- Bad Debts
of-receivables approach , bad debt expense is a
approach function of a company’s receivables 50 Existing balance
Method that estimates
bad debt expense as a balance. It is calculated in two steps. The 530 Adjustment required = Bad Debt Expense
percentage of receivables. first step is to calculate what the balance 480 Desired balance ($24 000 × 2%)
in the Allowance for Bad Debts account

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
102 ACCT3 Financial
 End of Bad Debt Expense 530 You may remember from our earlier example from
2019 CPA Australia’s Annual Report 2016, where it was stated
  Allowance for Doubtful Debts 530 that ‘historical experience has been that receivables that
   (To record bad debt expense) are past due beyond 90 days are difficult to recover’.
Assuming that SC Works has a credit balance of $870
Assets = Liabilities + Equity
in the allowance account prior to recording bad debt
–530 –530
expense, the company would make the following entry to
record bad debt expense.
The major advantage of the percentage-of-receivables
approach is that it results in a very meaningful net realisable Allowance for
value. This is because the allowance account is determined Bad Debts
as a set percentage of receivables. The disadvantage is that 870 Existing balance
it does not match expenses as well as the percentage-of- 3 187 Adjustment required = Bad Debt Expense
sales approach. This is because the adjustment necessary 4 057 Desired balance
is a function of both the set percentage and a company’s
prior experience with write-offs. As a result, current End of Bad Debt Expense 3 187
expenses are affected by prior-year experiences. 2019
  Allowance for Doubtful Debts 3 187
Ageing of accounts receivable
   (To record bad debt expense)
Many companies use a more refined version of the
Assets = Liabilities + Equity
percentage-of-receivables approach. Recognising that
receivables become less collectible as they get older, –3 187 –3 187
companies often prepare ageing schedules for
As you can see, the entry to record bad debt expense
ageing schedule their receivables. An ageing schedule is a
is the same as previously described. The difference is
A listing of accounts listing and summation of accounts receivable
receivable by their that an ageing schedule provides a more accurate
ages.
by their ages. Normally, receivables that are
estimate of the allowance for doubtful debts and
outstanding for 30 days or less are considered
therefore a better estimate of bad debt expense. But an
current and are grouped together. Receivables outstanding
ageing schedule has another benefit. It is a good internal
longer than 30 days are considered past due and are grouped
control activity.
together in 30-day increments. Companies then apply
Recall from Chapter 5 that control activities are one of
increasing uncollectible percentages to older receivables.
the five elements of a good internal control system. They
To illustrate, suppose that SC Works prepares an ageing
are procedures put in place to assist companies in operating
schedule at the end of 2019 as shown in Exhibit 6.1. SC
and reporting efficiently and effectively. Keeping track of
Works reports $66 000 of receivables and breaks them into
receivables and their ages helps meet these objectives.
‘current’ and several categories of ‘past due’. Each category
For example, an ageing schedule provides the information
is assigned an expected percentage of uncollectible
a company needs to pursue its receivables effectively. It
receivables that rises as the age of the receivables
also provides information for future credit decisions. A
increases. The necessary allowance balance is then
company may hesitate to provide credit to customers who
calculated by summing the totals from each category.
have past due receivables.

Number of days past due

Customer Current 1–30 31–60 61–90 Over 90 Total
Ma Manufacturing $4 100 $  4 100
Chen Company $2 400 2 400
WAG, Limited $2 750 2 750
Others 44 450 10 400 1 000 1 200 300 57 350
Totals 44 450 10 400 5 100 3 950 2 700 66 600
* % Uncollectible       1%       3%      15%       30%   50%
Allowance Balance $  445 $  312 $   765 $1 185 $1 350 $   4 057

EXHIBIT Ageing schedule of accounts receivable – SC Works
6.1

* The percentages will depend on the business’ past experience, their credit policy and current economic conditions.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 6 Receivables 103
 2017 2018
LO4 ANALYSING ACCOUNTS Source Accounts
$000 $000
RECEIVABLE Statement of Revenue 176 374 175 672
Profit and Loss
Any investor, creditor, or manager of a company should be Amount written 0 38
off as uncollectible
interested in how well a company manages its accounts (Note 7)
receivable. Because a receivable is an uncollected sale, the
Statement of Trade and Other 2 451 2 474
main question that should be asked of a company is how Financial Position Receivables
well it collects its receivables. In general, better collection
Total Assets 207 315 195 390
means better management of receivables.
Non-financial companies usually do not disclose bad EXHIBIT Account balances from the CPA Australia’s
6.2 Integrated Report 2017
debts expense because it is immaterial as part of total
Source: CPA Australia, 2017, Integrated Report 2017, https://www.cpaaustralia.com.au.
expenses. However, in 2017 CPA Australia provided more
insight into its receivables. The analysis requires information Given the CPA’s financial information in Exhibit 6.2,
from the ‘statement of financial position’ (balance sheet) horizontal and vertical analyses of accounts receivable and
and ‘statement of profit and loss and other comprehensive sales result in the calculations below. Note that the net
income’ and the notes to the accounts.6 realisable value of receivables, as reported on the statement
of financial position, is used in the calculations.
HORIZONTAL AND VERTICAL ANALYSES
Horizontal analysis
A good place to start the analysis of accounts receivable is
Dollar change Percentage
with horizontal and vertical analyses. Recall from Chapter change
2 that horizontal analysis calculates the dollar change in an Trade and Other Receivables 2 451  (23) = 1%
account balance, defined as the current-year balance less = (23)
– 2 474 – 2 474
the prior-year balance, and divides that change by the prior- Revenue –176 374 702 = 0.4%
year balance to yield the percentage change. Vertical = 702
175 672 175 672
analysis divides each account balance by a base account,
Vertical analysis
yielding a percentage. The base account is total assets for
2017 2016
financial position and net sales or total revenues for
statement of income accounts. These calculations are Trade and Other Receivables 2 451 = 1.2% 2 474 = 1.3%
207 315 195 390
summarised as follows:
Bad Debts Expense 0  = 0.0% 38         =   0.02%
176 374 175 672
KEY FORMULA 6.1 HORIZONTAL ANALYSIS
Source: CPA Australia, 2017, Integrated Report 2017, https://www.cpaaustralia.com.au/.

Dollar Change in Current-year Balance – The calculations show a small decrease in the CPA’s
Account Balance = Prior-year Balance
receivables. Horizontal analysis shows that CPA’s
Percentage Change Dollar Change receivables balance decreased by only $23 000, or 1 per
in Account Balance = Prior-year Balance cent, in 2017. Horizontal analysis of sales shows growth
in sales of under $1 million, or less than half of 1 per cent,
during the year, so it does not appear that receivables are
KEY FORMULA 6.2 VERTICAL ANALYSIS lower because of sales, which were higher. But the
change in the numbers is very small and limited
Percentage = For the balance For the income conclusions can be drawn. Vertical analysis also shows
sheet statement
that receivables as a percentage of assets were lower,
Account Balance or Account Balance 1.3 per cent in 2016 to 1.2 per cent in 2017. Bad debts
=
Total Assets Net Sales or Revenue appear not to be a problem for the CPA even in 2016 they
still make up less than $1 for every $4600 of revenue!

RECEIVABLES TURNOVER RATIO

The preceding analysis indicates that the CPA appears to be
managing its receivables very well. Another means to assess
the management of receivables is to calculate a company’s

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104 ACCT3 Financial
receivables receivables turnover ratio. The receivables Beyond the issue of not knowing how many sales
turnover ratio turnover ratio compares a company’s credit are on credit, the receivables turnover
A comparison of credit days-in-receivables
sales to receivables sales during a period to its average receivables ratio is sometimes difficult to interpret, A conversion of the
that measures a balance during that period. It is calculated as so it is often converted into the days-in- receivables turnover
company’s ability to follows: receivables ratio. The days-in- ratio that expresses
a company’s ability to
generate and collect
receivables. receivables (ratio) divides the generate and collect
receivables turnover ratio into 365 days receivables in days.
to express, in days, how long it takes a company to
Copyright © The Institute of Chartered Accountants Australia 2014. All rights reserved.

generate and collect its receivables. Thus, the days-in-

receivables is calculated as follows:

KEY FORMULA 6.4 DAYS-IN-RECEIVABLES

  365
Days-in-Receivables Ratio =
Receivables Turnover Ratio

365 = 60.03 days

6.08

A ratio of 60.03 indicates that it takes CSL about sixty

days between selling an item and collecting the receivable.
CPA Australia’s Although we do not know, if we assume 50 per cent of
Integrated Report 2017
CSL’s sales were on credit, then its days-in-receivables
would be 120 days. Whether this is good or bad requires
KEY FORMULA 6.3 RECEIVABLES TURNOVER RATIO some comparison, looking at the prior year as well as
Credit Sales similar businesses. But caution would still be needed
Receivables Turnover Ratio =
Average Receivables because some businesses attract customers by advertising
Where average receivables is:
‘easy credit’, obviously expecting higher bad debts and
slower receivable turnover, and possibly compensating by
Beginning Receivables + Ending Receivables/2
selling at higher prices than competitors not offering such
generous buy-now-pay-later conditions. Because
Because the ratio divides credit sales during a period governments are notoriously slow payers, CSL may be
by the average receivables balance during the period, it prepared to wait six months for some governments to pay.
indicates how many times during a period a company
generates and collects receivables. In general, companies ALLOWANCE RATIO
want this ratio to be higher rather than lower because a
One additional ratio that is useful in analysing a company’s
higher ratio indicates that the company collects, or turns
management of receivables is the
over, its receivables faster.
allowance ratio. The allowance ratio allowance ratio
For most reporting entities (financial statements are
compares the allowance account to gross Aallowance comparison of the
account
publicly available) it is not possible to calculate receivables
accounts receivable to determine the to receivables that
turnover because the percentage of sales made on credit
percentage of receivables that are measures the percentage
is unknown. For CSL most sales are probably made on of receivables that are
expected to be uncollectible in the future. expected to be uncollectible
credit. For CSL, if we assumed all operating revenue was in the future.
It is calculated as follows:
on credit, the figure is likely to be overstated:
6922.8 KEY FORMULA 6.5 ALLOWANCE RATIO
 = 6.08 times
(1107.2 + 1170.4) / 2
Average for Doubtful Debts
Allowance Ratio =
The 6.08 ratio indicates CSL’s 2017 sales were just over Gross Receivables
six times its average receivables balance. In other words, Where gross accounts receivable is:
the company was able to generate and collect its
Net Account Receivables + Allowance for Doubtful Debts
receivables balance over six times in 2017, every sixty days.

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CHAPTER 6 Receivables 105
 A higher ratio indicates that a company expects more
receivables to be uncollectible. In general, a company would analysis indicates that a high proportion of CSL’s assets
want this ratio to be as low as possible. The CSL allowance are in the form of receivables. If you read all of its annual
report this would be expected given CSL’s major customers
(provision) ratio for 2016 and 2017 is calculated as follows
are governments and large medical companies. Finally,
from the information in its balance sheet and Note 15 trade CSL makes the vast majority of its revenue from the sale
receivables. This shows a marked improvement in 2017. of goods; some comes from royalties and licence fees.
2017 2016
22.6 31.1 When a company accepts a promissory note, it has a note
= 1.9% = 2.8%
1170.4 (1107.2) receivable. Like other assets, a note receivable is reported on
YT
PPL HIS the balance sheet. However, its classification depends on its
A

Download the Enrichment terms. If the note is due within a year, it is classified as a
Modules for further practice
current asset. Otherwise, it is a non-current asset.
Accounting for a note receivable usually requires entries
to record the following:
LO5 NOTES RECEIVABLE ● issuance of the note
● interest earned on the note
An account receivable is an amount owed by a customer ● collection of the note.
who has purchased the company’s product or service. To illustrate, suppose that on 1 November 2018, Tata
Sometimes, because of a customer’s poor credit rating or Industries sells industrial robots to Zjax for $184 000. Tata
because of the size of the transaction, a company will enter accepts a six-month, 6 per cent promissory note from Zjax
into a more formal agreement with the customer beyond for payment. The note stipulates that Tata will receive both
a normal account receivable. This is often principal and interest from Zjax on 30 April 2019.
promissory note accomplished through a promissory
A written promise to pay
a specific sum of money note, which is a written promise to pay a RECORDING THE NOTE
on demand or at some specific sum of money on demand or at
specific date in the future. A note receivable is recorded at its face value,
some specific date in the future. note receivable
Promissory notes can be used to formalise a receivable or which is $184 000 in this example. Therefore, An asset created when
Tata would record the sale of the robots and a company accepts a
to loan money to another entity. In most cases, promissory promissory note.
notes require the payment of both principal and interest. the resulting note receivable as follows:
The company that will receive the principal and interest is 1 Nov. Note Receivable 184 000
called the payee. The customer or borrower who will pay 2018
the interest and principal is called the maker of the note.  Sales 184 000
We focus on accounting for the payee.   (To record sale in exchange for a
promissory note)

ANALYSIS
Assets  = Liabilities + Equity
Using CSL’s financial statements in +184 000 +184 000
Appendix B, calculate and interpret (1) horizontal analysis
and (2) vertical analyses of accounts receivable and sales. In this entry, Tata increases the Note Receivable account
Analysis: to reflect the receipt of the promissory note and increases
1  Horizontal analysis Sales to reflect the earning of revenue. As a result, both assets
Accounts Receivable (Trade and other receivables):
and equity increase. As in previous examples in this chapter,
($1170.4 – $1107.2) / $1107.2 = 5.7%
the effects on inventory and cost of goods sold are ignored.
Sales Revenue:
($6515.8 – $5909.5) / $5909.5 = 10.2%
2  Vertical analysis RECORDING INTEREST
Accounts Receivable (2017): Most promissory notes require that the maker pay interest
$1170.4 / $9122.7 = 12.8% to the payee. The amount of interest is a function of the
Sales Revenue (as a percentage of Total operating revenue): principal or face value of the note, the annual interest rate
$6615.8 / $6922.8 = 95.6% and the length of time the note is outstanding. The
The 5.7 per cent horizontal analysis indicates that calculation is as follows:
receivables increased during the year by almost 6 per In this example, Tata’s note receivable is outstanding
cent. With an increase in sales of over 10 per cent, an
for only six months. As a result, interest of 6 per cent will
increase in receivables would be expected, and probably
an even bigger increase. The 12.8 per cent vertical be charged for six of the twelve months of the year.

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106 ACCT3 Financial
Alamy Stock Photo/Garn Phakathunya
This entry increases Interest Receivable to reflect the
additional receivable Tata now has from Zjax. Tata will report
this receivable on its balance sheet until the interest is paid
in April 2019. The entry also increases Interest Revenue to
reflect the inflow of assets attributable to the year 2019. As
a result, both assets and equity increase.

COLLECTING THE NOTE

The collection of a note receivable is much like the collection
of an account receivable. When a note is collected, the note
receivable is decreased and cash is increased. However,
I, robot when a note receivable requires interest to be paid, the
collection of the note often includes the collection of
interest as well. This is the case for Tata.
KEY FORMULA 6.6 INTEREST EARNED On 30 April 2019, Tata collects cash and interest from
Zjax. The total interest over the six months Tata held the
Interest Earned = Principal × Annual Rate of Interest note is $5520. The principal is $184 000. Therefore, Tata
×T  ime Outstanding receives $189 520 in cash, recorded as follows:

30 April Cash 189 520

Therefore, interest over the life of the note is $5520, 2019
calculated as follows: Interest Receivable 1 840
Interest = Principal × Annual rate of interest × Time outstanding Note Receivable 184 000
= $184 000 × 0.06 × 6/12 months
= $5520 Interest Revenue 3 680
   (To record collection of note)
According to the calculation, Tata will receive $5520 of
Assets   =   Liabilities + Equity
interest at the maturity of the note. However, the revenue
recognition principle requires companies to record interest +189 520 +3 680
revenue when it is earned, even if cash will not be received –184 000
until later. Assuming that Tata has a financial year-end prior –1 840
to the maturity of the note, it must make an adjusting journal
entry to record interest earned during the year. Recall from This entry has four parts. First, the entry increases Cash
Chapter 4 that such an entry is an accrual adjusting entry. for the amount of cash collected by Tata. Second, it
To illustrate, suppose that Tata prepares financial decreases Interest Receivable to eliminate the asset that
statements on 31 December. Tata has not yet received any was created by the 31 December adjusting entry. Third, the
interest payment from Zjax because payment is not entry decreases Note Receivable by its principal value
required until 30 April 2019. However, Tata has earned two because the note has been collected and is no longer
months of interest, calculated as follows: outstanding. Finally, the entry increases Interest Revenue
for the four months of interest (January through April)
Interest earned = Principal × Annual rate of interest × Time outstanding
= $184 000 × 0.06 × 2/12 months earned in the current period ($184 000 × 6% × 4/12). This
= $1840 interest revenue will be reported on Tata’s 2019 statement
of comprehensive income. The result of the entry is a net
On 31 December Tata would record this interest
increase to assets of $3680 and an increase to equity of
revenue as follows:
$3680. If this seems low to you, remember that equity was
31 Dec. Interest Receivable 1 840 increased substantially when the sale was made and the
2018 note created. When Tata collects the note, it is simply
  Interest Revenue 1 840 exchanging one asset for another. The net $3680 increase
   (To record interest earned on note) to assets and equity results from the interest earned during
Assets  =  Liabilities + Equity the three months of the current year.
+1 840 +1 840 YT
PPL HIS
A

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online revision quizzes for this chapter

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CHAPTER 6 Receivables 107
 LO2
5 Recording bad debt expense
EXERCISES While reviewing outstanding accounts receivables, Frankie
determines that a receivable of $5000 is now uncollectible.
REQUIRED
Journalise the entry to record bad debt expense assuming
Frankie uses the direct write-off method. Why might the
LO1
direct write-off method be used? What are the limitations of
1 Recording accounts receivable the direct write-off method on the balance sheet and
On 4 March, Cole Company sells office supplies to a income statement.
customer for $60 000. Terms of the sale are 1/15, n/30. On
10 March, the customer returns $6000 of the goods. The 6 Estimating bad debt expense LO3

customer pays on 15 March.

A company uses the percentage-of-sales approach to
REQUIRED estimate bad debts. Sales for the year were $750 000 and
Prepare all journal entries to record the sale, its return and gross profit was $450 000. The company estimates that
the collection of the receivable. Ignore any effects on 5 per cent of sales are uncollectible.
inventory or cost of goods sold. REQUIRED
LO1
What is the company’s estimated bad debt expense for the
2 Recording sales returns year? Would your answer change if the company was able to
On 5 March, Monica’s Cooking Company sells inventory to a increase its gross profit from its sales?
customer for $3000. On 13 March, the customer returns
$750 of merchandise. The accountant recorded the return 7 Allowance method LO2, 3

with the following entry:

Le uses the allowance method to account for bad debt
13 March Sales 750 expense. Le makes credit sales of $170 000 during the year.
At year end, Le estimates that $9000 of those sales will not
Accounts Payable 750 be collected. The next year, Le determines that a $2500
receivable is uncollectible and should be written off.
REQUIRED
Prepare the entry the accountant should have made when REQUIRED
the merchandise was returned on 13 March and explain why Prepare the journal entries to record the credit sales, bad
the accountant’s entry was incorrect. Ignore any effect on debt expense and the write-off of uncollectible accounts.
cost of goods sold or inventory.
LO3
8 Estimating bad debt expense
LO1
3 Reporting accounts receivable Rachel’s Clothing Company has a receivables balance of
The following records the receipt of cash from a debtor $105 000 at the end of the year. Based on past history,
within the discount period: Rachel estimates that it will not collect 2 per cent of its
receivables balance. Prior to any year-end adjustment, the
Cash 2 425 balance in the allowance account was $200 debit.
Sales Discounts 75 REQUIRED
Accounts Receivable 2 500 a Prepare the journal entry to record bad debt expense for
the year. Show your calculation of bad debt expense in
REQUIRED T-account form.
Explain why the customer has paid only $2425 yet has their b Assume that the balance in the allowance account was a
debt reduced by the full $2500? $100 credit instead of the $200 debit. What is bad debt
expense in this situation? Show your calculation in
LO2
4 Direct write-off method T-account form.
Masters sells $7500 of goods to Johnson during January. In
LO4
April, Masters determines that it will be unable to collect the 9 Horizontal and vertical analyses
receivable from Johnson. The following information pertains to Lara Limited:
REQUIRED
2020 2019
Prepare the journal entries to record the sale and the bad
Net sales $350 000 $342 000
debt expense if Masters uses the direct write-off method.
Ignore any effect on cost of goods sold or inventory. Net accounts receivable 189 000 197 000
Bad debt expense 8 200 7 000
Total assets 410 000 425 000

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
108 ACCT3 Financial
REQUIRED REQUIRED
Prepare horizontal analyses of all four accounts and vertical Determine which method of accounting for bad debts Le Ma
analysis for bad debts expense and net accounts receivables. uses, record all journal entries associated with the allowance
Round percentages to one decimal point (e.g. 23.9%). account for the year, and determine the ending balance in
the allowance account.
LO4
10 Analysing receivables
LO2, 3
The following information pertains to Thirroul Theme Parks: 14 Uncollectible receivables
At 31 December, Duong Designers had gross accounts
Credit sales $900 000 receivable of $346 000. Historically, Duong’s Designers has
Net accounts receivable, beginning 63 000 estimated bad debt expense as 3 per cent of gross
receivables.
Net accounts receivable, ending 54 000
REQUIRED
Allowance for doubtful debts, ending 5 000
a Calculate bad debt expense for the year, assuming that
REQUIRED the allowance account currently has a credit balance of
Calculate Thirroul’s receivables turnover ratio, days-in- $5000. Again, calculate the expense assuming a debit
receivables ratio and allowance ratio. balance of $1200.
b Assume that on 29 December an account receivable of
LO2, 3, 4 $1000 was deemed uncollectible and written off. Prepare
11 Effects of recording bad debt expense
the journal entry to record this event. What effect does
You are the company secretary and shareholders are asking this have on (i) profit or loss this financial year (ii) the net
about how some of the accounting methods have impacted realisable value of receivables?
the figures in the financial statements. The chairwoman has
passed you a note during the annual meeting asking you to LO3
15 Ageing schedule for accounts receivable
fill out the information below so she can explain the effect of
the allowance method: Outdoor Living has the following accounts receivable at year
end, broken down by age:
Net Amount in Amount of Receivables
income accounts accounts turnover Age Amount
receivable receivables ratio
account reported on
Current $150 000
the financial One month overdue 40 000
statements
Two months overdue 18 000
Effect of
bad debt Three months overdue 8 000
expense Four months overdue 11 000
entry
Prior experience has shown that the company will
REQUIRED
probably collect 95 per cent of its current receivables.
Fill out the grid with increase, decrease or no effect. Furthermore, the collection percentage will fall by 10 per
cent (85%, 75% etc.) for each additional month an account
LO6
12 Accounting for notes receivable receivable remains outstanding past its due date.
On 1 March, Abby Actuarial accepted from Nguyen REQUIRED
Networks a six month, 8 per cent, $120 000 note receivable
Develop an estimate of Outdoor Living’s allowance account
and $30 000 in cash, in payment for professional services.
balance and prepare the journal entry for bad debt expense,
The note and interest were paid at maturity on 1 September.
assuming first the allowance has an existing $4000 credit
Abby has a 30 June year end.
balance and second $1000 debit balance.
REQUIRED
LO5
Prepare all journal entries Abby would make to properly 16 Recording notes receivable
account for the service and note. On 1 April, Choi Corporation accepted cash of $15 000 and a
six month, 6 per cent, $85 000 interest-bearing note from
LO2
13 Uncollectible receivables Palaza, Inc., as settlement of an account receivable. Choi
Le Ma reported the following information in its latest annual has a fiscal year end of 30 June, and Palaza paid the
report: principal and the interest at maturity.
REQUIRED
Allowance for bad debts, beginning balance $5 325
Identify the note’s maker and payee and prepare all
Bad debt expense for the year 975 appropriate journal entries from the acceptance of the note
Accounts receivable written off during the year 795 to the maturity date for the payee.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 6 Receivables 109
 LO5
The chartered accountant is trying to decide which
17 Interest on notes receivable method of accounting for bad debts to use. Knight Kiters is
Consider the following independent scenarios: attempting to maximise total comprehensive income to
i On 1 September last year, a company accepted a meet projected figures. The bad debt expense is material to
$20 000, 8 per cent, six-month note receivable. the company’s financial statements.
ii On 15 December last year, a company accepted a REQUIRED
$15 000, 10 per cent, four-month note receivable. a Calculate bad debt expense for 2021 under the direct
iii On 1 March this year, a company accepts a $10 000, write-off method and the allowance method.
5 per cent, eight-month note receivable.
b Calculate profit or loss under both methods (assume a
REQUIRED tax rate of 25 per cent).
Assuming a 30 June (this year) financial year-end, calculate c As a reporting entity does Knight Kiters have the option
current-year interest revenue for each of the above. of which method to use under Australian Accounting
Standards?

LO4
20 Analysing receivables
The following information was taken from the annual reports
of two high-end jewellery retailers:
PROBLEMS
Company A Company B
Net accounts receivable, 2021 $ 584 000 $ 460 000
Net accounts receivable, 2020 505 000 398 000
Net revenues, 2021 2 425 000 2 195 000
18 Accounts receivable entries LO1, 2, 3 Net revenues, 2020 2 200 000 1 500 000

During the 2019–20 financial year El-Kheir Electronics REQUIRED

entered into the following transactions: a Calculate the 2021 receivables turnover ratio for both
companies.
Sales on account $1 400 000
b Compare the two companies. Which one is more
Collections of credit sales 1 225 000 efficient with its receivables?
Write off accounts deemed uncollectible 20 000 c What other methods and factors would you consider
Received payments on accounts previously written off 7 500 when evaluating receivables? What other comparison
demonstrates one company’s efficiency over the other?
On its balance sheet for the year ended 30 June 2020,
LO5
El-Kheir reported gross accounts receivable of $707 000 21 Recording notes receivable
credit and an allowance account of $43 000 debit. On 15 February, Tran Corporation sold equipment to Adams
REQUIRED Corporation on account for $40 000. On 1 November, Tran
deemed the account uncollectible and wrote it off. On 31
Prepare all journal entries to record each of the transactions
December, Adams offered Tran a six month, 10 per cent,
that occurred in 2019–20 and the journal entry to record bad
$40 000 promissory note in payment of its obligation, which
debt expense at 30 June 2020, assuming that 5 per cent of
Tran accepted. Adams paid the principal and the interest at
accounts receivable at 30 June are uncollectible.
the maturity date. Tran uses the allowance method for bad
LO2, 3
debts.
19 Comparing methods for uncollectible
receivables REQUIRED
a Prepare all of Tran’s necessary journal entries from the
The following data pertains to the operations of Knight
date of the equipment sale to the maturity date of the
Kiters for 2021:
note. Ignore any effect on inventory or cost of goods
Net credit sales $925 000 sold.
b What would be Tran’s motives for offering a promissory
Net operating income (before bad debt expense) 135 000
note in settlement of such an old debt?
Write-offs of uncollectible accounts 17 500
Estimated uncollectible percentage of net credit sales 2%

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
110 ACCT3 Financial
 LO2, 3
23 Ethics in accounting
The Cho Corporation is in the process of closing its books
for the year. The company has been growing at an
CASES unexpected rate. The chief accountant at Cho is currently
determining the applicable percentage for the allowance for
bad debts and believes it should be based on 3 per cent of
net credit sales. The CEO of the company has expressed
concerns about achieving future market expectations and
approached the chief accountant with a request to increase
22 Research and analysis LO1, 4 the allowance for bad debts to 6 per cent of net credit sales
with the expectation that the lower net income will
Access the latest annual report for Cochlear Limited (ASX: decrease the pressure to perform in future years.
COH) (or a company chosen by your lecturer).
REQUIRED
REQUIRED
a What factors should be considered when determining
a Examine the company’s statement of comprehensive the applicable percentage to apply when using the
income and balance sheet and conduct horizontal and income statement or balance sheet approach?
vertical analyses of what you consider to be the four
b Should the chief accountant be concerned with the
most relevant accounts in both statements.
company’s growth rate when determining the allowance
b Examine the company’s receivables note. Answer as for bad debts? Explain.
many of the following as the information provided in the
notes to the accounts allows: LO2, 3
24 Written communication
i What is the company’s current year balance in its
allowance for doubtful debts (allowance for The Chief Financial Officer (CFO) of a manufacturing plant
impairment loss or similar-named) account? that sells light machinery throughout Australasia is
currently training new employees. In today’s training
ii What factors are considered when estimating the
session the group is told that total credit sales for the
balance?
year is $900 million, accounts receivable total
iii How often is the balance reviewed?
$120 million less a $3 million allowance for bad debts,
iv What likelihood does the company require before it and bad debt expense is $2 million. At the end of the
writes off a receivable? session the group is asked if they understand everything
v Why are there receivables ‘past due’ but not discussed; and all say yes except one trainee who is still
impaired? somewhat confused about why bad debt expense and
vi How does the company assess the risk and/or make the allowance balance differ.
estimates/judgements?
REQUIRED
c With the gathered information, calculate the company’s
As one of the trainees who understands the training
receivables turnover and days-in-receivables ratios for the
session, the CFO asks you to research this issue and
current financial year, and the company’s allowance ratio
prepare a presentation explaining the difference to present
for the current and previous financial year. Why should you
to the other trainees tomorrow. The presentation should run
be careful in interpreting these results (think – do you
between three and five minutes and should include some
know sales on credit or just total sales)?
PowerPoint slides.
d Based on your answers above, write a paragraph
explaining your opinion of the company’s receivables
position. Use your answers as supporting facts
(remember all sales may not be credit sales).

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 6 Receivables 111
 7
This chapter examines the accounting for inventory. In
particular, it examines how businesses record their
inventory and how they determine the cost of the
inventory that is sold. It also examines how inventory can
be estimated if needed and how inventory must be
adjusted if its market value falls below its cost. The
chapter then concludes with an analysis of a business’
inventory position. The appendix covers inventory
accounting under a periodic (sometimes known as a
physical inventory) system.

Inventory
LO1  ECORDING, EXPENSING
R
AND REPORTING
INVENTORY
LEARNING
OBJECTIVES
Inventory is a tangible resource that is held for resale in
the normal course of operations. For a
retailer, inventory is the stock (merchandise, inventory  A tangible
resource that is held for
After studying the material in this chapter, you goods) on the shelves or in the warehouse. resale in the normal
should be able to: For a car dealership the cars are inventory course of operations.
while for most businesses cars are non-
1 Describe inventory and how it is recorded,
expensed and reported. current assets. When a business decides to sell a non-current
asset, such as a car, it is not considered to be inventory
2 Calculate the cost of sales using different because it was not purchased and held as ‘intended for
inventory costing methods. resale’. For a manufacturer, inventory also includes the raw
3 Understand the profit and loss effects of materials and work-in-process related to producing a finished
inventory cost flow assumptions. product, which you may YT
PPL HIS

A
4 Demonstrate how inventory study in managerial Check out the video summary
for Chapter 7
can be estimated. accounting.

5 Apply the lower-of-cost-and-net-realisable-

value rule to inventory.
RECORDING INVENTORY
Following the cost principle, inventory is recorded at its
6 Evaluate inventory through the calculation
acquisition cost. This includes all costs incurred to get the
of horizontal, vertical and ratio analyses.
inventory delivered and, if necessary, prepared for resale.
7 Appendix: record purchases and calculate Like buying on eBay, we are interested in how much it
the cost of sales under a periodic system. costs in total (is ‘postage’ included, will we need to buy
batteries separately) not just the ‘price’. Cost also includes
any reductions granted by the vendor or supplier after
purchase. Examples of items affecting the cost of inventory
would include, but is not limited to, the following:
● purchase price
● taxes or duties paid
● cost of shipping and transit insurance
Express
● labour required to assemble the product
YT
PPL HIS
Throughout this ● returns to, allowances from (including purchase
A

chapter apply this discounts) from the supplier.

icons indicate
an opportunity While inventory is recorded at cost, how it is recorded
for online in the accounting system depends on the inventory
self-study through system that a business uses. A
CourseMate Express,
linking you to revision
perpetual inventory system updates perpetual inventory
quizzes, e-lectures, the Inventory account each time inventory system  Updates the
animations and more. inventory account each
is bought and sold – that is, perpetually. time inventory is bought or
Therefore,
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, purchases
scanned, or duplicated, inof inventory
whole are 02-200-202
or in part. WCN sold.
112
 Shutterstock.com/vipman 10 Oct. Inventory 300
 Cash 300
   (To record transportation-in)
Assets = Liabilities + Equity
+300
–300

Sometimes, a business will return inventory to the

vendor (supplier) or seek some reduction in the cost of
the inventory due to defective merchandise (inventory).
The former is called a purchase return, purchase returns
while the latter is a purchase allowance. and allowances  An
For a retailer, inventory is an important asset, and accounting for it
properly affects both the balance sheet and the income statement Both reduce the cost of the inventory account that accumulates
the cost of all inventory
purchased. returned to vendors as
To illustrate, suppose that on 12 October well as the cost reductions
from vendor allowances.
recorded directly into the Inventory Thirroul is granted a $1000 reduction in the
periodic (physical) cost of the goods (inventory) due to blemishes on the
inventory system  account. In contrast, a periodic
Updates the inventory (physical) inventory system updates inventory. Even though Thirroul keeps the inventory, its cost
account only at the end of has decreased due to the purchase allowance. Therefore,
an accounting period. the inventory account only at the end of
an accounting period – that is, Thirroul would reduce the cost of the inventory and the
periodically. Instead of recording purchases into the amount payable to the vendor with the following entry:
inventory account, they are recorded in an account called 12 Oct. Accounts Payable 1 000
Purchases, which is a temporary
purchases  An account  Inventory 1 000
used to accumulate the account that is closed to Inventory at the
cost of all purchases. end of the period. This chapter will   (To record purchase allowance granted
by vendor)
demonstrate inventory accounting under
Assets = Liabilities + Equity
a perpetual system. The periodic system is demonstrated
in the appendix to this chapter. –1 000 –1 000
To illustrate the recording of inventory, suppose that
In addition to returns and allowances, companies
Thirroul Takeaway purchases $20 000 of inventory on
sometimes receive discounts from vendors if payment is
account (on credit) on 10 October. The purchase would be
made within a certain time period. Such purchase discounts
recorded as follows:
reduce the cost of the inventory. To illustrate, suppose that
10 Oct. Inventory 20 000 Thirroul pays its remaining $19 000 bill to the vendor on 15
  Accounts Payable 20 000 October, which qualifies Thirroul for a 1 per cent discount. As
   (To record purchase of inventory) a result, Thirroul would save $190 ($19 000 × 1%) and pay only
$18 810. The entry to record payment would be as follows:
Assets = Liabilities + Equity
+20 000 +20 000 15 Oct. Accounts Payable 19 000
 Inventory 190
Both assets and liabilities increase as a result of this
 Cash 18 810
transaction.
   (To record payment)
In some cases, a business must pay for the
transportation (‘postage’). Such additional costs are called Assets = Liabilities + Equity
transportation-in and are added to the –190 –19 000
transportation-in  An
account that accumulates overall cost of the inventory. To illustrate, –18 810
the transportation costs of suppose that Thirroul pays a third-party
obtaining the inventory.
carrier $300 to transport the inventory to The entry decreases Accounts Payable for the full
its warehouse. Thirroul would record the payment with the $19 000 (since the debt is paid in full) and decreases Cash
following entry: by the $18 810 paid. The difference is a reduction to
Inventory because the purchase discount of $190 has
reduced the cost of the inventory. Both assets and
liabilities decrease.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 7 Inventory 113
 In some circumstances the supplier may allow a long The second entry records the effect of the sale on
period before payment is required. The purchase price Thirroul’s inventory and expenses. Cost of Sales increases
could then be considered to contain a financing element for the cost of the inventory sold. Inventory decreases for
and, in accordance with Accounting Standard AASB 102 the same amount (we could think of this as the ‘goods’
Inventories par. 18,1 some of the purchase price would be flow). As a result, both assets and equity decrease by $400
considered an interest expense. Consistent with this (remember an expense is a decrease in equity). The net
treatment, early payments resulting in any purchase effect of both entries on assets and equity is a $200
discount is considered to be a reduction in inventory, not a increase, which is equal to the gross profit that Thirroul
revenue or contra expense. earned on the sale.
Given the preceding activity, Thirroul’s net purchases of In contrast a service business only has a ‘money’ flow,
inventory can be calculated as follows: they do not have the corresponding ‘goods’ flow.

Gross purchases $20 000

Shutterstock.com/Marcin Balcerzak
Add: Transportation-in 300
Less: Purchase returns and allowances (1 000)
Less: Purchase discounts   (190)
Net purchases (Inventory balance) $19 110

EXPENSING INVENTORY
Inventory becomes an expense when it is sold. The account
Cost of Sales (COS) or Cost of Goods Sold (COGS) is used to
capture the amount of inventory expensed during a period.
Like the recording of inventory purchases, the recording of
cost of sales depends on a business’ inventory system. Under
a perpetual system, COS is updated each time inventory is
sold – that is, perpetually. Under a periodic system, COS is
calculated and recorded only at the end of the period – that
is, periodically. Again, this chapter will demonstrate inventory Inventory in the warehouse before it is sent to the customer
accounting under a perpetual system, with the periodic
system demonstrated in the appendix to the chapter. REPORTING INVENTORY AND COST OF SALES
To illustrate the recording of cost of sales, suppose that
on 2 November Thirroul sells inventory that cost them Inventory is expected to be sold within a year. Therefore, it
$400, to a customer for $600 cash. Thirroul would record is reported on the balance sheet as a current asset. Because
the sale with the following two entries: cost of sales is usually a large and important expense for a
retailer or manufacturer, it is normally reported as a separate
2 Nov. Cash 600 line item on the income statement just below sales.
  Sales (Revenue) 600 To illustrate, examine the balance sheet and income
   (To record sale of inventory) statement for CSL in Appendix B. Inventory is an important
Assets = Liabilities + Equity asset. CSL reported Inventories of over $2 billion in both 2016
and 2017 – its largest current asset. It also reported over
+600 +600
$3 billion in Cost of Sales in both years, its largest expense.
YT
PPL HIS
A

2 Nov. Cost of Sales 400 Review this content with the e-lecture

 Inventory 400
   (To record sale of inventory)
Assets = Liabilities + Equity LO2 I NVENTORY COSTING
–400 –400 METHODS
The first entry records the effect of the sale on Thirroul’s The previous section demonstrated the manner in which
cash and revenues. Both Cash and Sales increase for the inventory and cost of sales are recorded under a perpetual
amount of the sale. As a result, both assets and equity system. When a sale is made, Inventory (asset) is decreased
(revenue) increase by $600 (we could think of this as the and Cost of Sales (expense) is increased for the cost to the
‘money’ flow). retailer of the inventory that is sold. This section
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
114 ACCT3 Financial
 demonstrates how companies determine the cost of the inventory is unique; for example, a jewellery store that sells
inventory sold, the ‘Cost of Sales’. expensive individually designed jewellery.
For illustration purposes, suppose that Koala specifically
identifies each of its inventory items and provides the
ANALYSIS
Look at the financial statements detailed inventory activity as shown in Exhibit 7.1.
of CSL in Appendix B: Exhibit 7.1 shows that the 10 September sale consisted
• What name does the company use for its inventory of 30 $12 units and 35 $13 units for a total cost of $815. The
and cost of goods sold? 30 September sale consisted of 10 $12 units, 20 $13 units,
• Inventory is the company’s largest current asset. What 10 $14 units, and 10 $15 units for a total cost of $670.
is the second largest? Together, cost of sales for September is $1485 ($815 +
• Cost of sales (COS) is the company’s largest expense. $670). The 60 units remaining in ending inventory, as shown
What is the second largest? in the bottom right corner of Exhibit 7.1, have a cost of $870.
Analysis: CSL, because of the nature of its product is likely to use
CSL uses the names ‘Inventories’ in both the balance
specific identification. Each batch of medicine will be able
sheet in Note 4 and cost of sales in the income statement,
(there is no note for cost of sales). In 2017, trade and to be identified from manufacturing to customer (i.e.
other receivables was the company’s second-largest hospital, chemist, doctor) and in many cases consumer
current asset, less than half the value of inventory. Cost of (‘medicines to patient’ as CSL describes its business).
sales is by far the largest expense while research and Because most companies cannot track the actual cost
development is second largest, but selling and marketing of every inventory item that is sold, they cannot use the
is a close third at about 20 per cent the size of COS.
specific identification method. Instead, they must make an
assumption about the cost of inventory sold. They can
To determine the cost of inventory sold, companies can assume that the cost of the inventory sold is the cost of the
use one of the following four inventory costing methods. first unit purchased, the last unit purchased or an average
In Australia, AASB 102 does not permit the use of the third of all purchases.
YT
method (LIFO); however, this method is used in other parts Each of these three PPL HIS

A
of the world, primarily Japan and the US: assumptions is Check out the animated summary
on Specific Identification
● specific identification described as follows.
● first-in, first-out (FIFO)
first-in, first-out
● last-in, first-out (LIFO) FIRST-IN, FIRST-OUT (FIFO) (FIFO) method 
● moving average. The first-in, first-out (FIFO) method Calculates cost of sales
To illustrate each method, the following example will be based on the assumption
calculates cost of sales based on the that the first unit of
used. Suppose that Koala General Store sells goanna oil assumption that the first unit of inventory inventory available for sale
that it purchases from Bandicoot Manufacturing. During is the first unit sold.
available for sale is the first unit sold. That
the month of September, Koala experiences the following is, inventory is assumed to be sold in the order that it is
inventory activity: purchased. For many companies, the FIFO assumption
Unit may match the actual physical flow of their inventory.
Units Total
cost However, companies are not required to choose the
1 Sep. Beginning inventory 40 $12 $480 assumption that most closely matches their physical flow.
4 Sep. Purchase 60 $13 $780 Remember this is an assumption because the actual items
10 Sep. Sale (65) sold cannot be identified, they could be the oldest, the
15 Sep. Purchase 30 $14 $420 newest or any combination.
Exhibit 7.2 illustrates the calculation of cost of sales
23 Sep. Purchase 45 $15 $675
under the FIFO method.
30 Sep. Sale (50)
At each sale, the FIFO method requires Koala to assign
the costs of the first units purchased (the oldest stock on
SPECIFIC IDENTIFICATION hand) to cost of sales. On 10 September Koala sold
65 units. It therefore assumes that it sold all 40 units of
specific The specific identification method
beginning inventory and 25 of the units in Purchase #1. The
identification determines cost of sales based on the
method  Determines total cost of those 65 units was $805.
actual cost of each inventory item sold.
cost of sales based on the For the 30 September sale, Koala assumes that it sold
actual cost of each To use this method, a retailer must know
inventory item sold. the 35 units remaining from Purchase #1 and 15 units of
specifically which inventory item is sold
Purchase #2. The total cost of those 50 units was $665.
and the exact cost of that particular item. As a result, the
As a result of these two calculations, cost of sales for
method is most likely to be used by companies whose
September is $1470 ($805 + $665). The 60 units remaining
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 7 Inventory 115
 Transaction Inventory purchased Inventory sold Inventory on hand
1 Sep. Beginning inventory  40 $12 $ 480
4 Sep. Purchase #1 60 $13 $780  40 $12 $ 480
  60 $13 780
100 $1 260
10 Sep. Sell 65 units 30 $12 $360  10 $12 $ 120
35 $13   455  25 $13 325
65 $815   35 $ 445
15 Sep. Purchase #2 30 $14 $420  10 $12 $ 120
 25 $13 325
  30 $14 420
 65 $ 865
23 Sep. Purchase #3 45 $15 $675  10 $12 $ 120
 25 $13 325
 30 $14 420
  45 $15 675
110 $1 540
30 Sep. Sell 50 units 10 $12 $120   0 $12 $ 0
20 $13  260   5 $13 65
10 $14  140  20 $14 280
10 $15   150  35 $15 525
50 $670  60 $ 870
EXHIBIT Calculations for the specific identification method
7.1

Transaction Inventory purchased Inventory sold Inventory on hand

1 Sep. Beginning inventory  40 $12 $ 480
4 Sep. Purchase #1 60 $13 $780  40 $12 $ 480
  60 $13 780
100 $1 260
10 Sep. Sell 65 units 40 $12 $480   0 $12 $ 0
25 $13   325  35 $13 455
65 $805  35 $ 455
15 Sep. Purchase #2 30 $14 $420  35 $13 $ 455
  30 $14 420
 65 $ 875
23 Sep. Purchase #3 45 $15 $675  35 $13 $ 455
 30 $14 420
  45 $15 675
110 $1 550
30 Sep. Sell 50 units 35 $13 $455   0 $13 $ 0
15 $14   210  15 $14 210
50 $665   45 $15 675
 60 $ 885
EXHIBIT Calculations for the FIFO method
7.2

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
116 ACCT3 Financial
 in ending inventory, as shown in the bottom right corner of assumes that it sold all 60 units of Purchase #1 and five of
Exhibit 7.2, have a cost of $885. the units from beginning inventory. The total cost of those
Remember with FIFO we are not tracking the sale of each 65 units was $840.
item. Because we do not know if we have sold the oldest For the 30 September sale, Koala assumes that it sold
item in stock or the newest, FIFO is an assumption. Even for all 45 units of Purchase #3 and five units of Purchase #2.
items where a retailer may attempt to sell the oldest stock The total cost of those 50 units was $745.
first e.g. milk. Nothing stops a customer taking the newest As a result, cost of sales for September is $1585
milk from the back of the fridge; all milk of the same brand, ($840 + $745). Ending inventory, as shown in the bottom
YT
type and size will have the same barcode, regardless of the right corner of Exhibit 7.3, has PPL HIS

A
use-by date. Milk that expires in two days is indistinguishable a cost of $770. Check out the animated
summary on LIFO
from the milk expiring in 12 days to the computer program
perpetually tracking inventory. The same is likely to apply to MOVING AVERAGE
refrigerators, each brand and model
YT
The moving average method calculates cost of sales
PPL HIS will have the same barcode whether
based on the average unit cost of all
A

Check out the animated manufactured last week or last year. moving average
summary on FIFO inventory available for sale. That is, the method  Calculates cost
cost of each inventory item sold is of sales based on the
LAST-IN, FIRST-OUT (LIFO) average unit cost of all
assumed to be the average cost of all inventory available for sale.
last-in, first-out
(LIFO) method  The last-in, first-out (LIFO) method inventory available for sale at that time.
Calculates cost of sales
based on the assumption
calculates cost of sales based on the To calculate cost of sales at each sale date, a retailer
that the last unit of assumption that the most recent must calculate the average unit cost of the inventory
inventory available for sale purchases (the newest stock on hand) available for sale on that date. This calculation is conducted
is the first unit sold.
are sold first. As previously mentioned, as follows:
while not currently permitted in Australia, this method is
used in other parts of the world, primarily Japan and the
US. Exhibit 7.3 illustrates the calculations under the LIFO KEY FORMULA 7.1 AVERAGE UNIT COST
method. Cost of Goods Available for Sale
At each sale, the LIFO method requires Koala to assign Average Unit Cost =
Units Available for Sale
the costs of the last or most recent units purchased to cost
of sales. On 10 September, Koala sold 65 units. It therefore

Transaction Inventory purchased Inventory sold Inventory on hand

1 Sep. Beginning inventory  40 $12 $ 480
4 Sep. Purchase #1 60 $13 $780  40 $12 $ 480
  60 $13 780
100 $1 260
10 Sep. Sell 65 units  5 $12 $ 60  35 $12 $ 420
60 $13   780   0 $13 0
65 $840  35 $ 420
15 Sep. Purchase #2 30 $14 $420  35 $12 420
 30 $14 420
 65 $ 840
23 Sep. Purchase #3 45 $15 $675  35 $12 $ 420
 30 $14 420
  45 $15 675
110 $1 515
30 Sep. Sell 50 units  5 $14 $ 70  35 $12 $ 420
 25 $14 350
45 $15   675   0 $15 0
50 $745  60 $ 770
EXHIBIT Calculations for the LIFO method
7.3

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 7 Inventory 117
 Transaction Inventory purchased Inventory sold Inventory on hand
1 Sep. Beginning inventory  40 $12.00 $ 480
4 Sep. Purchase #1 60 $13 $780  40 $12.00 $ 480
  60 $13.00 780
100 $1 260
10 Sep. Sell 65 units 65 $12.60 $819  35 $12.60 $ 441
15 Sep. Purchase #2 30 $14 $420  35 $12.60 $ 441
 30 $14.00 420
 65 $ 861
23 Sep. Purchase #3 45 $15 $675  35 $12.60 $ 441
 30 $14.00 420
  45 $15.00 675
110 $1 536
30 Sep. Sell 50 units 50 $13.96 $698  60 $13.96 $ 838
EXHIBIT Calculations for the moving average method
7.4

Once the average unit cost is known, it is multiplied by the freshest and best but may end up with some pieces
YT
the units sold to determine cost of sales. Exhibit 7.4 delivered last month PPL HIS

A
contains Koala’s calculations under the moving average and others yesterday. Check out the animated summary
on Moving Average
method. Note that the average unit cost is rounded to the
nearest cent, while inventory sold and inventory on hand
is rounded to the nearest dollar. LO3 COMPARING INVENTORY
At the 10 September sale, Koala has 100 units
available for sale at a total cost of $1260. Therefore, the
COSTING METHODS
average unit cost is $12.60 ($1260/100). Koala uses that
The previous sections show that a business’ choice of
unit cost to determine the costs of the inventory sold and
inventory costing methods affects both its cost of sales
the inventory that remains. Having sold 65 units, Koala’s
and its ending inventory. To summarise these effects,
cost of sales on 10 September is $819 (65 × $12.60). The
Exhibit 7.5 puts Koala’s inventory data in a form known as
cost of the 35 units on hand after the sale is therefore
the cost-of-goods-sold model and compares the results of
$441 (35 × $12.60).
each of the three cost flow assumptions. The specific
For the 30 September sale, Koala must recalculate the
identification method is omitted from the comparison
average unit cost because it has purchased additional units
because of its infrequent use.
of inventory. This is why the term ‘moving average’ is used,
because the average cost per unit can change during the
Units FIFO Moving LIFO
period as new purchases are made. average
At 30 September, Koala has 110 units available for sale Beginning inventory  40   $480   $480   $480
at a total cost of $1536. Therefore, the new average unit Add: Net purchases 135   1 875   1 875 1 875
cost, rounded to the nearest cent, is $13.96 ($1536/110).
Cost of goods 175 $2 355 $2 355 $2 355
Having sold 50 units, Koala’s cost of sales on 30 September available for sale
is $698 (50 × $13.96). Less: Ending inventory   60   885   838   770
As a result of these two calculations, cost of sales for
Cost of sales 115 $1 470 $1 517 $1 585
September is $1517 ($819 + $698). Ending inventory, as
shown in the bottom right corner of Exhibit 7.4, has an EXHIBIT Comparison of inventory costing methods
7.5
average unit cost of $13.96, for a total cost of $838 (60 ×
$13.96).
The cost-of-goods-sold model summarises a business’
While moving average provides a compromise, giving
inventory activity during a period by adding purchases to
closing inventory and COS figures between the extremes
beginning inventory to yield cost of goods available for
of FIFO and LIFO, in reality most products cannot be
sale. This represents the total cost of the inventory that
mixed, and the average products are sold or remain. Most
could have been sold during the period. That cost is then
products come in their own package, one exception is fruit
allocated to either what was sold (cost of sales) or what
and vegetables where the customer attempts to select
was not sold (ending inventory).
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
118 ACCT3 Financial
 In Koala’s case, it began the month of September with FIFO Moving LIFO
40 units costing $480 and bought an additional 135 units average
costing $1875 during the month. So, it could have sold up Sales $5 240 $5 240 $5 240
to 175 units with a total cost of $2355. This is the case Cost of sales (1 470) (1 517) (1 585)
regardless of the inventory costing system chosen. Gross margin $3 770 $3 723 $3 655
However, the cost of the 115 units sold and the 60 units
Operating expenses (1 850) (1 850) (1 850)
unsold depends on the cost flow assumption.
Profit before tax $1 920 $1 873 $1 805
The FIFO method assigns the costs of the first and,
in this case, less expensive units purchased to cost of EXHIBIT Comparative statements of income
7.6
sales, thereby yielding the lowest cost of sales. It also
assigns the costs of the last and more expensive units
to ending inventory, thereby yielding the highest ending concern with using LIFO is not the lower profits
inventory. (accountants like prudent accounting methods); it is often
In contrast, the LIFO method assigns the costs of the the out-of-date value placed on closing inventory.
last and, in this case, more expensive units to cost of sales, Under a perpetual inventory system, the inventory
resulting in the highest cost of sales. The costs of the first account is updated each time inventory is bought or sold.
and less expensive units are assigned to ending inventory, However, many businesses take a physical count of
resulting in the lowest ending inventory. inventory at least once a year to confirm that the inventory
The moving average assigns the average costs of all balance from the accounting system matches the actual
units purchased to cost of sales. Therefore, it yields cost of inventory on hand. Taking a physical inventory is an example
sales and ending inventory that fall in between the FIFO of an internal control procedure discussed in Chapter 5. By
and LIFO extremes. counting inventory, a business can determine if it has lost
When a business experiences rising prices for its inventory due to theft, damage or errors in accounting.
inventory, these relative differences will continue. These
Newspix/Shannon Morris

relationships are summarised as follows:

Ending inventory Cost of sales
FIFO yields: Highest Lowest
Moving average yields: Middle Middle
LIFO yields: Lowest Highest

Because of these differences in both the income

statement accounts and balance sheet accounts, a reporting
entity (a business required to lodge financial statements
with the Australian Securities and Investments Commission
[ASIC]) must disclose the inventory costing method that it
uses.2 It should use the same method consistently. These
A stocktake sale is based on the concept of selling
requirements allow for meaningful comparisons of inventory the inventory rather counting it – a stocktake
activity across different businesses and across different
periods within the same business.
In the US, companies can use any of the four costing
methods. Some choose the LIFO method because of the LO4 ESTIMATING ENDING
resulting tax benefits. In Australia LIFO cannot be used for INVENTORY
either financial reporting or tax.
To illustrate, suppose that Koala generated revenues of A business must sometimes estimate its inventory
$5240 from its sale of inventory during September. balance. One example is when inventory is destroyed by
Suppose further that it incurred $1850 in operating fire. Another example is when a business may not be able
expenses during the month. Exhibit 7.6 contains to rely on its perpetual inventory records, for example if
comparative multi-step statements of income prepared there is high theft or wastage rates. In
under each inventory costing method. such cases, a business can estimate its retail method  A
Comparing the profit before tax under the LIFO and ending inventory with the gross profit method of estimating the
cost of inventory knowing
FIFO assumptions (which are the two extremes), you can (margin) method or retail method. Both the selling price and
see that Koala could report $115 less profit if it uses the rely on gross profit margins (the ‘mark- reducing it by the gross
profit percentage.
LIFO method rather than the FIFO method. Generally, the up’) to determine closing inventory values.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 7 Inventory 119
 AASB 102 paragraph 22 states: Beginning inventory (actual) $200
The retail method is often used in the retail industry
Add: Net purchases (actual) 90
for measuring inventories of large numbers of rapidly
changing items with similar margins for which it is Cost of goods available for sale (actual) $290
impracticable to use other costing methods. The cost Less: Cost of sales (estimated) (220)
of inventory is determined by reducing the sales value
of the inventory by the appropriate percentage gross Ending inventory (estimated) $ 70
YT
margin. The percentage used takes into consideration PPL HIS

A
inventory that has been marked down to below its Review this content with the e-lecture
original selling price. An average percentage for each
retail department is often used.3

With the retail method, once ending inventory is

counted (stocktake) and the selling price recorded (selling
LO5 LOWER-OF-COST-AND-NET
price may be determined from the price docket on the item REALISABLE VALUE
or from the computer records that provide the cash register
with the price to charge the customer when the item is The cost principle requires that inventory be recorded at its
scanned), the total sales value of inventory is reduced by cost. However, because of the principle of prudence, accounting
the profit margin. To illustrate, CSL has a gross profit margin rules require that inventory be reported on the balance sheet
of 51.9 per cent in 2017 (gross profit of $3596m/total at its net realisable value (NRV) if the market value is lower than
operating revenue of $6922.8m), and 50.1 per cent in 2016. the inventory’s cost. This is sometimes referred to as the
The COGS is then 48.1 per cent (100% – 51.9%). lower-of-cost-and-net-realisable-value
lower-of-cost-and-
To illustrate the gross profit method, assume that (LCNRV) rule. The LCNRV rule is applied at net-realisable-value
Howard Hardware is preparing financial statements and the end of each accounting period by (LCNRV) rule 
Requires inventory to be
needs to estimate cost of sales and ending inventory. comparing inventory costs to NRV. According reported on the balance
Howard has generated sales of $400 million. In the past, to the accounting standard AASB 102, NRV sheet at its market value if
the market value is lower
Howard’s gross profit percentage has averaged 45 per ‘refers to the net amount that an entity than the inventory’s cost.
cent. Assuming that this financial period is similar to prior expects to realise from the sale of inventory
periods, Howard can estimate that gross profit on current in the ordinary course of business’.4 When the cost is lower
sales is $180 million. All figures are in millions: than the NRV, we do not recognise the potential gain, nothing
further is done. However, when the NRV is lower than the cost,
Current quarter sales (actual) $400
the business must adjust its inventory down to the lower NRV.
Historical gross profit percentage × 45% To illustrate, suppose that Loyeung Company provides
Gross profit (estimated) $180 the 30 June inventory information shown in Exhibit 7.7.
Although the gain in item A is greater than the loss in
Current quarter sales (actual) $400 item B, the standard does not allow losses in one inventory
Gross profit (estimated) (180) item to be offset by gains in another. Only in limited
circumstances can similar items of inventory be treated as
Cost of sales (estimated) $220
a group of the same type. For Loyeung the two items of
Howard can then estimate cost of sales for the period inventory report a net gain of $30, but prudence requires
as $220. the recognition of the loss, although the item is yet to be
Now that Howard has estimated cost of sales, it can sold, but not the potential (unrealised) gain. Therefore, we
calculate its ending inventory by plugging the cost of sales record the above information as follows:
estimate into the cost-of-goods-sold model. Based on past
30 June Loss on Inventory 120
financial reports and purchase records, Howard knows that
 Inventory 120
it starts this period with $200 in inventory and bought $90
of inventory. This means that Howard had $290 in inventory    (To record loss on inventory item B)
available for sale during the period. With $220 in estimated Assets    =  Liabilities   +  Equity
cost of sales, the cost-of-goods-sold model yields a $70 –120 –120
estimate for ending inventory.

Item Units Unit cost Unit NRV Total cost Total NRV LCNRV Gain or (Loss)
A 5 $ 40 $ 70 $ 200 $ 350 $ 200 $ 150
B 8 $ 65 $ 50 $ 520 $ 400 $ 400 ($ 120)
EXHIBIT LCNRV calculation for L
­ oyeung Company as of 30 June
7.7

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
120 ACCT3 Financial
 The journal entry increases Loss on Inventory to reflect account, yielding a percentage. The base account is total
the loss in value of the inventory and decreases Inventory assets for balance sheet accounts and net sales or total
to adjust the account down to the $600 lower of cost and revenues for income statement accounts. These
net realisable value. As a result, both assets and equity calculations are summarised as follows:
decrease. Loyeung’s inventory is now ready to be reported
on the balance sheet at its more prudent LCNRV. KEY FORMULA 7.2 HORIZONTAL ANALYSIS

Dollar Change in Account Balance = C

 urrent-year Balance
– Prior-year Balance
ANALYSIS
Look at ‘Inventories’, Percentage Change in Account Dollar change
=
paragraph 4, in the CSL Financial Balance Prior – year balance
Report 2017 (available online). What inventory valuation
method does the company use?
Analysis: KEY FORMULA 7.3 VERTICAL ANALYSIS
The note indicates that the company uses the lower-of-cost For the For the income
-or-net-realisable-value method (cost includes direct balance sheet statement
materials, labour and an appropriate proportion of variable Account Balance Account Balance
and fixed overhead (these terms are discussed in detail in the Percentage = or
Total Assets Net Sales or Revenue
ACCT Managerial book). Net realisable value is the estimated
revenue that can be earned from the sale of a product less
the estimated cost of both completion and selling.

Shutterstock.com/Kzenon

LO6  VALUATING A BUSINESS’

E
MANAGEMENT OF
INVENTORY
Any investor, creditor or manager of a business should be
interested in how well the business manages its inventory.
A business manages its inventory by buying and selling Some inventory needs to be sold quickly or it will
spoil and have to be thrown out
efficiently and effectively.
The following sections examine the effectiveness of a Given Araya Accessories’ financial information in
retailer – let’s call it Araya Accessories Limited – in managing Exhibit 7.8, horizontal and vertical analyses of inventory and
its inventory. The examination will require information from cost of sales result in the following:
the company’s balance sheet and income statement. The
required information is found in Exhibit 7.8, excerpted from Horizontal analysis
the Araya Accessories Annual Report 2019. Change Percentage change
6 705
Source Accounts 2019 2018 (75) = 1.1%
Inventory –6 780
Income Net Sales $62 884 $61 471 6 780
(75)
statement Cost of Sales 44 157 42 929 44 157
1 228 = 2.9%
Balance Inventory 6 705 6 780 Cost of Sales –42 929
42 929
sheet Total Assets 44 106 44 560 1 228
Vertical analysis
EXHIBIT Account balances from Araya Accessories’ annual
7.8 report (all figures in thousands)
2019 2018
 6 705  = 15.2%  6 780  = 15.2%
Inventory
HORIZONTAL AND VERTICAL ANALYSES 44 106 44 560
44 157 = 70.2% 42 929 = 69.8%
An easy and useful place to start an examination of Cost of Sales
62 884 61 471
inventory is with horizontal and vertical analyses. Recall
from Chapter 2 that horizontal analysis calculates the dollar The calculations show a fairly stable inventory position.
change in an account balance, defined as the current-year Horizontal analysis of inventory shows a $75 million
balance less the prior-year balance, and divides that change decrease, which equals a 1.1 per cent reduction. Vertical
by the prior-year balance to yield the percentage change. analysis indicates that inventories made up 15.2 per cent
Vertical analysis divides each account balance by a base
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 7 Inventory 121
 of total assets in both 2018 and 2019. So, although
inventory stocks were down slightly, the decrease mirrored ‘CSL seeks to maintain appropriate levels of inventory and
an overall decrease in Araya Accessories’ total assets. safety stock and ensure that where practicable we have
alternative supply arrangements in place’.5
The analysis of cost of sales shows an increase of
$1228 million, which equals a 2.9 per cent increase. Cost of sales:
Furthermore, vertical analysis indicates that cost of sales
($3326.8 – $43 052.8) / $3052.8 = 9.0%
was 69.8 per cent of sales in 2018 and 70.2 per cent of
sales in 2019. The reason for this increase is that cost of Vertical analysis
sales increased faster than sales. This is a trend that should Inventory:
warrant observation in the future.
$2575.8 / $9122.7 = 28.2%

INVENTORY TURNOVER RATIO Cost of sales:

While horizontal and vertical analyses are useful for generating $3226.8 / $6615.8 = 50.3%
information about inventory, a more direct way to assess a
In this case we use sales revenue rather than total
business’ ability to sell its inventory is to
inventory turnover operating revenue because COS is directly associated
ratio  Compares cost of calculate the inventory turnover ratio. The with sales revenue rather than the pandemic fees,
sales during a period to inventory turnover ratio compares the royalties and licence revenue, and other income.
the average inventory
balance during that period cost of sales during a period to the average The horizontal analysis of inventory and cost of sales
and measures the ability inventory balance during that period. It is shows that CSL sold and stocked more inventory during
to sell inventory. the year (growth strategy). The 28.2 per cent vertical
calculated as follows:
analysis of inventory shows that just under one-third of the
company’s total assets are tied up in inventory. This seems
KEY FORMULA 7.4 INVENTORY TURNOVER RATIO reasonable, given that CSL is a major supplier of medicines.
Cost of Goods Sold The 50.3 per cent vertical analysis of cost of sales indicates
Inventory Turnover Ratio = that inventory cost is a large expense for the company. For
Average Inventory
the average dollar of sales, the cost of the inventory sold
Where average inventory is: was about 50 cents. This may seem high but most of the
Beginning Inventory + Ending Inventory research and development costs associated with coming
2 up with new medicines are not part of COS.
2 Inventory turnover ratio
Because this ratio compares the cost of all inventory $3326.8 / [($2575.8 + $2152.0) / 2] = 1.41
sold to the average cost of inventory on hand, it indicates
how many times a business can sell its inventory balance 3 Days-in-inventory
in a period. All other things being equal, a higher ratio 365 / 1.4 = 259 days
indicates that the business sold more inventory while
maintaining less inventory on hand. This means that the The 1.41 times inventory turnover ratio indicates that
business generated more sales revenue while reducing the CSL makes and sells its inventory less than twice per year.
The days in inventory ratio of 259 days indicates its
costs of stocking inventory on the shelves.
holding of large stocks. CSL can supply large quantities of
medicine quickly when a pandemic or similar mass health
emergency arises.
ANALYSIS
Using CSL’s information in
Appendix B, calculate and interpret:
Araya Accessories’ 2019 inventory turnover ratio is
1 horizontal and vertical analyses of inventory and cost
calculated as follows:
of sales
2 inventory turnover ratio 44 157
= 6.5
((6705 + 6780)/2)
3 days-in-inventory ratio.
Analysis: The 6.5 ratio indicates that Araya Accessories’ cost of
1 Horizontal analysis sales for 2019 was 6.5 times its average inventory balance.
Inventory: For every dollar of inventory on its shelves, on average, it
was able to sell over $6 of inventory during the period.
($2575.8 – $2152.0) / $2152.0 = 14.2% increase in
Because the turnover ratio is days-in-inventory
inventory 2016 to 2017
sometimes difficult to interpret, it is ratio  Converts the
In passing it is interesting to read in in the Director’s Report often converted into the days-in- inventory turnover ratio
into a measure of days by
of the full annual report, discussion of key risk management inventory ratio. The days-in-inventory dividing the turnover ratio
ratio converts the inventory turnover into 365 days.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
122 ACCT3 Financial
 ratio into a measure of days by dividing the turnover ratio purchases $20 000 of inventory on account on 10 October.
into 365 days. Thus, the days-in-inventory ratio is The purchase would be recorded as follows:
calculated as follows:
10 Oct. Purchases 20 000
365
= 56.2   Accounts Payable 20 000
6.5
   (To record purchase of inventory)
A ratio of 56.2 indicates that it takes Araya Accessories
about 56 days to sell as much inventory as it keeps on hand. Assets = Liabilities + Equity
Naturally, it would want this ratio to be as low as possible. +20 000 +20 000
YT
PPL HIS
Suppose further that Thirroul pays a third-party carrier
A

Download the Enrichment

Modules for further practice $300 cash to transport the inventory to its warehouse
(debit Purchases or Transportation-in and credit Cash). On
12 October Thirroul is granted a $1000 reduction in the cost
of the merchandise due to blemishes on the inventory
LO7 APPENDIX: PERIODIC (debit Accounts Payable and credit Purchases or Purchases
INVENTORY SYSTEM Returns and Allowances).
Finally, suppose that Thirroul pays its remaining $19 000
A periodic inventory system does not update the inventory bill to the vendor on 15 October, which qualifies Thirroul for
and cost of sales accounts during the period. When a 1 per cent discount. As a result, Thirroul would save $190
purchases are made, they are recorded in a temporary ($19 000 × 1%) and pay only $18 810. The entry to record
account called Purchases. When sales are made, the payment would be as follows:
resulting revenue (and increase in assets, cash or accounts
receivable) is recorded, but not the cost of sales (and the 15 Oct. Accounts Payable 19 000
decrease in inventory). As a result, businesses that use a  Purchases (or Purchase Discounts) 190
periodic system must calculate and update the Inventory  Cash 18 810
and the Cost of Sales accounts at the end of the period.
   (To record payment)
The following sections demonstrate the recording of
Assets = Liabilities + Equity
purchases and the determination of ending inventory and
cost of sales under a periodic system. –190 –19 000 –18 810

The entry decreases Accounts Payable for the full $19 000

RECORDING INVENTORY
and decreases Cash for the $18 810 net purchases  The
In a periodic system the following four temporary accounts may payment. The difference (the purchase value of inventory
be used to capture the cost of inventory purchases during a purchased and
discount) is a reduction in Purchases. transportation-in less
period. The Purchases account accumulates the cost of all Given the preceding activity, Thirroul’s purchase returns and
purchases. The Transportation-in account accumulates the net purchases of inventory can be allowances and purchase
discounts.
transportation costs of obtaining the inventory. Both increase calculated as follows:
the cost of inventory. The Purchase
Purchase Returns Returns and Allowances account Purchases $20 000
and Allowances Add: Transportation-in 300
account  An account
accumulates the cost of all inventory
that accumulates the cost returned to vendors as well as the cost Less: Purchase returns and allowances (1 000)
of all inventory returned to reductions from vendor allowances. The
vendors as well as the cost Purchase discounts (190)
reductions from vendor Purchase Discounts account accumulates Net purchases $19 110
allowances. the cost reductions generated from
Purchase Discounts suppliers (vendor) discounts granted for
account  An account
This is the same cost of net purchases as calculated
that accumulates the cost prompt payment; both reduce the cost of under the perpetual system discussed earlier in the chapter.
reductions generated from inventory. Each of the four accounts would Whether using a periodic or perpetual system, the cost of
vendor discounts granted
for prompt payments. then be closed at the end of the period net purchases is the same, just captured in different
when the Inventory and the Cost of Sales accounts.
accounts are updated.
To illustrate the recording of inventory, the example INVENTORY COSTING METHODS
used earlier in the chapter is repeated. While the four
A periodic system does not update the Inventory and the
accounts could be used, a simpler approach would be to
Cost of Sales accounts during the period. Thus, the
record all costs associated with purchasing inventory to the
balances in these accounts must be calculated at the end
Purchase account. Suppose that Thirroul Takeaway

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CHAPTER 7 Inventory 123
 of the period. This is accomplished in the following three First-in, first-out (FIFO)
steps:
Under the FIFO method, Koala assumes that the first units
1 Count the inventory on hand at the end of the period.
of inventory purchased are the first units sold. As a result,
2 Use an inventory costing method to assign a cost to
the costs of the last (most recent) purchases are assigned
the ending inventory.
to ending inventory. It can therefore calculate the cost of
3 Calculate cost of sales using the cost-of-goods-sold model.
ending inventory as follows:
To illustrate this process, the example used earlier in
the chapter is repeated. Suppose that during the month of Units Unit cost Total cost
September, Koala General Store experiences the following 23 Sep. purchase 45 $15 $675
inventory purchases: 15 Sep. purchase 15 $14 210

Units Unit cost Total Ending inventory 60 $885

1 Sep. Beginning inventory 40 $12 $480
The cost of all 45 units purchased on 23 September and
4 Sep. Purchase 60 $13 $780 15 of the units purchased on 15 September are assigned
15 Sep. Purchase 30 $14 $420 to ending inventory, yielding a cost of $885. Plugging this
23 Sep. Purchase 45 $15 $675 into the cost-of-goods-sold model yields Koala’s cost of
sales of $1470.
At the end of the month, Koala counts 60 units on hand.
Koala’s cost-of-goods-sold model for September is Units Cost
therefore as follows: Cost of goods available 175 $2 355
for sale
Units Cost – Ending inventory  60 885
Beginning inventory 40 $ 480 = Cost of sales 115 $1 470
Add: Net purchases 135 1 875
Cost of goods available for sale 175 $2 355 Last-in, first-out (LIFO)
Less: Ending inventory 60 ??? Again, LIFO is not used in Australia, but accounting
Cost of sales 115 ??? standards may change. Furthermore, management may
want COGS calculated using LIFO because LIFO provides
To calculate the cost of the 60 units in ending inventory the most up-to-date COS values.
and therefore the cost of the 115 units sold, Koala must Under the LIFO method, Koala assumes that the last
use one of the four inventory costing methods. units of inventory purchased are the first units sold. As a
Specific identification result, the costs of the oldest inventory are assigned to
ending inventory. Koala can therefore calculate the cost of
Under the specific identification method, Koala determines
ending inventory as follows:
the cost of ending inventory based on the actual cost of
the units on hand. Suppose that Koala knows the ending Units Unit cost Total cost
60 units of inventory are five $13 units, 20 $14 units and Beginning inventory 40 $12 $480
35 $15 units. It can therefore calculate the cost of ending 4 Sep. purchase 20 $13 $260
inventory as follows: Ending inventory 60 $740
Units Unit cost Total cost
The cost of all 40 units of beginning inventory and 20
4 Sep. purchase 5 $13 $ 65
of the units purchased first in September are assigned to
15 Sep. purchase 20 $14 $280
ending inventory, yielding a cost of $740. Plugging this into
23 Sep. purchase 35 $15 $525 the cost-of-goods-sold model yields Koala’s cost of sales
Ending inventory 60 $870 of $1615.

Plugging this cost of ending inventory into the cost-of- Units Cost
goods-sold model yields Koala’s cost of sales of $1485: Cost of goods available 175 $2 355
for sale
Units Cost – Ending inventory  60 740
Cost of goods available for sale 175 $2 355
= Cost of sales 115 $1 615
– Ending inventory 60 870
= Cost of sales 115 $1 485

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
124 ACCT3 Financial
Weighted average Koala can therefore calculate the cost of ending
inventory as follows, rounded to the nearest dollar:
Under the weighted average method, Koala assumes that
the cost of each unit in ending inventory and each unit sold Units Unit cost Total cost
is the average cost of all units available for sale during the Ending inventory 60 $13.46 $808
period. The weighted average cost per unit is calculated as
follows: Plugging this into the cost-of-goods-sold model yields
Koala’s cost of sales of $1547.
KEY FORMULA 7.5 WEIGHTED AVERAGE UNIT COST
Units Cost
Weighted Average Cost of Goods Available for Sale Cost of goods available for sale 175 $2 355
=
Unit Cost Units Available for Sale – Ending inventory  60 808
= Cost of sales 115 $1 547
Note here that under a periodic system, the average
Determining ending inventory quantities requires a
unit cost is based on the entire inventory available to be
physical count (stocktake) at the end of the period. Errors
sold during the period. As a result, the average unit cost
in the counting of inventory affect both the balance sheet
does not change during the period. Therefore, it is called a
(through inventory) and the income statement (through
weighted average instead of a moving average (as under
cost of sales). Moreover, because ending inventory in one
the perpetual system).
period becomes beginning inventory in the next period, an
Koala’s weighted average cost per unit, rounded to the
error can affect not only the current period, but also the
nearest cent, is calculated as follows:
next period. If only one error is made, then the over (under)
$2355 statement of COGS will be counterbalance in the next
= $13.46
175
period.
YT
PPL HIS

A
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CHAPTER 7 Inventory 125
 LO1, 2
6 Recording purchases and sales
of inventory
EXERCISES
Lowder Company purchased 275 units of inventory on
account for $5775. Due to early payment, Lowder received a
discount and paid only $5225. Lowder then sold 150 units
for cash at $55 each, purchased an additional 65 units for
cash at a cost of $1430, and then sold 100 more units on
1 Describe inventory LO1 credit for $58 each. Lowder uses a perpetual inventory
system.
How would you describe the physical nature of CSL’s
inventory? (This may require some research beyond REQUIRED
Appendix B in this book.) a Prepare all journal entries to record Lowder’s purchases
and sales assuming the FIFO inventory costing method.
LO1
2 Classifying inventory costs b Which journal entries would be different if Lowder used
If transportation–in is included in the cost of inventory, how the LIFO inventory costing method? How would they be
should the cost of freight-out (the cost of delivering the different?
goods to the customer) be classified? Why?
LO2
7 Inventory costing methods
LO1
3 Determining inventory costs Bond’s November inventory activity is as follows. Bond uses
Matthews Electronics purchased 1000 tablet computers a perpetual inventory system:
from a vendor for $75 000. The vendor gave Matthews a Date Transaction Units Unit cost Total cost
$1500 discount because of scratches on the cases of some
1st Beginning inventory 32 $55 $1 760
of the laptops. The cost to ship the tablets was $500.
7th Purchase 45 60 2 700
REQUIRED
Determine Matthews’ cost of inventory. 9th Sale 50
14th Purchase 52 65 3 380
LO1
4 Recording inventory purchases 30th Sale 61
On 20 March, Hazelwood Humatics purchased on account
REQUIRED
$112 000 worth of sensors with a list price of $123 000.
Hazelwood pays the vendor on 30 March, which qualifies Calculate the ending inventory and cost of sales under the
them for a 2 per cent discount. Hazelwood uses a perpetual FIFO, LIFO and moving average costing methods.
inventory system.
LO3
8 Effects of inventory methods
REQUIRED
Record Hazelwood’s purchase of the inventory and payment Assume that you are an accountant at a local computer
for the inventory. retailer and your boss asks you to explain the financial
statement impact of inventory costing methods. In
LO1, 2 particular, she is interested in whether the business should
5 Inventory purchases use the FIFO or LIFO method. She would like to use the
Consider the following separate situations. method that results in the highest net income, the highest
inventory balance and the lowest taxes. Note the purchase
Lucy’s Sarah’s Chan’s price of computers has been falling over the last decade and
Lounges Sofas Chairs
that trend is expected to continue.
Beginning inventory $4 000 $2 350  $ (e)
REQUIRED
Purchases (gross) 4 230 (c) 7 340
Explain the effects of using the LIFO and FIFO methods on
Purchase returns 470 800  550 income, inventory and taxes. Can your boss get all that she
Purchase discounts (a) 458  310 wants?
Transportation-in 150 500  420
LO2
9 Inventory costing methods
Cost of goods available (b) 7 320 8 790
for sale Huang Hardware provides the following information relating
to its July inventory activity. Huang uses a perpetual
Ending inventory 1 890 1 750 (f)
inventory system.
Cost of sales 5 220 (d) 7 590

REQUIRED
Calculate the missing amounts.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
126 ACCT3 Financial
 Date Transaction Units Unit cost Total cost inventory and purchased $150 000 during the year. It also
shows sales of $310 000 for the year. Normally, Marshall
1st Inventory 13 $8.00 $104.00
experiences a 55 per cent gross profit percentage on
7th Purchase 22 9.50 209.00 sales.
12th Sale 20 REQUIRED
18th Purchase 10 10.25 102.50 Use the gross profit method to estimate Marshall’s cost of
20th Sale 14 sales and ending inventory.

