NEVILLE

BOX BOX

MACMILLAN

FOR VCE
ACCOUNTING
MACMILLAN
ACCOUNTING
FOR VCE

Macmillan accounting for vce

units 3 & 4
first published 2019
author
neville box
3+4 3 4
MACMILLAN
ACCOUNTING
FOR VCE
3 4
Macmillan Accounting for VCE Units 3 & 4 First published 2019 by
1st edition MACMILLAN SCIENCE AND EDUCATION PTY LTD
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Title: Macmillan Accounting for VCE Units 3 & 4,
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CONTENTS
Introduction x
About the author xii
Acknowledgements xiii

FINANCIAL ACCOUNTING FOR

UNIT 3 A TRADING BUSINESS

1 THE ROLE OF ACCOUNTING

1.1 Why is accounting useful?
1
2
1.2 The role of accountants 4
1.3 The elements of accounting 6
1.4 Characteristics of accounting reports 8
1.5 The accounting assumptions 11
Chapter review 12
Chapter 1 exercises 12
Ethical considerations 15
Accounting in the real world 15
Chapter checklist 16

2 BALANCE SHEETS
2.1 Balance sheets
17
18
2.2 Classifying balance sheets 21
2.3 Classifying loans 24
2.4 Financial transactions and balance sheets 26

Chapter review 33
Chapter 2 exercises 33
Case study 38
Ethical considerations 39
Accounting in the real world 39
Chapter checklist 40

3 ACCOUNTING SYSTEMS AND BUSINESS

DOCUMENTS 42
3.1 The basic accounting process 42
3.2 The GST and business documents 43
3.3 Source documents for cash transactions 45
3.4 Source documents for credit transactions 48
3.5 Other business documents 49
3.6 Documents and information flow 53
3.7 Computerised accounting systems 56

978 1 4202 3962 1 iii

 UNIT 3
Chapter review 58
Chapter 3 exercises 58
Case study 62
Accounting in the real world 62
Chapter checklist 63

4 DOUBLE ENTRY RECORDING:

AN INTRODUCTION 65
4.1 Double entry accounting and the accounting equation 66
4.2 Double entry for revenues and expenses 71

Chapter review 75
Chapter 4 exercises 75
Ethical considerations 79
Chapter checklist 80

5 THE GENERAL JOURNAL AND

THE GENERAL LEDGER 81
5.1 From documents to ledger accounts 82
5.2 Balancing ledger accounts 86
5.3 The role of the trial balance 88
5.4 Extended example: from transactions to balance sheet 90
5.5 Accounting for drawings 97

Chapter review 98
Chapter 5 exercises 98
Case study 107
Chapter checklist 108

6 GENERAL JOURNAL TRANSACTIONS

6.1 Managing a double entry system
109
110
6.2 Contribution or withdrawal of assets 113
6.3 Donations of inventory and business advertising 115
6.4 Correcting errors through the general journal 116

Chapter review 118

Chapter 6 exercises 118
Chapter checklist 122

THE PERPETUAL INVENTORY SYSTEM 123

7 7.1 What is inventory? 124
7.2 What is perpetual inventory? 125
7.3 The inventory account 127

iv CONTENTS 978 1 4202 3962 1

 UNIT 3
7.4 Identifying the cost price of sales 128
7.5 The role of inventory cards 134
7.6 Inventory losses and gains 137
7.7 Donations of inventory for advertising purposes 142

Chapter review 144

Chapter 7 exercises 144
Ethical considerations 154
Chapter checklist 155

8 SALES RETURNS AND PURCHASES RETURNS

8.1 Credit notes for returns
157
158
8.2 Purchases returns 159
8.3 Sales returns 161
8.4 Recording returns in inventory cards 164
8.5 From inventory cards to the general journal 169

Chapter review 172

Chapter 8 exercises 172
Chapter checklist 180

9 INVENTORY VALUATION
9.1 Product costs and period costs
181
182
9.2 Cost price versus net realisable value 185
9.3 Determining an item's NRV 189

Chapter review 191

Chapter 9 exercises 191
Case study 195
Chapter checklist 196

CLOSING THE GENERAL LEDGER 197

10 10.1 Closing the general ledger 198
10.2 Closing the ledger account 199
10.3 The general journal and closing entries 202
10.4 Transfer of net profit 203
10.5 Other types of closing entries 205
10.6 Extended example: closing the ledger 207

Chapter review 211

Chapter 10 exercises 218
Chapter checklist 219

978 1 4202 3962 1 CONTENTS v

 UNIT 3

11 INCOME STATEMENTS 219

11.1 Preparing an income statement 220
11.2 Evaluating a net profit figure 223
11.3 Cost of goods sold and gross profit 225
11.4 Reporting discounts 227

Chapter review 228

Chapter 11 exercises 228
Case study 233
Chapter checklist 234

CASH FLOW STATEMENTS 235

12 12.1 The role of the cash flow statement 236
12.2 Classification of cash flows 238
12.3 Designing and preparing a cash flow statement 240
12.4 Cash flows and decision making 243
Chapter review 245
Chapter 12 exercises 245
Case study 251
Chapter checklist 252

MANAGEMENT AND ACCOUNTING REPORTS 253

13 13.1 Controlling inventory 254
13.2 Evaluating inventory turnover 258
13.3 Controlling accounts receivable 261
13.4 Evaluating accounts receivable turnover 264
13.5 Evaluating the cash cycle 266
13.6 Evaluating accounts payable turnover 268
Chapter review 271
Chapter 13 exercises 271
Chapter checklist 276

vi CONTENTS 978 1 4202 3962 1

 RECORDING, REPORTING, EVALUATING AND
UNIT 4 PLANNING ACCOUNTING INFORMATION

BAD AND DOUBTFUL DEBTS 279

14 14.1 What are bad and doubtful debts? 280
14.2 Writing off debts 282
14.3 Adjusting the allowance for doubtful debts account 284

Chapter review 286

Chapter 14 exercises 286
Ethical considerations 291
Chapter checklist 292

STRAIGHT-LINE DEPRECIATION 293

15 15.1 The meaning of depreciation 294
15.2 The straight-line method of depreciation 296
15.3 The adjusting entry for depreciation 297
15.4 Depreciation and the balance sheet 300
Chapter review 302
Chapter 15 exercises 302
Case study 306
Ethical considerations 307
Chapter checklist 308

THE REDUCING BALANCE METHOD

16 OF DEPRECIATION 309
16.1 The reducing balance method of depreciation 310
16.2 Comparing depreciation methods 313
16.3 Choosing a depreciation method 316

Chapter review 318

Chapter 16 exercises 318
Case study 321
Chapter checklist 322

BUYING AND SELLING NON-CURRENT

17 ASSETS 323
17.1 Recording the purchases of non-current assets 324
17.2 Disposal of non-current assets 326
17.3 Trading in non-current assets 330

Chapter review 334

Chapter 17 exercises 334
Case study 339
Chapter checklist 340

978 1 4202 3962 1 CONTENTS vii

 UNIT 4
PROFIT DETERMINATION AND BALANCE DAY
18 ADJUSTMENTS 341
18.1 Profit determination: underlying assumptions 342
18.2 Prepaid expenses 344
18.3 Accrued expenses 347
18.4 Inventory losses and gains 351
18.5 Extended example: adjusting and closing entries 352
18.6 The adjusted trial balance 358

Chapter review 360

Chapter 18 exercises 360
Case study 368
Chapter checklist 370

UNEARNED AND ACCRUED REVENUE 371

19 19.1 Unearned revenue 372
19.2 Unearned sales revenue 376
19.3 Accrued revenue (revenue owing) 378

Chapter review 382

Chapter 19 exercises 382
Case study 387
Ethical considerations 389
Chapter checklist 390

BUDGETING 391
20 20.1 The need for budgeting 392
20.2 Cash budgeting 394
20.3 Peparing a budgeted cash flow statement 396
20.4 Budgeted income statements 401
20.5 Budgeted balance sheets 404

Chapter review 409

Chapter 20 exercises 409
Case study 418
Chapter checklist 419

viii CONTENTS 978 1 4202 3962 1

 UNIT 4
BUDGET VARIANCE REPORTS 421
21 21.1 Reviewing budgets 422
21.2 Preparing budget variance reports 424

Chapter review 427

Chapter 21 exercises 427
Accounting in the real world 431
Chapter checklist 432

EVALUATION OF BUSINESS PERFORMANCE 433

22 22.1 The role of financial evaluation 434
22.2 Analytical ratios 439
22.3 Profitability indicators 441
22.4 Operating efficiency indicators 446

Chapter review 451

Chapter 22 exercises 451
Chapter checklist 454

ADDITIONAL PERFORMANCE INDICATORS 455

23 23.1 Liquidity analysis 456
23.2 Liquidity and cash flows 460
23.3 Gearing and financial stability 462
23.4 Other evaluation tools 465
23.5 Non-financial factors 468

Chapter review 471

Chapter 23 exercises 471
Accounting in the real world 477
Case study 478
Chapter checklist 480

Index 481

978 1 4202 3962 1 CONTENTS ix

 INTRODUCTION
Macmillan Accounting for VCE Units 3 & 4 is your introduction to the concepts of
double entry accounting as applied to small business. This textbook deals with all
areas of study, outcomes, key knowledge and key skills for Units 3 & 4 of the VCE
Accounting Study Design 2019–2023.

Key features
Your textbook contains a number of important features that are designed to support
your learning and prepare you for your assessments.
• Every chapter starts with a list of learning objectives, so that you understand the
topics you’re about to study. The unit progress bar and chapter outline help you
track how far you’ve progressed in the course.
• Key terms are highlighted in the text, with definitions in the margin nearby.
• The margins also contain study tips, pointing out the do’s and don’ts of exam
EXAM
SUCCESS success. Keep these tips in mind when it’s time to revise for your exams.
If accounts payable • At the end of each numbered section of a chapter is a short set of Check Your
turnover increases, you
may be asked to state Understanding questions, which focus on the major concepts introduced in that
one positive and one section. These include icons to the corresponding page of the student workbook.
negative in relation to
this change. Revise
• Every chapter ends with a review of its key information and a series of practical
answers for both exam-style exercises. These can be completed in the student workbook; use the
possibilities. icon to find the correct workbook page.
• The final page of each chapter is a checklist of the chapter's core concepts
and tasks.
• Many chapters also include case studies, ethical considerations for discussion, or
DON’T!
When recording a sales research activities about accounting in the real world.
return, do not debit the
sales account. Make sure
that you use the sales
returns account.

x 978 1 4202 3962 1

Online support
• Use the code on the inside front cover of your textbook to access the digital
version of the text.
• Your online resources also include additional support materials.
• Short, interactive review quizzes are provided for each chapter, to help you revise
key concepts.
• The spreadsheet icon in the margin shows when a blank Microsoft Excel SPREADSHEET X.XX

template is available for use with practical exercises.

• The QR code and weblink located at the end of each chapter link to a Mr Box on
Demand video. These short tutorial videos featuring the textbook author will help
you achieve maximum success in your studies.

978 1 4202 3962 1 xi

 ABOUT THE AUTHOR

Neville Box
Neville Box is an experienced and highly esteemed educator who has been teaching
VCE Accounting since 1981. He has been involved in the development of Accounting
Study Designs since 2008, including the new Study Design to be implemented
in 2019. His depth and breadth of knowledge, combined with his accessible
presentation style, makes him a sought-after presenter for teaching professional
development events. Neville currently teaches at St Bernard’s College in Essendon.

From the author

Publishing a VCE text requires a team effort involving many individuals. As an author,
I'm delighted that my partnership with Macmillan Education has been ongoing for
more than 25 years. Although I thank everyone in the team at Macmillan, there are
some key people I want to single out for special thanks. The production of this text
has been overseen by Patrick O'Duffy (Content Development Manager), who has
encouraged, supported and, at times, pushed me along to ensure that deadlines
were met. Thank you Patrick, for believing in this project and for taking a hands-on
approach to the development of the text. Your commitment has been exceptional
and I appreciate your work immensely. Your new ideas have been invaluable and are
a welcome addition to the text. Thank you to Olive McRae (Publishing Director) for
your ongoing support. It has been a pleasure to work with such a professional and
I certainly appreciate your input, guidance and enthusiasm. Thank you also to Erin
Dowling (Digital Product Manager) for your wonderful work with the video content.
Your positive attitude is infectious and you made the making of videos less stressful
than I thought it would be. Your work with Arlo Cook was outstanding and I thank
you sincerely. Thank you too, Arlo. I trust that the making of accounting videos was
also a little out of your comfort zone. I thank you for your professional approach and
your creative ideas.
Special thanks to Simon Phelan for his diligence in relation to the Macmillan
Accounting for VCE Units 3 & 4 Workbook. The workbook is a vital part of the series
and both teachers and students rely on this excellent resource as part of their VCE
studies. Thank you Simon for your many hours of dedicated work. Your ability to
meet deadlines has been exceptional and is greatly appreciated.
I would also like to acknowledge and thank my principal at St Bernard's College,
Dr Adam Taylor. Thank you for your support and encouragement, Adam. It is a
pleasure working in such a wonderful educational setting. Thank you also to my
students at St Bernard's. I appreciate your assistance, particularly in relation to 'road-
testing' some of the new material. Knowing what works and what perhaps won't
work in the classroom has always been invaluable as we continue to learn together. I
am privileged to work with such fine young men and I thank you all for your efforts.
Last, and certainly not least, I would like to acknowledge and thank my wonderful
wife, Therese. The undying support I have felt over the last two years when writing
this text has been amazing. Thank you for keeping me going when I perhaps didn't
feel like writing. Thank you for your love, your support and your total commitment
and belief in what I do. Despite your busy schedule, you are always there for me
and, as a simple gesture of my gratitude, I dedicate this book to you Therese. Thank
you.

xii 978 1 4202 3962 1

ACKNOWLEDGEMENTS
The author and publisher are grateful to the following for permission to reproduce
copyright material.

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978 1 4202 3962 1 xiii

3 UNIT
FINANCIAL ACCOUNTING
FOR A TRADING
BUSINESS
Small businesses are a major
part of the Australian economy.
In Victoria, large numbers
of sole proprietors (owners)
operate their own small
trading business, selling items
Area of Study 1:
Recording and analysing financial data

On completion of this unit the student should be

able to record financial data using a double entry
system; explain the role of the General Journal,

© VCAA; by permission.
General Ledger and inventory cards in the recording
of inventory, such as books,
process; and describe, discuss and analyse various
clothing, window glass, floor
aspects of the accounting system, including ethical
tiles and cakes to customers.
considerations.
Sole traders need financial
data to make effective business
decisions. It is this data that an Area of Study 2:
Preparing and interpreting accounting reports
accounting system provides.

In this unit you will learn about: On completion of this unit the student should be
able to record transactions and prepare, interpret and
•• the purposes of accounting analyse accounting reports for a trading business.
systems
•• how a sole trader uses the CHAPTERS
double entry system to
1 2 3 4 5 6 7
record financial data
•• the perpetual method of 8 9 10 11 12 13
recording inventory for a
small trading business
•• the assumptions that apply
when creating accounting
reports
•• the qualities required
to make accounting
information useful.

978 1 4202 3962 1

 1 THE ROLE OF ACCOUNTING

Accounting is more than just LEARNING OBJECTIVES

recording expenses, updating
a spreadsheet or balancing a By the end of this chapter, you will be able to:
budget. Accountants are financial •• explain why small businesses need financial
data experts who provide clients information [1.1]
with advice and information
•• name the different users of accounting information and
that helps them to run their
their needs [1.1]
businesses.
•• outline the role of professional accountants as
In this chapter you will learn
suppliers of financial information [1.2]
about the role of accountants and
the work they do. You will also be •• define the five key elements of accounting: assets,
introduced to the assumptions liabilities, owner’s equity, revenues and expenses [1.3]
that accountants need to consider •• distinguish between current and non-current assets
and follow in creating financial and liabilities [1.3]
reports. •• describe the six qualitative characteristics of financial
information and outline their role [1.4]
•• describe the four accounting assumptions and outline
their role [1.5]

UNIT 3 – PROGRESS 1 2 3 4 5 6 7 8 9 10 11 12 13

1.2 1.4

Characteristics Chapter review

The role of
of accounting
1.1 accountants 1.3 1.5 and exercises
reports

Why is accounting The elements of The accounting

useful? accounting assumptions

978 1 4202 3962 1 1

 1.1 WHY IS ACCOUNTING USEFUL?
It’s easy to underestimate the importance of accounting in business. While
entrepreneurs and executives are the visible faces of companies, accountants
work behind the scenes. Yet it’s that behind-the-scenes accounting work that gives
entrepreneurs the information they need to keep their businesses afloat.
Business owners need to know if their business is making or losing money,
and accounting does obviously involve reporting information about profits or
losses. However, this is only one aspect of accounting’s many uses. Although
invisible to some people, accounting is a core element of a successful business’s
overall management strategy. Accountants provide the financial information that
management needs to make better decisions.

ANSWERING FINANCIAL QUESTIONS

Managing a business, large or small, involves making decisions based on financial
information. Owners and managers have to consider many financial questions,
such as:
•• Is my business’s profit improving or declining?
•• Am I earning a sufficient return on my investment?
•• Can my business repay any of its outstanding debts?
•• Are my credit customers paying on time?
•• What is the cost of my business’s assets, and how are they financed?
To answer these questions, they need ready access to financial information about
every aspect of their business. This information comes from accountants, and from
the systems they manage to record financial data. By collecting, classifying and
reporting on that data in a meaningful form, they provide business owners with the
answers they need.
Many businesses, especially small ones, collapse as a result of a lack of available,
meaningful information. If a business owner is well informed, their business has a
better chance of surviving, or even thriving.

Accounting
provides
the financial
information that
every business
needs, whether
start-ups or large
corporations.

2 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

PROVIDING APPROPRIATE INFORMATION
There are many different types and uses of financial information relating to every
business. Table 1.1 shows that information that is important to one user may be
irrelevant to another.
The user of the financial data decides what information is relevant to them.
Accounting must meet the needs of individual users and be flexible enough to satisfy
a variety of purposes.

TABLE 1.1 Users of accounting and the information they need

User Information
Owners/managers Profit, liquidity, stability, sales, growth, budgets, inventory
of a business management, accounts receivable, accounts payable, return on
investment

Prospective owners Budgets, future earnings, predicted returns, stability, prospects of growth

Banks/lenders Liquidity, stability, budgets

Suppliers of goods Credit rating, reliability, stability
or materials

Employees/unions Stability of employment, profits, the likelihood of wage increases

Customers Pricing, credit facilities, future trading opportunities

Government Specific needs relating to their own specialist areas

departments

Accounting cannot provide answers to all business problems. However, if the

accounting system functions properly, meaningful reports based on accounting data
can be prepared to assist decision makers.
Accounting has a vital role to play in communicating financial information that is
accurate, timely and useful.

ETHICAL COMPLIANCE
In addition to financial indicators, some accounting users may be interested in a
business’s social or environmental impact, or its ethics. When evaluating issues
relating to social, environmental or ethical questions, you should consider the
potential impact of a decision on the following:
•• financial costs to a business
•• financial benefits to a business
•• the general reputation of a business and its owner(s)
•• the environment
•• the financial and emotional wellbeing of a business’s owners, and customers.

1.1 CHECK YOUR UNDERSTANDING WB PAGE 1

1 Explain why businesses need financial information.

2 Identify five different users of accounting information. For each user, describe
their main areas of interest in terms of financial information relating to small
businesses.
3 Describe some of the challenges that may be faced by small business owners in
their everyday operations.

978 1 4202 3962 1 [CH A P TER 1] T HE RO L E O F ACCO UN T IN G 3

 1.2 THE ROLE OF ACCOUNTANTS
In the past, accountants were often seen as record keepers (also called bookkeepers).
They were employed simply to keep financial records of all business transactions.
Management then used the records to make decisions.
This view of accounting is outdated. Modern accountants are at the forefront
of management decision making. Information and communications technology has
streamlined the actual record-keeping process, making it possible for accountants
to collect data quickly and accurately. This allows them to have more input into
interpreting results as part of a management team.
The key question for business owners is: ‘What does the financial data mean?’ It is
the accountant’s role to help owners and managers answer this question.
A large business may employ one or more specialist accountants. Most small
business owners, on the other hand, don’t have the resources to employ a full-time
accountant to help them interpret financial results and make better decisions in the future.
To serve the needs of different organisations and users of information, four
different types of accountants exist in the larger profession.

FIGURE 1.1 The four main types of accountants

TYPES OF
ACCOUNTANTS

PUBLIC ACADEMIC

PRIVATE GOVERNMENT

PUBLIC ACCOUNTANTS
Public accountants work in business for themselves. They may be sole proprietors, or
be in partnership with other accountants. They provide individuals or business owners
with expert advice on financial matters. Their areas of expertise may include taxation,
finance, auditing, small business management, record keeping, computerised
accounting, inventory control or credit control.
Accountants in public practice are usually members of the Institute of Chartered
Accountants in Australia (ICAA) or CPA Australia (the business name for the Australian
Society of Certified Practising Accountants, or ASCPA). These bodies have their own
procedures to ensure that their members are highly trained professional accountants.

4 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

PRIVATE ACCOUNTANTS
Private accountants are employed by one particular business as a private employee.
Larger businesses employ accountants on a full-time basis, so that their expertise
is always available for the benefit of the business. Companies often have a team
of accountants who specialise in different areas, such as business record keeping,
taxation, budgeting, payroll, inventory control or credit control.
Private accountants are also usually members of the ICAA or CPA Australia, but
choose to work for one employer rather than in public practice.

GOVERNMENT ACCOUNTANTS
Government accountants are employed by government departments and authorities
in the same way that larger businesses employ their own accountants. Federal, state
and local governments all conduct complex financial transactions.
While government departments don’t have the same profit motive as businesses,
they still need to report accurate financial information and plan for future operations.
Results of a year’s receipts and payments are required from all three types of
governments, and each is heavily involved in budgeting for future events.

ACADEMIC ACCOUNTANTS
Academic accountants are the smallest group of qualified accountants. Some
members of the ICAA and CPA Australia work in academia, usually in tertiary
education or in research for the professional bodies.
As well as helping to educate future accountants, many academics play a role
in the development of accounting standards, which set out generally accepted
accounting practices and procedures.

1.2 CHECK YOUR UNDERSTANDING WB PAGE 2

1 Name and describe the roles of the four types of accountants in society.
2 Of the four types of accountants, which are the most likely to be used by small
businesses? Justify your response.
3 List the types of financial services provided by accountants to small businesses.

978 1 4202 3962 1 [CH A P TER 1] T HE RO L E O F ACCO UN T IN G 5

 1.3 THE ELEMENTS OF ACCOUNTING
When accountants prepare financial reports, they are providing information on the five
elements of accounting: assets, liabilities, owner’s equity, revenues and expenses.
You will be considering and referring to these five elements throughout your
Accounting studies, so it is important to have a full understanding of each of them.

ASSETS
assets Assets are present economic resources controlled by an entity. An economic
economic resources under resource has the potential to produce economic benefits in the future. There are two
the control of an entity,
which have the potential
types of assets controlled by business entities: current assets and non-current assets.
to produce economic Current assets are held primarily for the purpose of sale or trading, or are
benefits reasonably expected to be converted into cash, sold or consumed by a business
entity within 12 months from the end of the current accounting period. The classification
any person, business or
organisation for which
of current assets includes cash on hand, cash at bank, inventory (the goods bought
accounting records are and sold by a trading business) and amounts owing by credit customers (known as
maintained accounts receivable).
Non-current assets are economic resources that a business expects to use
for a number of years, which are not held for the primary purpose of resale. This
classification includes assets such as vehicles, machinery, office furniture, computers
and shop fittings.

Office furniture is
an example of a
non-current asset.

LIABILITIES
liabilities Liabilities are present obligations of an entity to transfer economic resources.
obligations to transfer
Liabilities include commitments to suppliers of inventory (referred to as accounts
economic resources to
another entity payable), Goods and Services Tax (GST) owed to the ATO, and loans due for
repayment in future accounting periods. Liabilities may be current or non-current.
Current liabilities are obligations that are due to be settled within 12 months
from the end of the current reporting period. This classification of liabilities includes
accounts payable (which are often based on 30 days’ credit), GST owing, bank
overdrafts and short-term loans (up to 12 months).
Non-current liabilities are obligations that don’t need to be settled within 12
months of the current reporting period, such as a five-year personal loan or a 20-year
mortgage loan.

6 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

OWNER’S EQUITY
Owner’s equity is the residual value of the assets of an entity after deducting all its
liabilities. This definition of equity is based on the following equation, often referred to
as the accounting equation:

Assets = liabilities + owner’s equity

A = L + OE

This equation can be expressed in a second form to highlight the owner’s equity
(also known as the net worth of the owner):

Owner’s equity = assets – liabilities

OE = A – L

These terms, and their presentation in reports, will be covered in more detail in
Chapter 2.

REVENUES
revenues
Revenues are increases in assets or decreases in liabilities that result in an increase increases in assets, or
in owner’s equity, other than those relating to contributions by the owner. Revenue decreases in liabilities,
includes sales of goods or the provision of services, for either cash or credit. In both that result in an increase in
owner’s equity
cases an increase in assets occurs, as the firm has control over a future economic
benefit in the form of cash or accounts receivable. As long as the transaction can be
reliably measured, the revenue item may be recognised.
Revenue may also include items such as interest on investments, commissions
on sales and reductions in debts. For example, a reduction in a liability may occur if
a supplier offers a discount for prompt payment. If a firm settles its debts promptly
and receives a discount from a supplier, this satisfies the definition of a revenue item.
As long as there is an increase in assets (other than a contribution by the owner) or
a decrease in liability that leads to an increase in equity, a revenue item should be
recognised.

EXPENSES
Expenses are decreases in assets or increases in liabilities that result in a decrease expenses
in owner’s equity, other than those decreases or increases relating to distributions to decreases in assets, or
increases in liabilities, that
the owner. Expenses include items such as wages, rent, the cost of goods sold by a result in a decrease in
trading business, and discounts offered to accounts receivable. If a business decides owner’s equity
to offer a discount to credit customers for prompt payment of an amount, this leads to
a decrease in assets, which then leads to a decrease in owner’s equity.

ASSETS TO EXPENSES
Assets are resources under the control of an entity that produce economic benefits.
If the entity uses up these resources in its operations, these assets then become
expenses. Yet, by making these expenses, and using up these assets, the entity
generates and earns revenue.
For example, a builder buys building materials, such as wood, tiles, nails and pipes,
which are all assets of the company. The materials are used to construct a house, so

978 1 4202 3962 1 [CH A P TER 1] T HE RO L E O F ACCO UN T IN G 7

 these assets become an expense. The builder is then paid for the construction
work, and so earns a revenue. For a profitable building business, the revenue
earned for the work should be greater than the value of the assets that were
consumed as expenses. The builder can then use some of that revenue to
purchase more materials, gaining more assets for the next job.
This relationship between assets, revenues and expenses is vital in
determining a business’s profit.

1.3 CHECK YOUR UNDERSTANDING WB PAGE 3

1 Write a brief definition for each of the following terms: assets, liabilities, owner’s
equity, revenues and expenses.
2 Explain the difference between current assets and non-current assets. Give three
examples of each type of asset.
3 Explain the difference between current liabilities and non-current liabilities.

CHARACTERISTICS OF ACCOUNTING
1.4 REPORTS
The International Accounting Standards Board (IASB) approves the rules of accounting
worldwide. Rather than each country establishing its own rules and regulations, the
accounting standards accounting profession needed a set of internationally recognised accounting standards.
rules and regulations The aim was to establish a uniform approach to preparing financial statements that could
that outline acceptable
accounting practices and be followed by professional accountants around the world.
procedures The result was the Accounting Conceptual Framework, which describes the objectives
of financial reporting, the concepts on which it is based, and the six main characteristics
that all financial reports should have. These characteristics (shown in Figure 1.2) are
qualitative – that is, they relate to the focus and quality of a report’s content, rather than
how much content is provided.

From its London

offices, the
IASB develops
international
accounting
standards.

EXAM
SUCCESS
When asked to ‘justify’
something, be specific and
use correct terminology.
Vague responses will
cost you marks in
the exam.

8 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

FIGURE 1.2 The six main qualitative characteristics of financial reports

EXAM SUCCESS
Memorise the
specific terms for
these characteristics.
Relevance You will not be
awarded exam marks
if you use an incorrect
term, even if the
Understandability Faithful representation meaning is
the same.

QUALITATIVE
CHARACTERISTICS
OF FINANCIAL
REPORTS

Timeliness Comparability

Verifiability

RELEVANCE
For information to be relevant, it can potentially make a difference to the decisions relevance
usefulness of financial
made by users. Relevant financial information helps users form predictions about the information in helping
outcomes of past, present or future events. It may also provide suitable feedback users make decisions
about previous evaluations or decisions.
The nature of an item may not be the only test of whether it is relevant; its dollar
value is also important. If an item is insignificant in terms of its dollar value, it may
not be relevant information. For example, dollar amounts are usually rounded off in
financial statements to omit cents, as these small values have little or no impact on
decision making.

FAITHFUL REPRESENTATION
The financial information in the report must be a faithful representation of real-world faithful
representation
economic events. The users of the report should feel confident that the information the requirement that
presented is complete, correct and neutral. The report should not be based on financial information
personal opinions (to any significant degree) and should accurately represent events must accurately reflect
economic events
that took place during a specific time period.

COMPARABILITY
Comparability ensures that users can identify and understand similarities and comparability
the ability to compare
differences in financial reports by following consistent accounting standards and similar types of financial
policies. Information about an entity is more useful if it can be compared with similar information effectively
information either about other entities or about the same entity in different reporting periods. with other entities or over
different reporting periods

978 1 4202 3962 1 [CH A P TER 1] T HE RO L E O F ACCO UN T IN G 9

 VERIFIABILITY
verifiability Verifiability means that the information presented in reports accurately represents
the premise that financial
information is supported by
what it is intended to represent. This means the information is supported by evidence,
evidence that can be used such as invoices, receipts and bank statements, that users can check.
to check its accuracy

TIMELINESS
timeliness Timeliness means making information available to users as quickly as possible so that
providing information they can take action. Information that isn’t timely is potentially useless; the older it is,
to users as quickly as
possible so that it remains the less useful it will be.
useful for decision making For example, if the costs of running a business are getting out of control, the
owner needs to know as soon as possible to decide what to do. If this information
isn’t available until the end of the year, it may be too late: the damage to the business
may be so great that its future is at risk.

UNDERSTANDABILITY
understandability Understandability means that users with a reasonable knowledge of business and
financial information economic activities should be able to understand the financial information. Information
should be presented
clearly and concisely in reports should be presented clearly and concisely, and headings and sub-headings
so that users can easily should assist general users to navigate their way through and understand the content.
understand it

1.4 CHECK YOUR UNDERSTANDING WB PAGE 4

1 Sharon O’Neill buys a second-hand vehicle for her business at a cost of $18 000.
One of her friends tells her that the model she purchased is worth about $19 500.
What amount should Sharon use to record the vehicle’s value in her firm’s
financial reports? Explain your answer fully, with reference to a qualitative
characteristic of accounting.
2 Why is comparability important to accounting? How does it help management
with their decision making?
3 Name three business documents that may be used to satisfy the demands of
verifiability.
4 The owner of a small business says that cents may be omitted from all balance
sheets. State the qualitative characteristic that may support this statement, and
explain why the business owner may be correct.

10 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

1.5 THE ACCOUNTING ASSUMPTIONS
In addition to the six qualitative characteristics, four accounting assumptions guide accounting
assumptions
creators of financial reports. These assumptions are based on generally accepted accepted practices and
accounting practices and procedures; they help to ensure that financial reports are assumptions followed
when creating financial
prepared in a similar way across all businesses. reports
The accounting entity assumption stipulates that records of assets, liabilities and
accounting entity
business activities of an entity are kept separate from records relating to the activities assumption
of the owner of the entity or of other entities. A separate set of accounting records the requirement that a
business has its own
should be maintained for each entity, and any financial statements prepared should financial status and a
only provide information about that entity. separate position from
For accounting purposes, the business is always viewed as a separate entity, that of its owner or
other entities
regardless of whether it is a sole trader, a partnership or a company. This assumption
supports the qualitative characteristic of relevance; personal transactions are
excluded, as they are irrelevant to the business entity. This allows the performance of
the business to be evaluated, as financial decisions will be based only on the activities
of the business entity.
accrual basis
The accrual basis assumption is that revenue is recognised (recorded) when it assumption
is earned, not when the cash is received, and that expenses are recognised when recording revenue when
it’s earned and expenses
they’re incurred, not when they’re paid.
when they’re incurred
Under the accrual basis of accounting, profit is determined by subtracting
expenses incurred during a period from the revenue earned during that same period.
The going concern assumption is that a business entity will continue to operate, going concern
assumption
and not be wound up, in the foreseeable future. a business will continue
Financial statements prepared under this assumption help users to distinguish to operate, and isn’t
between assets that are expected to provide economic benefit in future periods, and expected to be wound
up in the near future
expenses that are totally consumed within the current reporting period.
The period assumption is that financial reports are prepared for a particular period period assumption
of time, such as a month, a quarter or a year. Revenues and expenses can then be financial activities are
recorded and reported
compared over the one period of time, allowing a profit or a loss to be determined for on for a particular
that reporting period. period of time
If this is done consistently, results can be compared from one reporting period to the
next, and the performance of the business entity can be evaluated in a meaningful way.

1.5 CHECK YOUR UNDERSTANDING WB PAGE 5

1 Max Wilson is the owner of a car detailing firm, a clothing business and a
hardware shop. Explain how the accounting entity assumption affects the
accounting for Max’s businesses.
2 Explain the link between the going concern assumption and the period
assumption.
3 The qualitative characteristic of relevance may be supported by an DON’T!
accounting assumption. State the accounting assumption and explain When asked for a
this link fully. qualitative characteristic
or an accounting assumption,
do not state one of each, even
if you think they’re both
correct. Always follow the
instruction in
the question.

978 1 4202 3962 1 [CH A P TER 1] T HE RO L E O F ACCO UN T IN G 11

 1 CHAPTER REVIEW

KEY CONTENT
•• [1.1] Accounting is a tool that analyses financial data and provides financial information. It
is a key part of a business’s overall management strategy.
•• [1.2] Users of financial information determine how it is to be used. Accounting must meet
the needs of the individual user and be flexible enough to satisfy a variety of purposes.
•• [1.3] Accountants are at the forefront of management decision making. There are four main
types of accountants: public, private, government and academic.
•• [1.4] Accountants provide information on five major elements of financial information:
assets, liabilities, owner’s equity, revenues and expenses.
•• [1.5] The Accounting Conceptual Framework describes the six main qualitative
characteristics that financial reports should have.
•• [1.6] There are four accounting assumptions that ensure financial reports are prepared in a
similar way across all businesses.

CHAPTER 1 EXERCISES

WB PAGE 6
1 Accounting elements
Melbourne Magazines publishes a range of magazines that are sold only to private
subscribers. The business accepts prepaid subscriptions; customers can pay in advance
for a one-, two- or three-year subscription. During 2022 the firm received a total of
$180 000 for its three-year subscriptions covering the years 2023, 2024 and 2025. How
should this $180 000 be reported in the financial reports of Melbourne Magazines for
the year 2022?
In your answer, discuss whether the amount in question should be treated as a revenue
item or a liability item. You should also refer to the definitions of the key elements of
accounting to justify your answer.

2 Accounting elements WB PAGE 7

To keep track of her business transactions, the owner of Strathmore Appliances

borrows a computer from her sister on a regular basis. The computer cost $5000 two
years ago and has recently been valued at $2800.
a How should the computer be treated in the books of Strathmore Appliances? Refer
to the appropriate definition of the accounting elements to support your answer.
b Would your answer change if the owner of Strathmore Appliances gave her sister
some electrical goods from the business as payment for the use of the computer?
Explain your answer fully.
c Would your answer change if the owner paid her sister $1800 for the computer?
Should the computer be recognised as an asset of the business? If you
answered ‘yes’, at what value should it be recorded: $5000, $2800 or $2500?
Justify your answer.

12 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

3 Accounting elements WB PAGE 8

The owner of Bateman’s Bookstore bought $500 worth of stationery during the current
reporting period. On 30 June 2022, he found that an unopened box of pens, worth $5,
hadn’t been used during the period.
a Should the entire $500 be reported as an expense in the firm’s reports? Refer to the
relevant qualitative characteristic in your answer.
b Would it make any difference to your answer if the value of unused stationery was
$150, rather than $5? Explain your answer fully.

4 Qualitative characteristics and accounting WB PAGE 8

assumptions
Kaylene Biffin, the owner of a small business that sells golf equipment, provides this
list of her assets to her accountant at the end of a reporting period:

Cash $12 000 (including $2000 in a personal

account)
Inventory $42 000 (valued at estimated selling
price: the cost price was $21 000)
Vehicle $29 000 (purchased for $45 000)

Kaylene’s accountant advises her that she hasn’t followed acceptable accounting
assumptions and qualitative characteristics.
State and explain which accounting assumption(s) and/or qualitative characteristic(s)
Kaylene hasn’t followed correctly.

5 Accounting elements WB PAGE 9

Lachlan Walsh owns a menswear store trading as Sneakerboy. He rents his business
premises from City Real Estate at a cost of $40 000 per annum. During recent
negotiations the two firms agree on a one-off payment of $99 000 on 1 January 2022
for the use of the property during 2022, 2023 and 2024. Lachlan believes that the
entire $99 000 should be written off as an expense in 2022, as it represents the loss of
economic resources for the year. However, a friend suggests that this would distort the
profits of the firm in the following two years.
Discuss both arguments, with reference to the definitions of the five accounting
elements and any relevant qualitative characteristics or accounting assumptions.

6 Accounting elements and qualitative WB PAGE 10

characteristics
Nick Zaita is the owner of Coburg Smallgoods. During the reporting period ending
31 December 2022, he purchased the following items:
•• computer ($2500)
•• printer ($450)
•• stapler ($10)
•• metal ruler ($4)
Nick estimates that all four items should have a useful life in the business of about
three years. However, a friend tells him that all the items are expenses to his business,
because they represent an economic sacrifice during 2022.

978 1 4202 3962 1 [CH A P TER 1] T HE RO L E O F ACCO UN T IN G 13

 a Explain the difference between an asset and an expense.
b Identify one reason why all four items should be reported as assets as at 31
December 2022.
c Identify one reason why some of the items should be treated as expenses during
2022.
d Explain how the qualitative characteristic of relevance may be applied to this
situation. Taking this characteristic into account, should any of the four items be
treated as expenses for 2022? Explain your answer fully.

7 Qualitative characteristics and accounting WB PAGE 11

assumptions
For each of the following situations, identify the relevant qualitative characteristic(s)
and/or accounting assumption(s), and explain how they should be applied.
a Marcus Gigliotti is the owner of Brunswick Party Hire. On 10 June, he bought 100
chairs costing a total of $3000. On 15 June, he bought an office desk for the family
home at a cost of $1000.
b Classic Styles is a hairdressing salon owned and managed by Betty Semini. In 2005,
Betty purchased the business premises for $450 000. Three independent valuers
have inspected the property this year and have valued it at $1.1 million, $1.15 million
and $1.2 million, respectively.
c The owner of Paula’s Laser Rejuvenation Clinic calculated the profit of her business
in her first year using a one-month reporting period. When she found that this
method was taking up too much of her time, she changed to a six-month reporting
period. She then got tired of that method and now determines her business’s profit
every two years.
d Elaine Hazard hasn’t been able to keep accurate files of the documents used by her
smartphone reselling business. However, she is confident that she can remember
the transactions for the last month and prepares an income statement on the basis
of her memories. She is reasonably confident that her estimate of sales for the
month is accurate.
e Johann Gleeson is the owner of Gleeson’s Hardware Warehouse. The business
has been struggling lately, and Johann isn’t certain that he will continue to operate
next year. With this in mind, he prepares a balance sheet on the basis of what he
expects to receive if he decides to sell the firm’s assets.
f Nancy Mifsud doesn’t think it’s necessary to prepare an income statement and
balance sheet every year. She has been in business as Moonee Ponds Camping
Gear for three years, and has just completed accounting reports for this three-year
period showing a profit of $65 000.

14 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 ETHICAL CONSIDERATIONS WB PAGE 13

Anthony Orlando operates an accounting practice that specialises in providing taxation

and business advice to retail traders. His business is located across the road from a major
shopping centre where he has several clients, including Lachlan Walsh, the owner of
Sneakerboy.
Recently the shopping centre expanded, bringing a number of potential new clients for
Orlando’s business. Two different business operators, both opening new luxury sneaker
stores, approached him for accounting advice. Anthony isn’t sure whether he should
provide advice to them. He has asked you what you think he should do.
Discuss this ethical issue. Consider both the potential benefits to Orlando’s business,
as well as the negative aspects associated with this decision. Also provide a conclusion,
including your recommendation to Orlando.

WB PAGE 14
ACCOUNTING IN THE REAL WORLD
Being a professional accountant takes more than just completing your VCE course. You
need to be a qualified Chartered Accountant (CA) or Certified Practicing Accountant (CPA),
both of which require a recognised tertiary qualification, practical experience of working
with a qualified accountant and ongoing professional development.
However, many opportunities open up for a qualified accountant. Certification is
recognised internationally and allows you to work anywhere in the world. Various
professions work with chartered accountants, helping them develop their skills and placing
them into interesting, challenging roles worldwide.
The two main professional accounting bodies in Australia are CPA Australia and the
Institute of Chartered Accountants in Australia. Visit their websites and answer the
following questions.
a What are the requirements for membership of these two organisations?
b How many members does each organisation have?
c What services and/or information are available for students of accounting?
d What are the benefits of being a member of each organisation? What professional
career opportunities would there be for you if you were to join one of them?

CPA Australia mea.digital/cpaaustralia

ICAA mea.digital/charteredaccountants

978 1 4202 3962 1 [CH A P TER 1] T HE RO L E O F ACCO UN T IN G 15

 CHAPTER CHECKLIST
Now that you have finished Chapter 1, double-check your progress.
Are you ready for your Unit 3 assessment?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
completed the end-of-chapter activities
handed in my workbook for marking.

I understand …

accounting assumptions and qualitative characteristics as applicable

the accounting elements: assets, liabilities, owner’s equity, revenues and expenses
classification of assets and liabilities into categories of current and non-current
ethical considerations when making business decisions in relation to operating
a trading business.

I can …

use correct accounting terminology

explain and apply relevant qualitative characteristics and accounting assumptions
distinguish between current and non-current assets, and current and non-current
liabilities
discuss ethical considerations involved in decisions made by owners of trading
businesses.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_1

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

16 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 2 BALANCE SHEETS

In Chapter 1 you learnt about LEARNING OBJECTIVES

accounting reports and how
they help management to make By the end of this chapter, you will be able to:
decisions. In this chapter you will •• explain the purpose of a balance sheet [2.1]
look at one of the most important
•• explain the concept of net worth [2.1]
reports – the balance sheet, which
•• prepare a balance sheet for a small business in both
shows a business’s financial
T-form and narrative form [2.1]
position.
Throughout this chapter and •• prepare a classified balance sheet using appropriate
this entire unit, keep in mind the headings [2.2]
six qualitative characteristics and •• explain the difference between interest-only loans and
the four accounting assumptions. instalment loans [2.3]
They inform all of the decisions •• show the two-fold effect of financial transactions on
that accountants make as they the balance sheet [2.4]
collect data and report on their
•• explain how revenues and expenses affect owner’s
findings.
equity in a balance sheet [2.4]

UNIT 3 – PROGRESS 1 2 3 4 5 6 7 8 9 10 11 12 13

2.2 2.4

Classifying Financial
2.1 balance sheets 2.3 transactions and
balance sheets

Balance sheets Classifying loans Chapter review

and exercises

978 1 4202 3962 1 17

 2.1 BALANCE SHEETS
The balance sheet is prepared at the end of every reporting period. It shows the
financial position of a business at a particular point in time. A balance sheet has three
main sections.
•• Assets: The economic resources controlled by an entity as a result of past events.
These resources have the potential to produce future economic benefits.
•• Liabilities: The present obligations of an entity to transfer economic resources as
a result of past events.
•• Owner’s equity: The residual value of the assets of an entity after its liabilities are
deducted. This is also referred to as the net worth of the business. The owner’s
equity usually consists of the capital contributed by the owner, plus any profits
earned by the firm that haven’t yet been distributed.
As you learnt in Chapter 1, the accounting equation connects these three concepts,
and is the basis of all balance sheets. It states that:

Assets = liabilities + owner’s equity

A = L + OE

To highlight the net worth of a business, it can be expressed as:

Owner’s equity = assets – liabilities

OE = A – L

FIGURE 2.1 Balance sheet: T-form presentation

CITY CYCLES: BALANCE SHEET AS AT 30 JUNE 2023

Assets $ Liabilities $ $
Cash at bank 3 000 GST clearing 1 000
Accounts receivable 15 000 Accounts payable 14 000
Inventory 50 000 Loan (due 30/6/25) 30 000 45 000
Office equipment 14 000 Owner’s equity
Vehicles 68 000 Capital – Ebony Rae 105 000
Total assets 150 000 Total equities 150 000

The accounting equation in this balance sheet is:

Assets $150 000 = liabilities $45 000 + owner’s equity $105 000

Equities are any legal claim on the assets of the business. Liabilities include all
external equities, as these are obligations of the business to outsiders. The internal
equity is the owner’s claim on the firm. This is the net worth of the business to the
owner, Ebony Rae.

18 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

NARRATIVE REPORTS
A T-form balance sheet can be redrafted into a narrative format. While a T-form
statement shows the basic accounting equation across the page, the narrative format
is prepared vertically, down the page.
A narrative statement can be prepared in two different styles. The first style shows
the assets of the firm in the top half of the report, followed by liabilities and owner’s
equity in the bottom half. Figure 2.2 presents the same City Cycles information as in
Figure 2.1, but in this standard narrative format.

FIGURE 2.2 Balance sheet: standard narrative presentation

CITY CYCLES: BALANCE SHEET AS AT 30 JUNE 2023

$ $
Assets
Cash at bank 3 000
Accounts receivable 15 000
Inventory 50 000
Office equipment 14 000
Vehicles 68 000
Total assets 150 000
Liabilities
GST clearing 1 000
Accounts payable 14 000
Loan (due 30/6/25) 30 000 45 000
Owner’s equity
Capital – Ebony Rae 105 000
Total equities 150 000

978 1 4202 3962 1 [CHAPTER 2] BAL ANCE SHEETS 19

 A second style of narrative report highlights the net worth of the business. Many
company reports use this style of presentation, and it has additional value when
preparing a classified report (page 21). This statement uses the accounting equation of
OE = A – L. Figure 2.3 shows the City Cycles report in this second style of format.

FIGURE 2.3 Narrative form balance sheet highlighting owner’s equity

CITY CYCLES: BALANCE SHEET AS AT 30 JUNE 2023

Owner’s equity
Capital – Ebony Rae 105 000
Is represented by:
Assets
Cash at bank 3 000
Accounts receivable 15 000
Inventory 50 000
Office equipment 14 000
Vehicles 68 000 150 000
Less: Liabilities
GST clearing 1 000
Accounts payable 14 000
Loan (due 30/6/25) 30 000 45 000
Net assets 105 000

In this style of narrative report, the owner’s equity figure is shown as being equal to
the net assets of the business. The value of the net assets is calculated by subtracting
the total liabilities from the total assets.
T-form and narrative form balance sheets show exactly the same information. The
only difference is the style of presentation.

2.1 CHECK YOUR UNDERSTANDING WB PAGE 16

1 Describe the purpose of preparing a balance sheet for a small business.

2 Explain what the term ‘net worth’ means.
3 State the two components of owner’s equity.
4 Identify the differences between a T-form and a narrative form of balance sheet.

20 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

2.2 CLASSIFYING BALANCE SHEETS
In order to provide more information about a business, a balance sheet can be
classified to include groups of similar items. Assets are usually classified according to
their liquidity; that is, how quickly they can be turned into cash or used up. Liabilities
are classified on the basis of how urgently they need to be repaid.
Typical headings used for classification are shown in Figure 2.4.

FIGURE 2.4 Typical balance sheet headings

EXAM SUCCESS
Balance sheets
are classified to help
satisfy the demands
of understandability.
Current assets Non-current assets

TYPICAL BALANCE
SHEET HEADINGS

Current liabilities Non-current liabilities

•• Current assets: This classification includes cash and other economic resources
that are usually held for the purpose of sale or trading. They are reasonably
expected or intended to be converted into cash, or sold, or consumed by a
business within 12 months from the end of the reporting period. Current assets
include cash on hand, cash at bank, short-term investments, inventory (goods held
for resale), materials or supplies (e.g. stationery), and amounts owing by credit
customers (usually referred to as accounts receivable).
•• Non-current assets: These are longer-term assets. They are usually acquired
with the intention of using them for a number of years and are not held for
resale. Typical non-current assets are computers, vehicles, machinery, furniture,
equipment, property and long-term investments.
•• Current liabilities: This classification includes all liabilities that are reasonably
expected to be settled within 12 months from the end of the reporting period.
Current liabilities include items such as bank overdrafts, short-term loans, and
amounts owing to suppliers who have extended credit to the business (usually
referred to as accounts payable).
•• Non-current liabilities: These are the longer-term obligations of the business,
which don’t need to be fully settled within 12 months. They are also known as
deferred liabilities. Debts for which the payment has been deferred over a period
greater than 12 months (e.g. mortgage loans) are listed under this heading.

978 1 4202 3962 1 [CHAPTER 2] BAL ANCE SHEETS 21

 Even though a loan may be taken out over 10 years, the amount due within the
following 12 months is still a current liability. The amount to be repaid over the
remaining nine years is a non-current liability.
Figure 2.5 redrafts the City Cycles T-form balance sheet using these headings to
classify assets and liabilities.

FIGURE 2.5 Classified balance sheet (T-form)

CITY CYCLES: BALANCE SHEET AS AT 30 JUNE 2023

Assets $ $ Liabilities $ $
Current assets Current liabilities
Cash at bank 3 000 GST clearing 1 000
Accounts receivable 15 000 Accounts payable 14 000
Inventory 50 000 68 000 Loan 15 000 30 000
Non-current assets Non-current liabilities
Office equipment 14 000 Loan (due 30/6/25) 15 000
Vehicles 68 000 82 000 Owner’s equity
Capital – Ebony Rae 105 000
Total assets 150 000 Total equities 150 000

You can see that City Cycles needs to repay a loan, which has been divided into
two parts. The loan is due over the next two years, with $15 000 due within the next
12 months, and the remaining $15 000 due the following year.
Classified statements can also be prepared using either of the two narrative
formats, as shown in Figures 2.6 and 2.7.

FIGURE 2.6 Classified balance sheet (standard narrative)

CITY CYCLES: BALANCE SHEET AS AT 30 JUNE 2023

Assets $ $
Current assets
Cash at bank 3 000
Accounts receivable 15 000
Inventory 50 000 68 000
Non-current assets
Office equipment 14 000
Vehicles 68 000 82 000
Total assets 150 000
Liabilities
Current liabilities
GST clearing 1 000
Accounts payable 14 000
Loan 15 000 30 000
Non-current liabilities
Loan (due 30/6/25) 15 000
Owner’s equity
Capital – Ebony Rae 105 000
Total equities 150 000

22 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

FIGURE 2.7 Classified balance sheet (narrative highlighting owner’s equity)

CITY CYCLES: BALANCE SHEET AS AT 30 JUNE 2023

Owner’s equity $ $
Capital – Ebony Rae
Is represented by: 105 000
Current assets
Cash at bank 3 000
Accounts receivable 15 000
Inventory 50 000 68 000
Current liabilities
GST clearing 1 000
Accounts payable 14 000
Loan 15 000 30 000
Working capital 38 000
Non-current- assets
Office equipment 14 000
Vehicles 68 000 82 000
120 000
Less: Non-current liabilities
Loan (due 30/6/24) 15 000
Net Assets 105 000

Working capital is the value of current assets minus current liabilities. It is the liquid working capital
current assets minus
funds of a business that can be used in its day-to-day trading operations.
current liabilities
Classified balance sheets provide more information than unclassified forms. The
longer-term assets are grouped together, with the firm’s liquid assets and short-term
obligations clearly identified. These groupings can be used as analytical tools when
examining a business.

2.2 CHECK YOUR UNDERSTANDING WB PAGE 17

1 Distinguish between the following sets of terms, and identify two examples for each.
a Current assets and non-current assets
b Current liabilities and non-current liabilities
2 Explain how a classified balance sheet is more informative for a business owner.
3 Explain what the term ‘working capital’ means.
4 A business has current assets of $150 000, but current liabilities of $190 000.
Calculate its working capital and comment on its working capital situation.

978 1 4202 3962 1 [CHAPTER 2] BAL ANCE SHEETS 23

 2.3 CLASSIFYING LOANS
When loans are included in a balance sheet, they can be classified in a number of
ways. Figure 2.4 (page 21) showed how a two-year loan may be reported as both
a current and a non-current liability, with half of the loan being shown under each
heading. The way a business owner treats a liability depends on the type of loan.
In basic terms, there are two ways a business may borrow money: interest-only
loans and instalment loans.

INTEREST-ONLY LOANS
interest-only loan Interest-only loans don’t require the borrower to repay the amount borrowed (the
a loan that only requires
principal) until the loan period has expired. Until that time, the borrower only has to
payment of interest
during its life, with the pay the interest due to the lender each year.
amount borrowed Interest-only loans are classified as non-current liabilities in balance sheets until the
repaid in one lump
sum at the end date the principal has to be repaid.

EXAMPLE 2.1

On 1 December 2023, Nadim’s Halal Foods borrows $40 000 as an interest-only loan over
five years at 10% per annum interest.
Over the course of the loan, the business only needs to pay the interest of $4000
(10% of $40 000) each year.
None of the principal (the original $40 000 borrowed) needs to be repaid until the five
years have passed (30 November 2028).

This type of loan has advantages for a business, as it gives the owner time to
accumulate the amount needed to make a single repayment of the principal. However,
it requires excellent planning skills, because the total amount borrowed has to be
available on the day the loan period expires.
Interest-only loans are classified as non-current liabilities because they don’t need
to be repaid within 12 months from the end of the current reporting period.

EXAMPLE 2.2

Nadim’s Halal Foods reports the $40 000 as a non-current liability for the first four years
that the business has the loan.
Its reporting period ends on 31 December each year, so the loan is reported under the
non-current liability heading at the end of 2023, 2024, 2025 and 2026.
When Nadim’s balance sheet is prepared on 31 December 2027, however, the loan
will be due in only 11 months (30 November 2028).
For this balance sheet, the loan is reported as a current liability because it will need to
be repaid within 12 months of the current reporting period.
When classifying an interest-only loan in a balance sheet, always check the date
when the principal has to be repaid.

INSTALMENT LOANS
instalment loan Instalment loans, as the name suggests, require the borrower to make scheduled
a loan that requires repayments throughout the life of the loan. These instalments are usually stated
scheduled repayments
of both principal and as a dollar amount, paid per month or per quarter. This allows a business owner to
interest throughout avoid having to make one lump sum payment, as is done with the repayment of the
its life
principal under interest-only loans.

24 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 However, instalment loans must be repaid constantly throughout the loan
period, which means owners have to ensure that cash is available each month to
meet the repayment. This may put a business under steady pressure for several EXAM SUCCESS
Questions in your
reporting periods. Accounting exam
may state the actual
EXAMPLE 2.3 monthly repayment of
a loan in dollar terms.
On 31 December 2023, Essendon Books borrows $50 000 from the bank over five years. Multiply the monthly
repayment by 12 to
ESSENDON BOOKS: BALANCE SHEET (EXTRACT) AS AT 31 DECEMBER 2023 determine the amount to
be reported as a current
Current liabilities liability. The remainder
Bank loan 10 000 of the loan is then
listed under
Non-current liabilities
non-current
Bank loan 40 000 50 000 liabilities.

The loan involves equal repayments over the five years, so the business must repay
one-fifth of the $50 000 in the next 12 months. To reflect this, $10 000 has been reported
as a current liability, with the remaining $40 000 as a non-current liability.
One year later, the situation would be:

ESSENDON BOOKS: BALANCE SHEET (EXTRACT) AS AT 31 DECEMBER 2023

Current liabilities
Bank loan 10 000
Non-current liabilities
Bank loan 30 000 40 000

As a full year has passed, one-fifth of the loan has been repaid. The business now
owes $40 000 in total to the bank.
Once again, the owner has an obligation due within the next 12 months (another
$10 000), which is reported as a current liability.
The non-current liability will be reduced by $10 000 each year until only $10 000
is left unpaid. When this occurs, the remaining $10 000 amount will be reported as a
current liability.
Note: The loan calculations in these examples only relate to the repayment of the
principal amount borrowed. The payment of interest on loans is treated separately,
because interest payments represent the cost of borrowing money. Interest is
reported as an expense item in each reporting period that the loan exists.

2.3 CHECK YOUR UNDERSTANDING WB PAGE 18

1 Distinguish between an instalment loan and an interest-only loan.

2 State one advantage and one disadvantage of both instalment and interest-
only loans.
3 Most business loans are instalment loans. Describe a business or industry
where interest-only loans may be more suitable. Explain your answer fully.

978 1 4202 3962 1 [CHAPTER 2] BAL ANCE SHEETS 25

 2.4 FINANCIAL TRANSACTIONS AND
BALANCE SHEETS
The balance sheet reports the values of assets, liabilities and owner’s equity at a given
date. These three main groups make up the basic accounting equation.
As you learnt in Chapter 1, two other categories of items are also affected by
transactions:
•• Revenues: Revenues usually arise through the provision of services or the sale of
goods; for example, charter fees for a bus company, ticket sales for a cinema, cash
or credit sales of inventory by a trading firm, and interest on investments.
•• Expenses: Expenses include such items as wages, advertising, rent, insurance,
depreciation of non-current assets and the cost price of inventory sold.
Under the accrual basis assumption of determining profit (see Chapter 1), revenue
earned minus expenses incurred equals the net profit earned for a period. All of the
revenue and expense items relating to a particular reporting period are shown in an
accounting report known as an income statement. The net profit or loss is then added
to or subtracted from the owner’s equity in the balance sheet.
Income statements will be covered in detail in Chapter 12. At this stage, it is
important to understand that revenues increase owner’s equity, while expenses
decrease it.

THE TWO-FOLD EFFECT OF TRANSACTIONS

Every financial transaction entered into by a business will affect at least two items
in the business’s balance sheet. This ‘two-fold’ effect of transactions is the basis of
double entry accounting. Figure 2.8 on the next page demonstrates how individual
transactions have a two-fold effect on the balance sheet of a small business.
In addition, transactions that attract the Goods and Services Tax (GST) have to be
reported in the balance sheet. When GST is collected by a business, it increases the
liability owing to the government. If a business pays GST on items purchased, this
GST liability decreases the GST liability, or may even create an asset (if the business is owed a
an obligation to the GST refund).
ATO because the
business has collected
(or charged) more GST
than it has paid Every financial
GST refund transaction will
an amount owed by affect at least
the ATO because the two items in the
business has paid balance sheet.
(or been charged)
more GST than it has
collected

26 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

FIGURE 2.8 The two-fold effect of transactions on the balance sheet

Transaction First effect Second effect

1 Owner deposited Increase Cash at Bank Increase Capital account

$200 000 cash to account (asset) by (owner’s equity) by
commence business $200 000 $200 000
2 Took out an interest-only Increase Cash at Bank Increase Loan account
loan of $60 000 account (asset) by $60 000 (liability) by $60 000

3 Bought shop fittings for Increase Shop Fittings Decrease Cash at Bank
$20 000 cash, plus GST of account (asset) by $20 000 account (asset) by $22 000
$2000
Decrease GST Liability
account by $2000
4 Purchased inventory on Increase Inventory account Increase Accounts Payable
credit for $25 000, plus (asset) by $25 000 account (liability) by
GST of $2500 $27 500
Decrease GST Liability
account by $2500
5 Sold goods for $3000 cash, [1] Increase Cash at Bank [3] Increase GST Liability
plus GST of $300 (cost account (asset) by account by $300
price of goods sold $1000) $3300 and decrease [4] Increase Capital
Inventory account account (owner’s
(asset) by $1000 equity) by $2000
[2] Total overall increase in [5] Revenue $3000 less
assets $2300 expense $1000 = $2000
profit
Total increase $2300
6 Paid wages for the week of Decrease Cash at Bank Decrease Capital account
$1000 account (asset) by $1000 (owner’s equity) by $1000,
as wages are an expense

Regardless of the nature of the transactions, there will always be at least two items
affected in the firm’s balance sheet.
For example, item 5 in Figure 2.8 shows what happens to the report when goods
are sold for cash:
One asset increases (Cash at Bank by $3300), while a second asset decreases
•• [1] 
(Inventory by $1000).
•• [2] The net effect of this transaction is a total overall increase in assets of $2300.
The GST Liability account increases by $300, because the business collects
•• [3] 
$300 on its sale on behalf of the government.
Owner’s equity also increases by $2000, because this is the actual profit made
•• [4] 
on the sale of the goods. This figure represents the net gain made on the sale.
The inventory sold cost $1000 and was sold for $3000, so the owner ultimately
•• [5] 
experiences a $2000 increase in net worth.
Similarly, in item 6, which involves the payment of an expense, both the Cash at Bank
account and the owner’s equity experience a decrease of $1000.
Always keep in mind that revenue items increase an owner’s equity, while expense
items decrease it.

978 1 4202 3962 1 [CHAPTER 2] BAL ANCE SHEETS 27

 TRANSACTION WORKSHEETS
A second way to show the effect of transactions on the balance sheet is to use a
worksheet. The worksheet is based on the accounting equation, with assets on the
left side and liabilities and owner’s equity on the right side.
The worksheet in Figure 2.9 includes the same transactions as in Figure 2.8, but this
time each item in the balance sheet is changed as the transactions are considered.

FIGURE 2.9 Worksheet approach

Owner’s
Transactions Assets Liabilities
equity

Cash at Inventory Shop GST Accounts Loan Capital

bank $ fittings clearing payable $ $
$ $ $ $
1 Owner +200 000 +200 000
deposited
$200 000
cash to
commence
business
2 Took out an +60 000 +60 000
interest-only
$60 000 loan
3 Bought –22 000 +20 000 -2 000
shop fittings
for $20 000
cash, plus
GST of
$2000
4 Purchased +25 000 –2 500 +27 500
inventory
on credit
for $25 000,
plus GST of
$2500
5 Sold goods +3 300 –1 000 +300 +3 000
for $3000 –1 000
cash, plus =
GST of $300 +2 000
(cost price
of goods
sold: $1000)
6 Paid wages –1 000 –1 000
for the
week of
$1000
Overall 240 300 24 000 20 000 (4 200) 27 500 60 000 201 000
result

The final results of the transactions may then be reported in a formal balance sheet,
using the accounting equation of assets = liabilities + owner’s equity.

28 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

BALANCE SHEET
Assets $ Liabilities $ $
Cash at bank 240 300 Accounts payable 27 500
GST clearing 4 200 Loan from bank 60 000 87 500
Inventory 24 000 Owner’s equity
Shop fittings 20 000 Capital 201 000
288 500 288 500

In relation to the GST, note that the balance of $4200 has been reported as an asset
(GST Clearing). At this point in time, the business has paid $4200 more in GST than it
has collected. Some accounting software may report this as a negative amount in the
current liabilities section of a balance sheet. However, this figure represents a future
benefit to the business (a GST refund), so it should be reported as a current asset.
While this example shows how transactions have a two-fold effect on the balance
sheet, it isn’t practical for real businesses to draw up tables like Figure 2.8 to record
transactions. Later chapters show some of the accounting procedures used in real
businesses. However, such procedures are still based on the principle that every
transaction has a two-fold effect on the balance sheet, no matter how large or small
the business.

PREPARING BALANCE SHEETS FOR EVERY TRANSACTION

A second approach is the preparation of a balance sheet after every transaction.
Again, accountants don’t record transactions this way in practice, but it’s a useful way
to learn about how transactions affect a firm’s accounting equation.
The following transactions relate to the business of Joulian’s Carpets. After each
transaction a new balance sheet has been prepared, showing the firm’s current
financial situation.

1 July AC Joulian deposited $300 000 to commence business

JOULIAN’S CARPETS: BALANCE SHEET AS AT 1 JULY 2023

Assets $ Owner’s equity $
Cash at bank 300 000 Capital 300 000
300 000 300 000

Balance sheet changes:

•• increase in Cash at Bank (asset) of $300 000
•• increase in Capital (owner’s equity) of $300 000.

2 July Purchased inventory for the business for cash at a cost of $30 000,
plus GST of $3000

JOULIAN’S FURNITURE: BALANCE SHEET AS AT 2 JULY 2023

Assets $ Owner’s equity $
Cash at bank 267 000 Capital 300 000
Inventory 30 000
GST clearing 3 000
300 000 300 000

978 1 4202 3962 1 [CHAPTER 2] BAL ANCE SHEETS 29

 Balance sheet changes:
•• Cash at Bank (asset) decreases by $33 000
•• Inventory (asset) increases by $30 000
•• business is owed $3000 for the balance of its GST account.

3 July Purchased a second-hand vehicle for the business at a cost of

$50 000, paying $10 000 cash with the balance payable to Auto
Sales within 60 days

JOULIAN’S CARPETS: BALANCE SHEET AS AT 3 JULY 2023

Assets $ Liabilities $
Cash at bank 257 000 Accounts payable 40 000
Inventory 30 000 Owner’s equity
GST clearing 3 000 Capital 300 000
Vehicle 50 000
340 000 340 000

Balance sheet changes:

•• Cash at Bank (asset) decreases by $10 000
•• Vehicle (asset) increases by $50 000
•• Accounts Payable (Auto Sales) (liability) increases by $40 000.

4 July Paid for advertising $3000 and insurance $2000 (plus GST of $300
and $200, respectively)

JOULIAN’S CARPETS: BALANCE SHEET AS AT 4 JULY 2023

Assets $ Liabilities $
Cash at bank 251 500 Accounts payable 40 000
Inventory 30 000 Owner’s equity
GST clearing 3 500 Capital 295 000
Vehicle 50 000
335 000 335 000

Balance sheet changes:

•• Cash at Bank (asset) decreases by $5500
•• GST clearing goes up by $500 (as these expenses attracted GST)
•• Capital (owner’s equity) decreases by $5000.

5 July Sold goods that cost $4000 for $10 000 cash, plus GST of $1000

JOULIAN’S CARPETS: BALANCE SHEET AS AT 5 JULY 2023

Assets $ Liabilities $
Cash at bank 262 500 Accounts payable 40 000
Inventory 26 000 Owner’s equity
GST clearing 2 500 Capital 301 000
Vehicle 50 000
341 000 341 000

30 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

Balance sheet changes:
•• $4000 worth of goods were sold, so Inventory (asset) decreases by $4000
•• Cash at Bank (asset) increases by $11 000 (including GST)
•• Capital increases by $6000, representing the profit made on the sale ($10 000 - DON’T!
$4000 = $6000). Even though
revenues and expenses
•• GST Clearing (asset) goes down by $1000. affect the owner’s equity,
these items are NOT
Note the change in GST Clearing. The business previously paid $3500 GST but reported in a balance
has now collected $1000 GST on its sales. The $1000 GST it collected has been sheet.
deducted from the GST it paid previously, meaning that the government now owes
the business a GST refund of $2500.

6 July Sold goods on credit for $10 000, plus GST of $1000 (cost price of
inventory sold $5000)

JOULIAN’S CARPETS: BALANCE SHEET AS AT 6 JULY 2023

Assets $ Liabilities $
Cash at bank 262 500 Accounts payable 40 000
Inventory 21 000 Owner’s equity
GST clearing 1 500 Capital 306 000
Accounts receivable 11 000
Vehicle 50 000
346 000 346 000

This transaction is similar to the previous one except that, instead of Cash at Bank
increasing, it results in the creation of an accounts receivable asset.
Balance sheet changes:
•• Accounts Receivable increases by $11 000 (sale of $10 000, plus GST of $1000)
•• GST Clearing decreases by $1000
•• Inventory (asset) decreases by $5000
•• Owner’s equity increases by $5000 ($10 000 – $5000 = $5000 profit).