26th Purchase 16 11.00 176.00 LO5

13 Applying lower-of-cost-and-net-
30th Sale 15 realisable-value
REQUIRED Kay Mart Company is preparing financial statements and
a Enter Huang’s information into a cost-of-goods-sold provides the following information about several of its major
model. What is unknown? inventory items.
b Calculate the ending inventory and cost of sales using
Ending inventory as of 30 June
the FIFO, LIFO and moving average costing methods.
Round dollar amounts to the nearest cent. Item Quantity Unit cost Replacement cost
on hand When (market value) as
c Calculate the sum of the ending inventory and cost of acquired of 30 June
sales for each method. What do you notice about the
differences in COS, ending inventory and the sum of R 25 $15 $19
COS and ending inventory for each method? S 60 22 20
T 34 30 33
LO2, 7
10 Inventory costing methods
U 50 10 11
Harrison, Charles and Company sells flower planters for $7
V 13 50 55
each. On its first day of business in July, the company
purchased 2000 planters for $3 each. The company sold 300 REQUIRED
units during the first month of operations and sold an additional
If Kay Mart uses the LCNRV rule, what should it report as
1300 units the next month. To prevent inventory stockouts
the balance of inventory?
during summer, the company bought an additional 700 units
for $4.50 each in October. The company sold 850 units from
LO6
November through June. The company uses a perpetual 14 Analysing inventory
inventory system and the FIFO inventory costing method. The following information is provided for three different
REQUIRED companies: A, B and C.
a Calculate Harrison, Charles and Company’s inventory in millions A B C
balance at the end of the financial year and its cost of Beginning inventory $ 569 $ 774 $ 989
sales for the financial year.
Ending inventory 423 214 356
b Would those balances be different if the company had
used the FIFO costing method under a periodic Cost of sales  1 376 1 232  1 771
inventory system? Sales  2 232  1 836  3 025

11 Estimating inventory LO4 REQUIRED

Susan’s Shop reported the following information for the Calculate the inventory turnover ratio and days in inventory
current year: ratio for each company. How do the companies compare?

LO6
Sales $1 800 000 15 Analysing inventory
Beginning inventory 50 000 Comparative statements of income for Wells Company are
Purchases 1 004 000 given as follows:

Gross profit percentage 40% Wells Company comparative statements of income

for the years ended 30 June 2020 and 2019
REQUIRED
2020 2019
Using the gross profit method, estimate Susan’s cost of sales
for the year and the ending inventory at year-end. Explain why Net sales $812 000 $812 000
a business might need to estimate its ending inventory. Cost of sales 649 600 664 364

LO4
Gross profit $162 400 $147 636
12 Estimating inventory and cost of sales
Operating expenses 84 448 79 724
Marshall experiences a fire in its warehouse at the end of
the year, which destroys its entire inventory. Marshall’s Net Profit $ 77 952 $ 67 912
records show that it started the year with $35 000 of

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 7 Inventory 127
 REQUIRED b Calculate the ending inventory and cost of sales
Prepare horizontal and vertical analyses of Wells’ statement using the FIFO, LIFO and weighted average costing
of income data and comment on the current status of the methods.
company. c Calculate the sum of the ending inventory and cost of
sales for each method. What do you notice about the
16 Analysing inventory LO6 answer for each method?
During the current year, Norlander implemented an inventory LO7
management system that it believes will result in greater 19 Appendix: Inventory costing methods
efficiencies and profits. Norlander’s CEO was therefore Bond’s November inventory activity follows. Bond uses a
disappointed when she saw the following condensed income periodic inventory system.
statement showing no increase in net income:
Date Transaction Units Unit cost Total cost
2019 2018 1 Nov Beginning inventory 32 $55 $1 760
Sales $650 000 $775 000 7 Purchase 45 60 2 700
Cost of sales 372 500 451 800 14 Purchase 52 65 3 380
Operating expenses 232 500 278 200 30 Ending inventory 18
Net income 45 000 45 000
REQUIRED
REQUIRED a Calculate the ending inventory and cost of sales under
Using horizontal and vertical analyses, provide reasoning to the the FIFO, LIFO and weighted average costing
CEO that the inventory management system was effective. assumptions.
Round percentages to one decimal point (e.g. 4.8%). b Which costing assumption gives the highest ending
inventory? Highest cost of sales? Why?
LO7
17 Appendix: Recording and reporting c Explain why the average item cost is not $60 under the
inventory weighted average costing assumption.
Lowder Company purchased 275 units of inventory on
account for $5775. Due to some defects in the merchandise,
Lowder received a $2 per unit allowance and paid only
$5225. Lowder then sold 150 units for cash at $55 each,
purchased an additional 65 units for cash at a cost of $1430,
and then sold 100 more units for cash at $55 each. Lowder PROBLEMS
uses a periodic inventory system.
REQUIRED
a Prepare all journal entries to record Lowder’s purchases
of inventory.
b Calculate Lowder’s cost of sales and ending inventory 20 Effects of inventory costing methods LO2

under the FIFO, LIFO and weighted average inventory on profits after tax
costing methods. For the weighted average method,
round all values to the nearest cent. Martin Merchandising Company has hired you to examine
whether the company should use the LIFO or FIFO inventory
LO7 costing assumption. The company uses a perpetual inventory
18 Appendix: Inventory costing methods system and has supplied the following information for the
(periodic system) month:
Huang Hardware provides the following information relating
to its June inventory. Huang uses a periodic inventory Beginning inventory 2000 units at $40 $  80 000
system and sold 49 units during the month. Purchases on 4 June 12 000 units at $45 540 000
Date Transaction Units Unit cost Total cost Sales on 18 June 10 500 units at $77 808 500
1st Inventory 13 8.00 $104.00 Operating expenses 148 000
7th Purchase 22 9.50 209.00 Small company tax rate 27.5%
18th Purchase 10 10.25 102.50
REQUIRED
26th Purchase 16 11.00 176.00 Martin requires you to prepare income statements under
Totals 61 $591.50 the LIFO and FIFO costing assumptions to show what
profits he might report and taxes he may pay. Explain to
REQUIRED Martin the reasons why such an analysis is irrelevant in
a Put Huang’s given information into a cost-of-goods-sold Australia.
model. What is unknown?

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128 ACCT3 Financial
 LO1, 2, 5
●● 2nd Purchased 15 additional boxes for $22 each. Paid
21 Recording inventory activity with cash
Campbell Company starts the month of January with 40 ●● 4th Paid freight costs of $30 on 2 January purchase
boxes of Bear Bars costing $20 each. The following ●● 10th Sold 45 boxes for $40 each
transactions occurred during the month.
●● 27th Purchased 10 additional boxes on account for
●● 2nd Purchased 15 additional boxes for $22 each; paid $23 each
with cash
●● 4th Paid freight costs of $30 on 2 January purchase REQUIRED
●● 10th Sold 45 boxes for $40 each Assuming that Campbell uses a periodic inventory system,
prepare all necessary journal entries related to Campbell’s
●● 27th Purchased 10 additional boxes on account for inventory activity. Calculate the cost of sales and the ending
$23 each inventory under the FIFO, LIFO and weighted average
REQUIRED costing methods.
Assume Campbell uses a perpetual inventory system and
LO7
the FIFO costing method. Prepare all necessary journal 24 Appendix: Inventory errors
entries related to Campbell’s inventory activity. Suppose that an organisation’s preliminary financial
Suppose that the inventory has a replacement value of statements show profit of $230 000 and ending inventory of
$375 at the end of the month. What entry, if any, is $39 500. Several years later it was discovered that ending
required? inventory should be $42 500.
LO6 REQUIRED
22 Analysing inventory
a Describe the error in the inventory account (for example,
The following is comparative financial data for JK Martin inventory was over/under stated by $XYZ) and calculate
Company and Stratton Company. All balance sheet data are the organisation’s correct net income for the year.
as of 30 June 2017 and 30 June 2018.
b What impact would the error have on the next year’s
JK Martin Stratton profit?
Company Company c Given the impact on the two years of profits, is the error
2018 2017 2018 2017 material?
Net sales $2 000 000 $550 000
Cost of sales 1 100 000 240 000
Operating expenses 305 000 75 000
Income tax expense 52 000 6 500
Cash 85 070 $ 82 508 16 100 $ 15 777
CASES
Inventory 250 000 225 000 70 000 65 600
Property & equipment 525 000 500 000 140 000 125 000
Current liabilities 65 000 75 000 35 000 30 000
Long-term liabilities 109 000 88 000 29 000 24 800 LO1, 3, 6, 7
25 Research and analysis
Ordinary shares, $10 par 490 000 490 000 115 000 115 000 Access the latest annual report for Cochlear Limited (ASX
Retained earnings 173 000 147 520 40 756 30 289 Code: COH).
REQUIRED
REQUIRED
a Examine the company’s income statement and balance
a Prepare a vertical analysis of the 2018 income data for JK
sheet and conduct horizontal and vertical analyses of the
Martin Company and Stratton Company. Is one company
company’s cost of sales and inventory balances.
more profitable than the other?
Compare to CSL.
b Prepare a horizontal analysis of the 2018 financial data
b Examine the company’s inventories note to its financial
for JK Martin Company and Stratton Company using
statements. Do they reveal the inventory costing
2017 as the base year. What does this analysis show?
method(s) used to account for its inventory? Does the
c Calculate the inventory turnover and days in inventory company follow the lower-of-cost-and-net-realisable-
ratios for 2018 for JK Martin Company and Stratton value rule? Is there any other information given about
Company. Do these ratios change your conclusions inventory?
about these companies?
c Calculate the inventory turnover and days-in-inventory
ratios for the latest year.
LO7
23 Appendix: recording inventory activity d Based on your answers above, write a paragraph
Campbell Company starts the month of January with 40 explaining your opinion of Cochlear’s inventory position.
boxes of Bear Bars costing $20 each. The following Use facts to support your answer.
transactions occurred during the month:

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CHAPTER 7 Inventory 129
 8
This chapter examines the accounting for non-current
assets – primarily property, plant and equipment (PPE) –
or as it is sometimes called, ‘fixed assets’. For most
companies, the objectives associated with non-current
assets are fairly simple. They want to acquire non-current
assets, use them productively for some period of time
and then dispose of them. Thus, the chapter examines
these three activities: the acquisition of non-current
assets, the depreciation (or amortisation for intangible
Non-current assets and assets) of non-current assets over their useful lives and
their disposal. It also examines a few issues that arise

intangible assets during the life of a non-current asset, such as additional

expenditures and revisions of original estimates. The
chapter then focuses on how to analyse a company’s
non-current asset position. It concludes with the
accounting for intangible assets and emphasising the
concept of ‘impairment’.
LEARNING
OBJECTIVES

LO1  ECORDING, EXPENSING

R
After studying the material in this chapter, you AND REPORTING NON-
should be able to: CURRENT ASSETS
1 Describe non-current assets and how they
are recorded, expensed and reported. A non-current asset is any tangible resource that is expected
2 Calculate and compare depreciation to be used in the normal course of operations for more than
expense using straight-line, reducing- one year and is not intended for resale. Examples include land,
balance (diminishing value) and units-of- buildings, equipment, furniture and fixtures. Non-current
activity methods. assets are reported on the balance sheet (statement of
financial position) and are classified as non-current assets
3 Understand the effects of adjustments that
may be made during a non-current asset’s because they are used for more than one year.
useful life. As you consider the definition of a non-current asset,
note that the phrase ‘not intended for resale’ differentiates
4 Record the disposal of non-current assets. a non-current asset from inventory. A computer that Dell
5 Evaluate non-current assets through the Corporation makes for sale is inventory, while that same
calculation and interpretation of horizontal, computer used by a lecturer at university is a non-current
vertical and ratio analyses. asset. Also, note that the phrase ‘used in the normal course
6 Depict the cash flow effect of acquiring and of operations’ differentiates a non-current asset from an
disposing of non-current assets. investment. Land on which a company builds its office is a
non-current asset, while land bought to be sold to a developer
7 Describe intangible assets and how they are
is an investment. The
recorded, expensed and reported. YT
PPL HIS
company’s intended use
A

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of the asset dictates how for Chapter 8
the asset is classified.

Express
RECORDING NON-CURRENT ASSETS
YT Following the cost principle, non-current assets should be
Throughout this PPL HIS
recorded at the cost of acquiring them. This includes all
A

chapter apply this

icons indicate costs incurred to get the asset delivered, installed and
an opportunity ready to use. Examples of expenditures to include in the
for online
cost of a non-current asset would therefore include, but
self-study through
CourseMate Express, not be limited to, the following:
linking you to revision ● purchase price
quizzes, e-lectures, ● taxes paid on the purchase
animations and more.
● fees such as legal (conveyancing) costs paid to a solicitor
130 ● delivery costs
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 ● insurance costs during transit The land requires $112 000 in clearing and removing waste
● installation costs. before it can be used. The timber harvested from the
To illustrate, suppose that Gavaskar Building Supply clearing is sold for $20 000. The total cost of the land is as
buys a delivery van with a purchase price of $63 000 and follows:
additional state stamp duty of $3600. Prior to receiving the
Purchase price $525 400
van, Gavaskar has a reversing camera and GPS with vehicle
tracking installed for $2400. Finally, Gavaskar pays $1400 Clearing and removal 112 000
for one year’s insurance. Given the preceding items, the Less: Sales of timber (20 000)
cost of Gavaskar’s van is determined as follows: Total cost $617 400

Purchase price $63 000 In this case, each cost is included in the asset because
Stamp duty 3 600 the land is not in the condition for use until each of the
activities is completed. Notice also that the proceeds from
Camera and GPS Tracker  2 400
the sale of the timber reduce the cost of the land.
Total cost $69 000

EXPENSING NON-CURRENT ASSETS

Courtesy CSL

A non-current asset converts to an expense as it is used or

consumed. The expensing of non-current assets is
accomplished through depreciation.
Depreciation is the process of allocating depreciation  The
the cost of a non-current asset over its process of systematically
useful life. Depreciation is an application and rationally allocating
the cost of a non-current
of the matching principle – because a non- asset over its useful life.
current asset is used to generate revenues depreciation
The portion of
period after period, some of its cost expense  a non-current asset’s cost
should be expensed in, or matched to, that is recognised as an
those same periods. The amount of expense in the current
period.
Accounting for non-current assets like this electron microscope
expense recognised in each period is accumulated
involves recording the purchase, depreciating the asset over its life known as depreciation expense. The depreciation  The
and then disposing of it
cumulative amount of depreciation cumulative amount of
depreciation expense
expense recognised to date is known as recognised to date on a
All of the costs except for the insurance are necessary non-current asset.
accumulated depreciation.
to get the asset into its condition and location for intended
Some students experience some
use and are therefore included in the cost of the van. The
confusion with depreciation because of its everyday use in
insurance covers the van during its operations and is
our language. For example, it is often said that a new car
therefore an operating expense during the year (debit
‘depreciates’ substantially in value once it is driven out of
Insurance Expense $1400, credit Cash $1400). Assuming
the dealer‘s showroom. When used in this way, the term
that Gavaskar paid cash, the entry to record the purchase
‘depreciation’ implies the price it could now be sold for is
of the van would be as follows:
much less than was paid. For our purposes, depreciation
Delivery Van (or Equipment) 69 000 is a process of allocating an asset’s cost, not a method of
 Cash 69 000 determining an asset’s market value.
   (To record the purchase of van)
While depreciation applies to non-current assets, not
all non-current assets are depreciated. Depreciation applies
Assets        =        Liabilities        +        Equity
only to those assets with limited useful lives. An asset has
   +69 000 a limited useful life when its revenue-generating potential
   –69 000 is limited by wear and tear and/or obsolescence. Most non-
current assets such as equipment and buildings have
Consider another example. Suppose a company limited useful lives and are therefore subject to depreciation.
purchases a block of land for a new building site. The The major exception to this is land, which has an unlimited
purchase price is $525 400 including stamp duty (taxes). useful life. As a result, land is not subject to depreciation.

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CHAPTER 8 Non-current assets and intangible assets 131
 Depreciation expense is normally calculated at the end
of an accounting period and is recorded with an adjusting
journal entry. Regardless of the non-current asset being
depreciated or the facts of the calculation, the general form
of the entry is the same: depreciation expense and
accumulated depreciation are increased.
To illustrate, suppose that Gavaskar calculates its van’s
depreciation as $10 000 for the first year. At year-end,
Gavaskar would make the following entry:

Year-end Depreciation Expense 10 000

  Accumulated Depreciation 10 000
   (To record the depreciation expense)
Assets      =      Liabilities      +      Equity
–10 000 –10 000

This entry increases Depreciation Expense for the

$10 000 of cost allocated to the current period. However,
instead of decreasing Delivery Van, the entry increases Not all assets need to be physically worn out to be fully depreciated
Accumulated Depreciation, which is a contra-asset account
that accumulates all depreciation recorded to date. Its
REPORTING NON-CURRENT ASSETS
balance is subtracted from the non-current asset account
to yield the carrying amount or net book value of the non- Non-current assets are reported on the balance sheet, as we
current asset. We will see an example of this later in the have seen with CSL, just below current assets. Notice CSL
chapter. The result of this entry is a decrease to both equity does not includes the word ‘net’ in the balance sheet for PPE,
and assets. but in Note 8 the $2943 million at 30 June 2017 is described
Like other expenses, depreciation expense is reported as ‘net carrying amount’, which is the carrying amount 
on the income statement. Most companies report it as a carrying amount representing the cost of The unexpired cost of a
separate line item in the notes to the accounts. the PPE that has not yet been depreciated/ non-current asset,
calculated by subtracting
amortised. It is calculated by subtracting the accumulated depreciation
accumulated depreciation to date from the from the cost of the non-
ANALYSIS current asset.
cost of PPE. For example, an asset costing
Look at CSL’s balance sheet and
$5000 with $1000 of accumulated depreciation would have
Note 8 in Appendix B. What YT
a carrying amount PPL HIS
general name does the company use for its major ­

A
non-current assets and what are the specific non-current (net book value) Check out the animated summary
on Depreciation
assets that make up the largest ­non-current asset? What of $4000.
is the total (historical) cost of the largest non-current
asset at 30 June 2017, and how much depreciation has
been accumulated to that date? Compare Land to Plant
and Equipment. Why might you expect a higher LO2 CALCULATING
percentage of accumulated depreciation/amortisation on
one rather than the other?
DEPRECIATION EXPENSE
Analysis:
When a company owns depreciable assets, it must
CSL’s major non-current asset is PPE. Note 8 shows six
specific PPE: land; buildings; leasehold improvements; calculate depreciation expense each period. Doing so
plant and equipment; leased PPE; and capital work in requires the following information about the asset:
progress. PPE in 2017 have a cost of $4525 million and ● Cost – the historical cost of the asset cost  The historical cost of
accumulated depreciation/amortisation $1582 million. being depreciated. This is the amount a non-current asset being
Land has no depreciation while buildings has $156 million. depreciated.
that was recorded when the asset
This reflects the unlimited life of land and the limited life
of buildings (which may be demolished because they look was purchased.
out of date or no longer serve the purpose for which they
were built rather than being physically worn out).

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132 ACCT3 Financial
residual value  An ●  Residual value (or salvage value) – KEY FORMULA 8.1 STRAIGHT-LINE METHOD
estimate of the value of a the market value of the asset at the
non-current asset at the end Cost – Salvage Value
of its useful life. end of its useful life. It is the amount Depreciation Expense =
Useful Life
useful life  The length of the company expects to receive when
time a non-current asset is the asset is sold, traded in, or
expected to be used in For Gavaskar’s delivery van, annual depreciation expense
operations. scrapped.
depreciable ●  Useful life – the length of time the under the straight-line method would therefore be:
amount  The difference asset will be used in operations. $65 000 – $15 000
between an asset’s cost Depreciation Expense = = $10 000
and its residual value. ●  D epreciable amount – the      5
difference between an asset’s cost Gavaskar would record the depreciation expense with
and its residual value is the asset’s the following adjusting journal entry at the end of the first
net cost to the company. It is the total year:
amount that should be depreciated
over the (useful) life of the asset. 31 Dec. Depreciation Expense 10 000
2018
depreciation Depreciation method refers to
method  The method the method used to calculate the   Accumulated Depreciation 10 000
used to calculate
depreciation expense, such depreciation expense. Generally    (To record the depreciation expense)
as the straight-line, Accepted Accounting Principles allow Assets          =          Liabilities          +          Equity
reducing-balance and units-
of-activity methods. the use of several different methods for –10 000 –10 000
calculating depreciation expense. This
chapter focuses on the following: The same entry would be made at the end of each year
● straight-line method until the end of 2022. Exhibit 8.1 illustrates depreciation
● reducing-balance method for the entire useful life of the asset.
● units-of-activity method. The depreciation schedule highlights several items.
To illustrate how depreciation expense is calculated First, depreciation expense is the same each period. This
under each method, the Gavaskar Building Supply will always be true under the straight-line method. Second,
example will be continued. The following information the accumulated depreciation account grows each year by
about Gavaskar’s delivery van is available: $10 000 until the balance equals the depreciable amount
● Purchase date: 1 January 2018 of the asset. This is no coincidence. The final balance in
● Cost: $65 000 accumulated depreciation is the total of all depreciation
● Estimated residual value: $15 000 expense recorded during the asset’s life. Therefore, the
● Estimated useful life: five years or 100 000 kilometres. balance should equal the asset’s depreciable amount. This
will be true regardless of the depreciation method used.
STRAIGHT-LINE METHOD Finally, the carrying amount decreases each year by
The straight-line method of $10 000 until it equals the residual value estimated for the
straight-line
method  A depreciation depreciation spreads depreciation asset. This is no coincidence either. Carrying amount
method that results in the expense evenly over each year of the represents the remaining unexpired cost of the asset.
same amount of Therefore, an asset’s final carrying amount should always
depreciation expense each asset’s useful life. It is a very simple
year of the asset’s useful life.
calculation. The depreciable amount of equal the estimated residual value at the end of the asset’s
the asset is divided by the useful life of the useful life. This will be true regardless of the depreciation
asset (in years) to yield the amount of depreciation expense method used.
per period. This calculation is shown in Key formula 8.1.

Accumulated
Year Calculation Depreciation expense Carrying amount
depreciation
$0 $65 000
2018 ($65 000 – $15 000) / 5 $10 000 10 000 55 000
2019 ($65 000 – $15 000) / 5 10 000 20 000 45 000
2020 ($65 000 – $15 000) / 5 10 000 30 000 35 000
2021 ($65 000 – $15 000) / 5 10 000 40 000 25 000
2022 ($65 000 – $15 000) / 5 10 000 50 000 15 000
EXHIBIT Depreciation schedule – straight-line method
8.1

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CHAPTER 8 Non-current assets and intangible assets 133
 REDUCING-BALANCE METHOD the first year is $19 500. In other words, $9500 of
depreciation expense is accelerated to the first year by
reducing-balance The reducing-balance method of
using the reducing-balance method instead of the straight-
method  A depreciation depreciation is an accelerated
method that accelerates line method.
depreciation expense into the method that results in more
In the second year of the asset’s life, the same formula
early years of an asset’s life.depreciation expense in the early
is used. However, the resulting depreciation expense is
years of an asset’s life and less
lower because the depreciation rate is applied to a lower
depreciation expense in the later years of an asset’s life.
carrying amount. With $19 500 in depreciation to date, the
As a result, the reducing-balance method is thought to
accumulated depreciation balance is $19 500, yielding a
more accurately reflect the pattern of use and the value of
carrying amount of $45 500 ($65 000 – $19 500). Therefore,
the benefit gained from the use or using up of the asset
depreciation expense in the second year would be:
than the straight-line method. More depreciation expense
Depreciation Expense for 2019 = 30% × ($65 000 – $19 500)
is recorded when the asset is more useful.
To calculate depreciation expense under the reducing- = $13 650
balance method, the rate of depreciation is determined by As you can see, depreciation expense for the second
a formula: 1 minus the nth root of the residual value divided year is lower than the first year, but it is still more than
by the cost (where n = useful life). For simplicity and to be would be calculated under the straight-line method. In
consistent with the suggested tax depreciation rate, this other words, depreciation expense is still being accelerated
may be approximated by taking the straight-line rate of to the early years of the asset’s life.
depreciation and multiplying it by 1.5 (or 2). For example, if In the fifth year of the asset’s life, the same formula is
an asset has a four-year life, it has a 25 per cent straight-line again used, but this time the carrying amount is $15 606
depreciation rate (calculated by dividing 100 per cent by (cost of $65 000 less accumulated depreciation of $49 394).
four years). The straight-line rate is then multiplied by 1.5 to Therefore, the calculation of depreciation expense for the
get 37.5 per cent. An asset with a five-year life would have fifth year is as follows:
a 20 per cent straight-line rate, which would be a reducing-
Depreciation Expense for 2022 = 30% × $15 606 = $4682
balance rate of 30 per cent. This rate is then multiplied by
the carrying amount (not the original cost less the residual Now, at this point we need to be careful. Over an
value, as with straight-line) of the asset to give the amount asset’s life, an entity cannot record more total depreciation
of depreciation expense for the period. This calculation is than the asset’s depreciable amount. Regardless of how
as follows: much depreciation expense is calculated to be, an asset’s
accumulated depreciation balance should never exceed the
KEY FORMULA 8.2 REDUCING-BALANCE METHOD asset’s depreciable amount. In our example, Gavaskar’s
Depreciation = Depreciation Rate × Carrying Amount depreciable amount is $50 000. Accumulated depreciation
after 2021 is $49 394. Therefore, depreciation expense in
= ( Straight-Line Rate × 1.5)
×  (Cost – Accumulated Depreciation) 2022 is limited to $606. This calculation is as follows:

Depreciable amount of asset ($65 000 – $15 000) $50 000

Because an asset’s carrying amount declines as the Less: Accumulated depreciation at the end of 2021 49 394
asset is depreciated, the amount of depreciation expense
Remaining depreciation to be taken $ 606
will therefore differ each period. In fact, depreciation
expense will become smaller and smaller each period as Even though the calculation yields $4682, depreciation
the depreciation rate is applied to a smaller carrying expense cannot reduce the carrying amount below the
amount. This stands in contrast to the straight-line method residual value. A schedule of depreciation for all five years
and is why the name of this method contains the words is shown in Exhibit 8.2. The calculated amounts in 2022
reducing balance. are struck through and are replaced with the necessary
Under the reducing-balance method, Gavaskar’s amounts.
depreciation expense for the first year of the asset’s life is Note that, as expected, depreciation expense is
calculated as follows: accelerated to the early years of the asset’s life. Note also
Depreciation Expense for 2018 = (20% × 1.5) × ($65 000 – $0) that, like the straight-line method, the reducing-balance
= $19 500 method results in a total of $50 000 of depreciation expense
and a resulting carrying amount that is equal to the estimated
You can now see how the reducing-balance method residual value of $15 000. The only difference between the
accelerates the depreciation. Instead of $10 000 of expense methods is when depreciation expense is recognised.
as under the straight-line method, depreciation expense in

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134 ACCT3 Financial
 Year Calculation Depreciation expense Accumulated depreciation Carrying amount
$0 $65 000
2018 (20% × 1.5) × ($65 000 – $0) $19 500 19 500 45 500
2019 30% × ($65 000 – $19 500) 13 650 33 150 31 850
2020 30% × ($65 000 – $33 150) 9 555 42 750 22 295
2021 30% × 22 295 6 689 49 394 15 606
2022 Cannot be 30% × $15 606 4 682 54 076 10 924
606 only 50 000 maximum 15 000 minimum
EXHIBIT Depreciation schedule – reducing-balance method
8.2

UNITS-OF-ACTIVITY METHOD limited vehicle use, but this includes all costs, fuel,
maintenance and depreciation.
Both the straight-line and reducing-balance methods are a
function of the passage of time rather than the actual use $65 000 – $15 000
Expense per Unit =
of the asset. Each method assumes that the calculated 200 000 kilometres
depreciation is a reasonable representation of the actual = $0.25 per kilometre
usage of the asset. In contrast, the
units-of-activity uni t s - of-ac tivi t y me thod of With a $0.25 per kilometre rate, the actual kilometres
method  A depreciation
method in which depreciation calculates depreciation driven in a given year is needed to calculate depreciation
depreciation expense is a based on actual asset activity. Because it expense. Assume that Gavaskar drives the van 48 000
function of the actual usage kilometres in 2018. Its depreciation expense for 2018 would
of the asset. relies on an estimate of an asset’s
lifetime activity, the method is limited to therefore be $12 000.
those assets (such as a photocopier) where units of activity Depreciation Expense = $0.25 × 48 000 = $12 000
can be determined precisely or with some degree of
Similar calculations would be made for the next four
accuracy.
years of the asset’s life. A depreciation schedule, complete
Calculating depreciation expense under the units-of-
with the actual kilometres driven in each of the five years,
activity method starts by calculating depreciation per unit
is shown in Exhibit 8.3.
of expected activity. Depreciation per unit of expected
As you review the schedule, note that depreciation
activity is the depreciable amount of the asset divided by
expense fluctuates as the asset’s activity fluctuates. As a
the estimated units of activity over the life of the asset.
result, depreciation expense is a function of usage. Second,
note that the total number of kilometres driven over the
KEY FORMULA 8.3 UNITS-OF-ACTIVITY METHOD
five years equals 200 000 kilometres. This assumption is
Cost – Residual Value made for simplicity. However, had Gavaskar driven the van
Depreciation Expense per Unit =
Useful Life in Units more than 200 000 kilometres, total depreciation expense
Depreciation Expense = D
 epreciation Expense per Unit over the life of the asset would still be limited to $50 000,
× Actual Units of Activity the asset’s depreciable amount.

Note that this calculation is very similar to the straight- COMPARING DEPRECIATION METHODS
line calculation. Depreciable amount is divided by estimated
The calculations in the previous sections demonstrate that
life. But, instead of calculating depreciation expense per
a company’s depreciation expense in a given year will
year, depreciation expense per unit of activity is calculated.
depend on the depreciation method chosen. For
Once depreciation expense per unit is known, depreciation
comparative purposes, Exhibit 8.4 summarises the annual
expense is determined by multiplying the per unit rate by
depreciation for Gavaskar’s van as well as the resulting
the actual units of activity during the period.
carrying amounts under the three methods.
For Gavaskar’s van, depreciation expense per unit will
The summary demonstrates that total depreciation
be a function of kilometres driven. Since Gavaskar
expense over the life of the asset is $50 000 regardless of
estimates that the van will be driven 200 000 kilometres,
the method chosen. However, each method arrives at
its estimated depreciation per kilometre would be
$50 000 differently. The straight-line method depreciates
$0.25 per kilometre. In passing, the Australian Taxation
the same amount each year. The reducing-balance method
Office allows a deduction of $0.66 per kilometre for
accelerates depreciation into the early years of the

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CHAPTER 8 Non-current assets and intangible assets 135
 asset’s life. The units-of-activity method depreciates

Science Photo Library/Look At Sciences/Hubert Raguetv

different amounts each year depending on the asset’s
usage. No depreciation method is right – they are just
different; and companies choose to use one over another
for different reasons. For taxation purposes the depreciation
method which is allowed and provides the earliest, largest
deduction is usually chosen. The depreciation method used
in the financial reports does not need to be the same as
chosen to calculate taxable income. Like all tax-deductible
expenses, depreciation reduces taxable income, which in
turn reduces income taxes. Assuming a 30 per cent tax
rate in the example above, the $50 000 of depreciation on
the van will lower taxes by $15 000. The advantage of the The use of the service potential of this equipment is shown as part of the
$2.9 billion of accumulated depreciation of Plant and Equipment in
reducing-balance method is that more of the tax savings Note 8 of CSL’s financial statements
are realised in the earlier years. This is beneficial to a
company because the company can temporarily use the
statements so that comparisons can be made among
cash that would otherwise be paid to the Australian
different companies. This is an application of the qualitative
Taxation Office.
characteristic of comparability. The disclosure is usually
Regardless of the method chosen, companies should
found in a note dedicated solely to PPE.
disclose their choices in the notes to their financial

Year Calculation Depreciation expense Accumulated depreciation Carrying amount

$0 $65 000
2018 $0.25 × 48 000 km $12 000 12 000 53 000
2019 $0.25 × 44 000 km 11 000 23 000 42 000
2020 $0.25 × 54 000 km 13 500 36 500 28 500
2021 $0.25 × 34 000 km 8 500 45 000 20 000
2022 $0.25 × 20 000 km 5 000 50 000 15 000
EXHIBIT Depreciation schedule—units-of-activity method
8.3

Straight-line Reducing-balance Units-of-activity

Year Depreciation Carrying Depreciation Carrying Depreciation Carrying
expense amount expense amount expense amount
2018 $10 000 $55 000 $19 500 $45 500 $12 000 $53 000
2019 10 000 45 000 13 650 31 850 11 000 42 000
2020 10 000 35 000 9 555 22 295 13 500 28 500
2021 10 000 25 000 6 689 15 606 8 500 20 000
2022 10 000 15 000 606 15 000 5 000 15 000
$50 000 $50 000 $50 000

EXHIBIT Comparison of three depreciation methods

8.4

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136 ACCT3 Financial
 To illustrate, suppose that Bechmann Supply purchased
ANALYSIS a machine for $90 000 on 1 January 2016. Bechmann
Look at CSL’s Note 8: Property, estimated at the time that that the machine would have a
plant and equipment in Appendix B
10-year useful life and a $10 000 residual value. Bechmann
What method of depreciation does the company use?
Which assets have the shortest useful life and which the used the straight-line method of depreciation and recorded
longest? What adjustments are made to residual values $8000 of depreciation expense [($90 000 – $10 000) / 10]
and useful life? each year as follows:
Analysis:
CSL uses straight-line depreciation. Plant and equipment
31 Depreciation Expense 8 000
Dec.
is expected to last 3 to 15 years and Buildings 5 to
40 years. Accumulated Depreciation 8 000
‘Assets’ residual values and useful life are reviewed and   (To record depreciation expense)
adjusted if appropriate at each reporting date. Items of
Assets         =         Liabilities         +         Equity
PPE are derecognised upon disposal or when no further
economic benefits are expected from their use or disposal.’ –8 000 –8 000

YT Now suppose that on 1 January 2020, Bechmann

PPL HIS
decides that the machine will last only eight years (another
A

Review this content with the e-lecture

four years) rather than the ten years originally estimated
and will have a residual value of only $6000 rather than
$10 000. When these revisions are made, Bechmann does
LO3  DJUSTMENTS MADE
A not correct the four previous depreciation expense entries
of $8000 because they were based on reasonable
DURING A NON-CURRENT estimates at the time. Instead, Bechmann calculates the
ASSET’S USEFUL LIFE remaining depreciable amount of the asset and spreads it
out over the remaining useful life.
Since non-current assets are used for multiple years, To do this, we must first calculate the net book value
companies sometimes must make adjustments as new of the asset on the date of revision. This represents the
information is available or as new activity occurs. These unexpired cost of the asset.
adjustments can arise from the following:
● changes in estimates Carrying amount at the time of estimate revision:
● additional expenditures to improve the non-current asset Cost of the asset, 1 January 2016 $90 000
● declines in the asset’s residual value (recoverable amount). Less: Accumulated depreciation for four years (4 x $8000) 32 000
Carrying amount on 1 January 2020 $58 000
CHANGES IN DEPRECIATION ESTIMATES
Next, we subtract from the carrying amount the asset’s
Calculating depreciation expense requires that a company
residual value, which will result in the asset’s remaining
estimate the asset’s useful life and its residual value. These
depreciable amount. Keep in mind that we use the revised
estimates are normally based on previous company
residual value. This is shown as follows:
experience with similar assets as well as factors such as the
manufacturer’s recommendations. As a result, they are usually Depreciable amount for future depreciation:
fair and reasonable. However, estimates can differ from Carrying amount on 1 January 2020 $58 000
actual experience. When such errors are small and will not Less: Estimated residual value 6 000
affect decision-making (i.e. are immaterial), they are usually
Remaining depreciable amount $52 000
ignored. When the estimates are materially wrong, though,
revisions can be made. We call this a change in estimate. Finally, under the straight-line method we calculate
When an estimate is changed, the change is made depreciation expense by dividing the remaining depreciable
prospectively, meaning that the change affects only the amount by the remaining useful life. In this case, the total
calculation of current and future depreciation expense. useful life is now estimated to be eight years instead of
Depreciation expense for prior years is not (retroactively) ten, which means that there are only four years remaining
corrected. Once an estimate is revised, current and future instead of six.
depreciation expense is calculated with the new estimate.
This is done by determining the remaining depreciable Depreciation expense under revised estimates:
amount of the asset at the time of the revision and Remaining depreciable amount $52 000
depreciating that cost over the remaining useful life using Divided by remaining useful life 4
the same depreciation method. Annual depreciation expense $13 000

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CHAPTER 8 Non-current assets and intangible assets 137
 With this new depreciation expense calculated,

Shutterstock.com/Tyler Olsen
Bechmann would make the following journal entry at the
end of Years 5 to 8:

31 Depreciation Expense 13 000

Dec.
Accumulated Depreciation 13 000
  (To record depreciation expense)
Assets       =       Liabilities       +       Equity
13 000 13 000

So, Bechmann depreciates $8000 per year in Years

1 to 4 and $13 000 per year in Years 5 to 8. This results in
$84 000 of total depreciation over the life of the asset,
which is equal to the original cost of the asset less its Capital or revenue expenditure?
revised residual value ($90 000 – $6000 = $84 000).
When a company has a material change in a non-current Given this information, the $1000 is a ‘revenue’
asset estimate, it will disclose the change in the notes to expenditure and should be expensed as follows:
its financial statements. AASB 108 Accounting Policies, 1 Jan. Maintenance Expense 1 000
Changes in Accounting Estimates and Errors (IAS 8) requires 2020
the disclosure of the nature and amount of a change in an Cash 1 000
accounting estimate. This is done to enhance the relevance,   (To record normal maintenance)
reliability and comparability of the financial statements.
Assets       =       Liabilities       +       Equity
–1 000 –1 000
EXPENDITURES AFTER ACQUISITION
Most non-current assets require expenditures throughout In contrast, the $8000 for upgrades meets the
their useful lives. The purchasing price of a car is only the recognition criteria in AASB 116 since the asset’s useful life
first cost. Expenditures for servicing, minor repairs and is extended two years. It should therefore be capitalised
even major repairs come with ownership. So, how are with the following entry:
these additional expenditures treated from an accounting
1 Jan. Air Conditioning Unit 8 000
standpoint? 2020
The accounting treatment for expenditures made during
Cash 8 000
the useful life of a non-current asset depends on whether
  (To record upgrade to asset)
they meet the ‘recognition criteria’ in AASB 116: ‘The cost
of an item of property, plant and equipment shall be Assets       =       Liabilities       +       Equity
recognised as an asset if, and only if: (a) it is probable that +8 000
future economic benefits associated with the item will flow –8 000
to the entity; and (b) the cost of the item can be measured
Notice that this entry results in an increase (Air
reliably’.1 Repairs and maintenance (sometimes called
Conditioning Unit) and decrease (Cash) to assets rather
revenue expenditures) maintain the expected useful life or
than a change in equity. This is because the company is
productivity of the asset. Repairs and maintenance are
capitalising the expenditure rather than expensing it.
expensed in the period in which they are incurred. They are
With this addition to the cost of the asset, depreciation
not added to the cost of the asset.
expense for 2020 must be recalculated. To do so, the company
To illustrate, suppose that a company purchases an air
follows the same general procedures used in the change of
conditioning unit for $50 000 on 1 January 2016. The
estimate scenario. It first calculates the carrying amount of
company estimates the asset’s useful life and residual
the asset and then adds the capital expenditure to obtain the
value at five years and $0, respectively. Using the straight-
updated carrying amount. This is shown as follows:
line depreciation method, the company records $10 000 of
depreciation expense each year. Now suppose that on Carrying amount after the capital expenditure:
1 January 2020, during the fifth year of the asset’s life, the Cost of the asset, 1 January 2016 $50 000
company incurs $1000 in ordinary maintenance and $8000 Less: Accumulated depreciation for four years 40 000
for upgrades. The upgrades allow the machine to be used Carrying amount on 1 January 2020 $10 000
productively in 2021 and 2022. Add: Upgrades made in 2020 8 000
Updated carrying amount on 1 January 2020 $18 000

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138 ACCT3 Financial
 Next, the company subtracts the asset’s residual value reports so that they can be confident and informed in
to get the remaining depreciable amount. Under the straight- making investment and other decisions’.2
line method of depreciation, the depreciable amount is then
divided by the remaining useful life to obtain depreciation
ANALYSIS
expense. In 2020, 2021 and 2022, the company will record Look at CSL’s Note 8 in
$6000 of depreciation expense each year. Appendix B. What does it say
about impairment?
Depreciation expense after capital expenditure:
Analysis:
Updated carrying amount on 1 January 2020 $18 000 Impairment testing for property, plant and equipment
Less: Estimated residual value 0 occurs if an impairment trigger is indicated. No
impairment triggers have been identified in the current
Remaining depreciable amount on 1 January 2020 $18 000
year.3
Divided by remaining useful life 3 To illustrate, suppose a company has equipment that
Annual depreciation expense $ 6 000 makes a unique toy that becomes extremely popular. The
equipment has a carrying amount of $140 000 and a
While the classification of post-acquisition expenditures higher market value. Suppose further that the toy
suddenly loses its popularity and the company is unable
may seem rather unimportant, it is actually an area of great
to alter the machine to produce anything else. As a result,
interest because of the potential for fraudulent behaviour the fair (market) value of the machine plummets to
by companies. One of the largest corporate frauds in recent $40 000. The company declares that the asset is impaired.
history centred on the treatment and reporting of revenue The asset impairment would be recorded as follows:
expenditures. In 2002, it was discovered that WorldCom
Loss on Impairment 100 000
was treating operating expenses associated with
telecommunication lines as capital expenditures. Instead   Non-current Asset 100 000
of appearing on the income statement (statement of    (To record permanent impairment of asset)
comprehensive income) as expenses, these costs were Assets    =    Liabilities    +    Equity
recorded as assets on the balance sheet. This resulted in –100 000 –100 000
a gross understatement of current expenses and
overstatement of profits. Over the seven quarters that it In the previous entry, Loss on Impairment is increased
committed this fraud, the company overstated its results to reflect the decline in value of the asset. This reduces
equity. This loss is considered to be part of the profit and
by several billion dollars.
loss, and the loss would be included with other expenses.
Only if the impairment loss was on a revalued asset would
ASSET IMPAIRMENT it be among other comprehensive income items in the
comprehensive income section. In addition, the Non-
Sometimes, a non-current asset’s ‘recoverable amount’ will
current Asset account is decreased to reflect the reduced
fall substantially due to changing market conditions, value. This reduces assets. After the impairment entry,
technological improvements, or other factors. In Australia, depreciation expense would be calculated based on the
renewable energy targets may make some assets (e.g. revised depreciable amount and remaining useful life.
some coal-fired power stations) reduce substantially in Asset impairments are not uncommon. In fact, AASB
value. When a non-current asset’s recoverable amount falls 136 requires ‘an entity shall assess at the end of each
reporting period whether there is any indication that an
materially below its carrying amount, the asset is
asset may be impaired’.4
considered impaired. Accounting Standard AASB 136
Impairment of Assets requires reporting entities to write
impaired assets down to the higher of an asset’s fair value ASSET REVALUATIONS
(selling price) less costs to sell and its value in use. This,
The Accounting Standard AASB 116 allows cost model  After
like the lower-of-cost-and-net-realisable-value rule with
either the ‘cost model’ or the ‘revaluation recognition as an asset, an
inventory, is an application of the concept of prudence
model’ as an entity’s accounting policy to item of plant, property and
(conservatism). The Australian Securities and Investments equipment shall be carried
measure plant, property and equipment. at its cost less any
Commission released ‘Impairment of non-financial assets:
The cost model states ‘after recognition accumulated depreciation
Materials for directors’, which stated: ‘Impairment testing and any impairment loss.
as an asset, an item of plant, property and
is the process of reviewing the values of assets shown in revaluation model  If
equipment shall be carried at its cost less fair value can be measured
the balance sheet of a company (known as the “carrying reliably the asset shall be
any accumulated depreciation and any
amount”) to determine whether those values continue to carried at a revaluation
impairment loss’. The revaluation amount.
5
be supportable or should be reduced’. It also stated that:
model states if ‘fair value can be
‘Financial reports should provide useful and meaningful
measured reliably the asset shall be carried at a revaluation
information for investors and other users of those financial
amount’.6 If the revaluation model is used, assets should

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CHAPTER 8 Non-current assets and intangible assets 139
 be revalued regularly to ensure the carrying amount does discarded, and sometimes there will be a cost in disposing
not differ materially from fair value at the end of the reporting of the asset. When the asset still has value, it will either be
period. sold or traded in for another asset, often a newer model.
Since the accounting for trading an asset is beyond the
Alamy Stock Photo/Sergio Azenha

scope of this book, we will focus on the first two cases –

discarding or selling the asset.
The accounting for the disposal of a non-current asset
consists of the following three steps:
1 Update depreciation on the asset.
2 Calculate gain or loss on the disposal.
3 Record the disposal.
The first step is to record any necessary depreciation
expense to update the Accumulated Depreciation account.
Usually, this means that depreciation expense must be
recorded for a partial period. For example, a company that
Assets are sometimes impaired because they are no longer popular records annual depreciation expense on 31 December and
sells equipment on the following 15 February must record
There are a number of restrictions on management depreciation expense for one and a half months at the time
simply revaluing assets to boost the business‘ profits. One of disposal.
is that all assets in a ‘class’ must be revalued. So we cannot The second step is to calculate any gain or loss on the
have a case where some machinery is revalued and other disposal by comparing the asset’s carrying amount to the
machinery is not. Examples of other classes of assets are proceeds from the asset’s sale, if any. When the proceeds
ships, furniture and fittings, office equipment, land and exceed the carrying amount, a gain on disposal is
buildings. But the significance of ‘comprehensive’ in a recognised. When the carrying amount exceeds the
statement of comprehensive income (rather than the proceeds, a loss on disposal is recognised. This is
simple income statement) may now become a little clearer. summarised below:
Upward revaluations are included in ‘other comprehensive KEY FORMULA 8.4 DISPOSALS
income’ not in the income statement. CSL includes ‘actuarial
gains/(losses) on defined benefit plans’ (see note 18) as part Gain on Disposal = Proceeds from Sale > Carrying Amount
of ‘other comprehensive income’. It is not important what Loss on Disposal = Proceeds from Sale < Carrying Amount
an actuarial gain is, but the fact that it is in comprehensive
income indicates the fair value has increased, but they have The third and final step is to prepare a journal entry that
not been sold and the gain actually made or ‘realised’. For decreases the asset account and its related accumulated
many people who own their own house, the increase in depreciation account. If the asset is sold and cash is
the fair value of their house makes them feel wealthier, but received, the entry must also record the increase in cash.
until the house is sold and the gain realised it is part of their Finally, any gain or loss on the disposal must be recorded.
income, not profit. To illustrate, suppose that a company purchases a
Over the years the way different increases in an entity’s machine on 1 January 2018 for $30 000. The company
value have been accounted for has changed, but the estimates the useful life and residual value to be four years
accounting standards divide income into two parts: ‘profit and $2000, respectively. The company uses the straight-
or loss’ and ‘comprehensive income’. Upward revaluations line method of depreciation and records depreciation
of assets are included in comprehensive income, while the expense annually on 31 December. Given these facts,
sale of an asset above its carrying amount would be annual depreciation expense for the machine is $7000
(normal) profits. [($30 000 – $2000) / 4].

LOSS EXAMPLE
LO4 DISPOSING OF Suppose further that the company sells the machine on
NON-CURRENT ASSETS 30 June 2020 for $12 000. To account for this sale, the
company must first update the accumulated depreciation
When a company decides that it no longer needs a non- account. The asset has been used for six months since the
current asset, it usually disposes of the asset in one of last time depreciation was recorded (31 December), so the
three ways. When the asset has no value, it will simply be company must record six months of depreciation expense.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
140 ACCT3 Financial
Since annual depreciation expense is $7000, six months GAIN EXAMPLE
of depreciation would be half of that, or $3500. Therefore,
To illustrate a gain example, suppose that the company
the following entry would be made on 30 June 2020:
sells the machine on 31 March 2021 for $8000. After
30 June Depreciation Expense 3 500 updating depreciation, the Accumulated Depreciation
2020
account would have a balance of $22 750:
  Accumulated Depreciation 3 500
Three full years (2018, 2019, 2020) $21 000
   (To record the depreciation expense)
One-quarter of 2021 ($7 000 × ¼)   1 750
Assets        =        Liabilities        +       Equity
Accumulated depreciation at 31 March 2021 $22 750
–3 500 –3 500

As a result of this entry, the accumulated depreciation Therefore, the machine’s carrying amount and the gain/
account is updated to a balance of $17 500 ($7000 in 2018, loss on disposal at 31 March 2021 can be calculated as
$7000 in 2019 and $3500 in 2020). With this balance, the follows:
gain/loss on disposal can be calculated as follows: Proceeds from sale $8 000
Proceeds from sale $12 000 Cost of machine $30 000
Cost of machine $30 000 Less: accumulated depreciation 22 750
Less: accumulated depreciation   17 500 Carrying amount at 31 March 2021   7 250
Carrying amount at 30 June 2020 12 500 Gain on sale $ 750
Loss on sale $ (500)
Because the sale proceeds of $8000 exceed the asset’s
Because the asset’s carrying amount of $12 500 carrying amount of $7250, the company generates a $750
exceeds the sale proceeds of $12 000, the company gain (revenue). With this information, the following journal
generates a $500 loss (expense). With this information, the entry can be prepared to record the disposal:
company can prepare the following journal entry to record 31 Mar. Cash 8 000
the disposal: 2021
Accumulated Depreciation 22 750
30 June Cash 12 000
2020   Gain on Disposal 750
Accumulated Depreciation 17 500   Machine 30 000
Loss on Disposal   500    (to record the sale of the machine)
 Machine 30 000 Assets        =        Liabilities        +        Equity
   (To record the sale of the machine)   +8 000 +750
Assets         =         Liabilities         +         Equity +22 750
+12 000 – 500
–30 000
+17 500
–30 000 Like the loss example, the entry decreases the
Machine account by $30 000. It also decreases the
The entry first decreases the Machine account by machine’s Accumulated Depreciation account by $22 750
$30 000 to eliminate the account. A common mistake is to eliminate the account and increases the Cash account
to think that the Machine account should be decreased by $8000 to reflect the asset received from selling the
by its carrying amount of $12 500. But remember that machine. Finally, the entry increases a Gain on Disposal
non-current assets are recorded and maintained at their account to reflect the gain on sale. Like the loss example,
costs, so the balance in the Machine account is $30 000 the net effect on the accounting equation is an equal
prior to disposal. Second, the entry decreases Accumulated change in assets and equity, with this example resulting
Depreciation by $17 500. Because the company no longer in a $750 increase to both.
YT
PPL HIS
has the asset, it should no longer maintain accumulated
A

depreciation for the asset. Third, the entry increases the Review this content with the e-lecture
Cash account to reflect the asset received from selling
the machine. Finally, the entry increases a Loss on
Disposal account to reflect the loss on sale. As a result of
the entry, assets and equity decrease by $500, the amount
of the loss.

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CHAPTER 8 Non-current assets and intangible assets 141
 income statement accounts. These calculations are
LO5  VALUATING A COMPANY’S
E summarised as follows:
MANAGEMENT OF
Horizontal analysis
NON-CURRENT ASSETS Dollar Change in = Current year Balance – Prior year Balance
Account Balance
Because non-current assets comprise the largest category
Percentage Change Dollar Change
of assets for most companies, it is usually a good idea to in Account Balance = Prior year Balance
evaluate a company’s management of its non-current
Vertical analysis
assets. A company manages non-current assets by
acquiring them, using them productively and then Account Balance
Account Balance or Net Sales or
replacing them. Therefore, two issues of importance for Percentage = Total Assets Net Sales or
any company with non-current assets would be as
Revenue
follows:
1 How productive are the company’s non-current assets Given the financial information in Exhibit 8.5, horizontal
in generating revenues? and vertical analyses of non-current assets and depreciation
2 What is the condition of the company’s non-current expense result in the following. Note that the carrying
assets? amount of property and equipment is used in the
The following sections examine these issues for the calculations. Note also that vertical analysis is conducted
non-current assets of a hypothetical vegetarian restaurant on both years of data.
chain, Kale Me Crazy (KMC). The examination will require
Horizontal analysis
information from the company’s balance sheet, income
Dollar change Percentage
statement and notes to the financial statements. The change
required information is found in Exhibit 8.5, excerpted from
Property and equipment 20 254.5   (730.2)
KMC’s 2019 Annual Report. = 3.5%
–20 984.7  20 984.7
(730.2)
HORIZONTAL AND VERTICAL ANALYSES Depreciation expense 1 161.6      16.6
= 1.5%
1 145.0  1 145.0
A good place to start an analysis of non-current assets is 16.6
with horizontal and vertical analyses. Recall from Chapter
Vertical analysis
2 that horizontal analysis calculates the dollar change in an
2019 2018
account balance, defined as the current-year balance less
the prior-year balance, and divides that change by the prior- Property and equipment 20 254.5 71.2% 20 984.7
= = 71.4%
28 461.5 29 391.7
year balance to yield the percentage change. Vertical
Depreciation expense    1 161.6 =   1 145.0
analysis divides each account balance by a base account, 4.9% = 5.0%
23 522.4 22 786.6
yielding a percentage. The base account is total assets for
balance sheet accounts and net sales or total revenues for The calculations show a fairly stable non-current asset
position. Horizontal analysis shows a slight decrease of
3.5 per cent in non-current assets and a slight increase of

Source Accounts 2019 ($m) 2018 ($m)

Income statement Total revenues $ 23 522.4 $ 22 786.6
Property and equipment, at cost 31 152.4 32 203.7
Less: Accumulated depreciation (10 897.9) (11 219.0)
Balance sheet Net property and equipment 20 254.5 20 984.7
Total assets 28 461.5 29 391.7
Notes to financial statements Depreciation expense   1 161.6   1 145.0
EXHIBIT Kale Me Crazy account balances from the 30 June 2019 Annual Report
8.5

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
142 ACCT3 Financial
 1.5 per cent in depreciation expense from 2018 to 2019.
Vertical analysis shows that non-current assets make up a ANALYSIS
Using CSL’s information in
large part of KMC’s asset base. In each year, slightly over
Appendix B, calculate and
71 per cent of the assets are non-current assets. Furthermore, interpret:
depreciation expense is shown to be about 5 per cent in each 1 horizontal and vertical analyses of non-current assets
year. This tells us that for every dollar in sales revenue, the and depreciation expense (Note 14 ‘Reconciliation of
company incurs about 5 cents in depreciation expense. Profits after tax to Cash Flow from Operations’)
Overall, both of these analyses indicate fairly stable non- 2 non-current asset turnover ratio
current assets over the two-year period. 3 average life and average age of non-current assets.
Analysis:
NON-CURRENT ASSET TURNOVER RATIO 1  Horizontal analysis
The preceding analyses indicate that KMC’s non-current Non-current assets:
assets are stable. But they do not indicate whether the ($4520.6 – 3744.7) / $3744.7 = 20.7%
company is using those non-current assets productively Depreciation (amortisation and impairment charges)
to generate revenues. One way to find expense:
non-current asset out is to calculate the non-current asset ($279.3 – 220.3) / $220.3 = 26.7%
turnover ratio  A
comparison of total turnover ratio. The non-current asset Vertical analysis
revenues to the average net turnover ratio compares total revenues Non-current assets:
carrying amount of non-
current assets that during a period to the average carrying $4520.6 / $9122.7 = 49.6%
measures the productivity amount of non-current assets during that Depreciation expense:
of non-current assets.
period. It is calculated as follows: $279.3 / $6922.8 = 4.0%

KEY FORMULA 8.5 NON-CURRENT ASSET

The horizontal analysis shows that while non-current
assets increased substantially (over 20%), depreciation
TURNOVER RATIO
expense was up even more. The almost 50 per cent
Non-current Asset Turnover Ratio = vertical analysis of non-current assets shows non-current
Total Revenues assets are (slightly) less important than current assets to
Average Net Carrying Amount of Non-current Assets
CSL. The 4.03 per cent vertical analysis of depreciation
expense indicates that while CSL has large non-current
Where average net book value is: assets, depreciation expense consumes just over
4 cents per dollar of operating revenue in the most
Beginning Net Carrying Amount + Ending Net Carrying Amount recent year.
2
2  Non-current asset turnover ratio:
$6922.8 / ($4520.6 + $3744.7) / 2 = 1.68
Because this ratio compares total revenues to non- The 1.68 non-current asset turnover ratio indicates that
current assets, it indicates the productivity of every dollar CSL generates $1.68 in revenue for every $1 of non-
invested in non-current assets. In general, companies want current assets that it owns. This number is almost
this ratio to be higher rather than lower. All other things meaningless in isolation, only when compared to previous
being equal, a higher ratio indicates that the company is or future years or similar biotechnology companies can
sense be made of this number.
using its non-current assets more effectively to produce
3 Average (Property, Plant and Equipment) life and
more revenue.
age ratios (figures from Notes 8 and 14)
The 2019 non-current asset turnover ratio is calculated
as follows: $4525 / 279.2 = 16.2 years
The 16.2 average life shows that CSL’s non-current assets
23 522.4 on average last just over 16 years.
= 1.14
(20 254.5 + 20 984.7) ÷ 2 $1582.3 / $279.2 = 5.7 years
The 1.14 ratio shows that KMC’s total revenues for 2019 The 5.7-year average age ratio indicates that the
company’s non-current assets are relatively young, having
were 1.14 times the average carrying amount of its non-
been used for less than six years. Taken together, these
current assets. In other words, for every dollar of two ratios indicate that CSL may not need significant non-
non-current assets, on average, the business was able to current asset replacement in the short term.
generate $1.14 in revenue during the period. Whether this
is good or bad requires some comparison. Its major
competitor’s non-current asset turnover ratio was 1.60,
while another competitor’s was 2.67. KMC lags its two
rivals in generating revenues from its non-current assets.

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CHAPTER 8 Non-current assets and intangible assets 143
 AVERAGE LIFE AND AGE OF
NON-CURRENT ASSETS
LO6 NON-CURRENT ASSETS
AND CASH FLOWS
In addition to understanding the productivity of non-current
assets, it is useful to understand the condition of a company’s Another important aspect of non-current assets is their
non-current assets. Non-current assets in poor condition are effect on a company’s cash flows. Non-current assets
usually less productive and normally require significant affect cash flows the most when they are purchased.
expenditures to either repair or replace. While a user of most Because companies often purchase significant amounts of
companies’ financial statements cannot physically examine non-current assets each year, the cash paid for them is
their non-current assets, one way to get a rough idea of the reported as a separate line item in the investing activities
general condition of a company’s non-current assets is to section of the statement of cash flows. The line item is
look at the age of the assets in comparison to their useful often labelled as capital expenditures or something similar.
lives. This can be accomplished by KMC is a little more specific, reporting the following on the
average useful life
of non-current calculating the average useful life and first line of its investing activities section:
assets  A comparison of average age of the assets.
the cost of non-current
assets to depreciation The average useful life of non- Kale Me Crazy 2019 capital expenditures from the
expense that estimates current assets represents the number statement of cash flows
the number of years, on in millions 2019 2018 2017
average, that a company of years, on average, that a company
expects to use its non- expects to use its non-current assets. It Property and equipment $(2 135.7) $(1 946.6) $(1 741.9)
current assets. expenditures
is calculated as follows:

KEY FORMULA 8.6 AVERAGE USEFUL LIFE RATIO

The negative number signifies a cash outflow. In 2019,
KMC spent over $2.1 billion in cash to purchase non-current
Cost of Non-Current Assets assets. In the two previous years, the company spent
Average Useful Life =
Depreciation Expense
about $1.9 billion and $1.7 billion. For the three years
combined, this totals over $5.8 billion in cash paid for non-
The ratio divides the total cost of non-current assets by current assets.
the amount of annual depreciation expense to approximate
the number of years that it will take to fully depreciate the
istock.com/Lighthousebay

assets. A higher number represents a longer useful life. You

may notice that this ratio is basically a rearrangement of the
calculation of straight-line depreciation. Therefore, the ratio
works best when the company uses the straight-line method.
In the case of CSL a more useful calculation
average age of non- may be to exclude: deferred tax; goodwill;
current assets  A
comparison of land; capital works in progress as these non-
accumulated depreciation current assets are not amortised or
to depreciation expense
that estimates the depreciated.
number of years, on The average age of non-current
average, that the In a restaurant, the money spent to create the right atmosphere
company has used its assets represents the number of years, on must be recouped from the dining public
non-current assets. average, that the company has used its non-
current assets. It is calculated as follows: A natural question arising from this data is where the
company got the $5.8 billion it needed for these investments
KEY FORMULA 8.7 AVERAGE AGE RATIO
in non-current assets. Did it borrow the money or did it have
 Accumulated Depreciation it on hand? We can get an idea of where the money came
Average Age =
Depreciation Expense from by looking one line above the capital expenditures.
There we find the cash provided by operating activities,
The ratio divides the accumulated depreciation balance by which is summarised as follows:
the amount of annual depreciation expense to approximate
the number of years that the assets have already been Kale Me Crazy’s 2019 operating cash flows from the
statement of cash flows
depreciated. A higher number means that the assets are
in millions 2019 2018 2017
older. Like the average useful life ratio, the average age ratio
Cash provided by $5 917.2 $4 876.3 $4 341.5
Y T
PL ISH works best when the company
operations
AP

Download the Enrichment uses the straight-line method.

Modules for further practice

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144 ACCT3 Financial
 other company, without permission from Cengage, can
ANALYSIS lawfully use the content of this book.
Look at CSL’s cash flow statement
A third intangible with which you may be familiar is a
in Appendix B. How much cash has
the company spent to acquire PPE over the past two franchise, which is the right, granted by franchise  The right to
years? Compare CSL’s net capital expenditures in the the franchisor to a franchisee to operate a operate a business under
most recent year to its cash from operations. business under its trade name. Examples the trade name of the
franchisor.
Analysis: of franchises are all around you. For
According to the investing activities section of its cash example, whenever you visit a McDonald’s, you may be
flow statement, CSL spent just over $1184 million ($689 + entering into a restaurant that is owned by an individual (the
$495) on PPE over the past two years plus $487 million on
franchisee) who has purchased from McDonald’s Corporation
intangibles and business acquired.
Its net capital expenditure (investing activity) in the (the franchisor) the right to operate the restaurant.
most recent year was $862.9 million while its cash
generated from operations was $1246.6 million. Thus, RECORDING INTANGIBLE ASSETS
CSL generated more than enough cash to pay for its
growth in non-current assets without having to borrow Like all other assets, intangible assets are recorded at their
the cash or dip into its reserves. But if you look further, of acquisition costs. However, what is included as an acquisition
the almost $384 million of free cash flow, over $600 cost can vary given the type of intangible asset and how it
million was paid in dividends, and over $300 million in is acquired. Two accounting standards relate directly to the
share buy-backs. Where did the extra come from? Net recognition, recording, expensing and disclosure of
borrowings of about $800 million paid this shortfall and
intangibles – AASB 138 (IAS 38) Intangible Assets and AASB
increased cash holdings. We look at cash flow statements
in more detail in Chapter 12. 3 Business Combinations. AASB 136 Impairment of Assets
is concerned with ensuring that assets, including intangibles,
are not carried at more than their recoverable amount (able
to be recovered through use or sale).
LO7 INTANGIBLE ASSETS Externally acquired
The easiest case is when an intangible asset is acquired
intangible asset  A resource In addition to plant, property and
through an external transaction. For example, suppose that
that is used in operations for equipment, companies often possess
more than one year but that has a company purchases a product patent from another
no physical substance.
non-current assets known as intangible
company for $100 000. Because the patent is purchased in
patent  The right to assets. An intangible asset is a resource
an arm’s length transaction with another company, the cost
manufacture, sell or use a that is used in operations for more than
particular product or process of the patent is the purchase price. In general, if an
exclusively for a limited period of
one year but has no physical substance.
intangible asset is acquired through an external transaction,
time. A patent is a good example. A patent is
its cost is the purchase price.
the right for the holder of the patent to
Alamy Stock Photo/creativep

manufacture, sell or use a particular product or process

exclusively for a limited period of time. Although the right
of exclusive use has no physical properties, it can be a very
valuable resource to the holder. Consider the pharmaceutical
industry. When a company develops a new drug, which will
be more valuable – the equipment that manufactures the
drug or the patent that provides for exclusive manufacturing
and selling rights to the drug? Pharmaceutical companies
will likely tell you that the patent is most valuable to them.
You are probably familiar with other
trademark (trade
name)  The right to use intangible assets. For example, a
exclusively a name, symbol trademark or trade name is the right The Apple logo is a well-known example of a trademark
or phrase to identify a
company. for a company to use exclusively a name,
copyright  The right to symbol or phrase to identify the company. A common example of an intangible that is created
reproduce or sell an artistic Often, you can tell if something is through an external transaction is goodwill. Goodwill is
or published work or created when one company buys another company and
software computer code. registered as a trademark if it has a small
™ or ® beside the name or symbol. The pays more than the value of the net assets goodwill  An intangible
Nike swoosh™ is an example of a trademark, as is the of the purchased company. Goodwill is asset equal to the excess
script Coca-Cola™ or the apple with a bite out of the side. equal to the excess of the purchase price that one company pays to
acquire the net assets of
This book is protected by copyright, which means no over the value of the purchased net another company.

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CHAPTER 8 Non-current assets and intangible assets 145
 identifiable assets. For example, suppose that Buyer development phase, six criteria must all be demonstrated
Company purchases Seller Company for $8 million before an asset can be recognised. These include:
when the value of Seller Company’s net identifiable ● the technical feasibility of completion for use or sale
assets is $6 million. In this transaction, Buyer Company ● how the intangible asset will generate probable future
pays $8 million and records $6 million of new assets economic benefits
and $2 million of goodwill. A condensed form of the entry ● the ability to measure reliably the expenditure
Buyer Company would make to record this transaction attributable to the intangible asset during its
would be as follows: development.
This may be easier for a biotechnology company that has
Net Assets of Seller Company 6 000 000
procedures in place to assess and measure many
Goodwill 2 000 000 developments than for a company developing a single idea
 Cash 8 000 000 for the first time. Surprisingly CSL has less than 5 per cent
   (To record depreciation expense) of total assets as non-goodwill intangibles.
Assets          =          Liabilities          +          Equity While some disagree with this accounting treatment,
6 000 000
it is another application of prudence. It is very difficult to
know whether particular research and development costs
+2 000 000 will result in productive assets and how long those assets
–8 000 000 might last. Given this uncertainty, expensing research, and
often many or all of the development costs, results in
The above entry records the decrease in cash resulting intangible assets not being overstated.
from the purchase and the increase in net assets acquired
through the purchase. The difference of $2 million is debited AMORTISING AND IMPAIRING
to Goodwill, which increases that asset account. The result INTANGIBLE ASSETS
of the entry is an increase and decrease to assets.
Like non-current assets that are
To understand what goodwill represents, think about amortisation  The
depreciated, intangible assets with limited process of spreading out
why a company would pay a premium for another company.
useful lives are amortised. Amortisation the cost of an intangible
The purchasing company might want to acquire the other asset over its useful life.
is the process of spreading out the cost
company’s customers, its reputation, its employees, its
of an intangible asset over its useful life. Two examples of
market share or its research. Whatever the reason, the
intangible assets with limited lives are patents and
purchasing company is paying for something intangible that
copyrights. Patents are granted for up to 20 years, and
the other company possesses. This intangible value is what
copyrights are granted for the life of the creator plus
goodwill represents. Note here that goodwill can be
70 years. Companies usually use the straight-line method
recorded by a company only when it purchases another
for amortisation.
company. Goodwill created internally by a company cannot
To illustrate, suppose that a company possesses a
be recorded as an asset because its cost cannot be reliably
$60 000 patent that has the maximum legal life of 20 years.
determined. Only through an independent purchase can
The company believes that the patent will be useful for only
the value of goodwill be objectively measured. CSL has
12 years and will then be worthless. Amortisation expense
over $1 billion of intangible assets (over 10 per cent of total
at the end of each year would be $5000 ($60 000 ÷ 12) and
assets) made up of almost $700 million of goodwill,
would be recorded as follows:
$170 million of intangible capital works in progress and over
$100 million of intellectual property. You can see CSL only End of Amortisation Expense 5 000
recognises goodwill as ‘any excess of the fair value of the year
purchase consideration of an acquired business over the Accumulated Amortisation Patent 5 000
fair value of the identifiable net assets … recorded as   (To record the amortisation expense)
goodwill’.7 Assets      =      Liabilities      +      Equity

Internally generated –5 000 –5 000

In the previous examples, intangible assets were purchased

The result of this entry is an increase to expenses and
externally and therefore recorded at their purchase prices.
a decrease to assets. Notice that the entry records
When an intangible asset is developed internally, the
amortisation expense based on the 12-year useful life, not
accounting is more conservative. AASB 138 divides
the 20-year legal life. Amortisation should be based on the
the internal generation of an intangible into two phases:
shorter of the legal life or useful life. We use an accumulated
the research and the development. Expenditure on research
amortisation contra-account because AASB 138 paragraph
is recognised as an expense when incurred. In the
118 requires disclosure of accumulated amortisation.
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146 ACCT3 Financial
 Amortisation applies only to intangible assets with assessment process requires management to make
limited lives. Assets with indefinite lives such as significant judgements. Determining whether goodwill
trademarks and goodwill are instead examined regularly has been impaired requires an estimation of the
(at least annually) to check for impairment. This is similar recoverable amount of the cash generating units using
to the impairment of non-current assets. In general, if a discounted cash flow methodology …’ (discounted
the fair value of the intangible asset falls below carrying cash flows are covered in Appendix A) ‘… [that] uses
amount, then the asset is impaired. In such a case, the cash flow projections based on operating budgets and a
company records a loss on impairment and reduces the three-year strategic business plan after which a terminal
asset to its fair value. As you can imagine, determining value … is applied.’8 Finally, intangibles with limited lives
whether an intangible asset is impaired can be very are subject to the same rules as plant, property and
subjective. In Note 7, CSL states: ‘The impairment equipment when accounting for revaluations.
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CHAPTER 8 Non-current assets and intangible assets 147
 Residual value is estimated at $2600. The machine produces
15 500 and 16 200 units in its first and second financial years
of operation, respectively.
REQUIRED
EXERCISES Calculate depreciation expense for the machine’s first two
years using the straight-line, reducing-balance (double
straight-line rate) and units-of-activity methods of
depreciation.

LO3
LO1 6 Change in useful life
1 Acquisition cost
A company purchases plant with an estimated useful life of
Li Pi Co. purchases equipment with a list price of $22 000.
15 years and a residual value of $35 000. When the plant has
Regarding the purchase, Li:
seven years of life remaining, the company estimates the
i received a 2 per cent discount off the list price remaining useful life is only five years – all else remains the
ii paid shipping costs of $800 same. The asset’s net carrying amount at the time of
iii paid $1750 to install the equipment, $1200 of which revision is $60 000.
was for a unique stand for the equipment
REQUIRED
iv paid insurance: $2800 for equipment; $300 for
delivery and $2500 for a two-year policy to cover Using the straight-line method, calculate depreciation
operations disruption expense for the first year after the revision.
v paid $600 to have the manufacturer train employees
LO2, 3
on safety features. 7 Change in estimates
REQUIRED On 1 July 2019, Ab Activators purchases gymnasium
equipment for $90 000 and estimates a useful life of eight
Determine the acquisition cost of the equipment. Comment
years and a residual value of $6000. On 1 July 2020, Ab
on why the $600 of safety training was included or not
Activators revises the equipment’s useful life from eight
included in the cost.
years to five years. It uses the straight-line method of
depreciation.
LO1
2 Acquisition cost
REQUIRED
Emily incurred the following expenditures when purchasing
a Calculate depreciation expense for 2019–20 and 2020–21
land: $470 000 purchase price, $35 000 in stamp duty and
financial years.
$19 000 for clearing. She sold a building on the land for
$8000. b Recalculate 2020–21 depreciation expense assuming
that Ab Activators leaves the useful life at eight years but
REQUIRED reduces the residual value to $0.
Determine the acquisition cost of the land.
LO3
8 Expenditures after acquisition
LO2
3 Determine net carrying amount Tiger Logistics acquired a new van for $75 000 in 2018. At
Equipment is purchased for $100 800. It has an estimated the end of 2021, accumulated depreciation on the van was
useful life of 10 years and a residual (salvage) value of $800. $25 000. On 1 January 2022, Tiger paid $2000 for routine
service on the van and $8000 to overhaul the engine. The
REQUIRED
engine work is anticipated to extend the useful life of the
Assuming straight-line depreciation, determine the net van by five years.
carrying amount of the asset after three years.
REQUIRED
4 Depreciation methods LO2 Calculate the net book value of Tiger’s van immediately after
the service and overhaul.
Xing Pty Ltd purchases a delivery van on 1 January for
$50 000. The van has an estimated useful life of five years LO3
and an estimated residual value of $5000. 9 Capital/revenue expenditures
A business incurs the following expenditures related to
REQUIRED
currently owned non-current assets:
For both the straight-line and reducing-balance methods of
i annual pressure washing of building, $10 000
depreciation (at twice the straight-line rate), prepare a
schedule of depreciation expense, accumulated depreciation ii new front door lock $250
and carrying amount over the life of the asset. Advise Xing iii new compressor for the air conditioner, $9000
of the advantages/disadvantages of the two depreciation iv repair of water damage caused by leaking roof, $7000
methods. v new tyres on tractor, $4000
vi replacement of standard windows with double
LO2 glazed energy-efficient windows, $18 000
5 Depreciation methods
Port Kembla Steel purchases a machine on 1 July for $60 000. vii addition of 100 square metres of office space, $44 000
The machine has an estimated useful life of seven years, viii modifications to machinery to improve efficiency,
during which time it is expected to produce 57 400 units. $14 400.
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
148 ACCT3 Financial
REQUIRED Revenues Non-current asset carrying amount
Identify each expenditure as a capital or revenue expenditure 2014 $ 4 889 $150
and explain why the accountant should classify the
expenditure as an ‘expense’ or ‘asset’. 2015 5 897 201
2016 6 583 245
LO3
10 Impairment entry 2017 8 563 395
Fung Factories acquired equipment for $450 000. On 2018 10 589 524
15 March 2020, Fung determines that the equipment is
2019 13 584 687
impaired by $65 000.
2020 14 555 793
REQUIRED
Prepare the entry to record the impairment of the REQUIRED
equipment. Calculate the non-current asset turnover ratio for the years
presented. What does the trend in the ratio tell you about
LO4 the company’s performance?
11 Disposal
Ellis Industries sells a building that has an original cost of
LO7
$300 000 and an accumulated depreciation balance of 15 Intangible assets
$200 000. Phoebe Pharmaceuticals incurred the following
REQUIRED expenditures:
Prepare the journal entry to record the sale assuming the i Research costs of $600 000 were incurred to
sales price was (a) $100 000, (b) $95 000 and (c) $108 000. discover a cure for the common cold.
ii Phoebe paid $170 000 in development costs before it
LO2, 4 knew if it was technically feasible to make it as a
12 Disposal
product available for sale.
On 1 January 2018, A&G Company pays $40 000 for iii Phoebe paid about $120 000 on development but
equipment with a 10-year estimated life and a $5000 was not able to reliably measure the expenditure.
estimated residual value. On 1 January 2022, A&G sells the
iv Phoebe incurred $180 000 exactly in costs once it
equipment for $18 500 (assume A&G use a calendar year as
knew it would be able to produce and sell the drug
its accounting financial reporting period).
for billions.
REQUIRED REQUIRED
Calculate the gain or loss on the sale assuming A&G uses
Determine the total cost of the patent and comment on the
the straight-line method of depreciation. Where should the
carrying amount the accountants would place on the patent
gain or loss on the sale be presented on the income
compared to its potential market value.
statement?