978 1 4202 3962 1 [CHAPTER 2] BAL ANCE SHEETS 31

 7 July Repaid Auto Sales $15 000 of amount owing

JOULIAN’S CARPETS: BALANCE SHEET AS AT 7 JULY 2023

Assets $ Liabilities $
Cash at bank 247 500 Accounts payable 25 000
Inventory 21 000 Owner’s equity
GST clearing 1 500 Capital 306 000
Accounts receivable 11 000
Vehicle 50 000
331 000 346 000

Balance sheet changes:

•• decrease in Cash at Bank (asset) of $15 000
•• corresponding decrease in Accounts Payable (Auto Sales) (liability) of 15 000.
As you can see, every financial transaction affects the balance sheet of a business
in at least two ways. Revenue earned increases the owner’s claim on the firm, while
expenses incurred decrease the owner’s equity.
Regardless of the nature of the transaction, the accounting equation must always
hold true: assets must always equal liabilities plus owner’s equity.

Individual or summary accounts?

If a business only has a few suppliers providing inventory on credit, it may maintain
individual accounts payable in the general ledger. At the end of the period, the
individual accounts may also be shown in the balance sheet. However, if a business
has numerous accounts payable, it may just provide a summary figure and a total of
the amount.
Similarly, if a business provides goods on credit, entries may be required in
multiple ledger accounts for each individual accounts receivable. Each individual
customer may also be listed in the balance sheet to provide relevant information.
However, if a business has many credit customers, this may clutter up the balance
sheet with unnecessary detail.

2.4 CHECK YOUR UNDERSTANDING WB PAGE 19

1 Explain how revenue and expense items affect the balance sheet of a business.
2 A business has collected GST of $1200 on its cash sales and has paid $400 GST to
its suppliers. Explain how this firm should report GST in its balance sheet.
3 GST may be reported in two different ways in a balance sheet. Describe these,
giving examples as part of your answer.

32 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 2 CHAPTER REVIEW

KEY CONTENT
•• [2.1] 
A balance sheet shows the financial position of a business at a particular point in
time. It provides information on assets, liabilities and owner’s equity, reflecting the
accounting equation: A = L + OE (or OE = A – L)
•• [2.1] Balance sheets can be created in a T-form style or narrative style. Narrative reports
show the same information as T-form reports but may be easier to understand.
•• [2.2]   In order to provide more information about a business, a balance sheet can be
classified to include groups of similar items under headings. Typical headings include:
• Current assets
• Non-current assets
• Current liabilities
• Non-current liabilities
•• [2.3]
A business may borrow money in the form of an interest-only loan or an instalment loan.
Interest-only loan: borrower repays the principal of the loan when loan period has expired.
Instalment loan: borrower makes scheduled repayments of the principal throughout
the life of the loan.
•• [2.4] Transactions such as revenues and expenses aren’t reported directly in a balance
sheet. However, they affect the value of assets, liabilities and owner’s equity, which
are reported.
•• [2.4] All transactions will affect at least two items in a firm’s balance sheet. This ‘two-fold’
effect of transactions is the basis of double entry accounting.

CHAPTER 2 EXERCISES

1 Classifying balance sheet items WB PAGE 20

The following items relate to the business Galaxy Games. For each item, state whether
it would appear in a balance sheet (under the headings ‘Current assets’, ‘Non-current
assets’, ‘Current liabilities’, ‘Non-current liabilities’ and ‘Owner’s equity’) or whether it is
irrelevant.
a Office furniture
b Cash on hand
c Bank overdraft
d Amounts owing by credit customers
e Office equipment
f Inventory of games
g GST refund due from the ATO
h Land and buildings

978 1 4202 3962 1 [CHAPTER 2] BAL ANCE SHEETS 33

 i Mortgage loan
j Office stationery on hand
k Owner’s personal vehicle
l Two-year term deposit made in the name of the business
m Three-year loan taken out by the owner’s husband
n Amount invested by the owner to commence business
o Amounts owing to suppliers of toys and games
p GST owing to the ATO

2 Preparing balance sheets

SPREADSHEET X.XX WB PAGE 20

The owner of Central Office Supplies provides the following information concerning his
business as at 30 September 2023.
•• Cash on hand $200
•• Inventory $56 000
•• Cash at bank $3200
•• Amounts owing by credit customers (accounts receivable) $4400
•• Vehicle $48 000
•• Amounts owing to suppliers (accounts payable) $3300
•• GST liability $300
•• Loan from National Australia Bank (due 31/8/23) $22 000
a Prepare a classified balance sheet as at 30 September 2023.
b State the accounting equation of the firm as at 30 September 2023.

3 Preparing balance sheets

SPREADSHEET X.XX WB PAGE 21

The following information is supplied by the owner of Vintage Vinyl on 31 August 2023.
•• Cash on hand $500
•• Bank overdraft $1000
•• Business premises $720 000
•• Accounts payable $6500
•• Inventory $59 700
•• Accounts receivable $4480
•• Office furniture and fittings $12 000
•• Vehicles – business $31 000 and private $28 000
•• Mortgage loan (due 2034) $180 000
•• Personal home loan $234 000
•• Loan for business vehicle $8000 (repayable over next two years)
•• GST liability $2400
a Using the relevant information from the items listed, prepare a classified balance
sheet for Vintage Vinyl as at 31 August 2023.
b Explain your treatment of the following items:
i vehicle – private ii personal home loan.
Refer to the relevant qualitative characteristic and/or accounting assumption in your
answer.
c  tate the accounting equation in the balance sheet in part a, clearly showing the
S
net worth of the business to the owner.

34 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

4 Preparing balance sheets WB PAGE 22

The following financial items relate to Schulberg’s Car Yard, a business that sells
quality cars.
•• Cleaning equipment $5800
•• Cash at bank $1000
•• Office furniture $5800
•• Starting capital contributed by Renee Schulberg $340 000
•• Accounts payable – Deluxe Car Auctions $129 000
•• Office equipment $4900
•• Inventory of cars $582 000
•• Accounts receivable $109 500
•• Loan from National Australia Bank (due 15/7/23) $15 000
•• Land and buildings $895 000
•• Inventory of cleaning materials $860
•• Mortgage loan on premises $375 000 (repayable $1600 per month)
•• GST paid $10 240
•• GST collected $15 440

Additional information
•• The owner says that she has earned a profit in the two years the business has been
operating, and that these amounts have been retained within the business. The
actual amount of these profits isn’t known.
•• A friend of the owner recently offered her $3500 for the firm’s office equipment.
•• The owner is thinking of buying a computer system for the business during October
2023 for about $2000.
a Prepare a classified balance sheet for Schulberg’s Car Yard as at 30 September
2023.
Explain your treatment of each of the additional information items. Refer to the
b 
qualitative characteristics or any relevant accounting assumptions.

5 The two-fold effect of transactions WB PAGE 22

Jack Rio set up his small business, Jack’s Cabinets, on 1 March 2023. During the first
week, he had the following business transactions:

Mar 1 The owner deposited $375 000 cash to start the business
2 Bought an office desk for $2000 cash, plus GST of $200
3 Purchased inventory for $10 000 cash, plus GST of $1000
4 Bought an office computer for $5000, plus GST of $500, on credit from
City Computers
5 Sold goods that had cost $4500 for $8500 cash, plus GST of $850
6 Paid for advertising $1000, plus GST of $100

Prepare a table to show the two-fold effect of each of these six transactions.
(Hint: Use the format shown in Figure 2.8.)

978 1 4202 3962 1 [CHAPTER 2] BAL ANCE SHEETS 35

 6 The two-fold effect of transactions
SPREADSHEET X.XX WB PAGE 23

The following information comes from the books of Smartphone Select:

May 1 The owner, Alice Dobson, contributed cash of $95 000, Inventory of
$15 000 and a vehicle valued at $25 000 to the business
2 Sold inventory for cash $9000, plus GST of $900 (cost price $4000)
3 Bought second-hand shop fittings for $14 000, paying $4000 deposit
with the balance due in 30 days to Colin Carpenter
4 Sold goods for cash $3000, plus GST of $300 (cost price $1200)
5 Sold goods on credit to S Catania for $2000, plus GST of $200 (cost
price $800)
6 Paid wages for week $500
7 Purchased more inventory on credit from Android Direct $8000, plus
GST of $800
8 The owner withdrew $1000 from the business for personal use
9 Paid advertising of $100, plus GST of $10
10 Received cash from S Catania $1200)

a Prepare a worksheet to show the two-fold effect of the listed transactions for the
period 1–10 May. Follow the format shown in Figure 2.8 and use the following
headings:
Assets: Cash at Bank, Inventory, Accounts Receivable, Vehicle, Shop fittings
Liabilities: GST, Accounts Payable
Owner’s equity: Capital
b Prepare a balance sheet as at 10 May 2023.

7 Transactions and the balance sheet

SPREADSHEET X.XX WB PAGE 24

The following transactions relate to Aberfeldie Camera Supplies. After each transaction,
prepare a new balance sheet for the business and state the accounting equation as at
that date.

2023
Apr 1 Farouk Hussain (proprietor) deposited $100 000 cash to commence
business
2 Bought inventory costing $8000, plus 10% GST, for cash
3 Purchased shop fittings on credit from Fawkner Shop Fitters at a cost
of $16 000, plus GST of $1600
4 Hussain contributed a personal computer valued at $1500 to the
business
5 Borrowed $5000 over three years from NAB
6 Repaid Fawkner Shop Fitters $10 000
7 Paid wages to the assistant of $800
8 Sold goods that had cost $1500 for $3000 cash, plus GST of $300

36 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

8 Preparing balance sheets WB PAGE 27 SPREADSHEET X.XX

Emily Paul is the owner of Kennels & Cages, a small business that specialises in
homes for pets. After each of the following transactions, prepare a new balance sheet
for the business.

2023
May 1 Emily contributed $120 000 cash and $3000 worth of equipment to
start her business
2 Paid first week’s rent of business premises $1000, plus $100 GST
3 Purchased inventory of kennels for $3600 cash, plus GST of $360
4 Purchased inventory of cages for $4400 on credit, plus GST of $440
5 Sold a kennel for $1500 cash, plus GST of $150 (cost price $700)
6 Paid for advertising $300, plus GST of $30
7 Bought a vehicle for $14 000, plus GST of $1400, paying $4000 cash,
with the balance funded by a loan from CAG Finance Co.
8 Emily withdrew $500 for personal use
9 Sold a kennel for $1800, plus GST of $180, on credit (cost price $800)
10 Paid accounts payable $2000

WB PAGE 31 SPREADSHEET X.XX

9 Preparing balance sheets
The following balance sheet and financial transactions relate to Total Turntables. The
business has an overdraft facility with the local bank.

TOTAL TURNTABLES: BALANCE SHEET AS AT 31 JULY 2023

Assets $ Liabilities $ $
Cash on hand 500 GST clearing 1 000
Cash at bank 1 100 Accounts payable 2 400
Accounts receivable 2 800 Loan – NAB 2 000
Inventory 72 500 Loan – EZ Finance 8 000 13 400
Office equipment 14 000
Owner’s equity
Capital – A Taranto 77 500
90 900 90 900

•• Payments to Accounts Payable were $900.

•• Two new turntable sets were purchased on credit at a cost of $1200 each (plus
10% GST) – these were added to the firm’s inventory.
•• Cash collected from Accounts Receivable $1500.
•• A new printer was purchased for the office for $900 cash, plus GST of $90.
•• Sales earned for the month totalled $8000, plus GST of $800, consisting of $3300
received in cash and $5500 to be received during September. (The cost of sales for
the month totalled $4000.)
•• Expenses paid during August were wages $2000, advertising $500 and rent $4600
(GST paid $510).
•• The owner withdrew $4500 from the business for personal use.
•• $1000 was paid off the loan from EZ Finance, and $500 was paid off the NAB loan.

Prepare a balance sheet to show the business’s financial position as of 31 August 2023.

978 1 4202 3962 1 [CHAPTER 2] BAL ANCE SHEETS 37

 CASE STUDY WB PAGE 31

Will Andrews is the owner of a small business trading as Andrews’ Art Supplies. Will
studied Accounting in high school, but his knowledge is a little rusty these days. He has
prepared a balance sheet for his business but has a few queries for you to consider.

Andrews prepared the following statement:

ANDREWS’ ART SUPPLIES: BALANCE SHEET AS AT 31 JULY 2023

Assets $ Liabilities $ $
Cash at bank 2 420 Bank overdraft 5 000
Accounts 5 460 Accounts 6 000
receivable payable
Inventory 42 000 GST clearing 5 260 16 260
Computer 3 000 Owner’s equity
Vehicle 36 000 Capital – W 72 620
Andrews
88 880 88 880

Additional information:
•• The last bank statement Will received, dated 31 July 2023, showed a balance of $2420
in the bank. However, he expects to run low on cash in the next couple of months
and has arranged an overdraft limit of $5000 with the bank. He has included this as a
liability in his report.
•• The inventory on hand cost the business $21 000, but Will always doubles the cost
price to determine the inventory’s selling price. He has shown inventory in the balance
sheet at the value he expects to receive when it is sold.
•• The computer is located at Will’s private home. It was actually purchased by his wife,
but she allows Will to use it to do the books of the business. She bought the computer
for $3000 one year ago.
•• The vehicle is used in the business to transport goods. It was purchased six months
ago for $31 000, but a friend of Will’s, who works in the car trade, tells him: ‘You got it
for a steal. That car normally sells for $36 000!’ Will has accepted his friend’s valuation.

1
SPREADSHEET X.XX Make a list of any qualitative characteristics of accounting, or any accounting
assumptions, that Will Andrews may have breached in preparing the above report. For
each breach you identify, explain your answer fully.
2 Redraft the balance sheet in line with generally accepted accounting practices and
assumptions.
3 State the accounting equation that truly represents the financial position of Andrews’
Art Supplies.

38 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 ETHICAL CONSIDERATIONS WB PAGE 32

Jon Holland is the owner of Network Connect, a small business that specialises in the
supply and installation of Wi-Fi networks for offices. Jon wants to purchase two new
vehicles for his team to use to visit customers and carry installation equipment. He is
concerned about the environment and is thinking of buying hybrid vehicles, rather than
cars with petrol or diesel engines. However, the new vehicles cost as follows.
•• Petrol-driven vehicle: $42 000
•• Diesel-driven vehicle: $46 000
•• Hybrid vehicle: $52 000
While the hybrid vehicles cost more, they may cost less to fuel and maintain on an
ongoing basis.
Jon is unsure about which vehicle to purchase and has asked for your opinion. Discuss
the options available to him and the financial implications of each. Which vehicle do you
recommend he purchase?

ACCOUNTING IN THE REAL WORLD WB PAGE 33

Accounting assumptions apply to every business, big and small. However, when you’re
dealing with larger businesses, there are more transactions to record, more assets to track
and generally more challenging work for an accountant.
To get a better idea of how complex accounting work can be, visit the websites of at
least three of these public companies in the retailing sector:
•• David Jones Ltd
•• Harvey Norman Ltd
•• JB Hi-Fi
•• Woolworths Ltd
Locate the balance sheet for each firm on their site, then create a spreadsheet with the SPREADSHEET X.XX

following elements:
a the name of each company
b the total assets figure from each company’s balance sheet
c the values for current assets and current liabilities for each company
d a list of the companies in order, according to the value of their total assets
e brief comments on your findings.

David Jones Ltd mea.digital/davidjones

Harvey Norman Ltd mea.digital/harveynorman
JB Hi-Fi mea.digital/jbhifi
Woolworths Ltd mea.digital/woolworths

978 1 4202 3962 1 [CHAPTER 2] BAL ANCE SHEETS 39

 CHAPTER CHECKLIST
Now that you have finished Chapter 2, double-check your progress.
Are you ready for your Unit 3 assessment?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
completed all end-of-chapter activities
handed in my workbook for marking.

I understand …

the effect of transactions on the accounting equation

the recording of transactions using manual methods and
ICT including spreadsheets
characteristics and use of classified accounting reports:
– Balance Sheet
ethical considerations in relation to recording and reporting
of accounting information.

I can …

use correct accounting terminology

apply theoretical knowledge to simulated situations
distinguish between current and non-current assets, and current and non-current
liabilities
analyse the effect of financial transactions on the accounting equation.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_2

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

40 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 3 ACCOUNTING SYSTEMS AND
BUSINESS DOCUMENTS

Effective accounting requires LEARNING OBJECTIVES

more than just keeping records of
transactions. Accountants need By the end of this chapter, you will be able to:
to have a system – a consistent •• outline the basic processes in an accounting system
method of collecting, storing [3.1]
and processing financial and
•• describe the requirements of documents in relation to
accounting data to be used by
GST transactions [3.2]
decision makers.
•• distinguish between the procedures involved in cash
In this chapter you will learn
and credit transactions [3.3, 3.4]
how to create and use accounting
systems. You will also learn about •• identify various business documents and describe the
the most common business role of each [3.5]
documents, and how to use them •• identify information flows that occur in a small
within an accounting system. business [3.6]
•• explain the advantages and disadvantages of
computerised systems [3.7]

UNIT 3 – PROGRESS 1 2 3 4 5 6 7 8 9 10 11 12 13

3.2 3.4 3.6

The GST Source Documents

and business documents and Chapter review
3.1 3.3 for credit 3.5 3.7 and exercises
documents information flow
transactions
Source
The basic Computerised
documents Other business
accounting accounting systems
for cash documents
process
transactions

978 1 4202 3962 1 41

 3.1 THE BASIC ACCOUNTING PROCESS
An accounting system is expected to generate particular types of financial information
about a business. This information is usually presented in accounting reports, such
as income statements and balance sheets. Such information has its origins in the
business business documents (e.g. invoices and receipts) where the raw data is created.
documents
documents that record The basic role of any accounting system is to take this raw data, record it
the raw financial appropriately and summarise the results in well-designed reports.
data of a business’s
transactions
FIGURE 3.1 The accounting process

Collection of raw data Recording of data Reporting of results

The success of a business’s accounting system will depend on the accounting

records and business documents it uses. These documents are the starting point of
the accounting process, so they must contain all the required details of the business’s
financial transactions.

DOCUMENT MANAGEMENT
Standard practice is to produce and retain copies of all business documents, to create
a permanent record of all financial events. Often these are digital copies, but some
businesses need to retain physical copies. Large businesses often make multiple
copies of their business documents, because there are many different users of the
same accounting data.
For instance, in a large trading business, the system might work as follows.
•• The original document is issued to the customer.
•• A white copy is sent to the general accounting department.
•• A
 blue copy is used by the accounts receivable department to update customer
accounts.
•• A green copy is used to update inventory records.
Each department needs specific details of the transaction. The colours make it easy to
identify where the document is to be used.
Small businesses don’t need as many copies and can take a simpler approach.
They might keep a single physical copy and perhaps a digital copy.

3.1 CHECK YOUR UNDERSTANDING WB PAGE 35

1 State the three basic steps in the accounting process.

2 Explain why it’s important to produce copies of all business documents.
3 How many copies should be made of business documents? Explain your answer fully.

42 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

3.2 THE GST AND BUSINESS DOCUMENTS
EXAM
The 10% Goods and Services Tax was introduced by the Australian government SUCCESS
The GST features on
in 2000, and has since become part of everyday life. The GST is applied to most most exam questions.
products and services, with a few exceptions such as fresh food. Businesses collect Make sure you know
the tax as part of their transactions. They then pay the recorded amount to the how to record and report
GST, but also revise
Australian Taxation Office on a regular basis. the related theory,
Businesses that collect GST register with the ATO and receive an Australian including how to
business number (ABN). The ABN is used as a reference for tracking GST transactions classify the GST in
a balance sheet.
and should appear on all business documents.
Almost all business documents require GST to be tracked and calculated, as it is a
basic part of doing business in Australia.

TAX INVOICES
When the GST legislation came into force, it led to the creation of a document
known as a tax invoice. Businesses issue a tax invoice whenever they provide tax invoice
goods or services to a customer. The tax invoice should contain several key pieces of business document
used to provide
information, including: evidence of
•• the name of the business providing the goods or services transactions that
include GST
•• the business’s ABN
•• the words ‘Tax invoice’ near the top of the document
•• a pre-printed document number (used as a reference number)
•• the date of the transaction
•• a description of the goods or services provided
•• the purchaser’s name, together with their address or ABN, if the transaction was
for $1000 or more
•• the GST-exclusive price, the GST amount and the GST-inclusive price for each item,
together with totals for these.
Figure 3.2 shows a typical tax invoice. This document satisfies the demands of the
ATO and gives the customer the details they need about their transaction.

FIGURE 3.2 A typical tax invoice

SANTO’S SPORTS STORE TAX INVOICE 1321 ABN 11 122 233 344
82 Queens Avenue
North Melbourne VIC 3051 Date: 13 Jan 2023
To: Brunswick Primary School Terms: 30 days
12 Sydney Road
Brunswick VIC 3056
Description Qty Unit price Subtotal GST Total
Junior footballs 10 $30.00 $300.00 $30.00 $330.00
Indoor soccer balls 20 $20.00 $400.00 $40.00 $440.00
Totals $700.00 $70.00 $770.00

Total (excluding GST) $700.00

Santo’s Sports Total GST payable $70.00
– Specialists in sporting supplies for schools Total Amount Payable (including GST) $770.00

978 1 4202 3962 1 [CHAPTER 3] ACCOUNTING SYSTEMS AND BUSINESS DOCUMENTS 43

 Although an invoice (page 43) is normally used to verify a credit transaction, some
businesses modify their tax invoices so that they can be used as evidence of a cash
sale. This simply involves printing ‘Cash receipt’ at the top of the document next to
‘Tax invoice’. The business must also remove any credit terms from the document, as
credit isn’t being extended. The document will then comply with ATO requirements,
while still providing the information the business owner needs.

GST AND RECEIPTS

Many small business owners don’t provide credit and only make cash sales. These
businesses cannot issue a formal tax invoice like the one in Figure 3.2. Instead,
they simply issue a cash register receipt at the time of sale. However, they still have
an obligation to keep track of all GST collected, and this should be stated on cash
receipts issued to customers.
‘Cash’ in this context refers to any non-credit based payment – it can be physical
banknotes and coins or digital funds, so long as the company isn’t extending credit to
the customer.
Figure 3.3 shows a cash receipt that complies with ATO requirements.

FIGURE 3.3 A typical cash register receipt showing GST charged

Centro Stationery
ABN 11 212 454 777
Date: 12/2/23
TAX INVOICE

1 box blue pens $5.50

1 box red pens $5.50
1 pkt printer paper $6.60
1 pkt office paper $7.70

Total payable $25.30*

Cash received $30.00
Change $4.70

*Total includes GST of $2.30

Received with thanks. Please call again.

Despite the words ‘Tax invoice’ on this document, this isn’t a credit transaction. It
is simply evidence of a receipt of cash. Legislation still requires that the words ‘Tax
invoice’ are used on such a document.
Note that the total GST collected is shown as a separate item on the bottom of
the receipt. This is important, because the business owner must be able to record all
receipts and payments of GST transactions.

3.2 CHECK YOUR UNDERSTANDING WB PAGE 36

1 Explain the role that business documents play in relation to the GST.
2 What is a tax invoice? Explain your answer fully.
3 State six different items that should be noted on a tax invoice.

44 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

3.3 SOURCE DOCUMENTS FOR CASH
TRANSACTIONS
There are several basic business documents that businesses use repeatedly in their
day-to-day activities. These are known as source documents, because they are the source documents
source of the original accounting data. business documents
that are the source of
To use documents as part of an accounting system, you must be able to identify financial data
the document, describe its function, and transfer its details to the appropriate
accounting record.
The most common business transactions are those involving cash inflows
(receipts) and cash outflows (payments).

CASH RECEIPTS
The document used to provide evidence of a cash inflow is a cash receipt. If a cash receipt
business receives cash, it issues a receipt to the customer and keeps a copy for itself. business document used
to verify that cash has
Older cash registers create paper copies, while newer ones create digital records, but been received from
the principle remains the same. At the end of the business day, the retained copies an outside entity
provide the owner with the total of all cash received.

Handwritten receipts
In addition to the receipt shown in Figure 3.3, a small business might issue a simple
handwritten receipt (see Figure 3.4). Although they are becoming less common, they
are still used by some traders. These receipts provide only the essential information:
the customer’s name, the date of the transaction and the amount of cash received.
Best practice is to write the amount received in both words and numbers, to
make it totally clear how much has been received. This also helps to prevent fraud, by
making it harder for someone to change the numbers on the receipt at a later date.

FIGURE 3.4 A typical handwritten cash receipt

MB Costuming Supplies ABN 04 213 984 618 Rec. 32

1004 Hoffmans Road
Essendon VIC 3040
Date: 16/1/23
Received from: L Palmer        
The amount of:    Four hundred dollars    $ 400.00
For: Payment on account        
Signed:   M Bateman              Thank you for your business

EFTPOS receipts
Changes in technology always influence accounting processes. There was a time
when all cash inflows involved literal cash, but now electronic transfers of funds are
commonplace, even in small businesses. The introduction of affordable, hand-held
devices to complete electronic transfers has changed how small businesses operate
on a day-to-day basis.

978 1 4202 3962 1 [CHAPTER 3] ACCOUNTING SYSTEMS AND BUSINESS DOCUMENTS 45

 EFTPOS EFTPOS systems allow businesses to record EFT receipts of cash, provide a copy
Electronic Funds
of the transaction to customers, and have funds deposited directly into their business
Transfer at Point of Sale
bank account. An added bonus is that the business handles less cash in carrying out
EFT receipt
document issued when its daily banking.
an EFT payment An EFTPOS terminal accepts both debit and credit cards, with no risk to the
has been made
business owner. However, when a credit card is used, the business owner isn’t
actually making credit available to a customer; such a sale is as good as cash to the
business owner. The bank is responsible for chasing up the amount owing via its usual
credit card practices, but the business that makes the sale will usually have the cash
in its account within 24 hours.

Paywave systems
may bring us
closer to a
cashless society.

The introduction of ‘tap and go’ or ‘paywave’ technology has seen a significant
increase in the use of both debit and credit cards. Some people see this as evidence
that we are moving towards a cashless society. The documentation relating to
EFTPOS transactions is therefore even more important for business owners, as it will
provide most of the information they need about their business’s sales activity.

FIGURE 3.5 A typical receipt from an electronic transfer of funds

ACME BANK
MB Costuming Supplies
1004 Hoffmans Road
Essendon 3040

CUSTOMER COPY
Merchant number: 312103
Terminal number: XY2132

PURCHASE
DEBIT MasterCard …….1355
Date/time: 26/02/23 11:57:30
Authorisation: 2419944
TOTAL: AUD $45.00

Figure 3.5 shows the details required by both the business and the customer,
including:
•• the name of the bank used by the business, which is linked to the EFTPOS
terminal (ACME Bank)
•• the name and address of the business making the sale (MB Costuming Supplies)

46 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

•• identification numbers for the EFTPOS terminal (merchant number and terminal
number)
•• the last four digits of the card being used (1355)
•• the date and time of the transaction (26 February 2023 at 11.57 a.m.)
•• an authorisation number (2419944)
•• the total dollar value of the transaction ($45 Australian, or AUD).
This receipt is a copy for the customer to keep for their records. The EFTPOS terminal
also produces a copy for the business’s records, which it should store for checking at
a later date. Banks usually provide a summary of EFTPOS transactions, which can be
printed on a daily basis by the terminal.

Cash payments
Traditional business practice was to always make cash payments by cheque. This
method automatically provided the business with a permanent record of all its
payments. The business’s bankers could verify all payments made by cheque, so proof
of payment could always be provided. The details of all cheques would be copied onto
the cheque butt, which acted as the copy of the original document.

Cheques were
once common but
are now being
phased out.

However, cheques are no longer commonly used in Australia, and are likely to
be phased out entirely by the early 2020s. EFTPOS terminals and online payment
systems have changed the way most businesses record both their sales and their
payments. Electronic transfers of funds are now the most efficient way of paying
suppliers. This has eliminated the use of cheques for almost all small business
owners.
EFT payments will be listed on bank statements, which are usually prepared bank statement
document that
monthly. The business owner can easily check all transactions via these statements. summarises all cash
They can also print or save a copy of any EFT payment at the time of payment if transactions between a
bank and its customer
required.

3.3 CHECK YOUR UNDERSTANDING WB PAGE 36

1 Why are business documents known as source documents?

2 Identify the two source documents used to provide evidence of cash transactions.
Describe the nature of each type of transaction.
3 Describe two benefits, for a small business owner, of using an EFTPOS terminal.

978 1 4202 3962 1 [CHAPTER 3] ACCOUNTING SYSTEMS AND BUSINESS DOCUMENTS 47

EXAM
SUCCESS 3.4 SOURCE DOCUMENTS FOR CREDIT
When recording from TRANSACTIONS
an invoice, always
check the name of
the business for which
Many businesses make credit available to their regular and trusted customers, which
you’re accounting. allows them to receive goods or services but pay for them later. Similarly, most
Remember, an invoice trading businesses purchase their inventory on credit from their suppliers. Buying
can be for a sale or
a purchase – check
inventory for cash can drain the liquid resources of a business, while trade credit
which one is provides time for a business to sell some of its inventory before accounts payable
happening. have to be paid.
Source documents are needed to provide evidence of all such credit transactions.

INVOICES
invoice An invoice informs a credit customer of the total cost of the goods provided. When goods
document that shows are purchased on credit, an invoice records the cost of the goods supplied. Invoices can
the creation of a
debt when a credit be both received and issued by businesses when buying and selling on credit.
transaction has For example, MB Costuming Supplies buys inventory on credit from its suppliers
taken place and provides products on credit to its customers. In this case, the business receives
an original invoice from its supplier whenever it purchases inventory items on a credit
basis. If MB Costuming Supplies sells goods on credit, it issues an invoice to the
account receivable and keeps a copy for accounting purposes. The invoice informs a
customer of the amount owing for a sale made on credit.
Figure 3.6 shows an invoice received when MB Costuming Supplies purchased goods.
Figure 3.7 shows an invoice issued by the same business when it provided goods on credit.

FIGURE 3.6 A typical purchase invoice

Central Tailoring Supplies TAX INVOICE DF8124

1804 Queensberry Street ABN 22 233 344 455
North Melbourne VIC 3051 Date: 12/3/23
To: MB Costuming Supplies Credit terms: 30 days
1004 Hoffmans Road, Essendon VIC 3040
Description Quantity Unit price Subtotal GST Total
Dressmaking scissors 12 $40.00 $480.00 $48.00 $528.00
10 mm clear buttons 100 $0.10 $10.00 $1.00 $11.00
Totals $490.00 $49.00 $539.00

Total (excluding GST) $490.00

Total GST payable $49.00
Total amount payable (including GST) $539.00

48 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

FIGURE 3.7 A typical sales invoice

MB Costuming Supplies

TAX INVOICE 124
1004 Hoffmans Road ABN 33 344 455 566
Essendon VIC 3040
Date: 21/3/23
To: L Barnes
98 Charles Road, East Malvern VIC 3145
Description Quantity Unit price Subtotal GST Total
1 m red nylon fabric 2 $10.00 $20.00 $2.00 $22.00
25 mm black rectangle buckle 6 $2.50 $15.00 $1.50 $16.50
Totals $35.00 $3.50 $38.50

Credit terms: Strictly 30 days Total (excluding GST) $35.00

Total GST payable $3.50
Total amount payable (including GST) $38.50

3.4 CHECK YOUR UNDERSTANDING WB PAGE 37

1 Why are some business documents pre-printed with sequential numbers?

2 Describe two different circumstances where an invoice may be used to provide
data about financial transactions.
3 Explain how an invoice can be used by management to help meet the demands
of the qualitative characteristic reliability.

3.5 OTHER BUSINESS DOCUMENTS

An accounting system gathers most of its data from source documents such as
invoices, payment forms and receipts. However, a business may use many other
documents in its daily operations.

MEMOS AND INTERNAL TRANSACTIONS

Sometimes a business makes a transaction that doesn’t involve another business
or individual; it only affects the business and its owner. These are known as internal
transactions, because they don’t involve external parties. Typical internal transactions
involve the owner contributing or withdrawing assets other than cash.
Contributions or withdrawals of cash can be recorded using the same documents
the business uses to record receipts and payments. However, if an owner withdraws
inventory from the business, none of the documents you have learnt about so far are
suitable. Invoices, receipts and EFT records are all designed for specific purposes
– a withdrawal of inventory isn’t one of them. Some businesses may also donate
inventory items for advertising purposes, or simply as a charitable act.
The identity of the recipient of withdrawn inventory isn’t important; the inventory
given away must still be accounted for, just like any other financial event. The cost or
memo
benefit of inventory changes must be recorded, and a note written to verify donations
note used to
made to organisations. As with all business documents, these notes – called office record internal
memorandums, or memos – can be used to provide verifiability. transactions

978 1 4202 3962 1 [CHAPTER 3] ACCOUNTING SYSTEMS AND BUSINESS DOCUMENTS 49

 Memos are another example of source documents, used to provide evidence of
internal transactions. Memos should be very simple in their design, as they are used
to record a range of unusual transactions.

FIGURE 3.8 A typical memo

MB Costuming Supplies

Date: 25/3/23
Office memo: W
 ithdrawal of one tailoring mini-torso
on stand
Cost price: $210
Memo No. 346 Signed: M Bateman

The memo in Figure 3.8 has all the details necessary to ensure that this internal
transaction isn’t overlooked. It shows the date of the transaction and includes a
brief description of the event. It also provides evidence of the cost price of goods
withdrawn by the owner. This information can be noted in the records of the business
on the appropriate date.

STATEMENTS OF ACCOUNT
A business that provides credit to its customers must ensure that accounts are
collected promptly. Many businesses allow their customers 30 days to settle their
accounts; some may allow 60 or even 90 days.
As multiple business documents may move between the business and a customer
statement of in any given month, there is a need to regularly review the situation. A statement
account of account is used to summarise the transactions involving a credit customer over
business document
issued to credit a given period (see Figure 3.9). Common business practice is to issue monthly
customers, statements of account.
summarising
transactions The statement should show the balance owing at the start of the month, all
between the customer purchases made during the month and any payments made in that time. The final
and the supplier figure on the monthly statement is the amount currently owing to the business.
A statement of account provides a compact summary of the month’s transactions.
It should also include references to any source documents relating to the transactions
that have occurred.

FIGURE 3.9 A typical statement of account

Central Tailoring Supplies Statement for: March 2023

1804 Queensberry Street Date: 31/3/23
North Melbourne VIC 3051
In account with: MB Costuming Supplies
1004 Hoffmans Road
Essendon VIC 3040
Date Details Debits $ Credit $ Balance $
Mar 1 Balance 300.00
Mar 3 Payment – thank you 300.00 0.00
Mar 12 Invoice DF8124 539.00 539.00
Mar 22 Invoice DF8168 56.00 595.00
BALANCE AT END OF MONTH 595.00

50 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

ORDER FORMS
An order form is used to request that a supplier deliver goods or materials to a order form
business (see Figure 3.10). However, placing an order isn’t a financial transaction. business document
that requests goods or
Orders may be changed or even cancelled. services from a supplier
When the goods are delivered, a payment form may be completed or an invoice
received, depending on whether it is a cash or a credit purchase. At this point, a transaction
has occurred, and the payment form or invoice becomes the source document.

FIGURE 3.10 A typical order form

MB Costuming Supplies Order No. 980

1004 Hoffmans Road
Essendon VIC 3040 Supplier:Central Tailoring Supplies
1804 Queensberry Street
North Melbourne VIC 3051
Please supply the following:
Quantity Description
12 Dressmaking scissors
100 10 mm clear buttons

Delivery requirements: Urgent – will pick up Signed: M Bateman

QUOTATIONS
A quotation, commonly called a quote, is an estimate of costs provided to a potential quotation
business document
customer (see Figure 3.11). that provides a
As with order forms, a quotation isn’t a source document because a transaction potential customer
with a cost estimate for
hasn’t yet occurred. The quotation may be rejected or need to be modified. The goods or services
customer has to agree to the price, and the business has to supply the goods or
perform the job, before a transaction has occurred.

FIGURE 3.11 A typical quotation form

MB Costuming Supplies Quotation No. 380

1004 Hoffmans Road
Essendon VIC 3040 Quote prepared for:
B Downe
321 Grieve St
North Coburg VIC 3058
Description

Supply of 40 metres of non-stretch cotton lace @ $5 per metre: $200.00

Delivered to above address

N.B. Quotation valid for 30 days only Signed: M Bateman

978 1 4202 3962 1 [CHAPTER 3] ACCOUNTING SYSTEMS AND BUSINESS DOCUMENTS 51

 DELIVERY DOCKET
A delivery docket is often included with a parcel of goods when a delivery is made
by a supplier. The business or person buying the goods is often asked to sign a copy
of the delivery docket, as this may be used as evidence that the goods have been
delivered and accepted by the purchaser. Delivery dockets do not usually have cost
prices stated. Rather, they simply state a description of the goods and the quantity
being delivered. These details will be stated on the invoice later, along with the actual
costs being charged. It should be noted that the details of a delivery docket are NOT
recorded in the accounting system. This takes place when the invoice is issued and all
costs, including GST, are formally advised.

SHIPPING CONFIRMATION
With many businesses now selling goods online, a shipping confirmation (also known
as an order confirmation) is now in common use. Once an order has been placed
online and the goods have been dispatched by the supplier, a shipping confirmation
will be sent to the customer. This is usually done via email, with many business
providing a confirmation number. In some cases, this number allows the customer
to ‘track’ the process of their delivery. With so much business being done via online
sales, the shipping confirmation has become an important part of business. However,
this document is another example of a non-recordable event. Just as an order is not
recorded in the accounting system, neither is an order or shipping confirmation. The
financial transaction will be recorded when cash changes hands, an invoice is issued
or an EFT is completed.

3.5 CHECK YOUR UNDERSTANDING WB PAGE 38

1 Describe the purpose of a statement of account.

2 State three different types of entries that may appear on a statement of account.
3 Explain why order forms and quotations don’t result in a financial transaction for
accounting purposes.

52 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 DOCUMENTS AND INFORMATION
3.6 FLOW
The source documents described so far are common to almost all businesses.
However, a trading business designs its accounting system to suit its own individual
needs, and it may require other documents to be recorded and analysed. Other
documents used may include cash register rolls, delivery dockets, employee pay slips
and bank statements, all of which may supply valuable data for accounting purposes.
The distribution of data in a business, which then informs actions and decision
making within the business, is known as information flow. Accounting systems information flow
are an integral part of information flow, as they record the business documents and the distribution of data
through a business
generate the reports that keep information moving. Accountants need to be able to
trace that information back to the original source documents in each case.

AN INFORMATION FLOW EXAMPLE

Figure 3.12 shows one extended information flow that could occur in the day-to-
day operations of a costuming retailer. The relevant business documents are shown
in brackets where applicable. This simple example shows the vital nature of the
information contained in business documentation.

FIGURE 3.12 A typical information flow, including business documents

Order form sent to Goods delivered by Supplier charges Supplier sends

wholesale supplier supplier (delivery business for goods statement at end of
(order form) docket) provided (purchase month (statement of
invoice) account

Business pays for Customer orders Goods provided to Customer pays for
goods supplied earlier goods from retailer customer (sales goods provided (receipt
(EFT receipt) (order form) invoice) or EFT record)

Additional inventory Sales staff are paid

is ordered from commission
supplier (order form) (EFT record)

Figure 3.12 doesn’t show all the possible information flows for this situation, but
it does show the importance of business documents in providing information for
management.
Documents will move in and out of a business on a continuous basis throughout
a reporting period. As information will be transmitted between many business
entities, it is vital that management follows an organised approach. This is the key to a
successful accounting system.

978 1 4202 3962 1 [CHAPTER 3] ACCOUNTING SYSTEMS AND BUSINESS DOCUMENTS 53

 OVERVIEW OF AN ACCOUNTING SYSTEM
Business documents create a great deal of paperwork, yet they are only the starting
point of an accounting system. The actual processes within an accounting system
trace the movement of raw data from business documents through to accounting
reports.
A typical double entry accounting system has eight core processes or elements.
You have already looked at the first of these – source documents. You will learn about
each of the remaining processes in upcoming chapters.

FIGURE 3.13 A double entry accounting system

1 2 3 4
Source documents General journal General ledger Trial balance
Invoices, receipts, EFT Daily entries of Details of individual Listing of all account
documents, and so on transaction data accounts balances (used to check
the general ledger)

5
1 6 7 8
Balance-day Accounting reports Evaluation of Planning for the future
Adjustments Cash flow statement, reports Decisions made for
Revenue and expenses income statement, Evaluating financial the business’s future,
accounts are adjusted balance sheet, and and non-financial including preparing
under the accrual method so on indicators budgets

Figure 3.13 represents a typical double entry accounting system. Refer back to this
flowchart as further topics are introduced, so that you can see how processes and
elements fit into the overall accounting system.

1 Source documents
These are the original sources and records of accounting data, which you have
already examined.

2 The general journal

This is sometimes known as a day book, as it is used on a daily basis to record the
details of the data contained in source documents. The journal represents the start
of the recording process. Ledgers, journals and day books may be physical books or
(more commonly) digital records.

3 The general ledger

A ledger consists of many individual accounts, which are used to record the details
of a particular item. For example, the Wages account contains the information
relating to the wages expense for a period. The Cash at Bank account shows all the
business’s cash transactions.
The general ledger is where the process of double entry accounting occurs. For
each transaction, entries are made in two accounts affected by the transaction. One
of these entries is known as a debit entry, and the other as a credit entry. These
entries contain information transferred from the journal to the ledger accounts. Raw
data from documents is recorded first in the general journal, then posted to the
ledger accounts.

54 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

4 Trial balance
The preparation of a trial balance is a checking procedure to verify that the double
entry procedure has been carried out correctly. The trial balance lists the balances
of all general ledger accounts. It allows you to check that the total of all the debit
entries equals the total of all the credit entries.

5 Balance-day adjustments
Under the accrual method of accounting, profit is defined as revenue earned less
expenses incurred. The information in a trial balance may not necessarily fall in line
with this definition, as the ledger accounts sometimes only include revenue received
and expenses paid.
Therefore, revenue and expense accounts are adjusted on the last day of
the reporting period (i.e. balance day) so that they equal the revenue earned and
expenses incurred.

6 Accounting reports
At the end of each reporting period, accounting reports are prepared to provide the
owners and/or managers with the results of the period’s activities.

7 Evaluation of reports
Once accounting reports have been prepared, the results must be evaluated and
problem areas identified. The business’s performance is usually measured by
comparing results against several criteria.
Areas of evaluation will usually include the business’s profitability, liquidity,
efficiency and financial stability. You will learn more about these areas in later
chapters.

8 Planning for the future

Management decisions should be made based on the current period’s results.
Budgets should be prepared in a variety of areas for future periods, to allow proper
planning decisions to be made. Cash budgets and budgeted income statements
should be prepared on a regular basis.

3.6 CHECK YOUR UNDERSTANDING WB PAGE 38

1 What is a journal? What is its purpose?

2 Outline the function of a ledger.
3 Explain the link between source documents, a journal and ledger accounts.
4 The accounting process doesn’t end when an income statement and a balance
sheet are prepared. Describe two important processes that occur after these final
reports have been completed.

978 1 4202 3962 1 [CHAPTER 3] ACCOUNTING SYSTEMS AND BUSINESS DOCUMENTS 55

 COMPUTERISED ACCOUNTING
3.7 SYSTEMS
The double entry accounting system described above is appropriate for a system where
an accountant makes manual entries on a daily basis. However, most businesses,
particularly larger ones, use computerised accounting systems, with commercial
software packages that take care of all their GST requirements.
For many small business owners, computerised accounting isn’t an option – it’s a necessity.

ADVANTAGES AND DISADVANTAGES

Computerised systems have several advantages:
•• They are more accurate, because human error is removed.
•• They can process data much faster than manual recording processes.
•• They can store large amounts of financial information efficiently.
Computers are reliable and accurate, so they have become a valuable tool for
management. However, the principles of double entry accounting still apply in a
computerised system. The principles of the overall accounting system are basically
the same for both manual and computerised recording methods.
There are two main disadvantages for small business owners considering an
accounting software package:
•• The cost of a computerised accounting system has decreased significantly, but it is
still significantly more expensive than a manual system.
•• The owner must have some computing skill and knowledge, and be willing to
introduce software packages as part of their business’s accounting system.
As with any business decision, the benefits of a computerised system should
be weighed against the costs of installing and using it. A very small business might
decide not to purchase a computerised system, because the volume of data wouldn’t
justify the extra expense. The larger the business, the more likely it is to benefit from
a computerised system.

Computers
have become
essential
accounting tools.

COMPUTERISED SYSTEMS IN PRACTICE

Commercial accounting packages all work on the same basic principle. The system takes
the raw data from the source documents and records it in accounts using the double
entry process. The output of the package acts as a trial balance, providing a summary of
the period’s transactions; some packages will also prepare the actual accounting reports.
A computerised package removes most of the need to record information manually.
This means the owner can focus more on evaluating the information generated by the
software.

56 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 Figure 3.1 (page 42) showed the basic accounting process in a manual system.
This diagram can be modified to show the basic steps in a computerised system.

FIGURE 3.14 The accounting process (computerised system)

Processing of data Output of information

Collection of raw data Data input
by software (reports)

Figure 3.14 highlights the fact that the computer is merely a tool used by
management to generate the required accounting information.
It is important that the business clearly defines its requirements before it
purchases and implements accounting software. Accounting packages are of little
use if they don’t produce the information the business requires. Software should also
make the process of recording and reporting more efficient. If there is no obvious net
benefit, the owner shouldn’t introduce a computerised system.

CHOOSING AN ACCOUNTING PACKAGE

There are several commercial accounting packages now in common use;
MoneyWorks, Mind Your Own Business (MYOB), QuickBooks and Xero are all popular
in Australia. All of these packages are relatively cheap, fairly simple to use, and
marketed as complete accounting systems for small businesses. They have been
created for use on a personal computer – or even on a tablet – and are an ideal tool for
a small business owner to keep track of a business’s financial affairs.
Typical accounting programs can be used to:
•• create business documents (order forms, invoices, statements, etc.)
•• record receipts and payments
•• record credit transactions
•• record inventory movements
•• prepare bank reconciliations
•• record all GST transactions
•• prepare accounting reports.

The aim of such programs isn’t to drive accountants out of business. In fact, many
accountants advise their clients to use such software so that the business keeps
organised records. The programs provide a structure that the user must follow. A
business owner is given reminders and checklists to ensure that all processes have
been completed properly. At the end of the year, of course, they should seek advice
regarding taxation from a qualified accountant.
For a small outlay, business owners can run accounting software that is
comprehensive, accurate and capable of generating a wide range of reports.

3.7 CHECK YOUR UNDERSTANDING WB PAGE 39

1 Identify three advantages of a computerised accounting system compared with a

manual system.
2 Describe the four basic steps in a computerised accounting system.
3 Should all businesses prepare their accounting records and reports by computer?
Explain your answer fully.

978 1 4202 3962 1 [CHAPTER 3] ACCOUNTING SYSTEMS AND BUSINESS DOCUMENTS 57

 3 CHAPTER REVIEW

KEY CONTENT
•• [3.1] 
The basic role of an accounting system is to record and report on financial
transactions. Business documents are the starting point of the accounting process
and provide the details of a business’s transactions.
•• [3.2] Almost all business documents require the 10% Goods and Services Tax to be
tracked and calculated.
•• [3.3] Source documents are core business documents that contain financial data. The
most common source documents for cash transactions are receipts, which record
cash inflow, and payment records, which record cash outflow.
•• [3.4] The main source documents for credit transactions are invoices, which record either a
sale or a purchase.
•• [3.5] Other key source documents include memos, which record internal transactions, and
statements of account, which summarise credit transactions over a period.
•• [3.5] Businesses also generate and use other documents, such as order forms or
quotations. However, these documents don’t record transactions and may not be
considered source documents by all accounting systems.
•• [3.6] Accounting systems are vital to the distribution of data within a business, which is
known as information flow.
•• [3.6] The processes within an accounting system trace the movement of data from
business documents through to accounting reports.
•• [3.7] Most small businesses use computerised, rather than manual, accounting systems.
The principles of the overall system are basically the same for both recording
methods.

CHAPTER 3 EXERCISES

1 Business documents WB PAGE 40

The following transactions relate to Anile’s Auto Parts. For each transaction, indicate the
business document used by the business.
Transaction
1 Charged a customer for a credit sale
2 Paid cash for spare parts
3 Received cash for goods sold
4 Sold goods via EFTPOS terminal
5 Purchased spare parts on credit
6 Paid monthly rent
7 Sent a bill to a customer for goods received
8 Paid accounts payable by EFT

58 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 WB PAGE 41
2 Identifying documents
Consider the following document, which was found in the offices of Ballarat Lighting.

BALLARAT LIGHTING No. 101

Shop 12 Henderson Road
Ballarat VIC 3350 Supplier: Zang Electricals
84 Grieve Street
Date: 5/4/23
Northcote VIC 3070
Please supply the following
Quantity Description
6 Tracey ceiling fans (with lights) – product No. 34211
10 Calypso desk lamps – model D321

Delivery required by 30/4/23 Signed: Alan Pitson

a What is the name of this document?

b Which business would have created this document?
c Will this document lead to the creation of other business documents in the future?
Explain your answer fully.
d Describe the two-fold effect that this document would have on the balance sheet of
Ballarat Lighting.

3 Credit transactions WB PAGE 41

The manager of Hernandez Handcrafted has the following document in his possession.

TOPLINE TIMBERYARD No. 24512

Geelong Road ABN 31 921 291 129
West Footscray VIC 3012 Date: 2/5/23
To: HERNANDEZ HANDCRAFTED Terms: 30 days
5 Charles Street, Hurstbridge VIC 3099 TAX INVOICE
Quantity Description Cost Sub-total GST Total
10 1000 × 100 × 50 mm treated pine $9.00 $90.00 $9.00 $99.00
20 3-metre sleepers $8.00 $160.00 $16.00 $176.00
Totals $275.00

Total (excluding GST) $250.00

Total GST payable $25.00
Total of this Invoice (including GST) $275.00

a What is the name of this document?

b What is the nature of the transaction shown in this document?
c Would Hernandez Handcrafted have created this document? Explain your answer.
d Explain what the note ‘Terms: 30 days’ means.
e Who has a GST debt to the ATO as a result of this transaction? Explain your answer
fully.
f Describe the two-fold effect this document has on the balance sheet of:
i Hernandez Handcrafted ii Topline Timberyard

978 1 4202 3962 1 [CHAPTER 3] ACCOUNTING SYSTEMS AND BUSINESS DOCUMENTS 59

 4 Credit transactions WB PAGE 42

Consider the following document.

AAA Stationery No. 6572

9121 Flinders Street ABN 37 217 771 178
East Melbourne 3002 Date: 4/2/23
Account name: City Cabs, 24 Spencer Avenue Terms: 30 days
Prahran VIC 3181 TAX INVOICE

Quantity Description Cost Sub-total GST Total

5 Reams 80 gsm printer paper $7.00 $35.00 $3.50 $38.50
20 A4 office pads $1.50 $30.00 $3.00 $33.00
$71.50

Total (excluding GST) $65.00

Total GST payable $6.50 All accounts are net 30 days

Total of this Invoice (including GST) $71.50

a Which business would have:

i created this document ii received this document?
b What type of document is this, and what is its purpose?
c What is the purpose of the number 6572 on this document?
d Explain how this document affects the balance sheet of AAA Stationery.

5 Cash transactions WB PAGE 43

Ava’s Aquarium Sales has a copy of the following document.

AVA’S AQUARIUM SALES ABN 04 213 984 618 No. 135

17 John Street
Williamstown VIC 3016
Date: 26/2/23
Received from: B Mason        
The amount of:   Fifty dollars    $ 50.00
For: Payment on account No. 11022      
Signed:    A Sharon              Thank you for your business

a What is the name of this source document?

b Explain why the amount is written in both words and numbers.
c A friend of Ava suggests that a computerised system could generate such
documents. Explain to Ava two benefits of using a computer for such a process.
d Describe two disadvantages of introducing a computer into Ava’s business.

60 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 WB PAGE 44
6 Office memos
Mara Brasco is the owner of Brasco’s Barbequing. She has provided you with the
following business documents.

BRASCO’S BARBEQUING
B
 RASCO’S BARBEQUING
Date: 3/3/23
Date: 22/2/23
Office memo: Donation of twin grill w/ folding cart to Pascoe
Office memo: One twin grill: cost $550
Vale Primary School for raffle prize
One BBQ smoker: cost $150 (Son’s birthday)
Cost price $690
Memo No. 101 Signed: M Brasco
Memo No. 102 Signed: M Brasco

a Describe the two transactions recorded on the two office memos.

b Explain why memos such as these are necessary.
c Explain the two-fold effect of memo number 101 on the balance sheet of Brasco’s
Barbequing.

WB PAGE 44
7 Identifying documents
The following document was found in the offices of Point Cook Computers, a small
business owned and operated by Brian Moloney.

POINT COOK COMPUTERS ABN 21 546 434 379

999 AVIATION ROAD Date: 30 June 2023
POINT COOK 3030
Statement for: Alessio & Associates
231 Geelong Road, Laverton VIC 3028
Date Details Debits $ Credit $ Balance $
1 Jun Balance 540
8 Jun Invoice 37282 430 970
15 Jun Payment – with thanks 540 430
24 Jun Invoice 37314 560 990

a What is the name of this business document?

b Which business:
i created the document? ii received the document?
c In a balance sheet prepared by Brian Moloney, under what heading would you
expect to find Alessio & Associates?
d Describe the nature of the transaction that occurred on 24 June.
e Explain the purpose of this document.

978 1 4202 3962 1 [CHAPTER 3] ACCOUNTING SYSTEMS AND BUSINESS DOCUMENTS 61

 WB PAGE 45
8 EFT transactions
Jack Chrystie, the owner of Northern Speed Cycle, has provided the following business
documents for your use.

EFT Receipt No. JA125112 Amount $2600

From Account: 04-546 8010 1956

Northern Speed Cycle WESTERN BANK

To Account: 099-404 1512 9125

AXE Sports Wear STATE BANK

Tuesday 4 April 2023 11.05 a.m.

a Describe the nature of the transaction evidenced by this document.

b Which common business document has been replaced by the above document?
Explain your answer fully.
c With which bank does AXE Sports Wear do its banking?
d In a balance sheet prepared for Northern Speed Cycle, under which classification
would you expect to find AXE Sports Wear? Justify your answer.

WB PAGE 46
9 Identifying documents
The following two documents have been generated by Valerie Horne, the owner of
Fawkner Fashions.

ACME BANK ACME BANK

Fawkner Fashions Fawkner Fashions
401 Douglas Avenue 401 Douglas Avenue
Fawkner 3060 Fawkner 3060

CUSTOMER COPY MERCHANT COPY

Merchant number: A2130 Merchant number: A2130
Terminal number: 535 Terminal number: 535

PURCHASE PURCHASE
DEBIT VISA ……. 8231 DEBIT VISA ……. 8231
Date/time: 5/3/23 15.52 Date/time: 5/3/23 15.52
Authorisation: 8382 Authorisation: 8382

TOTAL: AUD $68.00 TOTAL: AUD $68.00

a What are the names of these two documents?

b Explain why Horne has generated the two documents shown, and explain the
purpose of each of them.

62 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 CASE STUDY WB PAGE 46

Lynne Gray has decided to establish a small business, trading as Bayside Barista Beans.
She is unsure about a few organisational matters relating to the accounting needs of her
business, and has asked you for advice.
She provides you with the following notes:
•• A friend has advised Lynne to keep copies of all documents used in the day-to-day
affairs of her business.
•• She expects that most of her sales will be for cash, but occasionally she may sell on
credit to local schools.
•• She is considering seeing her bank to arrange an EFT terminal for her business.
•• Several coffee bean suppliers will provide the inventory she plans to sell. Lynne expects
all those suppliers to provide her with trade credit terms of 30 days.
•• Similarly, she may extend credit terms to customers with a proven credit history.
•• As most of her sales will be for cash, she anticipates always having cash in the register,
so paying her expenses in cash won’t be a problem. (There is a bank branch across the
road from the shop.)

1 Make a list of all the business documents that Lynne could reasonably expect to use in the
operation of her new business. Beside each document name, briefly note its purpose.
2 Which of the business documents you listed will run in sequential order, according to
their document numbers?
3 If Lynne makes a credit sale to a local cafe, name six different items that should appear
on the document she issues to the customer.
4 Lynne is considering using an EFT terminal. Explain to her the benefits of using EFT,
rather than offering credit to her customers.
5 Comment on Lynne’s method of paying expenses using cash from the cash register of
the business.
6 Lynne’s friend advises her that cash register rolls play two roles in accounting for a
small business. Describe these two roles.
7 Explain the link between business documents and the qualitative characteristics of
accounting.
8 Use a spreadsheet to design a tax invoice for Lynne’s business that would satisfy the SPREADSHEET X.XX

ATO in relation to its GST guidelines.

ACCOUNTING IN THE REAL WORLD WB PAGE 49

Accounting software packages are constantly being upgraded to suit the needs of
small businesses. Go online and research the latest programs available in relation to
computerised accounting.
1 Make a list of five accounting packages available for small business owners.
2 Write a brief description of each package, noting any unique features or advantages.
3 Which package do you think would be the most effective and useful to you in your
professional accounting future? Explain your answer.

978 1 4202 3962 1 [CHAPTER 3] ACCOUNTING SYSTEMS AND BUSINESS DOCUMENTS 63

 CHAPTER CHECKLIST
Now that you have finished Chapter 3, double-check your progress.
Are you ready for your Unit 3 assessment?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
completed all end-of-chapter activities
handed in my workbook for marking.

I understand …

documents used by a business to record financial transactions

the effect of transactions on the accounting reports.

I can …

use correct accounting terminology

apply theoretical knowledge to simulated situations.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_3

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

64 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 4 DOUBLE ENTRY RECORDING:
AN INTRODUCTION

In the last few chapters you have LEARNING OBJECTIVES

read mentions of ‘double entry
accounting’ – but what is it, and By the end of this chapter, you will be able to:
why is it useful for accountants •• define ‘double entry accounting’ [4.1]
working with small businesses?
•• state the rules of double entry for the different types
In this chapter you will become
of accounts [4.1]
familiar with the basic concepts of
•• determine when a debit entry or a credit entry is
double entry accounting, before
required in a variety of accounts [4.1]
studying them further in later
chapters. •• prepare an analysis chart showing debits and credits
for a variety of transactions [4.1]
•• state the rules of double entry for assets, liabilities,
owner’s equity, revenues and expenses [4.2]

UNIT 3 – PROGRESS 1 2 3 4 5 6 7 8 9 10 11 12 13

4.2

Double entry
for revenues and
4.1
expenses
Double entry
accounting and Chapter review
the accounting and exercises
equation

978 1 4202 3962 1 65

 4.1 DOUBLE ENTRY ACCOUNTING AND
THE ACCOUNTING EQUATION
double entry Chapter 2 introduced the concept of double entry accounting. You learnt there
accounting that, when a balance sheet is prepared following a financial transaction, two report
accounting system
in which two ledger items are affected by the same dollar amount. This is the essence of double entry
entries, a debit and a accounting: two items are affected by every transaction.
credit, are made for However, it’s not practical to prepare a new balance sheet after every transaction.
each transaction
Instead, accountants prepare a balance sheet at the end of each reporting period,
ledger account
financial record for while the transactions that occur during that period are recorded in ledger accounts.
all details of a All of these ledger accounts are kept together and make up a record called the
particular item general ledger.
general ledger A ledger account is simply a financial record that relates to a particular area
collection of ledger
accounts in which within the business. For example, the details relating to a business’s wages would
double entry be recorded in the Wages account. When wages are paid in cash, the other half of
accounting is used the double entry would be recorded in the Cash at Bank account. If the business
purchased a vehicle for cash, the details would be recorded in a Vehicles account and
the Cash at Bank account.

FIGURE 4.1 Sample ledger accounts

Vehicle
Date Cross-reference $ Date Cross-reference $
1 Mar Cash at bank 16 000

Wages
Date Cross-reference $ Date Cross-reference $
4 Mar Cash at bank 400

Cash at bank
Date Cross-reference $ Date Cross-reference $
Mar 1 Vehicles 16 000
Mar 4 Wages 400

LEDGER ACCOUNTS
A ledger account entry has three parts, completed in the following order:
1 the date of the transaction
2 the name of the other account affected by the double entry (referred to as a cross-
reference)
3 the actual dollar value of the transaction.
As Figure 4.1 shows, for every transaction, there is an entry on the left side of one
account and a corresponding entry on the right side of another account. This is the
nature of double entry accounting: one debit entry and one credit entry for each
financial transaction. The debit side is on the left side of a ledger account and the
credit on the right side.
Ledger account
Date Cross-reference $ Date Cross-reference $
DEBIT SIDE CREDIT SIDE

66 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 There are set rules as to whether an entry is a debit or a credit. The easiest way to
learn these rules is to work from the basic format of a T-form balance sheet:

BALANCE SHEET
ASSETS LIABILITIES
OWNER’S EQUITY

The format of the balance sheet shows the rules of double entry accounting. Assets
appear on the left side of the report and are debit in nature. Liabilities and owner’s
equity are on the right side and are credit in nature.
Assets will usually have debit balances and are increased by debit entries.
Liabilities and owner’s equity accounts will usually have credit balances and are
increased by credit entries.
The opposite is true if an account decreases. Assets are decreased with credits,
and liabilities and owner’s equity are decreased with debits (see Figure 4.2).

FIGURE 4.2 Rules for double entry recording (A, L, OE)

Account classification Increased by Decreased by

Assets Debits Credits

Liabilities Credits Debits

Owner’s equity Credits Debits

RECORDING LEDGER ENTRIES

There is a simple, consistent process for recording entries in ledger accounts.
1 State the two ledger accounts affected by the financial transaction.
2 Classify the accounts according to their balance sheet classifications.
3 State whether the account is being increased or decreased.
4 By referring to the rules of debit and credit, state whether the accounts will have a
debit or a credit entry.
You should follow these steps in sequence until you fully understand the rules of
double entry.

EXAMPLE
4.1 No GST to be recorded
A business purchases a second-hand vehicle for cash.
1 Two ledger accounts are affected: Vehicle/Cash at Bank
2 Balance sheet classifications: asset/asset
3 Increase or decrease: increase/decrease
4 Debit or credit: debit/credit
There is one debit entry and one credit entry, so the rules of double entry are satisfied.
The debit to the Vehicle account is required, because this account has to be increased.
The business has paid cash for the vehicle, so the Cash at Bank account is decreased and
assets are decreased by credit entries.

978 1 4202 3962 1 [CHAPTER 4] DOUBLE ENTRY RECORDING: AN INTRODUCTION 67

 Purchasing a
vehicle is recorded
as two entries in
the accounting
system.

EXAMPLE
4.2 No GST to be recorded

A business takes out a loan.

1 Two ledger accounts are affected: Cash at Bank/Loan
2 Balance sheet classifications: asset/liability
3 Increase or decrease: increase/increase
4 Debit or credit: debit/credit
Both ledger accounts are increased by the transaction. The Cash at Bank account is
increased because the business has received cash via the loan. The Loan account
is increased, because the business now has a present obligation to another entity.
However, one debit entry and one credit entry are still created by the transaction.
You should also get used to recording business transactions that include the GST.

EXAMPLE 4.3
GST to be recorded

A business buys a computer for $2000 cash, plus GST of $200.

In this case, three accounts will be affected by the transaction. You can use the same
approach to determine the debits and credits required.
1 Three ledger accounts affected: Computer/Cash at Bank/GST Clearing
2 Balance sheet classifications: asset/asset/liability
3 Increase or decrease: increase/decrease/decrease
4 Debit or credit: debit/credit/debit
There are two debit entries and only one credit entry. However, once amounts are
included, the entries must balance out. The Computer account is debited $2000, GST
Clearing is debited $200 and Cash at Bank is credited $2200. The two debit entries
therefore equal the same dollar amount as the credit entry to Cash at Bank.
‘GST Clearing’ is the usual title of the account used to keep track of all GST
transactions. Although it is generally viewed as a liability account, it may have either a
credit balance (liability) or a debit balance (asset).

68 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

ANALYSIS CHARTS
Rather than constantly repeating these four steps, an analysis chart can be used analysis chart
table used to break a
for the double entry process. It provides an analysis of a financial transaction, which transaction down into
identifies the double entry for ledger accounts. debit and credit entries
The analysis chart in Figure 4.3 shows how to determine the double entry for a
variety of financial transactions. In Figure 4.4, the actual ledger accounts are prepared,
showing the double entry for each transaction.
Work through the analysis chart to check that you can make the correct double
entry for each transaction.

FIGURE 4.3 Analysis chart

Account Increase/
Transaction Classification Debit/Credit
names Decrease

1 The owner Cash at bank Asset Increase Debit

contributed Capital Owner’s Increase Credit
$25 000 to equity
commence
business
2 The business took Cash at bank Asset Increase Debit
out a loan for Loan Liability Increase Credit
$10 000

3 Purchased a Computer Asset Increase Debit

computer for GST clearing Liability Decrease Debit
$3000 cash, plus Cash at bank Asset Decrease Credit
GST of $300

4 Made a loan Loan Liability Decrease Debit

repayment of $1000 Cash at bank Asset Decrease Credit

5 Bought inventory Inventory Asset Increase Debit

for $600 cash, plus GST clearing Liability Decrease Debit
GST of $60 Cash at bank Asset Decrease Credit

6 The owner Office Asset Increase Debit

contributed furniture Owner’s Increase Credit
an office desk Capital equity
worth $800 to the
business

Notice that dates aren’t used in Figure 4.4. Instead, the numbers where the date is
usually recorded refer to the number of the transaction in the analysis chart (Figure 4.3).
Note the entries that involve the GST. As there are two debits, the credit in the
Cash at Bank account can be combined to show both accounts (e.g. Computer/GST
Clearing).
The inventory account is used to record all movements of inventory in and out of
the business during a period. All purchases of inventory are recorded on the debit side
of the account.

978 1 4202 3962 1 [CHAPTER 4] DOUBLE ENTRY RECORDING: AN INTRODUCTION 69

 FIGURE 4.4 General ledger accounts
Cash at bank
Date Cross-reference $ Date Cross-reference $
EXAM 1 Capital 25 000 3 Computer/GST 3 300
SUCCESS clearing
Always use full titles
in the cross-reference 2 Loan 10 000 4 Loan 1 000
column. GST clearing 5 Inventory/GST clearing 660
must be written – not
just GST or GST Cl. Capital
Date Cross-reference $ Date Cross-reference $
1 Cash at bank 25 000
6 Office furniture 800

Loan
Date Cross-reference $ Date Cross-reference $
4 Cash at bank 1 000 2 Cash at bank 10 000

Computer
Date Cross-reference $ Date Cross-reference $
3 Cash at bank 3 000

GST clearing
Date Cross-reference $ Date Cross-reference $
3 Cash at bank 300
5 Cash at bank 60

Inventory
Date Cross-reference $ Date Cross-reference $
5 Cash at bank 600

Office furniture
Date Cross-reference $ Date Cross-reference $
6 Capital 800

4.1 CHECK YOUR UNDERSTANDING WB PAGE 51

1 Explain what is involved in the process of double entry accounting.

2 Distinguish between a ledger and an account.
3 State the three parts of an entry in a ledger account.
4 Describe how to determine the rules of debit and credit from the accounting
equation.

70 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 DOUBLE ENTRY FOR REVENUES AND
4.2 EXPENSES
Having applied the rules of double entry to the three classifications of A, L and OE,
we can expand them to include the other two types of ledger accounts: revenues and
expenses.
•• Revenues (R) usually cause an increase in assets, leading to an increase in
owner’s equity.
•• Expenses (E) usually cause a decrease in assets, leading to a decrease in
owner’s equity.
As revenue increases owner’s equity, revenue accounts are credit in nature and are
increased by credit entries. Expenses have the opposite effect on owner’s equity: they
are debit in nature and are increased by debit entries.
Figure 4.5 shows the table in Figure 4.2 expanded to include revenues and
expenses.

FIGURE 4.5 Expanded rules for double entry (A, L, OE, R, E)

Account classification Increased by Decreased by

Assets Debits Credits

Liabilities Credits Debits

Owner’s equity Credits Debits

Revenues Credits Debits

Expenses Debits Credits

Revenues
increase assets
and equity,
while expenses
decrease them.