LO5
13 Evaluate non-current assets
In its 2020 annual report, Mike reported the following
information (in thousands):
i beginning total assets $6821 PROBLEMS
ii ending total assets $7891
iii beginning PPE $2988 (at cost)
iv ending PPE $3132 (at cost)
v beginning accumulated depreciation $1293
vi revenues $12 253 LO1
vii depreciation expense of $252.
16 Acquisition cost
Sarah purchases an MRI machine with a list price of
REQUIRED
$922 000. Regarding the purchase, Sarah:
a Calculate the non-current asset turnover ratio of Mike’s i received a 5 per cent discount off the list price by
business. paying before delivery
b Calculate the average useful life of Mike’s non-current ii paid shipping costs of $8000
assets at the end of the 2020 financial year. iii paid $175 000 to install the equipment, $120 000 of
c Calculate the average age of Mike’s non-current assets which was to reinforce the floor to withstand the
at the end of the 2020 financial year. weight of the MRI
iv paid $3000 to have the story of the installation of the
LO5
14 Evaluate non-current assets MRI featured on the local news
The following data was taken from the annual financial v paid $2800 to insure the MRI
statements of Skippy Company (all figures in millions): vi paid $230 for a wireless safety cut-off switch
vii paid $6000 to have the manufacturer train employees
on the unique operating procedures.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 8 Non-current assets and intangible assets 149
 REQUIRED LO1, 2, 4
Determine the acquisition cost of the equipment (show
19 Non-current asset transactions and
calculations). reporting
A partial portion of the balance sheet at 31 December 2018,
17 Depreciation methods LO2, 4 for San Limited is presented below:

Sunrise Development Industries purchased a depreciable Land $500 000

asset for $150 000 on 1 July 2019. The asset has a five-year
useful life and a $30 000 estimated residual value. The Buildings $630 000
company will use the straight-line method of depreciation Less: Accumulated Depreciation 250 000 380 000
for book purposes. However, Sunrise will use the r­ educing- Equipment $ 65 000
balance method for tax purposes. Assume a tax rate of
30 per cent. Less: Accumulated Depreciation 22 000 43 000

REQUIRED Total Property and Equipment $923 000

a Prepare depreciation schedules using the straight-line
The following transactions occurred during 2019:
and reducing-balance methods (at 1.5 times the straight-
line rate) of depreciation for the useful life of the asset. 1 January • Retired equipment with a net book value of $2000.
b Calculate the tax savings for the financial year ended 30 The equipment was purchased for $8000. No
June 2020 from the use of the accelerated depreciation value was received from the retirement.
method for tax purposes. 1 January • Sold a building with an original 30-year useful
c Under the straight-line method of depreciation, what is life and no estimated salvage value for $90 000
the gain or loss if the equipment is sold (i) at the end of cash. The building was originally purchased on
June 2022 for $90 000 or (ii) at the end June 2023 for 31 December 2008 for $120 000 and depreciated
using straight-line.
$48 000?
d How is the gain or loss on the disposal of the equipment 30 April • Purchased land for $90 000.
presented in the financial statements assuming no 1 July • Purchased equipment for $30 000 by signing a
revaluations? long-term note payable.
31 December • Depreciation is recorded. Depreciation expense
LO1, 2, 3, 4
18 Various transactions for the year was $40 000 for buildings and $4500
On 1 January 2019, Ravioli Foods purchased a building for a for equipment.
cash price of $1 192 000 and accrued land tax of $114 950. REQUIRED
The building is estimated to have a useful life of 10 years
a Prepare journal entries to record all the above
and $500 000 residual value. On the same day, Ravioli paid
transactions.
$25 450 in cash plus stamp duty of $2290 for a new delivery
van that is estimated to have a useful life of five years and a b Prepare the property and equipment portion of San’s
residual value of $2200. Another $1100 was paid to paint the balance sheet at 31 December 2019.
van company colours with the company logo. Over the next
LO5
several years, the following events related to these non- 20 Evaluate non-current assets
current assets occurred. The following information was available from the 2020
1/7/2020 New information caused the estimated life of the financial statements of Papa John’s Pizza:
van to be reduced to three years total instead of 2020 2019
five years.
Net property and equipment $  189 992 $  198 957
17/12/2020 Repaired air conditioning system in the building
which broke down for one week, $5000. Total assets 386 468 401 817

1/7/2021 Renovated bottom floor of the building for $115 000, Depreciation expense 31 800 30 600
adding three years useful life to the building. Cost of property and equipment 388 080 408 074
1/1/2022 Sold van for $5350. Accumulated depreciation 198 088 209 117
1/7/2022 Sold building for $1 163 000. Total revenues 1 132 087 1 063 595
REQUIRED REQUIRED
Prepare all entries for 2019 to 2022. Ravioli Foods‘ annual Calculate and interpret:
depreciation expense is calculated on 30 June each a horizontal and vertical analyses of non-current assets and
financial year. depreciation expense
b non-current asset turnover ratio
c average life and average age of non-current assets.

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150 ACCT3 Financial
 LO7
d What intangible assets does the company have and are
21 Amortisation of intangible assets they amortised and/or impaired?
Ramon Productions purchased the copyright to a film script e Based on your answers above, write a paragraph
for $264 000 on 1 July. The copyright protects the owners’ explaining your opinion of this company’s non-current
legal rights for the next 20 years, but producers at Ramon asset position. Use your answers as supporting facts.
estimate it will only be able to use the copyright for the next
15 years. Ramon Productions uses the straight-line method 23 Written communication LO2
of amortisation and has a 30 June year-end.
Play Hard Fitness Centre is a chain of gymnasiums. Play’s
REQUIRED financial analysts have forecasted sales to remain at a
Prepare the journal entry to record amortisation expense for constant level for the next three years, but income taxes are
the first year. forecasted to grow by 5 per cent a year for the next five
years. Play Hard is about to refurnish 50 per cent of its
centres with new equipment that will have an estimated
useful life of five years. As a consulting accountant, you
know that companies can use one method of depreciation
for tax purposes and another for book purposes. The two
methods under consideration are the reducing-balance
CASES method and straight-line method of depreciation.
REQUIRED
Write a short memo recommending the method you would
use for tax purposes and the method you would use for
book purposes. Be sure to discuss the advantages and
LO1, 5, 6
22 Research and analysis disadvantages of both methods as well as the associated
Access the annual report of a company of your lecturer’s effects on income, depreciation over time, cash flows, etc.
choosing.
LO7
24 SMS Communication
REQUIRED
a Examine the company’s balance sheet (statement of In 144 characters or less explain what impairment is when
financial position) and conduct horizontal and vertical related to an intangible asset of indefinite life.
analyses of net PPE.
LO1, 3
b Calculate the company’s non-current asset turnover ratio. 25 Ethics in accounting
Also, calculate the company’s average age and useful life A friend of yours claims that he likes accounting because
ratios at the end of the current financial year. Cost and there is always a right and wrong answer to a question and
accumulated depreciation data, and depreciation and therefore there is no temptation for wrongdoing.
amortisation expense should be found in one or more of
REQUIRED
the Notes to the financial statements.
Using capital and revenue expenditures as an example,
c Examine the company’s statement of cash flows. How
explain how judgement can be involved in accounting
much cash did the company spend on PPE over the two
decisions and how an individual’s ethics can affect the
years presented?
manner in which he or she accounts for a particular item.

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CHAPTER 8 Non-current assets and intangible assets 151
 9
The creation and payment of liabilities is common to most
businesses. Some are generated daily and paid quickly.
Others are paid over time and often require the payment
of interest. Still others must be estimated and some may
never be paid. This chapter focuses first on how some
common current liabilities are generated and reported. It
then examines non-current liabilities with a specific focus
on the issue of bonds (sometimes known as debentures),
the interest and eventual payment. We also discuss the
obligations associated with leases and consider the
Liabilities treatment of potential obligations that may or may not
become liabilities. As in previous chapters, the final section
of the chapter focuses on the analysis of a company’s
position regarding its obligations. The appendix covers
bond pricing and the effective interest method for bond
amortisation.

LEARNING
OBJECTIVES
LO1 CURRENT LIABILITIES
After studying the material in this chapter, you A current liability is an obligation of a business that is
should be able to: expected to be paid (or satisfied) within one year (or the
1 Describe the recording and reporting of accounting cycle). Current liabilities can arise from regular
current liabilities. business operations such as the purchase of inventory,
the work of employees, and the incurring of taxes. Most
2 Describe the reporting of non-current current liabilities, such as accounts payable (and notes
liabilities and the cash flows associated with
payable), liabilities to employees and utility (e.g. electricity,
those liabilities.
internet) providers will be satisfied through the payment
3 Understand the nature of bonds of cash. Others, such as deferred revenues, in which a
(debentures) and record a bond’s issue, customer prepays for a service to be performed later, will
interest payments and maturity. be satisfied through the performance of the service.
4 Account for a bond that is redeemed prior The following sections present the accounting for
to maturity. some of the more YT
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A
common t ypes of Check out the video summaries
5 Recognise other liabilities such as leases for Chapter 9
and contingent liabilities. current liabilities.

6 Evaluate liabilities through the calculation

Getty Images/Lester Lefkowitz

and interpretation of horizontal, vertical and

ratio analyses.
7 Appendix: determine a bond’s issue price.
8 Appendix: record bond interest payments
under the effective interest method.

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152
TAXES PAYABLE CURRENT LIABILITIES WITH PAYROLL
When conducting business, companies generate a variety When discussing payroll there are two terms often used:
of tax obligations to the Commonwealth and State gross pay, the total amount of salary or
gross pay
governments. One example is income tax. Like individuals, wages, and net pay or ‘take home pay’ – The total pay before any
companies are subject to federal taxation of their taxable the gross pay minus deductions. deduction; in the simplest
form it is hours worked
income. Like individuals, they are often given time to pay Deductions come in two forms, times the agreed hourly
the bill, which creates a current liability. For example, required deductions , such as rate.
suppose a company has $205 000 of annual income tax employee income tax in which the net pay
Gross pay less deductions
expense and is not required to pay it until the next period. employee (the worker) does not have a such as tax.
The company would make the following journal entry at choice, and optional deductions or required deductions
year-end to record the expense in the proper period: voluntary deductions where the The amount(s) the
employer is legally obliged
employee may ask their employer (the to take out, such as tax,
Year-end Income Tax Expense 205 000
boss) to pay extra superannuation, before depositing the net
Income Tax Payable 205 000 pay in the employee’s
insurance, etc. on their behalf. When bank account.
           (To record the income tax expense) paying employee wages, employers optional deductions
Assets  =   Liabilities +   Equity must withhold income taxes owed by The amounts the
employee asks the
the employee. The employer then remits employer to take out, such
+205 000 –205 000
(sends) the withheld tax to the ATO. To as extra superannuation,
The entry increases both Income Tax Expense and illustrate, suppose that an employee before depositing the net
pay in the employee’s bank
Income Tax Payable. The result of the entry is a reduction earns a monthly salary of $10 000. Based account.
to equity (an expense) and an increase to liabilities. on the employee’s tax situation, the
Another type of tax payable is the Goods and Services employer must withhold 27 per cent of the salary for
Tax (GST). A business does not pay GST; it collects GST income tax. Also suppose the employee has asked for $765
from its customers and passes it on to the Australian to be paid into their superannuation fund (this is known as
Taxation Office (ATO). If a business provided a service or a voluntary deduction and is a contribution out of salary and
sold goods that were subject to GST it would add 10 per on top of the compulsory superannuation of 9.5 per cent
cent to the total price it charged the customer. Imagine the for employees earning more than $450 a month). On
drone filming business from Chapter 1, Aerial Filming, has payday, the company would prepare the following entry:
expanded, so you are now registered for GST. If you carried
Salaries Expense 10 000
out a large job for a customer and you wanted to receive
Income Tax Payable 2 700
$1000 for the work you did, you would charge the customer
$1100 ($1000 for you and $100 for the ATO). The following Superannuation Payable 765
entry records the customer being billed or paying you: Cash 6 535

Accounts Receivable or Cash 1 100 (To record payment of salary)

Service Revenue 1 000 Assets = Liabilities + Equity

GST Payable 100 –6 535     +2 700 –10 000

  (To record service provided plus GST) +765

Assets = Liabilities + Equity The entry increases Salaries Expense for the $10 000
+1 100 +100 +1 100 salary earned by the employee for the month. However, the
employee is paid only $6535 (this is the amount deposited
The advantage for a business of being registered for in the employee’s bank account — their ‘take-home pay’).
GST is being able to claim back the GST paid on those The difference is the amount that the employee owes in
goods and services for which they have been charged GST. taxes and superannuation the employee contributed. On
In the above example the business that purchased the behalf of the employee, the employer withholds the tax and
service from you would pay you $1100 but $100 of that superannuation and records the resulting liabilities. As a
would be ‘GST Receivable’, an asset for them. Although result of this entry, assets decrease, liabilities increase, and
they pay you $1100, they will claim back the $100 of GST equity decreases for the amount of the total salaries expense.
from the ATO and so the resulting cost for your customer In addition to withholding taxes on behalf of employees,
is only $1000. Individuals and businesses not registered employers may also pay other taxes such as state payroll
for GST cannot claim back the GST they pay, so the tax. Each state has different rates and thresholds. Small
government does not miss out completely (e.g. when you businesses with only a few employees generally do not
buy clothes, takeaway food etc.). have to pay payroll tax, but as a business expands they will
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CHAPTER 9 Liabilities 153
 reach the threshold. Payroll tax may be seen as a In this entry, Bugeja increases both Cash and Note
disincentive to employ more people. Let’s imagine the Payable by $100 000. As a result, both assets and liabilities
threshold is $1 million, and once total employee benefits increase. Since this note matures within a year, the note
rise above that level a 7 per cent payroll tax is paid on all payable would be reported as a current liability.
employee benefits. This is an additional tax; it is not On 31 August, Bugeja must pay Murray River Bank the
deducted from employees’ wages like income tax shown original $100 000 borrowed plus the interest on the note.
above. If your business had gross employee benefits of say Interest over the six months is calculated as follows:
$3.5 million, in the year you would incur $245 000 of
Interest = Principal × Annual Rate of Interest ×Time Outstanding
additional employment expenses. The following entry
= $100 000 × 0.08 × 6/12 months
records the expense and the resulting liability: = $4000
Payroll Tax Expense 245 000 Therefore, Bugeja would pay $104 000 to the bank and
Payroll Tax Payable 245 000 make the following entry on 31 August:
  (To record payroll tax) 31 Aug. Note Payable 100 000
Assets =    Liabilities + Equity Interest Expense 4 000
  +245 000 –245 000 Cash 104 000

These are called labour ‘on costs’ and would include   (To record payment of note and interest)
workers’ compensation insurance and compulsory Assets   =   Liabilities + Equity
superannuation (although superannuation paid by the –104 000 –100 000 –4 000
employee may be included in the ‘package’ an employee
is offered). In this entry, Bugeja increases Interest Expense to
reflect the cost of borrowing the $100 000 over the six
NOTES PAYABLE months. Bugeja also decreases the Note Payable account
Chapter 6 introduced the concept of a promissory note, because the note is being paid. Finally, Bugeja decreases
which is a written promise to pay a specific sum of money Cash for the payment of principal and interest. Because of
at some date in the future. That chapter focused on the the entry, Bugeja’s assets, liabilities and equity decrease.
party that accepted the note in exchange for cash. That is, If Bugeja’s financial year ended on 30 June, an adjusting
the accounting for notes receivable was demonstrated. entry would be needed to recognise the expense for four
This chapter focuses on the party that accepts cash in months and the liability at the end of the four-month period
exchange for the note. That is, the accounting for notes – Interest expense of $2667 and Interest payable of $2667
payable is now demonstrated. ($100 000 × 0.08 × 4/12).
When a company issues a promissory note to borrow
money (or delay payment for goods or services – effectively CURRENT PORTION OF NON-CURRENT DEBT
the same thing), the company generates A company that borrows long term may only pay interest
note payable a note payable. If the note is payable during the term of the loan and repay the principal (the
A liability generated by within a year, it is a current liability.
the issue of a promissory amount borrowed) at the end of the loan. To illustrate,
note to borrow money. Otherwise, it is a non-current liability. The suppose a company borrows $500 000 through a 10-year
accounting for a note payable consists of promissory note. Because the note is payable in 10 years,
recording the note, recording any interest that must be paid the company classifies the note as a non-current liability.
to the creditor and recording the payment of the note. In year 10, the note is reclassified as a current liability
To illustrate, suppose that on 1 March Bugeja Company because it will all be repaid in year 10). The
borrows $100 000 by signing an 8 per cent, six-month note current portion of non-current debt current portion of non-
with Murray River Bank. The note calls for interest to be represents the portion of a non-current current debt
The portion of a non-current
paid when the note is repaid on 31 August. On 1 March, liability that will be paid within one year. liability that will be paid within
Bugeja would make the following entry to record the note: Many long-term borrowings require a one year.
set amount to be repaid each month. At
1 Mar. Cash 100 000
the beginning of the loan the majority of the payment is
Note Payable 100 000 interest and a smaller amount of principal is repaid. (On a
  (To record the note) thirty year $500 000, 5% mortgage the monthly payment
Assets    = Liabilities + Equity would be approximately $2684. For the first payment
$2084 is interest and $600 repayment of principal.) In the
+100 000 +100 000
first year about $7500 of the principal will be repaid;

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154 ACCT3 Financial
therefore, at the beginning of the year $492 500 of the
mortgage will be reported as a non-current liability, $7500 LO2 NON-CURRENT LIABILITIES
current. At the beginning of the last year of the loan all the
outstanding principal of $31 350 will be reported as a A non-current liability is any obligation of a business that is
current liability. In the last year only $858 of the repayments expected to be satisfied or paid in more than one year or
is interest. (These numbers are not important, they can be beyond one accounting cycle. Like current liabilities, the
verified using online calculators.) As you consider these type and size of non-current liabilities can vary across
two examples, keep in mind that regardless of how the companies. However, the most common and largest non-
liability is classified on the balance sheet, the company is current liabilities often arise from borrowing money. While the
borrowing and repaying $500 000. The classification of the CAANZ had over $70 million in current liabilities, they have
note payable as current or non-current does not affect the just over $2 million in non-current liabilities. This is not
borrowing or repayment of the note. It only affects how the surprising given they use members’ fees to provide services
payable is reported (disclosed and classified) on the balance to members (including attracting students like
sheet. However, this balance sheet reporting is important you into the profession). Most businesses use shareholders’
because it tells users of the financial statements what and borrowed money to provide goods and services to clients/
obligations will require payment in the short term. During customers in order to earn a profit for their shareholders.
the Global Financial Crisis a number of companies, including While the balance sheet reports the balance in non-current
ABC Learning and Centro Properties, incorrectly reported liabilities, the cash flow statement reports the cash flows
current liabilities as non-current and in doing so misled associated with
YT
PPL HIS
users of their financial statements. These companies’ those liabilities in the

A
financing activities Review this content with the e-lecture
short-term borrowings had previously been renewed (rolled
over) every three or so months for several years by their section.
lenders. When it became difficult to borrow money, the
lenders asked for their money back and the companies
were faced with having to find hundreds of millions of LO3 BONDS
dollars within a few months. The misclassification of
liabilities as non-current rather than current, misled the A financial instrument that companies use to borrow money
users of the financial statements. on a long-term basis is a debenture or bond. The term
debenture is becoming less common in Australia, so we use
REPORTING CURRENT LIABILITIES the term ‘bond’, which is generally used in global financial
Current liabilities are reported in a separate section on a markets. The advantage of bonds is they provide the flexibility
balance sheet. The following is the current liabilities section of borrowing from a range of lenders and often at the most
of the balance sheet (as at 30 June 2017) of the Chartered competitive interest rates. The disadvantage when compared
Accountants Australia and New Zealand (CAANZ):1 with borrowing from a bank is the administrative work in
issuing bonds and paying interest to many lenders.
CAANZ 2017 and 2016 Current Liabilities (in thousands)
Notes 2017 2016
ANALYSIS
Fees in advance 10 $56 553 $54 241 Look at CSL’s balance sheet and
Trade and other payables 11 9 254 13 291 cash flow statement in Appendix B.
Using both statements, explain what happened to short-
Provisions 12   5 254   4 592 term debt during 2017.
Total $71 061 $72 124 Analysis:
CSL increased its current liabilities by over 17 per cent in
CAANZ reports over $70 million in current liabilities in 2017. The balance sheet shows the balance of Total
2017 (down a little on 2016). This total is made up mostly of Current Liabilities going from $1374.4 million in 2016 to
fees received in advance, primarily members who have paid $1618.1 million in 2017, providing almost $244 million in
their annual membership fees for the next financial year in cash to the business. The cash flow statement does not
appear to reflect this because borrowings (cash flows
the previous financial year. It also includes payments from financing activities) used $103.5 million in cash
received in advance for professional development courses outflows. But this reflects the increase in non-current
and students undertaking the CA Program who have paid rather than current liabilities. The increase in current
on or before 30 June for courses to be conducted on or after liabilities is to be found in the reconciliation of cash flows
1 July (so they can claim a tax deduction when paid – if you from operations to profits (Note 14) where it is mainly
explained by the increase in trade and other payables by
were wondering why they would pay in advance). Notes 10
$153.9 million
to 12 of the financial statements provide more detail.

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CHAPTER 9 Liabilities 155
bond A bond is a financial instrument in be annually or semi-annually. The maturity date is the date
A financial instrument which a borrower promises to pay future on which the face value must be repaid to
in which a borrower maturity date
promises to pay future interest and principal to a creditor in the creditor. These three terms, which do The date on which the face
interest and principal to exchange for the creditor’s cash today. The not change over the life of the bond, are value must be repaid to the
a creditor in exchange for creditor.
borrower ‘sells’ or ‘issues’ the bond and disclosed on the certificate that is given to
the creditor’s cash today.
records a liability. The creditor ‘buys’ the the creditor or the creditor’s trustee when the bond is
bond and records an investment. purchased.
The terms and features of a bond are determined by An example certificate is shown in Exhibit 9.1. This
the borrower (the issuer of the bond) and can vary widely, bond was issued by the Commonwealth Government
but they need to be competitive or no one will buy the bond through the Reserve Bank of Australia and had interest
(lend the borrower money). However, all bonds have a face coupons attached. It was a ‘bearer bond’ entitling the
value, a stated interest rate and a maturity date. person who had physical possession of the certificate to
face value The face value is the amount that the claim the interest and redeem the bond on maturity (or at
The amount that is repaid borrower company wants to borrow, but any stage if all future interest coupons were attached).
at maturity of a bond.
more accurately the amount that must be Note this was from a different era when interest rates were
stated interest rate
The contractual rate at repaid to the creditor (lender) upon considerably higher.
which interest is paid to maturity of the bond. Another name for While these terms establish both the amount to be paid
the creditor.
face value is principal value. The stated at maturity (the face value) and the amount of interest to
interest rate is the contractual rate at be paid each period (the stated interest rate), they do not
which interest is paid to the creditor. Other names for the establish the issue price for which the bonds are issued. A
stated rate include face rate, nominal rate, contractual rate bond’s issue price is a function of these terms as well as
or coupon rate. Along with this stated rate, a bond will a fourth item, the market rate of interest given the
specify the timing of interest payments. These will usually borrower’s risk.
Tyler/Image

EXHIBIT Example of a bond certificate

9.1

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156 ACCT3 Financial
 Market rate Bond price
6% Discount

Stated rate
5% 5% Par

4% Premium

EXHIBIT Premium or discount

9.2

The market (or effective) rate of

Alamy Stock Photo/Everett Collection Inc

market (or
effective) rate of interest is the rate of return that investors
interest in the bond markets demand on bonds of
The rate of return that
investors in the bond similar risk. The market rate is based on many
markets demand for complicated factors, including current and
bonds of similar risk.
expected economic conditions. However, its
relation to a bond’s issue price is relatively
straightforward. See an example of these concepts in
Exhibit 9.2.
When a bond pays interest at a rate that is equal to what
 Another kind of bond
creditors require in the market, the creditors will buy the
bond at its face value. Creditors are getting the return that
they require, so no adjustment to price is needed. As a BONDS ISSUED AT FACE VALUE
result, the borrower receives face value. We say that such To illustrate a bond issued at face value, suppose that on
bonds are issued at par or face value. 1 July 2019, Ma Manufacturing sells bonds with a face value
When a bond pays interest at a rate that is lower than of $100 000. The bonds carry a 6 per cent interest rate and
what creditors demand, the creditors will purchase the a 1 July 2029 maturity date. Interest is to be paid semi-
bond only if the price is discounted. By discounting the annually on 1 July and 1 January. Because the market rate
price, the borrower is effectively increasing the rate of of interest is also 6 per cent, the bonds sell at face value.
interest that the creditor earns. In fact, the bond will sell
only when the price is reduced enough so that the effective Recording the issue
interest rate that the creditor earns equals the market rate In this example, Ma would record the bond issue with a
of interest. Bonds that are issued for less than face value simple and straightforward entry to increase Cash and
are issued at a discount. Bonds Payable:
When a bond pays interest at a rate that is higher than
1 Jul. Cash 100 000
what creditors expect, the borrower will sell the bond only 2019
if the price is raised. By raising the price, the borrower Bonds Payable 100 000
effectively lowers the rate of interest that the creditor
  (To record bonds issued at face value)
earns. In fact, the bond will be able to be sold at a higher
price so the effective interest rate that the creditor earns Assets  = Liabilities + Equity
equals the market rate of interest. Bonds that are issued +100 000 +100 000
for more than face value are issued at a premium.
Actual issue prices are calculated using present value Note that this entry is practically the same as the entry
calculations. The chapter appendix illustrates these recording the note payable earlier in the chapter. This should
calculations. Here, you should simply understand that make sense since a bond is really just a more formalised
bonds sell for whatever price is necessary to make the note payable.
effective rate of interest equal to the market rate of interest.
Recording interest payments
The following sections demonstrate how to account for a
Once the bond is issued, Ma must pay interest on 1 July
bond’s issue, the periodic interest payments and the
and 1 January of each year. For any bond, the amount of
maturity of bonds under each scenario.
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CHAPTER 9 Liabilities 157
 interest paid each period is a product of the face value, paid. Thus, the total cost of borrowing the $100 000 over
the stated interest rate and the length of the payment the 10 years is $60 000.
period. In this example, interest is paid every six months,
or semi-annually, so the amount paid is $3000, calculated Recording the maturity
as follows: On the 1 July 2029 maturity date, Ma would record the
repayment of the bonds in addition to the last interest payment.
Interest Paid = Face Value × Stated Interest Rate × Time Outstanding
= $100 000 × 0.06 × 6/12 months
1 Jul. Bonds Payable 100 000
= $3000 2029
Therefore, on 1 January, Ma would record its interest Cash 100 000
payment with the following entry:   (To record repayment of the bonds)
1 Jan. Interest Expense 3 000 Assets  = Liabilities + Equity
2020
–100 000 –100 000
Cash 3 000
YT
  (To record payment of interest) PPL HIS

A
Check out the animated summary
Assets   =  Liabilities  + Equity on Bonds Issued at Face Value
–3 000 –3 000
BONDS ISSUED AT A DISCOUNT
Ma increases Interest Expense to reflect the cost of
borrowing over the six months and decreases Cash to reflect To illustrate a bond issued at a discount, suppose that on
the payment made to the bondholders. The overall effect of 1 July 2020, Nguyen Company issues bonds with a face
the transaction is a decrease to Ma’s assets and equity. value of $200 000, a stated interest rate of 7 per cent and
The next $3000 interest payment is scheduled for 1 a maturity date of 30 June 2025. Interest is payable
July 2020. However, assuming that Ma has a 30 June annually on 30 June. At the time of issue, the risk-adjusted
year-end, two entries are required. The first is a 30 June market rate of interest for Nguyen is higher than the
adjusting journal entry that accrues the interest expense stated rate of 7 per cent, and the bonds sell at a price of
and records the related payable so that the expense is $196 000, or a $4000 discount. At such a price, the bonds
properly recorded in the period in which the money was are said to have sold at 98, meaning that they were issued
used. The second entry records Ma’s payment on 1 July at 98 per cent of face value ($200 000 × 98% = $196 000).
2020. These two entries are shown as follows:
Recording the issue
30 Jun. Interest Expense 3 000 Nguyen would record the issue as follows:
2020
Interest Payable 3 000
1 Jul. Cash 196 000
2020
  (To record accrual of interest) Discount on Bonds Payable 4 000
Assets  = Liabilities + Equity Bonds Payable 200 000
+3 000 –3 000   (To record bonds issued at a discount)
Assets   = Liabilities + Equity
1 Jul. Interest Payable 3 000 +196 000 +200 000
2020
–4 000
Cash 3 000
  (To record payment of interest) In this entry, Nguyen increases Cash for the $196 000
received from the investors. Nguyen also increases Bonds
Assets = Liabilities + Equity
Payable to reflect the new obligation that it has. Notice that
–3 000 –3 000
Bonds Payable is recorded at the bond’s face value of
$200 000. The Bonds Payable account is always recorded
Note the overall effect of the two entries is to decrease
at the amount that will ultimately be repaid, which is face
assets and equity by the amount of the interest paid. This
value. The difference of $4000 is recorded in an account
is the same overall effect as the 1 January interest entry.
called Discount on Bonds Payable, which is a contra-liability
Interest is paid and recorded in the same manner
account. Its balance is subtracted from the Bonds Payable
every 30 June/1 July and 31 December for 10 years until
account to yield the net carrying amount (book value) of
the 1 July 2029, maturity date. Over time, Ma will make
the bonds. As a result, both assets and liabilities increase
20 payments of $3000 for a total of $60 000 of interest
by only $196 000.

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158 ACCT3 Financial
 After issue, the bonds would be reported on the balance KEY FORMULA 9.2 STRAIGHT-LINE METHOD
sheet as follows: OF AMORTISATION

1 July 2020
Discount at Issuance
Discount Amortised =
Bonds payable $200 000 Number of Interest Payments
Less: Discount on bonds payable 4 000
Carrying amount $196 000
With a $4000 discount and five annual interest
Notice that the carrying amount of $196 000 at the time payments, Nguyen must amortise $800 ($4000/5) each
of issue is equal to the cash received at issue. This will payment. As a result, Nguyen’s interest expense for each
always be the case at issue, regardless of the price of the period is $14 800. With this information, Nguyen can make
bond. the following entry to record the first annual interest
payment on 30 June 2021.
Recording interest payments
30 June Interest Expense 14 800
Nguyen’s bonds call for annual interest payments over the 2021
life of the bonds. Each payment is calculated as follows:
Discount on Bonds Payable 800

KEY FORMULA 9.1 INTEREST PAYABLE ON Cash 14 000

BONDS PAYABLE   (To record the payment of interest)
Interest Paid = Face Value × Stated Interest Rate Assets   =   Liabilities +  Equity
× Time Outstanding
–14 000 +800 –14 800
= $200 000 × 0.07 × 12/12 months
= $14 000
The entry affects three accounts. First, Cash is
decreased for the amount paid to the creditor. Second, the
Note that this $14 000 interest payment is calculated Discount on Bonds Payable account is decreased (or
the same way as the bond issued at face value. Whether ‘amortised’) by $800, resulting in a remaining balance of
a bond is issued at face value, at a discount or at a premium, $3200. Third, Interest Expense is increased by $14 800 to
interest paid on a bond is always: record the expense associated with the interest paid and
Face Value × Stated Interest Rate × Time Outstanding the discount amortised. It may be counterintuitive that
liabilities would increase as a result of the preceding interest
However, unlike the face value scenario, interest
entry. However, remember that the contra-liability Discount
expense will be greater than interest paid. Recall that
on Bonds Payable, which was first created for $4000, is
Nguyen received only $196 000 at issue but must repay
now only $3200. Therefore, the carrying amount of the
$200 000 at maturity. That $4000 discount is therefore an
bonds has increased by $800 because of the interest
additional cost to Nguyen that must be amortised over the
payment entry. This is illustrated as follows:
life of the bond. To amortise the discount is to gradually
reduce the discount balance and add the amount Issue 30 June 2021
amortised to interest expense. Therefore, at each interest Bonds payable $200 000 $200 000
payment date, interest expense will be greater than Less: Discount on bonds payable 4 000 3 200
interest paid.
Carrying amount $196 000 $196 800
There are two methods to amortise the discount on
bonds payable: the straight-line method and the effective The carrying amount will continue to increase by $800
interest method. Because the straight-line method is easier with each interest payment date as the discount is
to calculate and is often not substantially different from the amortised. After five interest payments, the discount will
results from the effective interest method, the straight-line be fully amortised (that is, it will have a zero balance) and
method is demonstrated here. However, the effective the carrying amount of the bonds will equal the face value
interest method is also demonstrated in the chapter of $200 000.
appendix. This movement of the carrying amount
amortisation
Under the straight-line method of from issue price to face value is best schedule
straight-line
method of amortisation , an equal amount of the illustrated in the schedule found in Exhibit A schedule that illustrates
amortisation discount is amortised each time interest is the amortisation of a bond
9.3. It is called an amortisation schedule discount or premium over
Method that amortises
an equal amount paid. The amount amortised is calculated as because it provides the details of the the life of a bond.
of the discount or follows: discount amortisation and the resulting
premium each time
interest is paid. expense amounts and carrying amount.

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CHAPTER 9 Liabilities 159
 Interest payment Interest paid Discount Interest expense Unamortised Carrying amount
amortised discount
1 $14 000 $  800 $14 800 $4 000 $196 000
2 14 000 800 14 800 3 200 196 800
3 14 000 800 14 800 2 400 197 600
4 14 000 800 14 800 1 600 198 400
5 14 000 800 14 800 800 199 200
$70 000 $4 000 $74 000 0 200 000

EXHIBIT Amortisation schedule – bonds issued at a discount
9.3

As you review the amortisation schedule, note that it BONDS ISSUED AT A PREMIUM
provides the dollar amounts for each annual interest entry.
To illustrate the accounting for a bond issued at a premium,
The first three columns provide the amounts of cash to be
suppose that on 1 January 2019, Amber Arbitrators issues
paid, discount to be amortised and interest expense to be
bonds with a face value of $50 000, a stated interest rate
recognised each year. Because the straight-line method of
of 8 per cent and a maturity date of 31 December 2021.
amortisation is used, the amounts are the same each year.
Interest is payable annually on 31 December. At the time
Thus, Nguyen would make the same interest entry every
of issue, the market rate of interest is lower than the stated
year until the bonds mature.
rate of 8 per cent, and the bonds sell at a price of $50 600,
Note also that the schedule confirms that the total cost
or a $600 premium. At such a price, the bonds are said to
of borrowing is a combination of the interest paid and the
have sold at 101.2, meaning that they were issued at 101.2
original discount. Total interest expense over the life of the
per cent of face value ($50 000 × 101.2% = $50 600).
bonds is $74 000, which is the sum of interest paid
($70 000) and the original discount ($4000). When bonds Recording the issue
are issued at a discount, total interest expense will always Amber would record the issue as follows:
exceed interest paid by the amount of the discount. An
alternative calculation of the total cost of borrowing is as 1 Jan. Cash 50 600
2019
follows:
Premium on Bonds 600
Interest payments ($200 000 × 7%) $ 14 000 Payable
× Number of payments ×5 Bonds Payable 50 000
= Total interest paid $70 000    (To record bonds issued at a premium)
+ Discount 4 000 Assets   = Liabilities   +  Equity
Total cost of borrowing $74 000 +50 600 +50 000
+600
Recording the maturity
In this entry, Amber increases Cash for the $50 600
In addition to the interest payment (and amortisation of
received from creditors. Amber also increases Bonds
discount), Nguyen must repay $200 000 on 30 June 2025
Payable for the face value of $50 000. The $600 received in
to satisfy its obligation. The entry to repay the bonds
excess of the face value is recorded in an account called
requires a decrease to both Cash and the Bonds Payable
Premium on Bonds Payable. The balance in Premium on
account.
Bonds Payable is added to the Bonds Payable account to
30 Jun. Bonds Payable 200 000 yield the bond’s carrying amount. The calculation of Amber’s
2025 carrying amount after issue is shown as follows:
Cash 200 000
1 Jan. 2019
  (To record repayment of the bonds)
Bonds payable $50 000
  Assets    =  Liabilities   + Equity
Plus: Premium on bonds payable 600
–200 000 –200 000
Carrying amount $50 600
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As a result of this entry, Amber’s assets and liabilities
A

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on Bonds Issued at a Discount increase by $50 600.

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160 ACCT3 Financial
Recording interest payments on Bonds Payable account is amortised or decreased by
$200, leaving a remaining balance of $400. Third, Interest
Amber’s bonds call for annual interest payments over the
Expense is increased by $3800 to record the expense
life of the bonds. Each payment is calculated as follows:
associated with the interest paid and the premium
Interest paid = face value × stated interest rate × time outstanding
amortised. After the entry, the carrying amount of the
= $50 000 × 0.08 × 12/12 months
bonds would be reported as follows:
= $4000
Issue 31 Dec. 2019
As in the discount example, Amber’s interest payment
will differ from its interest expense. Amber received Bonds payable $50 000 $50 000
$50 600 at issue but must repay only $50 000 at maturity. Plus: Premium on bonds payable 600 400
The $600 premium is a reduction in Amber’s cost. Like the Carrying amount $50 600 $50 400
discount example, the premium should be amortised over
the life of the bond. As a result, at each interest payment The bonds’ carrying amount is $200 less after the first
date, interest expense will be less than interest paid. interest payment. The carrying amount will continue to
The following is the amortisation calculation using the decrease by $200 each interest payment date as the
straight-line method. premium is amortised. After three payments, the premium
will be fully amortised and the carrying amount of the
KEY FORMULA 9.3 B
 OND DISCOUNT OR PREMIUM bonds will equal the face value of $50 000. The amortisation
AMORTISED EACH PAYMENT schedule in Exhibit 9.4 illustrates the change in the carrying
(STRAIGHT-LINE METHOD) amount of the bonds over time.
Like the amortisation schedule for bonds issued at a
Premium at Issuance
Premium amortised = discount, the first three columns in the schedule provide
Number of Interest Payments the amounts of cash to be paid, premium to be amortised
and interest expense to be recognised each year. Because
With a $600 premium and three annual interest of the straight-line method of amortisation, the amounts
payments, Amber must amortise $200 ($600/3) each are the same each year. Thus, Amber would make the same
payment. Therefore, interest expense for the year is $3800 interest entry every year until the bonds mature.
($4000 interest paid – $200 premium amortised). This leads The schedule also illustrates that the total cost of
to the following entry to record the first (and subsequent borrowing is comprised of interest paid and the original
two) interest payment on 31 December. premium. Total interest expense over the life of the bonds
is $11 400, which is the amount of interest paid ($12 000)
31 Dec. Interest Expense 3 800 minus the original premium ($600). When bonds are issued
Premium on Bonds Payable 200 at a premium, total interest paid will always exceed interest
Cash 4 000 expense by the amount of the premium. An alternative
calculation of the total cost of borrowing is as follows:
  (To record the payment of interest)
   Assets   =   Liabilities  + Equity Interest payments ($50 000 × 8%) $ 4 000
   –4 000 –200 –3 800 × Number of payments ×3
= Total interest paid 12 000
The entry affects three accounts. First, Cash is – Premium 600
decreased for the $4000 payment. Second, the Premium
Total cost of borrowing $11 400

Interest payment Interest paid Premium Interest expense Unamortised Carrying amount
amortised premium
0 $600 $50 600
1 $  4 000 $200 $  3 800 400 50 400
2 4 000 200 3 800 200 50 200
3 4 000 200 3 800 0 50 000
$12 000 $600 $11 400
EXHIBIT Amortisation schedule — bonds issued at a premium
9.4

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CHAPTER 9 Liabilities 161
 Recording the maturity months after the last interest payment date, the bond would
be amortised for those three months to update the carrying
Amber must repay $50 000 on 31 December 2021 to
amount. Interest payable for the three months would also
satisfy its obligation. The entry to repay the bonds requires
be recorded and would be paid in addition to the call price.
a decrease to both Cash and Bonds Payable:
The second step is to calculate any gain or loss on
31 Dec. Bonds Payable 50 000 retirement by comparing the carrying amount to the call
2021 price. When the carrying amount exceeds the call price,
Cash 50 000 the company is paying less than the value of the liability. In
  (To record repayment of the bonds) that case, the company records a gain on the redemption.
In contrast, when the call price exceeds the carrying
  Assets      =    Liabilities   +   Equity amount, the company is paying more than the value of the
–50 000 –50 000 liability. In that case, the company records a loss on the
redemption. This is summarised as follows:
YT
PPL HIS
A

Check out the animated summary

KEY FORMULA 9.4 G
 AIN OR LOSS
on Bonds Issued at a Premium
ON REDEMPTION

Gain on Redemption = Carrying Amount > Call Price

LO4 REDEEMING A BOND Loss on Redemption = Call Price > Carrying Amount

BEFORE MATURITY
To illustrate, suppose that Wollongong Waterworks
Sometimes a bond is redeemed or retired before maturity. issues a $20 million eight-year bond on 1 January 2020 to
This can occur when the bond has a feature that allows the fund the conversion of a pump station to an arts centre.
borrowing company to ‘call’ or retire the bonds at a certain The bond has a stated interest rate of 5 per cent and is
price. The call price is usually stated as a percentage of face callable at 103 any time after 2024. The bond pays interest
value. For example, a call price of 105 means that the bonds on 31 December each year. The bond sells for $19.2 million,
can be retired by paying the creditor 105 per cent of the or an $800 000 discount. A condensed amortisation
face value of the bonds. schedule is presented in Exhibit 9.5.
Bonds are retired early for various reasons. A company Now suppose that Wollongong decides to retire the
may simply want to reduce future interest expense or take bond a year early on 31 December 2026. The bond’s call
advantage of falling interest rates by replacing existing price of 103 means that Wollongong can retire the bond by
bonds with less costly (lower interest rate) bonds. Whatever paying the bondholder 103 per cent of face value, or $20.6
the reason, the accounting for the early retirement of a million ($20 million × 103%). According to the amortisation
bond consists of the following three steps: schedule, the 31 December 2026 carrying amount of the
1 Update the carrying amount of the bond. bond is $19.9 million (after the interest payment). Therefore,
2 Calculate gain or loss on the retirement. the gain or loss on redemption is calculated as follows
3 Record the retirement. (figures in thousands):

The first step is to update the carrying amount of the Call price $20 600
bond. Often this means that the bond must be amortised Less: Carrying amount on 31 Dec. 2026 19 900
for a partial period. For example, if a bond is retired three Loss on redemption $       700

Interest Interest paid Discount Interest expense Unamortised discount Carrying amount
payment amortised
$800 $19 200
31/12/20 $2 000 $100 $2 100 700   19 300
…
…

31/12/25 2 000  100 2 100 200   19 800

31/12/26 2 000  100 2 100 100   19 900
31/12/27 2 000  1000 2 100 0   20 000

EXHIBIT Condensed amortisation schedule (in thousands of $): bond issued at a discount
9.5

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162 ACCT3 Financial
 Wollongong would record the redemption with the
commenced an investigation into Quindell’s revenue
following journal entry (figures in thousands):
recognition principles. The investigation resulted in a
31 Dec. Bonds Payable 20 000 restate of the original 2014 profit of £175 million to
2026 an almost £140 million loss.
Some Australian banks have been forced to make
Loss on Redemption 700
major write-downs, after they sold S&G’s debt for
Discount on Bonds 100 around 20 cents in the dollar. The financially troubled
Payable law firm’s over $700 million debt was offloaded
Cash 20 600 to Anchorage and other hedge funds for less than
$150 million.
   (To record redemption of the bond)
Assets   = Liabilities + Equity

Alamy Stock Photo/Mick Sinclair

–20 600 –20 000 –700
+100

This entry first decreases the Bonds Payable account

by its face value of $20 million. Because Wollongong no
longer has the bond, it also decreases the remaining
$100 000 balance in the Discount on Bonds Payable. The
entry then reduces Cash for the amount paid to retire the
bond and records a $700 000 Loss on Redemption to
reflect the loss on retiring the bond. This loss account is
reported on the statement of income as an expense. The
overall effect of the entry is to decrease assets, liabilities
and equity.

LO5 ADDITIONAL LIABILITIES

MAKING IT REAL
The next two sections examine two additional types of
CLASS ACTION AGAINST
CLASS ACTION LAW FIRM liabilities that are common to many organisations: lease
In yet another chapter of the financial difficulties of liabilities and contingent liabilities.
class action law firm Slater and Gordon (S&G), the
group of international hedge funds led by LEASE LIABILITIES
Anchorage Capital Group decided to swap (some)
bonds they hold in S&G for approximately 95 per When companies acquire non-current assets, they have a
cent of the shares in the firm. Current shareholders few ways to pay for them. One option is to pay with cash
were told at the annual general meeting to expect on hand. Another option is to issue bonds or additional
little or nothing for their existing shares. S&G shares equity (shares) to raise the necessary capital. A third option,
reached almost $8 in early 2015 before falling to just
which is the focus of this section of the text, is to use lease
a few cents (before the 1/100 share split in
December 2017). financing.
The story began back in 2007 when S&G were the A lease is a contractual agreement lease
first law firm in the world to ‘go public’ (formed into a in which the lessee obtains the right to A contractual agreement
public company) and were listed on the Australian use an asset by making periodic in which the lessee
Securities Exchange. obtains the right to use
payments to the lessor. One of the an asset by making
With international expansion on the agenda, S&G
began acquiring law firms in Britain in 2012 and in major advantages of lease financing is periodic payments to the
lessor.
early 2015 issued bonds and shares to fund its largest its flexibility. Terms of usage, time limits
purchase, the professional services business of the and payments are a few of the many aspects of lease
insurance claims company Quindell for £637 million contracts that can vary. As a result, one lease can look
(at the time over $1.2 billion Australian). Soon after very different from another. However, according to the
the acquisition UK corporate regulator the FCA
accounting standard AASB 16 Leases, although there

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CHAPTER 9 Liabilities 163
 are two main types of lease: operating leases and CONTINGENT LIABILITIES
finance leases, the Standard introduces a single lessee
A contingent liability is an obligation that contingent liability
accounting model and requires a lessee to recognise
arises from an existing condition but the An obligation that
assets and liabilities for all leases with a term of more
outcome is uncertain and the resolution arises from an existing
than 12 months, unless the underlying asset is of low condition whose outcome
depends on a possible future event as is uncertain and whose
value. A lessee is required to recognise the right to use
evidenced in Exhibit 9.6. A good example resolution depends on a
the underlying leased asset and a lease liability future event.
of a contingent liability is legal action against
representing the obligations to make lease payments.2
a business (e.g. a media company being sued for defamation),
Operating leases were popular with companies
which is an uncertain condition, whose resolution depends
because they were a form of off-
off-balance-sheet on future events (e.g. a jury verdict).
balance-sheet financing, which occurs
financing The Accounting Standard, AASB 137 Provisions,
Occurs when a company’s when a company’s future obligations
Contingent Liabilities and Contingent Assets; ensures:
future obligations regarding an asset are not reported as a
regarding an asset are that appropriate recognition criteria and measurement
not reported as a liability liability on the balance sheet. A common
bases are applied to provisions, contingent liabilities
on the balance sheet. example was a non-cancellable operating
and contingent assets and that sufficient information
lease. Although such lease obligations is disclosed in the notes to enable users to understand
were not reported on the balance sheet, the old Accounting their nature, timing and amount.2
Standard (AASB 117), did requires future lease commitments Additionally:
to be disclosed in the notes to the financial statements. ‘contingent’ is used for liabilities and assets that
CSL in Note 13 reports Operating Lease commitments in are not recognised because their existence will be
2017 of $668.1 million, but only $25.4 million in Finance confirmed only by the occurrence or non-occurrence
Lease commitments. of one or more uncertain future events not wholly
within the control of the entity. In addition, the term
In contrast to operating leases, a
‘contingent liability’ is used for liabilities that do not
finance lease finance lease is a contract in which meet the recognition criteria.
A contract in which the the lessee obtains enough rights to The Standard distinguishes between:
lessee obtains enough
rights to use and control an use and control an asset such that the (a) provisions – which are recognised as liabilities
asset such that the lessee (assuming that a reliable estimate can be made)
lessee is in substance the owner of
is in substance the owner of because they are present obligations and it is
the asset. the asset – they obtain the risks and probable that an outflow of resources embodying
rewards of ownership. Because of this economic benefits will be required to settle the
effective ownership, accounting rules require that the obligations; and
(b) contingent liabilities – which are not recognised as
leased asset and the lease obligation (liabilities) be
liabilities because they are either:
recorded by the lessee and reported on the balance sheet. (i)  possible obligations, as it has yet to be
The asset is depreciated and the lease payments include confirmed whether the entity has a present
interest expense and the repayment of the loan. This is obligation that could lead to an outflow of
why such contracts are called finance leases – because resources embodying economic benefits; or
(ii)  present obligations that do not meet the
the asset has been financed by way of a lease rather than recognition criteria in this Standard (because
by reducing cash, other borrowings or issuing shares. The either it is not probable that an outflow of
actual entries associated with a finance lease and the resources embodying economic benefits
criteria for determining whether a contract is a finance will be required to settle the obligation, or a
sufficiently reliable estimate of the amount of
lease will be left to more advanced accounting courses. the obligation cannot be made).3

Circumstances Treatment
Report as a provision in statement
Probable and can be estimated
of financial position

Potentially a liability Possible or cannot be estimated Disclose on the notes

Remote Ignore

EXHIBIT Potential liability

9.6

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164 ACCT3 Financial
 Provisions are recognised as a liability, although there is
no certainty as to when they will be paid or the amount. They LO6  VALUATING A COMPANY’S
E
should be recorded and reported on the balance sheet MANAGEMENT OF
because they are present obligations that can reasonably be LIABILITIES
estimated and it is probable an outflow of resources will be
required to settle the obligation. A warranty meets these As a company operates its business, it will generate
two conditions. Most retailers and manufacturers will have liabilities. The generation of liabilities is usually the easy part
defective products that customers return, and most can of a business, it is the repayment of those liabilities that
reasonably estimate their future warranty claims by takes substantial work and can create significant problems.
reviewing historical claims. As a result, most companies The following sections examine the liabilities of a
include warranty obligations among their liabilities. These business we will call Aussie Beach Christmas (ABC) to see
kinds of liabilities are often referred to as estimated liabilities. how well it can meet its obligations. The examination will
In Note 16 CSL reports that employee benefits of $135.9 require information from the company’s balance sheet. The
million in 2017 is the major provision. required information is found in Exhibit 9.7, excerpted from
While probable liabilities are recorded as provisions ABC’s 2019 Annual Report.
under current or non-current liabilities in the balance sheet,
those that have only a remote probability of occurring can Source Accounts 2019 2018
be ignored. In between probable and remote is an area (figures in (figures in
thousands) thousands)
called possible. Possible liabilities are disclosed in the notes
as contingent liabilities. Contingent liabilities also include Current Assets $1 808 $1 683
probable liabilities that cannot be measured with sufficient Balance Total Assets 2 964 2 806
reliability. Contingent liabilities are not recorded and sheet Current Liabilities 1 365 1 226
reported in the balance sheet because their existence will Total Liabilities 1 889 1 782
be confirmed only by the occurrence or non-occurrence of Account balances from Aussie Beach Christmas’
EXHIBIT
one or more uncertain future events not wholly within the 9.7 2019 Annual Report
control of the entity.
Obviously objectivity or professional judgement is
needed to separate what is probable, possible and remote HORIZONTAL AND VERTICAL ANALYSES
and to determine if a reliable estimate can be made. An easy and useful place to start an examination of liabilities
This objectivity could allow management to move the is with horizontal and vertical analyses. Recall from Chapter
boundaries between these categories which would result 2 that horizontal analysis calculates the dollar change in an
in more or less liabilities being reported on the balance account balance, defined as the current-year balance minus
sheet. Disclosing something in the notes brings it to the the prior-year balance, and divides that change by the prior-
attention of investors, but it does not result in a change to year balance to yield the percentage change. Vertical
a company’s liabilities. analysis divides each account balance by a base account,
yielding a percentage. The base account is total assets for
balance sheet accounts and net sales or total revenues for
ANALYSIS
income statement accounts. These calculations are
Look at CSL’s contingent liability
note in Appendix B (Note 13). How summarised as follows:
much does the company potentially owe?
Analysis: KEY FORMULA 9.5 HORIZONTAL ANALYSIS
In its note, CSL does not report any dollar amount but
Dollar Change in Current Year Balance –
states under the heading ‘Litigation’: = Prior Year Balance
Account Balance
The group is involved in litigation in the ordinary course
of business. During the period ended 30 June 2017 the Percentage Change in = Dollar Change
Group became aware of two separate patent Account Balance Prior Year Balance
infringement actions brought by competitors. CSL is
highly confident in our intellectual property positions
which are the product of more than a decade of
innovative research by the Group. The company is
KEY FORMULA 9.6 VERTICAL ANALYSIS
vigorously defending against the claims.4

Balance sheet Income Statement

YT
PPL HIS Account Balance or Account Balance
Percentage =
A

Review this content Total Assets Net Sales or Revenue

with the e-lecture

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CHAPTER 9 Liabilities 165
 Given ABC’s financial information in Exhibit 9.7, 2018 ratio was almost exactly the same ($1683 / $1226 =
horizontal and vertical analyses of liabilities result in the 1.37). When interpreting the current ratio, it is a good idea
following: to gauge whether a company can turn its current assets
into cash. For example, a company that cannot sell its
Horizontal analysis
inventory cannot generate cash to pay its obligations. This
Change Percentage Change could be a risk for ABC. Over $1.6 million (figure not
Total liabilities 1 889 – 1 782 = 107 107 / 1 782 = 6.0% previously given) of its $1.8 million of current assets is
Vertical analysis inventory. One way to gauge the impact of inventory is to
2019 2018 calculate the inventory turnover ratio.
Total liabilities 1 889 / 2 964 = 63.7% 1 782 / 2 806 = 63.5% Recall from Chapter 7 that the inventory turnover ratio
is calculated as follows: Cost of Goods Sold / Average
The calculations show a fairly stable position with Inventory. ABC’s inventory turnover ratio is 1.7, meaning
regard to liabilities. Horizontal analysis shows a 6.0 per cent that the company sells its average level of inventory 1.7
increase in liabilities. However, vertical analysis shows that times during the year. If this is similar to industry standards,
total liabilities as a percentage of total assets was virtually then it would appear that ABC should not have a problem
unchanged over the two years. In both years, almost two- turning its inventory into cash and paying off its current
thirds of every dollar of assets was generated through liabilities.
debt. So, although liabilities are increasing, they are doing
so at the same rate as assets. DEBT TO ASSETS RATIO
Solvency refers to a company’s ability to
CURRENT RATIO continue in business in the long term by
solvency
A company’s ability to
Liquidity refers to a company’s ability to satisfying its total liabilities or obligations. continue in business in the
liquidity long term by satisfying its
A company’s ability to paypay off its current liabilities or obligations While predicting whether a company will liabilities.
its current liabilities in
the near future.
in the near future. Many parties are survive in the long term is very difficult, debt to assets ratio
interested in a company’s liquidity. For we can get an idea of a company’s Compares a company’s
current ratio total liabilities to its total
Compares a company’s example, a loan officer would be prospects by calculating the debt to assets and measures its
current assets to its ability to pay its liabilities
current liabilities and
interested in whether a company could assets ratio, which compares a
in the long term.
measures its ability to pay monthly interest. A supplier would company’s total liabilities to its total
pay current liabilities. want to know if it could expect prompt assets. It is calculated as follows:
payment. Employees are concerned with
their employer’s ability to satisfy payroll. One way to KEY FORMULA 9.8 DEBT TO ASSETS RATIO
measure a company’s liquidity is to calculate the current
ratio. Total Liabilities
Debt to Assets Ratio  =
The current ratio compares a company’s current Total Assets
assets to its current liabilities as follows:
This ratio takes all the obligations a company reports
KEY FORMULA 9.7 CURRENT RATIO
and divides by all of the assets the company reports,
yielding the percentage of assets that are provided by debt.
Current Assets Thus, the ratio is a good indicator of a
capital structure
Current Ratio = company’s capital structure – the mix The mix of debt and equity
Current Liabilities
of debt and equity that a company uses to that a company uses to
generate its assets.
generate its assets. Since debt must be
By comparing what a company expects to turn into
repaid, a company that uses more debt has a riskier capital
cash within a year to what it expects to pay within the year,
structure and therefore a greater risk of being unable to
this ratio suggests how well a company can pay its short-
meet its obligations.
term liabilities. A higher current ratio indicates a greater
ABC’s 2019 debt to assets ratio is calculated as follows:
ability to satisfy current liabilities.
$1889 = 0.637
ABC’s 2019 current ratio is calculated as follows: $2964
$1808 = 1.32 The 0.637 ratio shows that in 2019, 63.7 per cent of
$1365
ABC’s assets were generated through debt. Whether a
The 1.32 ratio shows that in 2019, ABC had $1.32 in ratio of 0.637, 0.437 or 0.837 is good or bad for a company
current assets for every dollar of current liabilities. That is, depends on many factors. Some companies willingly
ABC had more than enough current assets to satisfy its expose themselves to liabilities and the risk that comes
obligations coming due in the following year. The company’s with them in order to provide a greater chance of significant

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166 ACCT3 Financial
profits. Others purposely reduce their risk by limiting the
use of debt. Neither strategy is right or wrong – they are 3  Debt to assets ratio
just different. This issue will be discussed in more detail in
$4340.8 / $9122.7 = 64.9%
Chapter 12. At this point, you should simply recognise that
ABC appears to have more risk of insolvency than a You will note the 64.9 per cent debt to assets ratio is the
same as the vertical analysis above. This could be
competitor who has a 0.437 ratio and less risk than one
expressed as a debt to equity ratio of 1.9 to 1. Is this a
with 0.837! reasonable capital structure or (as investment guru Ben
As you consider the debt to assets ratios, you may Graham used to say) should the company own more than
recognise the numbers from earlier in the chapter. They are it owes? So, this may be regarded as medium risk, but
the same as those generated in the vertical analysis of total should CSL be using more of other people’s money?
Obviously the directors think so or they would issue more
liabilities. In fact, the debt to assets ratio is equivalent to a
shares or buy back fewer shares (covered in Chapter 11)
vertical analysis of total liabilities. Both the debt to assets and borrow less or repay more. Share price increases over
ratio and vertical analysis divide total liabilities by total the period show shareholders appear happy with the
assets and are interpreted the same. So, when you conduct share price going from $27 in 2011 to $140 in 2017.
a vertical analysis, you already have the debt to assets ratio.

ANALYSIS LO7  PPENDIX: DETERMINING A

A
Using CSL’s information in
Appendix B, calculate and
BOND’S ISSUE PRICE
interpret: (1) horizontal and vertical analyses of liabilities,
(2) the current ratio, and (3) the debt to assets ratio. Calculating the issue price of a bond requires the conversion
Analysis: of a bond’s future cash flows into today’s dollars. A
conventional interest-paying bond has two types of future
1  Horizontal analysis
cash flows: the one-time principal payment made at
Current Liabilities ($1618.1 – 1374.4) / $1374.4 = 17.4% maturity and the periodic interest payments made each
year. The bond’s issue price will always be the present
Non-current Liabilities (4340.8 – 3621.1) / 3621.1 = 19.9%
value of those future cash flows discounted back at the
Total Liabilities (5958.9 – 4995.5) / 4995.5 = 19.3% current market rate of interest.
To illustrate, suppose that the market rate of interest is
  Vertical analysis 8 per cent when the Bergomi Company issues a $100 000
four-year bond that pays interest annually at a rate of
Total Liabilities $5958.9 / $9122.7 = 64.9%
10 per cent. The future cash flows of this bond are
The 19.3 per cent horizontal analysis reflects an increasing represented graphically in Exhibit 9.8.
amount of obligations, slightly more in non-current The $100 000 principal payment is a single payment
liabilities. The 64.9 per cent vertical analysis of total
made at the end of year four. Therefore, it is discounted
liabilities shows that almost two-thirds of the company’s
assets are financed through debt, with just over 35 per back four periods at an 8 per cent rate using the appropriate
cent through equity. factor found in Appendix A, Exhibit A.4 on page 260: present
value of $1. The factor for four periods (n = 4) and a rate of
2  Current ratio
8 per cent (r = 8%) is 0.7350. Therefore, the present value
$4602.1 / $1618.1 = 2.8 of the $100 000 payment in four years is $73 500 ($100 000
The 2.8 current ratio indicates that CSL has almost $3 in × 0.7350).
current assets for every $1 of current liabilities. It may The $10 000 interest payments are made at the end of
appear that the company could very easily pay off its each of the next four years. Therefore, they constitute an
current liabilities with its current assets, but this is a annuity that is discounted back four periods at an 8 per cent
function of CSL selling on credit and holding large rate using the appropriate factor found in Appendix A:
amounts of inventory. Since most of CSL’s current assets
are tied up in inventory, it will be important for the
present value of an ordinary annuity. An annuity is a stream
company to continue to sell its inventory and one of the of the same dollar amount at set intervals for a number of
risks noted in the annual report is that inventories periods. The factor for four periods (n = 4) and a rate of 8
generally have expiry dates. per cent (r = 8%) is 3.3121. Therefore, the present value of
the four $10 000 annual payments is $33 121 ($10 000 ×
3.3121).

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CHAPTER 9 Liabilities 167
 Present value End of End of End of End of
at issuance year 1 year 2 year 3 year 4
$100 000 Principal payment

$10 000 $10 000 $10 000 $10 000 Interest payments

EXHIBIT Bergomi Company future cash flows

9.8

Premium case Par value case Discount case

8% market rate 10% market rate 12% market rate
Present value of a single payment of $100 000 $   73 500 $   68 300 $63 550
Present value of an annuity of $10 000 33 121 31 700 30 373
Issuance price $106 621 $100 000 $93 923

EXHIBIT Calculations of bond issue prices
9.9

Adding these two present values together yields percentage of the bond’s carrying amount. Under this
$106 621; so, the bond sells for a premium. This calculation, method, interest expense is calculated by multiplying the
along with similar calculations for 10 per cent and 12 per bond’s carrying amount by the market rate of interest at
cent market rates are shown in Exhibit 9.9. issue by the time outstanding.
Note that the prices calculated confirm that bonds are
issued for a premium when the stated interest rate exceeds KEY FORMULA 9.9 INTEREST EXPENSE (EFFECTIVE
the market rate, face value when the two rates are equal, INTEREST METHOD)
PLY THIS and a discount when the
P Interest Expense  =  Carrying Amount × Market Rate
A

Download the Enrichment market interest rate exceeds of Interest at Issue × Time Outstanding
Modules for further practice
the stated rate.
Once interest expense is known, the amount of
discount or premium amortised is the difference between
LO8  PPENDIX: EFFECTIVE
A interest expense and interest paid.
INTEREST METHOD OF KEY FORMULA 9.10 D
 ISCOUNT OR PREMIUM
AMORTISATION AMORTISED EACH PAYMENT
(EFFECTIVE INTEREST METHOD)
When a bond is issued at a discount or premium, the
Discount Amount Amortised = Interest
discount or premium must be amortised over the life of the Expense – Interest Paid
bond. The following sections demonstrate
Premium Amount Amortised = Interest Paid – Interest
effective interest the effective interest method of Expense
method of
amortisation amortisation.
Method that amortises the The effective interest method of
bond discount or premium To illustrate, we use examples with the fictional
so that interest expense amortisation amortises the bond organisation Bergomi, starting first with the discount
each period is a constant discount or premium so that interest
percentage of the bond’s example.
carrying amount. expense each period is a constant

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168 ACCT3 Financial
DISCOUNT EXAMPLE Because the Discount on Bonds Payable account is
reduced by this entry, the carrying amount of the bonds
For the Bergomi bonds, the market rate of interest was 12
will increase. As a result, the amount of interest expense
per cent and the $100 000 bond was issued for $93 923,
for the second interest payment will increase as well. In
resulting in a discount of $6077. The issue would be
fact, interest expense will continue to increase each
recorded with the entry below:
period as the bond’s carrying amount increases toward
1 Jan. Cash 93 923 the face value of $100 000. To illustrate this fact, a full
amortisation schedule for this bond is shown in Exhibit
Discount on Bonds Payable 6 077
9.10 (with the numbers rounded for presentation
Bonds Payable 100 000 purposes).
  (To record bonds issued at a discount) Note that, like the straight-line method of amortisation,
Assets    =  Liabilities   +   Equity the effective method amortises the bond discount to zero,
resulting in an ending carrying amount equal to the face
+93 923 +100 000
value. But, unlike the straight-line method, interest expense
–6 077
and the amount amortised under the effective interest
method are different each period. Again, this is because
At the end of the first year, interest expense, interest
the effective interest method makes sure that interest
paid and the amount of the discount amortised would be
expense is a constant percentage (12%) of the current
calculated as follows. Note that ‘time outstanding’ is
carrying amount.
omitted from the calculations because interest is paid
annually:
PREMIUM EXAMPLE
Interest Carrying $93 923 × $11 271
expense Amount × 12%
The market rate of interest was 8 per cent and the $100 000
Market Rate bond was issued for $106 621, resulting in a premium of
Interest paid Face Value × $100 000 × $10 000 $6621. The issue would be recorded with the following
Stated Rate 10% entry:
Discount Interest $11 271 – $  1 271
amortised Expense – $10 000 1 Jan. Cash 106 621
Interest Paid
Premium on Bonds Payable 6 621
With these values, Bergomi would record the following Bonds Payable 100 000
entry on the first interest payment date:
  (To record bonds issued at a premium)
Payment 1 Interest Expense 11 271
Assets     =  Liabilities  +  Equity
Discount on Bonds Payable 1 271
+106 621 +100 000
Cash 10 000
  (To record the payment of interest) +6 621

Assets   =  Liabilities + Equity

–10 000 +1 271 –11 271

Interest Interest Discount Interest expense Unamortised Carrying amount

payment paid amortised discount

$6 077 $ 93 923
1 $10 000 $1 271 $11 271 4 806 95 194
2   10 000   1 423   11 423 3 383 96 617
3   10 000   1 594   11 594 1 789 98 211
4 10 000 1 789 11 789 0 100 000

$40 000 $6 077 $46 077

EXHIBIT Amortisation schedule of bond discount using effective interest method
9.10

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CHAPTER 9 Liabilities 169
 At the end of the first year, interest expense, interest Because the carrying amount of the bonds decreases
paid and the amount of the discount amortised would be as a result of this entry, the amount of interest expense for
calculated as follows: the second interest payment will also decrease. Interest
expense will continue to decrease each period as the
Interest paid Face Value × $100 000 × $10 000
Stated Rate 10% bond’s carrying amount decreases towards the face value
of $100 000. To illustrate, a full amortisation schedule for
Interest Carrying Amount $106 621 × $  8 530
expense × Market Rate 8% this bond is shown in Exhibit 9.11 (with the numbers
Premium Interest Paid – $10 000 – $  1 470 rounded for presentation purposes).
amortised Interest Expense $8 530 Note that like the straight-line method of amortisation,
the effective method amortises the bond premium to zero,
With these values, Bergomi would record the following resulting in an ending carrying amount equal to the face
entry on the first interest payment date: value. But, unlike the straight-line method, interest
expense and the amount amortised are different each
Payment 1 Interest Expense 8 530 period under the effective method. Again, this is because
the effective interest method makes sure that interest
Premium on Bonds Payable 1 470
expense is a constant percentage (8%) of the current
Cash 10 000 carrying amount.
YT
PPL HIS
   (To record the first bond payment)

A
Test your understanding with the
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Assets   =    Liabilities   +   Equity

–10 000 –1 470 –8 530

Interest Interest Discount Interest Unamortised Carrying

payment paid amortised expense discount amount
$6 621 $106 621
1 $10 000 $1 470 $ 8 530   5 151   105 151
2   10 000   1 588 8 412   3 563   103 563
3   10 000   1 715 8 285   1 848   101 848
4 10 000 1 848   8 152 0   100 000
$40 000 $6 621 $33 379

EXHIBIT Amortisation schedule of bond premium using effective interest method
9.11

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170 ACCT3 Financial
 LO1, 2
5 Recording and reporting notes payable
On 1 July 2019, Williams Company borrows $100 000 from
the bank by signing a $100 000, 8 per cent, two-year note
EXERCISES payable. Annual interest is paid on 30 June. Williams has a
31 December financial year-end.
REQUIRED
a Prepare the journal entries to record the issue of the
note on 1 July 2019.
1 Current liabilities LO1 b Prepare the journal entry for the accrued interest at
31 December 2019.
Siu Software Store has total receipts for the day of $7326.
c Prepare the journal entry for payment of interest on
This total includes 10 per cent GST on all sales.
30 June 2020, assuming a reversing entry was not made
REQUIRED on 1 January 2020.
Calculate GST payable and prepare the journal entry to d How would Williams report the note payable on its
record the sales. (Hint: although you add 10 per cent to the 31 December 2019 and 2020 balance sheets?
price to calculate the GST payable, for prices that include
GST you divide the total price by 11.) 6 Recording bonds and interest LO2, 3

LO1 Gazal Galleries issued $500 000 of 10-year bonds on 1

2 Current liabilities January 2019. The bonds pay 8 per cent interest semi-
The following list represents liabilities on the 30 June annually on 1 July and 1 January. The market rate of interest
balance sheet of Martin Motors: on the date of issue was 8 per cent.
i money owed to employees for work performed in
REQUIRED
the last two weeks in June
a Prepare all journal entries necessary in 2019 assuming a
ii money owed to a supplier for goods purchased
30 June end of financial year.
based on the terms net 30
b How would the issue price change if the market rate
iii money owed to the government, based on the
was lower than 8 per cent? Higher than 8 per cent?
annual income of the business
iv money owed to the bank on a note due in July c What will be recorded in 2019 in the financing section of
the statement of cash flows?
v money owed to the ATO for GST collected.
REQUIRED 7 Recording bonds at a premium LO3

Identify the liability account that would likely be used to and a discount
report each item.
On 1 January 2020, Tran Ltd issues $3 million, five-year,
10 per cent bonds with interest payable on 1 July and 1
LO1
3 Current liabilities January. Tran prepares financials on 31 December and
On 1 March Powani Power People borrows $900 000 on a amortises any discount or premium using the straight-line
six-month, 6 per cent note from Darwin Bank. Assume method.
interest is paid at the maturity of the note. REQUIRED
REQUIRED Prepare the journal entries on 1 January, 1 July and 31 December
a Prepare the journal entry to record the receipt of cash 2020 assuming the bonds were issued at (a) 96 and (b) 103.
from the note.
LO3
b Prepare the journal entry to record the accrual of interest 8 Bond amortisation
if Powani prepares financial statements on 30 June. On 1 July 2019, XYZ Company issues $4 million, five-year,
c Prepare the journal entry to record the repayment of the 8 per cent bonds with interest payable on 30 June and 31
note at maturity. December. Thompson amortises any discount or premium
using the straight-line method.
LO1
4 Current liabilities REQUIRED
The employees of Pinehurst Company earned wages of Prepare a bond amortisation schedule assuming the bonds
$80 000 during the month of June. The following were were issued at (a) 101 and (b) 97. Why is it necessary (or at
withholdings related to these salaries: $5000 for health least desirable) to amortise the discount or premium rather
insurance, $3000 for voluntary superannuation contributions than simply account for it at the beginning or end of the
by the employees and $9000 for income tax. bond?
REQUIRED
a Prepare the journal entry to record the payment of these
salaries assuming they are paid on 30 June.
b Prepare the journal entry to record Pinehurst Company’s
additional payroll tax expense for June of $9800.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 9 Liabilities 171
 LO4 LO6
9 Bond redemption 12 Evaluate liabilities
After making a semi-annual interest payment, the carrying The following financial data were reported by Wang Wireless
amount of ABC Company’s bonds was as follows: for two recent years ($ in thousands):

Bonds payable $1 500 000 Wang Wireless

Balance sheet (partial)
Less: Discount on bonds payable 80 000
Current Prior
Carrying amount $1 420 000
Current assets $2 290 $  669
REQUIRED
Current liabilities 2 257 2 172
a Calculate the gain or loss on redemption, assuming ABC
redeems the bonds at 101. Total liabilities 9 801 9 854
b Prepare the journal entry to record the redemption. Total assets 5 131 6 200
c Can a company redeem the bonds it issues at any time?
Explain. REQUIRED
d Why might a company want to redeem its bonds before Conduct horizontal and vertical analyses of Wang’s
maturity? accounts and calculate the current and debt to assets ratios
for each year. How would the most recent ratios change if
LO5 Wang decided to pay off $1 million of current liabilities with
10 Leases cash?
Yang needs a new piece of equipment for her factory.
Instead of purchasing the asset, the business chooses to 13 Appendix: calculate bond issue price LO7
enter into a twelve-month operating lease with monthly
payments of $5000. The market rate of interest was 7 per cent when Greene
Corporation issued a $100 000 five-year bond that pays
REQUIRED interest annually at a rate of 10 per cent. Present value of
a Prepare the journal entry to record the first lease the principal is $71 300. The present value of the interest
payment. payments is $37 908.
b What are the financial reporting advantages of an REQUIRED
operating lease over a finance lease?
Calculate the amount of premium or discount at the time of issue.
c Why might Yang have chosen to lease the equipment
instead of buying it? LO7, 8
14 Appendix: bond interest and
LO5
amortisation
11 Contingent liabilities
On 1 July 2019, Tallakson Company issues a $50 000, five-
Tanner Toys had sales of $2 500 000 during the 2019–20 year, 8 per cent bond with interest payable annually on
financial year. In 2018–19, 5 per cent of sales were returned 30 June. The market interest rate at issue is 10 per cent.
for a refund because of defects, but Tanner believes that Tallakson uses the effective interest method of
recent product changes will reduce sales returns (warranty) amortisation.
expense to about 3 per cent of 2019–20 sales.
REQUIRED
REQUIRED
a Determine the issue price of the bond by using the
a What amount is Tanner expecting to refund customers appropriate table(s) in Appendix A.
for purchases made in 2019–20?
b Prepare the entry for the first interest payment on
b Should this amount be reported as a liability on the 30 June 2020.
financial statements? Why or why not?
c Prepare an amortisation schedule for the bond.
c Is Tanner using a reasonable means to estimate warranty
expense?
d If Tanner was being sued because one of its toys are
alleged to have injured several children, what would be
the financial reporting implications?

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
172 ACCT3 Financial
 REQUIRED
a Prepare the journal entry to record the payment of bond
interest on 1 July 2021.
b Prepare the journal entry to amortise the bond discount
PROBLEMS and pay the interest on 1 January 2022.
c Prepare the journal entry to record the redemption of the
bonds on 1 January 2022, after the interest has been
paid.
d Prepare the adjusting journal entry for 30 June 2022,
LO1 assuming that the bonds were not redeemed.
15 Recording and reporting current
liabilities
LO3, 4
The following is a list of liability accounts on the ledger of 17 Bond issue, interest, redemption
Chew House on 1 January: and reporting
Gateway Unlimited sold $2 million of six-year, 10 per cent
GST Payable $  7 500 bonds on 1 January 2019. The bonds pay interest semi-
Accounts Payable 9 500 annually on 1 July and 1 January. The bonds sold at 97. The
straight-line method is used to amortise any bond premium
Unearned Service Revenue 16 500
or discount.
The following transactions occurred during the month of REQUIRED
January: a Prepare all journal entries related to the bonds for 2019
  1 January Borrowed $25 000 from Perth Bank on a six- and 2020 and show how the bonds would be reported
month, 6 per cent note. on the 31 December balance sheet.
 9 Provided service for customers who had paid b How would the 2019 statement of cash flows be
$6 000 in advance (including GST). affected by the bonds?
 15  Paid ATO for GST collected in December, c Prepare a bond amortisation schedule.
$7500.
d On 1 July 2023, after the interest payment, Gateway
 18 Bought inventory on credit for $12 000 plus redeems the bonds for 101. Prepare the entry to record
GST. the redemption.
 23 Sold goods on credit for $3000, plus 10 per e How would the 2023 statement of cash flows be
cent GST. affected by the redemption?
The employees of Chew House earned gross salaries of
$45 000 during January. Withholdings were $4000 for LO6
18 Analysing liabilities
income tax and $1900 for voluntary superannuation
contributions. In addition state payroll tax was $2500. Explorer Limited’s board of directors is having its annual
Salaries earned in January will be paid during February. meeting to analyse the performance of the firm. One area
the board is focusing on is total liabilities. The following are
REQUIRED selected items of the 30 June 2020 balance sheet:
a Prepare journal entries for the January transactions.
b Prepare adjusting entries at 31 January for the salaries 30 June 2020 30 June 2019
expense, payroll tax expense and notes payable. Total assets $935 870 $902 225
c Create the current liability section of the balance sheet Total liabilities 575 430 562 855
at 31 January.
Total equity 360 440 339 370
LO2, 3, 4
16 Bond presentation, interest and REQUIRED
redemption
Conduct horizontal and vertical analyses of total liabilities
The following is an excerpt taken from the 30 June 2021 and interpret the results. Explain whether or not Explorer
balance sheet of the Wimbledon Company: should be pleased with its financial position based on these
calculations.
Current liabilities
Bond interest payable $  64 000 19 Appendix: comparing amortisation methods
Non-current liabilities On 1 January 2019, LED issues bonds with a face value of
Bonds payable 1 600 000 $300 000. These bonds have a stated interest rate of 4 per
Less: Discount on bonds payable (30 000) cent and interest is paid annually on 31 December. The
  Carrying amount 1 570 000 bonds mature in four years. The market interest rate at the
date the bonds are issued is 5 per cent.
The bonds have a stated interest rate of 8 per cent and
mature on 1 July 2026. Interest is paid semi-annually on 1
July and 1 January. The bonds are callable at 105 on any
semi-annual interest date.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 9 Liabilities 173
 REQUIRED LO5
21 Written communication
a Determine the amount of discount on the bonds at
issue. Lara Lawn and Leisure manufactures and sells all types of
yard equipment. The company was recently sued by a
b How much of the discount will be amortised in the first
plaintiff who claimed that a defective lawnmower caused a
year under (i) the straight-line method and (ii) the
serious injury. The company was made aware of this at the
effective interest method?
end of its fiscal year, but it is not sure how to report it in its
c Does interest expense each year differ under the financial statements.
straight-line and effective interest methods of
amortisation? REQUIRED
d Does total interest expense over the life of the bonds Write a brief memo explaining the possible treatments of
differ under the straight-line and effective interest this lawsuit for financial reporting purposes. Also, provide
methods of amortisation? some ideas on how to estimate the potential liability if the
company believes that liability is probable.

LO1
22 SMS Communication
In 144 characters or less explain the difference, if any,
between debt and liabilities.
CASES
LO1, 2, 6
23 Ethics in accounting
You are the accountant for a medium-size manufacturer. Your
company has some existing debt that requires the company
to maintain a current ratio of 1.50 or higher. If the ratio drops
below that value, the lender can increase the interest rate
LO1, 2, 5, 6
20 Research and analysis from 6 to 9 per cent. Recently, the company’s current ratio
Access the latest annual report for a company of your has been hovering around 1.50, and the CEO believes that
lecturer’s choosing or the latest CSL annual report. when some long-term debt maturing in the following year is
reported as current, the ratio will fall below 1.50. The CEO
REQUIRED
asks you to keep the long-term debt as a non-current liability
a Examine the company’s balance sheet and conduct instead of reclassifying it as a current liability. ‘After all’, he
horizontal and vertical analyses of all liability account says, ‘it is still reported as a liability’.
balances, including total liabilities.
REQUIRED
b Examine the financing activities section of the
company’s cash flow statement. Over the past two a Is there an ethical issue with the CEO’s request? How
years, did the company borrow or repay debt more? should you respond?
c Calculate the company’s current ratio and debt to assets b Research ‘Centro liabilities’ or ‘ABC Learning liabilities’ or
ratios for the most recent and the previous financial year. ‘Allco Finance Group liabilities’ and discuss if the
classification of liabilities is more than an ethical issue.
d Examine the company’s non-current liability note. What
type of debt was eliminated during the current financial
year? Did the company use cash to retire? Was any of
the remainder retired?
e Based on your answers above, write a paragraph
explaining your opinion of the company’s liability
position. Use your answers as supporting facts.

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174 ACCT3 Financial
 10
This chapter examines the accounting for partnerships.
From an accounting perspective, partnerships are more
complex than sole traders because we need to track the
contributions by each partner, distributions to each partner
and capital remaining of each partner. Because a
partnership ends if a partner leaves and a new partnership
is formed with the remaining partners or with the addition
of a new partner, the accounting is critical in both allocating
benefits to each partner and keeping the records associated
with these benefits. Unlike companies, partnerships are

Partnerships private business arrangements and usually do not have

publicly available financial statements.

LEARNING
OBJECTIVES

After studying the material in this chapter, you

should be able to:
1 Describe the characteristics of the
partnership form of business.
2 Account for a partner commencing a
partnership.
3 Calculate the allocation of profits and losses
to the partners.
4 Record the admission and withdrawal of
partners.
5 Explain the liquidation of a partnership.
6 Prepare the financial statements for a
partnership.

LO1 THE PARTNERSHIP FORM

OF BUSINESS
Express Chapter 2 introduced the three major forms of business:
Throughout this ISTEN UP the sole proprietorship (sole trader), the partnership and
L

chapter apply this the corporation (company). The following sections describe
icons indicate
some of the characteristics of the partnership form of
an opportunity
for online business that distinguish it from sole proprietorships and
self-study through companies. The English Partnership Act 1890 defined a
CourseMate Express, partnership as ‘the relation which subsists between
linking you to revision
quizzes, e-lectures, persons carrying on a business in common with a view of
animations and more. profit’. In the 1890s, most state governments in Australia
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175
 enacted similar legislation. The characteristics of a of personal effort put into the partnership. Not surprisingly,
partnership are as follows: when disputes arise each partner sees their contribution
● ease of formation as being critical to the success of the partnership business
● partnership agreement or the other partners’ decisions as leading to financial
● mutual agency and co-ownership of property failure. The court will be left to decide if a partnership exists,
● unlimited liability of owners (partners) and how business success or failure will be returned to or
● transferability of ownership burdened upon each partner.
● no partnership taxation
● capital account (and sometimes also current accounts) MUTUAL AGENCY AND CO-OWNERSHIP OF
for each partner. PROPERTY
YT
PPL HIS An advantage and disadvantage of a partnership is mutual
A

Check out the video summary

for Chapter 10 agency. Any partner can contract on behalf of the partnership.
The advantage is partnerships do not need to have every
partner sign a contract; the disadvantage is any partner can
EASE OF FORMATION bind the partnership in an agreement which could reasonably
Partnerships require no formal agreement and no registration be believed to be partnership business. So, a partner in an
with a government agency. Partnerships are attractive accounting partnership could buy an office building on behalf
because they combine the financial and human resources of of the partnership – each partner then becomes responsible
two to 20 individuals, often gaining synergistic benefits. for the repayments and each partner becomes a co-owner of
Partnerships often have only two partners; but in some the building. But when buying their own home, a partner does
professional groups, like large accounting firms, several not share the liability and asset ownership with the other
hundred partners are permitted (limit is 1000). You cannot be partners. Assets contributed to a partnership become the joint
forced to join a partnership, nor can you be forced to accept assets of each partner. There can be legal disputes about
a new partner in the partnership. A business partnership is whether both debt and assets are personal or partnership.
somewhat like a marriage, requiring cooperation and mutual Not surprisingly, when debts are large and difficult to repay,
respect to work successfully. You do not need a partnership the claim by individual partners is that the debts are shared,
agreement, but without one the provisions in the relevant and when assets have substantially increased in value, the
partnership Act will determine any disputes. A partnership is claim is that the assets are the individual’s.
not a separate legal or taxable entity. A partnership does not
own assets in its name; they are jointly owned by the partners. UNLIMITED LIABILITY OF OWNERS
Under a sole proprietorship and a partnership, owners are
PARTNERSHIP AGREEMENT personally liable for the actions and obligations of their
Although a partnership does not require a formal agreement, businesses. As a sole trader, accepting personal liability for
it is highly advisable to have one. While a business is your own actions is understood. However, in a partnership,
prospering, partners are friends and partners’ memories of personal liability for the partnership debts is sometimes
the arrangements entered into are similar, there may be no overlooked, especially when it is the result of the actions
disputes. But when partners fall out and are no longer of of one partner and that partner may not have been acting
one mind, memories differ and the sharing of risks and as mutually agreed. Further, if other partners cannot pay
rewards often can no longer be agreed on. In these cases their share of the debt, one partner may end up losing their
the provisions of the relevant partnership Act usually take home and all their other personal assets.
precedence. One of those provisions – equal sharing of Because of unlimited liability in partnerships,
profits and losses – can become contentious. This will often professionals, such as auditors, who may conduct their
be the case where substantially different amounts of business without the benefit of the limited liability afforded
capital have been contributed and vastly different amounts by a company, will usually place their personal assets in a
iStock.com/Wittelsbach Bernd
Alamy Stock Photo/Kevin Foy

iStock.com/Shaun Lowe

Alamy Stock Photo/Kristoffer Tripplaar

The large audit firms in Australia are partnerships and although they have liability limited by a
scheme approved under the professional standards legislation, all other partners are ultimately
personally liable when an auditor is successfully sued
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
176 ACCT3 Financial
trust to protect them from the actions of creditors and accounting for contributions, advances, profit (or loss
other partners. It is not unknown for an auditor in one city sharing) and drawings. The purchase and recording of assets,
to be sued for negligence and the damages to be paid by borrowings and repayments, the earning of revenue and
other partners from the same partnership who conduct incurring of expenses are accounted for in the same way for
business in a different city. Apart from ensuring personal all business entities. For a sole proprietor there is no need
assets are not legally available to pay partnership debts, to keep separate records of who contributed capital,
two other mechanisms are available to protect partners of expertise, clients, etc. because the benefit of all contributions
professional partnerships. First, professional indemnity goes to the single owner. Equally it is not important to have
insurance is available to pay in cases of professional a record of why distributions were made because all
negligence; second, liability capping schemes are now in withdrawals go to the single owner. For companies one main
place in all states in Australia, protecting professionals from account is kept for all shareholders. Detailed records are kept
large damages claims. Limited partnerships only limit the for ownership and dividends to every shareholder, but these
liability of a non-managing (sleeping) partner and are not a are not part of the main accounting system and the only
vehicle for limiting the liability of partners in business. thing that distinguishes one shareholder from another is the
number of shares they hold. For a partnership, detailed
TRANSFERABILITY OF OWNERSHIP accounting records need to be kept for each partner. To
facilitate this, accountants maintain a Capital account for
A major disadvantage of a partnership is the need to have
each partner. Accountants may also have a Current (or
all partners agree on any partner leaving a partnership,
Retained Earnings) account for each partner to deal with the
selling their place in the partnership to a new partner and
day-to-day transactions between a partner and the
the admittance of any new partner to expand the
partnership. Further, a Drawings account may also be used
partnership. In large professional partnerships much
for each partner in the same way drawings were used for a
attention is given to partners leaving. If terms and
sole trader in Chapter 3 (and an Advance account if money
payments are too harsh, it can be difficult to attract new
is borrowed from the partnership by one of the partners).
partners who could feel trapped into working with people
The reason for using several equity accounts for each partner
they may discover do not share their business values.
is to reflect the transactions between the partnership and
Independent valuations of the partners’ share of net
each partner as transparently as possible. Remember,
assets can avoid undesirable situations; for example, a
accounting is an information system.
partner who wishes to leave being forced to accept a
small fraction of what their share is worth, or a partner
Getty Images/Lester Lefkowitz

who the rest of the partnership wants to leave being able

to extract substantially more than their fair share.

NO PARTNERSHIP TAXATION
No taxation sounds wonderful, but this does not mean
partnership income is tax free. While companies pay income
tax and, as we will discover in the next chapter, shareholders
are taxed on dividends received (although they may get the
benefit of franking credits), partnerships are not taxable
entities. Partnership tax returns are prepared as a convenient
way to present the earnings of the partnership and show the
distribution of taxable income to each partner. All partnership
income must be fully distributed to the partners; unlike in a Partnerships – bringing people together
trust, there is not the option to retain income in the partnership.
Each partner then adds partnership income to all their other
taxable income. For taxation purposes, in many circumstances LO2 COMMENCING A
a partner who works in the business may be paid a salary PARTNERSHIP
(wage) and have tax withheld like any other employee; for
accounting purposes, we treat all payments to partners (other One of the distinguishing characteristics of a partnership
than return of capital) as distributions of profits. is multiple owners/managers. Unlike shareholders in a
company who contribute cash and are not involved in
CAPITAL ACCOUNTS FOR EACH PARTNER business operations beyond attending and voting at
Accounting is very similar for sole traders, partnerships and annual general meetings, partners may contribute assets
companies. The major difference for a partnership is in and liabilities and, as discussed above, are entitled to

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 10 Partnerships 177
 participate in the management of the business. In large Let us add complexity by imagining Emma was in
professional partnerships, many of the day-to-day business as a sole proprietor with the balance sheet shown
management functions are delegated to a senior in Exhibit 10.1 (borrowed from the Aerial Filming example
management team. Partnerships are often the result of in Chapter 1).
combining two existing businesses with assets such as
accounts receivable; plant, property and equipment; and Aerial Filming
possibly goodwill, as well as liabilities like accounts Balance sheet
at 28 February
payable and bank loans. The value of these items in the
Cash $1 940
books of the sole traders before the partnership is
Accounts receivable (money customers owe) 1 200
formed is irrelevant; it is the value of these items to the
partnership that is important. The new partnership is Supplies 100
buying the assets and assuming responsibility for the Drone 1 950
liabilities; we therefore value each contribution at current   Total assets $5 190
market (agreed) value. Loan from bank $2 000
  Total liabilities $2 000
CAPITAL ACCOUNT FOR EACH PARTNER
Contributed capital $1 000
The capital account for each partner Retained earnings   2 190
capital account for
each partner  Records records the fair market value of net
  Total equity   3 190
the current market value assets contributed. The simplest
of net assets contributed.   Total liabilities and equity $5 190
investment would be cash, as it requires
no valuation. Imagine Emma and James EXHIBIT Balance sheet for Emma Aerial Filming
each contributed $10 000 cash. This entry is very similar 10.1

to the first transaction we recorded when we debited

cash and credited capital in Chapter 3. In this case we The current market value of the assets and liabilities is
credit each partner’s capital account. the same as the carrying amount except accounts
receivable, of which they only expect to collect $1000;
Cash 20 000
Supplies, which are worth $150, and the drone, which cost
  Emma, Capital 10 000 $2600, had accumulated depreciation of $650 and has a
  James, Capital 10 000 current market value of $1900. When Emma combines her
  (Emma and James invested cash in the partnership) aerial filming business with James’ graphic design, we
Assets   =   Liabilities + Equity would record the following journal entry for Emma’s
+20 000 +20 000 contribution:

Cash 1 940
Shutterstock.com/Olga Vladimorova

Accounts Receivable 1 200

Drone 1 900
Supplies 150
  Allowance for Bad Debts 200
  Note Payable 2 000
  Emma, Capital 2 990
   (To record Emma’s investment in the partnership)
Assets  =   Liabilities + Equity
+4 990 +2 000 +2 990

A business partnership is somewhat

like a marriage

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
178 ACCT3 Financial
 A few matters to note: Chapter 4) the balance in the Retained Earnings account is
● The drone was entered at the current market value – no $100 000 and Geoff and Howard have agreed to share
accumulated depreciation was recorded because the profits equally.
partnership was ‘buying’ the asset from Emma, and The final closing entry would be as follows:
with the purchase of any asset, the previous owner’s
Retained Earnings 100 000
accumulated depreciation is irrelevant.
● Accounts receivable are recorded at their full amount   Geoff, Capital or Current 50 000
and an allowance for bad debts is established because   Howard, Capital or Current 50 000
the partnership is unsure which accounts will not be    (To record profit allocation)
received. Assets = Liabilities  + Equity
● The original value of Emma’s capital and retained +100 000
earnings is irrelevant because she is contributing net
assets which are recorded at their value to the new –100 000
business.
The entry decreases Retained Earnings because
With James’ contribution of assets and liabilities, the
allocations are the transferring of profits to each partner,
partnership balance sheet will be prepared once the journal
thus increasing each partner’s capital account. It is not
entries are posted to the ledger and a trial balance is
uncommon for each partner to also have a Current account
extracted. The statement is the result of the journal entries
where short-term changes in their owner’s equity are
in the books of the partnership and not a combining of
transacted.
Emma’s and James’ previous balance sheets.
YT
A partner may then withdraw cash (or other assets)
PPL HIS
from the business. This entry is similar to a sole proprietor,
A

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with the e-lecture but a record needs to be kept of which partner has
withdrawn the cash. In this case let us imagine Geoff
withdraws $15 000.
LO3 ALLOCATE PROFITS The distribution of cash on the payment date would be
AND LOSSES recorded as follows:

30 Jun. Geoff, Drawings 15 000

If there is no partnership agreement or the agreement is  Cash 15 000
silent on the sharing of profits and losses, then they will be
   (To record withdrawal of cash by Geoff)
shared equally. Much care and attention is usually given in
a partnership agreement to the sharing of profits and  Assets    = Liabilities  + Equity
losses. To be persuaded to join a partnership, each partner –15 000 –15 000
must believe they are being fairly rewarded for the different
contributions made. Equally, existing partners are likely to We now have two (or three if we also use a current
accept a new partner only if they believe the new partner account) partner’s equity accounts for Geoff. At the end of
will add to the earning potential of the partnership and will the year each drawings account will be closed to the
not be overcompensated to the detriment of existing current account or retained earnings account. If the
partners. partnership does not use current or retained earnings
Factors commonly chosen to compensate partners and accounts for each partner, then drawings would be closed
base distributions on are capital contributed, partners’ to the specific partner’s capital account. This is the same
service and set percentages. In professional partnerships, as accounting for profits, drawings and retained earnings
payments will often be based on a partner’s ability to of a sole trader except there are now accounts for each
generate profits and/or revenue for the partnership. partner, and some partnerships may use a current account
in addition to a capital account.
SHARING PROFITS BASED
ON A SET PERCENTAGE SHARING PROFITS BASED ON CAPITAL
BALANCES AND ON SERVICE
Regardless of the capital contributed and the partner’s
human resources applied to the business, the relevant Often partners seek to be rewarded according to the
partnership Act applies in the absence of agreement on contributions made: capital, service, ability, talent, etc. This
profit and loss sharing and says they will be shared equally. becomes a mathematical exercise in following the
Imagine that on 30 June, after all adjusting and closing partnership agreement and allocating profits accordingly.
entries (to and from the Profit and Loss Summary account Imagine Geoff and Howard had contributed capital of
or Income Summary Account, as in Closing Entries in $300 000 and $200 000 respectively for a total of $500 000.

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CHAPTER 10 Partnerships 179
 They agree the first $100 000 of profits are to be distributed these changes can have a major impact on the business,
on the basis of capital contributed, the next $180 000 on but for large professional partnerships, such changes are
the basis of service (where Geoff is to receive $70 000 per regular and the business continues much as before. There
annum and Howard $110 000) and any remaining profit or are several ways of admitting a new partner and a current
loss shared equally. This year the partnership made a profit partner withdrawing. In each case it requires the consent
of $250 000. of the other partners. From the perspective of ease in
accounting, let’s look at the simplest case first.
Partners’ share of profits
Geoff Howard Total PURCHASING A CURRENT
Total profit 250 000 PARTNER’S INTEREST
First $100 000 share based When purchasing an existing partner’s interest, the new
on capital contributed
partner pays the former partner directly. The amount paid
Geoff (300 000 / 500 000) × 60 000 is a private arrangement and has no effect on the dollar
$100 000
amounts in the partnership accounts. The partnership
Howard (200 000 / 500 000) × 40 000
records the change in partners by debiting the old partner’s
$100 000
Capital (and Current) account and crediting the new
(100 000)
partner’s Capital (and Current) account. Imagine on 31 July
Share based on service as agreed the old partner sells their partnership share to the new
Geoff 70 000 partner for $9.8 million dollars. At the time the balance in
Howard 110 000 the old partner’s Capital account was $1000 (there was no
(180 000) Current account).
Balance remaining (30 000) The journal entry would be as follows:
Profit or loss to be shared 31 Jul. Old Partner, Capital 1 000
equally
  New Partner, Capital 1 000
Geoff (15 000)
   (To record the sale of partnership interest)
Howard (15 000)
Assets   =   Liabilities + Equity
30 000
–1 000
Balance remaining 0
+1 000
Profits allocated to partners $115 000 $135 000 $250 000
Note that the $9.8 million is not recorded; this was a
The journal entry would be as follows:
private transaction between the new and old partners and
30 Jun. Retained Earnings 250 000 had nothing to do with the partnership. The entry in the
  Geoff, Capital 115 000 books of the partnership simply records one partner leaving
and the new partner entering. The same journal entry
  Howard, Capital 135 000
would be made if the new partner paid the former partner
   (To record profit allocation)
$200. Why would a new partner pay anything other than
Assets   =   Liabilities + Equity $1000 when they are receiving capital of $1000? As seen
+250 000 above in the sharing of profits, a partner is entitled to share
–250 000 profits in a particular way and in this partnership the share
of profits may have no relation to the dollar amount of
capital. Imagine the partnership is expected to have
$3 million of profits in the next financial year and the three
LO4  DMISSION AND
A partners share profits equally. Although the capital balances
of each partner may only be $1000, each is entitled to a
WITHDRAWAL $1 million profit allocation. Further, as we will discover later,
OF A PARTNER if the partnership is liquidated, each partner will receive a
share of the excess assets, and this partnership may own
Admitting a new partner or the withdrawal of a current assets worth tens of millions of dollars.
partner dissolves the old partnership and a new partnership
commences. For partnerships with two or three partners,

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180 ACCT3 Financial
 INVESTING IN THE PARTNERSHIP
MAKING IT REAL
A new partner may invest in the partnership, thus expanding
PARTNERSHIPS AND THE LAW1 the size of the partnership and adding to the resources of
While partnerships generally reveal little of their financial the partnership. This is relatively straightforward when the
operations, if there is a dispute between partners, much
amount of resources contributed is equal to the capital of
may come out in court about financial arrangements.
Fortunately, such disputes are rarely aired in court the new partner. Imagine a partnership with three existing
because most partnerships have a partnership agreement partners with equal shares. Each partner has a capital
that sets out the procedures to follow if there is a dispute. account with a credit balance of $100 000 (but for
One case that looked at dissolution of partnerships is simplification we will ignore the thousands). Imagine the
Trinkler v. Beale & Ors which concerned ‘fair dealing’ on new partner contributes $100 cash on 31 August for an
dissolution of a partnership. On appeal it was held that
equal share in the partnership.
the ‘Heads of Agreement’ (partnership agreement or
agreement to dissolve a partnership) was still valid The journal entry would be as follows:
although it did not specify the dollar value of land in the
31 Aug. Cash 100
partnership. On appeal it was held that a partner was
only required to compensate another partner with the   New Partner, Capital 100
‘fair value’ not the ‘full value’ of partnership property    (To record the admission of a new partner)
gained in the dissolution of a partnership.
In a more recent case, the Commissioner of State Assets =   Liabilities +  Equity
Revenue (Vic) v Danvest Pty Ltd & Anor, the +100 +100
ownership and change of ownership of assets was
considered, not so much from the partners’ In the old partnership, each partner had a one-third
perspective but from the government’s ability to
share and a capital balance of $100. In the new (expanded)
collect taxes on the ‘sale’ and ‘purchase’ of assets
which has implications for partnerships. partnership each partner has a one-quarter share and a
The Supreme Court decision was upheld that the sale capital balance of $100. This does not mean profits and
and purchase of the interest of partners in a partnership losses will be shared equally; that will depend on the terms
was not ‘a transfer of dutiable property’. The outcome of in the new partnership agreement.
this case has implications in Victoria for the collection of
stamp duty (until the law is changed). In other states the
stamp duty legislation has partnership-specific provisions
INVESTING IN THE PARTNERSHIP:
that impose the tax on partnership asset sales. In the BONUS TO NEW PARTNER
judgment Santamaria JA said the interests of the buyers
To attract a new partner, the current partnership may be
are not interests in an estate in fee simple and therefore
duty was not payable. Several High Court cases, when willing to allow the new partner a greater amount of capital
speaking of the interest of a partner in partnership than the new partner contributes. This could be the case
property, refer to it as a ‘beneficial interest’. when a financial planning partnership accepts a high-profile
business journalist who might be expected to attract many
more clients to the firm. When a new partner pays less
than the capital received, this is known as
bonus to the new
a bonus to the new partner. partner  When a new
Imagine the current partnership’s partner pays less than the
capital received.
simplified balance sheet is as below:

Assets Liabilities
Cash $500 Loans $700
Other assets $400
Partners’ equity
Sharma, Capital $100
Wang, Capital $100
Total assets $900 Total liabilities and equity $900

Sharma and Wang share profits and losses: 60 per cent

to Sharma and 40 per cent to Wang. On 30 September they
decide to admit Haddad with a 33.33 per cent interest in
the partnership upon the payment by Haddad of $70.

Better to involve the lawyers at the beginning of a partnership than at the end
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CHAPTER 10 Partnerships 181
 Before Haddad is admitted according to the profit and loss sharing arrangement,
  the capital in the partnership is $200 ($100 + $100) unless agreed otherwise:
After Haddad is admitted
Bonus to existing partners $40
  the capital in the partnership is $270 ($100 + $100 + $70)
60% to Sharma 24
Haddad receives a one-third share $90 ($270/3)
40% to Wang 16
Bonus to Haddad as new partner $20 ($90 – $70)
The journal entry would be as follows:
The bonus to Haddad comes from the existing partners
who share the decrease in their capital according to the 30 Sep. Cash 160
profit and loss sharing arrangement, unless agreed   Sharma, Capital 24
otherwise:
  Wang, Capital 16
Bonus to Haddad $20   Haddad, Capital 120
60% from Sharma 12   (To record the admission of a new partner with bonus
40% from Wang 8 to old partners)
   
Assets    =   Liabilities   + Equity
The new Capital balances would be Sharma $88, Wang     +160 +120
$92 and Haddad $90, total $270. The profit and loss sharing
+24
would depend on the new partnership agreement.
+16
The journal entry would be as follows:

30 Sep. Cash 70 The new balance sheet would appear as below.

Sharma, Capital 12 Assets Liabilities
Wang, Capital 8 Cash $660 Loans $700
  Haddad, Capital 90 Other assets $400
Partners’ equity
  (To record the admission of a new partner with bonus
to new partner) Sharma, Capital $124
Wang, Capital $116
Assets  =  Liabilities +  Equity
Haddad, Capital $120
+70 +90 Total assets $1 060 Total liabilities and equity $1 060
–20
Just to check, did Haddad end up with 33.33 per cent
of the capital?
INVESTING IN THE PARTNERSHIP:
BONUS TO EXISTING PARTNERS Total capital $360 ($124 + $116 + $120)
One third share $120 ($360/3)
Often the advantage in joining a successful partnership
outweighs the capital the new partner is willing to And that is Haddad’s Capital balance in the balance
accept. In these cases the new partner is willing to sheet above.
contribute more – this is known as
bonus to the bonus to the exis ting (old) WITHDRAWAL OF A PARTNER
existing (old) partners. Assume the original balance
partners  When a new Partners leave for many reasons: retirement, moving, other
partner pays more than sheet above where Sharma and Wang
the capital received. had $100 of capital each. Now imagine business opportunities, disagreements, etc. When a partner
Haddad is willing to contribute $160 to leaves, the old partnership is dissolved and a new one is
receive a 33.33 per cent share in the partnership. created. From an accounting perspective the simplest
situation is the old partner selling their interest to a new
Before Haddad is admitted partner. This is the same as illustrated above where the new
  the capital in the partnership is $200 ($100 + $100) partner buys the old partner’s share in the partnership. The
After Haddad is admitted amount paid is not relevant to the accounting of the
  the capital in the partnership is $360 ($100 + $100 + $160)
partnership; we simply debit the old partner’s capital account
Haddad receives a one-third share $120 (360/3) (with the credit balance amount immediately before leaving)
Bonus to existing partners $40 ($160 – $120) and credit the new partner’s capital account.
If a partner leaves with cash equal to the balance in their
The bonus to the existing partners comes from the new
capital account, the accounting is also simple. We debit the
partner and it is shared as an increase in their capital
old partner’s capital account and credit cash.

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182 ACCT3 Financial
 Complexity arises when the partner who is leaving The journal entry would be as follows:
takes more (or less) cash than their capital balance. This
30 Nov. Buildings 110
could be accounted for by adjusting the capital balances of
the remaining partners as we have done above. Assume Goodwill 800
the capital balances for Sharma, Wang and Haddad are as  Equipment 10
before: $124, $116 and $120 respectively. Now imagine the   Sharma, Capital 300
partners share profits and losses equally. The partners agree   Wang, Capital 300
to Wang leaving on 31 October with $200 cash. Wang’s   Haddad, Capital 300
capital account has only a $116 balance. The extra $84
  (To record revaluation of assets and profit on
would need to come from the remaining partner capital revaluation to partners equally)
accounts, shared equally as per their agreement.
Assets  =  Liabilities   
+ Equity
The journal entry would be as follows:
–10 +300
30 Oct. Wang, Capital 116 +910 +300
Sharma, Capital 42 +300
Haddad, Capital 42
 Cash 200 The new balance sheet would appear as below:
   (To record the withdrawal of a partner with bonus) Assets Liabilities
Assets  =   Liabilities + Equity Cash $   660 Loans $ 700
–200 –116 Equipment ($150 – $10) $   140
Buildings ($250 + $110) $    360 Partners’ equity
–42
Goodwill (newly $    800 Sharma, Capital $ 424
–42 recognised) ($124 + $300)
Wang, Capital $ 416
($116 + $300)
REVALUATION OF ASSETS BEFORE Haddad, Capital $ 420
WITHDRAWAL OF A PARTNER ($120 + $300)
Partners may take assets other than cash when they leave. Total assets $1 960 Total liabilities $1 960
and equity
The partnership agreement will often specify the revaluation
(or valuation) of assets before a partner leaves. Some assets, Such a revaluation is often necessary when personal
such as the clients of the business, often simply called relationships end and assets need to be divided up. In
goodwill, may not be recorded among the assets of the many cases arbitration is needed to determine how the
business. Consider the above example (before Wang assets are divided and in some cases the court may be
withdrew). Imagine this business was a property required to decide. This is also the case in some business
management business. They do not own the property, but partnerships if there is no written partnership agreement,
find tenants and collect rent on behalf of the landlord. In a dispute as to how the agreement should be interpreted or
business such as this, the clients (known as the ‘rent roll’) such changed circumstances that one partner believes
are the main asset of the business. The business may be parts of the agreement should not apply.
valued at current market value of other assets plus two times
the annual gross revenue from commission on rent collected. WITHDRAWAL OF A PARTNER
Listed in the partnership balance sheet before AT CARRYING AMOUNT
revaluation is cash $660 and other assets $400 (being
Imagine the partners agreeing to Sharma leaving on
equipment – carrying amount $150, and buildings – carrying
30 November and taking $124 in cash and part of the rent
amount $250). An independent valuation places the
roll (Goodwill) valued at $300 to set up his own business.
following value on the partnership assets at 29 November:
The journal entry would be as follows:
Cash $660
30 Nov. Sharma, Capital 424
Equipment (reduced $10) 140
 Cash 124
Building (increased $110) 360
 Goodwill 300
Goodwill (value of the ‘rent roll’ newly recognised) 800
   (To record the withdrawal of partner Sharma)
The partnership agreement states profits and losses Assets  = Liabilities + Equity
are shared equally. In total there has been an increase in –124 –424
asset value by $900 (–10 + 110 + $800). –300

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CHAPTER 10 Partnerships 183
 WITHDRAWAL OF A PARTNER AT MORE THAN
THE CARRYING AMOUNT
LO5 LIQUIDATION
Instead imagine the partners agreeing to Sharma leaving Partnerships dissolve and are reformed each time a partner
on 30 November and taking $199 in cash and part of the leaves or joins the partnership. But in most cases the
rent roll (Goodwill) valued at $300. This is known as a business continues much as it had
bonus to the bonus to the withdrawing partner before.The liquidation of a partnership liquidation of a
withdrawing because the departing partner takes is different; it involves the closing down partnership  The closing
partner  When the down of a business that
departing partner takes
more than their capital balance ($500 – of the business, and partners may take involves partners taking any
more than their capital $425 = $75). This loss or shortfall assets other than cash. In an orderly remaining assets.
balance. reduces the remaining partners’ capital liquidation three basic things happen:
in proportion to their partnership non-cash assets are sold, liabilities are paid and the partners
agreement, which is usually according to their sharing receive their share of any cash remaining. This should
of profits and loss. In this case let us imagine that the reduce the balance in all accounts to zero.
sharing ratio before Sharma leaves is 40 per cent
Sharma, 40 per cent Wang and 20 per cent Haddad. After SALE OF ASSETS
Sharma leaves the ratio is 4:2 (40%:20%) or more simply
Consider the partnership above after revaluation but before
2:1 (2/3:1/3).
any partners leave (with total assets of $1960).
The journal entry would be as follows:
Imagine the partners decide to liquidate the partnership
30 Nov. Sharma, Capital 424 at the end of December. Further imagine all non-cash
Wang, Capital (2/3 × $75) 50 assets (equipment, property and goodwill) are sold on
27 December for $1500, which is $200 above the carrying
Haddad, Capital (1/3 × $75) 25
amount. The profit on sale is shared among the partners in
 Cash 199
proportion to their profit and loss sharing ratio. In this
 Goodwill 300 example (and for the benefit of a different calculation) let
   (To record the withdrawal of partner Sharma) us imagine it is: Sharma 10 per cent, Wang 20 per cent and
Assets =   Liabilities + Equity Haddad 70 per cent.
–499 –424 The journal entry would be as follows:
–50 27 Dec. Cash 1 500
–25  Equipment 140
 Buildings 360
WITHDRAWAL OF A PARTNER AT LESS THAN  Goodwill 800
THE CARRYING AMOUNT   Sharma, Capital (10% of $200) 20
Now imagine Sharma was willing to leave with only $350   Wang, Capital (20% of $200) 40
in assets. The calculations and journal entry would be very   Haddad, Capital (70% of $200) 140
similar to the above, except in this case assets would be
  (To record the sale of non-cash assets and profit on
credited only $350. Sharma, Capital would still be debited sale)
$424 because Sharma is no longer a partner and has no
Assets = Liabilities + Equity
capital in the partnership. The bonus would be credited to
+1 500 +20
the remaining partners’ capital account, again in accordance
with their agreement to share profits and losses (Wang –140 +40
credit $50, Haddad credit $25). This is known as a bonus –360 +140

bonus to the
to the remaining partners because –800
remaining the withdrawing partners take less than
partners  When the their capital balance. Let’s imagine a less happy outcome where the assets
withdrawing partner
takes less than their could only be sold for $900, a loss of $400. In this case
capital balance. Cash would be debited $900. Each of the assets would be
credited as before, but the $400 shortfall would be divided
YT
as a loss among the partners and debited to their capital
PPL HIS
A

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184 ACCT3 Financial
accounts: Sharma $40 (10 per cent of $400), Wang $80 (20 The journal entry would be as follows:
per cent of $400) and Haddad $280 (70 per cent of $400).
27 Dec. Cash 400
The balance sheet as at 28 December would show:
Sharma, Capital (10% of $900) 90
Assets Liabilities
Wang, Capital (20% of $900) 180
Cash ($660 + $900) $ 1 560 Loans $ 700
Haddad, Capital (70% of $900) 630
Equipment $   0
Buildings $   0 Partners’ equity  Equipment 140
Goodwill $   0 Sharma, Capital $ 384  Buildings 360
($424 – $40)
 Goodwill 800
Wang, Capital $ 336
($416 – $80)   (To record the sale of non-cash assets and loss on sale)
Haddad, Capital $ 140 Assets = Liabilities + Equity
($420 – $280)
+ 400 –90
Total assets $1 560 Total liabilities $1 560
and equity –140 –180
–360 –630
PAYING THE LIABILITIES –800
Legally this can be difficult because the partners may be
This leaves Haddad’s capital account capital deficiency  A
responsible for debts against the partnership into the partner’s capital account
with a negative (debit) balance, a capital
future. As with the finalising of an estate or the winding up with a negative (debit)
deficiency. balance.
of a company, advertisements may need to be placed in
newspapers. For our example the accounting is easy, so Partners’ equity
let’s imagine on 29 December we repay the loans. The Sharma, Capital ($424 – $90) $ 334
journal entry would be as follows:
Wang, Capital ($416 – $180) 236
29 Dec. Loans 700 Haddad, Capital ($420 – $630) (210)
 Cash 700
If Haddad is willing to contribute $210 cash, the
   (Repaid all loans)
accounting becomes easy. The debit to Cash and credit to
Assets  =  Liabilities + Equity Haddad, Capital, increases cash and ‘increases’ Haddad’s
–700 –700 capital from minus (debit) $210 to zero. When the loans are
repaid, the cash exactly equals the sum of Sharma and
The partnership now has $860 cash which exactly Wang’s capital account balances. The partnership is
equals the combined total of the capital accounts. liquidated by debiting the remaining capital accounts and
crediting cash. All partnership accounts have a zero balance.
PARTNERS RECEIVE REMAINING CASH But what happens if Haddad cannot cover the capital
We have now arrived at a simple solution. With cash deficit? Over 110 years ago an English case known as
equalling capital, we debit each of the capital accounts with Garner v. Murray established the principle that capital
the amount shown as the balance in the above balance deficits are not shared according to profit and loss ratios
sheet and credit cash $860. All partnership accounts –
iStock.com/monkeybusinessimages

assets, liability and equity accounts – have a zero balance.

But what would happen if the partnership was
liquidating because the business had recently appeared on
an investigative television program with a journalist and
camera operator chasing the three partners down the
street? The non-cash assets would be almost worthless.
Now imagine we sold these assets on 27 December for
$400, a loss on sale of $900. The loss will be shared in the
same proportion as before.

Partners do not always receive cash when they leave the partnership

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CHAPTER 10 Partnerships 185
 (unless specified in the partnership agreement) but Original cash (before liquidation began) $660, plus sale
according to the capital balances prior to liquidation. of assets (in last example above) $400, less the repayment
Before the liquidation process commenced and the of the loan $700, gives a final cash balance $360. The final
assets were revalued, capital balances were: act is to repay the two remaining partners on 30 December.
The journal entry would be as follows:
Partners’ equity
Sharma, Capital $124 30 Nov. Sharma, Capital 225.5
Wang, Capital 116 Wang, Capital 134.5
Haddad, Capital 120  Cash 360
   (Pay remaining partners)
Therefore, if the partnership agreement is silent on
Assets   =   Liabilities + Equity
sharing ‘capital’ losses, the loss will be shared 124:116. The
–360 –225.5
$210 deficit is shared: Sharma $108.5 ($210 × 124/240) and
Wang $101.5 ($210 × 116/240). –134.5
The journal entry would be as follows:
This is of course the opposite of the very first journal
29 Dec. Sharma, Capital 108.5 entry; when a business was established, we debited
Wang, Capital 101.5 Cash and credited Capital. Now to end the business with
  Haddad, Capital 210 all accounts at zero balance we debit Capital and credit
Cash.
   (To record the sharing of the capital deficit)
Assets  =   Liabilities + Equity
+210
–108.5
LO6 PARTNERSHIP FINANCIAL
–101.5
STATEMENTS
Because a partnership differs from a sole proprietor only
Capital balances before and after Haddad’s deficit was
in the number of owners, it is with the multiple owners
allocated:
where the differences in financial statements arise. As
Partners’ equity Partners’ equity we have already seen in this chapter, the balance sheet
before deficit after deficit
allocated allocated shows a capital account for each partner. In the income
Sharma, Capital $334 Sharma, Capital $225.5 statement, the allocation of profits is shown at the
($424 – $90) ($334 – $108.5) bottom. The statement of changes in equity is the most
Wang, Capital $236 Wang, Capital $134.5 informative of partners’ relationship to the partnership.
($416 – $180) ($236 – $101.5)
We commence with the opening balance of each
Haddad, Capital ($210) Haddad, Capital 0
($420 – $630) ($210 – $210) partner’s capital. Any additional capital and profits
allocated are added and drawings are deducted to give
If the calculations are correct, after the loans (liabilities) the closing balance. Complexity is increased when
are repaid, the cash should equal the combined capital partners join or leave, assets are revalued, or the
balances. liquidation process commences.
YT
PPL HIS
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186 ACCT3 Financial
 LO3
5 Allocate profits
EXERCISES The XYZ partnership recorded a profit of $540 000.
REQUIRED
a If the three partners had nothing in their partnership
agreement on profit sharing, how would profits be
distributed?
LO1 b If the partners agreed on a $144 000 salary allowance for
1 Partnership form of business
each partner and the remaining balance divided 3:2:1,
How do each of the following characteristics relate to the calculate the amount owed to each partner.
partnership form of business? c Assume the same information as in (b) above except
a not a separate legal entity profit before salary allowance was only $372 000. What
b unlimited liability of owners would be the amount owed to each partner?
c ability to raise capital d Record the journal entries to allocate profits in (c) above.
d limited life
LO3
e taxation 6 Allocate profits and losses
f mutual agency Thien and Thu form a partnership. Thien contributes
g co-ownership $450 000 and Thu $300 000. Thien spends up to 80 hours
per week working on growing the business and servicing
h partner’s individual equity account
their clients. Thu drops into the office from time to time, but
i partnership agreement. spends most of his time studying. In a complex formula they
have agreed to share profits: first, $300 000 allocated
LO1
2 Partnership taxation according to capital contributed; second, the next $300 000
Most partnerships prepare a partnership tax return. Explain allocated 75 per cent to Thien and 25 per cent to Thu based
why a partnership tax return would be prepared when a on their service to the partnership; and any remaining
partnership is not a taxable entity. What information is likely amount to be allocated equally.
to be included in the tax return? REQUIRED
a If the partnership profit before any allocation is $660 000
LO2
3 Account for partners’ investment how much will be allocated to each partner?
Two sole traders, Amber and Leo, decide to form a b If the partnership had a profit of $372 000 before any
partnership and contribute the following: allocation, how much would be allocated to each
partner?
Amber Leo
c If the partnership had a loss of $420 000 before any
Cash $  3 000 $11 000 allocation, how much would be allocated to each
Equipment (at cost) 42 000 1 500 partner?
Accounts payable 13 000 4 000
LO4
7 Admission of a new partner
The market value of the equipment is $47 000 and $1000
Peter and Paul are partners; they share profits and losses
respectively.
equally. Their capital balances are $19 200 and $13 200
REQUIRED respectively. They admit Mary to a 25 per cent share of the
Prepare the journal entries to record the investment by both partnership.
partners. REQUIRED
LO2
a Prepare the journal entry or entries if Mary pays $10 800
4 Recording partnership formation to become a partner.
Sarah and Lucy formed a partnership by combining their sole b Prepare the journal entry or entries if Mary pays $12 800
trader businesses, contributing the following to the new to become a partner.
partnership (all figures in thousands). Sarah contributed cash c Prepare the journal entry or entries if Mary pays $3800
of $54 and land with a fair value of $390 that had cost $108. to become a partner.
The partnership also assumed Sarah’s business overdraft of
$144. Lucy contributed cash of $120 and equipment that LO4
cost $146, and she had accumulated depreciation of $70 8 Withdrawal of a partner
with a fair value of $84. The partnership also assumed Lucy’s Nguyen, Tran and Le are partners sharing profits and losses
accounts receivable of $22 and the provision for bad debts equally and with capital balances of $225, $675 and $450
(which upon review is believed to be adequate) of $2. respectively. Tran decides to leave the partnership and go
into business on her own.
REQUIRED
Prepare the journal entries to record the investment by both REQUIRED
partners. a Prepare the journal entries to record the retirement of
Tran if she is allowed to take $675 in cash.

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CHAPTER 10 Partnerships 187
 b Prepare the journal entries to record the retirement of $3 000 000. Other assets are cash, $378 000; accounts
Tran if she is allowed to take $375 in cash. receivable, $858 000 and office equipment $1 200 000 with
c Prepare the journal entries to record the retirement of accumulated depreciation of $210 000. Li also has a loan
Tran if she is allowed to take $825 in cash. from the bank of $1 455 000 and accounts payable of
$330 000. Before Zhijie Yang enters the partnership an
LO4 independent valuation has all assets and liabilities at current
9 Asset revaluation and withdrawal
carrying amount except the apartment block that has a
of partner current market value of $6 336 000. For a one-half share of
Nguyen, Tran and Le are partners sharing profits and losses the new partnership Yang will put in cash equal to the net
equally and with capital balances of $225, $675 and $450 assets Li has in the current business.
respectively. Before Tran leaves the partnership the assets
are revalued. Equipment is worth $12 less than the carrying
REQUIRED
amount (book value), and property $147 more than the Prepare the journal entries for the entry of both partners into
carrying amount. the partnership.

REQUIRED LO3
12 Distribution of profits
a Prepare the journal entries to record the revaluation of
property and equipment. Lara and Matthew are partners. They share profits 2/3 Lara,
1/3 Matthew (all figures in thousands) – capital is fixed at
b Prepare the journal entries to record the revaluation of
$540 and $360, respectively. Interest is calculated on
property and equipment if the partnership agreement
partners’ drawings, advances and capital at 6 per cent per
specifies profits and losses are allocated on the basis of
annum.
the capital balances.
The trial balance for the financial year, after adjusting and
c Prepare the journal entries to record the departure of
non-equity closing entries is (all figures in thousands):
Tran (after revaluation and profits and losses are allocated
on the basis of capital balances as in [b] above) if she is
The Lara and Matthew Partnership
allowed to take $842.50 in cash (record to the nearest Trial balance
cent). as at 30 June 2020
Debit Credit
LO5
10 Liquidation of a partnership
Accounts Receivable $   306
The following is the balance sheet for the Hildebrand
Inventory 504
Partnership (all figures in millions):
Buildings 450
Assets Liabilities
Accumulated Depreciation Buildings $  54
Cash $   98 Loans $ 140
Short-Term Bank Loan 64
Equipment $       20
Property $     72 Partners’ equity Accounts Payable 144
Di, Capital $   24 Profit and Loss Summary 422
Sue, Capital $  16 Lara, Salary 216
Gazza, Capital $  10
Matthew, Salary 144
Total assets $  190 Total liabilities and $  190
equity Lara, Current 36
Matthew, Current 108
The partners share profits and losses equally. Non-cash
assets are sold for their carrying amount. Lara, Advance (long term) 180
Lara, Capital 540
REQUIRED
Prepare the journal entries for the liquidation of the Matthew, Capital 360
Hildebrand Partnership. TOTAL $1 764 $1 764

Lara withdrew $36 on 1 January 2020 and Matthew

withdrew $72 on 1 November 2019 and $36 on 1 March
2020.

PROBLEMS REQUIRED
a Prepare a schedule for the profit distribution for the
financial year (ignore the thousands).
b Prepare the current accounts for both partners at 30
June 2020.
11 Formation of a partnership LO2 c Prepare the balance sheet at 30 June 2020.

Man Li has operated a successful student short-term

accommodation business. Currently she has a small
apartment block with a book value (carrying amount) of

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188 ACCT3 Financial
 LO4 LO2,3, 4, 5, 6
13 Admission of a partner 17 Partnership, comprehensive example
Chris is admitted to the Mary and Peter partnership. Before X, Y and Z form a criminal investigation partnership and call
her admission the partnership accounts show capital the business ‘Partners in Crime’ (PIC). Each partner brings
balance of $170 000 and $85 000 for Mary and Peter, different skills, experience and contacts to the business, but
respectively. each contributes $70 000 cash. They agree to share profits in
two steps. First Y will receive $70 000 and Z will receive
REQUIRED
$105 000 since they do most of the investigations and this
Prepare the journal entries for the admission of Chris if: reflects their respective abilities. The money paid to the
a Chris pays $95 000 directly to Peter for his share of the partners in this first step would be withdrawn monthly. Any
partnership. remaining profits will be shared 1:2:3 (X:Y:Z). The business
b Chris invests $85 000 for a 25 per cent interest in the started on 1 July 2019. By 30 June 2020 the business had
new partnership. made a loss (after the first-step distributions) of $56 000 and
c Chris invests $105 000 for a 25 per cent interest in the X decided to withdraw from the partnership on 1 July 2020.
new partnership. This left Y and Z without their ‘inside contact’ and it was
mutually agreed that X would take only $21 000 for her
LO4 equity interest.
14 Withdrawal of a partner
REQUIRED
Emily, Judy and Katt are partners. They share profits and
losses 5:3:2. Their equity balances are as follows: a Prepare the journal entries for the formation of the
partnership and the contribution of capital on 1 July 2019.
Capital account Current account b Prepare the journal entries for the two stages of profit
Emily $270 000 $  81 000 and/or loss distribution.
Judy 315 000 108 000 c Prepare the journal entries for the withdrawal of X.
Katt 126 000 36 000 d Calculate the ending balance in Y and Z’s capital
accounts.
Before Emily leaves the partnership they have the assets e Prepare the balance sheet for the new Y and Z
valued at current market value. Land and Buildings is partnership (i.e. after X has withdrawn).
increased by $243 000 and Accounts Receivable decreased
by $63 000. Emily is to receive $495 000 when she leaves
the partnership.
REQUIRED
Prepare the journal entries for the revaluation of the assets CASES
and the withdrawal of Emily from the partnership.

LO6
15 Liquidation of a partnership
Refer to the Hildebrand Partnership balance sheet in
Question 10 above. In the process of liquidation, the 18 Advising partners: formation LO1, 2
partnership sells the non-cash assets for $150 million more
than the carrying amount. The partnership shares profits on You are a first-year accounting student and also one of the
the basis of Capital account balances. most recognised rowers in the world, having won gold in the
coxless pairs at the 2018 Commonwealth Games on the
REQUIRED Gold Coast in a time of 5:59.98, the first pairs to ever break
Prepare the journal entries for the liquidation of the the six-minute barrier, smashing the world record by over
Hildebrand Partnership. eight seconds. You have been approached by a highly
respected and experienced business advisory firm to join
16 Liquidation of a partnership with capital LO6 their partnership. This will allow you to apply your business
deficiency knowledge, gain valuable work experience and potentially
earn excellent money. The partnership will only require a
Refer to the Hildebrand Partnership balance sheet in modest investment of your money and time, but in
Question 10 above. In the process of liquidation, the recognition of the contribution your name and face will give
partnership sells the non-cash assets for $32 million only. to the business, it is proposed that profits will be shared
The partners share profits and losses equally, but the equally. The current partnership has profits of over $900 000
partnership agreement has nothing on capital deficiency. per year shared by just two partners; you will become the
REQUIRED third partner. You are unsure what to do. You intend to seek
Prepare the journal entries for the liquidation of the legal/accounting advice but first you need to work through
Hildebrand Partnership if (a) Gazza contributes his deficit and this proposal systematically. That way when you pay for
(b) Gazza contributes nothing. professional advice you don’t pay for a lot of basic
information you could find out yourself.

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CHAPTER 10 Partnerships 189
 REQUIRED d Suggest why a client might be able to sue them as a
a List and explain the advantages and disadvantages of partnership, although they do not think of themselves as
forming this partnership. partners.
b List the items you would like to see specifically included e Explain the consequences of them not agreeing on a
in the partnership agreement. distribution of profits and having the matter settled by
the courts.
c When you seek professional advice, what other issues
would you like clarified?
LO1
d What alternative business arrangements might you 20 Partnership characteristics
propose (unfortunately this business cannot be Your mother has been good friends for a number of years
conducted by a company)? with Jonathan, a fellow amateur pastry cook and coffee
connoisseur. They have both won several cooking
19 Advising partners: profit distribution LO1, 3, 6 competitions and this season appeared together on
MasterKitchen and have just won. She has just sent you an
Dang and Tran have worked together on and off since 2018. SMS announcing: ‘OMG the most amazing news Jonathan
Initially they just brought their equipment and did some of and I (BFF) are going into partnership in the most elegant
the landscaping when the other had a job that was too big and stylishly fashionable coffee patisserie in the Southern
or was getting behind schedule. They usually agreed on a Hemisphere’. You are concerned that she may enter into a
price or agreed to do the same amount of work for the partnership based on her euphoria from the show’s success
other. They worked so well together that they started to and you want to warn her about the potential dangers.
tender on larger jobs and share the risks. These larger jobs
needed more equipment and during the 2020/21 financial REQUIRED
year Dang contributed $176 000 of equipment and Tran Reply to her SMS starting with: ‘Congrats Mum, so proud of
$144 000. Dang has an excellent reputation, having worked you, please not a partnership …‘. You can write a maximum
for 20 years in the local area, while Tran is acknowledged as of another 97 characters (spaces don’t count) to persuasively
the quicker and better designer. During 2020/21 they ‘paid’ warn her of the dangers of a partnership form of business.
themselves a wage of $104 000. After drawing this wage
they estimate they have probably made around $480 000 in 21 Partnership profit distribution LO1, 3
profits for the 2020/21 financial year and rather than spoil
their friendship they have approached you to determine how In 2006 Mr Mulvany, a former partner of the law firm Maron
their profits should be divided, given they don’t currently and Gould took legal action against his former partners
have a partnership agreement, not even a verbal one. alleging a $1 million bonus paid to the founding partner was
a distribution of profits not ‘post settlement expenses’ as it
REQUIRED was classified.
a Advise Dang and Tran of the potential ways that profits
REQUIRED
could be divided.
a Explain how such a bonus could be included in a
b Recommend one particular formula and why you would
partnership agreement?
propose this as a fair and equitable basis for sharing
profits. b From an accounting perspective, discuss the ethics of
classifying a bonus payment (distribution of profits) as
c Respond to their proposal that profits be divided
‘post settlement expense’.
according to their respective age.

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190 ACCT3 Financial
 11
This chapter examines the accounting for shareholders’
equity. We begin with a discussion of the corporate form
of business. We then examine how companies account for
issuing shares and cash or share dividends distributed on
those shares. Then some of the interesting aspects of
shares, such as share splits and buybacks are explored.
After discussing preference shares and preference share
dividends, the chapter concludes with a discussion on how
to analyse a company’s equity position.

Shareholders’ equity
LO1  HE CORPORATE FORM
T
OF BUSINESS
Chapter 2 introduced the three major forms of business:
LEARNING the sole proprietorship, the partnership and the corporation.
OBJECTIVES The following sections describe some of the characteristics
of the corporate form of business that distinguish it from
sole proprietorships and partnerships. These corporate
After studying the material in this chapter, you characteristics are as follows:
should be able to: ● separate legal entity
● ability to raise capital
1 Describe the characteristics of the corporate
● limited liability of owners
form of business.
● transferability of ownership
2 Discuss equity and show how it is recorded ● dividend imputation
and reported. ● regulation.
3 Understand cash dividends, share dividends
and share splits. SEPARATE LEGAL ENTITY
4 Investigate preference shares and how they A corporation is a separate legal entity. It is formed under
receive preference in dividends and the Corporations Act 2001 (as amended) and administered
other ways. by the Australian Securities and Investments Commission
5 Examine share buybacks and how they are (ASIC). After the promoter has lodged an application, ASIC
recorded and reported. registers the company and issues an Australian Company
Number (ACN). This costs around $500. All companies
6 Evaluate equity through the calculation and
must have at least one member (shareholder). Proprietary
interpretation of horizontal, vertical and
ratio analyses. companies must have no more than fifty members that are
not employees of the company. In most cases, this new
legal entity can buy, own and sell assets in its name and
can also borrow money. It can sue and be sued. In other
words, it has most of the rights and responsibilities of an
individual in society.

ABILITY TO RAISE CAPITAL

Express Many sole proprietorships and partnerships have limited
YT access to the capital needed to successfully operate or
Throughout this PPL HIS
expand their businesses. In contrast, corporations can
A

chapter apply this

icons indicate access capital through the sale of shares to investors, who
an opportunity then become shareholders. Many companies begin by
for online selling shares privately to a few owners. And while many
self-study through
CourseMate Express,
corporations stay privately owned, others ‘go public’ by
linking you to revision offering shares to the public through an Initial Public
quizzes, e-lectures, Offering (IPO). Such public offerings can generate
animations and more.
substantial amounts of capital. In Australia the federal
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191
 government sold Telstra in three instalments (T1: 1997 TRANSFERABILITY OF OWNERSHIP
$3.30,T2: 1999 $7.40 andT3: 2006 $3.60) in the ‘privatisation’
Another advantage of the corporate form of business is the
of the telecommunications business. CSL completed its
ease with which ownership can be transferred. When a
IPO in 1994 at 77 cents per share (the shares were originally
sole proprietor wants to transfer his or her ownership to
issued at $2.30 but a three-for-one share ‘split’ in 2007
another individual, the business itself must be sold. When
makes current share equivalence price 77c).
a partner wants to transfer an ownership interest to another
A great example familiar to most, if not all of you, is
investor (as we found in Chapter 10), usually all other
Facebook. When ‘going public’ Facebook’s IPO sold less
partners must agree. Once the transfer occurs, a new
than 20 per cent of the company and raised $16 billion at
partnership is formed. In both cases, the transfer of
$38 per share and made Mark Zuckerberg’s (who retained
ownership can be burdensome.
ownership of a little over 20 per cent) stock worth $19 billion
In contrast, when shareholders of a publicly traded
in May 2012. The shares did not see the spectacular ‘stag
company want to transfer ownership to another investor,
profit’ of LinkedIn which had doubled on its first day’s
they need only to sell the shares to other investors. Such
trading. Google Inc. raised over $1.6 billion in its 2004 IPO.
sales usually occur through an open share exchange such
If needed, a corporation can continue to raise capital in the
as the Australian Securities Exchange (ASX). They can be
future by selling additional shares. Google followed its IPO
accomplished by calling a broker or logging onto a website
with a second share offering in 2005, raising another
such as CommSec and executing a sell order. Hundreds of
$4.2 billion in capital. The ability to access capital through
millions of shares are bought and sold every trading day.
the sale of shares is certainly an advantage of the corporate
form of business.
DIVIDEND IMPUTATION
iStock.com/bombuscreative

While the corporate form has several advantages over sole

proprietorships and partnerships, dividend imputation
places companies on an equal footing by the removal of
the double taxation of income.
A company’s income is taxed by the Commonwealth
Government at the flat tax rate, currently 30 per cent for
all but small companies. Dividends paid to shareholders
are added to its other income (wages, interest) and is also
taxed on the shareholders’ personal tax returns. But if
company income tax has been paid on the income out of
which dividends are paid, those dividends are said to be
Facebook became a publicly traded corporation in 2012 when it sold
shares to the public for the first time. It raised $16 billion in the initial IPO ‘franked’ and have the tax paid ‘attached’ to them. As a
result, a company’s after-tax income paid in dividends is
LIMITED LIABILITY OF OWNERS not taxed twice.
To illustrate dividend imputation, suppose that a
Under a sole proprietorship and a non-limited liability
company earns $1000 in pre-tax earnings and is subject to
partnership, owners are personally liable for the actions
a 30 per cent company tax rate. The company would pay
and obligations of their businesses. However, shareholders
$300 in company tax. Suppose further that the company
normally have no personal liability for the company’s
distributed all $700 of its remaining profits to its only
obligations beyond their investment in the company’s
shareholder, who had a marginal personal tax rates of
shares. If a company defaults and cannot meet its
39 per cent. The shareholder would pay $390 (because the
obligations, creditors cannot seek the assets of the
dividend and company tax of $1000 is included in the
shareholders as compensation for the company’s default.
complexity of the imputation tax calculations) in personal
They can only pursue the assets of the company. As a
tax on the dividends but would be rebated the $300. Better
result of this limited liability, shareholders stand to lose
still, if the shareholder has a marginal tax rate of only
only the amount of their investments. This limited liability
21 per cent, she would pay $210 tax and be rebated the
of owners is a significant advantage of the corporate form
$300, meaning she would pay $90 less tax than if she had
of business.
not received the $700 dividends.

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192 ACCT3 Financial
 retained (kept) by the company. Sometimes the directors
ANALYSIS of the company may decide to signal that some of the
Look at front cover of CSL’s retained earnings may not be available for future dividends
Annual Report and the balance sheet in Appendix B.
by transferring them to a reserve. It is important to
What tells you that CSL is a company?
remember that neither retained earnings nor reserves are
Analysis:
You can tell in two ways. First, the company name refers a ‘store of cash’. The liability and equity sections of the
to CSL Limited. The ‘Limited’ stands for limited liability, a balance sheet show the sources of the entity’s resources;
characteristic of companies. Second, the balance sheet the asset section shows how those resources have been
shows balances in Contributed Equity, and Note 12 has used. In most circumstances the retained earnings and
listed ‘Ordinary shares issued and fully paid’. Unusually reserves have been used to buy plant, property and
the dollar amount is zero because as explained later in
equipment or inventory. CSL has almost $300 million in
the note ‘due to share buybacks being undertaken at
higher prices than the original subscription prices, the reserves and over $7.4 billion in retained earnings, but much
balance for ordinary share contributed equity has been less than $1 billion in cash.
reduced to nil and a reserve created …’1 The asset and liability section of a company’s balance
sheet is the same as for sole proprietors and partnerships; it
is the equity section that is different. Issued capital is known
REGULATION by various names: paid-up capital, share capital or contributed
A disadvantage of a company is the extent of regulation. equity. It refers to the money raised directly from new owners
Consider some of the reporting requirements of a publicly when the company issued shares to them. Notice that the
traded company such as CSL. These companies must file description ‘sold shares’ is not used. Ordinary shares are not
numerous reports with ASIC and the ASX if they are a listed always distributed via a sale. For example, some shares are
company. These include audited annual financial statements, issued to employees (usually senior
unaudited half-yearly financial statements and any management) as part of their compensation. issued shares  The
notifications of significant events, such as the hiring of a Thus, the description ‘issued shares’ (or number of shares a
company has distributed
new chief executive officer, the announcement of a dividend ‘paid-up capital’, ‘shares issued and fully to owners to date.
or the closing of a factory under the continuous disclosure paid’) may be used.
regime. Adherence to and compliance with laws and
regulations consume significant amounts of the time, labour SHAREHOLDER RIGHTS
and resources of companies, but are necessary because
When a company issues ordinary shares, it usually grants
stakeholders (especially creditors), due to limited liability,
to shareholders the following three rights:
only have the company (and not all the owners as with a
● The right to vote – ensures that a shareholder can
sole trader or partnership) to pay debts and compensation.
participate in company governance by voting on issues
YT
PPL HIS and actions that require owner consent or approval.
A

Review this content

Examples of such action are the election of directors
with the e-lecture
and approval (or not) of the ‘remuneration report’.
● The right to participate proportionally in dividends –
LO2 ORDINARY SHARES ensures that shareholders receive an appropriate
amount of any dividends declared by the company. For
One of the distinguishing characteristics of a company is example, if a shareholder owns 25 per cent of a
its ability to sell shares to investors to raise funds. The company’s ordinary shares, they have the right to receive
amount raised by issuing shares is called issued capital 25 per cent of any dividend the company distributes.
(or contributed equity) because the ● The right to participate proportionally in residual assets –
issued capital ensures that shareholders receive an appropriate
(contributed funds are contributed by investors
equity)  The amount of (through the company issuing shares) in amount of assets upon liquidation of the company. For
capital raised by issuing
exchange for an ownership claim on example, if a shareholder owns 10 per cent of a
shares to investors in
exchange for an ownership company assets. The most common type company’s ordinary shares when the company ceases
claim on company assets. of shares are called ordinary shares. operations and liquidates, they have the right to receive
It is also known as paid-up 10 per cent of all residual assets.
capital or share capital. Investors who purchase ordinary shares
ordinary shares  The are called shareholders and are the The right of pre-emption is related and ensures that
most common type of share owners of the company. The other part of shareholders can maintain their ownership percentage
capital. when new shares are issued. This is important in companies
equity is the retained earnings. These
are, as the name suggests, earnings (total comprehensive with a small number of shareholders and where shares are
income) of the company that have not been paid to not easily obtained on the open market as they are with
shareholders in the form of dividends, but have been listed companies.
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CHAPTER 11 Shareholders’ equity 193
 RECORDING ORDINARY SHARES shares and is therefore called ‘Application’. On 1 January
the application money was received for 10 000 shares.
In Australia and New Zealand shares no longer have a par
value. Par values were once used to determine a company’s 1 Jan. Cash Trust 5 000
legal capital and are still used in some other countries. For  Application 5 000
Australian accounting students, this reduced the difficulty   (Received applications for 10 000 shares)
of accounting for the issue of shares and means overseas
Assets = Liabilities + Equity
or old textbooks can appear unduly complex.
+5 000 +5 000
To illustrate, suppose that a company issues 100 shares
for $5 per share on 5 April. The company would record this
This entry increases the asset Cash Trust and increases
issuance as follows:
the liability Application. We classify it as a liability because
5 Apr. Cash 500 the money must be paid back or the applicant given
  Contributed Equity 500 shares.
When the shares are issued or allotted, the applications
  (To record issue of 100 shares at $5 per share)
are accepted as purchasing the shares (contributed equity),
Assets = Liabilities + Equity
the allotment money becomes due and the money in the
+5 00 +5 00 trust account is transferred into the company’s normal bank
account. On 2 February Madison issued (allotted) the
This entry increases Cash for the amount received
10 000 shares:
and increases Contributed Equity (Ordinary Share
Capital, Issued Capital) by the same amount. (Note this 2 Feb. Application 5 000
is very similar to the journal entry made when a sole Allotment 3 000
trader contributed money to the business, back in   Contributed Equity 8 000
Chapter 3.)
   (Allotted 10 000 shares)
Assets =  Liabilities   +  Equity
ISSUING SHARES BY INSTALMENT
+3 000 –5 000 +8000
Sometimes shares are issued by instalment, requiring
applicants for shares to pay some money when they apply
Getty Images/ Bloomberg/ Jeremy Piper

and more money later in the process. All three issues of

Telstra shares were by instalment, requiring a part payment
with the application and a further payment (a call) one year
later. Most companies require the full amount to be paid
with the application (on application); but a few may require
some money on application, more on
application  Both the
request to buy shares and the allotment or issue of shares and
the money payable when further payments, appropriately called
shares are applied for. calls. Companies issue a prospectus
allotment or issue 
The process of giving inviting the public to apply for shares by
shares to (some of) those filling out the application form and
who have applied for them providing the appropriate application The shares traded on the Stock Exchange
and also the money are ‘second-hand’ shares, they usually do
required at this stage from money. not involve trades with the company
shareholders. Madison forms a company and issues
call  The request for a prospectus seeking applications for This entry increases the asset Allotment, decreases the
further payment(s) and
the money with those 10 000 shares: 50 cents payable on liability Application and increases the equity Contributed
further payment(s). application, 30 cents on allotment and Equity (or Paid-up Capital). We have classified allotment as
prospectus  The legal an asset because once the shares are issued, the company
document offering shares
20 cents call. The application money
for sale and providing should initially be banked in a separate has a legal right to receive the money. At the same time,
details of the company, bank account (a trust account – for ease Madison can now claim application money as the company’s
past financial
performance and future we call it ‘Cash Trust’), because some or and the money in Cash Trust can be credited and Cash
prospects. all of it may be refunded. The money debited.
received is from investors applying for

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194 ACCT3 Financial
 On 3 March Madison receives the allotment money: 8 Feb. Application 1 000
3 Mar. Cash 3 000 Allotment 1 000
Allotment 3 000    (Apply excess application to allotment)
   (Received application money) Assets = Liabilities + Equity
Assets = Liabilities + Equity –1 000 –1 000
+3 000
This entry decreases the liability Application and also
–3 000 decreases the asset Allotment. Or we could combine the two
transactions – the refund and the allotment – in one entry.
This transaction reduces one asset – Allotment – and
increases another asset – Cash. 8 Feb. Application 6 000
When the call is made, it follows the same pattern as Allotment 2 000
the allotment: debit Call and credit Contributed Equity. The   Contributed Equity 8 000
receipt of the cash follows the same pattern: debit Cash,
   (Allotted 10 000 shares)
credit Call.
Assets = Liabilities + Equity

OVERSUBSCRIPTION +2 000 –6 000 +8 000

The process of selling shares by asking for applications often This entry decreases the liability Application by the full
oversubscription  results in more shares being applied for $6000 received, increases the asset Allotment (recognising
When more shares are than are available for sale. This is known as the new shareholders have only $2000 to pay on allotment)
applied for than are and increases the equity Contributed Equity by the amount
available to be issued.
oversubscription. Let us assume
Madison received applications for 12 000 of the application and allotment monies. Later, when the
shares on 2 February. The company would record the cash is received for allotment and call, less will be received
application as before by debiting Cash Trust and crediting because some or all has been paid on application.
Application, but this time with $6000 (12 000 shares × 50c).
Depending on the conditions set out in the prospectus, the ANALYSIS
Look at CSL’s Annual Report 2017
company has two options in how it treats the excess
‘Share Information’ and ‘Shareholder Information’ How
application money. many ordinary shares do CSL have issued in 2017?

Option #1 Analysis:
CSL has almost 453 454 237 shares issued. The majority of
On 8 February the company gives the excess money back shareholders (115 731 or 79.9%) own between one and
to the investor (i.e. refund). Madison also accepts the one thousand shares, but they own only 7.1 per cent of
application for 10 000 shares and in addition to refunding the company. The largest shareholder, HSBC Custody
the excess application money it will allot the shares as Nominees (Australia) Limited, holds (owns) over
156 million shares or 34.47 per cent of CSL – worth over
above on 2 February.
$21 billion – but this depends on the current share price.
8 Feb. Application 1 000 HSBC Custody Nominees (Australia) Limited is also the
largest shareholder in the largest companies in Australia: CBA 22
  Cash Trust 1 000 per cent; Westpac 24 per cent; BHP 25 per cent; ANZ 26 per
   (Refund excess application money) cent; NAB 24 per cent; Wesfarmers 17 per cent; Telstra 16 per
cent; Woolworths 22 per cent; Macquarie Bank 29 per cent.
Assets = Liabilities + Equity
HSBC invests on behalf of clients, so most (possibly all) of the
–1 000 –1 000 ownership is clients, which could be individuals, superannuation
funds, governments or other companies.
This entry recognises the refund part of the transactions
Alamy Stock Photo/Kristoffer Tripplaar

on 8 February by decreasing the asset Cash Trust and

decreasing the liability Application.

Option #2
Alternatively, on 8 February, rather than refund the
money and then ask for the allotment money, Madison
applies the excess Application to Allotment (and Calls in
Advance if there were applications for more than 16 000
shares).

HSBC Custody Nominees (Australia) Limited is the largest

shareholder in the largest companies in Australia
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 11 Shareholders’ equity 195
 FORFEITURE This entry increases the asset Cash, decreases the
equity account Forfeited Share Account and increases
If the allotment or call money is not paid, the company
the equity account Contributed Equity.
usually has the power to cancel the shares and the After paying the cost of reissue, any amount left in the
shareholder forfeits the shares. Money Forfeited Shares Account may be refunded to the original
forfeit  When a
shareholder does not already paid is, at least initially, kept by the shareholder.
pay the allotment and/or company and recorded as part of
call they lose the shares
they have paid some of shareholders’ equity (Forfeited Shares
the money to buy. Account), but not contributed equity.
Assume Madison made a call on 3 March
LO3 DIVIDENDS
(debit Call $2000 and credit Contributed Equity $2000) but
The goal of any company is to generate profits. Once
by the closing date of 4 April, money for only 9500 shares
generated, a company must decide whether or not to
had been received (debit Cash $1900 and credit Call $1900).
distribute those profits to its owners through dividends. A
This leaves a debit balance in Call of $100. But for the
dividend is a distribution of profits to owners. The decision
500 shares for which the call has not been paid, the
to distribute any dividend rests with the company’s board
application of 50 cents (500 × 50c = $250) and the allotment
of directors, which is the group of individuals elected by
of 30 cents (500 × 30c = $150) has been paid. On 5 May shareholders to govern the company and represent the
the shares are forfeited; the shareholder who paid the interests of all owners. The board will consider many factors
application and allotment on those shares loses their in its decisions, including the financial condition of the
money and is no longer a shareholder. company, the cash available for dividends and the
5 May Contributed Equity ($1 × 500) 500 company’s past history of dividends. When dividends
are distributed, they are stated as a per-share amount and
 Call 100
are paid only on issued shares and paid to the owner of the
 Forfeited Share Account ($250 + $150) 400 they on the date of record. If shares are
   (Forfeiture of 500 shares) sold the day after the date of record, they date of record  The
date that determines who
Assets =   Liabilities +  Equity are sold ex-dividend (without the dividend) receives the dividend –
and the previous owner will receive the the shares’ owner on the
–100 –500 date of record receives
dividend when paid weeks or months the dividend.
+400
later, although they have not owned the
shares for some time. This is why the market value of
This entry decreases the equity Contributed Equity,
shares (the price they are bought and sold for on the ASX)
decreases the asset Call and increases the equity Forfeited
usually falls by an amount approximately equal to the
Share Account.
dividend per share when the shares start trading ex-
The shares may later be reissued, often at a discount,
dividend (without the dividend). Market value of shares will
with the discount effectively being paid
reissue  When forfeited be discussed at the end of the chapter, but suffice to say
shares are again sold, by the original shareholder. Madison market value has little relation to the price at which shares
often at a discount to the reissues the shares on 6 June for 85
original issue price. were originally issued.
cents as being fully paid: When and how a company distributes dividends is
6 Jun. Cash (500 × 85c) 425 called a company’s dividend policy. A company’s policy can
often be found on its website. Dividends are normally paid
Forfeited Share Account 75
(500 × 15c) in cash, but they can also be paid in other forms such as
shares. The following sections discuss the practice of
 Contributed Equity ($1 × 500) 500
distributing dividends, starting with the most common
   (Reissue 500 at a 15c discount)
type – the cash dividend.
Assets =   Liabilities + Equity
+425 –75 CASH DIVIDENDS
+500 As the name suggests, a cash dividend cash dividend  A
is a distribution of cash to shareholders. distribution of cash to
shareholders.
When a company’s board decides that a
cash dividend is warranted, it will declare publicly that a
dividend will be distributed. The date on which the board

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
196 ACCT3 Financial
declaration declares the dividend is called the Reporting cash dividends
date  The date on declaration date. On this date, the board
which a company’s Companies usually report their dividends on two financial
legally obligates the company to pay the
board of directors statements. Dividends declared during the year are
declares a dividend. dividend, so a liability is created. The board’s
reported on the statement of changes in equity. Recall that
payment declaration will also include the date of
date  The date on dividends reduce retained earnings, so they are reported
record and the payment date. The payment
which a dividend will in the retained earnings column. The following is the
be distributed. date is the date on which the dividend will
retained earnings column of CSL’s 2017 statement of
be distributed. The date of record
changes in equity.
determines who receives the dividend. The shares’ owner
on the date of record receives the dividend. Retained Earnings $m
Balance at the beginning of the year 6 592.3
Recording cash dividends Profit for the period 1 337.4
The recording of cash dividends usually requires two
Other comprehensive income 75.5
entries. The first entry records the declaration of the
Dividends paid (601.3)
dividend and the resulting liability. The second entry records
the actual distribution on the payment date. Balance at end of year 7 403.9
To illustrate, suppose that a company with 100 000 Source: CSL Limited, Annual Report 2017, p. 83.

issued shares declares a 50 cent per share dividend on

Dividends are presented as negative numbers because
1 November. The dividend is payable on 30 November to
they are subtracted from retained earnings.
shareholders of record on 15 November.
Dividends paid during the year are reported on the cash
On the date of declaration, the company obligates itself
flow statement. Because a cash dividend is a distribution
to pay a $50 000 dividend (100 000 × $0.50). This obligation
of assets to an owner, dividends are considered to be a
would be recorded as follows:
financing activity. Therefore, they are reported in the
1 Nov. Retained Earnings 50 000 financing activities of the cash flow statement. The
  Dividends Payable 50 000 following is the financing activities section of CSL’s 2017
   (To record declaration of dividend) cash flow statement.

Assets =   Liabilities + Equity Financing activities section of CSL’s

+50 000 –50 000 2017 Statement of cash flows
2017 2016
The entry decreases Retained Earnings because US$m US$m
dividends reduce retained earnings. The entry also increases Cash flows from financing activities
Dividends Payable, which is a current liability. The result of Proceeds from the issue of shares  12.7  17.4
the entry is a reduction in equity and an increase in liabilities. Dividends paid  (601.4)  (579.0)
The distribution of cash on the payment date would be Proceeds from borrowings 1 381.4 1 564.3
recorded as follows:
Repayment of borrowings  (581.3)  (716.9)
30 Nov. Dividends Payable 50 000 Payment for shares bought back  (314.9)  (648.2)
 Cash 50 000 Net cash outflow from financing activities  (103.5)  (362.4)
   (To record payment of dividend) Source: CSL Limited, Annual Report 2017, p. 84.

Assets =  Liabilities   +   Equity

Because dividends are cash outflows, they are shown
–50 000 –50 000
as negative numbers on the cash flow statement. The
dividends paid as shown in the cash flow statement is the
This entry is simply a payment of an obligation. Both
same as the amount of dividend (declared) in retained
Dividends Payable and Cash are decreased for the amount
earnings. This is because CSL declares and pays its dividends
of the payment. As a result, both assets and liabilities
in the same financial period (Final dividend declared 88.67c
decrease.
August 2016, Paid October 2016, Interim declared 83.78c
Note that no entry is made on the date of record
February 2017, paid April 2017). The dividend declared
because no accounting transaction occurs on that date. The
(retained earnings) and the dividend paid (cash flow) are
date of record only determines who will receive the
often different because of some dividends declared in the
dividend. Therefore, it is a date with administrative
current financial year being paid in the next financial year,
importance only.