The steps for determining the double entry for a transaction can also be followed for
transactions involving revenues and expenses. The analysis chart in Figure 4.6 has
been created using the same procedures, but this time some of the transactions
involve revenue and expense items.

978 1 4202 3962 1 [CHAPTER 4] DOUBLE ENTRY RECORDING: AN INTRODUCTION 71

 FIGURE 4.6 Analysis chart (including revenue and expenses)

Increase/
Transaction Account names Classification Debit/Credit
Decrease

1 The owner Cash at bank Asset Increase Debit

contributed Capital Owner’s equity Increase Credit
$40 000 to
commence the
business
2 Bought Inventory Asset Increase Debit
inventory for GST clearing Liability Decrease Debit
$5000 cash,
Cash at bank Asset Decrease Credit
plus GST of
$500
3 Bought office Office Asset Increase Debit
furniture on furniture
credit for GST clearing Liability Decrease Debit
$3000, plus Liability
Accounts Increase Credit
GST of $300
payable
4 Sold goods for Cash at bank Asset Increase Debit
$1000 cash, GST clearing Liability Increase Credit
plus GST of
Sales Revenue Increase Credit
$100 (cost
and and
price of goods
sold $600) Cost of sales Expense Increase Debit
Inventory Asset Decrease Credit
5 Paid accounts Accounts Liability Decrease Debit
payable for payable
office furniture Cash at bank Asset Decrease Credit
bought
previously,
$3300
6 Sold goods Accounts Asset Increase Debit
on credit for receivable
$2000, plus GST clearing Liability Increase Credit
GST of $200
Sales Revenue Increase Credit
(cost of sales
and and
$800)
Cost of sales Expense Increase Debit
Inventory Asset Decrease Credit
7 Paid wages Wages Expense Increase Debit
$500 Cash at bank Asset Decrease Credit

Figure 4.7 shows how the double entries in Figure 4.6 would be recorded in ledger
accounts.

FIGURE 4.7 General ledger accounts

Cash at bank
Date Cross-reference $ Date Cross-reference $
1 Capital 40 000 2 Inventory/GST clearing 5 500
4 Sales/GST clearing 1 100 5 Accounts payable 3 300
7 Wages 500

72 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 Capital
Date Cross-reference $ Date Cross-reference $
1 Cash at bank 40 000

Accounts payable
Date Cross-reference $ Date Cross-reference $
5 Cash at bank 3 300 3 Office furniture/GST 3 300
clearing

Office furniture
Date Cross-reference $ Date Cross-reference $
3 Accounts payable 3 000

Sales
Date Cross-reference $ Date Cross-reference $
4 Cash at bank 1 000
6 Accounts receivable 2 000

Office furniture
Date Cross-reference $ Date Cross-reference $
3 Accounts payable 2 000

Inventory
Date Cross-reference $ Date Cross-reference $
2 Cash at bank 5 000 4 Cost of sales 600
6 Cost of sales 800

Cost of sales
Date Cross-reference $ Date Cross-reference $
4 Inventory 600
6 Inventory 800

GST clearing
Date Cross-reference $ Date Cross-reference $
2 Cash at bank 500 4 Cash at bank 100
3 Accounts payable 300 6 Accounts receivable 200

Accounts receivable
Date Cross-reference $ Date Cross-reference $
6 Sales/GST clearing 2 200

Wages
Date Cross-reference $ Date Cross-reference $
7 Cash at bank 500

THE INVENTORY CONTROL

Whenever a business purchases inventory, it must make a debit entry to the Inventory
account, as it represents an increase in an asset. The corresponding credit will go
in either the Cash at Bank account (for a cash purchase) or in the Accounts Payable
account (for a credit purchase).

978 1 4202 3962 1 [CHAPTER 4] DOUBLE ENTRY RECORDING: AN INTRODUCTION 73

 When goods are sold, the economic resource of inventory has been sacrificed and so
the asset becomes an expense. The double entry required is a debit to the Cost of Sales
account (to increase the expense) and a credit to Inventory (to decrease the asset).
Note that one double entry is required to record a purchase of inventory, but two
double entries are necessary whenever inventory is sold. This is because there are
actually two events:
•• the business earns revenue through the sale of goods.
•• the business sacrifices inventory (an asset) to earn its sales.
The first double entry is made to record the selling price of the goods to the customer
by the business. The benefit gained by the business is the value the goods are sold
for; this must be credited to the revenue account (i.e. the Sales account). The Cash
at Bank account is debited in the event of a cash sale, or the Accounts Receivable
account is debited if the sale was on credit. Regardless of whether it is a cash or a
credit sale, the GST Clearing account must always be credited when a sale is made.

When inventory
is purchased, the
asset is increased
with a debit entry.

The second entry records the cost price of the goods sold. Some of the business’s
inventory has been sacrificed in order to earn revenue, so the cost of the goods sold is
transferred from the Inventory account (an asset) to the Cost of Sales account (an expense).
This matches the definitions of the accounting elements; revenue results in an
increase in an asset (Cash at Bank or Accounts Receivables) and the relevant expense
is the current asset being used up or consumed to make the sale (Cost of Sales).
Entries may be made in ledger accounts (see Figure 4.7) because the transactions
occur during a reporting period.
The rules of double entry remain consistent for all businesses, regardless of their
size or structure.

4.2 CHECK YOUR UNDERSTANDING WB PAGE 52

1 Identify a transaction that would bring about the following changes to a business’s accounts:
a an increase in an asset account/an increase in a liability account
b an increase in an asset account/a decrease in another asset account
c a decrease in an asset account/a decrease in a liability account
d an increase in an asset account/an increase in an owner’s equity account.
2 Explain how the rules of debit and credit for revenue and expense accounts can be traced
back to their relationship with owner’s equity.
3 When a trading business sells goods, there are actually two transactions: one at cost
price and one at selling price. Explain fully the entries required for each of these two
transactions.

74 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 4 CHAPTER REVIEW

KEY CONTENT
•• [4.1] Double entry accounting notes that two items are affected by every transaction,
and so two accounts need to be updated – one with a debit and one with a credit.
The transactions that occur during each reporting period are recorded in ledger
accounts. These individual accounts, when combined, map up the general ledger.
•• [4.1] The three elements of a ledger entry are the date of the transaction, a cross-reference
to the other account affected by the transaction, and the dollar value of the transaction.
Assets appear on the left side of the ledger and are debits. Liabilities and owner’s
equity are on the right side and are credits.
•• [4.1] Analysis charts provide an analysis of a financial transaction, leading to the double entry
being determined for ledger accounts.
•• [4.2] Expenses and revenues can also be recorded in double entry accounting. Revenue
accounts are increased by credit entries; expense accounts are increased by debit
entries.
•• [4.2] Whenever inventory is purchased, a debit entry is made to the Inventory account and a
credit goes into the Cash at Bank or Accounts Payable account. When goods are sold, a
debit is made to the Cost of Sales account and a credit goes to Inventory.

CHAPTER 4 EXERCISES

1 Analysis chart A, L & OE WB PAGE 53 SPREADSHEET X.XX

Prepare an analysis chart (A, L, OE only) showing the double entries that result from
the following transactions for Simpson’s Stationery:
•• The owner contributed cash to the business.
•• Purchased office furniture for cash, including GST.
•• Bought a computer on credit from OK Computer Centre, including GST.
•• Borrowed money from NAB.
•• Bought inventory on credit from Wholesale Stationers (plus GST).
•• Made a repayment to OK Computer Centre by EFT.
•• The owner contributed an office desk to the business.

2 Analysis chart – all accounts WB PAGE 53 SPREADSHEET X.XX

The following transactions are from the business of Games Galaxy. Prepare an analysis
chart (all accounts) showing the double entry for each transaction.
•• Paid monthly rent, plus GST.
•• Bought goods for cash, plus GST.
•• Issued a quote to supply a cafe with eight board games, including charging GST.
•• Sold goods for cash, plus GST.

978 1 4202 3962 1 [CHAPTER 4] DOUBLE ENTRY RECORDING: AN INTRODUCTION 75

 •• Bought a laptop on credit from Office Needs, plus GST.
•• Bought inventory items on credit, plus GST.
•• Paid for advertising using the bank’s EFT facility (including GST).
•• Issued invoices to customers, including GST, for goods provided.
•• Sent an order form to supplier for goods required.
•• Paid accounts payable an amount owing for inventory purchases.
•• Received money from accounts receivable for goods supplied last month.
•• Paid insurance premium for year, including GST.

3 Analysis chart with dollar values

SPREADSHEET X.XX WB PAGE 54

Anthony Taranto is the owner of Taranto’s Guitars, a trading business that sells both
acoustic and electric guitars. He has provided a summary of transactions relating to his
business:
•• Taranto banked $150 000 cash in a business account to start his business.
•• Paid the first month’s rent: $9000, plus GST of $900.
•• Bought shop fittings for cash: $22 000, plus $2200 GST.
•• Purchased guitars for $34 000 on credit from Teknik Music Co. (charged $3400 GST).
•• Sold guitars that cost $4000 for $7900 EFT, plus GST of $790.
•• Paid for one month’s advertising: $1800, plus GST of $180.
•• Borrowed cash from NAB: $15 000.
•• Sold guitars on credit for $3080, including GST of $280, to DJ Touma (cost price of
sale $1600).
•• Purchased inventory for cash from Shaggy Music Company: $6600, plus GST of $660.
•• Repaid NAB $2000.
•• Paid wages for the first fortnight of operations: $1800 using EFT.
•• Cash sales of inventory totalled $4400, including GST of $400 (cost price $2200).
•• Purchased inventory from Morrison Music on credit for $13 400, plus GST of $1340.
Prepare an analysis chart for these transactions, including the two double entries
required whenever inventory is sold by the business.

4 Analysis chart with dollar values

SPREADSHEET X.XX WB PAGE 55

Luisa Lipsia owns and operates Perfect Perfumes, an online business that sells
perfumes and other cosmetics. She provides the following summary of transactions
relating to her business:
•• Lipsia banked $106 000 cash to start the business.
•• Purchased inventory on credit from Exotic Cosmetics for $16 500, including GST of
$1500.
•• Bought office equipment for cash for $14 000, plus GST.
•• Paid for advertising in local papers: $500 cash, plus GST.
•• Sold goods for $1100, including GST for cash. Goods were sold at a mark-up of 100%.
•• Made a credit sale for $2000, plus GST of $200. The cost price of the goods sold
was $980.
•• Paid Exotic Cosmetics the full amount owing by making an EFT.
•• Bought goods for cash: $500 plus GST.
•• Took out a loan from ACME Bank for $5000, with 5% interest on the loan to be
paid yearly.
•• Lipsia contributed two filing cabinets to the business, valued at $200.

76 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

•• Sold goods for cash for $900, plus GST. The goods sold had a mark-up of 50% on cost
price.
•• Collected $500 from accounts receivable via EFT.
Prepare an analysis chart for these transactions, including the two double entries
required whenever inventory is sold by the business.

5 Analysis of ledger accounts WB PAGE 56

The following accounts appeared in the general ledger of St Albans Auto Parts, a small
business owned and operated by Mitch Harding.
Cash at bank
$ $
1 Apr Capital 30 000 2 Apr Fittings/GST clearing 16 500
4 Apr Sales/GST clearing 660 3 Apr Inventory/GST clearing 3 300

Capital – Harding
$ $
1 Apr Cash at bank 30 000

Fittings
$ $
2 Apr Cash at bank 15 000

GST clearing
$ $
2 Apr Cash at bank 1 500 4 Apr Cash at bank 60
3 Apr Cash at bank 300 6 Apr Accounts receivable 10
5 Apr Accounts payable 40

Inventory
$ $
3 Apr Cash at bank 3 000 4 Apr Cost of sales 300
5 Apr Accounts payable 400 6 Apr Cost of sales 60

Cost of sales
$ $
4 Apr Inventory 300
6 Apr Inventory 60

Sales
$ $
4 Apr Cash at bank 600
6 Apr Accounts receivable 100

Accounts payable
$ $
5 Apr Inventory/GST clearing 440

Accounts receivable
$ $
6 Apr Sales/GST clearing 110

In chronological order, list the transactions that resulted in the double entries in these
ledger accounts.

978 1 4202 3962 1 [CHAPTER 4] DOUBLE ENTRY RECORDING: AN INTRODUCTION 77

 6 Analysis of ledger accounts WB PAGE 56

Cara Johnson is the owner of Caulfield Cosplay, a small business that specialises in
creating costumes for all occasions.

Cash at bank
$ $
1 May Capital 190 000 3 May Display equipment/ 22 000
GST clearing
5 May Sales/GST clearing 1 320 4 May Advertising GST 660
clearing

Capital – Johnson
$ $
1 May Cash at bank 190 000

Display equipment
$ $
3 May Cash at bank 20 000

GST clearing
$ $
2 May Accounts payable 1 500 5 May Cash at bank 120
3 May Cash at bank 2 000 6 May Accounts receivable 140
4 May Cash at bank 60

Inventory
$ $
2 May Accounts payable 15 000 5 May Cost of sales 500
6 May Cost of sales 600

Advertising
$ $
4 May Cash at bank 600

Sales
$ $
5 May Cash at bank 1 200
6 May Accounts receivable 1 400

Cost of Sales
$ $
5 May Inventory 500
6 May Inventory 600

Accounts payable
$ $
2 May Inventory/GST clearing 16 500

Accounts receivable
$ $
6 May Sales/GST clearing 1 540

78 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 a State the transactions that resulted in the double entries in these ledger accounts.
b Consider the GST account shown. On 6 May, does this business owe GST to the
ATO, or would it be owed a refund? Explain your answer fully.

ETHICAL CONSIDERATIONS WB PAGE 57

For several years the owner of Galaxy Games, Daniel Galati, has provided plastic carry
bags to his customers. The bags are in distinctive colours, with the name of the business
clearly displayed. As Daniel’s business is in a large regional shopping centre, he’s always
believed that the bags are a great advertising tool for his shop.

Some of Daniel’s customers have commented to him recently on the environmental

impact of plastic bags and he wants to explore possible alternatives. His choices include:
•• continue to use the plastic bags.
•• reduce use of the plastic bags by charging his customers $1 per bag
•• replace the plastic bags with recycled paper bags
•• discontinue the use of bags completely, and encourage customers to bring their
own bag.
Daniel has asked for your advice, including the possible consequences of his decision.
Write a report, discussing the possible implications of each choice. Your report should
include a recommendation to Daniel, justifying your decision.

978 1 4202 3962 1 [CHAPTER 4] DOUBLE ENTRY RECORDING: AN INTRODUCTION 79

 CHAPTER CHECKLIST
Now that you have finished Chapter 4, double-check your progress.
Are you ready for your Unit 3 assessment?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
completed all end-of-chapter activities
handed in my workbook for marking.

I understand …

characteristics of the General Ledger with T-form

accounts for manual recording
the GST clearing account
ethical considerations when making business decisions
in relation to operating a trading business.

I can …

identify and manually record financial data in the General Journal and General Ledger
use ICT to record financial data in the General Journal and General Ledger.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_4

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

80 978 1 4202 3962 1

 5 THE GENERAL JOURNAL
AND GENERAL LEDGER

In Chapter 4 you learnt how to LEARNING OBJECTIVES

create individual ledger accounts,
which record all the transactions By the end of this chapter, you will be able to:
for a particular account in a •• explain the purpose of a general journal [5.1]
reporting period. A trading
•• record financial transactions in the general journal
business will have multiple
[5.1]
accounts, and these make up
•• explain the purpose of the general ledger [5.1]
the general ledger.
•• record financial transactions in general ledger
Similarly, all of those
T-accounts [5.1]
transactions are recorded on
business documents, and •• formally balance a T-form ledger account [5.2]
the details of those individual •• describe the purpose of a trial balance and prepare one
documents are recorded in a from a general ledger [5.3]
general journal. In this chapter you •• use a trial balance to identify particular recording errors
will learn about the purpose of the [5.3]
general journal and the general
•• outline the errors a trial balance won’t detect [5.3]
ledger, and how to create and
use them. •• record drawings in the general ledger and show their
effect on owner’s equity [5.5]

UNIT 3 – PROGRESS 1 2 3 4 5 6 7 8 9 10 11 12 13

5.2 5.4

Extended
example:
Balancing ledger Chapter review
5.1 5.3 from transactions 5.5
accounts
to balance
sheet
From documents The role of Accounting
to ledger the trial balance for drawings
accounts

978 1 4202 3962 1 81

 FROM DOCUMENTS TO LEDGER
5.1 ACCOUNTS
Now that you are familiar with the basic rules of debits and credits in ledger accounts,
you are ready to learn how to record transactions in a formal double entry system.
The full system of double entry accounting was shown as a flow diagram in
Chapter 3 (Figure 3.13). Part of that diagram is shown in Figure 5.1 to remind you of
the steps involved.

FIGURE 5.1 The start of double entry recording

1 2 3 4
Source documents General journal General ledger Trial balance
Invoices, receipts, Daily entries of Details of individual Listing of all account
EFT documents, and transaction data accounts balances (used to check
so on the general ledger)

Financial transactions are recorded on business documents. These documents are

issued and received as part of the day-to-day activities of the business. It is important
that the details of all documents are recorded daily. This is the purpose of the general
journal, which is sometimes known as a day book. (Remember that journals and
ledgers can be physical or digital, despite their names.)
The debit and credit entries required when a document is issued or received are
made in the general journal first. The journal records all the details of the transaction.
These details include four key items:
•• the names of the accounts affected by the transaction
•• the dollar amounts involved
•• a description of the transaction
•• the document number used to provide all the above details.

Consider the general journal entry in Figure 5.2, which shows the result of a business
owner contributing $100 000 on 1 March to commence their business. The evidence
of this transaction was provided by Memo 001.

EXAM FIGURE 5.2 General journal entry to commence business

SUCCESS
When making multiple Date Details Dr Cr
The two accounts affected
entries in a general 1 Mar Cash at bank 100 000
journal, always check
by the transaction
Capital 100 000
that the total debits
equal the total Cash contribution by owner to commence business
credits. (Memo 001)

The date of the The narration, which explains The debit and
transaction the nature of the transaction credit entries

Regarding the four key items:

1 As the owner has contributed cash to the business, the two accounts affected are
Cash at Bank and Capital.
2 The dollar amount involved was $100 000, which results in an increase in Cash at
Bank (an entry in the debit column) and in Capital (an entry in the credit column).

82 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

3 A brief description of the event is provided below the account names. This is
known as a narration.
4 The narration includes a document number, which in this case is Memo 001.
Two traditions are usually followed when preparing a general journal entry:
•• The debit entries are shown first, followed by the credit entries.
•• The credit entries in a general journal are indented to the right.

For example, in Figure 5.2 the title for ‘Capital’ is indented in the details section.
The amount of detail recorded in the general journal cannot be included in the
general ledger accounts, as they would become difficult to read. Instead, once the
general journal entries have been compiled for a day, the debits and credits are posted
to the general ledger accounts.
‘Posting’ means transferring the details of debits and credits to the ledger accounts
so that the accounts are updated accurately and in a timely manner.
The general journal entry in Figure 5.2 would result in the following general ledger
accounts.
Cash at bank
Date Cross-reference $ Date Cross-reference $
1 Mar Capital 100 000

Capital
Date Cross-reference $ Date Cross-reference $
1 Mar Cash at bank 100 000

The Cash at Bank account has increased with a debit entry, and the cross-reference
noted is the Capital account. This cross-reference helps to explain the nature of the
cash receipt – the owner has injected capital into the business.
Similarly, the Capital account has a credit entry, with the cross-reference being
DON’T!
Cash at Bank. The cross-reference shows which asset was contributed by the You will lose exam
owner (cash). marks if you use
As a reporting period continues, day-to-day events are entered into the incorrect titles in either
the general journal or ledger
general journal and then posted to ledger accounts. This means that all the accounts. Make sure you
transactions of the business will end up being noted in the general journal, use the full title for
along with the relevant document numbers. each item. Don’t
abbreviate!
The general ledger is then updated on a regular basis (preferably daily), so
that relevant financial information is available to the owner or manager in a timely
manner, satisfying two of the key qualitative characteristics of accounting.

The general
ledger should
be updated on
a daily basis.

978 1 4202 3962 1 [CHAPTER 5] THE GENERAL JOURNAL AND GENERAL LEDGER 83
 RECORDING IN THE GENERAL JOURNAL
Following on from the previous example, this business owner conducts several more
transactions at the start of March.

Mar 1 The owner contributed $100 000 to commence business (Memo 001)
2 Paid rent for the first month: $4000, plus GST of $400 (EFT rec. 4501)
3 Borrowed $20 000 over five years from Acme Bank (EFT)
4 Bought inventory on credit for $33 000, including GST of $3000 (Invoice 546)
5 Sold goods for cash: $2000, plus GST of $200 (cost price of sale $1000)
(Receipt 5001)

The general journal entries resulting from these five transactions are shown in
Figure 5.3.
EXAM
SUCCESS FIGURE 5.3 General journal entries
Dates in accounting
records must be in Date Details Dr Cr
chronological order.
You will lose marks
1 Mar Cash at bank 100 000
if you record the Capital 100 000
transactions out
Cash contribution by owner to commence business
of order.
(Memo 001)

2 Mar Rent 4 000

GST clearing 400
Cash at bank 4 400
Paid rent (EFT rec. 4501)

3 Mar Cash at bank 20 000

Loan – ACME Bank 20 000
Five-year loan taken out (EFT)

4 Mar Inventory 30 000

GST clearing 3 000
Accounts payable 33 000
Bought inventory on credit (Invoice 546)

5 Mar Cost of sales 1 000

Inventory 1 000
Cash at bank 2 200
Sales 2 000
GST clearing 200
Sold goods for cash (Receipt 5001)

The general journal is extremely flexible; it can be used to record any type of
transaction. It relies on the user knowing the rules of double entry accounting, and
simply states (as shown above) the debits and credits for every transaction.
Once the entries are prepared in the general journal, they are then posted to
the relevant ledger accounts, as shown in Figure 5.4.

84 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

FIGURE 5.4 General ledger entries

Cash at bank
Date Cross-reference $ Date Cross-reference $
1 Mar Capital 100 000 2 Mar Rent/GST clearing 4 400
3 Mar Loan – ACME Bank 20 000
5 Mar Sales/GST clearing 2 200

Capital
Date Cross-reference $ Date Cross-reference $
1 Mar Cash at bank 100 000

Rent
Date Cross-reference $ Date Cross-reference $
2 Mar Cash at bank 4 000

GST clearing
Date Cross-reference $ Date Cross-reference $
2 Mar Cash at bank 400 5 Mar Cash at bank 200
4 Mar Accounts payable 3 000

Loan – Acme Bank

Date Cross-reference $ Date Cross-reference $
3 Mar Cash at bank 20 000

Inventory
Date Cross-reference $ Date Cross-reference $
4 Mar Accounts payable 30 000 5 Mar Cost of sales 1 000

Cost of sales
Date Cross-reference $ Date Cross-reference $
5 Mar Inventory 1 000

Accounts payable
Date Cross-reference $ Date Cross-reference $
4 Mar Inventory/GST clearing 33 000

Sales
Date Cross-reference $ Date Cross-reference $
5 Mar Cash at bank 2 000

5.1 CHECK YOUR UNDERSTANDING WB PAGE 59

1 Explain the purpose of the general journal.

2 Describe the purpose of a narration in a general journal entry.
3 Explain the link between the qualitative characteristics of accounting and the EXAM SUCCESS
When you’re
information in the general journal.
asked to explain
something, don’t just
repeat the definition
from the textbook.
Explain it in your
own words.

978 1 4202 3962 1 [CHAPTER 5] THE GENERAL JOURNAL AND GENERAL LEDGER 85
 5.2 BALANCING LEDGER ACCOUNTS
Ledger accounts may contain debits and credits from many transactions. The balance
of a particular account is the difference between the total debit entries and total credit
entries in that account. If an account has debit entries totalling $10 000 and credit
entries of $9000, the balance of the account is $1000 debit. An account with debits of
$350 and credits of $400 would have a credit balance of $50.
balancing an account A formal process of balancing an account should be done if it has more than one
entering a missing figure entry. Accounts are balanced at the end of a reporting period (i.e. on balance day) to
on one side of a ledger
account to bring it to the determine what is included in the balance sheet. When an account is balanced, the
total on the other side balancing procedure becomes part of the firm’s permanent records.
Figure 5.5 shows the formal balancing of a Cash at Bank account, prepared for the
month of March 2023.

FIGURE 5.5 Balancing a ledger account

Cash at bank
Date Cross-reference $ Date Cross-reference $
2023 2023
1 Mar Capital 50 000 2 Mar Rent/GST clearing 1 100
6 Mar Sales/GST clearing 1 100 9 Mar Advertising/ 440
GST clearing
12 Mar Sales/GST clearing 2 200 14 Mar Wages 1 800
18 Mar Sales/GST clearing 2 200 26 Mar Inventory/GST clearing 11 000
25 Mar Loan 10 000 30 Mar Insurance/GST clearing 660
29 Mar Sales/GST clearing 5 500 31 Mar Balance 56 000
71 000 71 000
1 Apr Balance 56 000

This account is balanced as follows:

•• The two sides of the ledger account are totalled, and the larger amount ($71 000)
is written on both sides of the account.
•• On the side with the lower total (the credit side, in this case), the difference
between the two sides ($56 000) is entered as the balance.
•• Once this balancing figure is entered, the two sides are now equal and the account
is ruled off as balanced.
•• The balancing figure was entered on the credit side, so it’s carried down to the
opposite side of the account. The Cash at Bank account now has a debit balance
of $56 000.

Balancing an account
means making sure
both sides of the ledger
add up to the same
amount, with the
balancing figure being
carried forward to the
new period.

86 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

The final balance is carried down on the last day of the reporting period – 31 March,
in this example. This amount would appear as a current asset in the firm’s balance
sheet for 31 March 2023. The balance in the ledger account is then ready for the new
reporting period, and therefore is an opening balance as at 1 April 2023.
The procedure is exactly the same if an account has a credit balance; that is, the
total credit entries exceed the total debits. The missing figure appears on the debit
side and is carried down to the credit side of the account. Figure 5.6 shows a loan
account (liability).

FIGURE 5.6 Balancing a ledger account (credit balance)

Loan
Date Cross-reference $ Date Cross-reference $
2023 2023
31 Mar Cash at bank 500 1 Jan Balance 6 000
30 Jun Cash at bank 500
30 Sep Cash at bank 500
31 Dec Cash at bank 500
31 Dec Balance 4 000
6 000 6 000
2024
1 Jan Balance 4 000

This account shows $6000 owing as at 1 January 2024. Four quarterly repayments
were made during the year, and the account was balanced at 31 December 2023
to show that a liability of $4000 still exists. This amount would be reported in the
business’s balance sheet at this date.

5.2 CHECK YOUR UNDERSTANDING WB PAGE 60

1 If a general journal records debits and credits, why is it necessary to prepare

general ledger accounts?
2 Explain why is it necessary to balance accounts at the end of a period.
3 For each of the following accounts, identify whether they would usually have a
debit or a credit balance at the end of a period.
a Loan from bank
b Accounts receivable
c Accounts payable
d GST clearing

978 1 4202 3962 1 [CHAPTER 5] THE GENERAL JOURNAL AND GENERAL LEDGER 87
 5.3 THE ROLE OF THE TRIAL BALANCE
During a reporting period, there may be hundreds or thousands of transactions
resulting in debits and credits in ledger accounts. With such a large amount of
trial balance recording, errors sometimes occur. A trial balance can be prepared during a reporting
list of general ledger
period, as well as at the end, to identify errors in double entry recording. It lists all the
accounts with their
balances; used to check general ledger accounts with their balances on a specific date.
that the total value of all
debits equals the value of Figure 5.7 shows an example of a trial balance for Modica’s Motorbikes.
all credits
FIGURE 5.7 Trial balance showing general ledger account balances

MODICA’S MOTORBIKES: TRIAL BALANCE AS AT 30 JUNE 2023

Dr Cr
Accounts payable 1 000
Accounts receivable 2 000
Advertising 1 000
Capital 9 000
Cash at bank 2 000
Cost of sales 4 000
GST clearing 1 000
Inventory 8 000
Sales 9 000
Wages 3 000
20 000 20 000

A trial balance is used to check that the total of all debit entries is equal to the total of
all credit entries. It doesn’t detect all errors – only those where the debits don’t equal
the credits.
A trial balance won’t detect the following errors:
•• An incorrect amount is entered for both debit and credit (e.g. entering $98 in both
accounts, instead of $89).
•• A debit or credit is entered in the wrong account (e.g. a rent payment is debited to
the Wages account).
•• The debit and credit entries are reversed – the account that should have been
debited is credited, and vice versa.
•• A transaction is omitted completely – neither the debit nor the credit is entered.
•• There are compensating errors – two recording errors occur, but they counteract
one another. The result is that the trial balance is in balance by sheer good luck!

A trial balance
will detect some
errors in this
business’s accounts,
but not all.

88 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

None of these errors will be detected by preparing a trial balance, because they all
comply with the rules of double entry – a debit for every credit for each transaction.
However, a trial balance should still be prepared regularly to detect errors that don’t
comply with the rules.

FIGURE 5.8 Common trial balance errors

Common
Omission trial balance Transposition
errors

Duplication

DETECTING ERRORS THROUGH A TRIAL BALANCE

A trial balance won’t balance if double entry accounting hasn’t been completed
properly. The cause of the problem must then be found. Errors occur for many
reasons, but some common errors are easily detected (see Figure 5.8 and Table 5.1).

TABLE 5.1 Finding and correcting trial balance errors

Debit or credit When a trial balance doesn’t balance, calculate the difference between
omitted the total debits and total credits. Check this figure against the
transactions recorded for the period in the general journal. This will
detect a single error where one debit or one credit has been omitted.

Duplication of a Two debits or two credits are sometimes made for one transaction. In
debit or credit this case, you can find the error by calculating the difference in the trial
balance totals and dividing by two.
For example, if wages of $2000 were paid, the correct double entry
is a debit to Wages and a credit to Cash at Bank. If both accounts were
debited, the total debits in the trial balance will be $4000 higher than
the credit side, because the Cash at Bank account was debited when it
should have been credited. Not only is the $2000 credit missing, but an
incorrect $2000 debit was also made.

Transposing You can locate a third type of error by dividing the difference in the trial
errors balance totals by nine. This will identify a transposing error, where a dollar
value has been incorrectly copied into a ledger account.
For example, a figure of $197 is entered as $179 in one account. The
difference in the trial balance due to this error would be $18, which is
exactly divisible by nine.

Transposing errors are more likely to occur with larger numbers. For example, a figure
of $12 540 may be entered as $12 450. The difference in this case is $90, which again
is exactly divisible by nine.
These methods don’t guarantee that all mistakes will be easily located in ledger
accounts. If several recording errors are made, these techniques won’t be useful.
If you use all three methods and still can’t identify the error, there may be multiple
recording errors. You will need to check each double entry against the transaction data.

978 1 4202 3962 1 [CHAPTER 5] THE GENERAL JOURNAL AND GENERAL LEDGER 89
 ALTERNATIVE PRESENTATION OF A TRIAL BALANCE
There are two acceptable methods of displaying the ledger account information in
a trial balance. The method used to prepare the trial balance in Figure 5.7 (page 88) is
one standard approach.
The other method groups together all the accounts with debit balances and all the
accounts with credit balances. This method, which uses a ‘T’ to distinguish between
accounts with debit and credit balances, is shown in Figure 5.9. Both methods are
acceptable, so use whichever you prefer.

FIGURE 5.9 T-format trial balance

MODICA’S MOTORBIKES: TRIAL BALANCE AS AT 30 JUNE 2023

$ $
Accounts receivable 2 000 Accounts payable 1 000
Advertising 1 000 Capital 9 000
Cash at bank 2 000 GST clearing 1 000
Cost of sales 4 000 Sales 9 000
Inventory 8 000
Wages 3 000
20 000 20 000

5.3 CHECK YOUR UNDERSTANDING WB PAGE 60

1 What is a trial balance? What is its function?

2 ‘If a trial balance balances, the double entry process has been done perfectly.’
Do you agree with this statement? Explain your answer.
3 Describe two types of errors that can be made in double entry accounting that
won’t cause a trial balance to not balance.

90 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 EXTENDED EXAMPLE: FROM
5.4 TRANSACTIONS TO BALANCE SHEET
This extended example shows the system of recording transactions in the general
journal, posting the entries to general ledger accounts, then preparing a trial balance
and accounting reports.
The following transactions take place during the month of March 2023. They all
relate to Fuller Furniture, a small business owned and operated by Harrison Fuller.
The transactions are entered into the business’s general ledger and a trial balance
is prepared as at 31 March 2023. From the trial balance, an income statement and
balance sheet are then prepared.

FULLER FURNITURE: TRANSACTIONS

Mar 1 Fuller deposited $80 000 in a separate bank account to commence the business
2 Purchased inventory for cash: $10 000, plus GST of $1000
3 Purchased a delivery van: $15 000 cash, plus GST of $1500
4 Paid rent for the first month: $1500, plus GST of $150
6 Paid advertising: $500, plus GST of $50
8 Purchased inventory on credit from Better Furniture $1200, plus GST of $120
11 Cash sales made to customers: $3000, plus GST of $300 (cost price $1500)
17 Charged D Colaco $500, plus GST of $50, for bar stools sold on credit
(cost price $300)
19 Paid postage: $100, plus GST of $10
21 Received from cash clients: $800 for sales, plus GST of $80 (cost price $400)
24 Invoiced P Connop $500, plus GST of $50 for recliner chair (cost price $200)
25 Received $550 from D Colaco on account
28 Received $900, plus GST of $90, from cash clients (cost price $450)
29 Paid advertising $500, plus GST of $50
30 Paid Better Furniture $200
31 Paid monthly petrol account: $150, plus GST of $15

FULLER FURNITURE: GENERAL JOURNAL

Date Details Dr Cr
1 Mar Cash at bank 80 000
Capital 80 000
Cash contribution by owner to commence business
2 Mar Inventory 10 000
GST clearing 1 000
Cash at bank 11 000
Bought inventory for cash
3 Mar Delivery van 15 000
GST clearing 1 500
Cash at bank 16 500
Bought delivery van for cash
4 Mar Rent 1 500

978 1 4202 3962 1 [CHAPTER 5] THE GENERAL JOURNAL AND GENERAL LEDGER 91
 GST clearing 150
Cash at bank 1 650
Paid rent
6 Mar Advertising 500
GST clearing 50
Cash at bank 550
Paid advertising
8 Mar Inventory 1 200
GST clearing 120
Accounts payable – Better Furniture 1 320
Bought inventory on credit
11 Mar Cost of sales 1 500
Inventory 1 500
Cash at bank 3 300
Sales 3 000
GST clearing 300
Sold goods for cash
17 Mar Cost of sales 300
Inventory 300
Accounts receivable – D Colaco 550
Sales 500
GST clearing 50
Sold goods on credit
19 Mar Postage 100
GST clearing 10
Cash at bank 110
Paid postage
21 Mar Cost of sales 400
Inventory 400
Cash at bank 880
Sales 800
GST clearing 80
Sold goods for cash
24 Mar Cost of sales 250
Inventory 250
Accounts receivable – S Connop 660
Sales 600
GST clearing 60
Sold goods on credit
25 Mar Cash at bank 550
Accounts receivable – D Colaco 550
Cash received on account
28 Mar Cost of sales 450
Inventory 450
Cash at bank 990

92 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 Sales 900
GST clearing 90
Sold goods for cash
29 Mar Advertising 500
GST clearing 50
Cash at bank 550
Paid advertising
30 Mar Accounts payable – Better Furniture 200
Cash at bank 200
Cash paid on account
31 Mar Petrol 150
GST clearing 15
Cash at bank 165
Paid petrol

Once all the transactions for March are recorded in the general journal, they are
posted to the general ledger accounts.

FULLER FRAMES: GENERAL LEDGER

Cash at bank
Date Cross-reference $ Date Cross-reference $
2023 2023
1 Mar Capital 80 000 2 Mar Inventory/GST clearing 11 000
11 Mar Sales/GST clearing 3 300 3 Mar Delivery van/ 16 500
GST clearing
21 Mar Sales/GST clearing 880 4 Mar Rent/GST clearing 1 650
25 Mar Accounts receivable – 550 6 Mar Advertising/ 550
D Colaco GST clearing
28 Mar Sales/GST clearing 990 19 Mar Postage/GST clearing 110
29 Mar Advertising/ 550
GST clearing
30 Mar Accounts payable – 200
Better Furniture
31 Mar Petrol/GST clearing 165
31 Mar Balance 54 995
85 720 85 720
1 Apr Balance 54 995

Capital
Date Cross-reference $ Date Cross-reference $
1 Mar Cash at bank 80 000

Inventory
Date Cross-reference $ Date Cross-reference $
2 Mar Cash at bank 10 000 11 Mar Cost of sales 1 500
8 Mar Accounts payable – 1 200 17 Mar Cost of sales 300
Better Furniture
21 Mar Cost of sales 400
24 Mar Cost of sales 250

978 1 4202 3962 1 [CHAPTER 5] THE GENERAL JOURNAL AND GENERAL LEDGER 93
 28 Mar Cost of sales 450
31 Mar Balance 8 300
11 200 11 200
1 Apr Balance 8 300

Cost of sales
Date Cross-reference $ Date Cross-reference $
11 Mar Cost of sales 1 500
17 Mar Cost of sales 300
21 Mar Cost of sales 400
24 Mar Cost of sales 250
28 Mar Cost of sales 450 31 Mar Balance 2 900
2 900 2 900
1 Apr Balance 2 900

GST clearing
Date Cross-reference $ Date Cross-reference $
2 Mar Cash at bank 1 000 11 Mar Cash at bank 300
3 Mar Cash at bank 1 500 17 Mar Accounts receivable – 50
D Colaco
4 Mar Cash at bank 150 21 Mar Cash at bank 80
6 Mar Cash at bank 50 24 Mar Accounts receivable – 60
S Connop
8 Mar Accounts payable – 120 28 Mar Cash at bank 90
Better Furniture
19 Mar Cash at bank 10
29 Mar Cash at bank 50
31 Mar Cash at bank 15 31 Mar Balance 2 315
2 895 2 895
1 Apr Balance 2 315

Delivery van
Date Cross-reference $ Date Cross-reference $
3 Mar Cash at bank 15 000

Rent
Date Cross-reference $ Date Cross-reference $
4 Mar Cash at bank 1 500

Advertising
Date Cross-reference $ Date Cross-reference $
6 Mar Cash at bank 500
29 Mar Cash at bank 500 31 Mar Balance 1 000
1 000 1 000
1 Apr Balance 1 000

Accounts payable – Better Furniture

Date Cross-reference $ Date Cross-reference $
30 Mar Cash at bank 200 8 Mar Inventory/GST clearing 1 320
31 Mar 1 120

94 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

 1 320 1 320
1 Apr Balance 1 120

Sales
Date Cross-reference $ Date Cross-reference $
11 Mar Cash at bank 3 000
17 Mar Accounts receivable – 500
D Colaco
21 Mar Cash at bank 800
24 Mar Accounts receivable – 600 EXAM SUCCESS
P Connop When recording
GST, always remember
31 Mar Balance 5 800 28 Mar Cost of sales 900 that if you’re buying
5 800 5 800 something, GST will
be debited: if you’re
1 Apr Balance 5 800
selling, GST will
Accounts receivable – D Colaco be credited

Date Cross-reference $ Date Cross-reference $

17 Mar Sales/GST clearing 550 25 Mar Cash at bank 550

Accounts receivable – S Connop

Date Cross-reference $ Date Cross-reference $
24 Mar Sales/GST clearing 660

Postage
Date Cross-reference $ Date Cross-reference $
19 Mar Cash at bank 100

Petrol
Date Cross-reference $ Date Cross-reference $
31 Mar Cash at bank 150

The general ledger accounts above have been balanced and the balances of all
accounts are now available to prepare the trial balance. Note how the balance of
‘Accounts receivable – D Colaco’ is zero as of 31 March, as the total debits are exactly
equal to the total credits, so that account is no longer listed in the trial balance.

FULLER FURNITURE: TRIAL BALANCE AS AT 30 JUNE 2023

$ $
Cash at bank 54 995 Capital 80 000
Inventory 8 300 Accounts payable – Better 1120
Furniture
Cost of sales 2 900 Sales 5 800 EXAM SUCCESS
GST clearing 2 315 If you are asked
for totals in the
Delivery van 15 000 exam, a mark will be
Rent 1 500 deducted if you don’t
provide them.
Advertising 1 000
Accounts receivable – S Connop 660
Postage 100
Petrol 150
86 920 86 920

978 1 4202 3962 1 [CHAPTER 5] THE GENERAL JOURNAL AND GENERAL LEDGER 95
 The total debit entries equal the total credits, so the trial balance balances.
The double entry process has been done correctly, so the accounting reports can
now be prepared. Of the five types of accounts used in the general ledger (A, L, OE,
R, E), two are used for the income statement (R, E) and the other three are used for
the balance sheet (A, L, OE).
As profit equals revenue less expenses, these items are used to prepare the
income statement. This leaves the accounts that make up the accounting equation:
A = L + OE.

FULLER FURNITURE: INCOME STATEMENT FOR MONTH ENDED 31 MARCH 2023

$ $
Sales 5 800
Less: Cost of sales 2 900
Gross profit 2 900
Less: Other expenses
Rent 1 500
Advertising 1 000
Postage 100
Petrol 150 2 750
Net profit 150

FULLER FURNITURE: BALANCE SHEET AS AT 31 MARCH 2023

Assets $ $ Liabilities $ $
Current assets Current liabilities
Cash at bank 54 995 Accounts payable – 1 120
Better Furniture
Inventory 8 300
GST clearing 2 315 Owner’s equity
Accounts receivable – 660 66 270 Capital 80 000
S Connop
Non-current assets Net profit 150 80 150
Delivery van 15 000
81 270 81 270

5.4 CHECK YOUR UNDERSTANDING WB PAGE 61

1 Put the following processes of an accounting system into the correct order:
•• income statement •• source documents
•• ledger accounts •• general journal
•• balance sheet •• trial balance.
2 Using the information in the balance sheet above, comment on the liquidity of this
business, taking into account the values of current assets and liabilities.
3 Would you be satisfied with the profit earned if you were the business owner?
Explain your answer fully.

96 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

5.5 ACCOUNTING FOR DRAWINGS
Drawings occur when the owner of the business withdraws assets for personal use. drawings
The most common asset withdrawn is cash. withdrawal of assets
by the proprietor of
Drawings are classified within the owner’s equity account, but they are the a business
opposite of capital and negative in nature. They require an entry opposite to that
made when an owner puts capital into the business. When an owner withdraws an
asset, the asset account involved will be credited, with the debit entry being made in
a Drawings account.
A cash withdrawal would be recorded as follows:
Cash at bank
Date Cross-reference $ Date Cross-reference $
10 Jan Drawings 500

Drawings
Date Cross-reference $ Date Cross-reference $
10 Jan Cash at bank 500

At the end of a reporting period, the balance of the Drawings account is treated as a
negative figure under the owner’s equity section of the balance sheet.
For example, if the Capital account had a balance of $50 000, the profit earned for
the year was $20 000 and the drawings during the period were $10 000, the owner’s
equity would be calculated and reported as follows.
BALANCE SHEET (EXTRACT)
Owner’s equity $ $ $
Capital 50 000
Net profit 20 000 70 000
Less: Drawings 10 000 60 000

Inventory records
must be updated
whenever a
purchase or sale
is made.

5.5 CHECK YOUR UNDERSTANDING WB PAGE 62

1 Describe the function of a ‘drawings’ account.

2 How are drawings classified – as A, L, OE, R or E? Explain your answer.
3 A business owner earns a profit of $50 000 this period, but withdraws $90 000 in cash
in the same period. Explain the potential impact this may have on the business.

978 1 4202 3962 1 [CHAPTER 5] THE GENERAL JOURNAL AND GENERAL LEDGER 97
 5 CHAPTER REVIEW

KEY CONTENT
•• [5.1] The general journal records all the key details of a transaction.The journal entry should
show the accounts affected, the dollar amounts and the reference numbers of all
related documents, and contain a brief description of the transaction.
•• [5.1] Once the general journal entries have been compiled, the debits and credits are posted
(transferred) to the general ledger accounts.
•• [5.2] Following the core principle of double entry accounting, each transaction from the
general journal should be recorded in at least two ledger accounts – one for credits and
one for corresponding debits.
•• [5.3] Ledger accounts may contain debits and credits from many transactions. The
balance of an account is the difference between the total debit entries and the total
credit entries.
•• [5.3] Accounts should be balanced at the end of a reporting period. Balancing involves
entering a missing figure on one side of a ledger account to bring it to the total on the
other side.
•• [5.4] Preparing a trial balance during a reporting period helps to detect errors in double entry
recording. A trial balance is used to check that the total of all debit entries is equal to
the total of all credit entries.
•• [5.5] Drawings occur when the owner of the business withdraws assets for personal use.
They require an entry opposite to that made when an owner puts capital into the
business.

CHAPTER 5 EXERCISES

1 Preparing the general journal

SPREADSHEET X.XX WB PAGE 63

Nik Brudenell is the owner of Dreamy Daze Music Store. In his first week of trading,
the following transactions took place.

Apr 1 Brudenell deposited $120 000 to commence the business (Receipt 601)
2 Paid rent of $1200, plus GST of $120 (EFT rec. 401)
3 Purchased shop fittings from Seddon Office Furniture on credit. Total cost was
$17 600, including GST (Invoice 2711)
4 Bought inventory for cash $10 000, plus GST of $1000 (EFT rec. 402)
5 Purchased inventory on credit from Top 40 Music: $5000, plus GST
(Invoice 989)

a Enter the above transactions into the general journal of Dreamy Daze Music Store.
b Prepare the Cash at Bank and GST Clearing general ledger accounts, including the
relevant entries from the general journal.

98 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1

2 Preparing the general journal WB PAGE 64 SPREADSHEET X.XX

Dave Congdon sells motorcycle parts in his business, trading under the name of DC
Bikes. On 1 March 2023, the following account balances existed:
•• Cash at Bank $12 000
•• Inventory $52 000
•• Accounts Receivable $9800
•• Accounts Payable $5400
•• GST Clearing $1200 Cr
•• Capital $67 200.
The following transactions took place in the first week of March 202.

Mar 1 Paid advertising $440, including GST

2 Sold goods on credit for $4000, plus GST (cost price $2200)
3 Took out a loan from NBA $10 000
4 Received cash from accounts receivable via EFT $2800
5 Cash sales of $3500, plus GST (cost of sales $1700)
6 Paid accounts payable via EFT $2400
7 Paid insurance $670, plus GST

a Prepare general journal entries to record the above transactions. (Narrations are not
required.)
b Prepare the following ledger accounts, including the relevant transactions from your
general journal: Cash at Bank, Inventory, Cost of Sales and GST Clearing.
c Balance the four ledger accounts prepared in part b.

3 General journal to ledger accounts WB PAGE 66 SPREADSHEET X.XX

Emma Robinson is the owner of Ambient Audio. The following transactions occurred in
her first week of operations in 2023.

May 1 Robinson deposited $145 000 in a separate bank account to set up the
business (Memo 501)
Purchased office furniture on credit from Commercial Furniture for $5200,
plus GST of $520 (Invoice 3829)
2 Bought shop fittings for cash $16 500 (including GST of $1500) (EFT rec. 301)
and paid the first month’s rent $8000, plus GST of $800 (EFT rec. 302)
3 Purchased inventory on credit for $25 000, plus GST of $2500 (Invoice 1919)
4 Cash sales $9000, plus GST of $900 (cost price $5000) (EFT summary), and
paid advertising of $600, plus GST of $60 (EFT rec. 303)
5 Issued an invoice for $4800, plus GST of $480, to Swinburne University for
goods provided (cost price $2400) (Invoice 001)
6 Cash sales $1540, including GST of $140 (cost price $700) (EFT summary)
7 Paid Commercial Furniture $2000 (EFT rec. 304), and made cash sales of
$2000, plus GST of $200 (cost price $1100) (EFT summary)
Bought inventory for cash $4000, plus GST $400 (EFT rec. 305)

a Enter the transactions into the general journal of Ambient Audio.

b Prepare all general ledger accounts by posting all entries from your general journal.
c Prepare a trial balance as at 7 May 2023.

978 1 4202 3962 1 [CHAPTER 5] THE GENERAL JOURNAL AND GENERAL LEDGER 99
 4 General journal to ledger accounts
SPREADSHEET X.XX WB PAGE 70

The following transactions relate to the business of Betty’s Boutique:

Jun 1 B Rubble deposited $150 000 to commence the business

Purchased the business premises for $720 000, paying $120 000 cash with the
balance being financed by a loan from NAB Finance
3 Bought inventory for $15 000 cash, plus GST of $1500, and office equipment
for $4500 cash, plus GST of $450
4 Purchased $18 000 worth of inventory on credit from Classic Clothes and was
charged GST of $1800
5 Sold goods for cash $4200, plus GST of $420 (cost price of goods sold $1900)
6 Paid wages of $450
7 Invoiced clients for credit sales $5800 and charged them GST of $580 (cost
price $2500)

a Prepare general journal entries for the above transactions. (Narrations are
not required.)
b Post your general journal entries to the general ledger accounts and balance the
accounts to determine their balances as at 7 June 2023.
c Prepare a trial balance as at 7 June 2023.

5 Analysis of the general journal

SPREADSHEET X.XX WB PAGE 74

Nick Smith operates a small business, Cake Craze, selling gourmet cupcakes and
doughnuts. He has provided the following extract from his general journal for the
month of June 2023.

GENERAL JOURNAL
Date Details Dr Cr
2 Jun Computer 2 000
Capital 2 000
4 Jun Inventory 6 000
GST clearing 600
Cash at bank 6 600
6 Jun Office furniture 5 000
GST clearing 500
Accounts payable 5 500
8 Jun Advertising 400
GST clearing 40
Cash at bank 440
10 Jun Cash at bank 220
GST clearing 20
Sales 200
Cost of sales 100
Inventory 100
12 Jun Inventory 5 400
GST clearing 540
Accounts payable 5 940
14 Jun Cost of sales 1 500
Inventory 1 500

100 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 Accounts receivable 3 300
Sales 3 000
GST clearing 300
16 Jun Cleaning of premises 100
GST clearing 10
Cash at bank 110

At 1 June 2023, the following account balances were noted:

•• Cash at Bank •• Inventory •• GST Clearing
$4300 debit $35 400 debit $3200 credit.
a Describe the transactions that have resulted in each of the journal entries shown.
b Prepare the relevant entries in the following general ledger accounts and balance
them at the end of June 2023: Cash at Bank, Inventory and GST Clearing.

6 Analysis of ledger accounts WB PAGE 75

The following accounts appeared in the general ledger of Armadale Auto Parts, a small
business owned and operated by Karen Rivalland.
Cash at bank
$ $
1 Jun Capital 30 000 2 Jun Fittings/GST clearing 16 500
4 Jun Sales/GST clearing 660 3 Jun Inventory/GST 3 300
clearing

Capital
$ $
1 Jun Cash at bank 30 000

Fittings
$ $
2 Jun Cash at bank 15 000

GST clearing
$ $
2 Jun Cash at bank 1 500 4 Jun Cash at bank 60
3 Jun Cash at bank 300 6 Jun Accounts receivable 10
5 Jun Accounts payable 40

Inventory
$ $
3 Jun Cash at bank 3 000 4 Jun Cost of sales 300
5 Jun Accounts payable 400 6 Jun Cost of sales 60

Cost of sales
$ $
4 Jun Inventory 300
6 Jun Inventory 60

Sales
$ $
4 Jun Cash at bank 600
6 Jun Accounts receivable 100

978 1 4202 3962 1 [CHAPTER 5] THE GENERAL JOURNAL AND GENERAL LEDGER 101
 Accounts payable
$ $
5 Jun Inventory/GST 440
clearing

Accounts receivable
$ $
6 Jun Sales/GST clearing 110

In chronological order, list the transactions that resulted in the double entries in the
above ledger accounts.

7 Detecting errors in a trial balance WB PAGE 76

The following errors were made in recording transactions in general ledger accounts.
a A debit to Wages of $500 was recorded as a debit to Insurance of $500.
b A $600 credit to Repair Fees was recorded as a debit to Repair Fees.
c A debit of $164 to Advertising was recorded as a debit of $146 to Advertising.
d A receipt of $50 interest was recorded as a debit to Interest and a credit to Cash
at Bank.
e A cash purchase of inventory of $300 wasn’t recorded in the books at all.
f $324 received from accounts receivable was debited to Cash at Bank as $324 and
credited to Accounts Receivable as $342.
g A credit sale of goods for $200 was recorded as a cash sale. The cost of sales of
$100 was recorded as a debit to Inventory and a credit to Cost of Sales.
h A cash sale of $550, including GST of $50, was recorded as a debit to Cash at Bank
$550, a debit to GST Clearing of $50 and a credit to Sales of $500.
For each error listed, state what difference there would be in the totals of a trial
balance. Explain your answers.

8 From documents to trial balance

SPREADSHEET X.XX WB PAGE 76

The documents shown below were found in the office of Vicky’s Vacs, a small
business that specialises in vacuum cleaners. The owner, Vicky Baron, still issues
many hand-written receipts and uses cheques to pay costs.
On 1 March 2023, the following account balances were available:
•• Cash at Bank $2300
•• Accounts Receivable – Domestic Cleaning $100, Inventory: $25 000
•• Accounts Payable – Victorian Vacuum Cleaners $200
•• GST Clearing $5000 (credit balance)
•• Capital – Baron $22 200.

Vicky’s Vacs ABN 04 213 984 618 Receipt 101

Shop 1
Black Arcade TAX INVOICE
Melbourne VIC 3000
Date: 2 / 3 / 23
Received from: M. Kingsley          
The amount of:    Four hundred & forty dollars    $ 440.00
For:   Cash sale—Hoover model BG345       GST included $  40.00
Signed:   V. Baron              Received with thanks

102 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 Vicky’s Vacs ABN 04 213 984 618 Receipt 102
Shop 1
Black Arcade TAX INVOICE
Melbourne VIC 3000
Date: 7/3/23
Received from: P Lazzaro         
The amount of:    Two hundred & twenty dollars    $ 220.00
For:    Cash sale – Lark Standard         GST included $  20.00
Signed:   V. Baron              Received with thanks

HOOVER INDUSTRIES TAX INVOICE A144 ABN 09 004 121 982

82 Queens Avenue
North Melbourne 3051 Date: 4/3/23
To: Vicky’s Vacs Terms: 30 days
Shop 1 Black Arcade
Melbourne VIC 3000

Description Qty Unit price Subtotal GST Total

Hoover WQ12 cleaners 10 $150.00 $1 500.00 $150.00 $1 650.00
Totals $1 500.00 $150.00 $1 650.00

Total (excluding GST) $1 500.00

Total GST payable $150.00
Total Amount Payable (including GST) $1 650.00

Vicky’s Vacs ABN 04 213 984 618 Receipt 103

Shop 1
Black Arcade TAX INVOICE
Melbourne VIC 3000
Date: 7/3/23
Received from: A Filardo          
The amount of:    Three hundred & thirty dollars    $ 330.00
For:   Cash sale – Lark Deluxe          GST included $  30.00
Signed:   V. Baron              Received with thanks

Your Bank Your Bank

DATE: 12 / 3 / 23 DATE: 13 / 3 / 23
Bal. b/f Bal. b/f

This chq. $ 165 This chq. $ 200

For: Advertising For: Wages

$ 150 $ 200
plus GST $  15 plus GST $  —
Bal. Bal.

Chq. no. 9145 Chq. no. 9146

978 1 4202 3962 1 [CHAPTER 5] THE GENERAL JOURNAL AND GENERAL LEDGER 103
 Vicky’s Vacs ABN 04 213 984 618 Receipt 104
Shop 1
Black Arcade TAX INVOICE
Melbourne VIC 3000
Date: 16/3/23
Received from: J Ha            
The amount of:    Three hundred & thirty dollars   $ 330.00
For:   Cash sale – Hoover model WQ12        GST included $  30.00
Signed:   V. Baron              Received with thanks

Vicky’s Vacs ABN 04 213 984 618 Receipt 105

Shop 1
Black Arcade TAX INVOICE
Melbourne VIC 3000
Date: 19/3/23
Received from:   A Erkihun        
 
The amount of:    Four hundred & forty dollars   $ 440.00
For:   Cash sale – Lark Deluxe         GST included $  40.00
Signed:   V. Baron              Received with thanks

Vicky’s Vacs TAX INVOICE 432 ABN 04 213 984 618

Shop 1 Black Arcade
Horsham VIC3400 Date: 21/3/23
To: Hinton Hotel Terms: 30 days
999 Flinders St
Horsham VIC 3400
Description Quantity Unit price Subtotal GST Total
Hoover WQ12 cleaners 6 $300.00 $1 800.00 $180.00 $1 980.00
Totals $1 800.00 $180.00 $1 980.00

Total (excluding GST) $1 800.00

Total GST payable $180.00
Total Amount Payable (including GST) $1 980.00

Your Bank Your Bank

DATE: 23 / 3 / 23 DATE: 26 / 3 / 23
Bal. b/f Bal. b/f

This chq. $ 66 This chq. $ 150

For: Stationery For: Wages

$ 60 $ 150
plus GST $  6 plus GST $  —
Bal. Bal.

Chq. no. 9145 Chq. no. 9148

104 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 Additional information
It is Vicky’s policy to double the cost price of all inventory items to determine selling
prices. For example, an item that sells for $300 has a cost price of $150.
a Using the source documents provided, enter the transactions relating to Vicky’s
Vacs in the general journal.
b Enter the opening balances into the general ledger accounts and post the entries
from the general journal prepared in question a.
c Prepare a trial balance as at 31 March 2023.

9 Balance sheet to balance sheet WB PAGE 81 SPREADSHEET X.XX

Lovejoy’s Lava Lamps has been operating as a small business for a number of years.
On 1 July 2023 the following assets and liabilities were in existence.

Assets $ Liabilities $
Cash at bank 4 000 Accounts payable 1 000
Accounts receivable 1 300 Loan from bank 12 000
Inventory 26 000 GST clearing 2 000
Shop fittings 25 000 Owner’s equity
Capital – Lovejoy ?

During July 2023, the following transactions occurred.

July 2 Purchased inventory on credit $1 700, plus GST of $170

3 Paid insurance $50, plus GST of $5 (for one month)
4 Received from cash clients $880, including GST of $80 (cost of sales $350)
5 Paid monthly loan repayment $500
6 Received $600 from N Flanders – accounts receivable
9 Cash sales $750, plus GST of $75 (cost of sales $350)
10 Paid $100 for stationery, plus GST of $10
11 Purchased new computer for $1650 cash (including GST of $150)
12 Lovejoy withdrew $100 for personal use
13 Received $1100 from cash sales, including GST of $100 (cost price $500)
14 Paid fortnight’s wages $650
16 Paid accounts payable for inventory purchases from last month $600
Sold goods for cash for $550, including GST of $50 (cost price $300)
Cash sales of goods $1200, plus GST of $120 (cost price $450)
19 Paid advertising account $180, plus GST of $18
20 Received $660 from cash client, including GST of $60 (cost of sale $300)
23 Sent out a quote for lamps for $1990 to Lunar Homes (including GST)
Received $530 from cash customer, plus GST (cost price $160) and invoiced
N Flanders for $550 for another credit sale, including GST (cost of sale $270)
28 Paid fortnight’s wages $650
30 Banked cash sales of $1880, plus GST of $188 (cost of sales $1030)

a Enter the above transactions into the general journal for Lovejoy’s Lava Lamps.
b Calculate Lovejoy’s capital figure as at 1 July 2023 and enter the opening balances
into ledger accounts.
c Enter the above transactions into the general ledger of Lovejoy’s Lava Lamps.
d Formally balance the ledger accounts and extract a trial balance as at 31 July 2023.
e Prepare an income statement for the month ended 31 July 2023.
f Prepare a classified balance sheet as at 31 July 2023.

978 1 4202 3962 1 [CHAPTER 5] THE GENERAL JOURNAL AND GENERAL LEDGER 105
 10 Balance sheet to balance sheet
SPREADSHEET X.XX WB PAGE 89

Deckard’s Drones had the following account balances in its general ledger on
1 August 2023.

$ $
Cash at bank 1 200 Accounts payable 2 750
Accounts receivable 300 Loan – Nissan Finance 15 000
Inventory 43 800 GST clearing 3 000
Vehicle 38 000 Capital – Deckard 62 550

During August 2023, the following transactions occurred:

Aug 2 Cash sales $3200, plus GST of $320 (cost of sales $1500)
3 Purchased goods on credit from Oz Electricals $5400, plus GST
4 Paid for petrol $165, including GST
5 Paid advertising account with local newspaper $140, plus GST of $14
8 Received from cash clients $2860, including GST of $260 (cost of sales $1400)
The owner withdrew $300 cash from the business
10 Invoiced J Walker $385 for credit sales, including GST of $35 (cost price $170)
11 Monthly insurance premium paid on vehicle $480, plus GST of $48
12 J Beam paid $300 on account
Paid for petrol $110, including GST of $10
13 Purchased stationery for cash $70, plus GST
16 Paid Oz Electricals $1500
17 Arranged with the bank an overdraft limit of $10 000
18 Received from cash customers $2800, plus GST of $280 (cost price $1500)
19 Purchased petrol for cash $121, including GST of $11
20 Inventory bought for cash $1800, plus GST of $180
23 Cash clients paid a total of $1980, including GST of $180 (cost of sales $950)
24 Loan repayment made to Nissan Finance $250
25 Paid for petrol $99, including GST
26 Paid J Walker $100
29 M Harvey withdrew cash for personal use $400
30 Submitted a quote to supply two large drones to Altona College (selling price
$1200 + $120 GST each, cost price $700 each)

a Enter the above transactions into the general journal for Deckard’s Drones. Use one
account for all accounts receivable and one account for all accounts payable.
b Enter the opening balances into the appropriate general ledger accounts and post
the general journal entries to your accounts.
c Formally balance the ledger accounts and extract a trial balance as at 31 August 2023.
d Prepare an income statement for the month ended 31 August 2023.
e Prepare a classified balance sheet as at 31 August 2023.

106 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 CASE STUDY WB PAGE 97

Jakob Smith is the owner of Smith’s Great Outdoors, a small business that specialises in
backpacks, tents and camping equipment. Smith has produced the following trial balance
at the end of the firm’s reporting period.
Smith had some difficulty getting his trial balance to balance. His investigation into the
accounts of the business revealed the following information.
•• A credit sale of $3740, with GST of
$374, was recorded as $3470 and SMITH’S GREAT OUTDOORS: TRIAL BALANCE AS AT
GST of $347. The cost price of the 31 MARCH 2023
sale was $1700; this was recorded $ $
as a debit to Inventory and a credit to Advertising 1 440 Capital 139 860
Cost of Sales. Cash at bank 5 290 Cash sales 86 340
•• A cash payment of $640 (plus GST of Commission revenue 1 540 Accounts payable 3 360
$64) for advertising was completely
Cost of sales 62 000 Credit sales 35 400
omitted from the ledger accounts
Drawings 10 800 Accounts receivable 2 500
of the business.
Insurance 2 300 GST clearing 4 000
•• Smith paid $540 insurance on his
family home and made an EFT Interest on loan 3 890 Loan from bank 21 000
payment from the business bank Inventory 55 400
account. As it was paid from the Office equipment 9 800
firm’s bank account, this payment Postage 1 020
was included in the Insurance Rent of premises 96 200
account shown in the trial balance.
Security expenses 1 320
•• A payment of a telephone bill of
Shop fittings 12 400
$440 (including GST of $40) was
accidentally debited to the Wages Telephone 2 840
account. (GST was recorded Wages 24 300
accurately.) 210 540
•• Smith withdrew $500 cash from Miscellaneous 1 920
the business in March 2023. expenses
Unfortunately, this has been 292 460 292 460
recorded as a withdrawal of
inventory.
•• A receipt of $200 from an account receivable was recorded as a cash payment to an
account payable.
•• A cash sale of $900 was recorded as a credit sale of $900. The cost of this sale was
recorded correctly, as was the GST.
•• Smith isn’t certain that he has sorted all of the accounts correctly in the trial balance.
He has asked that you check this, as he thinks some accounts may be listed on the
wrong side of the report.
•• Smith couldn’t get the trial balance to balance, so he created the item ‘Miscellaneous
Expenses $1920’ to get his trial balance in balance. No such expense had been paid
during the reporting period.

1 Jakob Smith has breached some accounting assumptions and/or failed to ensure that
his accounting information has the qualitative characteristics required. State and explain
the qualities and/or assumptions that he has breached, giving details of the items
affected by the breaches.
2 Redraft the entire trial balance for Smith’s business, considering the information
provided. Your redrafted trial balance should be accurate as at 31 March 2023.

978 1 4202 3962 1 [CHAPTER 5] THE GENERAL JOURNAL AND GENERAL LEDGER 107
 CHAPTER CHECKLIST
Now that you have finished Chapter 5, double-check your progress.
Are you ready for your Unit 3 assessment?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
completed the end-of-chapter activity
handed in my workbook for marking.

I understand …

the General Journal and General Ledger and their use in recording
transactions, both manually and using ICT, including:
– cash payments
– cash receipts
– drawings of inventory by the owner
the purpose and use of the pre-adjustment Trial Balance
the process of balancing General Ledger accounts for assets,
liabilities and owner’s equity
the recording of the transfer of drawings to the Capital account
in the General Journal and General Ledger.

I can …

identify and manually record financial data in the General Journal and General Ledger
use ICT to record financial data in the General Journal and General Ledger
explain the purpose of a Trial Balance.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_5

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

108 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 6 GENERAL JOURNAL
TRANSACTIONS

Chapter 5 introduced the concept LEARNING OBJECTIVES

of the general journal, and
showed how to use double entry By the end of this chapter, you will be able to:
accounting to record a number of •• use the general journal to establish a set of double
common transactions. However, entry records [6.1]
the general journal is a powerful
•• record the contribution of assets by a business owner
tool, and can be used to record far
[6.2]
more than sales and expenses.
•• record the withdrawal of assets by a business owner
In this chapter you will learn
how to record other types of
[6.2]
transactions, and how to correct •• record inventory being used for advertising purposes
errors via the general journal. [6.3]
•• correct recording errors through the general journal
[6.4]

UNIT 3 – PROGRESS 1 2 3 4 5 6 7 8 9 10 11 12 13

6.2 6.4

Contribution Correcting errors

or withdrawal of through the general
6.1 assets 6.3 journal
Donations of
Managing a double inventory Chapter review
entry system and business and exercises
advertising

978 1 4202 3962 1 109

 6.1 MANAGING A DOUBLE ENTRY SYSTEM
In previous chapters you learnt about many of the day-to-day financial transactions
business owners are required to record in a general journal and general ledger
accounts, using the rules of double entry accounting. In this chapter you will examine
some additional transactions.
For example, the following events may occur during the life of a business:
•• the owner contributes assets (other than cash)
•• the owner withdraws an asset (other than cash) for personal use
•• the owner decides to introduce a double entry accounting system
•• the owner returns inventory purchased to a supplier
•• a customer returns inventory sold
•• errors are made in the recording process and corrected via the general journal.

CONTRIBUTING MULTIPLE ASSETS

Often, the first time management uses a general journal is when the business is
created. This usually involves the business owner making a cash contribution, with
a debit entry to the Cash at Bank account and a credit entry to Capital as the first
double entry.
However, if the owner contributes multiple assets, such as cash and equipment,
an entry for each must be created in the general journal.

EXAMPLE 6.1

Linda Carter commences business on 1 March with a cash contribution of $60 000, a
vehicle valued at $35 000 and equipment valued at $5000.
Three different assets are contributed by the owner, all of which are created through
the general journal entry.

GENERAL JOURNAL
Date Details Dr Cr
1 Mar Cash at bank 60 000
Vehicle 35 000
Equipment 5 000
Capital 100 000
Assets contributed by owner to commence
business (Memo 001)

The principles of double entry are upheld in this general journal entry because the total
debits equal the total credits. The journal entry results in the following general ledger
accounts.