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CHAPTER 11 Shareholders’ equity 197
 and dividends declared in the previous period paid in this
period. CSL does not have a dividend reinvestment scheme. MAKING IT REAL
In a way they have the reverse: semi-regular share buybacks
(discussed in LO5: Share buybacks). DIVIDEND REINVESTMENT PLAN
Commonwealth Bank, Australia’s largest company,
offers one of the best known DRPs. Below is a brief
SHARE DIVIDENDS extract of information the bank provides about
While cash dividends are by far the most common type their DRP.
of dividend, some companies distribute share dividends. The DRP allows Shareholders to reinvest all or part
of any dividend paid on their Shares in additional
share dividend  A share dividend is a distribution of a
Shares instead of receiving the dividend in cash.
A distribution of a company’s ordinary shares to existing Shareholders are still entitled to franking credits on
company’s ordinary shares
to existing shareholders.
shareholders. Share dividends are dividends reinvested under the DRP. Participation in
declared by a company’s board of the DRP is entirely optional. The DRP is administered
in accordance with these DRP Rules. You can find
directors and are usually stated in percentage terms or one out how to participate in the DRP under the FAQs.
share for every number held. For example, a 10 per cent It is important that you read these DRP Rules
share dividend (one for 10) means that the company will carefully before deciding whether to participate in
the DRP. For the avoidance of doubt, the offer of
issue additional shares equal to 10 per cent of the issued
the DRP is made in compliance with Australian law
shares. So, an investor owning 10 000 shares will receive and any code, rules or other requirements relating
1000 additional shares (10 000 × 10%). to the offer of the DRP in Australia. If you have any
At first glance, a share dividend appears to be of great questions or need advice on whether you should
participate in the DRP, please contact an
value to shareholders because they receive more shares. independent professional adviser.
However, some argue that a share dividend has very little …
value to shareholders because they are not receiving any 8.1 Each Share issued or transferred under the
cash – they are receiving only shares. Furthermore, DRP will be issued or transferred at the Market
Price of Shares less such discount (if any) as the
because all shareholders receive the same percentage
Directors may determine from time to time and
increase in shares, a share dividend does not change a notify to ASX (rounded to the nearest cent).2
shareholder’s ownership percentage, but the ownership is
in a company which has not decreased its cash by paying
If you had perfect timing or had perfect foresight you
it out in dividends. Finally, a share dividend usually results
could have purchased one hundred Commonwealth Bank
in a reduction to the market price of individual shares such
of Australia (CBA) shares in early 2009 for just under $2400
that the total market value of a shareholder’s holdings
(the lowest price during the Global Financial Crisis). Over
remains little changed. For example, a company distributing
the next ten years each share has paid over $36 in dividends.
a 100 per cent share dividend will double the shares issued,
If you fully participated in the DRP after ten years you would
but this will usually result in the share’s market value being
own over one hundred and seventy shares, probably worth
cut in half. As a result, each shareholder will have a higher
around $15 000.
number of shares but no additional monetary value. Share
In the first six months you would have received a dividend
splits, discussed below, also reduce the market value of
of $1.13 per share or $113 for your one hundred shares. This
shares
$113 would have been reinvested in shares at the time
valued at just over $28, giving you four additional shares. The
DIVIDEND REINVESTMENT next dividend of $1.15 per share would be received on the
PLANS IN AUSTRALIA one hundred and four shares, as you now owned the original
A Dividend Reinvestment Plan (DRP), allows a shareholder investment plus the four shares from your first dividend
to take some, or all, of their dividend in the form of additional reinvestment. An additional two to five shares are received
shares. Dividend Reinvestment Plans are similar to share every six months when the dividend is paid; the more recent
dividends, but it is the shareholder who decides to receive the more shares because your portfolio is growing each time
shares not cash rather than it being imposed on all the dividend is received and reinvested.
shareholders with a share dividend. The investor can If this strategy was adopted from the IPO in September
nominate what percentage they wish to split between cash 1991 when shares were issued for $5.40 (or $540 for one
and shares. Often the DRP shares are offered at a discount. hundred shares) you would, by the end of 2018 own almost
Many companies have DRPs: the five large banks (CBA, five hundred shares worth (based at the time of writing on
Westpac, ANZ, NAB and Macquarie); Wesfarmers an estimated share price of around $80 per share) about
(not 2003–2007); Woolworths and Telstra (not 2008–2015). $40 000. Depending on your personal tax situation you may
CSL is the only Top 10 company in Australia that does not have also received an imputation credit of over $5000.
have a DRP. Hindsight makes the very best investors!

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
198 ACCT3 Financial
 Shares acquired through a DRP are treated as though share split instead of a share dividend. share split  An increase
the investor received a cash dividend and then used this A share split is an increase in a in the number of a
company’s issued shares
cash to buy additional shares in the company; as such the company’s shares according to some according to some
dividend is taxable (but subject to the same ‘franking credit’ specified ratio; for example, a company specified ratio.
as cash dividends). While the shares acquired from DRP that declares a 2-for-1 split recalls all
are treated for capital gains tax as if purchased for cash at shares from existing shareholders and issues two shares
the date they are alloted. in return, effectively doubling the number of issued
So why do companies distribute share dividends or have shares. As a result of this increase in the number of
DRP? There are a couple of potential reasons. First, they can shares, the market price of the shares usually falls
substitute for a cash dividend when a company does not proportionally. In a 2-for-1 split, the share price would be
have enough cash on hand and would otherwise be forced approximately halved. In Australia share splits are
to borrow or reduce investing activities. This motivation can common, with companies like BHP 2-for-1 (in 1989, 1995,
be especially strong when a company is trying to maintain 2001) and CSL 3-for-1, splitting their shares to reduce the
a long and uninterrupted history of dividends. Second, share market price to a level the company believes would be
dividends often reduce the market price of shares and like more attractive to investors. In Australia companies
a share split keep them in an ‘affordable’ range for the appear to want to keep the market price under $100; but
average investor. Distributing more shares in the marketplace interestingly, in 2015 CSL did not split its shares when
brings down the price of each individual share. the price approached $100 despite splitting its shares in
Like cash dividends, a share dividend is paid out of 2007 (see the Making it Real box ‘Share split’ for more).
Retained Earnings. However, unlike a cash dividend, a share In the US, shares sometimes have a market value in the
dividend is not a distribution of assets. It is a distribution of thousands. Famously, Berkshire Hathaway valued at over
ordinary shares. As a result, a share dividend simply transfers US$400 000 in 2018.
an amount from Retained Earnings to Contributed Equity. In Share splits are very similar to share dividends in that
contrast, a share split does not reduce Retained Earnings they both result in an additional number of issued shares.
and increase Contributed Equity; it simply increases the In fact, a 2-for-1 share split is the same as a 100 per cent
number of shares in the same contributed equity. share dividend. However, there are important differences.
A share split is not an accounting transaction, so no
SHARE SPLITS accounting entry is recorded. Second, while both do not
change total equity, a share dividend transfers amounts out
When a company wants to decrease the market price of
of Retained Earnings into Contributed Equity.
its shares to make them more affordable, it can use a

Share ownership certificates like this are no longer used

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CHAPTER 11 Shareholders’ equity 199
 CASH DIVIDENDS ON PREFERENCE SHARES
MAKING IT REAL When a company has both preference and ordinary shares
SHARE SPLIT issued, cash dividends must be allocated between the two.
It would appear that in Australia companies like to keep Because preference shareholders have dividend preference,
their share price under $100; few companies’ share they are paid first, followed by ordinary shareholders. The
prices have traded above this. The first was Poseidon in amount that is allocated to preference shareholders
1970 – its share price rose to $280 on a boom nickel depends on the dividend rate and whether the shares are
price, but it soon went bust. This may go some way to
cumulative or non-cumulative.
explain share splits as share prices rise towards triple
figures. CSL experienced a spectacular rise in its share The dividend rate refers to the annual dividend amount
price and in 2007 when its share price rose above $100, that preference shareholders normally receive. The rate is
it split its shares in a 3-for-1 share split. usually set as a dollar amount per share or as a percentage
Although CSL does not have a DRP, a shareholder of issue price. For example, preference shares may carry
could purchase shares on the ASX with the dividend
a dividend of 90 cents per share or a dividend of 6 per cent
received. CSL pays less dividends, but one share
purchased in 1994 for $2.30 would now have paid over of issue price.
$36 in dividends, and due to the 2007 share split you Preference shares are either cumulative or non-
would now have three shares worth around $420. If cumulative. Cumulative preference cumulative
only we could all go back in time! shares carry the right to receive current- preference shares 
Shares that carry the right
YT
year dividends and all unpaid dividends to receive current-year
PPL HIS
from prior years before dividends are dividends and all unpaid
A

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with the e-lecture paid to ordinary shareholders. This dividends from prior years
before dividends are paid to
means that if a company fails to pay a ordinary shareholders.
dividend one year, the missed dividend dividends in arrears 
LO4 PREFERENCE SHARES will be paid the next time dividends are The accumulated value of
unpaid prior-year dividends.
declared. The accumulated value of
While all companies issue ordinary shares, some also issue unpaid prior-year dividends is called dividends in arrears.
preference shares, which are a form of shares that Note that dividends in arrears are not a liability because
receive one or more priorities over dividends are declared at the discretion of the board of
preference shares 
A form of shares that ordinary shares. Usually, preference (or directors and become a legal obligation only when
receives one or more preferred) shareholders give up the right declared. Nonetheless, because dividends in arrears are
priorities over ordinary
shares. to vote in exchange for preference to informative, they are disclosed in the notes to the
dividends and preference to assets upon financial statements.
liquidation of the company. Preference to dividends means Non- cumulative preference
non-cumulative
that preference shareholders receive their dividends before shares carry the right to receive current- preference shares 
ordinary shareholders receive any dividends. year dividends only. If a company does not Shares that carry the right
to receive current-year
declare a dividend in a particular year, non- dividends only.
RECORDING PREFERENCE SHARES cumulative preference shareholders lose
the right to that annual dividend forever. As a result, a
Because it is a form of contributed equity, preference
company with non-cumulative preference shares will not
shares are recorded in the same manner as ordinary
have dividends in arrears.
shares. To illustrate, suppose that a company issues 500
To illustrate the allocation of dividends to preference
preference shares for $15 per share on 23 August. The
and ordinary shareholders, suppose that a company has
company would record this issuance as follows:
the following two types of shares:
23 Aug. Cash 7 500 ● Ordinary shares: 100 000 shares issued.
  Preference Shares 7 500 ● 5 per cent preference shares: 20 000 shares issued
   (To record sale of preference shares)
at $10.
Suppose further that they do not pay dividends in 2017
Assets =  Liabilities +   Equity
or 2018 but declare $64 000 of dividends in 2019. The
+7 500 +7 500 allocation of the 2019 dividend depends on whether the
preference shares are cumulative or non-cumulative.
This entry increases Cash by $7500, which is the
amount paid by the investor and Preference Shares
(Contributed Preference Equity) are increased by $7500.
As a result of this entry, both assets and equity increase.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
200 ACCT3 Financial
Cumulative preference shares LO5 SHARE BUYBACKS
If the shares are cumulative, the preference shareholders
receive not only the current-year annual dividend but also
Like any investor, a company can purchase (buy back)
the two years of dividends in arrears. The annual dividend
shares of its own in the marketplace. The practice of a
on preference shares is 50 cents per share ($10 × 5%) and
company purchasing its own shares is commonplace in
$10 000 in total ($0.50 per share × 20 000 shares). Therefore,
publicly traded companies today. One reason why a
$30 000 is allocated to preference shareholders, with the
company purchases its shares is to provide a tax-effective
remainder going to ordinary shareholders.These calculations
return to some shareholders and increase future returns to
are illustrated as follows:
the remaining shareholders. Another reason may be to
Preference shares are cumulative Preference Ordinary acquire shares from shareholders who hold small parcels
$10 000 of shares, who are expensive to service and who may not
Dividends in arrears: year 2018 10 000 know how to (or want to) incur the cost of selling through
a broker. Other purchases of shares may be for an employee
Current-year preference dividend 10 000
share scheme or a management incentive scheme. Share
Distribute remainder to ordinary $34 000
($64 000 – $30 000) buybacks are usually done ‘off-market’ where a company
offers to buy and the shareholder needs to simply sign the
Total allocated in 2019 $30 000 $34 000
form and all transfer details are handled by the company.
Once the allocation of dividends is calculated, they ‘On-market’ buybacks involve the company purchasing
would record the declaration and payment of the dividend shares put up for sale on the ASX. For example, CSL buys
as follows: the shares just like any investor; the seller, as usual, has no
knowledge of who the buyer is and CSL reports to the ASX
Date of Retained Earnings 64 000 how many shares they have purchased each day. Exhibit
declaration
11.1 is the announcement of CSL’s on-market share
 Ordinary Share Dividend Payable 34 000 buyback.
 Preference Share Dividend Payable 30 000
   (To record declaration of dividend) RECORDING SHARE BUYBACKS
Assets =  Liabilities + Equity Apart from removing the shareholders or reducing their
+34 000 –64 000 holdings on the share register so they no longer receive
dividends (or fewer dividends if they did not sell all their
+30 000
shares) and have their voting rights removed or reduced, it
As is the case with any cash dividend, the net overall is also necessary to reduce the shareholders’ equity and
result of the declaration and payment of the dividend is a the cash paid out.
decrease in a company’s equity and its assets. In October 2016 CSL notified shareholders of its share
buyback. The sale of shares (to CSL or another investor) will
Non-cumulative preference shares be attractive to some shareholders as the buyback tends to
If the company’s preference shares are non-cumulative, support the share price as the company is creating further
the preference shareholders receive only the current-year demand for the shares. On-market buybacks do not have the
annual dividend. The missed dividends in 2017 and 2018 advantage of some off-market buybacks where some current
are irrelevant to the calculation for the current year. investors take advantage of the tax implications of the
Therefore, only $10 000 is allocated to preference buyback price being a substantially ‘fully franked’ dividend.
shareholders, with the remainder going to ordinary To illustrate, suppose that a company buys back 1000 of its
shareholders. These calculations are illustrated as own ordinary shares on 3 May when the shares are trading
follows: for $32 per share. They would record the purchase as follows:

Preference shares non-cumulative Preference Ordinary 3 May Contributed Equity 32 000

Current-year preference dividend $10 000  Cash 32 000
Distribute remainder to ordinary $54 000    (To record share buyback)
shareholders ($64 000 – $10 000)
Assets =   Liabilities   +  Equity
Total allocated in 2019 $10 000 $54 000
–32 000 –32 000

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 11 Shareholders’ equity 201
 APPENDIX 3C
Rule 3.8A
Announcement of buy-back (except minimum holding buy-back)
Information and documents given to ASX become ASX’s property and may be made public.
Introduced 1/9/99. Origin: Appendix 7B. Amended 13/3/2000, 30/9/2001, 11/01/10

Name of entity ABN/ARSN

CSL Limited 99 051 588 348

We (the entity) give ASX the following information.

Information about buy-back
1 Type of buy-back: 6 Whether shareholder/unitholder:
On-Market. No approval is required for buy-back.
2 Class of shares/units which is the subject of the buy-back (eg, ordinary/ 7 Reason for buy-back:
preference): Ongoing capital management.
Ordinary. 8 Any other information material to a shareholder’s/unitholder’s decision
3 Voting rights (e.g., one for one): whether to accept the offer (e.g., details of any proposed takeover bid):
One for one. None, apart from any information publicly disclosed by CSL Limited (the
4 Fully paid/partly paid (and if partly paid, details of how much has been Company) through ASX on or prior to the date of this notice.
paid and how much is outstanding):
Fully paid.
5 Number of shares/units in the class on issue:
455,920,280
On-market buy-back
9 Name of broker who will act on the company’s behalf: 12 If the company/trust intends to buy back shares/units within a period
To be advised to ASX no later than the trading day prior to the date of of time – that period of time; if the company/trust intends that the buy-
the first trade under the buy-back. back be of unlimited duration – that intention:
10 Deleted 30/9/2001. The Company intends to buy-back shares in the period 27 October 2016
11 If the company/trust intends to buy back a maximum number of shares - to 25 October 2017 (inclusive) or earlier if the maximum number of
that number: shares in Item 11 above is bought back prior to that date.
Note: This requires a figure to be included, not a percentage. The Company reserves the rights to suspend or terminate the buy-back
Up to that number of shares for which the total buy-back consideration at any time
paid or payable is 13 If the company/trust intends to buy back shares/units if conditions are
A$500 million. The Company reserves the right to suspend or terminate met - those conditions:
the buy-back at any time. N/A.
Employee share scheme buy-back
14 Number of shares proposed to be bought back: 15 Price to be offered for shares:
N/A. N/A.
Selective buy-back
16 Name of person or description of class of person whose shares are 18 Price to be offered for shares:
proposed to be bought back: N/A.
N/A.
17 Number of shares proposed to be bought back:
N/A.
Equal access scheme
19 Percentage of shares proposed to be bought back: 21 Price to be offered for shares:
N/A. N/A.
20 Total number of shares proposed to be bought back if all offers are 22 Record date for participation in offer:
accepted: Cross reference: Appendix 7A, clause 9.
N/A. N/A.
Compliance statement
1 The company is in compliance with all Corporations Act requirements relevant to this buy-back.
or, for trusts only:
1 The trust is in compliance with all requirements of the Corporations Act as modified by Class Order 07/422, and of the trust’s constitution, relevant to this
buy-back.
2 There is no information that the listing rules require to be disclosed that has not already been disclosed, or is not contained in, or attached to, this form.

Sign here: __________________________ Date: _____________

(Director/Company secretary)
Print name:

EXHIBIT CSL’s 2017 share buyback notice to the Australian Securities Exchange
11.1

Source: CSL Limited 2007 Notice of buy-back.

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202 ACCT3 Financial
 ANALYSIS Company M approved the buyback on 1 May
Look at CSL’s Statement of 2017, on the terms anticipated in its earlier letter to
changes in equity in Appendix B. How much was spent shareholders.
on share buybacks in 2016 and 2017? Where else in the The market value of Company M shares at the
Annual Report is the share buyback disclosed? How about time of the buyback (if the buyback didn’t occur and
CSL’s own shares and not shares in other companies? was never proposed) is $10.20.
Ranjini received a cheque for $9600 (1000 shares ×
Analysis:
$9.60) on 8 June 2017.
In 2016 CSL spent $670 million and in 2017 $334 million.
Because it was an off-market share buyback and
This resulted in the negative Contributed Equity
the buyback price was less than what the market
decreasing even further from ($3560.4) million at the
value of the share would have been if the buyback
beginning of the 2016 financial year to ($4534.3) million at
hadn’t occurred, Ranjini works out her capital gain for
the end of the 2017 financial year.
the 2016–17 year as follows.
In the statement of cash flows, financing activities
(discussed in Chapter 1 and in more detail in the Chapter
12) ‘payment for shares bought back’ is reported. The Capital proceeds
amounts are not identical because the statement of Calculations Per For 1000
changes in equity is prepared on an accrual basis, while share shares
the statement of cash flows is obviously cash. Market value $10.20 $10 200
For the keen reader, Note 12 explains the share
buyback reserve is negative because buybacks are Dividend 1.40 1 400
undertaken at higher prices than the original subscription Market value minus dividend 8.80 8 800
prices.
less cost base 6.00 6 000
The entry decreases Contributed Equity and
decreases Cash for the $32 000 paid to acquire the Capital gain (before applying any discount) 2.80 2 800
shares. Notice that Contributed Equity is decreased with
a debit. As a result of this entry, both assets and equity Ranjini takes her capital gain into account in
decrease. Buybacks are usually made from contributed completing Item 18 on her tax return. She also
equity, but for taxation reasons frequently much of an includes her dividend.
off-market share buyback is nominated as dividend,
which carries franking credits. In these cases it is likely In 2016 when Telstra conducted its off-market buyback,
Retained Earnings would also need to be debited. But
the buyback price was $4.43 per share (a 14% discount to
again, this is a reduction in equity and does not appear
on the income statement. The accounting standard the market price), of which $1.78 per share was the capital
AASB 101 Presentation of Financial Statements requires component and $2.65 the dividend component (fully
share buybacks to be reported in the statement of franked). The buyback was less than 3 per cent of Telstra’s
changes in equity. issued capital. Demand was so great that the highest
discount was applied, and Telstra also needed to scale back
the buyback for those YT
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MAKING IT REAL offering to sell more than Download the Enrichment
880 shares. Modules for further practice
SHARE BUYBACKS
The reference below from the Australian Taxation
Office (ATO) website emphasises the importance of
the tax implications of share buybacks. Buybacks often LO6  VALUATING A COMPANY’S
E
appeal to limited groups of shareholders who can take
advantage of the significant proportion of the buyback
MANAGEMENT OF EQUITY
price being classified as a dividend (with the resulting
dividend imputation credit) and the corresponding Because a company’s equity represents the owners’ claim
smaller capital gain (or larger capital loss). on company assets, shareholders are particularly interested
ATO Example: Off-market buyback including in a company’s ability to manage its equity. Some of the
dividend3 issues that are important to most shareholders are as follows:
Ranjini bought 10 000 shares in Company M in January 1 How does the company generate wealth for shareholders?
2003 at a cost of $6 per share, including brokerage.
2 How does the company reward its shareholders
In January 2017, the company wrote to its
shareholders advising them it was offering to buy through dividends?
back 10 per cent of their shares for $9.60 each. The 3 How does the company’s equity affect its cash flows?
buyback price was to include a franked dividend of The following sections examine these three issues for
$1.40 per share (and each dividend was to carry a a hypothetical biotechnology company. The examination
franking credit of 60c). requires information from all four of the company’s financial
Ranjini applied to participate in the buyback
statements. The required information is found in
to sell 1000 of her shares.
Exhibit 11.2, excerpted from the company’s 2020 annual
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 11 Shareholders’ equity 203
 Source Account 2020 2019
Balance sheet Total Assets $ 2 241 $ 1 931
Total Equity 1 287 1 110
Total Comprehensive Income 216 204
Income statement Earnings per Share 2.18 2.06
Cash Dividends Declared 40 33
Statement of changes in equity Dividends per Share 0.40 0.33
Ordinary Shares Issued 99 99
EXHIBIT Account balances from a biotechnology company’s 2020 annual report
11.2

report. All amounts are rounded to the closest million The horizontal analysis reveals that total equity increased
except the per-share data. by $177 million during 2020, which is an increase of
15.9 per cent from the prior year. The vertical analysis
HORIZONTAL AND VERTICAL ANALYSES shows that total equity as a percentage of total assets was
stable at a little over 57 per cent in each year. So, while total
A good place to start the analysis of shareholders’ equity
equity increased, it stayed the same when compared to
is horizontal and vertical analyses. Recall from Chapter 2
assets. Although not reported here, a closer look at specific
that horizontal analysis calculates the dollar change in an
equity accounts would reveal whether the increase in
account balance, defined as the current-year balance less
equity was due to an increase in retained earnings or
the prior-year balance, and divides that change by the prior-
contributed equity.
year balance to yield the percentage change. Vertical
analysis divides each account balance by a base account,
yielding a percentage. The base account is total assets for EARNINGS PER SHARE
balance sheet accounts and net sales or total revenues for The preceding analysis did not show if the biotech’s total
income statement accounts. These calculations are equity grew due to issuing new shares or to profitable
summarised as follows: operations. Shareholders want greater claims on assets
resulting from profitable operations. Another measure of
KEY FORMULA 11.1 HORIZONTAL ANALYSIS the ability to generate equity through profitable operations
Dollar Change in Current-year is earnings per share (EPS). Calculating
= – Prior-year Balance earnings per share
Account Balance Balance EPS is technical; so technical in fact that (EPS)  A comparison of
Percentage Change Dollar Change an accounting standard AASB 133 a company’s total
= comprehensive income to
in Account Balance Prior-year Balance Earnings per Share has been issued and the number of ordinary
requires Australian companies to report shares issued that
measures the ability to
‘basic’ and ‘diluted’ EPS. This is more generate wealth through
KEY FORMULA 11.2 VERTICAL ANALYSIS
complex than we need at this level and profitable operations.
For the For the income we will stay with a simple calculation.
balance sheet statement
EPS compares a company’s total comprehensive income
Account Balance Account Balance
Percentage = or to the number of ordinary shares issued. It is calculated
Total Assets Net Sales or Revenue
as follows:

Given the biotech’s financial data in Exhibit 11.2, KEY FORMULA 11.3 EARNINGS PER SHARE
horizontal and vertical analyses result in the following:
Earnings Total Comprehensive Income
=
per Share Average Number of Ordinary Shares Issued
Horizontal analysis
Change Percentage change
Where average ordinary shares issued is:
1 287
177 = 15.9%
Total equity –1 110 KEY FORMULA 11.4 A
 VERAGE ORDINARY SHARES
1 110
177 OUTSTANDING
Vertical analysis
Beginning Shares Outstanding + Ending shares Issued
2
 1 287  = 57.4%  1 110  = 57.5%
Total equity
 2 241  1 931

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
204 ACCT3 Financial
 Earnings per share is a useful ratio because it 18 cents of additional wealth through profitable operations.
‘standardises’ earnings for a company, but because each How does this compare to other biotechs?
company has a different number of issued shares it cannot
be used to compare different companies, only the same DIVIDEND PAYOUT RATIO
company over time. The percentage change in the ratio can
In addition to examining how well a company generates
be used to compare the relative change in profitability of
additional equity, shareholders often examine how a
companies of vastly different sizes.
company pays out that equity through dividends. One ratio
The biotech’s earnings per share is calculated as follows
to do this is the dividend payout ratio.
using the information in Exhibit 11.2:
The dividend payout ratio dividend payout
216 compares a company’s dividends to its ratio  A comparison of a
= 2.18
(99 + 99) ÷ 2 earnings. The ratio demonstrates the company’s dividends to its
earnings that measures
The 2.18 ratio reveals that the biotech earned $2.18 in percentage of earnings a company has the percentage of current
profit for every ordinary share issued. Is this an improvement decided to distribute to owners through earnings distributed to
owners.
over the previous years? For a company like BHP or the cash dividends. The dividend payout ratio
Commonwealth Bank earning billions of dollars a year, it is is calculated by dividing total dividends by total
difficult for a shareholder to comprehend. But converting comprehensive income, or by dividing dividend per share
that to an EPS of $2 or $3 makes it easy to understand. As by earnings per share. Either way, the result will be the
a holder of a small number of shares you can easily see if same (except for small differences due to the rounding of
the company is earning more or less each year for you. per share values). Both calculations are as follows:
Telstra had earnings (total comprehensive income) in 2017
of around $4 billion and an EPS of 33 cents while CSL’s KEY FORMULA 11.7 DIVIDEND PAYOUT RATIO
earnings of around $2 billion and an EPS of $3.81, reflecting Dividend Payout Ratio =
the number of shares issued. Dividend Dividend per Share
Total Comprehensive Income or Earning per Share
RETURN ON EQUITY
Another measure of a company’s ability to generate wealth Most companies report both total and per share
is return on equity. Return on equity earnings on their income statement, total dividends on
return on equity  A
comparison of a company’s c o m p a r e s a c o m p a ny ’s t o t a l their statement of changes in equity and per-share
net income to average dividends in the notes to the financial statements. These
shareholders’ equity that
comprehensive income to its average
measures the ability to use shareholders’ equity and provides an amounts are included in Exhibit 11.2 and are used to
existing equity to generate indication of how well a company uses calculate the biotech’s dividend payout ratio as follows:
additional equity.
its existing equity to generate additional Calculation based on totals:
equity. Shareholders naturally want this ratio to be as high 39
= 18.1%
as possible. It is calculated as follows: 216
Calculation based on per share amounts:
KEY FORMULA 11.5 RETURN ON EQUITY
0.40
Total Comprehensive Income = 18.3%
Return on equity = 2.18
Average Shareholders’ Equity
A ratio of 18.3 per cent (or 18.1 per cent – the difference
due to rounding) indicates that for every dollar of earnings
Where average shareholders’ equity is: during 2020, the biotech declared about 18 cents in cash
dividends. But is an 18.3 per cent ratio better or worse than
KEY FORMULA 11.6 AVERAGE EQUITY
a competitor with a 93.8 per cent ratio? The ratios simply
Average Equity =
Beginning Equity + Ending Equity reflect each company’s dividend policy. For 2020, the biotech
2 paid out more of its earnings than its competitor. Thus,
shareholders who want to receive more of the profits in
The biotech’s return on equity is calculated as follows dividends would prefer a higher ratio. However, shareholders
from the information in Exhibit 11.2: who want the company to plough more earnings back into
operations instead of paying more dividends would prefer
216
= 18.0% a low payout ratio. The problem some companies face when
(1287 + 1110)/2)
earnings fall and/or they wish to maintain an increasing
The 18.0 per cent ratio indicates that for every dollar of
dividend is that the payout ratio rises.
equity held during 2020, the biotech generated almost

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 11 Shareholders’ equity 205
 ANALYSIS 5 Dividend yield
Using CSL’s information in
$1.32 / $110 = 1.2%
Appendix B, calculate and interpret:
1 horizontal and vertical analyses of total equity The 1.2 per cent dividend yield implies CSL shareholders
2 earnings per share are not chasing dividends. Telstra had a dividend yield of
7.2 per cent and CommBank was 5.1 per cent in 2017.
3 return on equity
But remember a shareholder’s return is made up of
4 dividend payout ratio dividends and capital gains or losses (increases or
5 dividend yield, assuming a market price of $110 on decreases in share price). If you look at CSL’s share price
30 June 2016. between the end of June 2016 and the end of June 2017,
We can round to the closest $ million as the difference it rose from $110 to $138. CSL was a much better
is not material. investment than the dividend yield alone may indicate.
Analysis: This is even better if you consider the best interest rate
was less than 3 per cent during this period. While
1 Horizontal analysis
dividends are often stable, no one knows what share
($3164 – $2567) / $2567 = 23.4% prices will be in the future and there is the potential to
make a substantial loss on shares. This is why share
Vertical analysis
investment is considered higher risk than bank deposits.
$3164 / $9123= 34.7%
The 23.4 per cent horizontal analysis reflects an increase
in CSL’s total equity, mainly in retained earnings. The 34.7 DIVIDEND YIELD
per cent vertical analysis shows that a little over one-third In addition to knowing what percentage of earnings is
of the company’s assets are financed through equity.
paid in dividends, shareholders want to know how much
2 Earnings per share
their investment in a company returns to them. Shareholders
$1337 / 4455 = $2.94 generate a return on their investment in two ways: an
Relying on Note 10 and using Net profits for the period increase in the share price and a receipt of dividends. The
the $2.94 earnings per share indicates that CSL earned return from receiving dividends can be
dividend yield ratio 
$2.94 for each issued share. This ratio is higher than the calculated with the dividend yield ratio. A comparison of dividends
previous year ($2.69) due to both an increase in net The dividend yield ratio divides per share to the market
profits (+$95m) and a reduction in average issued shares price per share that
dividends per share by the market price measures the percentage
(–7m). EPS information is given at the bottom of the
income statement (as per AASB 133) and the detail given (at the beginning of the period) per share return from dividends.
in Note 10. The observant student will note that the CSL as follows:
and above calculation is based on Net profits. If total
comprehensive income is used, EPS is $3.32, but the KEY FORMULA 11.8 DIVIDEND YIELD
difference is more impressive when compared to the
comprehensive income EPS calculation from the previous Dividends per Share
Dividend yield =
year of $2.26, a substantial 47 per cent increase on 2016 Market Price per Share
(9% increase in EPS based on net profits).
3 Return on equity According to Exhibit 11.2, the biotech reports dividends
$1510 / ($3164 + $2567) / 2 = 52.7% per share of 40 cents on its 2020 statement of changes in
The 52.7 per cent return on equity ratio indicates that equity. We will use a share price of $10, which is the closing
CSL earned almost 53 cents in total comprehensive price on the last day of the previous financial year (30 June
income after tax for every $1 of total equity. Such a return 2020). As a result, the dividend yield reveals the return to
gives the company many options. One option is to pay a shareholder who bought the shares at the beginning of
dividends to the owners, a second to buy back shares, the financial year.
while another is to retain the profits and grow the
company. CSL does all three. 0.40
= 4%
4 Dividend payout ratio 10.00
The 4 per cent ratio indicates that an investment in the
$601 / $1510 = 39.8%  or  $1.32 /$3.322.09 = 39.8%
biotech on 30 June 2019 would yield a return from dividends
The almost 40 per cent dividend payout ratio indicates equal to 4 cents for each dollar invested. This may be
that CSL paid to owners 40 cents for every dollar after considered a high dividend yield for a biotechnology company
tax it earned during the year. We can use either the total
which is likely to be reinvesting earnings in research and
numbers or the per-share numbers; they provide the
same approximate 40 per cent. It should be noted CSL development. If these dividends were fully franked (they
provided an additional ‘return’ to shareholders have the benefit of dividend imputation), they would have a
through its $315 million share buyback. before-tax return for the investor of almost 6 per cent.

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206 ACCT3 Financial
SHAREHOLDERS’ EQUITY AND CASH FLOWS
ANALYSIS
When examining a company’s equity, it is always important Look at CSL’s statement of cash
to analyse how equity has been used to generate or use flows in Appendix B. How much cash has the company
cash. Equity can significantly affect a company’s cash paid in dividends and for the repurchase of shares over
the past two years? How much has the DRP saved the
through the issuance of shares, the buyback of shares and
company in cash outflows?
the payment of cash dividends. Each of these activities is
Analysis:
reported in the financing activities section of the statement
According to the financing activities section of CSL’s
of cash flows. statement of cash flows, it paid $601 million in dividends
In addition to examining the statement of cash flows, in 2017 and $579 million in 2016. It repurchased $315
it can be beneficial to examine the notes to the financial million shares in 2017 and $648 million in 2016. CSL does
statements to find additional information with cash flow not have a DRP.
consequences.
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CHAPTER 11 Shareholders’ equity 207
 LO2
5 Recording forfeiture and reissue of shares
EXERCISES Given the information in Question 4, assume when the call
was made a shareholder of 2000 shares did not pay the call.
In accordance with the prospectus the shareholder forfeited
the shares and the company reissued the shares at a
20 cent per share discount.
REQUIRED
LO1
1 Corporate form of business Prepare the journal entries to record that the call money was
How does each of the following characteristics relate to the not received the forfeiture of the shares and the reissue of
corporate form of business? the 2000 shares.
a formation/registration
LO2, 5
b separate legal entity 6 Share terminologies
c liability of owners The shareholders’ equity section of Ma Company’s balance
d ability to raise capital sheet follows:
e transferability of ownership Equity
f taxation Contributed equity $4 020 000
g regulation. Retained equity 1 425 000
LO2 Total shareholders’ equity 5 445 000
2 Recording ordinary shares
Steggles Limited issued 4000 shares for $10 per share on
1 March and 7500 shares for $5 per share on 1 June. Note 11 Contributed equity

REQUIRED Number of ordinary shares 450 000

Prepare the journal entries to record the share issue. REQUIRED
a How many ordinary shares are issued?
LO2, 4, 5
3 Recording share transactions b How much in total equity has Ma received from the
Lucy Limited registered her company on 1 April and entered issue of shares?
into the following equity transactions: c What was the opening balance in retained earnings if
5 Apr. Issued 30 000 ordinary shares for $180 000. during the year Ma had total comprehensive income of
31 May Purchased 1000 shares in a buyback for $50 000. $1 191 000 and declared dividends of $666 000?
1 Oct. Issued 3000 preference shares for $65 per share.
LO3
31 Dec. Paid a $1 dividend on all shares. 7 Cash dividends
On 15 December Taylor Limited declared a cash dividend of
REQUIRED
$1.5477 per share to be paid on 15 January to shareholders
Prepare the journal entries to record the transactions. of record on 31 December. Taylor has 77 million ordinary
shares issued.
LO2
4 Recording share transactions, instalments
REQUIRED
Gross Limited released a prospectus seeking 100 000 ordinary
Identify the date of declaration, the date of record and the
shares. The prospectus required investors to pay 80 cents on
payment date. Prepare journal entries on those dates as
application, 70 cents on allotment and a call of 60 cents.
appropriate. Explain why no journal entry is required on one
Applications for 100 000 shares were received on 1 July and
of the dates.
the shares were allotted on 2 August. The allotment money
was received on 3 September. A call was made on 4 October LO3, 4
and the call money was received on 5 November. 8 Cash dividends
Chen Company declares a $90 000 dividend. Chen has
REQUIRED
80 000 ordinary shares issued. Chen’s 20 000 preference
a Prepare the journal entries to record the above transactions. shares are cumulative, 5 per cent and had a $12 per share
b Assume the above information, except on 1 July issue price. Chen has not paid dividends in the past three
applications were received for 123 000 shares. The years.
prospectus allowed Gross to reject any application the
company deemed inappropriate and to scale back other REQUIRED
applications and apply the excess application money to a Determine how the $90 000 in dividends should be
allotment. Gross rejected applications for 13 000 shares, allocated to preference and ordinary shareholders.
refunding the money to the applicants, and scaled back b Prepare the journal entry that would be recorded on the
one application for 30 000 shares to 20 000 shares, declaration date.
applying the excess application money to allotment. c Determine how the $90 000 in dividends should be
c Prepare the journal entries to record the receipt of the allocated to preference and ordinary shareholders,
application money, the refund, the issue of shares and the assuming that the preference shares are non-cumulative.
receipt of the allotment money for the above transactions.
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
208 ACCT3 Financial
 LO3 LO6
9 Share dividends 13 Evaluate equity
Maxfield Manufacturing declared a share dividend of The following is selected financial information for Lee Ltd:
$1.50 per share on 1 July to be distributed on 1 August to
shareholders of record on 15 July. On 1 July, Maxfield has (in millions) 2020 2019
250 000 issued and paid-up ordinary shares. Maxfield’s Average ordinary shareholders’ equity $3 430.5 $2 921.6
shares are trading at $15 per share on 1 July. Dividends declared on ordinary shares  125.5  104.3
REQUIRED Total comprehensive income after tax  775.9  691.4
a Prepare all necessary journal entries to record the share
dividend. REQUIRED
b Show your calculations in determining how many shares a Calculate the return on equity for Lee for 2020 and 2019.
would the holder of 1000 shares expect to receive in the b Calculate the dividend payout ratio for both years.
share dividend? c Compare the financial performance for the two years
and comment on which year was more successful based
LO3
10 Share dividends versus share splits on these measures and possible reasons why.
Chan Limited is looking to increase its number of issued
LO6
shares to bring down its current share price of $11. The 14 Evaluate equity
board of directors is trying to decide if a 2-for-1 share split or Laura Limited is trying to calculate different financial
a 100 per cent (or one-for-one) share dividend is more measures to analyse its performance. The total
appropriate. Chan’s equity is as follows (all figures in comprehensive income for the year was $80 million. There
millions): are 150 million shares issued.

Contributed equity (430 000 shares) $  860 000 REQUIRED

Retained earnings   7 775 000 a Calculate earnings per share (EPS) for the year.
b What does the EPS indicate about the company’s
Total shareholders’ equity $8 635 000
financial performance? What could the EPS be compared
REQUIRED to, what could it not be compared to? Why?
a Assess the advantages and disadvantages of the share c What might the company do to improve this financial
split versus the share dividend. measure?
b Create a new equity section based on Chan choosing LO6
(i) a share dividend or (ii) a share split. 15 Evaluate equity
The following is from the financial statements of Bond
11 Preference shares and preference LO4 Boomerangs from the last two years:
dividends
2021 2020
The shareholders’ equity section of Restaurant Electronics
Limited’s balance sheet shows: Total assets $1 685 $1 730
Total liabilities  900  875
Ordinary shares (190 000 shares issued) $1 440 000
Total shareholders’ equity  785  855
Preference shares (cumulative, 28c 600 000
annual dividend, 150 000 shares issued) REQUIRED
Conduct a horizontal analysis, and vertical analysis for both
The company paid dividends up to and including 2018,
years.
but no dividends in 2019.
LO6
REQUIRED 16 Evaluate equity
a Calculate the dividend on the ordinary and preference Beatson Boutiques provided the following information from
shares in 2020 if total dividends are $559 000. its financial statements:
b Prepare the journal entry to record the above dividend
Total comprehensive income $164 500
transactions if the dividends were declared on 8/8/20
and paid on 10/10/20. Average number of ordinary shares 235 000
Average shareholders’ equity 576 000
LO5
12 Share buyback
REQUIRED
On 15 January, Capital Company purchased on market
10 000 shares of its own ordinary shares when the shares Calculate the earnings per share and return on equity for
were trading at $45. Beatson Boutiques. How are the two profitability ratios
different?
REQUIRED
Prepare the journal entry to record the share buyback.

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CHAPTER 11 Shareholders’ equity 209
 1 May All allotment money due was received.
1 June The call was made for the remaining
PROBLEMS outstanding money.
1 July All call money except that owing on 40 000
shares was received.
1 August The shareholders who did not pay their call
had their shares forfeited.
LO2, 3, 5, 6
1 September The forfeited shares were reissued at a
17 Recording and reporting equity 5 cent per share discount.
Czernkowski Company had the following balances in its REQUIRED
shareholders’ equity at 1 January:
Prepare the journal entries to record the above transactions.
Contributed equity (450 0000 $2 100 000
LO6
ordinary shares) 19 Evaluating equity
Retained earnings 2 225 000 The following are financial measures from the financial
statements of Browning Brothers for the past two years:
During the year, Czernkowski had the following transactions:
1 Mar. Issued 200 000 ordinary shares for cash at $8 per This year Last year
share. Total assets $4 255 350 $3 895 700
1 Jul. Declared a 1 for 10 share dividend, payable
Total liabilities 2 050 150   1 980 300
1 August. The shares were trading at $7 per
share on 1 July. Total shareholders’ equity 2 205 200   1 915 400
15 Aug. Declared a 50 cent per share cash dividend of
REQUIRED
record on 1 September, payable 15 September.
a Conduct a horizontal analysis of Browning Brothers.
1 Oct. Bought back 6000 ordinary shares for $45 000.
Comment on your findings and possible reasons for
31 Dec. Revenue for the year $1 620 000, expenses for these findings.
the year $1 100  000.
b Conduct a vertical analysis for both years for Browning
REQUIRED Brothers. Compare and briefly interpret the results of the
a Prepare the journal entries to record the transactions. two years.
b Prepare Czernkowski’s 31 December shareholders’
LO6
equity section of the balance sheet. 20 Evaluating equity
c Calculate earnings per share for the year. Olson Outlet is trying to determine if its equity is
comparable to other outlets in the area.
LO2, 3
18 Issuing shares: instalments, 2021 2020
oversubscription, forfeiture and reissue
Total assets $1 374 000 $1 506 000
The following information is available for Liu Limited for 2019:
Total liabilities 588 000 732 000
1 January Liu Limited was registered as a new
company. Total equity 786 000 774 000
1 February A prospectus was issued inviting Total comprehensive income 198 500
applications for 900 000 ordinary shares at Average number of ordinary 266 000
$1 per share. The prospectus specified   shares issued
50 cents payable on application, 30 cents
Average equity 780 000
on allotment and the 20 cents balance
when called. Market price of shares 21
1 March Applications were received for 1 400 000 Total dividends 59 000
shares.
Dividends per share 0.25
1 April Directors accepted applications for 700 000
shares and allocated those shares. As per REQUIRED
the provision of the prospectus, applications a Conduct horizontal and vertical analyses for Olson.
for 300 000 shares were scaled back and
b Calculate the earnings per share and return on equity.
allocated 200 000 shares (with the excess
application money applied to allotment) and c Calculate the dividend payout ratio and the dividend
the directors rejected applications for yield.
400 000 shares and refunded the money to
the applicants.

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210 ACCT3 Financial
 from recycling wooden fences, is growing, and Lara is
exploring the idea of purchasing a brand-new manufacturing
CASES facility. Because she does not have the money to do so, she
believes her options are to borrow the money or to convert
the business to a corporation and sell shares.
REQUIRED
Describe the alternatives available to Lara. Which alternative
would you consider best? Make sure to explain the
LO2, 3, 5, 6
21 Research and analysis advantages and disadvantages of the course of action that
Access the latest annual report for a public company of your you recommend.
lecturer’s choosing.
LO1, 4
REQUIRED 23 Ordinary or preference shares,
investors’ perspective
a Examine the company’s balance sheet and conduct
horizontal and vertical analyses of the company’s total A friend has emailed you to ask for some investing advice.
(shareholders’) equity. She is considering buying shares in a certain company and is
b Calculate the company’s return on equity ratio. Using the trying to determine whether she wants to invest in the
dividend and price data from the ASX website (or a financial company’s ordinary or preference shares.
services website), calculate the company’s dividend yield, REQUIRED
assuming that an investor purchased the shares on the last Draft an email to your friend explaining the similarities and
day of the previous financial year. differences between ordinary and preference shares. Include
c Examine the company’s statement of retained earnings reasons why you feel one might be preferable.
and determine the value of share dividends declared
during the financial year. 24 Ethics
d Examine the financing activities section of the company’s
Explain the advantages and disadvantages of investing
cash flow statement. How would you characterise the
(buying shares, becoming a shareholder) in companies.
company’s activity over the past two years?
Beyond seeking financial return, what other matters might
e Based on your answers above, write a paragraph you consider when choosing companies to invest in?
explaining your opinion of the company’s position. Use
your answers as supporting facts.

LO1, 2
22 Raising the money to expand
a business
Lara Steele is an entrepreneur and owner of ‘Wood by
Steele’, a sole proprietorship. The business, which
manufactures tables, chairs, cabinets and other furniture

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CHAPTER 11 Shareholders’ equity 211
 12
As discussed in Chapter 1, the statement of cash flows
provides information on how a company generates and
distributes cash over a period of time. This chapter
examines the purpose and format of the statement of cash
flows and demonstrates how the statement is prepared.
Emphasis is given to the two approaches to preparing the
operating section. The chapter concludes with an analysis
of how to use the statement to generate useful information
about a company and its cash. Guidance is provided by
AASB 107 Statement of Cash Flows.

Statement of cash flows

LO1 THE STATEMENT OF
CASH FLOWS
LEARNING
One of the most important resources of any company is
OBJECTIVES
cash. If a company cannot generate sufficient cash, its
ability to continue operations is significantly limited. As a
result, management, investors and creditors want to know
After studying the material in this chapter, you how a company is managing its cash. How does the
should be able to: company spend its cash? How does it generate cash?
1 Describe the purpose and format of the What are the prospects of the company paying a cash
statement of cash flows. dividend? Will the company be able to satisfy its upcoming
interest and loan obligations? Does the company have
2 Understand the process of preparing the
enough cash to expand its research facilities? Answers to
statement of cash flows.
these and other questions can be found through an
3 Prepare the operating activities section of examination of the statement of cash flows.
the statement of cash flows using the The statement of cash flows is a statement of cash
direct method. financial statement that summarises a flows  A financial
4 Prepare the operating activities section of company’s inflows and outflows of cash statement that summarises
a company’s inflows and
the statement of cash flows using the over a period of time. Its purpose is to outflows of cash over a
indirect method. inform users on how and why a company’s period of time with a
purpose to inform users on
5 Outline the investing activities section of the cash changed during the period. So that it how and why a company’s
statement of cash flows. is as informative as possible, the cash changed during the
period.
statement groups and reports cash flows
6 Summarise the financing activities section
in three major categories: operating, investing and
of the statement of cash flows.
financing. Cash flows from each of the three categories are
7 Evaluate the statement of cash flows then combined to determine the company’s net change in
through the calculation and interpretation of cash and cash equivalents. This net change will be equal to
ratio analyses. the difference between the beginning and ending cash and
cash equivalents balances from the balance sheet
(statement of financial position). Note that from this point
forward, the term cash will be used to represent cash and
cash equivalents.
Express The basic structure of the statement of cash flows is
YT
Throughout this PPL HIS as follows:
A

chapter apply this

icons indicate + / – Cash Flows Provided (Used) by Operating Activities
an opportunity + / – Cash Flows Provided (Used) by Investing Activities
for online
self-study through + / – Cash Flows Provided (Used) by Financing Activities
CourseMate Express, = Net Increase (Decrease) in Cash
linking you to revision
quizzes, e-lectures, + Cash, Beginning of Year
animations and more. = Cash, End of Year
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212
 Operating cash flows are reported first on the statement
of cash flows. Like most companies, CSL reports operating
cash flows using the direct method. AASB 107 allows the
indirect method but encourages entities ‘to report cash
flows from operating activities using the direct method’.1
The indirect method calculates operating cash flows by
adjusting profit or loss from an accrual basis to a cash basis.
This calculation will be demonstrated later. In Australia
when reporting entities use the direct method they are
required to disclose a reconciliation of cash flows from
operating activities to profit or loss, which is similar to the
calculation of cash flows from operations used for the
indirect method. CSL’s reconciliation is in Note 14,
reproduced in Exhibit 12.2.

CASH FLOWS FROM INVESTING ACTIVITIES

Cash flows provided (used) by cash flows provided
One of the keys to success for a company like CSL is investing activities are those cash (used) by investing
to convert its products (medicines) into cash activities  Cash inflows
inflows and outflows arising from the and outflows arising from
acquisition and disposal of non-current the acquisition and
The following sections discuss the three groupings disposal of non-current
of cash flows. For illustration purposes, Exhibit 12.1 assets. They are often called investing assets; often called
contains CSL’s statement of cash flows for the year cash flows and would include the investing cash flows.
YT
PPL HIS ending 30 June 2017. All following:
A

Check out the video summary dollar amounts are in US ● cash inflows from the sale of property, plant, equipment
for Chapter 12 or investments
millions.
● cash outflows for the purchase of property, plant,
CASH FLOWS FROM OPERATING ACTIVITIES equipment or investments.
Investing cash flows are reported after operating
Cash flows provided (used) by
cash flows provided
activities. Exhibit 12.1 reveals CSL had net cash outflows
operating activities are those cash
(used) by operating from investing activities of $862.9 million in 2017. The main
activities  Cash inflows inflows and outflows arising from the
contributor to that total in both years was payments for
and outflows arising from company’s operations. These inflows and
the company’s operations; property, plant and equipment (PPE).
sometimes called operating outflows are sometimes called operating
cash flows. cash flows and would include the
CASH FLOWS FROM FINANCING ACTIVITIES
following:
● cash inflows from collection of receivables and cash Cash flows provided (used) by cash flows provided
financing activities are those cash (used) by financing
sales or services activities  Cash inflows
● cash outflows for operating items such as payments to inflows and outflows associated with the and outflows associated
creditors, salaries and rent paid and tax paid. generation and return of capital. These are with the generation and
return of capital; often
Basically, any cash flow associated with a company’s often called financing cash flows and called financing cash flows.
revenues or expenses should be considered an operating would include the following:
cash flow. Because of this, the net cash flow from ● cash inflows from borrowings or share issues
operating activities can be thought of as net profit or loss ● cash outflows to satisfy debt obligations or to
on a cash basis. CSL in 2017 reports a ‘Net cash inflow repurchase shares
from operating activity’ of $1246.6 million, up over 5 per ● cash outflows for dividends to shareholders.
cent on 2016. Basically, any cash flows associated with non-current
liabilities or equity (other than interest payments) are
considered to be financing cash flows.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 12 Statement of cash flows 213
 CONSOLIDATED STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED 30 JUNE 2017

Consolidated Entity
2017 2016
US$m US$m

Cash flows from Operating Activities

Receipts from customers (inclusive of goods and services tax) 6,749.2 5,982.7
Payments to suppliers and employees (inclusive of goods and services tax) (4,946.9) (4,417.0)
1,802.3 1,565.7
Income taxes paid (468.3) (326.2)
Interest received 6.7 14.1
Borrowing costs (94.1) (75.0)
Net cash inflow from operating activities 1,246.6 1,178.6
Cash flows from Investing Activities
Proceeds from sale of property, plant and equipment 0.1 0.1
Payments for property, plant and equipment (689.1) (495.1)
Payments for intangible assets (171.5) (70.6)
Payments for business acquisition (Net of cash acquired) - (244.6)
(Payments)/receipts from other financial assets (2.4) 0.1
Net cash outflow from investing activities (862.9) (810.1)
Cash flows from Financing Activities
Proceeds from issue of shares 12.7 17.4
Dividends paid (601.4) (579.0)
Proceeds from borrowings 1,381.4 1,564.3
Repayment of borrowings (581.3) (716.9)
Payment for shares bought back (314.9) (648.2)
Net cash outflow from financing activities (103.5) (362.4)
Net increase in cash and cash equivalents 280.2 6.1
Cash and cash equivalents at the beginning of the financial year 555.3 555.5
Exchange rate variations on foreign cash and cash equivalent balances 7.5 (6.3)
Cash and cash equivalents at the end of the financial year 843.0 555.3

The consolidated statement of cash flows should be read in conjunction with the accompanying notes.

EXHIBIT CSL’s Statement of cash flows 2017

12.1

Source: CSL Limited, Annual Report 2017, p. 84.

Financing cash flows are reported after investing cash NET INCREASE (DECREASE) IN CASH
flows. Exhibit 12.1 reveals CSL had net cash outflows
After a company reports its operating, investing and
from financing activities in 2017 of $103.5 million, due to
financing cash flows, it sums the three and reconciles the
dividends paid, repayment of borrowings and payments
company’s beginning and ending cash balances. The
for shares bought back. In both 2017 and 2016 CSL
following is a condensed version of CSL’s Statement of
borrowed around $1.5 billion but repaid almost half the
cash flows, showing only the major subtotals:
borrowings.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
214 ACCT3 Financial
NOTES TO THE FINANCIAL STATEMENTS
FOR THE YEAR ENDED 30 JUNE 2017 CONTINUED

EFFICIENCY OF OPERATION Cash,

Cash
Note 14: short
Cash and Cash Equivalents, Cash Flows other
2017 2016
US$m US$m • Ca
• At
Reconciliation of cash and cash equivalents
Cash at bank and on hand 562.7 442.0 • In
m
Cash deposits 281.8 114.6
to
Less bank overdrafts (1.5) (1.3) of
Total cash and cash equivalents 843.0 555.3
For th
Reconciliation of Profit after tax to Cash Flows from Operations the fin
Profit after tax 1,337.4 1,242.4 Cash
Non-cash items in profit after tax: of cas
Depreciation, amortisation and impairment charges 279.2 220.3 that a
prese
Loss on disposal of property, plant and equipment 8.7 2.3
Gain/(loss) on acquisition - (176.1)
Share-based payments expense 12.2 6.1
Changes in assets and liabilities:
Increase in trade and other receivables (72.5) (45.3)
Increase in inventories (389.2) (216.5)
(Increase)/decrease in retirement benefit assets (0.4) 2.3
Increase in net tax assets (111.0) (12.7)
Increase in trade and other payables 153.9 116.0
(Decrease)/increase in deferred government grants (0.6) 4.5
Increase in provisions 21.4 19.7
Increase in retirement benefit liabilities 7.5 15.6
Net cash inflow from operating activities 1,246.6 1,178.6

Non-cash financing activities

Acquisition of plant and equipment by means of finance leases 4.0 3.2

EXHIBIT CSL’s Reconciliation of Profit after tax to Cash Flows from Operations
12.2

Source: CSL Limited, Annual Report 2017, Note 14: Cash and Cash Equivalents, Cash Flows, p. 108.

108 CSL Limited Annual Report 2017 In 2017 CSL showed a substantial increase in cash. This
CSL’s condensed statement
of cash flows increase consisted of the sum of operating, investing and
2017 2016 financing cash flows. In the statement of cash flows the
$ 555.5 cash and cash equivalents are shown ‘net of bank overdraft’.
Cash and cash equivalents at the beginning $ 555.3
of the financial year In the balance sheet the cash figures are a little over one
Net cash provided by operating activities 1 246.6 1 178.6 million higher as we do not subtract the overdraft (part of
(810.1)
interest bearing current liabilities) from the current asset
Net cash used in investing activities (862.9)
cash.
Net cash used in financing activities (103.5) (362.4)
(6.3)
Exchange rate variation on foreign cash [not 7.5 ADDITIONAL DISCLOSURES
important]
Cash and cash equivalents at the end of the 843.0 555.3 All reporting entities prepare a statement of cash flows
financial year using a format similar to what has been described. In
CSL, Annual Report 2017, p. 84. addition, as required by AASB 107:

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CHAPTER 12 Statement of cash flows 215
 Investing and financing transactions that do not require
the use of cash or cash equivalents shall be excluded US operations to a private equity fund. The
from a statement of cash flows. Such transactions shall treasurer of ABC Learning at the time emailed the
be disclosed elsewhere in the financial statements in CFO, saying the Australian operations were hounding
a way that provides all the relevant information about him for money and he needed $20 million from its UK
these investing and financing activities.2 subsidiary held in a Scottish bank. There was a
In Note 14 CSL reports ‘non-cash financing activities problem because part of the money was held in trust
YT
PPL HIS – acquisition of plant and equipment for prepaid childcare. So desperate was the
Australian operation for cash, it negotiated that the
A

Review this content by means of finance leases’ of $4.0

with the e-lecture money be sent as a loan. The court was told the
million 2017, $3.2 million 2016. founder and Chief Executive Officer, Mr Groves,
began slowing payments to ABC’s creditors including
the Australian Taxation Office, ABC’s auditors,
lawyers and accountants.
LO2  REPARING THE
P
STATEMENT OF
is, they are prepared by rearranging numbers already
CASH FLOWS provided by the accounting system (trial balance).
The preparation of the statement of cash flows is different.
Chapter 4 discussed the preparation of the statement of
First, information is collected from a variety of sources.
comprehensive income, the statement of changes in
Second, preparing the statement requires an examination of
equity and the balance sheet. Each of these statements is
the changes in all non-cash accounts. To understand why,
prepared with numbers from an adjusted trial balance. That
consider the fundamental accounting equation:
Assets = Liabilities + Equity

Cash can be isolated by breaking it out from other

MAKING IT REAL assets to yield the following:
ABC LEARNING (OR NOT LEARNING) Cash + Non-Cash Assets = Liabilities + Equity
Companies cannot function without adequate cash.
Moving non-cash assets from the left side of the
Therefore, the statement of cash flows is of special
interest to stakeholders such as investors and equation to the right side then results in the following:
creditors who must determine if the company has the Cash = Liabilities + Equity – Non-Cash Assets
ability to continue operations. The statement of cash
flows informs financial statement users on how cash Using ∆ to denote a change, this equation can also be
was used and generated during a period. rewritten to show that the change in cash for a given period
is equal to the changes in all other non-cash accounts
Fairfax Syndication/Robert Rough

(liabilities, equity and non-cash assets):

∆ Cash = ∆ Liabilities + ∆ Equity – ∆ Non-Cash Assets

As a result, to explain a company’s change in cash, you

must explain the changes in the company’s non-cash
accounts. And to do that, you need the following three
items:
● a comparative balance sheet
● an income statement
● additional information on changes in account balances.
A comparative balance sheet provides the beginning
and ending balances of all accounts, but of interest now
Kindergarten accounting at ABC Learning
are the non-cash accounts, from which changes for the
period are calculated. A statement of comprehensive
During the April 2010 Federal Court public
examination of ABC Learning, which went into
income provides a company’s revenue and expense
receivership in November 2008, the court was told balances for the period. These balances are used to
that Goldman Sachs had warned the board in April prepare the operating activities section of the statement
2008 that without new funding ABC Learning would of cash flows. Additional information on changes in
run out of cash in two months. The cash was required account balances is needed to determine if a balance
for short-term cash flow requirements and to avoid
changed because of non-cash activity. For example, the
breaching loan agreements with its bankers. To raise
cash, ABC Learning urgently sold over half its issue of shares to satisfy a debt obligation changes both
equity and liability balances, but cash is not affected.
Knowledge of such significant non-cash transactions
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
216 ACCT3 Financial
 keeps one from erroneously concluding that the company will be used. Note that the Sunshine Company provides
received cash for the issue of shares and paid cash for the both a statement of comprehensive income and a
retirement of the debt. comparative balance sheet and that all numbers are in
millions, but for simplicity, references to the millions will
DIRECT AND INDIRECT METHODS FOR be omitted in the discussions. Additional information will
OPERATING CASH FLOWS be provided as needed.

When preparing the statement of cash flows, all companies The Sunshine Company
report cash flows from operating, investing and financing Income statement for year ended 30 June 2020
(in millions)
activities. The manner in which cash flows from investing
and financing activities are reported is the same for all Sales $432
companies. However, companies can report their cash Cost of goods sold  281
flows from operating activities using one of two methods: Gross profit $151
● the direct method Expenses:
● the indirect method.
Depreciation expense $25
Under the direct method, a company
direct method  Method Insurance expense 14
calculates and reports its cash inflows
of reporting cash flows from Salaries expense 63
operating activities in which from operations followed by its cash
cash inflows and outflows outflows for operations. Typically, Electricity expense  28  130
from operations are reported
separately on the statement cash inflows come from cash sales (or Profits before tax $ 21
of cash flows. cash received from services paid in cash) Income tax expense    8
and collections of accounts receivables, $  1
Gain on sale of equipment
but are often reported as one figure. Cash outflows are
Total comprehensive income $ 14
broken out into a few categories including cash payments
for: inventory, operating expenses, and interest and tax. The
difference between inflows and outflows is the company’s The Sunshine Company
net cash flow from operating activities. The method is called Comparative balance sheet as at 30 June 2020
‘direct’ because both inflows and outflows are shown 2020 2019
directly on the statement. Cash and cash equivalents $ 18 $ 45
Under the indirect method, a Accounts receivable 45 41
indirect company reports its cash flows from
method  Method of Inventory 101 92
reporting cash flows from operating activities by adjusting its net
operating activities in Prepaid insurance  11  15
income from an accrual basis to a cash
which net income is Total current assets $175 $193
adjusted from an accrual basis. The method is called ‘indirect’
basis to a cash basis. because it does not directly report cash Investments 22 0
inflows and cash outflows from Property and equipment, at cost 232 166
operations. Rather, it reports the adjustments necessary Less: Accumulated depreciation   (57)   (37)
to convert net income (profit or loss) to the net cash flow
Total assets $372 $322
from operating activities. Adjustments typically arise from
Accounts payable $ 37 $ 29
non-cash revenues and expenses (gains and losses) and/
or changes in current assets and current liabilities. Salaries payable 21 21
Both the indirect and direct methods will yield the same Electricity payable 27 22
net cash flows from operating activities. The only difference Taxes payable   0   7
between the methods is the manner in which cash flows Total current liabilities $ 85 $ 79
are reported. Because the Australian accounting standards   0
Non-current liabilities  45
require companies that use the direct method to also
Total liabilities $130 $ 79
disclose the reconciliation of cash flows from operations
Contributed equity $155 $165
to net profit, we concentrate on the indirect method, which
calculates cash flow from operations in the same way as Retained earnings  87  78
the reconciliation is prepared. Total equity $242 $243
Total liabilities and equity $372 $322
EXAMPLE DATA
EXHIBIT The Sunshine Company financial statements
To demonstrate how to prepare a statement of cash flows, 12.3

the information for a hypothetical company in Exhibit 12.3

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 12 Statement of cash flows 217
 Receivable account increases when sales are made but no
LO3  EPORTING CASH FLOWS
R cash is collected. Therefore, a $4 increase means that $4
FROM OPERATING of its $432 of sales were not collected during the year.
ACTIVITIES: DIRECT Therefore, cash collections were $428.

METHOD Sales for the period $432

Less: Increase in accounts receivable   4
This section demonstrates the calculation of cash flows
Cash collected from sales $428
from operating activities under the direct method.
Note that had Sunshine’s accounts receivable decreased
Firebox.com Ltd

during the year, the decrease would have been added to sales.
The conversion of sales to cash collections can be
summarised as follows:
Balance from Adjustment Balance for
statement of statement of
comprehensive cash flows
income
– Increase in accounts
receivable
= Cash collected
Sales or
from sales
+ Decrease in accounts
receivable

A second approach for calculating cash receipts from

sales is to prepare the journal entry that Sunshine would
hypothetically make if it recorded its annual sales and the
change in receivables in only one entry.
Given sales of $432, Sunshine would credit Sales for
Great products are only useful if you can receive $432. It would also debit Accounts Receivable for $4 to
the cash from customers reflect the increase in the account. To balance the entry, it
would debit Cash for $428. Thus, cash collections from sales
When reporting operating cash flows under the direct
are $428.
method, companies calculate and report cash receipts
from operating activities and cash payments for operating Hypothetical entry Accounts Receivable 4
activities. Cash receipts are calculated by converting Cash 428
revenues from the statement of comprehensive income  Sales 432
to cash collections. Cash payments are calculated by
converting expenses to cash payments.
The following sections demonstrate this conversion CASH PAID FOR INVENTORY
process. The first section considers cash receipts from Sunshine shows $281 of cost of goods sold during the
customers. The next sections consider cash payments in year. To convert this expense to cash paid for inventory, it
three main groups: cash paid for inventory, for operating must first calculate total purchases for the period and then
expenses and for income taxes. For each calculation, two calculate the cash paid for those purchases.
approaches are demonstrated – one focusing on the To calculate purchases, Sunshine must examine the
changes in account balances and another using a debit/ inventory account. Inventory increased by $9 during the
credit approach. year. An increase in inventory means that it bought more
inventory than it sold. Therefore, it must have purchased
CASH RECEIVED FROM CUSTOMERS $290 of inventory during the year.
The Sunshine Company’s statement of comprehensive Inventory sold during the period $281
income shows that the company generated $432 in sales
Plus: Increase in inventory   9
during the year. To determine cash receipts from those
Inventory purchased during the period $290
sales, the balance sheet account related to sales – accounts
receivable – must be examined.
Note that had Sunshine’s inventory decreased during
Sunshine’s balance sheet shows that accounts
the year, the decrease would have been subtracted from
receivable increased $4 during the year. The Accounts
inventory to calculate purchases.

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218 ACCT3 Financial
Balance from statement of Adjustment Adjustment Balance for statement
comprehensive income of cash flows
Cost of goods sold + Increase in inventory – Increase in accounts payable
or = Purchases or = Cash paid for inventory
– Decrease in inventory + Decrease in accounts payable

To calculate cash paid for these purchases, Sunshine Prepaid insurance decreased $4, meaning that Sunshine
must examine accounts payable. Accounts payable used $4 of insurance it had purchased in a previous period.
increased $8 during the year. The accounts payable account As a result, cash paid for insurance in the current period
increases when purchases are made but no cash is paid. was only $10.
Therefore, it must have paid for only $282 of its $290 in
Insurance expense for the period $14
purchases.
Less: Decrease in prepaid insurance   4
Inventory purchased during the period $290 Cash paid for insurance $10
Less: Increase in accounts payable   8
Cash paid to suppliers for the period $282 Note that had Sunshine’s prepaid insurance increased
during the year, the increase would have been added to
Note that had Sunshine’s accounts payable decreased insurance expense.
during the year, the decrease would have been added to The conversion of insurance expense to cash paid for
purchases to calculate cash paid. insurance is summarised in the following table:
The conversion of cost of goods sold to cash paid for
Balance from Adjustment Balance for
inventory can be summarised as shown in the following statement of statement of
table. comprehensive cash flows
income
Cash paid for inventory can also be determined by
+ Increase in prepaid
preparing the entry that Sunshine would hypothetically insurance
make to record the activity in the Cost of Goods Sold, = Cash paid for
Insurance expense or
insurance
Inventory and Accounts Payable accounts. – Decrease in prepaid
insurance
Given cost of goods sold of $281, Sunshine would debit
Cost of Goods Sold for $281. It would also debit Inventory Using the entry approach to calculate cash payments
$9 for its increase during the year and credit Accounts for insurance, Sunshine would debit Insurance Expense for
Payable $8 for its increase during the year. To balance the $14 and credit Prepaid Insurance for $4. Cash would then
entry, it would credit Cash for $282. Thus, cash paid for be credited to balance the entry, showing cash payments
inventory is $282. for insurance to be $10.
Hypothetical Cost of Goods Sold 281
entry Hypothetical Insurance Expense 14
entry
Inventory 9
  Prepaid Insurance 4
  Accounts Payable 8
 Cash 10
 Cash 282
Salaries expense and
CASH PAID FOR OPERATING EXPENSES electricity expense
Sunshine shows $63 of salaries expense and $28 of
Sunshine’s statement of comprehensive income shows
electricity expense during the year. To determine the cash
several operating expenses. The following sections
paid for these operating expenses, the related accounts –
demonstrate how operating expenses are converted to
Salaries Payable and Electricity Payable – must be examined.
cash paid. The first section illustrates an expense related
Salaries payable did not change during the year, so it
to a current asset. The second section illustrates two
must have paid exactly $63 to employees.
expenses relating to current liabilities.
Salaries expense for the period $63
Insurance expense
Change in salaries payable   0
Sunshine’s Statement of comprehensive income shows
Cash paid to employees $63
$14 of insurance expense during the year. To determine the
cash paid for insurance, the related balance sheet – prepaid
Electricity Payable increased $5 during the year,
insurance – must be examined.
meaning that Sunshine used electricity during the year for

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 12 Statement of cash flows 219
 which it did not pay. Therefore, it paid only $23 for electricity Income tax expense for the period $ 8
during the year.
Plus: Decrease in taxes payable   7
Electricity expense for the period $28 Cash paid for taxes $15
Less: Increase in electricity payable   5
Note that had the taxes payable increased during the
Cash paid for electricity $23
year, the increase would have been subtracted from
income tax expense.
Note that had Sunshine’s electricity payable decreased
The conversion of income tax expense to cash paid for
during the year, the decrease would have been added to
taxes is summarised in the following table:
electricity expense.
The conversion of these operating expenses to cash Balance from Adjustment Balance for
paid for salaries and electricity can be summarised as statement of statement
comprehensive of cash flows
follows: income
Balance from Adjustment Balance for – Increase in taxes
statement of statement of payable
= Cash paid for
comprehensive cash flows Income tax expense or
taxes
income + Decrease in taxes
– Increase in salaries payable
payable
= Cash paid for To calculate cash payments using the entry method,
Salaries expense or
salaries
+ Decrease in salaries Sunshine would debit Income Tax Expense for $8 and debit
payable Taxes Payable for $7. Cash would be credited to balance
– Increase in electricity the entry, showing cash payments to be $15.
payable
= Cash paid for
Electricity expense or Hypothetical Income Tax Expense 8
electricity
+ Decrease in electricity entry
payable
Taxes Payable 7
Using the entry approach to calculate the cash payments  Cash 15
for salaries, Sunshine would debit Salaries Expense for
$63. Nothing is recorded for Salaries Payable because the
OTHER REVENUES AND EXPENSES
account balance was unchanged. Cash is then credited to
balance the entry, showing cash payments to be $63. Sunshine’s Statement of comprehensive income contains
two additional items: depreciation expense and gain on
Hypothetical Insurance Expense 63 sale of equipment. For the following reasons, these items
entry
are ignored under the direct method.
 Cash 63 Recall from Chapter 8 that depreciation expense is a
For electricity, Sunshine would debit Electricity Expense non-cash charge, meaning that cash is not affected when
for $28 and credit Electricity Payable for $5. Cash would be depreciation is recorded. As a result, depreciation expense
credited to balance the entry, showing cash payments to is not included when preparing the operating activities
be $23. section under the direct method. This is always the case.
Recall also from Chapter 8 that a gain on the sale of
equipment occurs when cash received from the sale
Hypothetical Electricity Expense 28
entry exceeds the equipment’s carrying value. Because the sale
  Electricity Payable 5 of equipment is an investing activity, all cash received from
the sale will be reported as a cash inflow from investing
 Cash 23
activities. As a result, the gain on the sale is not included
when preparing the operating activities section under the
CASH PAID FOR TAXES direct method. The same would be true for a loss on the
Sunshine’s statement of comprehensive income shows sale of equipment.
$8 of income tax expense during the year. To determine
the cash paid for taxes, the related balance sheet account NET OPERATING CASH FLOWS
– taxes payable – must be examined. Based on the previous calculations, Sunshine’s operating
Taxes payable decreased $7 during the year, meaning activities section of its statement of cash flows is shown
that Sunshine paid not only current-year taxes of $8, but in Exhibit 12.4. A summary of adjustments used to
also $7 of prior-year taxes. Thus, taxes paid in this period generate the numbers is found in Exhibit 12.5.
were $15.
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
220 ACCT3 Financial
 The Sunshine Company ADJUSTMENTS FOR NON-CASH ITEMS
Cash flows from operating activities 2020 Accrual-based profit or loss (or net income) often includes
Cash receipts from customers $428 expenses that have no related cash consequences. The
Less cash payments: most common example is depreciation expense, which is
  To suppliers $282 an allocation of the historical cost of a fixed asset. While
depreciation reduces accrual-based profits, it does not
  To employees 63
result in any cash payment. Therefore, to adjust profits to
  For insurance 10
a cash basis, the effect of depreciation must be removed.
  For electricity 23 This is accomplished by adding depreciation expense back
  For taxes   15  393 to profits. Other examples of non-cash expenses are
Net cash provided by operating activities $ 35 amortisation expense, bad debt expense and impairment
losses. Some therefore mistakenly think these are inflows
EXHIBIT The
 Sunshine Company’s operating cash flows
12.4 using the direct method
of cash, but they are not. Depreciation and the like are
expenses that reduce profits, but they are not cash outflows
YT
PPL HIS that reduce cash from operating activities.
A

Review this content The general adjustment for all non-cash expenses is
with the e-lecture
therefore as follows:
Adjustment rule for non-cash expenses
LO4  EPORTING CASH FLOWS
R Add back to profit all non-cash expenses
FROM OPERATING Sunshine’s statement of comprehensive income in
ACTIVITIES: INDIRECT Exhibit 12.3 shows only one non-cash expense:
METHOD depreciation expense of $25. Therefore, the $25 would be
added back to profits.
This section demonstrates the calculation of cash flows
from operating activities under the indirect method. ADJUSTMENTS FOR GAINS AND
When reporting operating cash flows under the indirect LOSSES FROM INVESTING AND
method, companies calculate and report net cash flows from FINANCING ACTIVITIES
operating activities by adjusting the profit or loss from an
Sometimes, a company’s profits will include a gain or loss
accrual basis to a cash basis. This requires many adjustments,
arising from an investing or financing activity. For example,
but they can be grouped into three main types:
a company might generate a gain from the sale of
● non-cash effects on net income
equipment or a ‘loss on disposal of property, plant and
● gains and losses from investing and/or financing
equipment’ or ‘reconciliation of profit after tax to cash flows
activities
from operations’ (see Exhibit 12.2 taken from CSL Note
● changes in current assets and liabilities.
14). Another company might generate a gain from the early
The following sections demonstrate these
retirement of debt or a ‘loss on acquisition’ (again see
adjustments using the Sunshine Company information
Exhibit 12.2).
in Exhibit 12.3.