Cash at bank
$ $
1 Mar Capital 60 000

Vehicle
$ $
1 Mar Capital 35 000

110 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 Equipment
$ $
1 Mar Capital 5 000

Capital
$ $
1 Mar Cash at bank 60 000
Vehicle 35 000
Equipment 5 000
100 000

These entries are used to establish an accurate snapshot of the business when
it is first established. The Cash at Bank account and the non-cash assets are
created via the general journal entry. The three assets contributed by the owner
are then accumulated in the Capital account, reflecting the fact that the owner has
commenced trading with $100 000 starting capital.

CONTRIBUTING A LIABILITY
In addition to the assets invested into a business when it is set up, an owner may also
bring some established debts into a business.

EXAMPLE 6.2

Linda Carter’s vehicle was financed by a loan of $18 000. This means that the owner
doesn’t have a net worth of $100 000; when liability is taken into account, her net worth
becomes $82 000 ($100 000 – $18 000). The opening general journal entry then changes.
GENERAL JOURNAL
Date Details Dr Cr
1 Mar Cash at bank 60 000
Vehicle 35 000
Equipment 5 000
Loan – NAB 18 000
Capital 82 000
Assets and liabilities contributed by owner
to commence business (Memo 001)

If a liability is contributed to a business, along with a number of assets, this has a

negative effect on the owner’s Capital account, as the net worth of the business to
the owner has been reduced.

EXAMPLE 6.3

Linda Carter’s updated Capital account takes into account the liability that has also been
created.

Capital
$ $
1 Mar Loan – NAB 18 000 1 Mar Cash at bank 60 000
Vehicle 35 000
Equipment 5 000

978 1 4202 3962 1 [CHAPTER 6] GENER AL JOURNAL TR ANSACTIONS 111

 ESTABLISHING A NEW DOUBLE ENTRY SYSTEM
Another possible scenario is a business that has been operating for a number of years
using single entry accounting but has now decided to establish a set of double entry
books. In this situation the values for all accounts, as shown in the balance sheet, can
be used as the data to be entered in the general journal.

EXAMPLE 6.4

Siliato’s Sports has used single entry accounting to this point, with the following details.

Assets $ Liabilities $
Cash at bank GST clearing 1 000
Accounts receivable Accounts payable 2 000
Inventory Loan – OK Finance 5 000
Shop fittings 24 000 Owner’s equity 24 000
Accumulated 7 000 17 000 Capital 34 000
depreciation

The proprietor, Adrian Siliato, decides to introduce a full double entry system on 1 July
2023, using this information as the starting point. A general journal entry is created to set
up the business.
GENERAL JOURNAL
Date Details Dr Cr
1 Jul Cash at bank 4 000
Accounts receivable 3 000
Inventory 18 000
Shop fittings 24 000
Accumulated depreciation – shop fittings 7 000
GST clearing 1 000
Accounts payable 2 000
Loan – OK Finance 5 000
Capital 34 000
Assets and liabilities contributed by owner
to commence business (Memo 76)

Note that when setting up double entry for an existing business, the profit and/or
opening journal entry drawings for the previous reporting period aren’t required in the opening journal entry.
general journal entry The general journal entry in Example 6.4 uses the accounting equation to
made on the first day of
business, or on the first determine the capital figure of the owner. The account for accumulated depreciation is
day of a double entry shown as a credit entry along with the liabilities of the business, as they both reduce
recording system being
established
the owner’s equity in the business.
Once this entry is posted to the general ledger, the double entry system is
officially started. All the usual entries can now be made in the journal on a daily basis.

112 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 CONTRIBUTION OR WITHDRAWAL
6.2 OF ASSETS
The most common asset contributed to or withdrawn from a business by a proprietor
is cash. However, there may be times when an owner decides to contribute or
withdraw a different asset. Consider the events entered into the journal below.

Jul 1 The owner contributed an office desk to the business, with a fair
value of $200.
2 The owner withdrew inventory with a value of $100 for personal use.

These transactions are recorded in the general journal as shown in Figure 6.1.

FIGURE 6.1 General journal entries for contribution or withdrawal of assets other than cash

GENERAL JOURNAL
Date Details Dr Cr
1 Jul Office furniture 200
Capital 200
Owner contributed an office desk to the
business (Memo 12)
2 Jul Drawings 100
Inventory 100
Owner withdrew inventory for personal use
(Memo 13)

Whenever an owner puts an asset into a business, the particular asset account must
be debited and the Capital account credited. If an asset is withdrawn, the opposite
occurs – the Drawings account is debited (to record the negative effect on owner’s
equity) and the particular asset account is credited.
Withdrawing inventory is more complicated. When a business buys its inventory,
it records a debit entry to the Inventory account. If the owner withdraws some of
this inventory, the asset account must be reduced to reflect the decrease that has
occurred in the amount of inventory on hand.
Always remember that the Inventory account should show the cost of goods
available for sale at any time during the reporting period. If a decrease in inventory
occurs because of a withdrawal by the owner, this transaction must result in a credit
entry to the Inventory account.

USING FAIR VALUE FOR ASSETS

In Figure 6.1, the owner contributed an office desk to the business valued at $200. If the
business actually purchased the office desk from someone else, the verifiable cost of the
asset would be used, as this would be supported by a source document (e.g. an invoice).
In this case, the business didn’t buy the asset. The owner originally purchased the
desk and has now contributed the asset from their personal resources to the business
entity. This means that there is no source document to verify the cost of the asset to
the business. The owner may have a document that proves the cost of the asset when
it was first purchased, but the item may now be several years old, so its original cost
has no relevance to the business.

978 1 4202 3962 1 [CHAPTER 6] GENER AL JOURNAL TR ANSACTIONS 113

 A fair value needs to be
estimated for second-
hand assets like a
used desk.

When a business owner contributes a second-hand asset to their business, they

make an estimate of the asset’s value to provide a relevant value for the balance
fair value sheet. This is known as the fair value of an asset, which is based on a reasonable
estimate of an asset’s
value, used when a
estimate of its current market value. Usually a business owner makes this estimate
second-hand asset based on advice from their accountant or an expert in the appropriate field.
is contributed to a The estimate won’t satisfy the demand of verifiability, because there is no source
business
document available to verify the actual current value of the asset. However, to satisfy
the demands of relevance and faithful representation, a reasonable estimate may be
used as an asset’s fair value, so that meaningful information can be reported in the
balance sheet.

6.2 CHECK YOUR UNDERSTANDING WB PAGE 100

1 Explain what the term ‘fair value’ means, and describe the circumstances when
fair value may be used in accounting.
2 ‘Fair value should never be used, because there are no source documents to
support it.’ Do you agree with this statement? Explain your answer fully.
3 A conflict may exist between verifiability and relevance if assets are valued
at fair value. Explain how this conflict may occur. Which of the two qualitative
characteristics do you think should be followed?

114 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 DONATIONS OF INVENTORY AND
6.3 BUSINESS ADVERTISING
EXAM SUCCESS
Another unusual transaction is where a business gives away some of its inventory If an owner donates
for advertising or promotional purposes. For example, it may donate goods from stock for advertising
purposes, always
inventory to local schools or sporting groups to assist with fundraising or as part of a debit the advertising
sponsorship deal. account. Do not use
Although donations are often a gesture of goodwill towards the local community, ‘Donations’.

they also represent advertising for the business. Whether a sign is erected in the
rooms of a cricket club or the business is mentioned in a school’s newsletter, there is
usually a two-way relationship between the business and the group benefiting from
the donated goods. The problem is how to record such an event in the books of the
business.
Assuming that the business receives a material benefit from advertising in the
local community, it’s logical to create an Advertising account. However, no form of
advertising has actually been paid for, so it doesn’t involve a cash flow. The business
has simply given away inventory to someone else, and the inventory levels of the
business have decreased.

FIGURE 6.2 General journal entry for advertising via donation of inventory

GENERAL JOURNAL
Date Details Dr Cr
1 May Advertising 100
Inventory 100
Owner donated two soccer balls @ $50
each to the local school (Memo 31)

The general journal shown in Figure 6.2 creates an Advertising expense account of
$100 and decreases the Inventory account with the cost price of the goods given
to the local school. This ensures that the Inventory account is accurate and that the
goods sacrificed by the business are treated as expenses.
This is the correct accounting treatment because the business has suffered a loss
of economic resources, which leads to a decrease in the owner’s equity.

Inventory items
can be donated
to others as
an advertising
activity.

978 1 4202 3962 1 [CHAPTER 6] GENER AL JOURNAL TR ANSACTIONS 115

 CORRECTING ERRORS THROUGH
6.4 THE GENERAL JOURNAL
Another use of the general journal is to correct errors made in the recording process,
correcting entry
general journal entry through the use of correcting entries.
made in order to When accounts are balanced and a trial balance is prepared, errors may be
correct an error detected that need to be corrected. If incorrect debits or credits are located in the
accounts, they shouldn’t just be erased, written over or otherwise changed. This is
unacceptable accounting practice, as it makes it difficult to detect fraud. Instead, if an
error is detected it must be corrected by making a correcting entry in the journal.
When correcting an error through the general journal, two things have to be done.
First, the error(s) in the books must be removed. This may mean making a credit entry
to counteract an incorrect debit (or vice versa).
Second, the missing correct entry must be introduced. This can be shown by
adding correcting entries.

EXAMPLE 6.5

The following errors are found in the records of Lloyd’s Locks:

1 A payment of $80 for advertising was incorrectly debited to insurance.
2 An invoice for $40, plus GST of $4, was charged to B Andrews but should have been
charged to P Andrews.
3 A payment of $123 for petrol was recorded in the cash payments journal as $132.
A series of correcting entries are made in the general journal.

GENERAL JOURNAL
Date Details Dr Cr
30 Nov Advertising 80
Insurance 80
Correction of error – advertising debited to
insurance (Memo 11)
30 Nov Accounts receivable – P Andrews 44
Accounts receivable – B Andrews 44
Correction of error – incorrect Accounts
Receivable account charged (Memo 12)
30 Nov Cash at bank 9
Petrol expense 9
Correction of error – payment of $123
recorded as $132 (Memo 13)

In the first two entries in Example 6.5, the credit entry is used to eliminate an error:
•• Insurance has been credited because of an incorrect debit.
•• Accounts Receivable – B Andrews has also been credited to remove an error.
The debits in the first two entries introduce the debit entry that should have been
made in the first place. When these two entries are posted, the record will accurately
reflect events.
Note that, in the second entry, no adjustments are required to the Sales account,
the Inventory account, the Cost of Sales account or the GST Clearing account. This
is because the error just involved the credit entry being made against the wrong

116 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
accounts receivable. All of the other accounts have correct entries, and don’t require
any corrections.
The third entry differs slightly. When an incorrect figure has been entered, there
are two possible ways to correct the error.
1 If the journal has already been posted, this error will now be in the general ledger
accounts. In this situation, a journal entry is necessary to correct the mistake – the
$9 correcting entry.
2 If the journal hadn’t already posted, then the double entry in the general journal
will be correct, but the amount debited to the Petrol expense account is incorrect.
In this situation, it’s appropriate to rule a line through the incorrect figure and write
the correct number above it. (In a spreadsheet, you might replace the incorrect
figure, but leave a comment on the cell to note the original error.) As mentioned
earlier, numbers aren’t erased from the books; any corrections should be clearly
visible, including the incorrect original amount.
A set of ledger accounts shouldn’t contain many errors, but when they are found, a
formal general journal entry is the best way to correct them. This leaves no doubt as
to what has been corrected in the ledger accounts. It also fits with the systematic
approach to accounting, because all entries in accounts can be traced back to their
source via a journal entry.

General ledgers
create a trail
of all entries in
accounts back to
their source.

6.4 CHECK YOUR UNDERSTANDING WB PAGE 101

1 ‘If a business owner donates inventory items to a local community group, an expense
item is created.’ Do you agree with this statement? Explain your answer fully.
2 Carlson Education Supplies donates two computers to Carlton Primary School. State
the two-fold effect that this event has on the balance sheet of the business.
3 What is the acceptable accounting procedure when an error is detected in a general
ledger account? Explain why this procedure is followed.

978 1 4202 3962 1 [CHAPTER 6] GENER AL JOURNAL TR ANSACTIONS 117

 6 CHAPTER REVIEW

KEY CONTENT
•• [6.1] When a business owner contributes multiple assets to create a business,
each asset must be recorded in the general journal entry. Liabilities
brought into the business at the start should also be recorded in the
Owner’s Capital account.
•• [6.1] When an existing business begins using double entry accounting, the
values for all accounts (as shown in the balance sheet) are used as the
data to be entered in the general journal. The profit and/or drawings for the
previous reporting period aren’t required in the opening entry.
•• [6.2] Whenever an owner puts an asset into a business, the asset must be
debited and the Capital account credited. If an asset is withdrawn, the
opposite occurs. If the owner withdraws inventory, the asset account
must be reduced.
•• [6.2] If the owner adds their own assets to the business, this isn’t a purchase
and the business won’t have a source document to verify the asset’s cost.
Instead, a fair value should be estimated and recorded.
•• [6.3] Businesses often donate inventory as a form of advertising. This should
be reflected in the general ledger by decreasing the Inventory account,
then recording the value of the inventory as an expense in an Advertising
account.
•• [6.4] When errors are detected in accounts, it is unacceptable to simply change
or erase them. Instead, correcting entries should be made in the journal to
fix the balance and make a note of the error.

CHAPTER 6 EXERCISES

1 Opening entry: assets only

SPREADSHEET X.XX WB PAGE 102

Laura Pase decides to open a business trading as Champion Sound. On 1 April 2023
she contributes cash of $50 000, a vehicle with an agreed value of $32 000 and PA
equipment valued at $12 000. These details are noted on Memo 101.
a Prepare the opening general journal entry for the business on 1 April.
b State the accounting equation of the business as at 1 April 2023.

WB PAGE 102
2 Opening entry: including liability
SPREADSHEET X.XX

John Di Meglio commences business on 1 March 2023, trading as Western Wholesalers.

He contributes the following assets: cash $68 000, vehicle $36 000 and equipment
$23 000. Di Meglio financed the vehicle with a loan from NAB for $10 000, which is now
the responsibility of the business. All details were recorded on memo 201.
a Prepare the opening journal entries for Western Wholesalers.
b Prepare a balance sheet for the business as at 1 March 2023.
c Explain how Di Meglio would have determined the value of $36 000 for his vehicle.

118 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
3 Single entry to double entry WB PAGE 104 SPREADSHEET X.XX

Aaron Turner is the owner of Traralgon Gifts. He has used single entry accounting since
he started the business. A friend suggests that he should convert to double entry
accounting. Using the following information, prepare the opening general journal entry
on 1 August 2023 to establish a set of books under double entry accounting.

ASSETS AND LIABILITIES AS AT 31 JULY 2023

$ $
Cash on hand 200 GST clearing 500
Cash at bank 2 200 Accounts payable 3 600
Accounts receivable 3 200 Loan – AGC 7 500
Inventory 44 300 Loan – NAB 12 400
Display equipment 12 600
Less: Accumulated (2 600)
depreciation
Computer 3 200

4 Single entry to double entry WB PAGE 104 SPREADSHEET X.XX

Lauren Mbele’s business, Afrique Hairdressing Supplies, has been operating for a
number of years using a system of single entry accounting. Lauren has decided that the
business is now too complex for single entry and wants to set up a full set of double
entry records. The balance sheet of the business as at 30 June 2023 is provided below.

AFRIQUE HAIRDRESSING SUPPLIES: BALANCE SHEET AS AT 30 JUNE 2023

Assets $ $ Liabilities $ $ $
Cash on hand 200 GST clearing 300
Accounts receivable 660 Cash at bank 1 000
Inventory 40 340 Loan – MT Finance 14 700 16 000
Shop fittings 20 000 Owner’s equity
Less: Accum. dep’n 6 000 14 000 Capital 45 000
Office equipment 9 000 Net profit 4 700 49 700
Less: Accum. dep’n 2 500 6 500 Less: Drawings 4 000 45 700
61 700 61 700

Prepare the necessary general journal entry to establish a double entry system on 1 July
2023.

5 Contributions and withdrawals of assets WB PAGE 105 SPREADSHEET X.XX

The owner of Third Dimension Print Supplies, Ed Bendis, had the transactions during
January 2023.

Jan 3 Bendis contributed a computer from his home to the business.

The computer had a fair value of $2300 (Memo 101).
Jan 24 Bendis needed to do some repairs at home on his own 3D printer.
He took some inventory items from the shop, which had originally
cost the business $120. These items were going to be sold for $250
(Memo 102).

Prepare the general journal entries to record each of these events.

978 1 4202 3962 1 [CHAPTER 6] GENER AL JOURNAL TR ANSACTIONS 119

 6 Inventory used for advertising
SPREADSHEET X.XX WB PAGE 105

Lydia Lawrence is the owner of Northside Music & Beats. She receives a request from
Northcote Primary School to donate some goods for the school’s annual raffle. Lydia
decides that it may be beneficial for her business, as the principal has guaranteed
advertising space in the school newsletter.
On 31 March 2023, she takes some inventory from her shelves, which was selling for
a total of $1200, and notes the details on Memo 162. Lawrence also advises that she
applies a mark-up of 100% on all goods sold.
a Prepare the general journal required as a result of the above information.
b State the two-fold effect of your entry on the accounting equation of Northside
Music & Beats.

7 Inventory used for advertising

SPREADSHEET X.XX WB PAGE 105

Wodonga Kidsport is owned and managed by Bill Teggelove. The local Lions Club
contacts a number of local businesses, looking for donations of toys and sporting
goods. Teggelove is keen to help out, as he sees it as a good way to build goodwill for
his business with the local community. He decides to provide the following goods, and
notes their details on office memo 218 (issued 10 April 2023).

Quantity Item Cost price Selling price

2 Bicycles $150.00 $295.00
2 Tricycles $125.00 $245.00
3 Cricket sets $45.00 $99.00

a Prepare the general journal entry to account for the donated goods.
b A friend of Teggelove’s suggests that any goods donated from his business are
supposed to be recorded as drawings, because they’re no longer available for sale.
Do you agree with this statement? Explain your answer fully, with reference to the
accounting assumptions and/or qualitative characteristics of accounting.

8 Correction of errors
SPREADSHEET X.XX WB PAGE 106

At the end of November 2023, the following errors are found in the general ledger of
Paint ’n ’ Paper. Prepare general journal entries to correct these mistakes.
a A payment of $400 for wages was incorrectly debited to the Drawings account.
b A receipt of $100 from accounts receivable – J Blake was recorded as being
received from J Black.
c A debit of $540 to insurance was entered in the payments journal as $450.
d Cash sales of $200 were incorrectly credited to commission revenue.
e A payment of $150 for the hire of equipment was incorrectly debited to the
Equipment account.

120 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
9 Correction of errors WB PAGE 107 SPREADSHEET X.XX

Prepare the required general journal entries to ensure the correct recording of the
following information in the books of Fidget Factory on 30 November 2023.
a An office desk purchased for cash to use in the business’s office was accidentally
debited to the Inventory account (Memo 41). The cost of the desk was $600.
b The owner contributed office furniture to the business from his personal assets. The
furniture had a fair value of $500 but it was recorded as $50 (Memo 42).
c J Barton paid the business $480 on account. However, an entry was made against
Accounts Receivable – J Burton (Memo 43).
d Inventory that cost the business $100 was donated to the local school for a fete.
This was incorrectly debited as drawings by the proprietor (Memo 44).
e A payment of advertising for $191 was incorrectly recorded in the general journal as
insurance of $119 (Memo 45).

10 A review of general journal entries WB PAGE 109 SPREADSHEET X.XX

The following information relates to a small business trading under the name of
Peninsula Vintage Furniture. Prepare general journal entries (if necessary) for each of
the items listed.
a On 12 March 2023 the owner contributed a computer to the business from her
home. The machine had a fair value of $750 (Memo 81).
b Registration and insurance was paid on the business’s delivery van during the year.
The total cost was $820. On 14 June 2023 it was discovered that the full amount
had been debited to the Delivery Van account (Memo 82).
c On 7 July 2023 the owner found that a payment made in late June was incorrectly
recorded in the journal. The payment was for courier fees totalling $248. However,
the journal entry shows a payment of $284 (Memo 83).
d On 19 July 2023 the owner donated some goods to the Salvation Army. The goods
had originally cost $500 and usually sell for $950. The owner was unsure how to treat
such an item and decided to treat it as a withdrawal for personal use (Memo 84).
e The business completed an EFT for $1280 to an accounts payable. Unfortunately,
the payment was recorded in the journal as advertising expense.
f A loan application was submitted to the bank in early August. The business
requested an amount of $25 000 to buy a second delivery van. On 8 August the
owner realised that she had made an error, as she had intended to ask for a loan of
$28 000.
g A piece of furniture withdrawn by the owner on 17 August 2023 was accidentally
recorded as a cash sale. The item taken home originally cost $90 and usually sells
for $160, plus GST of $16 (Memo 86).

978 1 4202 3962 1 [CHAPTER 6] GENER AL JOURNAL TR ANSACTIONS 121

 CHAPTER CHECKLIST
Now that you have finished Chapter 6, double-check your progress.
Are you ready for your Unit 3 assessment?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
handed in my workbook for marking.

I understand …

the General Journal and General Ledger and their use in recording
transactions, both manually and using ICT, including:
– establishment of a double entry system
– inventory used for advertising purposes
– contribution of non-current assets at fair value by the owner.

I can …

identify and manually record financial data in the General Journal and General Ledger
use ICT to record financial data in the General Journal and General Ledger.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_6

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

122 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 7 THE PERPETUAL
INVENTORY SYSTEM

The success of a trading business LEARNING OBJECTIVES

depends on its ability to buy and
sell goods to make a profit. These By the end of this chapter, you will be able to:
goods are referred to as inventory, •• define ‘inventory’ [7.1]
stock or merchandise. Most of the •• explain what is involved in a physical stocktake [7.1]
business’s transactions will involve
•• outline the features of the perpetual inventory system
changes to inventory. These
[7.2]
changes need to be recorded
•• outline the role of the Inventory account [7.3]
accurately in the business’
accounting system. •• describe the double entry requirements of a trading
In this chapter you will learn business using perpetual inventory [7.3]
how to use the double entry •• explain the identified cost and the first in, first out
accounting system to record (FIFO) methods of valuing inventory [7.4]
changes to inventory. You will also •• record movements of inventory on inventory cards,
learn how to use the perpetual using the first in, first out (FIFO) method and identified
inventory system and inventory cost [7.5]
cards to keep current records.
•• prepare appropriate entries in ledger accounts for the
purchase and sale of inventory [7.5]
•• calculate, record and report inventory losses and gains
[7.6]
•• record inventory card entries for donations [7.7]

UNIT 3 – PROGRESS 1 2 3 4 5 6 7 8 9 10 11 12 13

7.2 7.4 7.6

What is perpetual Identifying the Inventory losses

inventory? cost price of sales and gains Chapter review
7.1 7.3 7.5
7.7 and exercises

Donations of
The Inventory The role of
What is inventory? inventory
account inventory cards
for advertising
purposes

978 1 4202 3962 1 123

 7.1 WHAT IS INVENTORY?
inventory A trading business buys inventory and sells it at a higher price to earn its revenue.
goods purchased by a
trading business for the
If it sells enough inventory during the reporting period, the revenue it earns should
purpose of resale exceed its expenses, resulting in a profit.
The definition of trading inventory excludes some items that a business may sell
occasionally. Non-current assets, such as equipment and vehicles, may be sold for a
gain or a loss at the end of their useful lives. However, when management purchases
such assets, the intention isn’t to resell them to earn revenue. Non-current assets are
bought with the intention of owning them for several reporting periods, for use within
the business.

THE PHYSICAL STOCKTAKE

physical stocktake Once every reporting period, a business must carry out a physical stocktake of its
the process of counting
units of inventory on hand
inventory. The aim of a stocktake is to determine the actual amount of inventory on
at a particular point in hand at a given date. The value of inventory at that time is included in the business’s
time balance sheet as a current asset. It’s also used as a check on the inventory records
kept under the perpetual method of recording inventory movements (explained later in
the chapter).
A stocktake has two stages. First, the number of units of each type of inventory is
physically counted. Second, the cost price of each of these units is used to calculate a
total value for inventory on hand.
inventory sheet Inventory sheets are used to record the details of a stocktake. Figure 7.1 shows a
record used to note typical inventory sheet.
details of goods on hand
when doing a physical
stocktake FIGURE 7.1 A typical inventory sheet

Inventory item Quantity Cost $ Value $

AB cricket bats 50 200 10 000
CV cricket balls 400 40 16 000
Mitre soccer balls 80 30 2 400
Kooka hockey sticks 60 30 1 800
Total inventory on hand 30 200

Note that the quantity on hand of each inventory unit is stated, as well as its actual
cost. In this example, the business’s inventory on hand would be stated as $30 200.

7.1 CHECK YOUR UNDERSTANDING WB PAGE 111

1 Explain how an item may be classified as inventory for one business, but as a non-
current asset for another.
2 Define ‘physical stocktake’.
3 Describe the two processes that must carried out as part of the stocktaking process.

124 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
7.2 WHAT IS PERPETUAL INVENTORY?
Perpetual inventory (also known as continuous inventory) involves keeping records of perpetual inventory
a system of recording
all inventory movements throughout the reporting period. While a physical stocktake
movements of inventory
determines the amount of inventory on hand on balance day, the perpetual method items on a continuous
updates the balance of inventory on hand continuously. basis throughout a
reporting period
Every time inventory moves in or out of the business, the inventory balance
is updated. When inventory is purchased, the balance increases; when sales are
made, the balance decreases. Even withdrawals of inventory by the owner must be
accounted for, as these also decrease the balance of inventory on hand.
There is a lot of recording required under the perpetual inventory system. Inventory
is usually recorded at cost price, so there is a need for information regarding the cost
prices of inventory throughout the reporting period.
So, what are the benefits to management if it uses the perpetual inventory
method? Figure 7.2 summarises its advantages and disadvantages.

FIGURE 7.2 Advantages and disadvantages of the perpetual inventory method

Advantages Disadvantages

Greater control Additional record

keeping

Identifies speed of
turnover Additional costs

More efficient Doesn’t replace

reordering physical stocktake

Interim profit
reports

Identifies
inventory losses

ADVANTAGES OF PERPETUAL INVENTORY

1 Greater control over inventory is possible, because up-to-date information is
available throughout the reporting period. With more information, management
can make better decisions in relation to inventory. When computerised inventory
systems are used, information can be continually updated as transactions occur.
This information is timely and highly valuable to management.
2 Slow-moving and fast-moving lines of inventory can be identified. An
inventory card is used to record all movements of an inventory item. Cards are
maintained throughout the reporting period, so precise information is available

978 1 4202 3962 1 [CHAPTER 7] THE PERPETUAL INVENTORY SYSTEM 125

 about how often sales occur for each item. Management can then make decisions
based on that information, such as increasing the level of items that sell well, or
reducing/eliminating slow-moving items.
3 Reordering of inventory is more efficient. Perpetual inventory involves keeping a
record of how many units of each item are on hand at any time. When the number
of units reaches a certain level, an order can be sent to the relevant supplier. This
avoids the problem of running out of inventory and possibly missing out on sales.
4 Interim profit reports can be prepared without doing a stocktake. This is one
of the big advantages of perpetual inventory. As records are continually updated,
in terms of both selling prices and cost prices of goods sold, a gross profit figure
can be calculated daily. This is extremely valuable information for management. If
an estimate of operating expenses can be made, an estimated net profit figure can
be calculated for each week or month of the reporting period. (It can only be an
estimate of profit, though, as the physical stocktake may reveal other information
such as inventory losses.)
5 The level of inventory losses or gains can be measured. The perpetual method
can identify the goods lost during the period (in conjunction with a physical
stocktake). Losses may occur due to theft or breakages, and the level of such losses
can be measured in the perpetual system. Management may then react to such
losses and make the appropriate decisions, such as installing security systems.

DISADVANTAGES OF PERPETUAL INVENTORY

1 Additional record keeping. Inventory balances must be updated on a continuous
basis. This may increase the workload of the owner/manager or require more staff.
2 Additional costs may be incurred. These costs may relate to extra staff and/or
equipment. For example, many perpetual systems run on computerised systems.
These systems and their software have to be purchased if management decides to
use the perpetual inventory method.
3 It’s still necessary to do a physical stocktake at the end of the reporting
period. Even though perpetual inventory continuously updates inventory records,
events such as breakages, theft and errors may lead to these records being
inaccurate. The only way to determine the actual inventory on hand is to count
it. Therefore, even with all the additional work and record keeping, perpetual
inventory doesn’t eliminate the need for a periodic stocktake.
Given all these disadvantages, perpetual inventory must produce significant benefits
for it to be used. Which it does; perpetual inventory provides owners with information
that is vital to inventory management. The benefits of maintaining the system usually
far outweigh the costs.

7.2 CHECK YOUR UNDERSTANDING WB PAGE 112

1 Briefly explain what is involved in the perpetual inventory system.

2 Identify and describe three advantages of perpetual inventory.
3 Identify and describe three disadvantages of perpetual inventory.

126 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
7.3 THE INVENTORY ACCOUNT
As you have seen in earlier chapters, purchases of inventory are debited to an asset
account in the form of the Inventory account. During the reporting period, as sales
are made, the cost price of these sales is transferred from the Inventory account to
a Cost of Sales account (an expense). The Inventory account is used to record all inventory account
movements of inventory. general ledger account
used to record
Inventory is an asset, so whenever it increases, the Inventory account must be transactions affecting
debited. If the level of inventory decreases, the Inventory account must be credited inventory
(see Table 7.1). The balance of the Inventory account represents the total cost of
inventory on hand at a point in time.

TABLE 7.1 Summary of the Inventory account

INVENTORY
Increases in inventory are caused by: Decreases in inventory are caused by:
• buying goods • selling goods
• inventory gains • inventory losses
• capital contributions of inventory • drawings of inventory
• inventory used for advertising

The Inventory account is a summary of total inventory and is backed up by records of

individual inventory items in subsidiary records known as inventory cards. The total of all
inventory cards must equal the balance of the Inventory account in the general ledger.

Changes to the
level of inventory
are recorded in
the Inventory
account.

978 1 4202 3962 1 [CHAPTER 7] THE PERPETUAL INVENTORY SYSTEM 127

 DOUBLE ENTRY UNDER THE PERPETUAL METHOD
This is a good time to revisit the basic double entries relating to inventory movements,
to help you get a full understanding of all recording for inventory. Table 7.2 summarises
the double entries required for buying and selling inventory for cash or credit.

TABLE 7.2 Double entry under perpetual inventory

Transaction Source document Double entry

1 Bought goods for EFT receipt Inventory Dr
cash GST clearing Dr
Cash at bank Cr
2 Bought goods on Purchase invoice Inventory Dr
credit (original) GST clearing Dr
Accounts payable Cr
3 Sold goods for cash Receipt (copy) or EFT Cash at bank Dr
receipt (merchant Sales Cr
copy) GST clearing Cr
(with selling price)
and
Cost of sales Dr
Inventory Cr
(with cost price)
4 Sold goods on credit Sales invoice (copy) Accounts receivable Dr
Sales Cr
GST clearing Cr
(with selling price)
and
Cost of sales Dr
Inventory Cr
(with cost price)

7.3 CHECK YOUR UNDERSTANDING WB PAGE 113

1 Outline the role of the Inventory account under the perpetual inventory method.
2 What classification applies to the Inventory account? Explain your answer.
3 Outline the role of the Cost of Sales account. What classification applies to this
account?
4 State two financial transactions that:
a increase the Inventory account
b decrease the Inventory account.
5 State the double entries required for each of the following transactions under the
perpetual inventory method:
a purchased inventory for cash
b purchased inventory on credit
c sold goods for cash
d sold goods on credit.

128 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 7.4 IDENTIFYING THE COST PRICE
OF SALES
Table 7.2 summarised the source documents for the data in the general journal and
general ledger. These documents contain details such as the cost of purchasing
inventory (purchase invoices) and the prices charged to customers for inventory sold
(sales invoices and receipts).
One item that is not included on the source documents is the cost price of the
sales made by the business. These prices must be entered in the general journal on a
continuous basis throughout the period, and therefore must be readily available. So,
how are cost prices recorded for accounting purposes? Figure 7.3 summarises the
different methods.

FIGURE 7.3 Methods of recording cost prices

Identified cost
Lorem ipsum

FIFO RECORDING LIFO

COST PRICES

Weighted
average cost

Cost prices may be identified using one of the following methods:

1 An identified cost method, which identifies the actual cost of each item of
inventory when it is sold.
2 The first in, first out (FIFO) method, which assumes that the first inventory
purchased is the first inventory sold.
3 The last in, first out (LIFO) method, which assumes that the business sells its most
recent purchases first.
4 The weighted average cost method, which calculates an average of the cost price
of each item of inventory and applies this cost when a sale is made.
An owner of a trading business has a basic choice to make when recording cost
prices of goods sold. They can either identify the actual cost of all goods, or make an
assumption about the movement of inventory over time.
This is the main difference between identified cost and the other methods. The
identified cost method records the actual cost price of every item of inventory sold. identified cost
FIFO, however, simply assumes that the first goods in are the first goods out. method
system of recording
Note: While there are four methods of applying costs to inventory, the VCE Accounting the actual cost of each
individual unit
Study Design only requires knowledge of the identified cost and first in, first out of inventory
methods. The other methods aren’t explored in this textbook.

978 1 4202 3962 1 [CHAPTER 7] THE PERPETUAL INVENTORY SYSTEM 129

 THE IDENTIFIED COST METHOD
If a business uses identified cost, it must decide how cost prices can be identified
during a reporting period. This must be done in a relatively easy way. The general journal
needs to be written up daily, and the cost prices of all sales are required for both cash
and credit sales. Figure 7.4 summarises the common methods of identifying cost prices.

FIGURE 7.4 Common methods of identifying cost prices

Manual coding

SYSTEMS FOR
IDENTIFYING
COSTS

Computerised Fixed mark-up

coding

Manual coding systems

One simple way to identify the cost of inventory is through a manual coding system.
Such systems are cheap to implement and are effective if the volume of sales isn’t too
high. A business that sells large items, such as lounge suites or televisions, could use
a manual coding system.
The code involves a series of letters or numbers on the price tag of each item,
such as the price tag shown in Figure 7.5.