Balance from statement Adjustment Balance for statement of

of comprehensive cash flows
income
Sales – Increase in accounts receivable  OR  + Decrease in accounts receivable = Cash collected from sales
Cost of goods sold + Increase in inventory  OR  – Decrease in inventory = Cash paid for inventory
and
– Increase in accounts payable   OR  + Decrease in accounts payable
Operating expenses + Increase in current assets  OR  – Decrease in current assets = Cash paid for operations
or
– Increase in current liabilities  OR  + Decrease in current liabilities
Income tax expense – Increase in taxes payable  OR  + Decrease in taxes payable = Cash paid for taxes
EXHIBIT Summary of adjustments used in the direct method
12.5

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 12 Statement of cash flows 221
 When such activity occurs, the entire cash inflow Sunshine’s balance sheet shows changes in several
associated with the transaction will be reported as either current assets and current liabilities. The following sections
an investing or a financing cash flow. As a result, the effect describe the adjustment that each change requires.
of the gain or loss must be removed from profits so that
operating cash flows are not affected by the transaction. Change in accounts receivable
Gains must be subtracted from profits, and losses must be Sunshine’s balance sheet shows a $4 increase in accounts
added back to profits. receivable. Accounts receivable increases when sales are
made without receiving cash. Therefore, $4 of the reported
Adjustment rules for gains and losses from investing
and financing activities
sales revenue was not collected in cash and must be
removed from revenues. Removing $4 from revenue is
Subtract from profits any gains arising from investing or financing
activities. accomplished by subtracting $4 from profits.
Add back to profits any losses arising from investing or financing
activities.
Change in inventory
Sunshine’s inventory increased by $9 during the year.
Sunshine’s Statement of comprehensive income Inventory increases when a company purchases more
shows only one gain or loss from an investing or financing inventory than it sells. Therefore, it must have purchased
activity: a $1 gain on the sale of equipment. Because the $9 more in inventory than it sold during the year. So that
cash received from the sale will be reported as cash inflow cash flows reflect all payments for purchases, the $9 must
in investing activities, the effect of the gain must be be added to cost of goods sold. This results in a reduction
subtracted from profit to determine cash flow from to profits of $9 to reflect the cash flow associated with
operations. Therefore, profits are reduced by $1 to arrive at inventory.
the cash flow from the operating activities figure.
Change in prepaid insurance
ADJUSTMENTS FOR CURRENT ASSETS AND Sunshine has a decrease in prepaid insurance of $4.
CURRENT LIABILITIES Prepaid insurance decreases when a company uses
insurance that it has already purchased. Thus, a decrease
The third type of adjustment involves the changes in a
of $4 means that it used $4 of insurance that it purchased
company’s current assets and current liabilities. Current
in a previous period. As a result, insurance expense is $4
assets and current liabilities change during a period because
greater than the cash paid for insurance and should be
a company’s revenues do not equal cash received and its
reduced to reflect the cash paid for insurance. Reducing
expenses do not equal cash paid.
cash paid for expenses by $4 is accomplished by adding
For example, a change in accounts receivable means
$4 to profits.
that a company’s cash collections do not equal its sales
revenue. If accounts receivable increases, sales revenue is Change in accounts payable
greater than cash collections. If accounts receivable Sunshine’s balance sheet shows that accounts payable
decreases, cash collections are greater than sales revenue. increased by $8 during the year. Accounts payable increases
Likewise, a change in salaries payable means that a when inventory is purchased without paying cash, so an
company’s cash payments do not equal its salaries $8 increase means that it did not pay for $8 of its purchases
expense. If salaries payable increases, salaries expense is calculated previously. Therefore, the $8 must be removed
greater than cash payments. If salaries payable decreases, from expenses. This is accomplished by adding $8 to profit.
cash payments are greater than salaries expense.
Because the indirect method adjusts accrual-based Change in electricity payable
income to cash-based income, these differences must be Sunshine has an increase of $5 in electricity payable.
removed from the accrual-based profit or loss to arrive at Electricity payable increases when a company incurs
cash flows from operating activities. That is, the revenues electricity expense but does not pay cash. Thus, the $5
and expenses must be adjusted so that they reflect cash increase means that the expenses are $5 greater than the
receipts and cash payments. This is accomplished with the cash paid. As a result, the $5 of expenses must be removed
following adjustments: from profits. This is accomplished by adding $5 to profits
to reflect the cash outflow associated with electricity.
Adjustment rules for current assets and current liabilities
Add a decrease in current assets to net income. Change in taxes payable
Subtract an increase in current assets from net income. Sunshine’s balance sheet shows that taxes payable
Add an increase in current liabilities to net income. decreased $7 during the period to end at a zero balance.
Subtract a decrease in current liabilities from net income. Taxes payable decreases when a company pays not only
for current-period taxes but also prior-period taxes. The $7

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
222 ACCT3 Financial
decrease therefore means that it paid $7 more than it
expensed. As a result, the $7 should be added to expenses. LO5 CALCULATING CASH
This is accomplished by subtracting $7 from profits. FLOWS FROM INVESTING
You will note there is a certain repetitiveness to these ACTIVITIES
payables. Rather than trying to learn this as a formula
(increase in payable, less cash outflow etc.) try to think of This section demonstrates the calculation of cash flows
the logic. from investing activities. Recall that investing activities
include the purchase and sale of non-current assets such
as PPE, intangible assets and long-term investments.
To calculate cash flows from investing activities, all
changes in non-current assets must be examined. In
general, an increase in a non-current asset suggests a
purchase and therefore a cash outflow. A decrease
suggests a sale and therefore a cash inflow. However, to
be sure, any available information on the changes must be
examined to determine whether the change resulted from
a non-cash transaction or whether the change was the net
A trip down logic lane: the logic of saving cash by not paying your bills effect of both increases and decreases to the account.
(increasing payables), by getting those who owe you to pay quickly To illustrate, consider again Sunshine’s balance sheet
(reducing receivables) and running down inventory levels (reducing
inventory) are important in preparing the cash flow from operations – in Exhibit 12.3. It shows three non-current asset accounts:
but may be critical for the survival of your business
Investments, Property and Equipment, and Accumulated
Depreciation. In the following sections, each account
balance is examined to determine Sunshine’s cash flows
NET OPERATING CASH FLOWS from investing activities.
The six adjustments from changes in current assets and
current liabilities, along with the two adjustments for non- INVESTMENTS
cash items, are shown in Exhibit 12.6. The adjustments
According to Sunshine’s balance sheet (Exhibit 12.3),
result is $35 in net cash provided by operating activities. If
investments increased $22. Without any information to the
you are learning both the direct and indirect methods, you
contrary, it is assumed that it purchased investments for
should note that the $35 is the same as calculated under
$22 cash. Thus, a cash outflow of $22 from the purchase
the direct method. Note this is the same as shown in CSL’s
of investments is reported in investing activities.
reconciliation earlier in Exhibit 12.2 and in Appendix B
(Note 14: Cash and cash equivalents).
EQUIPMENT
The Sunshine Company Sunshine’s balance sheet shows a $66 increase in
Cash flows from operating activities 2020
property and equipment during the year. Thus, it must
have purchased equipment during the year. The statement
Profits $14
of comprehensive income shows a $1 gain on the sale
Adjustments to reconcile profits after income tax to
net cash inflows from operating activities of equipment. Thus, it must have sold equipment during
the year. As a result, there are both cash inflows and
  Depreciation expense $25
outflows related to equipment. Each will be considered
  Gain on sale of equipment (1)
separately.
  Increase in accounts receivable (4)
  Increase in inventory (9) Cash inflows
  Decrease in prepaid insurance 4 Although the information is not in the financial statements
presented, let’s assume Sunshine discloses that the $1
  Increase in accounts payable 8
gain on the sale of equipment arose from selling equipment
  Increase in electricity payable 5
with a cost of $10 and accumulated depreciation of $5 for
  Decrease in taxes payable (7)  21 $6. Thus, a $6 inflow from the sale of equipment should be
Net cash provided by operating activities $35 included in investing activities. Note here that the gain from
the sale is ignored. Only the cash flow from the sale is of
EXHIBIT The
 Sunshine Company’s operating cash flows
12.6 using the indirect method interest at this point. The gain has already been accounted
for previously in cash flows from operating activities.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 12 Statement of cash flows 223
 Cash outflows Because interest is an expense that is reported on the statement
of comprehensive income, payments for interest are reported
Sunshine’s equipment account increased $66 during the
as operating activities rather than financing activities.
year. Without any additional information, it would be assumed
To calculate cash flows from financing activities, the
that it purchased $66 in equipment for cash. However, the
additional information discloses that equipment with a cost balances for non-current liabilities, equity accounts and
of $10 was sold during the year. Therefore, it must have dividends must be examined. In general, an increase in a
purchased $76 in equipment during the year. liability or an equity account such as ordinary shares suggests
a cash inflow from either borrowing or selling shares. A
ACCUMULATED DEPRECIATION decrease in a liability or dividends suggests a cash outflow
from payments to creditors or investors. However, to be
Recall from Chapter 8 that Accumulated Depreciation is sure, any available information on the changes must be
the account that ‘collects’ the depreciation expenses. examined to determine whether the change resulted from
Therefore, it changes when either depreciation expense is a non-cash transaction or whether the change was the net
recorded or depreciating non-current assets are sold. effect of both increases and decreases to the account.
Depreciation expense does not affect cash, and any sale
of equipment is already considered when examining the

AAP Image; Alamy Stock Photo/

martin berry; iStock.com/Katharina13
equipment account. Gains or losses on the sale of non-
current assets are backed-out (taken out) in the
reconciliation. Therefore, the change in the accumulated
depreciation account can be ignored.

SUMMARY OF INVESTING CASH FLOWS

The three cash flows from investing activities are shown
Banks are the primary source of business borrowings
in Exhibit 12.7. The three items resulted in a net cash
outflow from investing activities of $92. Sunshine was To illustrate, consider again the Sunshine Company’s
using its cash to invest in additional non-current assets. balance sheet in Exhibit 12.3. It shows one non-current
The Sunshine Company
liability and two equity accounts. It provides no additional
information regarding the accounts. In the following
Cash flows from investing activities 2020
sections, each account balance is examined to determine
Purchase of equipment $(76)
Sunshine’s cash flows from financing activities.
Sale of equipment 6
Purchase of investments  (22) NON-CURRENT LIABILITIES
Net cash used in investing activities ($ 92)
According to Sunshine’s balance sheet, non-current

EXHIBIT The
 Sunshine Company’s investing cash flows liabilities increased $45 during the year. Without any
12.7
information to the contrary, it is assumed that it borrowed
YT
PPL HIS $45 in cash. Thus, a cash inflow of $45 from the borrowings
A

Download the Enrichment is reported in financing activities.

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CONTRIBUTED EQUITY
LO6 CALCULATING CASH Sunshine’s balance sheet shows a $10 decrease in
FLOWS FROM FINANCING shareholders’ equity.Thus, without any additional information,
ACTIVITIES it is assumed that Sunshine must have repurchased (bought
back) shares for $10 cash. Thus, a cash outflow of $10 from
This section demonstrates the calculation of cash flows from the share buyback is reported in financing activities.
financing activities. Recall that financing activities include The issue of shares and the buying back of shares are
borrowing and repaying debt (non-current liabilities) and cash relatively uncommon activities (CSL’s semi-regular
inflows and outflows from/to the shareholders/investors buybacks are an exception). After the initial public offer
(equity). Common financing activities include the issuing of (floating the company), some companies may never issue
shares or debt and the repurchase (buyback) of shares, the more shares or repurchase shares. Many companies
payment of dividends and the repayment of debt. Note that would only undertake these activities every few years.
although payments of dividends to shareholders are considered This is not to be confused with the daily trading on the
a financing activity, payments of interest to creditors are not. Australian Securities Exchange (ASX) where current
owners sell their shares to other owners who wish to
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
224 ACCT3 Financial
increase their shareholding or new owners (investors).

Alamy Stock Photo/tom carter

None of the money from this daily trading enters or leaves
the company.

RETAINED EARNINGS
The fourth and final account is retained earnings. Recall
from earlier chapters that the retained earnings balance
is affected by two things; profits or losses and dividends
declared. Profits increase the balance while dividends
decrease the balance. Sunshine’s balance sheet shows
that retained earnings increased $9 during the year,
from $78 to $87. The statement of comprehensive While building depreciation is an expense but not a cash outflow,
income shows that profits were $14. Therefore, repairs are both a cash outflow and an expense

dividends declared can be calculated as follows:

The Sunshine Company
Retained earnings, beginning balance $78 Statement of cash flows
Plus: Profits 14 30 June 2020

Less: Dividends declared   ?? × ?? = $5 Cash flows from operating activities

Profits after income tax $   14
Retained earnings, ending balance $87
Adjustments to reconcile profits after tax to
Now that dividends declared are known, the amount net cash provided by operating activities
paid can be calculated. If dividends were not paid, the   Depreciation expense $ 25
balance sheet would show a balance in dividends payable   Gain on sale of equipment (1)
in current liabilities. Neither year shows a balance, so all $5   Increase in accounts receivable (4)
of the dividends must have been paid. Thus, a cash outflow
  Increase in inventory (9)
of $5 from the payment of dividends is reported in financing
  Decrease in prepaid insurance 4
activities.
  Increase in accounts payable 8
NET FINANCING CASH FLOWS   Increase in electricity payable 5

The three cash flows from financing activities are shown   Decrease in taxes payable  (7)   21
in Exhibit 12.8. The three items resulted in a net cash Net cash provided by operating activities $   35
inflow from financing activities of $30. Sunshine generated Cash flows from investing activities
$30 more from financing activities than it paid. Purchases of equipment $ (76)
Sale of equipment 6
The Sunshine Company
Purchases of investments  (22)
Cash flows from financing activities 2020
Net cash used in investing activities (92)
Long-term borrowings $45
Cash flows from financing activities
Payment of dividends (5)
Long-term borrowings $  45
Repurchase of shares (10)
Payment of dividends (5)
Net cash provided by financing activities $30
Repurchase of ordinary shares   (10)

EXHIBIT The
 Sunshine Company’s financing cash flows Net cash provided by financing activities   30
12.8
Net decrease in cash $ (27)
Cash, beginning of the year 45
COMPLETE STATEMENT OF CASH FLOWS: Cash, end of the year $ 18
INDIRECT METHOD

EXHIBIT The
 Sunshine Company statement of cash flows
Sunshine’s final statement of cash flows, using the 12.9 (indirect method)
indirect method, is shown in Exhibit 12.9. The net
decrease in cash of $27 corresponds to the change in the
cash account from Sunshine’s balance sheet. Like the
tide, cash flows both ways.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 12 Statement of cash flows 225
 For CSL, the cash flow information is summarised in a company’s ability to generate cash for expansion, for
Exhibit 12.10 below. other forms of improved operations, for the repayment of
debt, or for increased returns to shareholders.
Source Accounts 2017 2016 While free cash flow can be defined in many ways, the
Statement Cash flows from operating $1 247 $1 179 most straightforward definition is as follows:
of cash activities
flows Cash flows from operating activities
Net capital expenditures 689 495
(on PPE) Less: Capital expenditures on PPE (and possibly intangibles and
business acquisitions
Expenditure on intangibles 172 315
and business acquisitions Less: Dividends (and possibly share buybacks)
Dividends paid 601 579 = Free cash flow
Shares bought back 315 648
The calculation starts with cash flows from operating
Notes Average debt maturing in ($1 373 + ($1 133 +
11 (d) next five years $2 259) / 5 1 636) / 5 activities, which is a measure of a company’s ability to
= 726 = 554 generate cash from its current operations. It then subtracts
A
 ccount balances from CSL’s 2017 Annual Report
capital expenditures, which refers to the cash that a
EXHIBIT
12.10 (rounded to nearest $ million) company spends on PPE (and in CSL’s case it could be
Source: Adapted from CSL’s Annual Report 2017. argued purchase of intangibles and business acquisitions
could also be included because of the regularity of this as
a means of expansion), and payments to shareholders
during the year. The cash that remains is ‘free’ to be used
LO7  NALYSING A COMPANY’S
A as the company chooses.
STATEMENT OF CSL’s free cash flow is calculated as follows from the
CASH FLOWS information in Exhibit 12.10:
2017 2016
The statement of cash flows reports how a company
Cash flows from operating activities $1 247 $1 179
generated and used its cash during the year. As a result,
– Capital expenditures on PPE 689 495
the statement can be used to answer many questions
about a company’s cash. Two of the broader questions that – Dividends 601 579
can be addressed are as follows: Free cash flow ($ 43) $ 105
1 Is the company able to generate enough cash to grow?
2 Is the company able to generate enough cash to satisfy In 2017, CSL had negative free cash flow. That is, it
its obligations? generated less cash from operations than it paid for PPE
and dividends. If we included expenditure on intangibles,
The following sections examine these questions
business acquisitions and share buybacks the figure
for CSL.
would be negative $530 million (– $858 million in 2016).
The examination will require the information from CSL’s
To maintain a similar financing and expansion strategy
statement of cash flows and notes to the financial
CSL will need to have net borrowings of well over half a
statements.
billion dollars each year.
FREE CASH FLOW
CASH FLOW ADEQUACY RATIO
When assessing a company’s cash flows, a commonly
A second ratio that is commonly used to cash flow adequacy
used calculation is free cash flow. This is the cash a
assess a company’s cash is the cash flow ratio  Compares free cash
company generates in excess of its investments in flow to the average amount
adequacy ratio. The cash flow adequacy of debt maturing in the next
productive capacity and payments to shareholders in the
ratio compares free cash flow to the five years and measures the
form of dividends (and in CSL’s case it could be argued ability to pay maturing debt.
average amount of debt maturing in the
share buybacks because of the regular buybacks and the
expectation this has built). Free cash flow is a measure of

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
226 ACCT3 Financial
next five years. Details are given in Note 11 (d) of CSL’s The negative free cash flow in 2017 indicated an
Annual Report 2017 where ‘Contractual payments due’ are apparent inability to repay any debt from operations after
divided into ‘1 year or less’, ‘Between 1 year and 5 years’ buying PPE and paying dividends. In fact, cash would need
and ‘Over 5 years’. to be raised to maintain the same dividends in 2018. Even
in 2016, less than 20 per cent of debt could be repaid from
KEY FORMULA 12.1 CASH FLOW ADEQUACY RATIO free cash flow. Despite this apparent cash shortage, CSL
Cash Flow Adequacy Ratio = Free Cash Flow undertook $387 million in other capital expenditure and
Average Amount of Debt share buybacks in 2017. Such an analysis is limited and
Maturing in Five Years
misses the richer information contained in CSL’s statement
of cash flows.
Because this ratio compares free cash flow to maturing
During the 2016/17 financial year CSL’s share price
debt, it represents a company’s ability to generate enough
increased from $111.93 to $138.03, over 23 per cent, while
cash to pay its debt. In general, companies may like this
the Australian share market increased on average (All
ratio to be higher rather than lower. All other things being
Ordinaries Index) less than 9 per cent. CSL is a large rapidly
equal, a higher ratio indicates a greater ability to generate
growing biotechnology company, which warrants deeper
sufficient cash from operations to pay upcoming debt.
analysis; this is undertaken in the next chapter.
For CSL in 2017 the calculation is meaningless and in YT
PPL HIS
2016 less than 20 per cent.

A
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CHAPTER 12 Statement of cash flows 227
 LO1
3 Classify cash flows
A business entered into the following transactions:
i purchased new machinery for $24 000 cash
EXERCISES ii paid an account payable relating to inventory of
$2500 with cash
iii recorded cash sales of $52 000 for the period
iv purchased a new warehouse for $275 000. The seller
of the building accepts 10 000 shares as payment
v issued debentures at face value of $25 000
LO1
1 Classify cash flows vi repurchased 200 of the company’s own shares on
A business enters into the following independent the open market for $7000
transactions: vii purchased a new light truck for $18 000 by signing a
i issued $290 000 of ordinary shares in exchange for 180-day note payable
cash viii collected cash of $3000 from a customer in
ii borrowed $480 000 from the bank satisfaction of accounts receivable
iii received $270 000 in cash from accounts receivable ix sold 550 BHP shares for their book value of $25 000
iv $76 000 is paid to an account payable x paid $200 for renewal of the meteor insurance policy
v exchanged (issued) $55 000 of ordinary shares upon xi paid dividends of $5000 in cash.
conversion of debentures (bonds) with a face
REQUIRED
value of $55 000
Classify each transaction as a cash inflow or outflow from
vi declared and paid a cash dividend of $748 000
operating activities, investing activities or financing activities,
vii sold an investment costing $130 000 for $130 000 in
or as an item reported in a supplemental schedule of the
cash
statement of cash flows.
viii bought back shares, $920 000
ix paid tax, $110 000 LO2
4 Direct versus indirect method
x purchased property, $800 000.
Illustrate with an example the additional information
REQUIRED contained in the indirect method of calculating the cash flow
Classify each of the preceding transactions as a cash inflow from operations compared to the direct method. In your
or a cash outflow from operating, investing or financing example show at least one increase and one decrease in
activities, or as a non-cash transaction. current assets and the same in current liabilities that
highlight the differences. Also include a profit on sale of
2 Classify cash flows LO1 property and depreciation of equipment.

A company enters into the following transactions: LO3

5 Calculate cash paid for salaries
i interest is paid on a note payable
ii salaries are paid to the company’s employees Calculate the cash paid:
iii bonds are issued in exchange for cash i Salaries expense was $250 000 for the year. During
the year salaries payable increased $25 000.
iv income taxes are paid by the company
ii COGS was $980 000. Inventory at the beginning of
v new heavy machinery is purchased with cash
the year was $66 000 and ending inventory $85 000.
vi convertible bonds are issued in exchange for land
iii Rent expense $99 000. Opening balance of prepaid
vii cash dividends are paid to shareholders
rent $8000, closing balance $9000.
viii the shares of another company are purchased as an
investment REQUIRED
ix the company buys back its own shares on the market Determine the amount of cash paid for salaries, inventory
and retires them and rent during the year.
x shares are given to the bank in return for cancellation
LO3
of a loan 6 Calculate cash collections
xi an amount due from a customer is collected Emma’s balance sheet showed an accounts receivable
xii intangible assets are purchased from another balance of $75 000 at the beginning of the year and $97 000
company for cash. at the end of the year. Emma reported sales of $1 150 000
on her income statement.
REQUIRED
Indicate whether each transaction would appear under REQUIRED
operating, investing or financing activities. Also note if a Using the direct method, determine the amount that Emma
transaction is a significant non-cash transaction that would will report as cash collections in the operating activities
require additional disclosure. section of the statement of cash flows.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
228 ACCT3 Financial
 LO3
i decrease in accounts payable
7 Calculate cash paid for purchases ii increase in accounts receivable
The Kapyong Company’s balance sheet included an iii purchase of a new conveyor belt system
inventory balance of $105 000 at 30 June 2019 and $142 000 iv buyback of shares
at 30 June 2020. Accounts payable balances were $78 000
v gain on the sale of old conveyor belt system
and $47 000 at 30 June 2019 and 30 June 2020,
vi depreciation expense
respectively. Kapyong’s accounts payable only relate to
inventory purchases. Cost of goods sold as reported on the vii increase in inventory
2020 income statement was $885 000. viii increase in bank loans
ix bad debt expense.
REQUIRED
Using the direct method, determine the amount that REQUIRED
Kapyong will report as cash paid for inventory in the Indicate whether each item should be added to profit,
operating activities section of the statement of cash flows. deducted from profit or not reported in the reconciliation of
profits to cash flow from operations.
LO3
8 Calculate cash paid for operating
LO4
expenses 11 Prepare operating cash flows under the
The following information is available for a company’s rent indirect method
and income taxes: The following information was reported by Imma Imports:

Prepaid rent, beginning of year $25 000 2019 2018

Prepaid rent, end of year 31 000 Accounts receivable $110 000 $94 000

Rent expense 40 000 Inventory 70 000 90 000

Cash paid for rent during the year (a) Prepaid insurance 24 000 20 000

Income taxes payable, beginning of year 25 000 Accounts payable 44 000 30 000

Income taxes payable, end of year 31 000 Income taxes payable 20 000 28 000

Income tax expense 40 000 Interest payable 24 000 18 000

Cash payments for income taxes (b) Profit after tax 490 000

Accounts payable, beginning of year 800 Depreciation expense 50 000

Accounts payable, end of year 300 REQUIRED

Inventory purchased during the year 25 500 Prepare the operating activities section of the statement of
cash flows using the indirect method and explain why cash
Cash paid for inventory (c)
flows from operating activities is more or less than profits
REQUIRED after tax.
Calculate the missing information.
LO3, 4, 5
12 Reporting cash flows from sale of
9 Identify indirect method adjustments LO4 equipment
A company experiences the following items during the year: A company sells equipment with a book value of $23 000 for
$25 000 cash.
i depreciation expense
ii increase in income taxes payable REQUIRED
iii decrease in accounts receivable a How would the sale of equipment be reported in the
iv increase in prepaid expenses cash flow from operating activities under the (i) indirect
v decrease in inventory method and (ii) the direct method?
vi increase in accounts payable b Where else on the statement of cash flows would the
vii gain on sale of investments. sale be reported and how?

REQUIRED LO4, 5, 6
13 Classifying transactions under the
a Identify whether each item would be an addition to or indirect method
subtraction from net income when calculating operating
cash flows using the indirect method. The following is a list of transactions and changes in account
balances that occurred during the year:
b Choose one of the items and explain on your Facebook
i income taxes payable decreased
wall why the item is treated the way you have stated
above. ii paid cash in satisfaction of a matured bond payable
iii declared a cash dividend
10 Classify adjustments under the indirect LO4 iv accounts payable increased
method v accounts receivable doubled before returning to the
beginning of the year balance
A company that uses the indirect method to report operating
vi sold equipment for cash and made a substantial gain
activities experiences the following events:
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 12 Statement of cash flows 229
 vii purchased a new warehouse by issuing debentures iv $250 000 was paid to buy back the company’s own
viii purchased inventory for cash shares
ix bought back own shares in open market. v depreciation expense for the year was $300 000
vi notes of $250 000 were issued.
REQUIRED
Assuming the indirect method for operating activities, REQUIRED
indicate whether each transaction would be included in Use this information to calculate cash flows from financing
operating activities, investing activities, financing activities, activities.
non-cash disclosures or not reported. Note that some
transactions may impact multiple sections. 17 Analysing cash flows LO7

LO5
Duong and Dinh are both online retail companies. The
14 Calculate cash flows from investing following financial information regarding each company is
activities available:
The following information is taken from the balance sheet of
The Cheese Board: Duong Dinh
Cash flows from operating activities $450 000 $450 000
2021 2020
Profits after income tax 250 000 250 000
Equipment $85 000 $120 000
Capital expenditures 100 000 130 000
Accumulated depreciation (equipment) 50 000 55 000
Dividends declared and paid 60 000 20 000
Depreciation expense of $15 000 was reported on the Average amount of debt maturing in five 40 000 60 000
statement of comprehensive income for 2021. Equipment years
with an original cost of $35 000 was sold for $500 profit
(gain). REQUIRED
REQUIRED a Indicate which company generated more free cash flow.
Calculate the amount of cash received from the sale of the b Indicate which company has the better cash flow
equipment. adequacy ratio.

LO7
15 Calculate cash flows from investing LO5 18 Interpreting investing and financing cash
activities flows
The following transactions occurred during the year: Pazmandy reports the following cash flows from investing
a A new warehouse was purchased for cash in the amount and financing activities over the past three years (in
of $330 000. thousands):
b The company’s own shares were purchased (bought 2020 2019 2018
back) on market for $280 000. Cash flows from investing activities
c An old warehouse costing $240 000 was sold for
Purchase equipment $(803) $(2 768) $ (752)
$135 000, resulting in a gain of $15 000.
Sales of investments – 1 204 –
d The company purchased shares in Howard and Company
for $22 500 cash. Purchase of investments – (1 204) –
e Shares of Samantha Stores were sold for $37 500, Net cash used by investing activities (803) (2 768) (752)
resulting in a gain of $22 500. Cash flows from financing activities
REQUIRED Issuance of long-term debt – – 3 200
Use this information to calculate cash flows from investing Payment of dividends (50) (50) (66)
activities.
Share buyback – (1 200) –

16 Calculate cash flows from financing LO6 Net cash used/provided by financing (50) (1 250) 3 134
activities
activities
The following transactions occurred during the year: REQUIRED
i ordinary shares were issued in exchange for new From the information above, describe the major ways in
equipment which Pazmandy used investing and financing cash flows
ii a cash dividend of $200 000 was paid over the last three years.
iii a 90-day note payable was issued for $50 000 cash

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
230 ACCT3 Financial
   Total assets $900 000 $820 000
Accounts payable $ 110 000 $105 000
Unsecured syndicated bank loan   180 000   200 000
PROBLEMS (long-term)
  Total liabilities $290 000 $305 000
Ordinary shares $350 000 $280 000
Retained earnings 260 000 235 000
LO3   Total shareholders’ equity   610 000   515 000
19 Prepare operating cash flows under the
direct method   Total liabilities and shareholders’ equity $900 000 $820 000

The following information is provided for the Hildebrand

The following additional information is available:
Company:
i Profits after tax for 2022 were $50 000.
Balances at 30 June 2021 2020 ii Cash dividends of $25 000 were paid during the year.
iii A portion of unsecured syndicated bank loan matured
Accounts Receivable $ 2 500 $ 1 500
and was repaid during the year.
Inventory 26 000 32 000 iv Ordinary shares were issued for cash.
Maintenance Supplies 2 000 1 000 v Property and equipment were purchased for cash.
Accounts Payable 4 000 3 000 No non-current assets were sold during the year.
vi The change in accumulated depreciation is a result of
Taxes Payable 2 000 3 500 depreciation expense.
Interest Payable 1 500 2 500
REQUIRED
2021 income statement Prepare a statement of cash flows for the year using the
Revenue $80 000 direct method for the operating activities section and
prepare a reconciliation of profits after tax to cash flow from
Cost of goods sold   55 000
operations.
  Gross profit 25 000
LO3, 4, 5
General and administrative expense 6 000 21 Prepare a statement of cash flows
Depreciation expense   2 000 Available financial information for 2RAR Company is as
follows (figures in thousands):
  Total operating expenses 8 000
  Profit before interest and tax 17 000 Comparative balance sheets as at 30 June
Interest expense   4 000 2021 2020
  Profit before income tax 13 000 Cash and cash equivalents $   75 000 $ 45 000

Income tax expense   4 000 Accounts receivable 45 000 55 000

  Profit after income tax $  9 000 Inventory 200 000 175 000

Prepaid insurance   30 000   35 000
REQUIRED
  Total current assets 350 000 310 000
Prepare the operating activities section of the statement of
cash flows using the direct method. Prepare the Property, plant and equipment 800 000 720 000
reconciliation of profit after income tax to net cash inflow Accumulated depreciation (240 000) (170 000)
from operating activities.
  Total property, plant and equipment 560 000 550 000

20 Prepare a statement of cash flows LO4, 5, 6   Total assets 910 000 860 000

using the indirect method Accounts payable 110 000 115 000
The balance sheets for the Intelligence Company are as follows: Accrued salaries   10 000   35 000
  Total current liabilities 120 000 150 000
Comparative balance sheets as at 30 June
Loans 180 000 230 000
2022 2021
Cash and cash equivalents $  65 000 $  45 000   Total liabilities 300 000 380 000

Accounts receivable 50 000 55 000 Contributed equity (shares) 350 000 250 000

Inventory 125 000 175 000 Retained earnings   260 000   230 000

Property, plant and equipment 930 000 745 000   Total equity 610 000 480 000

Accumulated depreciation (270 000) (200 000)    Total liabilities and equity 910 000 860 000

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 12 Statement of cash flows 231
 Income statement for the year ended Accounts payable $ 120 $ 135
30 June 2021
Income taxes payable 155 175
Sales revenue $  450 000   Total current liabilities $ 275 $ 310
Cost of goods sold   (225 000) Bonds payable 400 325
  Gross profit $  225 000   Total liabilities $ 675 $ 635
Depreciation expense (70 000) Contributed equity 525 475
Other operating expenses   (30 000) Retained earnings 322 217
  Profit before interest and tax $  125 000   Total shareholders’ equity $ 847 $ 692
Interest expense   (20 000)    Total liabilities and equity $1 522 $1 327
  Profit before income tax $  105 000
Income tax expense   (30 000) The following additional information is available:
i operating expenses include $35 million of
  Profit after income tax $  75 000
depreciation
ii property and equipment were acquired for cash
The following additional information is available:
iii additional contributed equity was shares issued for
i Cash dividends of $45 000 were declared and paid
cash
during the year.
iv additional cash was obtained by issuing bonds
ii Equipment was purchased for cash (no PPE was sold).
v dividends were paid.
iii A portion of the loans were repaid with cash.
iv Shares were issued for cash. The CEO has posed some questions regarding this year’s
results. She is pleased that the profit margin is approaching
REQUIRED 15 per cent. However, the decrease in the cash balance
Prepare a statement of cash flows for 2RAR for 2021 using during such a profitable year troubles her.
the direct method and a reconciliation of profit after income
REQUIRED
tax to net cash flow from operations.
a Prepare a statement of cash flows for Complete
LO2, 3, 4,5, 6, 7
Company using the direct method for operating cash
22 Prepare a statement of cash flows flows. Prepare a separate schedule showing the
The following is Complete Company’s two financial reconciliation of profit after tax to cash flows from
statements (in millions): operations.
b Based on your work, explain to the CEO why cash
Income statement for the year ending decreased during a profitable year.
30 June 2019
Sales $ 750
Cost of goods sold 450
  Gross profit $ 300
Operating expenses 100
  Income before interest and taxes $ 200
CASES
Interest expense 15
  Income before taxes $ 185
Income tax expense 75
LO1, 7
 Profits $ 110 23 Research and analysis
Access the latest available annual report for both CSL and
Balance sheet as at 30 June
Cochlear. Please note, both companies financial year ends
2019 2018 30 June, with the latest annual reports usually available in
Cash $ 45 $ 80 September. They are easy to find by doing an internet search
Accounts receivable 155 115 for the company name and ‘annual report’ and the
appropriate year.
Inventory 225 190
REQUIRED
Prepaid insurance   22  32
a Examine the companies’ statements of cash flows.
  Total current assets $447 $417 Identify the major cash inflows and outflows in investing
Property and equipment 1 250 1 050 and financing activities. Briefly discuss how these have
changed from those shown in this chapter and Appendix B.
Accumulated depreciation   (175)  (140)
b Calculate the companies’ free cash flow in the current
  Total property and equipment $1 075 $  910 year. Has this improved?
  Total assets $1 522 $1 327 c Where have both companies obtained their cash?

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
232 ACCT3 Financial
 LO7 LO7
24 Ethics in accounting 26 Free cash flow and financing options
You are the accountant of a small company that wants to Sarah is an entrepreneur and the founder of Chemical
expand. The CEO is negotiating a loan with the bank and the Supply Company. During the last year, Chemical Supply
bank requires a statement of cash flows. The CEO is generated $400 000 in operating cash flows, paid $250 000
concerned because operating cash flows are down in capital expenditures (as it does almost every year), and
compared to prior years. The main reason is deteriorating paid $50 000 in dividends. Sarah is interested in significantly
collections from accounts receivables. The CEO presents expanding this year. To do so, she needs to spend $1 million
three options to address the situation prior to year-end and on equipment in addition to her normal capital expenditures.
the preparation of the statement of cash flows: She believes that if she buys the equipment, her operating
i convert some of the oldest receivables to long-term cash flows will increase by at least 50 per cent and could
notes receivable possibly double. She has spoken with the bank, which has
ii sell some receivables to a collector for $0.65 per $1 offered the following two note options where an equal
of receivables amount of principal is due each year:
iii delay payment of all outstanding accounts payable i two-year, 5 per cent, $1 000 000 note
until the next year. ii six-year, 7 per cent, $1 000 000 note.

REQUIRED REQUIRED
a Comment on the appropriateness of each option. a What is Chemical Supply Company’s current free
b Is there an ethical dilemma involved? cash flow.
c How would you respond to the CEO? b Identify the advantages and disadvantages of each
option the bank provides.
25 SMS Communications: Statement of LO1 c Which option should Sarah choose and why?
cash flow (SCF) d What other alternatives are available for expansion and
what are the advantages and disadvantages of these?
During the CEO’s address at the annual general meeting the
Chair of the Board of Directors, sends you the following
SMS: ‘why do we have a stupid @#%& SCF?’. In 140
characters or less prepare a sentence the Chair could read
to the meeting simply explaining the reason why the annual
report includes a statement of cash flows (SCF).

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 12 Statement of cash flows 233
 13
The first 12 chapters of this book examined the various
aspects of financial accounting – the process of identifying,
measuring and communicating economic information to
external stakeholders to permit informed decisions. This
chapter demonstrates how to analyse the products of this
process – the statement of comprehensive income,
balance sheet, statement of cash flows and statement
changes in equity – to make informed decisions about a
company; that is, it focuses on financial statement analysis.

Financial statement We will use the financial statements of the biotechnology

company Cochlear, which helps ‘people hear and be

analysis heard’. Cochlear is a Top 50 company, about one-sixth the

size of CSL (and not a direct competitor). Although
substantially different in size, financial statement analysis
allows us to compare and contrast the two companies.
This brings together much of the analysis conducted at the
end of most chapters, making it more coherent and
LEARNING extending the analysis.
OBJECTIVES Financial statement analysis can help investors and
creditors understand how effectively and efficiently
companies like Cochlear and CSL are conducting their
businesses and the resulting financial performance,
After studying the material in this chapter, you especially in comparison to each other.
should be able to:
Leon Sidik

1 Understand the nature of financial

statement analysis.
2 Calculate and interpret horizontal and
vertical analyses.
3 Assess profitability through the calculation
and interpretation of ratios.
4 Assess liquidity through the calculation and
interpretation of ratios.
5 Assess solvency through the calculation and
interpretation of ratios.
6 Calculate and interpret a DuPont analysis.

Cochlear and CSL are two of the largest biotechnology companies in

Australia

LO1 FINANCIAL STATEMENT

Express
YT
ANALYSIS
Throughout this PPL HIS
A

chapter apply this Financial statement analysis is the

icons indicate financial statement
an opportunity
process of applying analytical tools to a analysis  The process of
applying analytical tools to
for online business’ (usually a company’s) financial a company’s financial
self-study through statements to understand the business’ statements to understand
CourseMate Express, the business’ financial
financial health. The goal of such an
linking you to revision health.
quizzes, e-lectures, analysis is to provide some context for
animations and more.
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
234
 understanding the accounting numbers on the financial conference calls and notifications of shareholder meetings
statements. Ultimately, financial analysis should help all can contain useful information. Finally, it is always a good
stakeholders (investors, creditors, employees even idea to consult independent, third-party analysis.
management), or any other interested party, better understand For publicly listed companies it is also useful to look at
a business’ financial performance and position, and therefore the share price history as investors have a vested interest
make better decisions for, and about, that business. Enabling in knowing all they can about the companies in which they
good decisions is one goal of financial accounting, and it are buying and selling shares.
should be the product of financial statement analysis. Exhibit 13.1 shows a five-year increase by CSL
Financial analysis requires the following: of around 160 per cent, and by Cochlear of around
● financial information 120 per cent, while the weighted average of the top
● standards of comparison 50 companies listed on the ASX 50 Index is just over
● tools of analysis. 20 per cent.
YT
PPL HIS In this chapter, the financial information provided by
A

Check out the video summary Cochlear will be used to illustrate the process of financial
for Chapter 13
analysis. Our focus will be predominantly on information
FINANCIAL INFORMATION from the income statement and the balance sheet. As a
result, only those two statements are shown in the text.
Reporting entities must file their annual financial statements
However, when information beyond these two statements
with the Australian Securities and Investments Commission
is required, it will be provided. The most recent financial
(ASIC). All publicly listed companies must also prepare
statements for listed companies are available in their
audited financial statements each year and file them with the
annual reports, online.
Australian Securities Exchange (ASX). These statements
include the income statement, balance sheet, statement of
STANDARDS OF COMPARISON
changes in equity and statement of cash flows. Financial
statements contain current and prior-year data for comparative When conducting a financial analysis, there should be
purposes and are the starting point for any analysis. some benchmarks for comparison. The most common
In addition to financial statements, reporting entities benchmark is the prior year(s) of the same company. This
provide other information that should be consulted to is often called an intracompany comparison because it is a
enhance a financial analysis. For example, a company’s comparison within a company. Horizontal analysis (time
notes to its financial statements (as you have seen in series) is an excellent example of intracompany analysis.
Chapter 2) provide further explanation of items on the Another common benchmark is competitors.
financial statements and additional disclosures not included Comparisons among competitors are often called
on the statements. A company’s management’s discussion intercompany comparisons (cross-sectional analysis)
and analysis will contain the most senior insiders (usually because they are between companies, usually for the
the chairperson and CEO) commentary on aspects of same time period. Vertical analysis is an excellent tool for
company operations, corporate governance, risk analysis intercompany analysis because it removes the effect of
and future plans. Even company press releases, earnings company size.

CSL Limited 160%

Cochlear 140%
ASX 50 Index 120%
100%
80%
60%
40%
20%
0
–20%
–40%
Jul 13 Jul 14 Jul 15 Jul 16 Jul 17

EXHIBIT Comparison of CSL, Cochlear and the ASX 50 Index for the five years 2013 to 2017 inclusive
13.1

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 13 Financial statement analysis 235
 A final benchmark is industry standards. Often, industry both dollar and percentage terms. The actual calculations
benchmarks can be obtained from financial websites and are as follows:
are especially useful when there is more than one main
competitor. KEY FORMULA 13.1 HORIZONTAL ANALYSIS
The analysis in this text will use both intracompany and
Dollar Change
intercompany comparisons. Cochlear and CSL are used for in Account = Current-year Balance − Prior-year Balance
intercompany comparisons. Even though comparison Balance
seems less ideal because they supply very different types Percentage Dollar Change
of medical products (hearing implants versus vaccines and Change in =
Account Balance Prior-year Balance
plasma), they are ideal to demonstrate the advantages of
financial statement analysis due to their substantially
different sizes. A comparison of the raw data in the financial Horizontal analysis is a simple but powerful analytical
statements may not yield much insight as Cochlear had tool. It reveals significant changes in account balances and
total comprehensive income in 2017 of A$222 million therefore identifies items for further investigation. For
compared to CSL’s US$1510; however, analysis we have example, a large increase in say carbon capture expense
conducted in previous chapters, such as return on assets, focuses attention on why this expense increased so much
makes the size and currency differences irrelevant. or how environmentally active the company has become.
That is the nature of horizontal analysis – it often provides
ANALYSIS TOOLS the right questions to ask, but care needs to be exercised
not to immediately jump to obvious conclusions. Some
There are many tools used to conduct a financial analysis.
large percentage changes may be the result of a very small
Three of the more common are:
expense in the previous financial year.
● horizontal analysis
Horizontal analysis is calculated for both the balance
● vertical analysis
sheet and the income statement. Changes in critical
● ratio analysis.
account balances, such as inventory for a manufacturer or
Horizontal analysis is a comparison of a company’s
liabilities for a company in financial trouble, are usually
financial results across time. Vertical analysis is a
examined first. We also examine any significant changes
comparison of each line in the financial statement to a
in other account balances. Insignificant changes are often
base account from the same financial statement. Ratio
ignored because they would not affect decision-making.
analysis is the comparison of items from the financial
For example, an account that grows from $1 million to
statements (and other financial information, such as share
$3 million experiences a 200 per cent increase, but such
price) that are thought to be related (like a person’s
an increase is immaterial to a $50 billion company.
height and weight) to provide a more comprehensive
understanding of the financial results. Typically, individual Balance sheet horizontal analysis
ratios are grouped together to assess various aspects Exhibit 13.2 contains a horizontal analysis of Cochlear’s
(profitability, solvency etc.) of a company’s financial 2017 (and 2016) balance sheet. The analysis was undertaken
performance and prospects. on an Excel spreadsheet where the 2016 figure was
The remainder of this chapter demonstrates and subtracted from the 2017 figure to obtain the dollar change
discusses horizontal, vertical and ratio analyses of [=B5–C5] and then the percentage change by dividing the
Cochlear’s 2017 financial statements and draws dollar change by the 2016 figure and rounding to two
comparisons with CSL. decimal places [=ROUND(D5/C5,2)]. We see Cash has
increased 19 per cent.
The analysis shows mixed changes in asset accounts.
LO2 HORIZONTAL AND Overall, Cochlear increased total assets by almost
VERTICAL ANALYSES $180 million in 2017, which represents a 19 per cent
expansion. Cochlear experienced the largest dollar change
HORIZONTAL ANALYSIS in intangible assets – increasing almost $116 million (52%) –
but the largest percentage increase on the balance sheet
Horizontal analysis was first introduced in Chapter 2. Recall was (current) loans and borrowings up over 2000 per cent
that horizontal analysis is a technique that compares (but less than $81m) increase. Caution must be exercised
account balances over time. Horizontal analysis is a in looking only at the dollar change or only looking at the
technique that calculates the change in an account balance percentage change.
from one period to the next and expresses that change in

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236 ACCT3 Financial
 A B C D E
Cochlear
1
Balance Sheet

2017 2016 $change %change

2 $000 $000 $000
3 ASSETS        
4 Current assets        
5 Cash and cash equivalents 89 540 75 417 14 123 0.19
6 Trade and other receivables 292 139 281 925 10 214 0.04
7 Forward exchange contracts 18 430 11 454 6 976 0.61
8 Inventories 160 011 154 103 5 908 0.04
9 Current tax assets 7 278 6 208 1 070 0.17
10 Prepayments 18 562 13 921 4 641 0.33
11 Total current assets 585 960 543 028 42 932 0.08
12 Non-current assets
13 Other receivables 906 1 507 –601 –0.40
14 Forward exchange contracts 7 760 10 713 –2 953 –0.28
15 Property, plant and equipment 120 107 86 878 33 229 0.38
16 Intangible assets 339 976 224 338 115 638 0.52
17 Investments 15 064 13 755 1 309 0.10
18 Deferred tax assets 66 586 77 144 –10 558 –0.14
19 Total non-current assets 550 399 414 335 136 064 0.33
20 TOTAL ASSETS 1 136 359 957 363 178 996 0.19
21 LIABILITIES        
22 Current liabilities        
23 Trade and other payables 130 911 110 354 20 557 0.19
24 Forward exchange contracts 2 041 12 643 –10 602 –0.84
25 Loans and borrowings 84 687 3 978 80 709 20.29
26 Current tax liabilities 26 326 13 701 12 625 0.92
27 Employee benefit liabilities 52 412 45 485 6 927 0.15
28 Provisions 24 992 33 675 –8 683 –0.26
29 Deferred revenue 25 246 31 264 –6 018 –0.19
30 Total current liabilities 346 615 251 100 95 515 0.38
31 Non-current liabilities        
32 Trade and other payables 33 917 – 33 917 1.00
33 Forward exchange contracts 3 111 3 547 –436 –0.12
34 Loans and borrowings 134 235 189 260 –55 025 –0.29
35 Employee benefit liabilities 11 038 13 750 –2 712 –0.20
36 Provisions 54 711 44 027 10 684 0.24
37 Deferred tax liabilities 5 837 7 122 –1 285 –0.18
38 Deferred revenue 3 248 – 3 248 1.00
39 Total non-current liabilities 246 097 257 706 –11 609 –0.05
40 TOTAL LIABILITIES 592 712 508 806 83 906 0.16
41 NET ASSETS 543 647 448 557 95 090 0.21
42 EQUITY        
43 Share capital 169 367 158 940 10 427 0.07
44 Reserves –12 801 –14 662 1 861 –0.13
45 Retained earnings 387 081 304 279 82 802 0.27
46 TOTAL EQUITY 543 647 448 557 95 090 0.21
EXHIBIT Horizontal analysis of Cochlear Limited balance sheet as at 30 June 2017 and 2016
13.2

Source: Cochlear Limited, Annual Report 2017, p. 58.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 13 Financial statement analysis 237
 Overall, total liabilities increased by 16 per cent (almost Income statement horizontal analysis
$84m) – a little less than total assets (19%). However,
The analysis shows that revenue increased 11 per cent
because the percentage increase in total liabilities was
while cost of sales increased only 7 per cent (but it should
smaller than total assets, the percentage change in equity
be noted COS is a relatively small percentage of sales
was greater (21%). In effect, Cochlear grew its assets by
(as we will explore later). This led to an 18 per cent
increasing equity ($95m) more than liabilities ($84m).
increase in net profits, but only 13 per cent in total
Caution needs to be exercised when looking at percentage
comprehensive income due to changes in the fair value
and dollar changes. If liabilities were $10 and equity $90, a
of cash flow hedges (but not shown in the condensed
$10 increase in liabilities would be 100 per cent, while a
version in Exhibit 13.3) – which is beyond our discussion
$45 increase in equity would only be 50 per cent. A more
in this book.
detailed examination of equity shows the increase in
Revenue increased by 11 per cent while the percentage
retained earnings (27%, $83m) was the main driver on
increase in expenses was lower, leading to a 20 per cent
increasing total equity. The fall in reserves, although
increase in results from operating activities. This
13 per cent (about half of the increase in retained earnings),
demonstrates how smaller increases in expenses below
was minor in dollar terms (less than $2m). The analysis of
the increases in revenue can have a substantial impact
the balance sheet alone raises more questions: why did
on results.
inventory increase only 4 per cent when total assets
increased 19 per cent? The income statement may shed
VERTICAL ANALYSIS
more light.
Exhibit 13.3 contains a horizontal analysis of a Vertical analysis was also introduced in Chapter 2. Recall
condensed version of Cochlear’s 2017 and 2016 income that vertical analysis is a technique that compares account
statement and statement of comprehensive income. balances within one year. Formally, vertical analysis is an

A B C D E

Cochlear
1
Income statement

  2017 2016 $ change % change

2 $000 $000 $000
3 Revenue 1 253 838 1 130 552 123 286 0.11
4 Cost of sales –358 373 –333 593 –24 780 0.07
5 Gross profit 895 465 796 959 98 506 0.12
6 Selling and general expenses –348 928 –324 144 –24 784 0.08
7 Administration expenses –83 474 –79 287 –4 187 0.05
8 Research and development expenses –151 929 –145 080 –6 849 0.05
9 Other income 4 466 14 156 –9 690 –0.68
10 Results from operating activities 315 600 262 604 52 996 0.20
11 Finance income – interest 742 468 274 0.59
12 Finance expense – interest –7 517 –8 806 1 289 –0.15
13 Net finance expense –6 775 –8 338 1 563 –0.19
14 Profit before income tax 308 825 254 266 54 559 0.21
15 Income tax expense –85 209 –65 345 –19 864 0.30
16 Net profit 223 616 188 921 34 695 0.18
17 Other comprehensive (loss)/income, net of tax –1 608 6 904 –8 512 –1.23
18 Total Comprehensive Income 222 008 195 825 26 183 0.13
EXHIBIT Horizontal analysis of Cochlear Limited (condensed) income statement (and comprehensive income) for the
13.3 2017 financial year

Source: Adapted from Cochlear Limited, Annual Report 2017, pp. 56–57.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
238 ACCT3 Financial
analytical technique that states each account balance on a
financial statement as a percentage of a base amount on MAKING IT REAL
the statement. The base account is total assets for the
balance sheet and revenues for the income statement. The HEALTHCARE IS A GROWTH SECTOR
actual calculation is as follows: This Making it real box goes beyond simple financial
statement analysis by adding sector-wide data.
KEY FORMULA 13.2 VERTICAL ANALYSIS Health insurance: Don’t blame young people
for your rising premiums1
For the balance For the income In 2017 the Australian Government announced
sheet statement changes to slow the yearly bump in health insurance
Account Balance Account Balance
premiums, aimed mostly at young health insurance
Percentage = or users. But do these measures address what is at the
Total Assets Net Sales or Revenue
heart of the yearly premium increase?
These measures indicate the problem is that
young people are not taking up or retaining private
Like horizontal analysis, vertical analysis is a simple but health insurance policies. This therefore means that
powerful tool. The dividing of each account balance by the age groups who are more likely to claim are the
either assets or revenues accomplishes two purposes. biggest private health care users. This is somewhat
First, it shows the relative importance of each account to supported by ‘the proportion of insurance
the company. Second, it standardises the account balances customers aged 20 to 29 falling from 10.3 per cent
to 9.4 per cent over the last five years’.
by firm size so that companies of different sizes can be
However, this fact alone is not enough to justify
compared. the increases in premiums we are seeing. The real
To illustrate, suppose a company with $10 million in reason is simply that the costs of insuring customers
total assets has $1 million in cash while another company is growing rapidly. ‘Benefits paid per customer
with $100 billion in assets has $2 billion in cash. The increased by around 4.7 per cent per year over the
$100 billion company has more cash, but it is also a much past five years … the number of hospital visits
funded by health insurance increased by an average
bigger company. A vertical analysis would show that the of 5.5 per cent per year over the past five years’.
smaller company has 10 per cent of its assets in cash This very issue is reflected in public health
($1/$10 = 10%) while the larger company has only spending and so it seems this is more likely to be an
2 per cent of its assets in cash ($2/$100 = 2%). By dividing overall trend than something that can be curbed.
by total assets, the analysis makes possible a meaningful ‘Australian government spending on health increased
by 4.4 per cent in real terms in the decade to
comparison of two companies of vastly different sizes.
2013–14.’ And this trend is also seen worldwide,
Because vertical analysis removes the effect of size (and with OECD countries’ health care spending growth at
for CSL and Cochlear, currency differences), an analysis an average of 4 per cent in real terms.
conducted on a financial statement is appropriately called So, it seems we are ‘spending more on health
a common-size financial statement. care because it is increasingly valuable to us both as a
society and as individuals taking out insurance
Balance sheet vertical analysis contracts’.
Exhibit 13.4 contains a vertical analysis of Cochlear’s 2017
iStock.com/Natali_Mis

and 2016 balance sheet. Percentage changes have been

rounded to the closest 1 per cent.
The analysis shows large percentages of assets in
trade and other receivables (2016 29%, 2017 26%) and
intangible assets (2016 23%, 2017 30%). In contrast CSL
in 2017 had 13 per cent of total assets in receivables and
12 per cent in intangibles. Here the advantage of vertical
analysis is highlighted: Cochlear has $292 million in
receivables; CSL (when converted to Australian dollars)
has $1560 million, which reveals that Cochlear is holding
over double the receivables of CSL as a percentage of
total assets.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 13 Financial statement analysis 239
 A B C D E
Cochlear
1
Balance sheet 

2017 % Total 2016 % Total

2  
$000 assets $000 assets
3 ASSETS        
4 Current assets        
5 Cash and cash equivalents 89 540 0.08 75 417 0.08
6 Trade and other receivables 292 139 0.26 281 925 0.29
7 Forward exchange contracts 18 430 0.02 11 454 0.01
8 Inventories 160 011 0.14 154 103 0.16
9 Current tax assets 7 278 0.01 6 208 0.01
10 Prepayments 18 562 0.02 13 921 0.01
11 Total current assets 585 960 0.52 543 028 0.57
12 Non-current assets        
13 Other receivables 906 0.00 1 507 0.00
14 Forward exchange contracts 7 760 0.01 10 713 0.01
15 Property, plant and equipment 120 107 0.11 86 878 0.09
16 Intangible assets 339 976 0.30 224 338 0.23
17 Investments 15 064 0.01 13755 0.01
18 Deferred tax assets 66 586 0.06 77 144 0.08
19 Total non-current assets 550 399 0.48 414 335 0.43
20 TOTAL ASSETS 1 136 359 1.00 957 363 1.00
21 LIABILITIES        
22 Current liabilities        
23 Trade and other payables 130 911 0.12 110 354 0.12
24 Forward exchange contracts 2 041 0.00 12 643 0.01
25 Loans and borrowings 84 687 0.07 3 978 0.00
26 Current tax liabilities 26 326 0.02 13 701 0.01
27 Employee benefit liabilities 52 412 0.05 45 485 0.05
28 Provisions 24 992 0.02 33 675 0.04
29 Deferred revenue 25 246 0.02 31 264 0.03
30 Total current liabilities 346 615 0.31 251 100 0.26
31 Non-current liabilities        
32 Trade and other payables 33 917 0.03 - 0.00
33 Forward exchange contracts 3 111 0.00 3 547 0.00
34 Loans and borrowings 134 235 0.12 189 260 0.20
35 Employee benefit liabilities 11 038 0.01 13 750 0.01
36 Provisions 54 711 0.05 44 027 0.05
37 Deferred tax liabilities 5 837 0.01 7 122 0.01
38 Deferred revenue 3 248 0.00 - 0.00
39 Total non-current liabilities 246 097 0.22 257 706 0.27
40 TOTAL LIABILITIES 592 712 0.52 508 806 0.53
41 NET ASSETS 543 647 0.48 448 557 0.47
42 EQUITY        
43 Share capital 169 367 0.15 158 940 0.17
44 Reserves -12 801 -0.01 -14 662 -0.02
45 Retained earnings 387 081 0.34 304 279 0.32
46 TOTAL EQUITY 543 647 0.48 448 557 0.47
EXHIBIT Vertical analysis of Cochlear Limited balance sheet as at 30 June 2017 and 2016
13.4

Source: Cochlear Limited, Annual Report 2017, p. 58.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
240 ACCT3 Financial
 The analysis of liabilities and equity shows in 2017 over health sector this difference reflects the different products
half (52%) of the company’s assets are generated by liabilities, that each company supplies, and no conclusions can be
but this is a small decrease from 2016 (53%) with the majority drawn about efficiencies.
of those liabilities in current trade and other payables (12%) At this point comparisons become more difficult. Both
and non-current loans and borrowings (also 12%). Between have research and development expenses – CSL 10 per
2016 and 2017 the percentage of assets generated through cent; Cochlear 12 per cent. Other expenses are listed
equity increased marginally from 47 per cent to 48 per cent, differently – CSL: selling and marketing expenses, and
which is exactly as expected given the marginal reduction in general and administration expenses: Cochlear: selling and
total liabilities. This takes us back to Chapter 1 where we first general expenses, and administration expenses. Even a
discussed Assets = Liabilities + Equity. comparison of total comprehensive income requires care.
Overall, the vertical analysis shows a different balance Again, although both are health sector companies the
sheet in contrast to CSL (see Chapter 2), where property, 23 per cent for CSL compared to the 18 per cent for
plant and equipment (PPE) (32%) and inventory (28%) Cochlear may reflect different business models as much
were the largest assets. It also highlights CSL’s greater as different products. Some businesses rely on small profit
reliance on debt (65%) compared to Cochlear (52%). margins and large turnovers (the sale of fuel by a service
station), while others survive on high profit margins and
Income statement vertical analysis small turnover (the convenience store side of a service
Exhibit 13.5 contains a vertical analysis of Cochlear’s station). Supermarkets thrive on low profit margins (around
2017 and 2016 income statement (and comprehensive 5 per cent for the major Australian supermarkets) and very
income). large turnovers. In all this analysis it is important to
The analysis shows cost of sales is only 29 per cent remember that when annual reports are available to the
of revenue, leaving a gross profit of 71 per cent. This is general public they YT
PPL HIS
much the same as 2016, but a higher (better) gross profit are also available to

A
margin than CSL (54%). While both companies are in the Review this content with the e-lecture
competitors.

A B C D E
Cochlear
1
Income statement

2017 % 2016 %
2  
$000 Revenue $000 Revenue
3 Revenue 1 253 838 1.00 1 130 552 1.00
4 Cost of sales −358 373 −0.29 −333 593 −0.30
5 Gross profit 895 465 0.71 796 959 0.70
6 Selling and general expenses −348 928 −0.28 −324 144 −0.29
7 Administration expenses −83 474 −0.07 −79 287 −0.07
8 Research and development expenses −151 929 −0.12 −145 080 −0.13
9 Other income 4 466 0.00 14 156 0.01
10 Results from operating activities 315 600 0.25 262 604 0.23
11 Finance income – interest 742 0.00 468 0.00
12 Finance expense – interest −7 517 −0.01 −8 806 −0.01
13 Net finance expense −6 775 −0.01 −8 338 −0.01
14 Profit before income tax 308 825 0.25 254 266 0.22
15 Income tax expense −85 209 −0.07 −65 345 −0.06
16 Net profit 223 616 0.18 188 921 0.17
17 Other comprehensive (loss)/income, net of tax −1 608 0.00 6 904 0.01
18 Total Comprehensive Income 222 008 0.18 195 825 0.17
EXHIBIT Vertical analysis of Cochlear’s income statement
13.5

Source: Adapted from Cochlear Limited, Annual Report 2017, pp. 56–7.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 13 Financial statement analysis 241
 KEY FORMULA 13.3 P
 ROFITABILITY RATIOS:
LO3 PROFITABILITY ANALYSIS PROFIT MARGIN

One of the most important aspects of any financial analysis Total Comprehensive Income
Profit Margin =
is profitability. Everyone associated with a company – Revenue
shareholders, creditors, employees and suppliers – all want
the company to generate profits; because without profits 222
Cochlear 2017: 17.7%
the business will (eventually) cease. To determine a 1254
company’s profitability, one can look at profits (or total
comprehensive income); but that tells only a portion of the 2017 2016
story. It does not reveal how efficiently and effectively Cochlear 17.7% 17.3%
those profits were generated. To find out, one must
CSL 21.8% 17.1%
compare profits to other company values such as sales,
assets, equity, share capital and market prices. Cochlear’s 2017 profit margin is 17.7 per cent, meaning
The following ratios are commonly used to analyse that the company generated a little under eighteen cents
profitability. Note that each ratio compares profits to some of profit for every dollar of revenue in 2017. This is a
other financial aspect of the company. In each case we will marginal improvement on 2016, but shows Cochlear did
use ‘total comprehensive income’, because this is the not have the substantial increase experienced by CSL.
figure usually quoted as a company’s ‘bottom line profit’. Both companies’ annual reports highlight improvement
Because each ratio reveals something different about a in 2017, especially CSL; its first ‘Business Highlight’ was
company’s profit, they are best used in tandem so that a ‘CSL reports net profit after tax …’
broad understanding of a company’s profitability can be
obtained. RETURN ON EQUITY
Profitability ratio Relationship The return on equity ratio compares return on equity
comprehensive income to the average ratio  Compares
Profit margin Profit to sales comprehensive income to
balance in (shareholders’) equity during average shareholders’
Return on equity Profit to average total (shareholders’) equity
the year. The ratio represents how equity and measures the
Return on assets Profit to average total assets effectively a company uses the resources ability to generate profits
from equity.
Earnings per share Profit to issued shares (equity) provided by shareholders during
Price to earnings Profit to share price the year to generate additional resources for its owners.
Shareholders naturally want this ratio to be as high
In the following sections, the text will explain each ratio as possible.
and show the calculations for Cochlear. Unless otherwise
noted, data for each calculation is obtained from KEY FORMULA 13.4 P
 ROFITABILITY RATIOS:
Exhibits 13.2 and 13.3. After the calculation of Cochlear’s RETURN ON EQUITY
ratios, CSL’s ratios will be provided for comparison
Total Comprehensive Income
purposes. Then a summary of what was learned from the Return on Equity =
ratios about the two companies’ profitability will be Average Shareholders Equity
discussed. Where average shareholders’ equity is as follows:
(Beginning equity + Ending equity)
PROFIT MARGIN 2

profit margin The profit margin ratio compares

ratio  Compares profits to net sales. A higher ratio 222
comprehensive income to Cochlear 2017: = 44.7%
net sales and measures indicates a greater ability to generate (449 + 544)/2
the ability to generate profits from sales. Figures are rounded
profits from sales. to the nearest million dollars, for ease 2017
of calculation. The rounding also Cochlear 44.7%
acknowledges judgement and choices in accounting, which CSL 52.7%
means the numbers are often not mathematically precise,
but not materially misstated. Results are usually reported In Australia companies are required to show the figures
to one decimal place because ratios are guides, unlike, for for the current and previous year. This means if we wished
example, Olympic results where gold medals can be to calculate any ratio involving averages, we would need
decided by one thousandth of a second. the previous financial statements to obtain the opening
balance for this year.
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
242 ACCT3 Financial
 The 2017 ratio of 44.7 per cent shows that Cochlear EARNINGS PER SHARE
generated almost 45 cents in profits for every dollar of
Earnings per share (EPS) compares a company’s profit to
resources provided by shareholders. This is lower than CSL,
the average number of ordinary shares issued during the
but still substantially higher than the average return on
year. The ratio represents the return on each share owned
equity for Australian companies of around 10 per cent.
by an investor. Although companies normally disclose EPS
The result may be due, at least in CSL’s case, to the
on their income statement, the calculation will be
­semi-regular share buybacks and for both companies
demonstrated nonetheless.
the high ‘gearing’, as discussed later in the chapter
The beginning and ending outstanding shares might be
(LO5 Solvency analysis).
collected from the notes to the accounts but this does not
give a weighted average. Most companies show how their
RETURN ON ASSETS
EPS are calculated and the weighted average number of
return on assets The return on assets ratio compares shares is given (for Cochlear, Note 2.5: Equity and reserves,
ratio  Compares returns (comprehensive income) to shows the weighted average shares in 2017 as 57.4 million
comprehensive income to
average total assets and
average total assets during the year. shares issued).
measures the ability to It represents a company’s ability to
generate profits from generate profits from its entire resource
assets. KEY FORMULA 13.6 P
 ROFITABILITY RATIOS:
base, not just those resources provided EARNINGS PER SHARE
by owners. Like the return on equity, investors would like
Total Comprehensive Income
the ratio as high as possible. Earnings per Share =
Average Number of Ordinary
Shares
KEY FORMULA 13.5 PROFITABILITY RATIOS:
RETURN ON ASSETS Where the average number of ordinary shares is as follows:
(Beginning Balance of Ordinary Shares +
Total Comprehensive Income Ending Balance of Ordinary Shares)
Return on Assets =
Average Total Assets 2
Where average total assets is as follows:
(Beginning Total Assets + Ending Total Assets) 222
Cochlear 2017: (all figures in millions)
2 57
= $3.89 per share

222 This is very similar to the figure provided by Cochlear

Cochlear 2017: = 21.2% who calculated EPS on ‘net profits attributable to equity
(1136 + 957)/2
holders of the parent entity’ and did not include other
2017 comprehensive income of minus $1.6 million, which in 2017
was immaterial. This was not the case in 2016 when other
Cochlear 21.2%
comprehensive income added almost 4 per cent to total
CSL 18.9%
comprehensive income, nor for CSL when it added over
The 2017 ratio of 21.2 per cent shows Cochlear 11 per cent. Therefore, the figure shown here for CSL is
generated over 21 cents in profits for every dollar of assets significantly different to CSL’s calculation in its annual report
possessed during the year; slightly more than CSL. This which is based on net profits. Cochlear, like other listed
result is not surprising given Cochlear has large intangible companies, also reports ‘diluted EPS’. Diluted EPS takes
assets that it has researched and developed rather than into account options that have been issued, but is beyond
purchased, and as such a large amount of intellectual the scope of our analysis here.
property is not recorded on the balance sheet. CSL has Note that an EPS has not been included for comparison
similar research and development. The accounting with CSL. While it is very useful comparing Cochlear’s 2016
standards do not allow research costs to be recorded as figure ($196 / 57.1 = $3.43 per share) to the 2017 figure to
an asset or ‘capitalised’ to a limited extent, but does show the substantial increase ($0.46 or 13.4%), comparing
allow this with all development costs. CSL EPS of $3.31 (or $2.94 as calculated in its annual
Sometimes the return on assets is calculated using report, not including comprehensive income) is meaningless
earnings before interest and tax (EBIT). This is used to because ownership in companies is divided into different
measure how efficiently management is using assets and numbers of shares. If a company were to split its shares
to remove the effect of borrowings (interest expense) and as we saw in Chapter 11 and profits were to remain the
taxes that are levied on taxable income rather than same, the EPS would halve. Further CSL’s EPS is in US
accounting profit. dollars, which could be easily converted into Australian

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 13 Financial statement analysis 243
 dollars, but a simple comparison of figures from the annual KEY FORMULA 13.7 P
 ROFITABILITY RATIOS:
report makes such a comparison even more meaningless. PRICE EARNINGS RATIO
EPS is useful because it reduces a number such as
$222 million or 1.5 billion into an easily comprehensible $2 Current Share Price
Price to Earnings Ratio =
or $3 per share figure. For a shareholder with 1000 shares, Earnings per Share
they know their share of the profit is only $2000. EPS is
vital for probably the single most quoted ratio of a listed The following calculation of Cochlear’s 2017 P/E ratio
company; price earnings ratio. uses the $155.45 share price at the close of business on
We have chosen to use total comprehensive income 30 June 2017, the end of the company’s financial year (and
rather than net profits because Accounting Standard the last trading day of the financial year).
AASB 101 Presentation of Financial Statements:
prescribes the basis for presentation of general purpose 2017
financial statements to ensure comparability both with Cochlear 40
the entity’s financial statements of previous periods
and with the financial statements of other entities. CSL 42
It sets out overall requirements for the presentation of
financial statements, guidelines for their structure and Cochlear’s ratio of 40 shows that a share of Cochlear
minimum requirements for their content.2 was selling for 40 times EPS at the close of the 2017
financial year. While we cannot compare one company’s
All public companies need to report comprehensive
EPS to another, we can make valid comparisons of P/E
income.
ratios. It would appear investors have marginally more
confidence in the future prospects of CSL (P/E 42) when
Alamy Stock Photo/360b;
Courtesy CSL

compared to Cochlear, but the difference is small and you

should not read too much into this. The higher the P/E ratio
the more confidence shareholders have in the future. These
two companies can be expected to have substantially
increased earnings in future years. These P/E ratios are
CSL Cochlear and CSL operate in the same health sector, not as direct
competitors, but they do compete for similar investors unlikely to be the same as current quoted P/E ratios,
because it is no longer 30 June 2017 and the ratios are
usually calculated on profits not comprehensive income as
PRICE TO EARNINGS RATIO we have done here.
price to earnings The price to earnings ratio (P/E) ratio These ratios are significantly higher than the average
(P/E) ratio  Compares compares profits to the current market P/E ratio of 16 for the top 50 companies listed on the ASX.
comprehensive income to
a company’s share price price of the company’s ordinary shares. For comparison, let us look at the supermarkets;
and provides an indication Because a company’s share price Woolworths and Wesfarmers (Coles) had P/E ratios of 22
of investor perceptions of represents the value per share, the ratio
the company. and 19 respectively at the same time. This indicates either
uses EPS rather than total profits. It is their current profits are prudently (conservatively) calculated
also the first ratio in which profits are in the denominator and/or investors expect the future earnings of these
rather than the numerator. That is why the ratio is called retailers to be better than present earnings, but not as
price to earnings rather than earnings to price. prudent as/better than our two health sector companies.
Because the P/E ratio uses share prices, it provides an Cochlear’s and CSL’s earnings are likely to be prudently
indication of current investor perceptions of the company. stated because much of the research and development
For example, a P/E ratio of 10 means that investors are expenditure is currently expensed when it is likely to (1) not
willing to pay 10 times current EPS to buy one share. yield immediate benefits and (2) only be undertaken if the
A higher P/E ratio generally indicates that investors are expected future payoffs are greater than the expenditure.
more optimistic about the future prospects of a company,
and a lower ratio is the reverse. (If you, as a student, sold SUMMARY OF PROFITABILITY
your future earnings stream you could expect a very high
Based on the five ratios examined, it is clear that Cochlear
P/E ratio as you are forgoing current earnings to invest in
is profitable and that its profitability has increased over the
yourself, which should result in substantially higher future
two years. The Chairman’s report began with ‘Cochlear
earnings compared to current earnings.)
reported a record net profit of $224 million, an increase of
18% on the FY16 result …’3 This is a trend to watch closely,
especially in an industry that depends on prosperity and
health priorities.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
244 ACCT3 Financial
 Liquidity ratios Relationship
ANALYSIS
Because we have already Current ratio Current assets to current liabilities
calculated profitability ratios for Quick ratio Cash-like assets to current liabilities
CSL in 2017, obtain a copy of CSL’s previous Annual
Report. Using this information, calculate CSL’s profitability Receivables turnover ratio Sales (Revenue) to accounts receivable
ratios and make a general assessment about the Inventory turnover ratio Cost of goods sold to inventory
company’s profitability.
Analysis: As in the previous section on profitability, the following
CSL’s share price closed on 30 June 2016 at $112.18. sections will explain and calculate each ratio for Cochlear
Profit margin has been calculated above: using data from Exhibits 13.2 and/or 13.3. A comparison
$1044 ÷ $5910 = 17.7% of Cochlear’s and CSL’s ratios will follow each calculation.
After all ratios are presented, a summary of what has been
Return on equity: Total comprehensive income /
Average (shareholders’) equity = learned about Cochlear’s liquidity will be provided.
$1044 ÷ [($2747 + $2567) ÷ 2] = 39.3%
Return on assets: Total comprehensive income / CURRENT RATIO
Average Total Assets = $1044 ÷ The current ratio is one of the most frequently used ratios
[($6401 + $7563) ÷ 2] = 14.9% in financial analysis. It compares current assets to current
Earnings per share: Total comprehensive income / liabilities. It therefore compares assets that are cash or
Average Issued Shares = $1044 ÷ should be turned into cash within one year to liabilities that
[(465 + 457) ÷ 2] = $2.26
should be paid within one year. A higher ratio indicates
(Here we have used the opening and closing balances more assets available to satisfy current obligations and
which ended up being one million shares less than the therefore greater liquidity.
CSL reported weighted average.)
Price to earnings ratio: S
 hare Price/Earnings per Share = KEY FORMULA 13.8 L IQUIDITY RATIOS:
$112.18 ÷ $2.26 = 29.6 CURRENT RATIO
CSL showed many positive signs of profitability
Current Assets
growth between 2016 and 2017. All ratios have increased, Current Ratio =
none more so than EPS up from $2.26 to $3.31 Current Liabilities
(46% increase) and the P/E ratio up from 29.6 to 42.0
(42% increase). It seems obvious now why the share price
586
rose substantially in the 2017 financial year, but caution Cochlear 2017: = 1.7 times
347
needs to be exercised when trying to out-predict the
share market. It has been said that no one rings a bell
when a stock market reaches its highest point, nor when 2017 2016
the market bottoms. What will be the price in June 2020? Cochlear 1.7 2.2
CSL 2.8 2.8
YT
PPL HIS
A

Review this content Cochlear’s ratio of 1.7 shows that it had $1.70 in current
with the e-lecture
assets for every dollar of current liabilities. This is less than
both the prior year, and CSL’s ratios. This means that
LO4 LIQUIDITY ANALYSIS Cochlear is becoming more liquid over time.
While the trend in liquidity should be monitored, a
A major concern in any financial analysis is an assessment ratio near two may, by some unsophisticated analysts,
of a company’s liquidity, which refers to the ability of a be considered ideal. Some investors may be critical of
company to satisfy its short-term obligations. A company maintaining a current ratio that is too high. They would
must maintain the ability to pay its liabilities as they come rather the company keep only an adequate amount of
due. Failing to do so can result in additional expenses and, assets in current assets and invest the rest in more
ultimately, bankruptcy. As a result, everyone associated productive and higher-yielding assets such as PPE, or
with a company – shareholders, creditors, employees, intangibles like intellectual property. Current ratios will
suppliers – wants to see adequate liquidity. ‘improve’ when sales slow, because inventory (current
The following ratios are commonly used to assess a asset) increases. Further for most individuals and
company’s liquidity. While each ratio reveals information on businesses future earnings are likely to be the main
its own, using the ratios together provides a much richer source of resources to pay future debts. We may need
understanding of liquidity. Note that each ratio focuses on to look at a more critical liquidity measure such as the
some aspect of either current liabilities or current assets. quick ratio.

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CHAPTER 13 Financial statement analysis 245
 QUICK RATIO RECEIVABLES TURNOVER RATIO
While the current ratio is a useful measure of liquidity, it The receivables turnover ratio compares a company’s credit
does have some limitations. In particular, current assets sales during a period to its average accounts receivable
often include inventory that must be sold before cash balance during that period. It measures a company’s ability
can be generated to pay off current liabilities. Because to make and collect sales. A higher turnover ratio means
of this, several additional ratios are used to provide that the company is better able to generate and collect
more detail regarding a company’s liquidity. One is sales. Therefore, a higher ratio generally leads to better
quick ratio  Compares
the  quick ratio, which compares a liquidity. The ratio uses net sales as a substitute because
cash and near-cash assets company’s cash and ‘near-cash assets’, credit sales are not usually reported by companies. In the
to current liabilities and called quick assets, to its current case of a biotechnology manufacturer such as Cochlear or
measures the ability to
pay current liabilities liabilities. Quick assets include cash, CSL, credit sales are likely to make up most of net sales.
immediately. short-term investments and accounts For a retailer like Woolworths net sales are likely to be a
receivable. Sometimes called the acid- very poor substitute.
test ratio, the quick ratio measures the degree to which a
company could pay off its current liabilities in a few weeks KEY FORMULA 13.10 L IQUIDITY RATIOS:
rather than many months. Like the current ratio, a higher RECEIVABLES TURNOVER RATIO
quick ratio indicates greater liquidity.
Net Sales
ReceivablesTurnover Ratio =
KEY FORMULA 13.9 LIQUIDITY RATIOS: Average Accounts Receivable
QUICK RATIO Where average accounts receivable is:

Cash + Short-term Investments + (Opening Balance of Accounts Receivable

Accounts Receivable + Closing Balance of Accounts Receivable)
Quick Ratio =
Current Liabilities 2

Current Assets –
Inventory 1254
Quick Ratio Simple Calculation = Cochlear 2017: = 4.4 times per year or
Current Liabilities (282 + 292)/2 a turnover of 83 days
(365 / 4.4)
We have adopted the simpler calculation of Current CSL has a turnover of 6.1 times a year or once every
Assets less Inventory divided by Current Liabilities which 60 days.
gives us the same (or similar) answer: In a business where the majority of sales or services
(586 – 160) are provided on credit, trends in accounts receivables
Cochlear 2017: = 1.2
347 turnover ratios often can indicate whether management
is keeping good control of the credit department
2017 2016
(responsible for determining which customers are allowed
Cochlear 1.2 1.5 to buy now and pay later) and the collections department
CSL 1.3 1.2 (responsible for collecting the money from customers who
were supposed to pay later).
These low ratios are not surprising given manufacturers’
major current asset is inventory. Cochlear’s ratio of 1.2 INVENTORY TURNOVER RATIO
shows that at the end of its financial year, the company had
The inventory turnover ratio compares a company’s cost of
$1.20 in cash and near-cash assets for every dollar of
goods sold during a period to its average inventory balance
current liabilities. This indicates that Cochlear could easily
during that period. It reveals how many times a company
pay its current liabilities if they came due in the next few
can sell its average inventory balance in a period. In general,
weeks, assuming it could rapidly collect its accounts
companies want this ratio to be higher because it indicates
receivable. Note in passing, the quick ratio for CSL is
that the company sold more inventory while maintaining
substantially lower than its current ratio, while the impact
less inventory on hand. This means that the company
on Cochlear is not so pronounced. This is due to the larger
generated more sales revenue while reducing the costs of
percentage inventory make-up of CSL’s current assets
stocking inventory on the shelves; but a fast turnover might
compared to Cochlear’s.
also indicate a business is not holding some items and
missing out on potential sales. For CSL holding stock of
vaccines in case of epidemics may be important not just

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246 ACCT3 Financial
for profits but for humanitarian reasons and also for
maintaining a reputation for reliability of supply. LO5 SOLVENCY ANALYSIS
KEY FORMULA 13.11 LIQUIDITY RATIOS: A third component of any financial analysis is an examination
INVENTORY TURNOVER RATIO of solvency, which refers to a company’s ability to satisfy
its long-term obligations. If a company cannot satisfy its
Cost of Goods Sold
Inventory Turnover Ratio = obligations and becomes insolvent, it can fall into
Average Inventory bankruptcy, which can result in significant losses to
Where average inventory is as follows: investors and creditors. Therefore, both investors and
Beginning inventory + Ending inventory creditors are interested in assessing solvency.
2 A company’s solvency is related to its financial
use of financial leverage, which is the leverage  The degree
to which a company
degree to which a company obtains obtains capital through
358
Cochlear 2017: = 6.3 times capital (funds) through debt rather than debt rather than equity in
(160 + 154)/2
equity in an attempt to increase returns to an attempt to increase
returns to stockholders.
2017 shareholders. Leverage is beneficial to
shareholders when the return on borrowed funds exceeds
Cochlear 6.3
the cost of borrowing those funds. In that case, leverage
CSL 1.4
is positive. It is harmful, or negative, when the cost of
A 6.3 ratio shows that during 2017 Cochlear sold over borrowing the funds exceeds the return on those borrowed
$6 of inventory for every $1 of inventory it had on average funds. As a company uses more financial leverage, it
on its shelves. Unlike supermarkets that are likely to creates an opportunity for greater returns to shareholders,
closely examine their competitors‘ inventory turnover ratio, but it also creates greater solvency risk.
companies in this sector have vastly different biotechnology A simple example will demonstrate this. If a company
inventory and no comparisons can be drawn. Inventory commences by selling one $1 share and borrows $9 it
turnover is product specific; newspapers turn over daily, would have $10 of assets financed 90 per cent from
while car parts for older model cars may turn over once borrowings and 10 per cent equity, and have a debt to equity
every five or so years. ratio of 9:1. If it invests the $10 and earns a return on assets
of 10 per cent it would have $10 ($100 x 0.1) of revenue.
SUMMARY OF LIQUIDITY ANALYSIS Further assume its only expense is interest of 5 per cent
on the money borrowed. Expenses are $4.50 ($90 x 0.05)
Based on the four ratios examined, it appears that Cochlear and therefore profits $5.50 ($10 − $4.50). This provides a
has sufficient liquidity. The largest current assets are tied to return on equity of 55 per cent ($5.50 / $10). But what
accounts receivable, so for Cochlear, keeping an eye on this happens if the assets only earn a 2 per cent return (ROA =
turnover is important. For CSL the major asset is inventory 2%). Revenue is $2 ($100 x 0.02), expenses remain $4.50
and this turnover is critical. While it is commendable/ giving a loss of $2.50 ($2.00 − $4.50). While ROA is small
advisable to keep stocks for the good of humanity and but positive, ROE is negative 25 per cent (−$2.50 / $10).
reputation for reliability of supply, having large quantities of Financial leverage is neither good nor bad, just risky.
inventory approaching the use-by- date could be a concern. Although it is impossible to know whether a company
will or will not be able to pay future obligations and remain
ANALYSIS solvent, the following three ratios can provide some
Using CSL’s information from its indication of a company’s general solvency:
2016 Annual Report, calculate
CSL’s inventory turnover ratio and make an assessment Solvency ratios Relationship
about the company’s liquidity compared to 2017.
Debt to assets Total liabilities to total assets
Analysis:
Debt to equity Total liabilities to total equity
Inventory turnover = Cost of Goods Sold/
Average Inventory = $3035 / ($2352 + $1756) / 2 = 1.6 Times interest earned Income to interest expenses
(in 2015 the figure was 1.5)
As in the previous sections, the following sections will
CSL appears to be maintaining around eight months of explain and calculate each ratio for Cochlear using data
average inventory levels over the three years. In the 2017
from Exhibits 13.2 and/or 13.3. A comparison of Cochlear’s
annual report CSL recognises the vulnerability of
inventory and discusses it as one of its key manufacturing and CSL’s ratios will follow each calculation. After all ratios
and supply risks. are presented, a summary of what was learned about
Cochlear’s solvency will be provided.

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CHAPTER 13 Financial statement analysis 247
 DEBT TO ASSETS RATIO DEBT TO EQUITY RATIO
The debt to assets ratio compares a company’s total The debt to equity ratio compares a debt to equity
liabilities to its total assets and yields the percentage of company’s total liabilities to its total equity. ratio  Compares total
assets provided by creditors. As such, the ratio provides a Exactly like the debt to assets ratio, this liabilities to total equity and
measures a company’s
measure of a company’s capital structure. Capital structure ratio provides a measure of a company’s capital structure and
refers to the manner in which a company has financed its capital structure and financial leverage, financial leverage.
assets – either through debt or equity – and how much but by directly comparing the two aspects
financial leverage a company is using. Since debt and any of capital structure: liabilities and equity. As with the debt
related interest must be repaid, companies with a higher to asset ratio a higher debt to equity ratio indicates a riskier
percentage of assets provided by creditors may be seen as capital structure and therefore greater risk of insolvency.
having a ‘riskier’ capital structure. In other words, it is using Companies with higher debt to equity ratios are also said
more financial leverage, and therefore has a greater risk of to have high leverage.
insolvency (but also potentially, the ‘risk’ of greater returns).
KEY FORMULA 13.13 S
 OLVENCY RATIOS:
Alamy Stock Photo/Benny Marty

DEBT TO EQUITY RATIO

Total Liabilities
Debt to Equity Ratio =
Total Equity

593
Cochlear 2017: = 1.1
544

The 1.1 per cent indicates that for $1 of equity there is

$1.10 of debt.The debt to equity ratio is simply a rearrangement
of the debt to asset ratio. If assets are financed 52 per cent
by debt they must be financed 48 per cent by equity (given
Will a company have the cash to pay back its debts? the balance sheet equation from Chapter 1: A = L + E).
If debt is $52 and equity $48 then the debt to equity ratio is
KEY FORMULA 13.12 SOLVENCY RATIOS: 52 / 48 = 1.08 or rounded to 1.1. The debt to assets and debt
DEBT TO ASSETS RATIO to equity ratios are simply different perspectives of exactly
the same capital structure; therefore, the debt to equity ratio
Total Liabilities
Debt to Assets Ratio = tells us nothing more about Cochlear’s and CSL’s solvency
Total Assets
than the debt to asset ratio. We could also calculate an equity
to asset ratio, which if added to the debt to asset ratio always
Cochlear 2017:
593
= 0.52
equals 100 per cent (because assets are financed by either
1136 debt or equity – no other sources).

2017 2016 TIMES INTEREST EARNED

Cochlear 52% 53%
In addition to examining a company’s capital structure, it is
CSL 65% 66% wise to assess whether a company can pay the interest on
its debt. Simply because a business has a low debt ratio
Cochlear’s ratio of 52 per cent (or 0.52) shows over half
does not mean it is generating enough revenue to pay all
its assets are financed by debt. For CSL the figure is close
expenses. To answer this question, many use the times
to two thirds. These ratios have decreased marginally since
interest earned ratio.
2016 for both companies. If there were not advantages in
The times interest earned ratio times interest
borrowing then few businesses would have debt (liabilities).
compares a company’s profits to its earned ratio 
From a personal perspective it may be considered ‘good’ to
interest expense. It shows how easily a Compares income to
interest expense and
be debt free, but many students within 10 years of
company can pay interest out of current- measures the ability to pay
graduating may borrow to buy their own home, pushing
year earnings. As such, it helps creditors interest out of current
their debt to asset ratio to 80 per cent (borrow $800 000 to earnings.
and investors determine whether a
buy $1 000 000 home) or even higher. Debt is not good or
company can service its current debt by making its required
bad, debt brings increased risk. With shareholders a dividend
interest payments. The numerator is often expressed as
is paid if a company makes a profit, but debt-holders require
EBIT and calculated as profits plus interest plus tax (total
interest regardless of the prosperity of the business.
comprehensive income or profits has already deducted
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248 ACCT3 Financial
interest and tax, so we add them back to get EBIT). It is Cochlear’s ratio of 39 indicates that the company earned
what a company’s profit (comprehensive income) would many times more than its interest expense. Specifically, for
be if it paid no interest and no tax. every dollar of interest expense, the company earned almost
Let us return to the individual (or couple or group) $40 in profits. CSL’s ratio, although lower, is still very high,
borrowing to buy a home. First, the financial institution which is curious given its higher debt ratio. Financial
(bank) will not lend more than the net proceeds from the institutions often use a similar ratio when individuals seek a
future sale of the home (in case it has to repossess and home loan. The amount of monthly repayments is limited to
sell the property). Second, the financial institution will a percentage of disposal income. Because interest on home
usually have restrictions on the amount that repayments loans is not tax deductible in Australia, after-tax income is
are allowed to take up of disposable income. This is a usually used and ratios of three may be considered prudent.
concept very similar to the ‘times interest earned ratio’, During the 2016 and 2017 property price ‘boom’ the Reserve
especially at the beginning of a home loan when the vast Bank of Australia was suggesting banks needed to be more
majority of the repayment is interest. cautious with respect to both household debt ratios and times
interest earned ratios (usually referred to as the percentage
KEY FORMULA 13.14 SOLVENCY RATIOS: TIMES of disposable income consumed by repayments). The former
INTEREST EARNED RATIO is important when (not if) property prices fall, and the latter
Total Comprehensive Income + when interest rates rise and/or household income falls.
Times Interest Interest Expense + Income Tax Expense
=
Earned Ratio Interest Expense SUMMARY OF SOLVENCY
Based on the three ratios examined, it appears that both
Note that the ratio adjusts income by adding back interest companies’ capital structure is trending toward a little less
expense (finance costs) and income tax expense. These are debt. Thus, its solvency risk has decreased marginally. This
added back to ‘gross up’ income to the amount of earnings chapter is a brief introduction to financial statement analysis
that were available to make interest payments (before and has involved a number of simplifications. Caution
interest is paid and before tax because if you were paying should be exercised in reading too much into the superficial
out all your EBIT in interest payments there would be no analysis we have YT
PPL HIS
earnings and so no tax to pay). Once this adjustment is

A
conducted on Cochlear Download the Enrichment
made, the ratio yields the number of times that current and CSL. Modules for further practic
interest payments could be made out of current earnings. A
higher ratio indicates a greater ability to make payments, and
therefore less risk of insolvency. A high ratio may also indicate
an overly cautious approach to the business and that excellent
LO6 DUPONT ANALYSIS
available opportunities are not being taken advantage of.
All investors want to maximise the returns on their
EBIT is a difficult concept and may take some time to
investments in a company. An investor’s return is measured
grasp. Further when extracting the numbers from published
by the return on equity. To better understand how the return
financial statements often the words ‘interest expenses’
was generated, investors may conduct a DuPont analysis.
are not used more often than ‘finance costs’.
A DuPont analysis provides insight
DuPont
(2706 + 346 + 939) into how a company’s return on equity analysis  Decomposes
Cochlear 2017:   222 + 8 + 85 / 8 = 39 times
346 was generated by decomposing the a company’s return on
equity into measures of
return into three components: operating operating efficiency, asset
2017 2016
efficiency, asset effectiveness and capital effectiveness and capital
Cochlear 39 30 structure.
structure. The actual calculations of the
CSL 22 20 analysis are as follows:

KEY FORMULA 13.5 DUPONT ANALYSIS

Operating Asset Capital Return on

Efficiency Effectiveness Structure Equity

Total Total
Comprehensive Comprehensive
Income Sales Assets Income
× × =
Sales Assets Equity Equity

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CHAPTER 13 Financial statement analysis 249
 The first component is a company’s operating The third component is a company’s capital structure.
efficiency. It is calculated as comprehensive income For this analysis, it is calculated as assets divided by equity.
divided by sales, which is also known as the profit margin This ratio is similar to the debt to assets and debt to equity
ratio. This component reveals a company’s ability to earn ratios in that it measures how a company has financed its
profits from sales. The higher the ratio, the more efficient assets. The higher the ratio, the more a company is
a company is at turning sales into profits. But remember, financing its assets with debt rather than equity. So, a
different companies adopt different business models and higher ratio means more financial leverage and a riskier
may achieve their financial goals by reducing profit margins capital structure. Sometimes, this ratio is called the
and increasing turnover (sales revenue) to more than leverage multiplier.
compensate. We calculated this ratio earlier in this chapter. Another measure of performance is Economic Value
The second component is a company’s effectiveness Added, which compares profits before interest with the
at using its assets. It is calculated as sales divided by cost of capital on equity and interest-bearing liabilities.
assets. This ratio is commonly known as the asset turnover The cost of capital is the return required by resource
ratio. It measures the ability of a company to generate sales providers. If a business cannot add value it should return
from its asset base. The higher the ratio, the more effective the funds to the providers to be used more economically
a company is in generating sales given its assets (or the elsewhere.
lower the carrying amount of assets, due to old assets For listed companies, current share price reflects all
being recorded at historic cost or assets such as internally publicly available information. It is unlikely from the simple
generated intangibles not being recorded). Both CSL and analysis undertaken in this chapter that you will discover
Cochlear appear to have little of their intellectual property overpriced or underpriced shares. The aim of this chapter
recorded and as such have a low asset figure. In contrast as the conclusion to introductory financial accounting is to
a company like Westfield, that owns many shopping better understand how the financial reports are used and
centres (PPE), has an asset turnover of less than 15 per why production of the financial statements is critical to a
cent. Asset effectiveness is as much about the operating well-functioning capital market. This is only the start of
model of a business and may explain why many businesses the journey.
lease property rather than buy. While Cochlear has 14 per Now you have made it to the end – welcome to the
cent of assets in PPE, CSL has 32 per cent, which may be wonderful world of accounting.
a function of the requirement for specialist PPE or a YT
PPL HIS

A
strategy of owning rather than renting. Test your understanding with the
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250 ACCT3 Financial
 LO2
5 Horizontal and vertical analysis
EXERCISES The statements of comprehensive income of the
Brancatisano company for the past two years are as follows:

Statements of comprehensive income

For the years ending 30 June

2021 2020
LO1
1 Financial statement analysis Revenues $300 000 $250 000
Financial statement analysis is defined as the process of
Cost of goods sold   125 000   100 000
applying analytical tools to a company’s financial statements
to understand the company’s financial health. Gross profit $175 000 $150 000

REQUIRED Operating expenses   75 000   50 000

Identify and briefly describe the three items required to Profits before interest and taxes $100 000 $100 000
conduct successful financial statement analysis. Why are Interest expense   35 000   15 000
these items needed?
Profits before taxes $  65 000 $  85 000
2 Calculate inventory turnover ratio LO4 Income tax expense   25 000   30 000
In 2019, Rose Rug Rats generated net sales of $1 136 000 Comprehensive income net of tax   3 000   7 000
and cost of goods sold of $657 000. Ralph’s average Total comprehensive income $  43 000 $  62 000
inventory of rugs during the year was $86 600.
REQUIRED
REQUIRED
Calculate and interpret a horizontal and vertical analysis of
Calculate Rose’s inventory turnover ratio for the year and
Brancatisano’s income statements.
briefly explain what the result means.
LO2
LO5 6 Vertical analysis
3 Calculate times interest earned ratio
The following asset information is available for Samantha
Chen Carpet Cleaning Service has total comprehensive
Limited:
income of $125 600 in 2019. Interest expense was $12 550
during the year, and income tax expense was $42 000.
2020 2019
REQUIRED
Cash $  15 000 $  10 000
Calculate Chen’s times interest earned ratio and briefly
explain the result. Accounts receivable 30 000 25 000
Inventory 75 000 75 000
LO2
4 Horizontal and vertical analysis Total current assets 120 000 110 000
The following asset information is available for Wakefield Property and equipment 205 000 210 000
Automotive:
Total assets $325 000 $320 000
2019 2018
REQUIRED
Cash $  105 000 $  180 000 Calculate a vertical analysis of assets for both years.
Accounts receivable 180 000 165 000 Comment on any differences that may be material.

Inventory   375 000   525 000 LO2

7 Interpret vertical analysis
Total current assets $  660 000 $  870 000
A supermarket and a jewellery store provide the following
Property and equipment   525 000   450 000 vertical analyses of certain accounts from their income
Total assets $1 185 000 $1 320 000 statement and balance sheet:

REQUIRED Company A Company B

a Calculate a horizontal analysis of Wakefield’s assets. Gross profit 26.0% 55.2%
b Calculate a vertical analysis of Wakefield’s assets.
Operating expenses 22.2% 48.0%
Net income 3.8% 7.2%
Inventory 30.4% 68.2%
Property and equipment 57.8% 12.5%

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CHAPTER 13 Financial statement analysis 251
 REQUIRED LO3, 4, 5
Identify which company is likely to be the supermarket and 10 Interpret ratios
which is likely to be the jewellery store. Explain the reasons The following information is available for Radovich
for your conclusions. Researchers:

8 Vertical and horizontal analysis LO2 2020 2019

Petrulis Petroleum is applying for a substantial increase in its Profit margin 8.7% 8.3%
loan from Murray Bank. The income statements of Petrulis Return on assets 10.2% 10.4%
for the past year and expected (budgeted) results for the
Price to earnings ratio 13.5 12.0
following year are as follows (all figures in millions):
Quick ratio 0.8 0.9
Statements of comprehensive income Inventory turnover ratio 5.5 7.2
For the years ending 30 June
Receivable turnover ratio 11.3 15.5
Budgeted Actual
2021 2020 Times interest earned 7.2 6.4

Revenues $725 $700 REQUIRED

Cost of goods sold 345    385 For each ratio, indicate whether the change in the ratio is
favourable, unfavourable or indeterminate and why.
Gross profit $380 $315
Operating expenses 175    180 11 Define ratios LO3, 4, 5

Earnings before interest and taxes $205 $135 Identify the appropriate ratio or ratios for each of the
Interest expense 45    40 following descriptions:
Earnings before taxes $160 $ 95 a shows the return to each share owned by an investor
Income tax expense 55    30 b measures the difference between current assets and
current liabilities
Comprehensive income net of tax 23 29
c measures the ability of a company to generate profits
Total comprehensive income $128 $ 94 from sales
d provides a measure of a company’s capital structure
REQUIRED
As the accounting student on internship at the bank you e shows a company’s ability to generate profits from its
have been asked to calculate a vertical and horizontal entire resource base
analysis of Petrulis’ actual 2020 and budgeted 2021 f gives information as to how a company manages its
statements of comprehensive income. Provide comment on inventory
any unexpected results the analysis reveals and that the g measures a company’s capital structure using liabilities
bank may wish to discuss with Petrulis. and equity
h shows how effectively a company uses its current equity
LO3, 4, 5
9 Identify ratios to generate additional equity
Identify each of the following ratios as a profitability, liquidity i measures a company’s ability to meet its obligations in a
or solvency ratio. Which ratio is likely to best indicate what few weeks rather than many months
equity investors believe is the future of the company j shows how well a company can pay interest on debt out
compared to the present? Why? of current-year earnings
a return on equity k measures a company’s ability to collect sales on credit
b debt to assets ratio l provides an indication of current investor perceptions of
c times interest earned the company.
d quick ratio
LO3
e inventory turnover ratio 12 Profitability ratios
f accounts receivable turnover ratio The following financial information about Howard
g price to earnings ratio Enterprises is available:
h profit margin Sales $1 200 000
i current ratio
Net profit 260 000
j debt to equity ratio.
Average total assets 1 800 000
Average shareholders’ equity 880 000

The following additional information is available:

i The contributed capital was made up of 250 000 ordinary
shares. No shares were issued during the year.
ii The shares were recently trading for $10.00 (per share).

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
252 ACCT3 Financial
REQUIRED Revenues (sales)
Calculate the following ratios:
Connor Cookers 207 349 194 655
a profit margin
b return on equity
Olson Ovens 160 123 176 896
c return on assets Cost of goods sold
d earnings per share Connor Cookers 80 153 79 411
e price to earnings. Olson Ovens 76 740 71 561

13 Profitability ratios LO3 REQUIRED

a For each company, calculate the following for 2019:
The following financial information is available about Lim
i accounts receivable turnover ratio
Limited for the financial year ended 31 December:
ii inventory turnover ratio
Net profits $  150 000 iii current ratio
Ordinary shares, 1 January 400 000 iv quick ratio.
b Based on your calculations, discuss the liquidity of both
Ordinary shares, 31 December 500 000
companies and indicate what caution needs to be
Share (market) price at 31 December 10.00 exercised in drawing conclusions about either company‘s
Sales 945 000 ability to pay their debts in the short term.
Total assets, 1 January 800 000 LO4
15 Transactions affecting liquidity ratios
Total assets, 31 December 1 000 000
Taylor Tools has $50 000 of cash and accounts receivable,
Shareholders’ equity, 1 January 450 000 $135 000 of total current assets and $100 000 of total
Shareholders’ equity, 31 December 475 000 current liabilities prior to the following transactions:
i sales on account of $10 000
REQUIRED
ii paid cash for accounts due to suppliers, $15 000
Calculate and interpret the following:
iii received cash for accounts receivable of $15 00
a profit margin iv prepaid expenses of $7500 with cash
b return on equity v purchased inventory of $20 000 on account
c return on assets vi paid a $5000 cash dividend
d earnings per share vii repaid short-term loans of $10 000 with cash
e price earnings ratio. viii purchased short-term investments of $15 000
with cash
LO4
14 Liquidity ratios ix borrowed $25 000 from the bank by signing a
The following information was taken from the financial 90-day note
statements of Connor Cookers and Olson Ovens: x sold inventory of $30 000 for cash.
REQUIRED
(in millions) 2019 2018
Indicate whether each transaction would increase, decrease
Total current assets or have no effect on Taylor’s current and quick ratios. Treat
each transaction independently.
Connor Cookers $ 46 448 $249 664
Olson Ovens 155 117 153 188 LO5
16 Solvency ratios
Cash The following information was taken from the financial
Connor Cookers 24 311 48 936 statements of TK Company:
Olson Ovens 28 894 28 406
2021 2020
Accounts receivable
Total assets $400 000 $250 000
Connor Cookers 8 216 186 766
Total liabilities 150 000 150 000
Olson Ovens 114 645 114 511
Total equity 250 000 100 000
Inventory
Earnings before interest and tax 70 000 60 000
Connor Cookers 13 921 13 962
Interest expense 14 000 15 000
Olson Ovens 11 578 10 271
Current liabilities REQUIRED
Connor Cookers 69 036 74 457 Calculate:
a the debt to assets ratio
Olson Ovens 80 220 85 037
b the debt to equity ratio
c times interest earned for both years.

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CHAPTER 13 Financial statement analysis 253
 LO5
17 Solvency ratios
The following financial information regarding Emily’s Editors PROBLEMS
Pty Ltd is available:

2019
Total assets $    530 000
Total liabilities 140 000 LO2, 3, 4, 5
20 Analysing financial statements
Total shareholders’ equity 390 000
The following financial information is available for Porch
Posers at 30 June:
2019 Statement of comprehensive income
Comparative balance sheet
Revenue $   250 000
Cost of goods sold 125 000 2020 2019

Gross profit 125 000 Cash $  25 000 $  25 000

Operating expenses 40 000 Accounts receivable 30 000 25 000
Profits before interest and taxes 85 000 Inventory 75 000 75 000
Interest expense 10 000 Total current assets 130 000 125 000
Profits before taxes 75 000 Property, plant and equipment 400 000 315 000
at carrying amount
Income tax expense 25 000
Total assets   530 000   440 000
Comprehensive income (no tax) 12 000
Accounts payable 40 000 50 000
Total comprehensive income $   62 000
Other current liabilities 25 000 40 000
REQUIRED Total current liabilities 65 000 90 000
a Calculate the following ratios:
Debentures payable 75 000 150 000
i debt to assets
ii debt to equity Total liabilities 140 000 240 000
iii equity to assets Share equity 290 000 150 000
iv times interest earned. Retained earnings 100 000 50 000
b Discuss the solvency of Emily Editors. Does the Total shareholders’ equity 390 000 200 000
company rely more on equity or debt to finance its
operations? Total liabilities and equity $530 000 $440 000
c What is the relation between the first three ratios?
During the period Porch issued 140 000 shares in
addition to the 150 000 already issued. The share price at
LO6
18 DuPont analysis 30 June 2020 was $11.00.
The following financial information about Pazmandy
Pulmonary Proprietary is available: 2020 Income Statement
Revenue $400 000
2019
Cost of goods sold 210 000
Total average assets $400 000
Gross profit 190 000
Total average equity 250 000
Operating expenses 55 000
Sales 70 000
Profits before interest and taxes 135 000
Net profits 14 000
Interest expense 15 000
REQUIRED Profits before income tax 120 000
Prepare a DuPont analysis for Pazmandy.
Income tax expense 50 000
LO6 Net profits $  70 000
19 DuPont analysis
Discuss the limitations of DuPont analysis for a technology REQUIRED
company like Google, Apple, Facebook or LinkedIn. Why do a Calculate all profitability, liquidity and solvency ratios.
accounting standards not generally recognise internally
b Comment on Porch Poser‘s overall profitability, liquidity
generated intangible assets?
and solvency.

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254 ACCT3 Financial
21 Analysing financial statements LO2, 3, 4, 5 Issued capital 250 000 250 000

Amanda’s Anchors has applied for a loan from a local bank. Retained earnings 100 000 40 000
The bank is basing its decision on the following information: Total shareholders’ equity 350 000 290 000
Total liabilities and $600 000 $545 000
Ratio Industry average
shareholders’ equity
Current ratio 1.5
REQUIRED
Quick ratio 0.80
a For Amanda’s Anchors, calculate the ratios for which the
Receivable turnover ratio 18 bank has an industry average. After comparing Amanda’s
Inventory turnover ratio 20 ratios to the industry averages, should the bank approve
the loan? Why or why not?
Debt to assets ratio 0.56
b As Amanda’s accountant, present a case to the bank on
Times interest earned 6.52 why comparing ratios to industry averages is a limited
Profit margin 10.25% way to analyse a business and the other factors the bank
might consider in lending the business money (such as
Return on assets 11.50%
security for the loan, future prospects and why some
Return on equity 20.30% ratios might be more important than others). Use
Cochlear’s or CSL’s ratios calculated in this chapter to
support your case.
Amanda’s Anchors
Statement of comprehensive income c The bank has also asked why Amanda’s earnings per
For the year ended 30 June 2020 share is only $0.83 when the industry average is $2.56.
Sales revenues $600 000 Politely point out to the bank why this is irrelevant.

Cost of goods sold    350 000 LO3, 4, 5

22 Using ratios to evaluate a business
Gross profit 250 000 purchase
Other expenses    100 000 You are a senior analyst for Xeon Zoom, a large corporation
Profits before interest and taxes 150 000 whose sole activity is the acquisition of quality subsidiary
companies. Your manager has just come to you with the
Interest expense    25 000
following financial statements for Ahem Biscuit Company
Profits before taxes 125 000 (ABC), a confectionery business based in Thirroul, which is
Income tax expense    65 000 currently trading at $5 per share. She wants you to analyse
the company and give a recommendation on whether or not
Net profits $   60 000 to submit a bid for ABC. All dollar figures are in thousands.

Amanda’s Anchors Comparative balance sheet at 30 June for ABC

Statement of financial position
2019 2018
30 June 2020 30 June 2019 Cash $ 10 000 $ 20 000
Cash $  75 000 $       60 000 Accounts receivable 30 000 45 000
Accounts receivable 30 000 20 000 Inventory 105 000 75 000
Inventory 30 000 20 000 Prepaid insurance 5 000 15 000
Prepaid insurance 5 000 5 000 Total current assets 150 000 155 000
Total current assets 140 000 105 000 Property and equipment 220 000 200 000
Property and equipment 600 000 550 000 Intangible intellectual property   100 000   85 000
Accumulated depreciation (140 000) (110 000) Total assets   470 000   440 000
Total property and equipment 460 000 440 000 Accounts payable 60 000 50 000
Total assets   600 000   545 000 Notes payable 25 000 25 000
Accounts payable 60 000 60 000 Total current liabilities 85 000 5 000
Other current liabilities 40 000 45 000 Bonds payable 280 000 280 000
Total current liabilities 100 000 105 000 Total liabilities 365 000 355 000
Bonds payable 150 000 150 000 Issued equity (Avg. 100 000 shares) 75 000 75 000
Total liabilities 250 000 255 000 Retained earnings 30 000 10 000
Total equity 105 000 85 000
Total liabilities and equity $470 000 $440 000

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
CHAPTER 13 Financial statement analysis 255
 The following preliminary financial information has been
Income statement for ABC for the financial year
ended 30 June 2019 prepared by the accountants of Kim Company. All figures
in millions:
Sales $250 000
Cost of goods sold 150 000 Current assets $100

Gross profit 100 000 Current liabilities 75

Administrative expenses 25 000 Income before interest and taxes 25

Depreciation expense 15 000 Interest expense 7

Total operating expenses 40 000 Your senior accounting manager calls to your attention
Operating income   60 000 that the $100 million of current assets include $10 million
Interest expense 10 000 worth of an investment in callable bonds, which do not
mature for five years but will be callable if the company so
Income before taxes    50 000 desires in 10 months. She also notes $5 million of the
Income tax expense 25 000 current revenue is attributed to a service contract for which
Kim has received payment but has not yet performed
Net income $     25 000
the services. There is no reason why the contract will not
be fulfilled.
REQUIRED
a Based on the financial information presented above, is
Kim within the guidelines in its credit agreement?
CASES b Would you change the treatment of the two items your
senior manager brought to your attention? Do you see
any problem with the way these items are classified?
Explain your answer.
c Based on your response to (b), prepare revised financial
information if it is necessary. If you revised the
23 Research and analysis LO1, 3, 4, 5, 6 information, is Kim still compliant with its loan
agreement?
Access the most recent publicly available annual report for
Cochlear and/or CSL (as instructed by your lecturer) through LO1, 2, 3, 4, 5
the company website(s). 25 Written communications
REQUIRED You have been given the following information about the
company you work for by your CFO (chief financial officer).
a Examine the company’s financial statements and
Analysts have been predicting a strong year in 2021.
calculate all profitability, liquidity and solvency ratios
(or a subset of these chosen by your lecturer) for the 2020 2019 2018
most recent year. To calculate the P/E ratio, use the ASX
or similar website (or even an old-fashioned newspaper) Horizontal analysis of sales 37.0% 22.0% 15.0%
to determine current share price. Profit margin 8.2% 7.5% 6.8%
b Based on your answers to (a), write a paragraph Return on equity 13.1% 12.3% 11.1%
explaining your opinion of the financial health of the
company(s). Current ratio 2.4 2.1 1.8
c If you have calculated selected ratios for both Quick ratio 0.6 1.0 1.2
companies, discuss their relative performance. Is the Inventory turnover ratio 2.6 4.0 4.7
change in share price over the last two or three years
consistent with your analysis? Debt to assets ratio 0.8 0.7 0.6
Times interest earned ratio 4.4 5.5 6.6
LO4
24 Ethics in accounting
REQUIRED
Kim Company currently has a line of credit with Murray a Prepare a brief press release highlighting the strong
River Bank. The interest rate on the line of credit increases performance of the company. Use the analysis above to
from 4.25 per cent to 8.25 per cent if the following terms of support your positive conclusions.
the credit agreement are not met:
b SMS your CFO expressing concern about the press
i Kim’s current ratio must remain above 1.2 at all times
release you have written. Point out the negative financial
ii Kim’s times interest earned must be 3.0 or greater at indicators that would indicate the company’s financial
all times. future may not be all positive, especially given
predictions of rising interest rates.

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256 ACCT3 Financial
 APPENDIX
Time value of money
A

happens? Will you earn an additional $6 of interest? It

INTRODUCTION
depends on whether the bank pays you simple interest or
When decisions are affected by cash flows that are paid or compound interest. Simple interest is simple interest
received in different time periods, it is necessary to adjust interest on the invested amount only, Interest on the invested
those cash flows for the time value of money (TVM). whereas compound interest is interest amount only.
compound interest
Because of our ability to earn interest on money invested, on the invested amount plus interest on Interest on the invested
we would prefer to receive $1 today rather than a year from previous interest earned but not amount plus interest on
now. Likewise, we would prefer to pay $1 a year from now withdrawn. Simple interest is sometimes previous interest earned
but not withdrawn.
rather than today. A common technique used to adjust cash computed on short-term investments and
flows received or paid in different time periods is to discount debts (that is, those that are shorter than
those cash flows by finding their present six months to a year). Compound interest is typically
present value (PV)
The amount of future cash value (PV), which is the amount of computed for financial arrangements longer than one year.
flows discounted to their future cash flows discounted to their We will assume that interest is compounded in all examples
equivalent worth today.
equivalent worth today.To fully understand in this book. Extending the future-value formula to find the
the calculations involved in finding the PV amount we have in the bank in two years gives us the
of future cash flows, it is necessary to step back and following formula:
examine the nature of interest and the calculation of interest FV(Year 2) = PV(1 + r )(1 + r )
received and paid. Interest is simply a payment made to use or
someone else’s money. When you invest money in a bank FV(Year 2) = PV(1 + r )2
account, the bank pays you interest for the use of your
In our example, FV(Year 2) = 100(1 + 0.06)2, or $112.36.
money for a period of time. If you invest $100 and the bank
We earned $6.36 of interest in Year 2, which is $6 on our
pays you $106 at the end of the year, it is clear that you
original $100 investment and $0.36 on the $6 of interest
earned $6 of interest on your money (and 6 per cent interest
earned but not withdrawn in Year 1 ($6 × 0.06).
for the year).
In this example, we have assumed that compounding
is on an annual basis. Compounding can also be
FUTURE VALUE calculated semi-annually, quarterly, monthly, daily or
even continually. Go back to our original $100 investment
Mathematically, the relationship between your initial in the bank. If the bank pays 6 per cent interest
investment (present value PV  ), the amount in the bank at compounded semi-annually instead of annually, we
the end of the year (future value FV ), and the interest rate would have $106.09 after one year. Note that the interest
(r) is as follows: rate is typically expressed as a percentage rate per year.
FV(Year 1) = PV(1 + r ) We are really earning 3 per cent for each semi-annual
period, not 6 per cent. It is usually easier to visualise the
In our example, FV(Year 1) = 100(1 + 0.06) = $106. If you concept of interest rate compounding graphically, with
leave your money in the bank for a second year, what the help of timelines. Exhibit A.1 graphically

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
257
 Annual compounding
$100.00 6% $106.00

0 1 year

Semiannual compounding
$100.00 3% $103.00 3% $106.09

0 6 months 1 year

Monthly compounding
$100.00 $100.50 $101.00 $101.51 $102.02 $102.53 $103.04 $103.55 $104.07 $104.59 $105.11 $105.64 $106.17
0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5%

0 1 2 3 4 5 6 7 8 9 10 11 12 months

EXHIBIT The impact of more frequent compounding on the future value of $100
A.1

demonstrates the impact of annual, semi-annual and combinations of n and r. These tables are still commonly
monthly compounding of the 6 per cent annual rate on used, and an example is provided in Exhibit A.2. The
our original $100 investment. factors in the Exhibit are commonly referred to as
Mathematically, our formula for future value can once cumulative factors (CFs) and are simply calculations of
again be modified slightly to account for interest rates (1 + r)n for various values of n and r.
compounded at different intervals. FV(n periods in the future) = Using this new terminology, the future value formula is
PV(1 + r)n, where n is the number of compounding periods simply:
per year multiplied by the number of years, and r is the FV(n periods in the future) = PV(CFn,r)
annual interest rate divided by the number of compounding
periods per year. Before the advent of handheld calculators With 6 per cent annual compounding, our $100
and computers, tables were developed to simplify the investment grows to:
calculation of FV by providing values for (1 + r)n for several $100(CF1,6%) = $100(1.060) = $106.00

n/r 0.5% 1% 2% 3% 4% 5% 6% 7% 8% 10% 12%

 1 1.0050 1.0100 1.0200 1.0300 1.0400 1.0500 1.0600 1.0700 1.0800 1.1000 1.1200
 2 1.0100 1.0201 1.0404 1.0609 1.0816 1.1025 1.1236 1.1449 1.1664 1.2100 1.2544
 3 1.0151 1.0303 1.0612 1.0927 1.1249 1.1576 1.1910 1.2250 1.2597 1.3310 1.4049
 4 1.0202 1.0406 1.0824 1.1255 1.1699 1.2155 1.2625 1.3108 1.3605 1.4641 1.5735
 5 1.0253 1.0510 1.1041 1.1593 1.2167 1.2763 1.3382 1.4026 1.4693 1.6105 1.7623
 6 1.0304 1.0615 1.1262 1.1941 1.2653 1.3401 1.4185 1.5007 1.5869 1.7716 1.9738
 7 1.0355 1.0721 1.1487 1.2299 1.3159 1.4071 1.5036 1.6058 1.7138 1.9487 2.2107
 8 1.0407 1.0829 1.1717 1.2668 1.3686 1.4775 1.5938 1.7182 1.8509 2.1436 2.4760
 9 1.0459 1.0937 1.1951 1.3048 1.4233 1.5513 1.6895 1.8385 1.9990 2.3579 2.7731
10 1.0511 1.1046 1.2190 1.3439 1.4802 1.6289 1.7908 1.9672 2.1589 2.5937 3.1058
11 1.0564 1.1157 1.2434 1.3842 1.5395 1.7103 1.8983 2.1049 2.3316 2.8531 3.4785
12 1.0617 1.1268 1.2682 1.4258 1.6010 1.7959 2.0122 2.2522 2.5182 3.1384 3.8960
24 1.1272 1.2697 1.6084 2.0328 2.5633 3.2251 4.0489 5.0724 6.3412 9.8497 15.1786
36 1.1967 1.4308 2.0399 2.8983 4.1039 5.7918 8.1473 11.4239 15.9682 30.9127 59.1356
48 1.2705 1.6122 2.5871 4.1323 6.5705 10.4013 16.3939 25.7289 40.2106 97.0172 230.3908

EXHIBIT Future value of $1

A.2

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258 ACCT3 Financial
 With 6 per cent semi-annual compounding: Keys Display Description
$100(CF2.3%) = $100(1.0609) = $106.09
12 P/YR 12 Sets compounding periods per
year to 12.
With 6 per cent monthly compounding:
12 N 12 Sets the number of compounding
$100(CF12.5%) = $100(1.0617) = $106.17
periods to 12.
Most financial calculators will compute future value FV 106.17 Calculates the future value.
after the user inputs data for PV, the annual interest rate,
Likewise, many spreadsheet programs have built-in
the number of compounding periods per year, and the
functions (formulas) that calculate future value. The Excel
number of years. For example, using a business calculator
function called FV simply requires input of an interest rate
to compute the future value of $100.00 with 6 per cent
(Rate), number of compounding periods (Nper) and present
annual compounding requires the following steps:
value (Pv) in the following format: = FV(Rate, Nper, Pmt,
Keys Display Description Pv, Type).1 Entries for Pmt and Type are not applicable to
simple future-value problems. To calculate the future value
1 P/YR 1.00 Sets compounding periods per
year to 1 because interest is of $100 in one year at 6 per cent interest compounded
compounded annually. monthly, enter = FV(0.5%, 12, −100). Excel returns a value
Stores the present value as a of $106.17 (see Exhibit A.3).
100 ± PV –100.00
negative number.

6.0 I/YR 6.0 Stores the annual interest rate. PRESENT VALUE
1 N 1 Sets the number of years or
compounding periods to 1. A PV formula can be derived directly from the future value
formula. If:
FV 106.00 Calculates the future value.
FV(n periods in the future) = PV(1 + r)n
Calculating the future value of $100 with 6 per cent
monthly compounding simply requires changing both the then:
compounding periods per year (P/YR) and number of
compounding periods (N) to 12.
PV =
FV
(1 + r )n
 or PV = FV
1
(
(1 + r )n )

EXHIBIT Finding the future value using the FV function in Excel

A.3

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
APPENDIX A Time value of money 259
 Just as a CF table was developed to calculate (1 + r)n,
PV tables calculate 1 ÷ (1 + r)n for various combinations of
PV = $1000  ( 1
(1 × 0.08)2 )
= $857.34
n and r. These factors are called discount factors, or DFs.
Or using the DF table:
An example of a DF table is provided in Exhibit A.4. Our
PV formula can now be rewritten as follows: PV = $1000(DF2, 0.08) = $1000(0.8573) = $857.30 (rounded)
PV = FV(DFn,r)
Once again, the frequency of compounding affects our
Now we are ready to calculate the PV of a future cash calculation. Just as more frequent compounding increases
flow. For example, how much must be invested today at 8 future values, increasing the frequency of compounding
per cent compounded annually to have $1000 in two years? decreases PVs. This is demonstrated in Exhibit A.5 for
Mathematically: annual, semi-annual and quarterly compounding.

n/r 0.5% 1% 2% 3% 4% 5% 6% 7% 8% 10% 12%

1 0.9950 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9091 0.8929
2 0.9901 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8264 0.7972
3 0.9851 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7513 0.7118
4 0.9802 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.6830 0.6355
5 0.9754 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6209 0.5674
6 0.9705 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5645 0.5066
7 0.9657 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835 0.5132 0.4523
8 0.9609 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820 0.5403 0.4665 0.4039
9 0.9561 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4241 0.3606
10 0.9513 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.3855 0.3220
11 0.9466 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3505 0.2875
12 0.9419 0.8874 0.7885 0.7014 0.6246 0.5568 0.4970 0.4440 0.3971 0.3186 0.2567
24 0.8872 0.7876 0.6217 0.4919 0.3901 0.3101 0.2470 0.1971 0.1577 0.1015 0.0659
36 0.8356 0.6989 0.4902 0.3450 0.2437 0.1727 0.1227 0.0875 0.0626 0.0323 0.0169
48 0.7871 0.6203 0.3865 0.2420 0.1522 0.0961 0.0610 0.0389 0.0249 0.0103 0.0043

EXHIBIT Present value of $1

A.4

Annual compounding
$857.30 PV = $1000(DF2,.08) $1000.00
8% 8%

0 1 year 2 years

Semiannual compounding
$854.80 PV = $1000(DF4,.04) $1000.00
4% 4% 4% 4%

0 1 year 2 years

Quarterly compounding
$853.50 PV = $1000(DF8,.02 ) $1000.00
2% 2% 2% 2% 2% 2% 2% 2%

0 1 year 2 years

EXHIBIT The impact of more frequent compounding on the present value of $1000
A.5

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
260 ACCT3 Financial
 Using a business calculator to compute PV is similar to Simplifying by dividing each side by $100, 1 = 2 ÷ (1 + r)6
computing future value; for example, the PV of $1000 and multiplying each side by (1 + r)6, the equation is simplified
received or paid in two years at 8 per cent compounded to (1 + r)6 = 2. The value of r can be calculated by using a
quarterly requires the following steps: financial calculator or mathematically by using logarithmic
functions.2 When using a business calculator, the following
Keys Display Description steps are typical:
4 P/YR 4.00 Sets the compounding periods
per year to 4. Keys Display Description

1000 FV 1000.00 Stores the future value as a 1 P/YR 1.00 Sets compounding
positive number. periods per year to 1.
8.0 I/YR 8.0 Stores the annual interest rate. 200 FV 200 Stores the future value.
8 N 8.0 Sets the number of compounding 100 ± PV –100 Stores the present value
periods to 8. as a negative number.
PV –853.49 Calculates the present value. 2 N 2.0 Sets the number of
compounding periods
In Microsoft Excel, the built-in function is called PV and to 2.
requires input of the applicable interest rate (Rate), number
I/YR 0.122462 Calculates the annual
of compounding periods (Nper), and future value (Fv) in the interest rate.
following format: = PV(Rate, Nper, Pmt, Fv, Type). In the
previous example, entering = PV(2%, 8, −1000) returns a The tables can also be used to solve for n and r.
value of $853.49. Note once again that Pmt and Type are Using our table formula, PV = FV(DFn,r), if PV = 100 and
left blank in simple PV problems, as they were in future FV = 200, DF must be equal to 0.5. If we know that n
value calculations (see Exhibit A.6). is equal to 6, we can simply move across the table until
When FV and PV are known, either formula can be used we find a factor close to 0.5. The factor at 12 per cent
to calculate one of the other variables in the equations (n is 0.5066. If we examine the factors at both 10 per cent
or r). For example, if you know that your $100 bank deposit (0.5645) and 14 per cent (0.456), we can infer that the
is worth $200 in six years, what rate of interest compounded actual interest rate will be slightly higher than 12 per
annually did you earn? Using the mathematical PV formula: cent. Our logarithmic calculation is 12.2462 per cent.

PV = FV ( 1
(1 + r )n )
  or  $100 = $200 1
(1 + r )6 ( )
In Microsoft Excel, the RATE function requires input of
Nper, Pv and Fv in the following format: = RATE (Nper,

EXHIBIT Finding the present value using the PV function in Excel

A.6

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
APPENDIX A Time value of money 261
 EXHIBIT Finding the interest rate using the RATE function in Excel
A.7

Pmt, Pv, Fv, Type, Guess). Because Excel uses an Solving the equation by using logarithms or a financial
iterative trial-and-error method to calculate the interest calculator gives us an n of 6.116 years.3 Using the DF formula,
rate, Guess provides a starting point. It is generally not DF must again be equal to 0.5. If r is known to be 12 per cent,
necessar y but may be required in complicated we simply move down the 12 per cent column until we find
problems. Entering = RATE(6, −100, 200) returns an a DF close to 0.5. Not surprisingly, we find a factor of 0.5066
interest rate of 12.2462 per cent (see Exhibit A.7). for an n of 6. Examining the factors for an n of 5(0.5674) and
The calculation of n is done in a similar fashion. If we 7(0.4523), we can infer that the actual time will be something
know that our investment earns 12 per cent, but do not slightly greater than 6 years. The NPER function in Microsoft
know how long it will take for our $100 to grow to $200, Excel requires input of Rate, Pmt, Pv, Fv and Type in the
mathematically, we have the following: following format: = NPER (12%, −100, 200), and returns a
value of 6.116 years. Note that Pv is entered as a negative

PV = FV ( 1
)
(1 + r )n (
1
or $100 = $200 (1 + 0.12)n ) amount and that Pmt and Type are not necessary, as this is
essentially a PV problem (see Exhibit A.8).

EXHIBIT Finding the number of periods using the NPER function in Excel
A.8

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262 ACCT3 Financial
 The mathematical formula for PVA can be derived from
ANNUITIES
the formula for PV and is equal to:

( )
annuity An annuity is a series of cash flows of 1
A series of cash flows equal amount paid or received at regular 1–
of equal amounts paid PVAn,r = R (1 + r)n
or received at regular intervals.4 Common examples include r
intervals. mortgage and loan payments. The PV of
an ordinary annuity (PVA) is the amount where R refers to the periodic payment or withdrawal
invested or borrowed today that will provide for a series of (commonly called a rent). Calculated values for various
withdrawals or payments of equal amount for a set number combinations of n and r are provided in Exhibit A.9.
of periods. Conceptually, the PV of an annuity is simply the The PVA formula can therefore be rewritten as follows:
sum of the PVs of each withdrawal or payment. For PVA = R(DFAn,r)
example, the PV of an annuity of $100 paid at the end of
each of the next four years at an interest rate of 10 per cent As previously discussed, common examples of
looks like this: annuities are mortgages and loans. For example, say you
are thinking about buying a new car. Your bank offers to lend
PVA $100 $100 $100 $100 you money at a special 6 per cent rate compounded
10% 10% 10% 10%
monthly for a 24-month term. If the maximum monthly
0 1 year 2 years 3 years 4 years
payment you can afford is $399, how large a car loan can
Although cumbersome, the PV of an annuity can be you get? In other words, what is the PV of a $399 annuity
calculated by finding the PV of each $100 payment, using paid at the end of each of the next 24 months, assuming
the PV table in Exhibit A.4. an interest rate of 6 per cent compounded monthly? Using
a timeline, the problem looks like this:
PVA = $
 100(DF1,.10) + $100(DF2,.10) + $100(DF3,.10) +
$100(DF4,.10)
= $100(0.9091) + $100(0.8264) + $100(0.7513) +
$100(0.6830)
= $316.98

PVA $399 $399 $399 $399 $399 $399 $399 $399 $399 $399 $399 $399 $399 $399 $399 $399 $399 $399 $399 $399 $399 $399 $399 $399
0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5%  
0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5%

0 24 months

n/r 0.5% 1% 2% 3% 4% 5% 6% 7% 8% 10% 12%

 1 0.9950 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9091 0.8929
 2 1.9851 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.8080 1.7833 1.7355 1.6901
 3 2.9702 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730 2.6243 2.5771 2.4869 2.4018
 4 3.9505 3.9020 3.8077 3.7171 3.6299 3.5460 3.4651 3.3872 3.3121 3.1699 3.0373
 5 4.9259 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.7908 3.6048
 6 5.8964 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173 4.7665 4.6229 4.3553 4.1114
 7 6.8621 6.7282 6.4720 6.2303 6.0021 5.7864 5.5824 5.3893 5.2064 4.8684 4.5638
 8 7.8230 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098 5.9713 5.7466 5.3349 4.9676
 9 8.7791 8.5660 8.1622 7.7861 7.4353 7.1078 6.8017 6.5152 6.2469 5.7590 5.3282
10 9.7304 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601 7.0236 6.7101 6.1446 5.6502
11 10.67700 10.3676 9.7868 9.2526 8.7605 8.3064 7.8869 7.4987 7.1390 6.4951 5.9377
12 11.6189 11.2551 10.5753 9.9540 9.3851 8.8633 8.3838 7.9427 7.5361 6.8137 6.1944
24 22.5629 21.2434 18.9139 16.9355 15.2470 13.7986 12.5504 11.4693 10.5288 8.9847 7.7843
36 32.8710 30.1075 25.4888 21.8323 18.9083 16.5469 14.6210 13.0352 11.7172 9.6765 8.1924
48 42.5803 37.9740 30.6731 25.2667 21.1951 18.0772 15.6500 13.7305 12.1891 9.8969 8.2972

EXHIBIT Present value of an ordinary annuity

A.9

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APPENDIX A Time value of money 263
 Mathematically: The PVA formula can also be used to calculate R, r, and

( )
1 n if the other variables are known. This is most easily
1–
PVA24,0.005 = 399 (1 + 0.5)24 accomplished using the DFA table or using a financial
0.005 calculator. If the car you want to buy costs $20 000 and you
can afford a $3000 down payment (your loan balance is
Using the DFA table:
$17 000), how much will your 36 monthly payments be,
PVA24,0.005 = $399(DFA24,0.005) = $399(22.5629) = $9002.60 assuming that the bank charges you 6 per cent interest
(rounded)
compounded monthly?
The following steps are common when using a business Using the DFA table:
calculator: PVA36, 0.005 = R(DFA36, 0.005)
Keys Display Description
$17 000 = R(32.871)
12 P/YR 12.00 Set periods per year.
2×12 N 24.00 Stores number of periods R = $517.17
in loan.
The following steps are common when using a business
0 F±V 0 Stores the amount left to pay
after 2 years.
calculator:

6 Stores interest rate. Keys Display Description

6 I/YR

399 +– PMT –399.00 Stores desired payment as 12 P/YR 12.00 Set periods per year.
a negative number.
3×12 N 36.00 Stores number of periods
P±V 9002.58 Calculates the loan you can in loan.
afford with a $399 per month
payment. 0 F±V 0 Stores the amount left to pay
after 3 years.
In Microsoft Excel, the PV function is used to calculate 6 I/YR 6 Stores interest rate.
the PV of an annuity, with additional entries for the payment
17 000 P±V 17 000 Stores amount borrowed.
amount (Pmt) and type of annuity (Type). The payment is
entered as a negative number, and the annuity type is 0 for PMT –517.17 Calculates the monthly
ordinary and 1 for an annuity due. The format is therefore payment.
PV (Rate, Nper, Pmt, Fv, Type). Entering =
In Microsoft Excel, the calculation is simply =
PV(0.5%,24,−399,0,0) returns a value of $9002.58 (see
PMT(0.005, 36,−17000,0,0) (see Exhibit A.11).
Exhibit A.10).

EXHIBIT Finding the present value of an annuity using the PV function in Excel
A.10

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264 ACCT3 Financial
 EXHIBIT Finding the payment using the PMT function in Excel
A.11

In a similar fashion, assume that a used-car dealer offers In Excel, = RATE(48, −350,12,000,0) generates a
you a ‘special deal’, in which you can borrow $12 000 with monthly rate of 1.4667 per cent and an annual rate of 17.60
low monthly payments of $350 per month for 48 months. per cent. The use of the RATE function requires that the
What rate of interest are you being charged in this case? payments are the same each period. Excel’s IRR function
Using the DFA table: is more flexible, allowing different payments. However,
PVA48,.?? = $350(DFA48,.??) each payment has to be entered separately. For example,
if the car is purchased for $17 000 with annual payments
$12 000 = 350(DFA48,.??) of $4000, $5000, $6000 and $7000 at the end of each of
the next four years, the interest rate charged on the car
DFA48,.?? = 34.2857 loan can be calculated by using the IRR function (see
Exhibit A.12).
Looking at the row for an n of 48, we see that a DFA of
34.2857 is about halfway between an r of 1 per cent and r
of 2 per cent (closer to 1 per cent), which means that you
are being charged an annual rate of almost 18 per cent
(1.5% × 12) – not such a good deal after all! Using a
business calculator, observe the following:
Keys Display Description

12 P/YR 12.00 Set periods per year

4×12 N 48.00 Stores number of periods
in loan

0 F±V 0 Stores the amount left to

pay after 4 years

12,000 P±V 12,000 Stores amount borrowed EXHIBIT Finding the interest rate using the IRR
A.12
350 +– PMT –350 Stores the monthly payment

I/YR 17.60 Calculates the annual

interest rate

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
APPENDIX A Time value of money 265
 APPENDIX
CSL Limited, annual report 2017
B

¢
¢ $
$
$ ¢
¢

$
¢

$ $ ¢

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266
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APPENDIX B CSL Limited, annual report 2017 267
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268 ACCT3 Financial
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APPENDIX B CSL Limited, annual report 2017 269
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270 ACCT3 Financial
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APPENDIX B CSL Limited, annual report 2017 271
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272 ACCT3 Financial
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APPENDIX B CSL Limited, annual report 2017 273
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274 ACCT3 Financial
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APPENDIX B CSL Limited, annual report 2017 275
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276 ACCT3 Financial
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APPENDIX B CSL Limited, annual report 2017 277
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278 ACCT3 Financial
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APPENDIX B CSL Limited, annual report 2017 283
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284 ACCT3 Financial
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APPENDIX B CSL Limited, annual report 2017 285
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286 ACCT3 Financial
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288 ACCT3 Financial
 3  ‘Samsung makes record profit of $109m a day as
chip demand soars’, The Guardian, Samsung, 31 Chapter 7
October 2017, https://www.theguardian.com/ 1  Australian Accounting Standards Board, ‘Accounting
technology/2017/oct/31/samsung-record-profit-112m- Standard 102 Inventories, 2015’, paragraph 18,
a-day-chip-demand-soars; Sam Byford, ‘Samsung http://www.aasb.gov.au/admin/file/content105/c9/
predicts record profits for second straight quarter’, AASB102_07-15.pdf.

ENDNOTES
The Verge, 12 October 2017, https://www.theverge. 2  Ibid., paragraph 36.
com/2017/10/12/16467628/samsung-q3-2017-record- 3  Ibid., paragraph 22.
earnings-guidance; ‘Samsung record profits mask 4  Ibid., paragraph 7.
crisis without and within’, Financial Times, 13 October 5  CSL Limited, Annual Report 2017, p. 55.
2017, https://www.ft.com/content/981eed6c-9c46-
11e7-8cd4-932067fbf946; Richard Lawler, ‘Samsung
collects record profits, again’, ENGadget, 31 October Chapter 8
2017, https://www.engadget.com/2017/10/31/ 1  Australian Accounting Standards Board, ‘Accounting
samsung-q3-2017-earnings-oled-iphone-x/; Saheli Standard 116 Recognition, 2014’, paragraph 7.
Roy Choudhury, ‘Samsung predicts record profits for 2  ASIC, Impairment of non-financial assets: Materials
third quarter as memory business booms’, CNBC, 12 for directors, http://asic.gov.au/regulatory-resources/
October 2017, https://www.cnbc.com/2017/10/12/ financial-reporting-and-audit/directors-and-financial-
The running case for the book is CSL Limited Annual samsung-third-quarter-earnings-guidance.html. reporting/impairment-of-non-financial-assets-
Report 2017. Excerpts can be found in Appendix B, and 4  CSL Limited, ‘Five Year Summary’, Annual Report materials-for-directors/ Accessed 19/12/2017
the company’s online version at: http://annualreport.csl. 2017, p. 6. 3  CSL Limited, Annual Report 2017, p. 98.
com.au/home.htm. 5  Myer, Annual Report 2017, p. 61; JB Hi-Fi, Annual 4  Australian Accounting Standards Board, ‘Accounting
Report 2017, p. 64. Standard 136 Impairment of Assets, 2015’,
6  CSL Limited, ‘Notes to the financial statements’, paragraph 9.
Chapter 1 Annual Report 2017, p. 86. 5  Australian Accounting Standards Board, ‘Accounting
1  Australian Government Auditing and Assurance 7  CSL Limited, ‘Our Corporate Responsibility’, http:// Standard 116 Recognition, 2014’, paragraph 30.
Standards Board, Auditing Standard, ‘Auditing corporateresponsibility.csl.com.au/ (accessed 6  Ibid., paragraph 31.
Standard ASA 570: Going Concern’, Auditing and 02/03/2018). 7  CSL Limited, ‘Note 7: Intangible Assets’, Annual Report
Assurance Standards Board, 2015, 8  ASX Corporate Governance Council, Corporate 2017, p. 97.
http://www.auasb.gov.au/admin/file/content102/ Governance Principles and Recommendations, 3rd 8  Ibid.
c3/ASA_570_2015.pdf. Edition, 2014.
2  ‘Understanding Financial Statements’, from
Customer Service FAQs. Copyright © 2000–2015 Chapter 9
Dun & Bradstreet, Inc. Used by permission. http:// Chapter 4 1  Chartered Accountants Australia and New Zealand,
www.dnb.com/customer-service/understanding- 1  CSL Limited, Annual Report 2017, p. 89. Annual Report 2017, p. 81.
financialstatements.html. 2  Wesfarmers, 2017 Annual Report, p. 104. 2  Australian Accounting Standards Board, ‘Accounting
3  Australian Accounting Standards Board, ED 264 Standard 137 Provisions, Contingent Liabilities and
‘Conceptual Framework for Financial Reporting’, Contingent Assets’, ‘Objective’, 2015, p. 6.
paragraph 1.2, June 2015, http://www.aasb.gov.au/ Chapter 5 3  Ibid., paragraph 12–13.
admin/file/content105/c9/ACCED264_06-15.pdf. 1  Warfield & Associates, Employee fraud in Australian 4  CSL Limited, Annual Report 2017, p. 107
4  Australian Accounting Standards Board, © financial institutions, 2013, http://warfield.com.au/
Commonwealth of Australia 2004. All legislation wp-content/uploads/2015/12/pub1.pdf.
herein is reproduced by permission but does not 2  CSL, Annual Report 2017, p. 125. Chapter 10
purport to be the official or authorised version. It is 3  Ibid., pp. 55–56. 1  Trinkler v. Beale & Ors [2009] NSWCA 30;
subject to Commonwealth of Australia copyright. 4  Ibid., ‘Note 14: Cash and Cash Equivalents, Cash Commissioner of State Revenue (Vic) v Danvest Pty
The Copyright Act 1968 permits certain reproduction Flows’, p. 108. Ltd & Anor (December 2017, Court of Appeal, Victoria).
and publication of Commonwealth legislation. In 5  Ibid., p. 101.
particular, s.182A of the Act enables a complete copy
to be made by or on behalf of a particular person. For
Chapter 11
reproduction or publication beyond that permitted by
Chapter 6 1  CSL Limited, ‘Note 12: Equity and RE ‘, Annual Report
the Act, permission should be sought in writing from 1  CSL Limited, Annnual Report 2017, p. 109. 2017, p. 106.
the Commonwealth available from the Australian 2  CPA Australia, ‘Notes to the financial statements: 2  Commonwealth Bank, ‘Dividend reinvestment
Accounting Standards Board. Requests in the first 7 – Trade and Other Receivables’, Annual Report plan’, https://www.commbank.com.au/about-us/
instance should be addressed to the Administration 2016, p. 84. shareholders/managing-your-shares/dividend-
Director, Australian Accounting Standards Board, 3  CPA Australia, 2017, Integrated Report 2017, https:// reinvestment-plan.html. The full document is
PO Box 204, Collins Street West, Melbourne, www.cpaaustralia.com.au/~/media/corporate/allfiles/ available at their website.
Victoria, 8007; Copyright © International Financial document/about/annual-report-2017.pdf?la=en. 3  Australian Taxation Office, ‘Share buy-backs’, 2011,
Reporting Standards Foundation. All rights reserved. 4  Nina Hendy, ‘When will my invoice be paid? Chasing https://www.ato.gov.au/General/Capital-gains-tax/
Reproduced by Cengage Learning Australia with the late payers a big cost for small business’, Sydney Shares,-units-and-similar-investments/Share-buy-
permission of the International Financial Reporting Morning Herald, 26 September 2017, http://www. backs/.
Standards Foundation®. No permission granted to smh.com.au/small-business/finance/when-will-my-
third party users of this publication to reproduce or invoice-be-paid-chasing-late-payers-a-big-cost-for-
distribute. small-business-20170926-gyp2bk.html’ Chapter 12
5  ‘How do I get a copy of my credit report?’. Published 1  Australian Accounting Standards Board, ‘Accounting
by Office of the Australian Information Commissioner, Standard 107 Statement of Cash Flows, 2016’,
Chapter 2 © Australian Government. For more information visit Paragraph 19.
1  Australian Accounting Standards Board, ‘Accounting the Office of the Australian Information Commissioner 2  Ibid., Paragraph 42.
Standard 108: Accounting Policies, Changes in (OAIC), http://www.oaic.gov.au/privacy/privacy-
Accounting Estimates and Errors’, http://www.aasb. topics/credit-and-finance/how-do-i-get-a-copy-ofmy-
gov.au/admin/file/content105/c9/AASB108_07- credit-report’
04_COMPmay11_07-11.pdf. Published by Australian 6  Chartered Accountants Australia and New Zealand,
Accounting Standards Board, © 2011. ‘Notes to the financial statements: 7 – Trade and
2  CSL Limited, ‘Independent Auditor’s Report for the year Other Receivables’, Financial Report 2014, http://
ended 30 June 2017’, Annual Report 2017, p. 121. www.charteredaccountants.com.au/The-Institute/
Who-we-are-and-what-we-do/Annual-report.aspx.

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289
 3  Using a business calculator, simply input 1 P/YR,
Chapter 13 Appendix A 200 FV, 100 PV, and 12 I/ YR and solve for n. In
1  Peter Sivey, ‘Health insurance: Don’t blame young 1  Built-in functions can be accessed in Microsoft Excel logarithmic form, (1 + 0.12)n = 2 can be rewritten as
people for your rising premiums’, ABC News, 19 by clicking on the Paste function icon, clicking on log(1 + .12)n = log 2, or n log 1.12 = log 2.
October 2017, http://www.abc.net.au/news/ financial, and then scrolling down to the desired Therefore, n = (log 2) ÷ (log 1.12) = 6.116.
2017-10-18/health-insurance-dont-blame-young- function. 4  An ordinary annuity is paid or received at the end
people-for-rising-premiums/9061936. 2  In logarithmic form, (1 + r)6 = 2 can be rewritten as of each period, whereas an annuity due is paid or
2  Australian Accounting Standards Board, Accounting log(1 + r)6 = log 2, or 6 log(1 + r) = log 2. Therefore, received at the beginning of each period. In examples
Standard 101 Presentation of Financial Statements, log(1 + r) = log 2 ÷ 6, which simplifies to throughout this book, we will assume the annuity is
2015, paragraph 1. log(1 + r) = 0.1155245. Switching back to the ordinary.
3  Cochlear, Annual Report 2017, equivalent exponential form, e0.1155245 = (1 + r),
‘Chairman’s report’, p. 2. (1 + r) = 1.122462, and r = 0.122462 (12.2462%).

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290 Endnotes
 change in  222 Australian Company Number (ACN)  191
gross 105 Australian Securities and Investments
recording 97–8 Commission (ASIC)  19, 119, 139, 191, 193, 235
reporting 98–9 Australian Securities Exchange (ASX)  2, 19, 31,
accrual basis of accounting  3, 60–74, 222 192–3, 196, 201, 224–5, 235
accrued expense  67–9 share buyback notice example 202

INDEX
adjustment 70–1 Australian Taxation Office (ATO)  135, 153, 203
general rule  68–9 average age of non-current assets  144
accrued revenue  64–5 average cost of inventory  122
adjustment 70 average useful life of non-current assets  144
general rule  65
accumulated depreciation  66, 131–2, 140–1,
179, 223–4 B
balance never exceeding depreciable bad debt expense estimates  102–3
amount 134 bad debt expenses  99
depreciation expense totals  133 balance sheets  5–7, 11–12, 20–2, 72, 89, 114,
accuracy 10 120, 130, 155, 165, 178–9, 236–50
acid-test ratio  246 horizontal analysis  236–8
acquisition costs  145 linking income statement with  7
adjustment/adjusting entries  62–9 reporting at a moment in time  6
A to account balances  49 third in financial statement preparation 
AASB 3 Business Combinations 145 accrual accounting and  60–74 7, 54
AASB 15 Revenue from Contracts with of cash balances  85–6 vertical analysis  239–41
Customers  3, 61 for current assets and current bank reconciliation  84–7
AASB 16 Leases 163–4 liabilities 222–3 bankruptcy 245
AASB 101 Presentation of Financial ‘fixed’ to properly reflect expenses  66–7 bearer bonds  156
Statements  20, 25, 244 ‘fixed’ to properly reflect revenues  63–4 Board of Directors  31, 33
AASB 102 Inventories  114–15, 120 for gains and losses from investing and bond certificates  156
AASB 107 Statement of Cash Flows 212–13, financing activities  221–2 bond issue
215–16 journalising and posting  70–1 determining issue price  167–8
AASB 108 Accounting Policies, Changes in made during non-current asset’s useful at a discount  158–60, 168
Accounting Estimates and Errors  20, 138 life 137–40 at face value  157–8, 168
AASB 116 Property, plant and equipment 139–40 measuring ‘financial weight’ 72 at a premium  157, 160–2, 168
AASB 133 Earnings per Share 204 for non-cash items  221 bonds 155–62
AASB 136 Impairment of Assets  139, 145 preparing adjusted trial balance  71 call price  162
AASB 137 Provisions, Contingent Liabilities and advertising  4, 105, 185 carrying amount  160–1
Contingent Assets 164 ageing 103 future cash flow types  167
AASB 138 Intangible Assets 145–6 ageing schedule  103 redeeming before maturity  162–3
account balances  216 allotment/issue 194–5 terms 156
adjustments 49 allowance for doubtful debts  100, 102 bonus to the existing (old) partners  181
division by base account as percentage allowance method  100–1 bonus to the new partner  181
see vertical analysis allowance ratio  105–6 bonus to the remaining partners  184
dollar change – current-year balance minus amortisation  21–2, 160–2 bonus to the withdrawing partner  184
prior-year balance see horizontal analysis effective interest method of  168–70 borrowing  4, 8, 26, 90, 154–5, 158, 160, 224, 226
over time see horizontal analysis of intangible assets  146–7 from lender range  155
recording rules  46–7 amortisation schedule  160–2, 169–70 ‘bottom line profit’ 24
at a specific time see trial balance annual reports  82 buildings 130
within one year see vertical analysis annuity 167–8 business
zeroed out at each period end  98 application  194, 195 assets cost–liabilities difference
accountability  83, 88 arbitration 183 see equity
accounting 1 ASA 570 Going Concern 3 forms of  18–19, 175–7, 191–3
dual nature of  42, 46 asset accounts  47 GST registration  153
language of  11–12 asset effectiveness  249–50 knowledge of see chart of accounts
methods 10 asset impairment  139, 146–7 language of see accounting
accounting cycle  40–54, 60–74 asset turnover ratio  250 obligations 155
accounting equation  6, 42, 216, 239 assets  1, 5–6, 11, 21–2, 40, 88, 97, 100, 106–7, policies and procedures see internal
accounting transactions and  42–5 113–14, 141, 158, 163–4, 195, 197, 201, 250 control
accounting information  84 activity of  135 snapshots of see balance sheets
adequate documentation  83 claimed 6
independent verification  84 claiming see receivables
qualitative characteristics  9 in a ‘class’ 140 C
reviewing and reconciling  84 conversion 21 call 194
transferred/posted to ledgers  48 current see current assets call price  162
accounting information systems  40–2, 216 generation from liabilities versus equity capital  6, 191–2
cloud 49–50 see capital structure share or issued  22
accounting period  2, 11, 49 intangible see intangible assets capital account for each partner  178
accounting transactions  40–54 non-current see non-current assets capital accounts  177, 179, 181
accounting equation and  42–5 overstating 10 capital balances  179, 183, 186
affecting at least two accounts see dual revaluations  139–40, 183 capital deficiency  185–6
nature of accounting revenue-generating  8, 90 capital expenditures  90
arm’s length transaction  145 safeguarding 84 capital structure  29, 166, 248–50
journalising see journals sales 184–5 carrying amount  132–4, 138–9, 142, 147,
accounts  40–1, 50–3 at a specific point in time  5, 54 160–1, 169–70, 178
listings see trial balance theft of  83 comparison to call price  162
offsetting 101 see also accounting equation; deferred partner withdrawal at/less than/more
zero balance partnership accounts  185 expense than 183–4
accounts payable  5, 22, 152 auditing  81, 84, 193 cash  5, 21, 88–9, 166
change in  222 auditor’s report  31 analysis 89–92
accounts receivable  21, 179 Australian Accounting Standards  31 cash on hand  92
ageing of  103 also under specific AASB Standard conversions 218–20
analysis 104–6 Australian Accounting Standards Board inflows and outflows  223–4
cash from total see net realisable value (AASB) 19 internal control and  81–92

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291
 management see cash flow statements corporation (or company)  19, 191–3 more earlier; less later  134
net increase (decrease) in  214–15 capital raising ability  191–2 recognition 134
paid for inventory  218–19 corporate collapse  81 depreciation methods/comparisons
paid for operating expenses  219–20 dividend imputation  192–3 133, 135–7
paid for taxes  220 evaluating inventory management  121–3 depreciation schedules  133, 136
partners receiving remaining cash  185–6 evaluating liability management  165–7 direct method  217
petty cash replenishing, Cash Over and limited liability of owners  192 direct write-off method  99–100
Short 88 ‘publicly listed’ 19 directors’ report  31
received from customers  218 regulation 193 disclosure  10, 25, 104, 119, 165, 193, 215–16
safeguarding 84 separate legal entity  191 discount  98, 113
cash accounts  41 transferability of ownership  192 bond issue at  158–60, 169
cash balances  85–6 Corporations Act 2001 (Cth)  20, 191 discretion 10
cash basis of accounting  60–1 Corporations Regulations  31 dividend imputation  192–3
cash controls  84–8 cost  2, 132 dividend payout ratio  205–6
cash dividends  196–8, 200–1 cost model  139 Dividend Reinvestment Plan (DRP)  198–9
cash equivalents  88–9 cost of capital  250 dividend yield ratio  206
cash flow cost of sales  24, 114, 120 dividends  6, 11, 47, 90, 177, 196–200
from financing activities  213, 224–6 assumptions 115–18 ex-dividend trading  196
free 90–2 cost principle  5, 11, 112, 120, 130 expense and dividend accounts  47–8
hedges 25 cost–benefit analysis  84 franked 192
inflows and outflows see cash flow cost-of-goods-sold model  118, 124 not ‘double taxed’ 19
statements credit  46, 50 receipt of  206
from investing activities  213–14, 223–4 ‘easy credit’ 105 reinvestment plans in Australia  198–9
non-current assets and  144–5 see also debit and credit rules right to participate proportionally in  193
from operating activities – direct and credit balances  102–3 as temporary account  72
indirect methods  213, 218–23 credit cards  88 dividends in arrears  200
reporting see cash flow statements credit memoranda  85–6 documentation 83
shareholders’ equity and  207 credit ratings  102 petty cash receipts as  88
cash flow adequacy ratio  226–7 credit reporting body (CRB) 101 dollar, the  2
cash flow statements  8–9, 89, 144–5, 197 creditors  5, 8, 156 bond’s future cash flow conversion to  167
Cash Over and Short  88 credits 182 dollar change in account balance  25–6, 89,
cash payments  218 cumulative preference shares  200–1 104, 121, 165, 204, 236, 238
cash receipts  218 currency 2 gross dollar ‘mark-up’  24
cash transactions  85 comparisons in one versus currency ‘double taxed’ 19
‘cashless’ society  85 conversions 26 drawings  6, 11, 47
chart of accounts, example 41–2 current assets  21, 89, 106, 114 dual nature of accounting  42, 46
cheques 85 current liabilities  22, 152–5, 166 dual-entry accounting system  46–9
‘bounced’ see non-sufficient funds (NSF) with payroll  153–4 recording transactions in  48–50
cheque current market value  178–9 DuPont analysis  249–50
double-signed cheque  87 current portion of non-current debt  154–5
choice 20 current ratio  166–7, 245
closing entries  73, 98 E
closing process  72–4 earnings before income taxes see profits
collusion 84 D before income tax expense
Committee of Sponsoring Organizations damages 177 earnings before interest and tax (EBIT)  243,
(COSO) 82 date of record  196 248–9
common-size financial statements  26 days-in-inventory ratio  122–3 earnings per share (EPS)  25, 204–5, 243–4
communication 84 days-in-receivables ratio  105 economic entity  2, 11, 19
comparability  10, 12, 31, 136 debentures see bonds economic information  25
comparative balance sheets  216–17 debit  46, 50 over short time periods  2
comparison 235–6 debit and credit rules  46–8 economic resources  5
comparisons  26, 92, 162 debit balances  102 Economic Value Added  250
of depreciation methods  135–7 debit cards  88 effective interest method of amortisation 
of gross accounts receivable to allowance debit memoranda  86 168–70
account 105 debits 182 discount example 169
of inventory costing methods  118–19 debt  22, 90, 166 interest expense/amounts each period
see also bank reconciliation non-current debt  154–5 differing 169
competitors 235 repayment  224, 227, 249 premium example 169–70
comprehensive income, other  25 debt to assets ratio  166–7, 248 Electronic Funds Transfer (EFS) Code  86
Conceptual Framework for Financial Reporting  11 debt to equity ratio  248 employees  8, 83
conservatism see prudence debtors see receivables salaries/wages to  5
consolidated balance sheet  20 decision making  5, 9, 103, 139, 235–6 segregation of duties  83–4
consolidated statement of cash flows  91, 214 declaration date  197 work – liability creation  152
consolidated statement of comprehensive deductions  153, 155 ending inventory  118–20, 124
income 23–4 deferred expense  65–7 entry approach  219–20
Consumer Price Index (CPI)  26 adjustment 70–1 equipment  4, 130, 184, 223–4
contingent liabilities  164–5 general rule  67 see also plant and equipment; property,
contra-asset accounts  66, 101, 146 deferred revenue  62–4, 152 plant and equipment
contracts 164 adjustment 70 equity  6, 11, 40, 47, 88, 90, 97, 100, 106–7, 114,
contra-liability accounts  158 general rule and exception  63–4 141, 158, 163, 166, 193, 201, 248, 250
contra-revenue accounts  98 subscription revenue  62–3 evaluating a company’s management
contributed capital  6, 11 deferred tax assets  21 of 203–7
contributed equity  22, 199, 204 deposit in transit  85 liability and equity accounts  47
control activities  83–4 depreciable amount  133 movements in  25
control environment  82 depreciation  8, 21–2, 61, 131, 164 reporting see statement of changes in
co-ownership 176 acceleration of see reducing balance equity
copyrights  21, 145–6 method of depreciation sources 22
corporate culture  82 as asset cost allocation  131 at a specific point in time  5, 54
corporate governance  31, 33 depreciation expense  4–5, 66–7, 131–6, see also accounting equation
Corporate Law Economic Reform Program 139–40, 221 error  83, 86, 119
(Audit Reform and Corporate Disclosure) Act collection see accumulated depreciation bank errors  85
(CLERP 9)  81 as function of usage  135 being error-free  10, 83

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292 Index
 correction 87 Generally Accepted Accounting Principles components 82–4
omissions or misstatements  9 (GAAP)  19–20, 61, 100, 133 establishing responsibility  83
estimates  9–10, 165 gift cards  64 limitations 84
of bad debt expense  102–3 Global Financial Crisis (GFC)  72, 101, 155, 198 Internal control – integrated framework
changes in depreciation estimates  137–8 global financial markets  155 [report] 82
of ending inventory  119–20 going concern  2–3, 11 internal transactions  40
ethics 82 goods 155 International Accounting Standards Board
evaluation  121–3, 142–4, 203–7 delayed payment for  154 (IASB) 20
expenditures  90, 138–9, 146 ‘goods flow’ 114 International Financial Reporting Standards
expense and dividend accounts  47–8 Goods and Services Tax (GST) 153 (IFRS) 20
expenses  3–4, 11, 22, 48, 87 goodwill  21–2, 145–7, 183–4 inventory  5, 19, 21, 112–25, 193
match with revenue recognition period governance information  31, 33 change in  222
see matching principle government evaluating a company’s management
operating (other) expenses  24 Commonwealth and State  153 of 121–3
over a specific period of time  4 as poor payers  105 gross dollar ‘mark-up’  24
recurring 24 removal of double taxation of income see impact of see inventory turnover ratio
as temporary account  72 dividend imputation ‘not intended for resale’ non-current asset
understating 10 taxes payable to see taxes differentiation 130
expensing gross margin see gross profit periodic counting of  84
inventory 114 gross pay  153 physical 119
non-current assets  131–2 gross profit  24 purchase of  152
external transactions  40 margin 120 inventory costing methods  118, 123–5
gross profit method  120 inventory turnover ratio  166, 246–7
growth 26 investing activities  8, 89–90
F GST Receivable  153 investing in partnership  181–2
face value  156, 170 investing cash flows  213–14, 222–4
bond issue at  157–8 investment  21, 156, 223
bonds payable always at  158 H investors  6, 8, 191
fair market value  178 hedges/hedging  25, 163 invoices 83
fair value  139–40 historical cost principle  5 issued capital  22
faithful representation  10, 12 horizontal analysis  25–6, 89–90, 104, 121–2, issued capital (contributed equity) 193
feedback 10 142–3, 165–7, 204, 236–8 issued shares  193
finance leases  164 human element  84
financial accounting  2–12
basic assumptions  2–3, 11–12
J
financial activities
I journal entries
immateriality 104 adjusting entries and example 62–72
personal–business separation see
income 22 on petty cash fund replenishment  88
economic entity assumption
divisions – ‘profit or loss’ and recording to financial statements
financial information  9, 30–3, 235
‘comprehensive income’ 140 example 50–4
flow of  5
double taxation of  192 journals 48
relevant and faithfully represented  10
overstating 10 judgements 20
systems 40–2
income statements  3–5, 11–12, 22–5, 99, 216, caution under uncertainty see prudence
financial instruments, bonds  155–62
financial leverage  247 236–50
financial position reporting see balance sheets consolidated 23–4 L
financial statement analysis  234–50 first in financial statement labour ‘on costs’ 154
financial statements  2, 5, 18–33, 119, 155, preparation  54, 71 land 130–1
186, 235 horizontal analysis  238 last-in, first-out (LIFO) method  117, 119, 124–5
format 20–1 linking balance sheet with  7 AASB  102’s Australian use preclusion  115,
information beyond  30–3 ‘profit and loss’ section  4 117, 119
notes to  10, 30–1 structure 4 lease 163
preparing  7, 54, 71–2 vertical analysis  241 lease liabilities  163–4
publicly available  105 income tax expense  25 ledgers 48–9
recording journal entries example 50–4 independent auditor’s report  31–2 posting to  48, 50–3
relationship between  7 independent verification  84 reconciling business’ books  85–6
financing activities  8, 89–90 indirect method  217 leverage 247
financing cash flows  213–14, 222, 224–6 industry standards  236 liabilities  5–6, 11, 22, 40, 62–3, 113, 152–70,
first-in, first-out (FIFO) method  115–17, 119, 124 information under accounting information 193, 197, 238, 248
fixed assets  130 Initial Public Offering (IPO)  191–2, 198, 224 current 22
fixtures 130 insolvency 247–8 evaluating a company’s management
forecasting 10 insurance expense  65–6, 131, 219 of 165–7
forfeiture (shares)  196 change in prepaid insurance  222 misclassification of  155
formulae  4, 6–8, 26, 89–90, 104–5, 107, 117, pre-paid 21 non-current 22
121–2, 125, 133–5, 140, 143–4, 160–1, intangible assets  5, 21–2, 90, 130–47, 223 partners paying  185
165–6, 168, 204–6, 227, 236, 239, 242–5 externally acquired  145–6 probable, possible and remote  164–5
franchise 145 impairing of  146–7 at a specific point in time  5, 54
franchise rights  21 internally generated  146 understating 10
fraud  81, 139 integrated reporting  33 warranty obligation inclusion  165
free cash flow  226 integrity 82 see also accounting equation; accrued
furniture 130 inter- intracompany comparisons  235–6 expense
future cash flows  167–8 interest  4, 106–7, 224 liability and equity accounts  47
future interest  156 market rate of see market (or effective) liability capping schemes  177
rate of interest limited liability  19, 192
purchasing current partner’s interest  180 liquidation  179, 184–6
G recording 106–7 liquidity  21, 166
gains 162 interest expense  68–9, 170 liquidity analysis  245–7
example non-current assets  141 as percentage  169 long-term debt  22
potential (unrealised) gain  120 interest payments  157–61, 167 loss  3, 162
on sales  220 interest rates  155, 157, 249 example non-current assets  140–1
‘gearing’ 243 interest-bearing liabilities  22 ‘true and fair’  4
general journals  48 internal control  81–2, 103, 119 lower-of-cost-and-net-realisable-value (LCNRV)
general ledgers  49, 54 cash and  81–92 rule 120–1

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Index 293
 ownership 164 property  5, 21, 184
M co-ownership 176 property, plant and equipment (PPE) 90, 130,
management’s discussion and analysis  31–2 transferability of  177, 192 132, 136, 147, 193, 213, 223
market (or effective) rate of interest  157, 168 ownership interest  6 proprietary (private) companies  19, 191
mark-up 24 prospectus 194–5
matching principle  4, 11, 60, 100, 131
materiality  9–10, 12
P provisions 165
prudence  10, 12, 98, 100, 119–20, 146
maturity  107, 158, 160, 162 par values  194
public companies  19, 81, 163, 191, 235
maturity date  156 Partnership Act 1890  175–6, 179
purchase discounts  113
redeeming bonds before  162–3 partnerships 175–9
purchases 113
misleading information  155 bonus to new and existing partners  181–2
purchases returns and allowances  113
monetary unit  2, 11 capital accounts for each partner  177–9
money commencing 177–9
flows 42 day-to-day management functions  178 Q
‘money flow’  114 ease of formation  176 quick ratio  246
as receivable  5 financial statements  186
formation 19
monitoring 84
monthly service charge  87 law and  181 R
moving average method  117–19 mutual agency and co-ownership  176 rate of return  157
multi-step income statement  22 no partnership taxation, but not ratio analysis  236
mutual agency  176 tax-free 177 raw materials  112
non-managing (sleeping) partner  177 receipts  88, 218
partner admission and withdrawal  180–4 receivables  5, 97–107
N partnership agreement  176, 179, 181 collection  87, 104
negligence 177 profit allocation  179–80 ‘current’ and ‘past due’ 103
net assets  178–9 sharing profits  179–80 recording at time of sale  97
net book value  132 transferability of ownership  177 uncollectible  99–101, 103
net financing cash flows  225 unlimited liability of owners  176–7 receivables turnover ratio  104–5, 246
net income  22, 221 past experience  102 reconciliation  61, 213, 215
net increase (decrease) in cash  214–15 patents  21, 145–6 bank 84–7
net loss  7, 213 payment date  197 independent verification  84
net operating cash flows  220–1, 223 payments  90, 154, 218, 224 recording/records
net pay  153 to partners  177 for account balances change see debit and
net profit  7, 54, 213 from petty cash funds  87–8 credit rules
net purchases  123 payroll, current liabilities with  153–4 of accounts receivable  97–8
net realisable value (NRV) 98, 100, 120–1 percentage-of-receivables approach  102–3 of bad debt expense  100
neutrality 10 percentage-of-sales approach  102 bond issue  157–60
non-cancellable operating leases  164 percentages  26–9, 89–90, 102, 104, 121–2, of cash dividends  197
non-cash expenses  221 142–3, 165–7, 169, 204, 236, 238 detailed records for each partner  177
non-cumulative preference shares  200–1 periodic (physical) inventory system  113–14, error-free accounting records  10, 83
non-current asset turnover ratio  143 123–5 of expenses when incurred see matching
non-current assets  21, 66, 106, 130–47, 163 perpetual inventory system  112–14, 123, 125 principle
adjustments made during useful life  petty cash funds  87–8 4-step process for accounting
137–40 plant and equipment  5, 21 transactions 50–3
average life and age  144 post-acquisition expenditures  139 of intangible assets  145
cash flows and  144–5 prediction 10 of interest  106–7
disposal 140–1 see also estimates interest payments  157–61
evaluating a company’s management pre-emption 193 of inventory  112–14, 123
of 142–4 preference shares  200–1 in journal and posting to ledger  50–3
expenditure after acquisition  138–9 cash dividends on  200–1 journal entries example  50–4
information 132 premium 146 maturity  158, 160, 162
‘not intended for resale’ differentiation bond issue at  160–2 of non-current assets  130–1
from inventory  130 present value  167 notes receivable  106
‘recoverable amount’ 139 price to earnings ratio (P/E) ratio  244 of ordinary shares  194
non-current debt, current portion of  154–5 principal  106, 154, 156, 167 of preference shares  200
non-current liabilities  22, 154–5, 224 principal value see face value of revenue and expense  60
non-sufficient funds (NSF) cheque  87 privatisation 192 of revenues when earned see revenue
norms 102 products  8, 112 recognition principle
notes payable  152, 154 professional indemnity insurance  177 safeguarding 84
formalised see bonds profit  3, 6, 54, 250 of share buybacks  201–2
notes receivable  106–7 allocation 179–80 of transactions  40–54
notes to the financial statements  10, 207, 235 borrowed money to earn  155 a write-off/recovery  100–1
quantitative and qualitative information distribution 177 reducing balance method of depreciation 
in 30–1 generation  179, 196, 242 134–5
gross profit  24 regulation (companies/corporations)  193
overstating 139 reissue (shares)  196
O reconciliation 61 relevance  9–10, 12
off-balance-sheet financing  164 reduction see expenses rent 4
operating (other) expenses  24 ‘stag profit’ 192 reporting/reports 33
operating activities  8, 61, 89–90 ‘true and fair’  4 of accounts receivable  98–9
operating cash flows  213, 218–23 profit and loss statement see income accrual- and cash-based income  61
operating efficiency  249–50 statements annual reports  82
operating expenses  99 profit margin ratio  242 auditor’s report  31
operating leases  164 profit sharing cash and cash equivalents  88–9
optional deductions  153 based on capital balances and of cash dividends  197–8
ordinary annuity  167–8 service 179–80 cash flows see cash flow statements
ordinary shares  193–6, 224–5 based on set percentage  179 cash flows from operating activities 
other comprehensive income  22–3, 25 profitability 22 218–23
other information (management’s discussion/ reporting see income statements of cost of sales  114
analysis) 31–2 profitability analysis  242–5 credit reports  101
outstanding cheque  85 profits before income tax expense  25 current liabilities  155
oversubscription (shares) 195 promissory notes  106, 154 directors’ report  31

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294 Index
 equity see statement of changes in equity share buybacks  26, 90, 198, 201–3, 224, 226 taxes  4–5, 22, 152, 177
error 83 on-market 201–3 no partnership taxation  177
financial position see balance sheets share dividends  198 withheld 153
financial reporting objectives  9–10, 81 share price history  235, 250 taxes payable  153
of inventory  114 share splits  199–200 change in  222–3
of non-current assets  132 shareholders  6, 22, 31, 90, 177 temporary accounts  113, 123
profitability see income statements annual reports to  82 reset to zero  72–3
sustainability reporting  32–3 borrowed money to earn profit for  155 zeroed out at each period end  73, 98
required deductions  153 rights of  193 theft  83, 119
Reserve Bank of Australia  156 shareholders’ equity  191–207 timeliness  10, 12
reserves  193, 238 shares  191, 193–6, 200–1 times interest earned  248–9
residual assets  193 franked  203, 206 time/timing expressions
residual value  133–4, 139 market price of  198–9, 206 chronological journals  48
resources  5, 193 shares issue  6, 22 of financial statements  7–8
of businesses see assets by instalment  194–5 specified timing of interest
combined with partnership  176 single-step income statement  22–3 payments 156
decreases see expenses sole proprietorship (sole trader) 18–19 timing of revenue/expense recording 
increases see revenues sole traders  18–19 60
retail method  119–20 solvency 166 ‘tone at the top’ 82
retained earnings  6–7, 11, 22, 29, 54, 72–3, solvency analysis  247–9 total comprehensive income  24
179, 193, 197, 199, 204, 225 specific identification method  115–16, 124 trade names  145
changes in  7 spreadsheets  26, 42–5 trade receivables see receivables
voluntary distributions out of see stakeholders  32–3, 193 trademarks  21, 145
dividends standards of comparison  235–6 transaction analysis  42–5
return on assets ratio  243 stated interest rate  156 transactions see accounting transactions
return on equity  205, 242–3 statement of cash flows  212–27 transportation-in 113
revaluation model  139–40 analysis 226–7 trends  25–6, 102, 122, 244–5
revenue accounts  47 complete statement, indirect trial balance  48–9
revenue expenditures  138 method 225–6 functions 49
revenue received in advance see deferred preparing 216–17 preparing 54
revenue statement of changes in equity  7–8, 11, 29–30, preparing adjusted  71
revenue recognition principle  3, 11, 60, 64, 107 186, 197
see also accrual basis of accounting second in financial statement
revenues  1, 3, 11, 22, 47, 63–4, 220 preparation  7, 54 U
over a specific period of time  4 statement of changes in equity (retained uncertainty  9–10, 146
as temporary account  72 earnings section) 7, 11–12 material uncertainty  2, 9–10
see also retained earnings statement of comprehensive income see uncollectible receivables  99–101, 103
rights  21, 191, 193 income statements understandability  10, 12
risk  164, 166–7 ‘comprehensive’ significance  140 unearned revenue see deferred revenue
sharing with partnerships  176 statement of financial position see balance units-of-activity method  135
risk assessment  83 sheets unlimited liability (of owners)  176–7
rounding 125 statement of profit or loss and other useful life  133, 137–40, 144
comprehensive income  23–4 utilities  4, 219–20
stock 112
S stocktake  120, 125
salaries  5, 22, 177, 219–20 straight-line method of amortisation  146,
V
salaries expense  67–8 160–1 verifiability  10, 12
sales  8, 22, 24, 97, 220 to zero  169–70 vertical analysis  26–9, 89–90, 104, 121–2,
of assets  184–5 straight-line method of depreciation  133, 142–3, 165–7, 204, 236, 238–41
cost of sales reporting  114 139–40, 144 see also debt to assets ratio
terms 98 superannuation 153–4 voluntary deductions  153
sales revenue  24 suppliers  8, 22 voting rights  193
Sarbanes-Oxley Act  2002 (US)  82 accounts payable to  5
sector-wide data  239
security 84
sustainability reporting  32–3
W
segregation (of duties)  83–4 wages  4–5, 22
selling price  120 T warranties 165
service revenue  64–5 T-accounts  46, 49, 65–8, 70–1, 73, 85 weighted average  125
services 155 ‘take home pay’ see net pay withholding tax  153
delayed payment for  154 tangible resources  112 work-in-process 112
monthly service charge  87 tax deductions  155 write-offs and recovery  99–102

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Index 295
NOTES

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
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Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
REVIEW KEY DEFINITIONS LEARNING OBJECTIVES

accounting income statement

The process of identifying, The financial statement that LO1 Explain the four assumptions made when communicating
measuring and communicating reports a company’s revenues accounting information.
economic information to permit and expenses over a specific
informed judgements and period of time. LO2 Describe the purpose and structure of an income
decisions.
balance sheet statement and the terms and principles used to create it.
economic entity A financial statement that
assumption reports a business’ assets, LO3 Describe the purpose and structure of a balance sheet and
The assumption made by liabilities and equity at a specific the terms and principles used to create it.
accountants that the financial point in time.
activities of a business can be asset LO4 Describe the purpose of a statement of changes in
separated from the financial An economic resource that is
activities of the business’
equity and how it links the income statement and the
objectively measurable, results balance sheet.
owner(s). from a prior transaction and will
accounting period provide future economic benefit. LO5 Describe the purpose and structure of a cash flow
assumption cost principle statement and the terms and principles used to create it.
The assumption made by The principle that assets should
accountants that economic be recorded and reported at
information can be meaningfully the cost paid to acquire them.
LO6 Appreciate the objectives of financial reporting and the
captured and communicated Sometimes referred to as the
qualitative characteristics that make accounting
over short periods of time. ‘historical cost principle’. information useful.
monetary unit liability
assumption An obligation of a business that
LO7 Review the language of accounting.
An assumption made by results from a past transaction
accountants that the dollar is
the most effective means to
and will require the sacrifice of
economic resources at a future
KEY FORMULAS
communicate economic activity. date.
going concern equity KEY FORMULA 1.1 INCOME STATEMENT
assumption The difference between a
The assumption made by business’ assets and liabilities, Revenues – Expenses = Net Profit or Net Loss
accountants that a company representing the share of assets (or Income, more formally, Total Comprehensive Income)
will continue to operate into the that is claimed by the business’
foreseeable future. owner(s).
income statement contributed capital
The resources that investors KEY FORMULA 1.2  THE RELATIONSHIP BETWEEN ASSETS,
(profit and loss
statement) contribute to a business in LIABILITIES AND EQUITY
The income statement reports exchange for ownership
a company’s revenues and interest. Assets = Liabilities + Equity
expenses and the resulting dividends
profit or loss. Profits that are distributed
revenue to owners (usually called
KEY FORMULA 1.3  STATEMENT OF CHANGES IN EQUITY
An increase in resources drawings if the business is not
a company). (THE RETAINED EARNINGS PART)
resulting from the sale of goods
or the provision of services. retained earnings Retained Earnings, Beginning Balance
revenue recognition Profits that are kept in the
business. +/– Net Profit/Loss
principle
The principle that revenue – Dividends
statement of changes
should be recorded when in equity = Retained Earnings, Ending Balance
a resource has been earned A financial statement that
and not just when the cash is reports the change in a
received. business’ equity (contributed
KEY FORMULA 1.4  THE CASH FLOW STATEMENT
expense equity, reserves and retained
A decrease in resources earnings) over a specific period Cash Flows Provided (Used) by Operating Activities
resulting from the operation of of time.
a business. cash flow statement +/– Cash Flows Provided (Used) by Investing Activities
matching principle A financial statement that +/– Cash Flows Provided (Used) by Financing Activities
The principle that expenses reports a business’ sources and
should be recorded in the period uses of cash over a specific = Net Increase (Decrease) in Cash
resources are used to generate period of time.
+ Cash at the beginning
revenues.
= Cash at the end

FINANCIAL
1 ACCOUNTING
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REVIEW KEY DEFINITIONS

relevance
The capacity of accounting
to arrive at the same or similar
outcomes.
DEMONSTRATION PROBLEM
information to make a difference timeliness On 1 March, Sarah begins a tutoring service that she will operate for four
in decisions. When information is provided months. With $400 borrowed from a friend and $1000 of her own money,
materiality quickly enough that the user
she purchases a $1200 accounting licence and software and $80 of
The threshold at which a can take action.
financial item begins to affect supplies. Sarah promises to pay her friend $10 interest at the end of each
understandability
decision-making. The ability of accounting month and to pay back the full $400 at the end of June.
faithful representation information to be Sarah charges $50 per tutoring session. During March, she
Financial information that is comprehensible to those conducted 40 sessions and bought $100 of additional supplies. At the
presented in a way that is who have a ‘reasonable
complete, neutral and free from understanding of business end of the month, Sarah has not collected on sixteen of the 40 sessions,
error. and economic activities and and she has $50 of supplies left over. Sarah withdrew $400 from the
accounting and a willingness
comparability
to study the information with
business during March. Prepare Sarah’s income statement and
The ability to use accounting
reasonable diligence’. statement of changes in equity for the month ending 31 March and her
information to be weighed
against or contrasted to the Conceptual Framework balance sheet on 31 March.
financial activities of different for Financial Reporting
businesses. The objectives, characteristics
verifiability and concepts that guide the DEMONSTRATION PROBLEM SOLUTION
When information allows manner in which accounting is
different independent observers practised. Sarah’s Tutoring Service
Income statement
for the month ending 31 March
Revenue: $2 000
Expenses:
 Depreciation (licence and $ 300
software 1/4 months)
 Supplies 130
 Interest 10
Total expenses 440
Net Income $1 560

Sarah’s Tutoring Service

Statement of changes in equity
for the month ending 31 March
Retained earnings, 1 March $0
Add: Net income 1 560
Less: Dividends 400
Retained earnings, 31 March $1 160

Sarah’s Tutoring Service

Balance sheet
at 31 March
Cash $810
Accounts receivable 800
Licence and Software (net) 900
Supplies 50
  Total assets $2 560
Note payable $ 400
  Total liabilities $ 400
Contributed capital $1 000
Retained earnings 1 160
  Total equity 2 160
Total liabilities and equity $2 560
FINANCIAL
1 ACCOUNTING
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REVIEW
TERMS USED TO IDENTIFY AND DESCRIBE ECONOMIC INFORMATION

Term Definition Reported on the

Asset A resource of a business Balance sheet

Liability An obligation of a business Balance sheet
Equity The difference between assets and liabilities Balance sheet
Contributed equity (capital) Equity resulting from contributions from owners Balance sheet
(often from issuing shares)
Retained earnings Equity resulting from profitable operations Balance sheet and statement of changes
in equity (change in retained earnings)
Revenue An increase in assets resulting from selling Income statement
a good or providing a service
Expense A decrease in assets resulting from selling Income statement
a good or providing a service
Dividend (Drawings) A distribution of profits to owners Statement of changes in equity

PRINCIPLES USED TO MEASURE ECONOMIC INFORMATION

Principle Definition Ramification

Revenue recognition Revenues are recorded when they are earned The receipt of cash is not required to record a revenue. If you
sell to a customer who will definitely pay you next week,
the revenue is earned when the sale is made, not when you
receive the cash
Matching Expenses are recorded in the time period For many assets, the cost of the asset must be spread over
when they are incurred to generate revenues the periods when it is used – we call this depreciation
Cost Assets are recorded at their historical costs Except in a few cases, market values are not used for
reporting asset values

ASSUMPTIONS MADE WHEN COMMUNICATING ECONOMIC INFORMATION

Assumption Definition Ramification

Economic entity The financial activities of a business can be accounted for We do not have to worry that the financial
separately from the business’ owners information of the owner is mixed with the
financial information of the business
Monetary unit The dollar, unadjusted for inflation, is the best means of All transactions need to have a specific dollar
communicating accounting information value to be recorded

Accounting period Accounting information needs to be communicated effectively Most businesses prepare half-yearly and annual
over short periods of time financial statements
Going concern The company for which we are accounting will continue its If an entity is not selling its assets, then assets
operations indefinitely (like the drone) are recorded at the value to the
business (cost less depreciation)

FINANCIAL
1 Copyright ACCOUNTING
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REVIEW
QUALITATIVE CHARACTERISTICS THAT MAKE ACCOUNTING INFORMATION USEFUL

Term Definition Ramification

Relevance Accounting information should have the capacity to Information should have predictive or feedback value
affect decisions and should be timely
Materiality The threshold over which an item could begin to affect When an amount is small enough, normal accounting
decisions procedures are not always followed. Note CSL reports
to the nearest $0.1 million
Faithful Faithfully represent the phenomena that it purports to Financial reports represent economic phenomena in
representation represent words and numbers
Prudence When uncertainty exists, accounting information should An entity should choose accounting techniques that
(Conservatism) present the least optimistic alternative guard against overstating revenues or assets
Comparability Accounting information should be comparable across Entities must disclose the accounting methods that they
different businesses. This is aided by consistency where use so that comparisons across companies can be made
use of the same accounting method aids comparability
Verifiability Verifiability helps assure users that information is Different knowledgeable and independent observers
faithfully represented could reach consensus
Timeliness Information available to decision-makers before they The older the information generally the less useful it is
make decisions
Understandability Accounting information should be comprehensible by Users must spend a reasonable amount of time studying
those willing to spend a reasonable amount of time accounting information for it to be understood
studying it

FINANCIAL STATEMENTS USED TO COMMUNICATE ECONOMIC INFORMATION

Statement Purpose Structure Links to other statements

Income statement Shows a company’s revenues and Revenue – Expenses = Net Profit/ Net profit goes to the statement
expenses over a specific period of Loss of changes in equity to calculate
time retained earnings
Balance sheet Shows a company’s assets, Assets = Liabilities + Equity The balance in retained earnings
liabilities and equity at a specific comes from the statement of
point in time changes in equity
The balance in cash should agree
with the ending cash balance on
the cash flow statement
Statement of changes Shows the changes in a company’s Beginning Retained Earnings + Ending retained earnings goes to
in equity (retained retained earnings over a specific Profits (or – Losses) – Dividends = the balance sheet
earnings section) period of time Ending Retained Earnings
Cash flow statement Shows a company’s inflows and Operating Cash Flows +/– Investing The ending cash balance on the
outflows of cash over a specific Cash Flows +/– Financing Cash cash flow statement should agree
period of time Flows = Net Change in Cash with the balance in cash on the
balance sheet

FINANCIAL
1 ACCOUNTING
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REVIEW KEY DEFINITIONS LEARNING OBJECTIVES

sole proprietorship (sole non-current asset

trader) A resource that is used in a
LO1 Explore the three major forms of business.
A business owned by one company’s operations for more
person. than one year and not intended LO2 Define Generally Accepted Accounting Principles
partnership
for resale. (GAAP) and their origins.
A business that is formed when current liability
two or more proprietors join An obligation that is reasonably LO3 Describe the main classifications of assets, liabilities
together to own a business. expected to be satisfied within and equity in a balance sheet.
one year.
company (or
corporation) non-current liability
LO4 Discuss the main subtotals of income on an income
A separate legal entity that is An obligation that is not statement.
established by registering with expected to be satisfied within
ASIC. one year. LO5 Analyse the balance sheet and the income statement
Australian Securities contributed equity using horizontal and vertical analyses.
and Investments The amount of equity a
Commission (ASIC) company generates through LO6 Describe the structure of a statement of changes in
The agency charged with
the sale of shares to investors equity.
(shareholders).
protecting investors and
maintaining the integrity of multi-step income LO7 Look at the types of information usually disclosed along
securities markets. statement with financial statements.
public company Calculates income by grouping
certain revenues and expenses
A separate legal entity in which
ownership is available to the together and calculating several KEY FORMULAS
general public. subtotals of income.

Generally Accepted other comprehensive KEY FORMULA 2.1 ASSETS

Accounting Principles income
Includes gains and losses not Current Assets
(GAAP)
included in traditional revenue
The accounting standards,
and expense items. + Non-current Assets
rules, principles and procedures
that comprise authoritative sales revenue = Total Assets
practice for financial The resources that a company
accounting. generates during a period from
selling its inventory.
Australian Accounting
Standards Board (AASB) cost of sales KEY FORMULA 2.2 HORIZONTAL ANALYSIS
The standard-setting body The cost of the inventory sold
whose mission is ‘to develop during a period. Dollar Change in Current Year Balance –
and maintain high-quality =
gross profit (gross Account Balance Prior Year Balance
financial reporting standards’. margin)
International Financial The profit that a company Percentage Change Dollar Change
=
Reporting Standards generates when considering in Account Balance Prior Year Balance
(IFRS) only the sale price and the cost
Standards issued by the of the product sold.
International Accounting operating expenses
Standards Board. Recurring expenses that a KEY FORMULA 2.3 VERTICAL ANALYSIS
International company incurs during normal
Accounting Standards operations. For the For the income
Board (IASB) profits before income balance sheet statement
A board, similar to the AASB, tax expense Account Balance Account Balance
whose mission is to develop The profit that a company Percentage
a single set of high-quality generates when considering Total Assets Net Sales or Revenue
standards requiring transparent both the cost of the inventory
and comparable information. and the normal expenses
consolidated balance incurred to operate the
business.
sheet vertical analysis notes to the financial present fairly, in conformity
A type of balance sheet that income tax expense A method of comparing statements with Australian Accounting
groups together the parent The amount of income tax a company’s account The additional textual and Standards, the company’s
company and its subsidiaries as expense for a given period. balances within one year numerical information financial condition and
one reporting entity. horizontal analysis by dividing each account immediately following the results of operations and
current asset A method of analysing a balance by a base amount to financial statements. cash flows.
Any asset that is reasonably company’s account balances yield a percentage. directors’ report
independent
expected to be converted to over time by calculating common-size auditor’s report Forms part of the financial
cash or consumed within one absolute and percentage financial statement A report, prepared by a report and covers matters
year of the balance sheet date. changes in each account. A statement in which registered company auditor which are the Board of
all accounts have been for the shareholder, stating Directors‘ responsibility.
standardised by the overall an opinion on whether the
size of the company. financial statements

FINANCIAL
2 STATEMENTS
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REVIEW
DEMONSTRATION PROBLEM DEMONSTRATION PROBLEM SOLUTION
The following items were taken from the financial statements
of Susan’s Sportswear Suppliers. Use the items to prepare a Susan’s Sportswear Suppliers Income statement
for the year ending 30 June
multi-step income statement for the year ending 30 June and
a classified balance sheet at 30 June. For each statement, Net sales $951 786 100.0%
prepare a vertical analysis. All dollar amounts are in thousands Cost of sales 511 101 53.7%
of dollars.
Gross profit $440 685 46.3%
Accounts payable $  62 432 Selling, general and 250 496 26.3%
Accounts receivable 206 024 administrative expenses
Accrued liabilities 43 789 Other revenues and expenses:
Cash and cash equivalents 264 585   Interest revenue 2 107 0.2%
Contributed capital 205 465   Interest expense (1 627) 0.2%
Cost of sales 511 101 Profits before income tax $190 669 20.0%
Current portion of long-term debt 4 596 Income tax expense 70 548 7.4%
Deferred tax asset, current 17 442 Net profit $120 121 12.6%
Deferred tax liability, non-current 7 716
Goodwill 12 157
Susan’s Sportswear Suppliers
Income tax expense 70 548 Balance sheet as at 30 June
Income taxes payable 8 069 Assets
Intangibles and other assets 24 475 Current assets:
Interest expense 1 627 Cash and cash equivalents $264 585 33.8%
Interest revenue 2 107 Accounts receivable, net 206 024 26.3%
Inventories 126 808 Inventories, net 126 808 16.2%
Non-current loan 16 335 Deferred tax asset 17 442 2.2%
Net sales 951 786 Prepaid expenses and other current assets    6 028 0.8%
Prepaid expenses and other 6 028 Total current assets $620 887 79.2%
current assets
Property, plant, and equipment, net 126 247 16.1%
Property, plant and equipment 126 247
Intangibles and other assets 24 475 3.1%
Retained earnings 435 364
Goodwill    12 157 1.6%
Selling, general and 250 496
administrative expenses Total assets $783 766 100.0%

Liabilities and shareholders’ equity

Current liabilities:
Accounts payable $ 62 432 8.0%
Accrued liabilities 43 789 5.6%
Income taxes payable 8 069 1.0%
Current portion of long-term debt 4 596 0.6%
Total current liabilities $118 886 15.2%
Non-current loan 16 335 2.1%
Deferred tax liability 7 716 1.0%
Total liabilities $142 937 18.2%
Shareholders’ equity:
Contributed capital $205 465 26.2%
Retained earnings 435 364 55.6%

FINANCIAL Total shareholders’ equity $640 829 81.8%

2 STATEMENTS
Copyright
Total liabilities and shareholders’ equity $783 766 100.0%
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REVIEW KEY DEFINITIONS LEARNING OBJECTIVES

accounting information dual-entry accounting

system system
LO1 Describe the purpose of an accounting information
The system that identifies, A system of accounting in which system.
records, summarises and every accounting transaction
communicates the various affects at least two accounts. LO2 Analyse the effect of accounting transactions on the
transactions of a business.
debit accounting equation.
accounting transaction A use of funds, recorded on the
Any economic event that affects left-hand side of a T-account. LO3 Understand how T-accounts and debits and credits are
a business’ assets, liabilities
credit
used in a dual-entry accounting system.
and/or equity at the time of
A source of funds, recorded
the event.
on the right-hand side of a
LO4 Explain the purpose of the journal, ledger and trial
account T-account. balance.
An accounting record that
journal
accumulates the activity of a
A chronological record of
LO5 Record and post accounting transactions, prepare a trial
specific item and yields the
transactions. balance, income statement, the changes in equity and
item’s balance. balance sheet.
ledger
chart of accounts A collection of accounts and
The list of accounts that a
business uses to capture its
their balances.
KEY EXHIBIT
business activities. trial balance
A listing of accounts and their
dual nature of balances at a specific point Type of Normal Increase Decrease
accounting in time. account balance with a with a
Every accounting transaction
Asset Debit Debit Credit
must affect at least two
accounts. Liability Credit Credit Debit
Equity Credit Credit Debit
Revenue Credit Credit Debit
Expense Debit Debit Credit
Dividend Debit Debit Credit

Summary of debit and credit rules

DEMONSTRATION PROBLEM
The following transactions occurred during the first month of operations
for Clear Windows Limited. Prepare all necessary journal entries, post the
information to the ledger and prepare a trial balance at 31 March.

1 Mar. Issued shares for $30 000 cash.

1 Purchase a used delivery van for $17 200 cash.
3 Purchased cleaning supplies for $5000 cash.
3 Paid $2400 cash on a one-year insurance policy effective 1 March.
12 Billed customers $4800 for cleaning services.
20 Paid $2300 cash for employee salaries.
21 Collected $4000 cash from customers billed on 12 March.
25 Billed customers $5200 for cleaning services.
31 For the month, paid for and used $600 of fuel.
31 Declared and paid $200 cash dividend.

RECORDING ACCOUNTING
3 TRANSACTIONS
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REVIEW
DEMONSTRATION PROBLEM SOLUTION
1 Mar. Cash 30 000 Accounts
Cash receivable Equipment
Contributed equity 30 000
30 000 17 200 4 800 4 000 17 200
  (Initial investment by owner)
4 000 5 000 5 200
1 Mar. Equipment 17 200
2 400 6 000 17 200
Cash 17 200
2 300
  (Purchase of delivery van)
600
3 Mar. Supplies 5 000
200
Cash 5 000
6 300
  (Purchase of supplies)
3 Mar. Prepaid insurance 2 400
Prepaid Contributed
Cash 2 400 Insurance Supplies Equity
  (Purchase of insurance policy) 2 400 5 000 30 000
12 Mar. Accounts receivable 4 800 2 400 5 000 30 000
Service revenue 4 800
  (Provide services on account) Service Salaries Fuel
20 Mar. Salaries expense 2 300 Revenue Expense Expense

Cash 2 300 4 800 2 300 600

  (Pay employees) 5 200

21 Mar. Cash 4 000 10 000 2 300 600

Accounts receivable 4 000

  (Collect receivables from customers) Dividend
Note: this is the exchange of one asset for another; it is not the earning 200
of revenue. Revenue was earned on 12 March when the customer was
billed 200
25 Mar. Accounts receivable 5 200
Service revenue 5 200
Clear Windows Limited
  (Provide services on account) Trial balance at 31 March
31 Mar. Fuel expense 600 Cash $ 6 300
Cash 600 Accounts receivable 6 000
  (Pay for fuel consumed) Prepaid insurance 2 400
31 Mar. Dividend 200 Supplies 5 000
Cash 200 Equipment 17 200
  (Declared and pay dividend) Contributed equity $30 000
Service revenue 10 000
Fuel expense 600
Salaries expense 2 300
Dividends     200
Totals $40 000 $40 000

RECORDING ACCOUNTING
3 TRANSACTIONS
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REVIEW KEY DEFINITIONS LEARNING OBJECTIVES

cash basis of accounting account balances to the

Records revenues when cash is Retained Earnings account.
LO1 Explain how profit is measured and reported under the
received and records expenses accrual and cash bases of accounting.
temporary accounts
when cash is paid. Accounts that accumulate
accrual basis of balances only for the current
LO2 Identify the four major circumstances in which adjusting
accounting period. journal entries is necessary.
Records revenues when closing entries
they are earned and records Entries made in the journal
LO3 Record and post adjusting journal entries as well as
expenses when they are and posted to the ledger that prepare an adjusted trial balance and financial
incurred. eliminate the balances in statements.
adjusting journal entries all temporary accounts and
Entries made in the general transfer those balances to the LO4 Understand the purpose of the closing process and
journal to record revenues Retained Earnings account. prepare closing entries.
that have been earned but not accounting cycle
recorded and expenses that The sequence of steps in which LO5 Describe the steps of the accounting cycle.
have been incurred but not an accounting information
recorded. system captures, processes and
closing process reports a company’s accounting DEMONSTRATION PROBLEM
The process of transferring all transactions during a period.
revenue, expense and dividend
Given the following 31 March unadjusted trial balance for Company
Xiang and the additional information at the end of the month, prepare all
necessary adjusting journal entries and prepare an adjusted trial balance
as of 31 March.

Company Xiang
Unadjusted trial balance
31 March

Debit Credit
Cash  $ 6 300
Accounts receivable   6 000
Equipment 17 200   
Prepaid insurance   2 400
Supplies 5 000   
Contributed equity $30 000
(ordinary shares)
Service revenue     10 000
Fuel expense      600
Salaries expense   2 300
Dividends 200
Totals  $40 000   $40 000

Additional Information:
1 Depreciation on equipment is $250 monthly.
2 One-twelfth of the insurance expired during the month.
3 A count shows $1000 of cleaning supplies on hand at 31 March.
4 Earned but unpaid employee salaries were $350 on 31 March.

ACCRUAL ACCOUNTING
4 AND ADJUSTING ENTRIES
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REVIEW
DEMONSTRATION PROBLEM SOLUTION
Company Xiang
Adjusting journal entries
on 31 March
1 Depreciation expense 250
Accumulated depreciation 250
    (To record depreciation on the equipment: $250 as given)
2 Insurance expense 200
Prepaid insurance 200
  (To record expired insurance: $2 400 × 1/12)
3 Supplies expense 4 000
Supplies 4 000
  (To record supplies used: $5 000 unadjusted – $1 000 counted)
4 Salaries expense 350
  Salaries payable 350
  (To record salaries earned but not paid: $350 as given)

Company Xiang
Adjusted trial balance
31 March

Debit Credit
Cash   $ 6 300
Accounts receivable   6 000
Equipment  1 7 200
Prepaid insurance   2 200
Supplies   1 000
Accumulated depreciation   $ 250
Salaries payable   350
Contributed equity   30 000
Service revenue   10 000
Depreciation expense       250
Fuel expense       600
Insurance expense       200
Salaries expense   2 650
Supplies expense   4 000
Dividends         200
Totals $40 600 $40 600

ACCRUAL ACCOUNTING
4 AND ADJUSTING ENTRIES
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REVIEW KEY DEFINITIONS LEARNING OBJECTIVES

internal control bank reconciliation

The system of policies and The process of reconciling the LO1 Identify the role of internal control in a business.
procedures used in a company differences between the cash
to promote efficient and balance on a bank statement LO2 Describe five components of internal control.
effective operations, reliable and the cash balance in a
financial reporting and business’ records. LO3 Understand two methods of internal control over
compliance with laws and
regulations.
deposit in transit cash – bank reconciliations and petty cash funds.
A deposit that has been made
control environment by the business but has not LO4 Appreciate the reporting of cash and cash equivalents.
The atmosphere in which the cleared the bank as of the
members of an organisation statement date.
conduct their activities and
LO5 Analyse cash through the calculation and interpretation
carry out their responsibilities.
outstanding cheque of horizontal, vertical and ratio analyses and free cash
A cheque that has been flow.
risk assessment distributed by the business but
The identification and analysis has not cleared the bank as of
of the risks that threaten the
achievement of organisational
the statement date. KEY FORMULAS
petty cash fund
objectives.
An amount of cash kept on hand
control activities to pay for minor expenditures. KEY FORMULA 5.1 HORIZONTAL ANALYSIS
The policies and procedures
cash
established to address the risks
A medium of exchange. Dollar Change in = Current Year Balance −
that threaten the achievement
cash equivalent Account Balance Prior Year Balance
of organisational objectives.
Any investment that is readily
information and Percentage Change = Dollar Change
convertible into cash.
communication in Account Balance Prior Year Balance
Required for the open flow of free cash flow
relevant information throughout The excess cash a company
an organisation. generates beyond what it
needs to invest in productive
monitoring capacity and pay dividends to KEY FORMULA 5.2 VERTICAL ANALYSIS
The assessment of the quality shareholders.
of an organisation’s internal
control. Cash
Percentage =
Total Assets

KEY FORMULA 5.3 FREE CASH FLOW

Cash Flows from Operating Activities

– Capital Expenditures
– Dividends
= Free Cash Flow

DEMONSTRATION PROBLEM

Bank reconciliation
At the end of January, Sarah (the company) shows a cash balance of
$65 000. The 31 January bank statement shows a balance of $64 170.
Sarah discovers the following:
1 deposits of $4250 and $2300 made on 30 January and 31 January,
respectively, do not appear on the January bank statement
2 cheques written in late January for $620 (No. 12983), $950
(No. 12986) and $1200 (No. 12989) do not appear on the
January bank statement
3 the bank showed a $200 customer cheque deposited by Sarah and
returned to the bank for non-sufficient funds (NSF)
4 the bank charged a $50 service fee
5 the bank collected a $500 receivable from one of Sarah’s customers
6 a cheque that Sarah wrote cleared the bank at $300 but was
erroneously recorded in Sarah’s books at $3000.

CASH AND INTERNAL

5 CONTROLS
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REVIEW
Prepare a bank reconciliation for Sarah.

DEMONSTRATION PROBLEM SOLUTION

Sarah’s bank reconciliation
at 31 January
Balance per bank statement $64 170
Add deposits in transit:
30 January $4 250
31 January  2 300 6 550
Deduct outstanding cheques:
No. 12983 $ 620
No. 12986 950
No. 12989 1 200 2 770
Actual cash balance $67 950
Balance per company (Sarah’s) $65 000
records
Add:
Collection of receivable $ 500
Error by Sarah 2 700 3 200
Deduct:
Service fee $ 50
NSF check 200 250
Actual cash balance $67 950

CASH AND INTERNAL

5 CONTROLS
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REVIEW KEY DEFINITIONS LEARNING OBJECTIVES

account receivable percentage-of-

An amount owed by a customer receivables approach
LO1 Describe the recording and reporting of receivables.
who has purchased the Method that estimates bad debt
company’s product or service. expense as a percentage of
LO2 Compare the methods used to account for uncollectible
net realisable value receivables. receivables.
The amount of cash that a ageing schedule
company expects to collect A listing of accounts receivable
LO3 Contrast the methods for estimating bad debt expense.
from its total accounts by their ages.
receivable.
receivables turnover
LO4 Evaluate accounts receivable through the calculation
bad debt expense ratio
and interpretation of horizontal, vertical and ratio
The expense resulting from the A comparison of credit sales
analyses.
inability to collect all accounts to receivables that measures a
receivable. company’s ability to generate LO5 Understand the accounting for notes receivable.
direct write-off method and collect receivables.
Method in which bad debt
expense is recorded when a
days-in-receivables
A conversion of the receivables
KEY FORMULAS
company determines that a turnover ratio that expresses a
receivable is uncollectible and company’s ability to generate KEY FORMULA 6.1 HORIZONTAL ANALYSIS
removes it from its records. and collect receivables in days.
allowance method allowance ratio
Method in which companies A comparison of the allowance
Dollar Change in Current-year Balance –
Account Balance = Prior-year Balance
use two entries to account account to receivables that
for bad debt expense – one to measures the percentage of
estimate the expense and a Percentage Change Dollar Change
receivables that are expected to in Account Balance =
second to write off receivables. be uncollectible in the future. Prior-year Balance
allowance for doubtful promissory note
debts A written promise to pay a
The dollar amount of specific sum of money on
receivables that a company demand or at some specific KEY FORMULA 6.2 VERTICAL ANALYSIS
believes will ultimately be date in the future.
uncollectible.
note receivable Percentage = For the balance For the income
percentage-of-sales An asset created when a sheet statement
approach company accepts a promissory
Method that estimates bad note. Account Balance or Account Balance
=
debt expense as a percentage Total Assets Net Sales or Revenue
of sales.

KEY FORMULA 6.3 RECEIVABLES TURNOVER RATIO

Credit Sales
Receivables Turnover Ratio =
Average Receivables
Where average receivables is:
Beginning Receivables + Ending Receivables/2

KEY FORMULA 6.4 DAYS-IN-RECEIVABLES

  365
Days-in-Receivables Ratio =
Receivables Turnover Ratio

KEY FORMULA 6.5 ALLOWANCE RATIO

Average for Doubtful Debts

Allowance Ratio =
Gross Receivables
Where gross accounts receivable is:
Net Account Receivables + Allowance for Doubtful Debts

KEY FORMULA 6.6 INTEREST EARNED

Interest Earned = Principal × Annual Rate of Interest

6 RECEIVABLES ×T  ime Outstanding

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REVIEW
DEMONSTRATION PROBLEM DEMONSTRATION PROBLEM SOLUTION
1 Accounts receivable 900
Bad debt estimation and write-off
Allowance for bad debts 900
Chen Ball Allocators (CBA) provides the following partial balance
sheet and income statement information for the financial 2 Bad debt expense ($75 200 × 2%) 1 504
year ended 30 June 2020. Assume that Chen Ball uses the Allowance for bad debts 1 504
allowance method for recording bad debts. Net realisable value:

Gross accounts receivable at 30/06/2020 $11 760 Gross accounts receivable $11 760

Allowance for bad debts at 30/06/2020 Credit balance Less: Allowance ($138 + $1 504)    1 642
$138 Net realisable value $10 118
Net sales for year ended 30/06/2020 $75 200 3 Bad Debt Expense 450
Receivables written off during year ended 30/06/2020 900 [($11 760 x 5%) – $138]
Allowance for bad debts 450
Required Net realisable value:
1 Prepare the journal entry that CBA made during the year Gross accounts receivable $11 760
to write off the $900 in receivables.
Less: Allowance   450
2 Prepare the journal entry to record bad debt expense
Net realisable value $11 310
for the financial year if CBA estimates that 2 per cent of
net sales will be uncollectible. Calculate the resulting net 4 The $900 that was written off
during the year as the direct
realisable value of receivables.
write-off method only recognises
3 Prepare the journal entry to record bad debt expense as an expense the receivables
for the financial year if CBA estimates that 5 per cent of written off (as with tax
receivables will be uncollectible. Calculate the resulting deductibility).
net realisable value of receivables.
4 Assume that instead of the allowance method, CBA uses
the direct write-off method. What would CBA recognise
as bad debt expense for the financial year ended 30 June
2020?

6 RECEIVABLES
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REVIEW KEY DEFINITIONS LEARNING OBJECTIVES

inventory retail method

A tangible resource that is held A method of estimating the cost LO1 Describe inventory and how it is recorded, expensed
for resale in the normal course of inventory knowing the selling and reported.
of operations. price and reducing it by the
gross profit percentage. LO2 Calculate the cost of sales using different inventory
perpetual inventory
system lower-of-cost-and- costing methods.
Updates the inventory account net-realisable-value
each time inventory is bought (LCNRV) rule LO3 Understand the profit and loss effects of inventory cost
or sold. Requires inventory to be flow assumptions.
periodic (physical) reported on the balance
sheet at its market value if the LO4 Demonstrate how inventory can be estimated.
inventory system
market value is lower than the
Updates the inventory account
inventory’s cost.
only at the end of an accounting LO5 Apply the lower-of-cost-and-net-realisable-value rule to
period. inventory turnover ratio inventory.
Compares cost of sales during a
purchases
period to the average inventory
An account used to accumulate LO6 Evaluate inventory through the calculation of horizontal,
balance during that period and
the cost of all purchases.
measures the ability to sell
vertical and ratio analyses.
transportation-in inventory.
An account that accumulates LO7 Appendix: record purchases and calculate the cost of
the transportation costs of
days-in-inventory ratio sales under a periodic system.
Converts the inventory turnover
obtaining the inventory.
ratio into a measure of days by
purchase returns and
allowances
dividing the turnover ratio into
365 days.
KEY FORMULAS
An account that accumulates
net purchases
the cost of all inventory returned KEY FORMULA 7.1 AVERAGE UNIT COST
The value of inventory
to vendors as well as the
purchased and transportation-
cost reductions from vendor
in less purchase returns and Cost of Goods Available for Sale
allowances.
allowances and purchase Average Unit Cost =
Units Available for Sale
specific identification discounts.
method Purchase Returns and
Determines cost of sales based
Allowances account
on the actual cost of each
An account that accumulates
KEY FORMULA 7.2 HORIZONTAL ANALYSIS
inventory item sold.
the cost of all inventory returned
first-in, first-out (FIFO) to vendors as well as the
Dollar Change in Account Balance = C
 urrent-year Balance
method cost reductions from vendor – Prior-year Balance
Calculates cost of sales based allowances. Percentage Change in Account Dollar change
on the assumption that the first =
Purchase Discounts Balance Prior-year balance
unit of inventory available for
account
sale is the first unit sold.
An account that accumulates
last-in, first-out (LIFO) the cost reductions generated
method from vendor discounts granted KEY FORMULA 7.3 VERTICAL ANALYSIS
Calculates cost of sales based for prompt payments.
on the assumption that the last For the For the income
unit of inventory available for balance sheet statement
sale is the first unit sold. Account Balance Account Balance
Percentage = or
moving average method Total Assets Net Sales or Revenue
Calculates cost of sales based
on the average unit cost of all
inventory available for sale.
KEY FORMULA 7.4 INVENTORY TURNOVER RATIO

Cost of Goods Sold

Inventory Turnover Ratio =
Average Inventory

Where average inventory is:

Beginning Inventory + Ending Inventory
2

KEY FORMULA 7.5 WEIGHTED AVERAGE UNIT COST

Weighted Average Cost of Goods Available for Sale

=
Unit Cost Units Available for Sale

7 INVENTORY
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REVIEW
DEMONSTRATION PROBLEM
B’Elanna began with 32 widgets that had cost $55 each, she then purchases another 45 widgets at $60 each,
she then sells 50 widgets. Calculate Cost of Sales using FIFO, LIFO and Moving (Weighted) Average.

FIFO (assumes we sell the oldest first, the $55 widgets, and then the next oldest, the $60 widgets)

Transaction Inventory purchased Inventory sold Inventory on hand

Beginning Inventory 32 $55 $1 760
Purchase 45 $60 $2 700 32 $55 $1 760
45 $60 2 700
77 $4 460
Sell 50 units 32 $55 $1 760 27 $60 $1 620
18 $60 1 080
50 $2 840

LIFO (assumes we sell the newest first, the $60 widgets, and then the next newest, the $55 widgets)

Transaction Inventory purchased Inventory sold Inventory on hand

Beginning Inventory 32 $55 $1 760
Purchase 45 $60 $2 700 32 $55 $1 760
45 $60 2 700
77 $4 460
Sell 50 units 5 $55 $ 275 27 $55 $1 485
45 $60 2 700
50 $2 975

Moving average (assumes we sell the average $57.92 widgets $4460 / 77 = $57.92 note it is not a simple
average of $55 + $60 = $115 / 2 = $57.50, because there is more $60 widgets)

Transaction Inventory purchased Inventory sold Inventory on hand

Beginning Inventory 32 $55.00 $1 760
Purchase 45 $60 $2 700 32 $55.00 $1 760
45 $60.00 2 700
77 $4 460
Sell 50 units 50 $57.92 $2 896 27 $57.92 $1 564

7 INVENTORY
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REVIEW KEY DEFINITIONS LEARNING OBJECTIVES

depreciation its cost less any accumulated

The process of systematically depreciation and any LO1 Describe non-current assets and how they are recorded,
and rationally allocating the impairment loss. expensed and reported.
cost of a non-current asset over revaluation model
its useful life. If fair value can be measured LO2 Calculate and compare depreciation expense using
depreciation expense reliably the asset shall be straight-line, reducing-balance (diminishing value) and
The portion of a non-current carried at a revaluation amount. units-of-activity methods.
asset’s cost that is recognised non-current asset
as an expense in the current LO3 Understand the effects of adjustments that may be
turnover ratio
period. made during a non-current asset’s useful life.
A comparison of total revenues
accumulated to the average net carrying
depreciation amount of non-current assets LO4 Record the disposal of non-current assets.
The cumulative amount that measures the productivity
of depreciation expense of non-current assets. LO5 Evaluate non-current assets through the calculation and
recognised to date on a non- average useful life of interpretation of horizontal, vertical and ratio analyses.
current asset.
non-current assets
carrying amount A comparison of the cost of non- LO6 Depict the cash flow effect of acquiring and disposing of
The unexpired cost of a non- current assets to depreciation non-current assets.
current asset, calculated by expense that estimates the
subtracting accumulated number of years, on average,
depreciation from the cost of
LO7 Describe intangible assets and how they are recorded,
that a company expects to use
the non-current asset. its non-current assets.
expensed and reported.
cost average age of non-
The historical cost of a current assets KEY FORMULAS
non-current asset being A comparison of accumulated
depreciated. depreciation to depreciation
residual value expense that estimates the KEY FORMULA 8.1 STRAIGHT-LINE METHOD
An estimate of the value of a number of years, on average,
non-current asset at the end of that the company has used its Cost – Salvage Value
non-current assets.
Depreciation Expense =
its useful life. Useful Life
depreciable amount intangible asset
The difference between an A resource that is used in
asset’s cost and its residual operations for more than one
year but that has no physical KEY FORMULA 8.2 REDUCING-BALANCE METHOD
value.
substance.
useful life Depreciation = Depreciation Rate × Carrying Amount
The length of time a non-current patent
asset is expected to be used in The right to manufacture, sell = ( Straight-Line Rate × 1.5)
operations. or use a particular product or ×  (Cost – Accumulated Depreciation)
process exclusively for a limited
depreciation method period of time.
The method used to calculate
depreciation expense, such trademark (trade name) KEY FORMULA 8.3 UNITS-OF-ACTIVITY METHOD
as the straight-line, reducing- The right to use exclusively
balance and units-of-activity a name, symbol or phrase to
Cost – Residual Value
methods. identify a company. Depreciation Expense per Unit =
Useful Life in Units
straight-line method copyright
A depreciation method that The right to reproduce or sell Depreciation Expense = D
 epreciation Expense per Unit
results in the same amount of an artistic or published work or × Actual Units of Activity
depreciation expense each year software computer code.
of the asset’s useful life. franchise
reducing-balance The right to operate a business
KEY FORMULA 8.4 DISPOSALS
method under the trade name of the
A depreciation method that franchisor.
Gain on Disposal = Proceeds from Sale > Carrying Amount
accelerates depreciation goodwill
expense into the early years of An intangible asset equal to the Loss on Disposal = Proceeds from Sale < Carrying Amount
an asset’s life. excess that one company pays
units-of-activity method to acquire the net assets of
A depreciation method in which another company.
KEY FORMULA 8.5 NON-CURRENT ASSET TURNOVER RATIO
depreciation expense is a amortisation
function of the actual usage of The process of spreading out
the asset. the cost of an intangible asset
Non-current Asset Turnover Ratio =
cost model over its useful life. Total Revenues
After recognition as an asset, Average Net Carrying Amount of Non-current Assets
an item of plant, property and
equipment shall be carried at Where average net book value is:
Beginning Net Carrying Amount + Ending Net Carrying Amount
2

NON-CURRENT ASSETS
8 AND INTANGIBLE ASSETS
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REVIEW
KEY FORMULA 8.6 AVERAGE USEFUL LIFE RATIO DEMONSTRATION PROBLEM SOLUTION
Cost of Non-Current Assets 1 ($113 250 − $8250) / 10 = $10 500 depreciation expense
Average Useful Life =
Depreciation Expense per year.
2 Reducing rate = (100% ÷ 10) × 1.5 = 15% Year 1: 15% ×
$113 250 = $16 988 depreciation expense Year 2: 15% ×
KEY FORMULA 8.7 AVERAGE AGE RATIO ($113 250 − $16 988) = $14 439 depreciation expense
Year 3: 15% × ($113 250 − $16 988 − $14 439) = $12 273
 Accumulated Depreciation
Average Age = depreciation expense.
Depreciation Expense
3 ($113 250 − $8250) / 17 500 = $6 depreciation expense per
hour 3000 hours × 6 = $18 000 depreciation expense
DEMONSTRATION PROBLEM 4 Cost of the asset $113 250
Matthew Robin Limited (MRL) purchases a new machine Less: Accumulated depreciation for 52 500
for $113 250. The machine has a useful life of 10 years and a five years ($10 500 × 5)
residual value of $8250. MRL estimates that the machine will
Carrying value at time of revision $60 750
be used for 17 500 hours.
1 Calculate the machine’s annual depreciation expense using Less: Residual value 8 250
the straight-line method. Remaining depreciable cost $52 500
2 Calculate depreciation expense for the first three years Divided by remaining useful life ÷7
of the asset’s life using the reducing-balance method at (5 years + 2 more years)
1.5 times the straight-line rate (round to the nearest dollar). Depreciation expense for year 6 $ 7 500
3 Assuming that the machine is used for 3000 hours one
year, calculate depreciation expense for that year using the
units-of-activity method. 5 Cost of the asset $113 250
4 Suppose that after five years of straight-line depreciation, Less: Accumulated depreciation 63 000
MRL increases the machine’s useful life an additional two for six years ($10 500 × 6)
years. Calculate depreciation expense for year six. Carrying value at time of revision $50 250
5 Suppose instead that after six years of straight-line Sales price 48 000
depreciation, MRL sells the machine for $48 900. Calculate
Loss on sale $ 2 250
the gain or loss on the sale.

NON-CURRENT ASSETS
8 AND INTANGIBLE ASSETS
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REVIEW KEY DEFINITIONS LEARNING OBJECTIVES

gross pay amortisation schedule

The total pay before any A schedule that illustrates the LO1 Describe the recording and reporting of current
deduction; in the simplest form amortisation of a bond discount liabilities.
it is hours worked times the or premium over the life of a
agreed hourly rate. bond. LO2 Describe the reporting of non-current liabilities and the
net pay lease cash flows associated with those liabilities.
Gross pay less deductions such A contractual agreement in
as tax. which the lessee obtains the LO3 Understand the nature of bonds (debentures) and
right to use an asset by making record a bond’s issue, interest payments and maturity.
required deductions
periodic payments to the lessor.
The amount(s) the employer is
legally obliged to take out, such off-balance-sheet LO4 Account for a bond that is redeemed prior to maturity.
as tax, before depositing the financing
net pay in the employee’s bank Occurs when a company’s LO5 Recognise other liabilities such as leases and contingent
account. future obligations regarding liabilities.
optional deductions an asset are not reported as a
liability on the balance sheet.
The amounts the employee asks LO6 Evaluate liabilities through the calculation and
the employer to take out, such finance lease interpretation of horizontal, vertical and ratio analyses.
as extra superannuation, before A contract in which the lessee
depositing the net pay in the obtains enough rights to use
employee’s bank account.
LO7 Appendix: determine a bond’s issue price.
and control an asset such that
note payable the lessee is in substance the
owner of the asset.
LO8 Appendix: record bond interest payments under the
A liability generated by the issue effective interest method.
of a promissory note to borrow contingent liability
money. An obligation that arises from
current portion of non- an existing condition whose
outcome is uncertain and
KEY FORMULAS
current debt
whose resolution depends on a
The portion of a non-current
future event. KEY FORMULA 9.1 INTEREST PAYABLE ON
liability that will be paid within
one year. liquidity BONDS PAYABLE
A company’s ability to pay its
bond
A financial instrument in which
current liabilities in the near Interest Paid = Face Value × Stated Interest Rate
a borrower promises to pay
future. × Time Outstanding
future interest and principal to current ratio = $200 000 × 0.07 × 12/12 months
a creditor in exchange for the Compares a company’s current = $14 000
creditor’s cash today. assets to its current liabilities
and measures its ability to pay
face value
current liabilities.
The amount that is repaid at
maturity of a bond. solvency KEY FORMULA 9.2 STRAIGHT-LINE METHOD
stated interest rate A company’s ability to continue OF AMORTISATION
in business in the long term by
The contractual rate at which
satisfying its liabilities.
interest is paid to the creditor. Discount at Issuance
debt to assets ratio Discount Amortised =
maturity date Number of Interest Payments
Compares a company’s total
The date on which the face
liabilities to its total assets and
value must be repaid to the
measures its ability to pay its
creditor.
liabilities in the long term.
market (or effective) rate KEY FORMULA 9.3 B
 OND DISCOUNT OR PREMIUM
capital structure
of interest AMORTISED EACH PAYMENT
The mix of debt and equity that
The rate of return that investors
a company uses to generate its (STRAIGHT-LINE METHOD)
in the bond markets demand for
assets.
bonds of similar risk.
effective interest Premium at Issuance
straight-line method of Premium amortised =
method of amortisation
amortisation Number of Interest Payments
Method that amortises the bond
Method that amortises an
discount or premium so that
equal amount of the discount
interest expense each period
or premium each time interest
is a constant percentage of the
is paid. KEY FORMULA 9.4 G
 AIN OR LOSS ON
bond’s carrying amount.
REDEMPTION

Gain on Redemption = Carrying Amount > Call Price

Loss on Redemption = Call Price > Carrying Amount

9 LIABILITIES
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REVIEW
KEY FORMULA 9.5 HORIZONTAL ANALYSIS KEY FORMULA 9.8 DEBT TO ASSETS RATIO

Dollar Change in Current Year Balance – Total Liabilities

= Prior Year Balance Debt to Assets Ratio =
Account Balance Total Assets
Percentage Change in = Dollar Change
Account Balance Prior Year Balance
KEY FORMULA 9.9 INTEREST EXPENSE (EFFECTIVE
INTEREST METHOD)

KEY FORMULA 9.6 VERTICAL ANALYSIS Carrying Amount × Market Rate

Interest Expense  =  of Interest at Issue × Time
Balance sheet Income Statement  Outstanding

Percentage = Account Balance or Account Balance

Total Assets Net Sales or Revenue
KEY FORMULA 9.10 D
 ISCOUNT OR PREMIUM
AMORTISED EACH PAYMENT
(EFFECTIVE INTEREST METHOD)
KEY FORMULA 9.7 CURRENT RATIO
Discount Amount Amortised = Interest Expense –
Interest Paid
Current Assets
Current Ratio = Premium Amount Amortised = Interest Paid –
Current Liabilities
Interest Expense

9 LIABILITIES
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REVIEW KEY DEFINITIONS LEARNING OBJECTIVES

capital account for each bonus to the remaining

partner partners LO1 Describe the characteristics of the partnership form of
Records the current market When the withdrawing partner business.
value of net assets contributed. takes less than their capital
bonus to the new balance. LO2 Account for a partner commencing a partnership.
partner liquidation of a
When a new partner pays less partnership LO3 Calculate the allocation of profits and losses to the
than the capital received. The closing down of a business partners.
that involves partners taking any
bonus to the existing
(old) partners
remaining assets. LO4 Record the admission and withdrawal of partners.
When a new partner pays more capital deficiency
than the capital received. A partner’s capital account with LO5 Explain the liquidation of a partnership.
a negative (debit) balance.
bonus to the
withdrawing partner
LO6 Prepare the financial statements for a partnership.
When the departing partner
takes more than their capital
balance. DEMONSTRATION PROBLEM
The following transactions occurred; all figures are in trillions of dollars:
●● January: Julius and Cleopatra decided to form a partnership. Julius
contributed an Empire worth $810 and debts of $330. Cleopatra
contributed intangible assets that were said to be priceless, but the
accountants valued the goodwill at $720.
●● February: They decided to admit Mark to the partnership. Mark
contributed $900 of ships for a 2/7 share in the partnership.
●● March: The new partnership has agreed to share profits; the first
$300 according to the service each contributes (Cleo $150, Julius
$60 and Mark $90), the next $270 to be shared equally and any
remaining profit or loss according to their capital balances before any
allocation of profit. The partnership earned a profit of $360.
●● April: The partners withdraw their share of the profits in cash.
●● May: Julius decides to leave the partnership taking 80 per cent of
the Empire and $300 of ships. But before he withdraws the Empire
is revalued from $810 to $1125.
●● June: The Empire is now crumbling, Cleopatra and Mark decide
to liquidate the partnership, the remaining ships are sold to the
Athenians for $30 in gold. Odoacer purchased the remainder of the
Empire for $15 of gold, the goodwill is sold to Tourism Egypt for a
handful of gold ($300 and the original debts were repaid in gold.
The remaining gold was distributed to the partners to take to their
afterlife.

DEMONSTRATION PROBLEM SOLUTION

Jan. Empire 810
Goodwill 720
Debts 330
Capital Cleopatra 720
Capital Julius 480
Feb. Original net assets 720 + 480 = $1200 plus the new assets
$900 = $2140. 2/7 = Mark’s Capital = $600, bonus of $300
shared 2/5 to Julius 3/5 to Cleo (120:180).
Ships 900
Capital Mark 600
Capital Cleopatra 180
Capital Julius 120

10 PARTNERSHIPS
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REVIEW
Now, 80 per cent of the Empire is $1125 x 0.8 = $900,
March: Partners sharing profits
plus Julius takes $300 ships giving total assets withdrawn of
Cleo Julius Mark Total $1200 but Julius has a capital balance of $600 plus the share
Total profit 360 of revaluation of $90 = $690. So the bonus to the departing
First $300 on service as agreed 150 60 90 (300) partner is $510 ($1200 – $690) which will be shared
between the remaining partners according to the sharing ratio
Next $270 equally 90 90 90 (270)
before Julius decided to leave, which was 3:2 Cleopatra:Mark
Balance remaining (210) ($510 x 3/5 = $306, $510 x 2/5 = $204).
Loss to be shared according to (90) (60) (60) 210
the capital account balances Capital Julius 690
300:200:200 (3:2:2)
Capital Cleopatra 306
Balance remaining 0
Capital Mark 204
Profits allocated to partners $150 $90 $120 $120
Empire 900
Ships 300
March Retained earnings 360
Capital Cleopatra 150
Capital Julius 90
Capital Mark 120
Apr. Capital Cleopatra 150
Capital Julius 90
Capital Mark 120
Cash 360
May. Remembering profits are shared according to capital balances,
3:2:2 which is $135:$90:$90
Empire 315
Capital Cleopatra 135
Capital Julius 90
Capital Mark 90

10 PARTNERSHIPS
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REVIEW KEY DEFINITIONS LEARNING OBJECTIVES

issued capital payment date

(contributed equity) The date on which a dividend LO1 Describe the characteristics of the corporate form of
The amount of capital raised will be distributed. business.
by issuing shares to investors share dividend
in exchange for an ownership A distribution of a company’s LO2 Discuss equity and show how it is recorded and
claim on company assets. It is ordinary shares to existing reported.
also known as paid-up capital shareholders.
or share capital.
share split
LO3 Understand cash dividends, share dividends and share
ordinary shares An increase in the number of splits.
The most common type of share a company’s issued shares
capital. according to some specified LO4 Investigate preference shares and how they receive
issued shares ratio. preference in dividends and other ways.
The number of shares a preference shares
company has distributed to A form of shares that receives LO5 Examine share buybacks and how they are recorded and
owners to date. one or more priorities over reported.
application ordinary shares.
Both the request to buy shares cumulative preference LO6 Evaluate equity through the calculation and
and the money payable when interpretation of horizontal, vertical and ratio analyses.
shares
shares are applied for.
Shares that carry the right to
allotment or issue receive current-year dividends
The process of giving shares and all unpaid dividends from KEY FORMULAS
to (some of) those who have prior years before dividends are
applied for them and also the paid to ordinary shareholders.
money required at this stage KEY FORMULA 11.1 HORIZONTAL ANALYSIS
dividends in arrears
from shareholders.
The accumulated value of Dollar Change in Current-year
call unpaid prior-year dividends. = – Prior-year Balance
Account Balance Balance
The request for further
non-cumulative
payment(s) and the money with Percentage Change Dollar Change
preference shares =
those further payment(s). in Account Balance Prior-year Balance
Shares that carry the right to
prospectus receive current-year dividends
The legal document offering only.
shares for sale and providing
earnings per share (EPS) KEY FORMULA 11.2 VERTICAL ANALYSIS
details of the company, past
A comparison of a company’s
financial performance and For the For the income
total comprehensive income to
future prospects.
the number of ordinary shares balance sheet statement
oversubscription issued that measures the ability
When more shares are applied Account Balance Account Balance
to generate wealth through Percentage = or
for than are available to be profitable operations. Total Assets Net Sales or Revenue
issued.
return on equity
forfeit A comparison of a company’s
When a shareholder does not net income to average KEY FORMULA 11.3 EARNINGS PER SHARE
pay the allotment and/or call shareholders’ equity that
they lose the shares they have measures the ability to use Earnings Total Comprehensive Income
paid some of the money to buy. existing equity to generate =
per Share Average Number of Ordinary Shares Issued
reissue additional equity.
When forfeited shares are again dividend payout ratio
sold, often at a discount to the A comparison of a company’s
original issue price. dividends to its earnings that KEY FORMULA 11.4 AVERAGE ORDINARY SHARES
date of record measures the percentage of OUTSTANDING
The date that determines who current earnings distributed to
receives the dividend – the owners. Beginning Shares Outstanding + Ending Shares Issued
shares’ owner on the date of dividend yield ratio 2
record receives the dividend. A comparison of dividends
cash dividend per share to the market price
A distribution of cash to per share that measures
shareholders. the percentage return from
dividends.
declaration date
The date on which a company’s
board of directors declares a
dividend.

SHAREHOLDERS’
11 EQUITY
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REVIEW
KEY FORMULA 11.5 RETURN ON EQUITY KEY FORMULA 11.7 DIVIDEND PAYOUT RATIO

Total Comprehensive Income Dividend Payout Ratio =

Return on equity =
Average Shareholders‘ Equity Dividends Dividend per Share
or
Total Comprehensive Income Earnings per Share

KEY FORMULA 11.6 AVERAGE EQUITY

KEY FORMULA 11.8 DIVIDEND YIELD
Beginning Equity + Ending Equity
Average Equity =
2 Dividend per Share
Dividend yield =
Market Price per Share

SHAREHOLDERS’
11 EQUITY
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REVIEW KEY DEFINITIONS LEARNING OBJECTIVES

statement of cash flows direct method

A financial statement that Method of reporting cash LO1 Describe the purpose and format of the statement of
summarises a company’s flows from operating activities cash flows.
inflows and outflows of cash in which cash inflows and
over a period of time with a outflows from operations are LO2 Understand the process of preparing the statement of
purpose to inform users on how reported separately on the cash flows.
and why a company’s cash statement of cash flows.
changed during the period.
indirect method LO3 Prepare the operating activities section of the statement
cash flows provided Method of reporting cash flows of cash flows using the direct method.
(used) by operating from operating activities in
activities which net income is adjusted
from an accrual basis to a cash
LO4 Prepare the operating activities section of the statement
Cash inflows and outflows of cash flows using the indirect method.
arising from the company’s basis.
operations; sometimes called cash flow adequacy
operating cash flows.
LO5 Outline the investing activities section of the statement
ratio of cash flows.
cash flows provided Compares free cash flow to
(used) by investing the average amount of debt
maturing in the next five years
LO6 Summarise the financing activities section of the
activities statement of cash flows.
Cash inflows and outflows and measures the ability to pay
arising from the acquisition and maturing debt.
disposal of non-current assets;
LO7 Evaluate the statement of cash flows through the
often called investing cash calculation and interpretation of ratio analyses.
flows.
cash flows provided KEY FORMULA
(used) by financing
activities
Cash inflows and outflows KEY FORMULA 12.1 CASH FLOW ADEQUACY RATIO
associated with the generation
and return of capital; often Free Cash Flow
Cash Flow Adequacy Ratio =
called financing cash flows. Average Amount of Debt
Maturing in Five Years

DEMONSTRATION PROBLEM
A company provides the following comparative balance sheets and
income statement. Prepare the company’s statement of cash flows
for the year using the direct method for operating cash flows. In a
supplemental schedule, show operating cash flows under the indirect
method. Assume that the change in equipment was caused by a purchase
of equipment for cash.

Income statement Balance sheet

for the year ended as at 30 June
30 June 2021

2021 2020
Service revenue $  40 000 Cash and cash $ 3 000 $ 4 000
equivalents
Depreciation (20 000) Accounts receivable 7 000 8 000
expense
Salaries (13 000) Equipment 100 000 73 000
expense
Profits before $ 7 000 Accumulated (55 000) (35 000)
taxes depreciation
Income tax 2 000 $ 55 000 $ 50 000
expense
Profits after tax $ 5 000 Salaries payable $ 5 000 $ 1 000
Ordinary shares 24 000 24 000
Retained earnings 26 000 25 000
Total liabilities and $ 55 000 $ 50 000
shareholders’ equity
STATEMENT OF
12 CASH FLOWS
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REVIEW
DEMONSTRATION PROBLEM SOLUTION
Cash received from customers: Cash paid for equipment:
Service Revenue + Decrease in Accounts Receivable Change in Equipment Balance is Attributable to Equipment
= $40 000 + $1000 = $41 000 Bought for Cash = $27 000

Cash paid to employees: Cash paid for dividends:

Salaries Expense – Increase in Salaries Payable Retained Earnings + Profits After Tax – Dividends = Ending Retained Earnings
= $13 000 – $4000 = $9000 $25 000 + $5000 – ?? = $26 000 ?? = $4000

Cash paid for income tax:

Income Tax Expense +/– Changes in Income Tax Payable
= $2000 + $0 = $2000

Statement of cash flows

for the year ended 30 June 2021
Cash flows from operating activities
Cash receipts from customers $ 41 000
Less cash payments:
to employees $ (9 000)
for taxes (2 000) (11 000)
Net cash provided by operating activities $ 30 000
Cash flows from investing activities
Cash paid for equipment $ (27 000)
Net cash used in investing activities (27 000)
Cash flows from financing activities
Cash paid for dividends $ (4 000)
Net cash used in financing activities (4 000)
Net decrease in cash and cash equivalents $ (1 000)
Cash, beginning of year 4 000
Cash, end of year $ 3 000

Reconciliation of profits after tax to net cash flow from operations

Profits after tax $ 5 000
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation expense $ 20 000
Decrease in accounts receivable 1 000
Increase to salaries payable 4 000 25 000
Net cash from operating activities $ 30 000

STATEMENT OF
12 CASH
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REVIEW KEY DEFINITIONS LEARNING OBJECTIVES

financial statement quick ratio

analysis Compares cash and near-cash LO1 Understand the nature of financial statement analysis.
The process of applying assets to current liabilities and
analytical tools to a company’s measures the ability to pay LO2 Calculate and interpret horizontal and vertical analyses.
financial statements to current liabilities immediately.
understand the business’ financial leverage LO3 Assess profitability through the calculation and
financial health. The degree to which a company interpretation of ratios.
profit margin ratio obtains capital through debt
Compares comprehensive rather than equity in an LO4 Assess liquidity through the calculation and
income to net sales and attempt to increase returns to
interpretation of ratios.
measures the ability to generate stockholders.
profits from sales. debt to equity ratio LO5 Assess solvency through the calculation and
return on equity ratio Compares total liabilities to interpretation of ratios.
Compares comprehensive total equity and measures a
income to average company’s capital structure and
financial leverage.
LO6 Calculate and interpret a DuPont analysis.
shareholders’ equity and
measures the ability to generate times interest earned
profits from equity.
ratio KEY FORMULAS
return on assets ratio Compares income to interest
Compares comprehensive expense and measures the
income to average total assets ability to pay interest out of KEY FORMULA 13.1 HORIZONTAL ANALYSIS
and measures the ability to current earnings.
generate profits from assets. Dollar Change
DuPont analysis
price to earnings Decomposes a company’s in Account = Current-year Balance − Prior-year Balance
(P/E) ratio return on equity into measures Balance
Compares comprehensive of operating efficiency, asset
effectiveness and capital
Percentage Dollar Change
income to a company’s share =
structure.
Change in
price and provides an indication
Account Balance Prior-year Balance
of investor perceptions of the
company.

KEY FORMULA 13.2 VERTICAL ANALYSIS

For the balance For the income

sheet statement
Account Balance Account Balance
Percentage = or
Total Assets Net Sales or Revenue

KEY FORMULA 13.3 PROFITABILITY RATIOS:

PROFIT MARGIN

Total Comprehensive Income

Profit Margin =
Revenue

 ROFITABILITY RATIOS:
KEY FORMULA 13.4 P
RETURN ON EQUITY

Total Comprehensive Income

Return on Equity =
Average Shareholders‘ Equity
Where average shareholders’ equity is as follows:
(Beginning equity + Ending equity)
2

FINANCIAL STATEMENT
13 Copyright ANALYSIS
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REVIEW
 ROFITABILITY RATIOS:
KEY FORMULA 13.5 P KEY FORMULA 13.10 LIQUIDITY RATIOS:
RETURN ON ASSETS RECEIVABLES TURNOVER RATIO

Total Comprehensive Income Net Sales

Return on Assets = ReceivablesTurnover Ratio =
Average Total Assets Average Accounts Receivable
Where average total assets is as follows: Where average accounts receivable is:
(Beginning Total Assets + Ending Total Assets) (Opening Balance of Accounts Receivable +
2 Closing Balance of Accounts Receivable)
2

 ROFITABILITY RATIOS:
KEY FORMULA 13.6 P
EARNINGS PER SHARE KEY FORMULA 13.11 LIQUIDITY RATIOS:
INVENTORY TURNOVER RATIO
Total Comprehensive Income
Earnings per Share =
Average Number of Ordinary Cost of Goods Sold
Shares Inventory Turnover Ratio =
Average Inventory
Where the average number of ordinary shares is as follows:
Where average inventory is as follows:
(Beginning Balance of Ordinary Shares +
Ending Balance of Ordinary Shares) Beginning inventory + Ending inventory

2 2

 OLVENCY RATIOS:
KEY FORMULA 13.12 S
 ROFITABILITY RATIOS:
KEY FORMULA 13.7 P
DEBT TO ASSETS RATIO
PRICE EARNINGS RATIO

Total Liabilities
Current Share Price Debt to Assets Ratio =
Price to Earnings Ratio = Total Assets
Earnings per Share

 OLVENCY RATIOS:
KEY FORMULA 13.13 S
KEY FORMULA 13.8 L IQUIDITY RATIOS:
CURRENT RATIO DEBT TO EQUITY RATIO

Current Assets Total Liabilities

Current Ratio = Debt to Equity Ratio =
Current Liabilities Total Equity

KEY FORMULA 13.9 LIQUIDITY RATIOS: KEY FORMULA 13.14 SOLVENCY RATIOS: TIMES
QUICK RATIO INTEREST EARNED RATIO

Cash + Short-term Investments + Total Comprehensive Income +

Accounts Receivable Times Interest Interest Expense + Income Tax Expense
Quick Ratio = =
Earned Ratio Interest Expense
Current Liabilities

Current Assets –
Inventory KEY FORMULA 13.15 DUPONT ANALYSIS
Quick Ratio Simple Calculation =
Current Liabilities
Operating Asset Capital Return on
Efficiency Effectiveness Structure Equity

Total Total
Comprehensive Comprehensive
Income Sales Assets Income
× × =
Sales Assets Equity Equity

FINANCIAL STATEMENT
13 ANALYSIS
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REVIEW
DEMONSTRATION PROBLEM DEMONSTRATION PROBLEM SOLUTION
The following information was taken from past financial Profitability ratios:
statements of the Ma Company:
Profit margin $4 155 / $27 756 15.0%
Current Return on equity $4 155 / [($6 672 + $6 780) / 2] 61.8%
Prior year
year
Return on assets $4 155 / [($29 865 + $29 589) / 2] 14.0%
Current assets $ 10 950 $ 11 391
Earnings per share $4 155 / [(3 021 + 3 132) / 2] $1.35
Quick assets 5 856 6 942
Price to earnings $93.19/ $1.35* 69
Total assets 29 856 29 589
* EPS is taken from the above calculation
Current liabilities 10 975 10 464
Total liabilities 23 193 22 809 Liquidity ratios:
Total shareholders’ equity 6 672 6 780 Current ratio $10 950 / $10 975 1.00
Quick ratio $5 856 / $10 975 0.53
Net sales 27 756
Solvency ratios:
Cost of sales 11 124
Debt to assets $23 193 / $29 856 0.78
Income before interest and taxes 6 084
Debt to equity $23 193 / $6 672 3.48
Interest expense 162
Time interest earned $6 084 / $162 37.56
Net income 4 155

Other information:
Ordinary shares issued 3 021 3 132
Share price at year end $ 93.19
Calculate all profitability, liquidity, and
solvency ratios for the current year.

FINANCIAL STATEMENT
13 Copyright ANALYSIS
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NOTES

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NOTES

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NOTES

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202