FIGURE 7.5 Price tag with numeric code

Fancy Fashions
1804325012
$65.00

The customer can see the selling price of $65 for the item, but the numbers in the
middle of the price tag are meaningless to them. They are a simple code for the
following information:
•• The first four digits (1804, in this example) indicate the date of purchase by the
store (18 April).
•• The next four digits (3250) indicate that the cost price of the item was $32.50.
•• The last digits (12) are a code for the supplier of the goods (i.e. the wholesaler).
This is only one example of a simple coding system that can be varied to suit the
needs of the individual business.

130 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 Rather than a simple numeric code, a different coding system may be used to more
effectively ‘hide’ the cost price of inventory. The price tag shown in figure 7.6 uses an
alphabetic code so that the cost price of inventory is not known by anyone other than
management.

FIGURE 7.6 Price tag with alphabetical code

Once again, when a customer sees this item on display, the selling price is clearly
marked but the letters above it are meaningless. Management, however, has included
the cost price of the item on its price tag by using the following code:
C H R O M E T A P S
1 2 3 4 5 6 7 8 9 0

Super Sports Store

CM/TS
$29.95

Each letter is used to denote a particular number. The letter C indicates 1, the letter
M indicates 5, and so on. The slash in CM/TS distinguishes the dollars from the cents.
The cost price of this item is $15.70.
Once such a code has been used for a short while, management can determine
the cost price of any inventory item at a glance. The letters used in the code don’t
really matter, but the cost price can be deciphered more quickly if the code is easy to
remember, as in the example of chrome taps. The only important consideration is that
10 letters are needed and that they all must be different.
A side benefit of using a code is that staff members can easily determine the cost
price of an item, and therefore the profit margin. This is useful in situations where a
customer asks for a discount. The seller can check the cost price on the spot and know
how low the price can be adjusted before the business loses money on the deal.

Fixed mark-up systems

Some small business owners prefer to keep things very simple and apply a specific
mark-up to all products being sold. For example, it’s easy to determine selling prices
by applying a 100% mark-up to all inventory, doubling all cost prices. If a mark-up of
100% is applied, working backwards from selling prices to cost prices is also simple –
just halve the selling price.
However, not all small businesses apply one mark-up to all items of inventory, or
one as simple as the 100% example. The formula below is very useful.

Selling price x 100

Cost price =
100 + Mark-up

For example, inventory with a selling price of $40 was found in the stocktake of a business
that marks everything up by 60%. To determine its cost price, use the following formula.

$40 x 100 $4000

Cost price = 100 + 60 = 160 = $25

978 1 4202 3962 1 [CHAPTER 7] THE PERPETUAL INVENTORY SYSTEM 131

 The answer can always be checked by working from the cost price back to the
selling price, as shown below.
Mark-up = 60% of $25 = $15
The selling price = $25 + $15 = $40

For such a system to work, it’s assumed that selling prices and mark-ups don’t change
over time. If the mark-up hasn’t been maintained because some inventory is sold at a
reduced price, the system would have to be adjusted.

Computerised coding systems

Manual systems may be suitable for some small businesses, but if the number of sales
per day is high, they become impractical. The information relating to cost prices must be
copied from each price tag during the day, or all price tags must be removed at the point
of sale and then collated later. This can be difficult in shops that sell high-volume goods,
such as a supermarket.
A computerised system, based on product barcodes, overcomes this problem.
Barcodes now appear on almost all products. The use of a scanner at the checkout
enables many different types of financial information to be recorded instantly. A barcode
can include information such as the product’s country of origin, the supplier of the
goods, the cost price of the item and its selling price.
If a business can afford a barcoding system, daily reports can be generated on
matters such as:
•• total dollar sales for the day
•• total value of the cost of sales for the day
•• number of units sold of each inventory item
•• reorder requirements of each item of inventory.
Such information is highly valuable to management. One of the demands of accounting
information is that it be timely (see Chapter 1), which means that information must
be available quickly enough to be useful. A perpetual system that can generate a daily
financial summary of inventory movements meets this demand.
Many small, sole-proprietor businesses may not have the funds to computerise their
inventory systems, but on a smaller scale the principles remain the same. Cost prices
can be recorded daily if the volume of sales doesn’t make this impractical.

Computerised
systems and
barcode scanners
help record high
volumes of sales.

132 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
THE FIRST IN, FIRST OUT (FIFO) METHOD
Perpetual inventory depends on management being able to record a cost price at
the actual time of sale. However, it is sometimes not be possible to identify the
actual cost.
Consider a petrol station that has inventory on hand of 10 000 litres of fuel, costing
$1.00 per litre. The business then purchases an additional 10 000 litres of fuel at a cost
of $1.05 per litre. When the business sells 4000 litres of fuel the next day, what is the
cost price of the sale – $1.00, $1.05, or an average of the two lots of inventory? As all
the fuel mixes together, it’s impossible to distinguish one lot of inventory from another.
Another possibility is that management simply chooses not to apply an identified
cost system. The hassle of coding every single item, or the cost of a computerised
inventory system, deters many small business owners from applying identified cost
continuously through the reporting period.
If perpetual inventory is desirable, management may instead assume that the
business’s inventory follows the pattern of first in, first out (FIFO). This is a simplified first in, first out (FIFO)
a system of recording
system that satisfies the demands of the perpetual system but is much easier to apply. inventory costs, based on
For accounting purposes, FIFO assumes that the first goods purchased are the first the assumption that the
goods sold. This is acceptable, because most trading businesses try to sell inventory first goods purchased are
the first goods sold
in roughly the same order as it’s purchased. Inventory should be rotated when new
deliveries arrive, to prevent items from becoming shop-soiled due to customer
handling. Also, in the case of perishables with use-by dates, inventory may become
unsaleable because the use-by date has passed.

IDENTIFIED COST VERSUS FIFO

To demonstrate the differences between identified cost and the FIFO method, the
purchases and sales details of a product for January 2023 are listed below.

Purchases Sales
1 Jan Lot #1 50 units @ $6.00 $300 4 Jan 40 units from Lot#1 @ $12.00
each

6 Jan Lot #2 50 units @ $6.20 $310 9 Jan 30 units from Lot#2 @ $12.50
each

13 Jan Lot #3 50 units @ $6.50 $325 18 Jan 20 units from Lot#3 @ $12.50
each

24 Jan Lot #4 50 units @ $6.60 $330 31 Jan 50 units from Lot#4 @ $12.90
each

Total 200 units $1 265 Total 140 units

On 31 January, a physical stocktake reveals that 60 units were on hand after 140 units
had been sold during the month.
Two questions need to be answered in relation to the accounting reports for this
business:
•• What is the value of cost of sales to be reported in the income statement for January?
•• What is the dollar value of inventory that will be reported in the balance sheet?

978 1 4202 3962 1 [CHAPTER 7] THE PERPETUAL INVENTORY SYSTEM 133

 If the FIFO system is used, the 60 units in inventory would be valued as 50 at $6.60
and 10 at $6.50, for a total of $395 (50 × $6.60 = $330; 10 × $6.50 = $65; $330 + $65
= $395). This is because the earlier purchases are assumed to be sold first.
The FIFO assumption gives the information below.

FIRST IN, FIRST OUT

Cost of sales Inventory on hand
50 units @ $6.00 $300 10 units @ $6.50 $65
50 units @ $6.20 $310 50 units @ $6.60 $330
40 units @ $6.50 $260
140 units $870 60 units $395

To determine the cost of sales and a value for inventory on hand under an identified
cost method, the price tags of all units need to be examined. A physical stocktake
provides the following information.

IDENTIFIED COSTS
Cost of sales Inventory on hand
40 units @ $6.00 $240 10 units @ $6.00 $60
30 units @ $6.20 $186 20 units @ $6.20 $124
20 units @ $6.50 $130 30 units @ $6.50 $195
50 units @$6.60 $330
140 units $886 60 units $379

A different result occurs when you compare identified cost to the FIFO method.
Identified cost is the preferred method because it reports the situation as it actually
happened. FIFO is only an assumption of what took place, so it’s not necessarily as
accurate as identified cost.
In the above example, FIFO writes off only $16 less as cost of sales for the period,
and inventory on hand is $16 higher. In a business where hundreds or thousands of
different stock items are sold daily, this difference may be large.
Discrepancies between the two methods tend to correct themselves over time, as
one period’s inventory at end becomes the inventory on hand for the start of the next
reporting period. Thus, over two consecutive periods, the differences between the
two methods usually cancel each other out.
Although FIFO may not exactly reflect the actual inventory flow over a period, it’s
a completely acceptable method of inventory valuation. As identified cost usually
requires additional record keeping, FIFO is an acceptable alternative that is easy to
apply to inventory, regardless of the types of products being used.

7.4 CHECK YOUR UNDERSTANDING WB PAGE 114

1 Describe two different methods a trading business can use to identify the cost
price of inventory on hand.
2 List four items of financial information that can be generated daily if a trading
business uses a computerised bar-coding system.
3 Explain the difference between the identified cost method and the first in, first
out method.

134 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
7.5 THE ROLE OF INVENTORY CARDS
An inventory card is a subsidiary record used to record the financial transactions of inventory card
one particular inventory item. An inventory card should contain all relevant details of subsidiary record used to
note down all movements
the individual item. These details vary from business to business, but usually include: of an individual inventory
•• the name (or description) of the item item

•• the product code number (if applicable)

•• the name of the supplier
•• the location of the item (particularly useful in larger businesses)
•• the minimum and maximum number to be in inventory (when the minimum
number is reached, the item is reordered back up to the maximum)
•• the valuation method in use (we’ll concentrate on the FIFO method at this stage)
•• all purchases and sales in relation to the product.
With all these details, the design of inventory cards can vary. As with all accounting
records, an inventory card must suit the needs of the individual business. Figure 7.7
shows a typical inventory card for a perpetual inventory system.
Like most modern accounting tools, an inventory card may be a digital record, such
as a spreadsheet, rather than a physical card.

FIGURE 7.7 Inventory card

Inventory item: Product code: STV Valuation: FIFO Min: 5 Max: 15

Sonya 100 cm TV 84920
Supplier: IN OUT Balance
Wholesale
Electricals
Date Details Qty Cost Value Qty Cost Value Qty Cost Value
1 Jul Balance 5 480 2400
2 Jul Invoice 843 10 490 4900 5 480
10 490 7300
3 Jul Receipt 210 2 480 960 3 480
10 490 6340
4 Jul Invoice 101 3 480 1440
2 490 980 8 490 3920
5 Jul Receipt 211 3 490 1470 5 490 2450
6 Jul Invoice 877 10 490 4900 15 490

This card shows five transactions over several days:

•• July 1: five units are on hand, with each item costing $480.
•• July 2: 10 units are purchased on credit, as noted by Invoice 843. Note the impact
on the Balance column; the business now holds five units with a cost price of $480
and 10 at a cost of $490. It’s crucial that the cost prices of inventory purchased are
kept in the order of purchase, allowing the FIFO rule to be applied when inventory
is sold.
•• July 3: two units are sold for cash (Receipt 210). As the first inventory bought
cost $480 per unit, it’s assumed that this is the inventory sold. Two of the $480
units are therefore moved to the Out column, leaving three at $480. All the $490
inventory remains in the business at this stage.

978 1 4202 3962 1 [CHAPTER 7] THE PERPETUAL INVENTORY SYSTEM 135

 •• July 4: five units are sold (Invoice 101).The application of the FIFO rule is crucial here.
The business still has three units left at $480 each, and 10 units with a cost of $490
each. Because five were sold, under the FIFO assumption three of them are assigned
the cost price of $480, while the other two are given the cost price of $490.
•• July 5: only one cost price is left, so the three units sold on this day are allocated
the cost price of $490 per unit.
•• July 6: 10 new units are purchased. With this purchase, the cost price is the same
as that previously charged. In such a case, the units can simply be added to the
existing inventory. This can only be done if the latest cost price is the same as the
last lot of inventory purchased by the business.

MANAGING USE OF INVENTORY CARDS

When inventory is purchased at different prices, these cost prices must be recorded
in order within the inventory card. Cost prices may increase and decrease, but this
doesn’t affect the application of the FIFO rule. If the cost prices are kept in the order
in which they occurred, the FIFO rule can be applied when inventory is sold.
The other important point to note is that all financial data recorded relates to the
cost price of the inventory item. The selling price of the televisions (and the related
GST) is irrelevant to the entries made in the inventory card.
For inventory cards to be an effective tool, they must be updated on a regular
basis, preferably daily. This provides management with the most recent information
about inventory levels. It also identifies the items that are selling well and those that
are virtually not selling at all. Management can make better decisions when this sort
of information is available and is updated daily.

INVENTORY CARDS AND THE GENERAL LEDGER

The Inventory account (page 127) is part of the double entry requirements of a trading
business using perpetual inventory. Debits and credits are made to the Inventory
account, with the usual cross-referencing to other general ledger accounts.
The Inventory account is used to record entries from the general journal for
purchases, purchases returns, sales and sales returns. It doesn’t show individual
inventory details. The balance of the Inventory account at the end of a period should
equal the total inventory on hand at that time.
Inventory cards are not part of the general ledger double entry process. They act
as a subsidiary record to note the details of individual inventory items. The number
of inventory cards used by a business depends on the number of different inventory
items sold, as a separate card is maintained for each line of inventory.
Table 7.3 shows the relationship between inventory cards and the Inventory
account.

TABLE 7.3 The link between inventory and inventory cards

General ledger Subsidiary record

Inventory account Inventory cards
• one single record for total inventory • many individual records
• no individual details of inventory items • not part of double entry recording
• updated continuously during the period. • updated continuously during the period.

136 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
Management can use the two types of records as a control mechanism, because
the total of all inventory cards can be checked against the balance of the Inventory
ledger account.
Errors may be detected by comparing the two sets of records. The balance of
the Inventory account can be determined in the usual way from the general ledger.
To check this figure, determine the closing balances of all the inventory cards; there
should be the same dollar amount as recorded in the Inventory account.
A schedule can be prepared for this purpose, such as the one shown in Figure 7.8.

FIGURE 7.8 Schedule of inventory cards showing final balances

Inventory description Product Code Quantity Cost $ Value $

Sonya 60 cm CTV STV84920 30 200 6 000
Sonya 100 cm CTV STV84921 50 500 25 000
Kembrook Blu-ray recorder KM84343 20 600 12 000
Kembrook Next 4G tablets KM84392 10 850 8 500
Balance of Inventory ledger account 51 500

It’s important to be able to relate the entries in an inventory card to the double
entries in the general ledger. The most obvious link between the two records is that
the entries on the debit side of the Inventory account occur when inventory increases,
and equate to the entries in the In column on the inventory cards. Similarly, credits to
the Inventory account equate to the Out column on the inventory cards.
An important element is the Details column on the inventory card (see Figure 7.7).
The source documents stated in this column indicate the nature of the transaction in
each case, and should always be stated for future reference.

7.5 CHECK YOUR UNDERSTANDING WB PAGE 115

1 What is the purpose of an inventory card?

2 How many inventory cards does a trading business need? Explain your answer
fully.
3 State five different pieces of information relating to inventory that may be
recorded on an inventory card.
4 Explain the link between the columns in inventory cards and the debits and
credits in the Inventory account.

978 1 4202 3962 1 [CHAPTER 7] THE PERPETUAL INVENTORY SYSTEM 137

 7.6 INVENTORY LOSSES AND GAINS
One control mechanism already mentioned is to check inventory cards against
the Inventory account in the general ledger. A second mechanism is to check the
inventory records against the physical items on hand at a particular time – a physical
stocktake. This should be done to determine whether the situation depicted in the
inventory cards matches the actual inventory items in the business.
inventory loss Two possibile outcomes of a stocktake are an inventory loss or an inventory gain.
adjustment required
when the number of •• An inventory loss occurs when the physical stocktake reveals an amount of
units revealed by a inventory on hand that is less than that shown by the inventory cards.
stocktake is less than
the number of units on •• An inventory gain occurs when the physical stocktake figure is higher than the
an inventory card value depicted by the inventory cards.
inventory gain
adjustment required
when the number of CAUSES OF LOSSES AND GAINS
units revealed by a
stocktake is greater Inventory losses may be caused by:
than the number of units •• undersupply by suppliers, when the number of items delivered to the store is less
on an inventory card
than the amount stated on the purchase invoice
•• oversupply to customers, when the amount of goods supplied to customers
exceeds the quantity stated on the sales invoice
•• theft by customers, staff and others
•• recording errors in inventory cards, leading to an overstatement of the units that
should be on hand
•• duplicate invoices issued by a supplier, when a supplier accidentally invoices a
business a second time
•• stocktaking errors, such as some goods not being counted in the stocktake.
Inventory gains may be caused by:
DON’T! •• oversupply by suppliers, when the number of items delivered to the store is
If asked for a cause of greater than the amount stated on the purchase invoice
inventory loss, don’t
state ‘stocktaking errors’,
•• undersupply to customers, when the quantity of goods supplied to customers is
as this can cause an less than the quantity stated on the sales invoice
inventory loss or gain.
•• recording errors in the inventory cards, leading to an understatement of the
Explain your
answer fully. number of units that should be on hand
•• stocktaking errors, such as some goods being counted twice in the stocktake.
The business’s internal control mechanisms should pick up many of these issues.
For example, undersupply by a supplier shouldn’t be allowed to occur; all deliveries
should be checked against the relevant invoices, and any undersupply addressed
immediately.
However, human error may overcome the best internal control procedures. For
example, staff performing stocktakes often work long hours through the night, and
counting errors can sometimes be made.
The role of accounting is to reduce, if not eliminate, the variety of errors that can
occur throughout any given reporting period.

Shoplifting
The most common cause of a discrepancy between the two inventory figures is
theft, particularly shoplifting. Many trading businesses experience some degree of
shoplifting, and for retail outlets it can be a very expensive item.

138 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 Trading businesses are affected by shoplifting in two ways:
•• When goods are stolen, the business suffers a loss equal to the cost of the item.
•• The business may also lose money if it spends money on security to deter
shoplifters, such as cameras or guards.
Because of shoplifting, most businesses usually suffer an inventory loss rather than
an inventory gain.

ADJUSTING FOR AN INVENTORY LOSS

If an inventory loss or gain is revealed on balance day, the books must be adjusted to
reflect the true situation.
An inventory loss occurs when the number of items identified in a physical
stocktake is less than the number stated on an inventory card. When this occurs,
the inventory card for that product must be adjusted to reflect the true situation.
Information from the physical stocktake must be available before an adjustment for
inventory loss can be made.

EXAMPLE 7.1

Yoshi Unlimited, a computer retailer, conducts a physical stocktake of Centrum Elite

computers on 30 June, which reveals that 14 Centrum Elite computers were on hand.
However, after the business sold one computer on 25 June, 15 units should have been in
inventory. For some reason (possibly theft), one computer is missing.
The inventory card is adjusted to reflect the true situation.
Note the number of units on hand after the sale made on 25 June.

Inventory item:
CENTRUM Elite Product code: Valuation: FIFO
computer PC60333
Supplier: Computer
IN OUT Balance
City
Date Details Qty Cost Value Qty Cost Value Qty Cost Value
1 Jun Balance 10 1 500 15 000
4 Jun Invoice 645 2 1 500 3 000 8 1 500 12 000
9 Jun Invoice 646 3 1 500 4 500 5 1 500 7 500
15 Jun Invoice 321 12 1 600 19 200 5 1 500
12 1 600 26 700
18 Jun Invoice 667 1 1 500 1 500 4 1 500
12 1 600 25 200
25 Jun Invoice 672 1 1 500 1 500 3 1 500
12 1 600 23 700
30 Jun Memo 21 1 1 500 1 500 2 1 500
12 1 600 22 200

The FIFO assumption also applies to inventory losses. If items are lost, they are
assumed to be the oldest items in inventory.

EXAMPLE 7.2

As Yoshi Unlimited is missing one computer, it’s assumed to be the older inventory
purchased, so the inventory loss is recorded as $1500. Memo 21 is written to note the
details of this event, and this document number is stated in the Details column of the
inventory card.

978 1 4202 3962 1 [CHAPTER 7] THE PERPETUAL INVENTORY SYSTEM 139

 All inventory cards should be checked in this manner on balance day, by verifying the
number of goods actually on hand and checking these details against what is stated in
the individual inventory cards.
Whatever is recorded in the inventory cards must also be recorded in the Inventory
account in the general ledger. The Inventory account must always represent a summary
of inventory cards, and therefore must be adjusted for all inventory losses. As usual,
entries to general ledger accounts must originate in the business’s general journal.

EXAMPLE 7.3

The loss of one Centrum Elite computer is the only inventory loss identified by Yoshi
Unlimited in its stocktake. The loss of $1500 is recorded in the general ledger.
GENERAL JOURNAL
Date Details Dr Cr
30 Jun Inventory loss 1 500
Inventory 1 500
Adjustment for inventory loss as revealed
by physical stocktake – loss of 1 Centrum
Elite computer (Memo 21)

The loss is then posted to the general ledger, which includes an inventory balance of
$40 000.
Inventory
$ $
30 Jun Balance 40 000 30 Jun Inventory loss 1 500

Inventory loss
$ $
30 Jun Inventory 1 500

The adjusting entry for an inventory loss reduces the asset account Inventory (credit)
and increases the expense account Inventory Loss (debit).

EXAMPLE 7.4

Yoshi’s Inventory account indicates that $40 000 of total inventory should have been on
hand on 30 June. As one computer is missing, an inventory loss of $1500 has occurred.
The credit to Inventory of $1500 decreases this asset account to the amount actually
on hand: $40 000 - $1500 = $38 500 inventory. This amount is reported in the business’s
balance sheet.
BALANCE SHEET (EXTRACT) AS AT 30 JUNE
Current assets $
Inventory 38 500

140 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
ADJUSTING FOR AN INVENTORY GAIN
An inventory gain occurs when the number of units actually on hand is greater than
the number of units shown on an inventory card.
This is an unusual event, as it seems that units of inventory have appeared from
nowhere. In fact, inventory gains usually occur from recording errors, stocktaking
errors, oversupply by the business’s supplier or undersupply to the business’s
customers. An inventory loss may occur through shoplifting or some other form of
theft, but gains usually come from errors in the accounting system.
Regardless of the cause, both inventory cards and the Inventory account must be
adjusted to reflect the actual situation on balance day.

EXAMPLE 7.5

Coffee Mundo has an inventory gain of two units recorded on 31 May.

The physical stocktake reveals that 48 units were on hand, rather than 46 as indicated
by the inventory card.

Inventory item: Classic Product code:

Valuation: FIFO
coffee machine CCM4300
Supplier: Gilly Buyatt IN OUT Balance
Date Details Qty Cost Value Qty Cost Value Qty Cost Value
27 May Invoice 255 5 40 200 25 40
28 42 2 176
28 May Receipt 146 2 40 80 23 40
1 600 28 42 2 096
30 May Invoice 265 4 40 160 19 40
28 42 1 936
31 May Invoice 276 1 40 40 18 40
28 42 1 896
31 May Memo 32 2 42 84 18 40
30 42 1 980

The adjustment for the inventory gain increases the number of units shown in the
inventory card – from 46 (18 + 28) to 48 (18 + 30).
When there is a gain, units should be recorded in the inventory card at the latest
purchase price recorded in the stock card. This is in response to the demands of
faithful representation. As it’s impossible to determine when the stock gain happened,
it’s reasonable to use the latest purchase price experienced by the business, as this is
the most relevant cost price to the business at the end of the period.
As with an inventory loss, the adjustment for a gain must be recorded in the
Inventory account.

EXAMPLE 7.6

The Coffee Mundo manager can’t be sure which units were incorrectly recorded or
wrongly supplied. The two units are recorded in the inventory card at the latest purchase
price in the stock card ($42), and the adjustment is recorded in the Inventory account.

978 1 4202 3962 1 [CHAPTER 7] THE PERPETUAL INVENTORY SYSTEM 141

 GENERAL JOURNAL
Date Details Dr Crl
31 May Inventory 84
Inventory gain 84
Adjustment for inventory gain as revealed
by physical stocktake (Memo 32)

Inventory
$
31 May Balance 25 000
31 May Inventory gain 84

Inventory gain
$ $
31 May Inventory 84

The adjusting entry for an inventory gain increases the asset account Inventory (debit)
and the revenue account Inventory Gain (credit).

EXAMPLE 7.7

The Coffee Mundo Inventory account indicates that $25 000 of total inventory should
have been on hand on 31 May, but this is inaccurate because an error occurred during
the period. The debit to Inventory of $84 increases this asset account to the amount
actually on hand.

RESPONDING TO INVENTORY GAINS AND LOSSES

Although it’s possible for an inventory gain to occur in a particular inventory card, theft
from businesses (particularly shoplifting) will usually be greater than any required
adjustments for inventory gains. Therefore, when adjusting the overall inventory for a
business, it’s likely that an inventory loss may still exist.
The identification of inventory losses is a major advantage of the perpetual
inventory system. Not only can the type of inventory missing be identified, but also
the cost of any missing items.
Management then has the information available to make appropriate decisions.
Repeated inventory losses of a particular product, or in a specific department, may
indicate a serious problem that needs attention.
Perpetual inventory should provide up-to-date information about all movements
of inventory. Management can then be informed about any problems that may exist
within the structure of the business in relation to inventory.

7.6 CHECK YOUR UNDERSTANDING WB PAGE 116

1 What is the purpose of a physical stocktake in the perpetual inventory system?

2 In relation to the Inventory account, describe the circumstances that exist for:
a an inventory loss to occur
b an inventory gain to occur
3 Make a list of the possible reasons why an inventory loss occurs.
4 State the double entry to record:
a an inventory loss
b an inventory gain.

142 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
7.7 DONATIONS OF INVENTORY FOR
ADVERTISING PURPOSES
Chapter 6 discussed transactions that involved the donation of goods to a charity, a
school or a local community organisation (page 115). These transactions are recorded
in the general journal as below.

Advertising expense Debit

Inventory Credit

As donations of goods reduce the inventory held by a business, the Inventory account
is obviously affected. As always, if the Inventory account is affected, so too is the
inventory card of the goods being donated.

FIGURE 7.9 General journal entry for inventory used for advertising purposes
GENERAL JOURNAL
Date Details Dr Cr
1 May Advertising 100
Inventory 100
Owner donated two footballs to the local
school @ $50 each (Memo 51)

The general journal entry in Figure 7.9 records the donation of two footballs to a school.
The narration refers to Memo 51, and the cost price was recorded as $50 each.
This information would have originated in the inventory card for the footballs. The
FIFO assumption of inventory flow should be applied in the usual fashion. Figure 7.10
shows the inventory card entry for the donation.

FIGURE 7.10 Inventory card showing a donation of goods for advertising purposes

Inventory item:
Product code: Valuation: FIFO
Footballs
ANFL6770
Supplier: Sherrin Pty Ltd IN OUT Balance
Date Details Qty Cost Value Qty Cost Value Qty Cost Value
24 Apr Invoice 757 20 52 1 040 10 50 500
20 52 1 040
28 Apr Receipt 121 2 50 100 8 50 400
20 52 1 040
30 Apr Receipt 124 4 50 200 4 50 200
20 52 1 040
1 May Memo 51 2 50 100 2 50 100
20 52 1 040

The business had 24 footballs in inventory on 30 April. When the two footballs were
donated on 1 May, it was assumed that they came from the $50 inventory, as usual
under the FIFO method.
As a donation of goods isn’t a common event, a memo should be made to take
note of all the details.

978 1 4202 3962 1 [CHAPTER 7] THE PERPETUAL INVENTORY SYSTEM 143

 7 CHAPTER REVIEW

KEY CONTENT
•• [7.1] Inventory is the goods that a trading business buys and sells to make a profit – in
particular, the goods it has on hand or in its warehouse.
•• [7.1] A physical stocktake involves counting the units of inventory on hand at a particular
point in time. It should be conducted every reporting period.
•• [7.2] The perpetual inventory process involves keeping records of all inventory movements
throughout the reporting period, and updating the balance of inventory on hand
continuously. While it requires significant additional work and record keeping, it
provides a great deal of useful information to management.
•• [7.3] The Inventory account is used to record a summary of all transactions affecting the
inventory of a trading business. The balance of the Inventory account represents the
total cost of inventory on hand at a point in time.
•• [7.4] The cost price of the inventory units sold by a trading business must be entered in
the general journal on a continuous basis throughout the period. Cost prices must
therefore be recorded in some way. The identified cost method identifies the actual
cost of each item of inventory when it’s sold.
•• [7.4] The first in, first out (FIFO) method assumes that the first inventory purchased is the
first inventory sold. The FIFO method may not reflect the actual inventory flow over
a period, but it’s still an acceptable method of inventory valuation that reduces the
amount of record keeping required.
•• [7.5] An inventory card is a subsidiary record used to record transactions for one particular
inventory item. An inventory card should contain all relevant details of the individual
item. Inventory cards aren’t part of the general ledger double entry process, and should
be checked against the Inventory account.
•• [7.6] A physical stocktake may reveal losses or gains in inventory when compared to
inventory cards. The cards should be corrected to show the loss or gain, and the
correction noted and recorded in the general ledger.
•• [7.7] To keep track of the donation of goods for advertising purposes, the donation is
recorded as a memo in the General journal, and the memo number is noted in the
Details column of the inventory card.

CHAPTER 7 EXERCISES

WB PAGE 117
1 Inventory sheets
Josh Tabone has just completed a physical stocktake for his business, which deals in
electrical goods. The following details have been provided.

Quantity Inventory item Cost $ Value $

45 Toasters 25.90 42.95
30 Stick blenders 22.00 36.50
12 Microwave ovens 140.00 249.00
10 Waffle makers 29.30 46.50
14 Sandwich presses 22.50 39.75
Using the above details, prepare a table to determine the value of inventory on hand.

144 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 WB PAGE 117
2 Identifying cost
Nathan Pilon owns Pile-On Sport. He applies a mark-up of 75% to all inventory held. He
is trying to determine the cost prices of some of the goods sold and has asked for your
assistance. The following selling prices have been identified for the specified inventory items.

Cricket bats $379.00

Footballs $105.00
Football jumpers $95.00
Soccer balls $55.00
Netballs $42.50

Using the identified cost method, determine the actual cost of inventory on hand at the
end of the period. Hint: use the following formula:

Cost price = (selling price x 100) / (100 + mark-up)

3 Identifying cost WB PAGE 118

The physical stocktake for Mordialloc Menswear reveals the following items on hand on
30 June 2023.
Item Selling price Mark-up applied
Ties $18 50%
Shirts $48 80%
Trousers $85 90%
Suits $290 120%
14 22.50 39.75

a Calculate the identified cost of each of the items listed.

b Prove your answers to question a by working from the cost prices back to the
selling prices, using the mark-ups specified.

WB PAGE 118
4 Identifying cost v FIFO
Hurstbridge Hardware purchases electric drills on several different occasions during
2023, as shown below.

21 Jan Purchase lot #1 40 drills @ $24.50

28 Mar Purchase lot #2 30 drills @ $24.90
26 Jun Purchase lot #3 50 drills @ $25.20
12 Aug Purchase lot #4 40 drills @ $25.20
30 Nov Purchase lot #5 30 drills @ $25.50

On 31 December 2023 a physical stocktake shows that there were 45 drills in

inventory. An examination of the price tags on these 45 drills reveals the following:
•• 20 drills had a cost price of $25.50
•• 20 drills had a cost price of $25.20
•• 5 drills had a cost price of $24.50.
a Using the identified cost method of inventory valuation, calculate the value of the
cost of sales for electric drills for the year ended 31 December 2023.
b What is the value of inventory on hand as at 31 December 2023 if this business
used the identified cost method?

978 1 4202 3962 1 [CHAPTER 7] THE PERPETUAL INVENTORY SYSTEM 145

 c Using the FIFO assumption of inventory flows, calculate the value of the cost of
sales for electric drills for the year ended 31 December 2023.
d What is the value of inventory on hand as at 31 December 2023 under the FIFO
method?
e Which method, identified cost or FIFO, will determine the most accurate profit for
this business? Explain your answer fully.

5 General ledger — perpetual inventory

SPREADSHEET X.XX WB PAGE 120

Docking’s Collectables uses the perpetual inventory method. The owner of the
business supplies the following details for the month of July 2023.
DOCKING’S COLLECTABLES: ACCOUNT BALANCES AS AT 1 JULY 2023
$ $
Cash at bank 3 000 GST clearing 1 000
Accounts receivable 3 000 Accounts payable 7 000
Inventory 60 000 Mortgage loan 190 000
Shop fittings 28 000 Capital – J Docking 422 000
Premises 526 000
620 000 620 000

Transactions for July:

Jul 2 Sold goods that had cost $400 for $800 cash, plus GST of $80
(Receipt 951)
4 Bought goods on credit from Media Wholesalers for $1200, plus GST
of $120 (Invoice 2848)
6 Sold goods on credit (Invoice 613) to P Di Venuto for $990, including
GST of $90 (cost price $500)
7 Paid assistant’s wages $700
11 The owner withdrew $300 in cash
12 Sold goods for cash $590, plus GST of $59 (cost price $290)
13 Sold goods on credit for $1000 to K O’Neill. GST added to invoice
$100 (cost price $500)
14 Paid assistant’s wages $700
16 Paid yearly insurance $970, plus GST of $97
17 Bought goods from Media Wholesalers for $1430, including GST of
$130 (Invoice 2918)
19 Accounts receivable paid $680 (discount expense $20)
20 The owner withdrew $740 in cash
21 Paid assistant’s wages $700
23 Sold goods on credit to K O’Neill for $800, plus GST of $80 (cost
price $400) and to P Manser for $450, plus GST of $45 (cost price
$220)
24 Sold goods for cash for $280, plus GST of $28 (cost price $150)
25 Cash purchases of inventory $550, including GST of $50
26 The owner donated $250 worth of inventory items to the Portland
Pop Culture Expo for a fundraising raffle, on the condition that the
business name is featured on all raffle tickets printed. The donated
goods would usually sell for $450 (Memo 12)

146 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 27 Accounts receivable paid $290 (discount granted $10)
28 Paid assistant’s wages $700
29 Purchased inventory from Animation Superstore for $1600, plus GST
of $160 (Invoice 14342)
Paid accounts payable $2000
30 Cash purchases of inventory $640, plus GST of $64
Cash sales of $500 and $800, plus GST of $50 and $80, respectively
(cost prices $250 and $400, respectively)

a Record the above transactions in general ledger accounts. (Note: Use one account
for accounts receivable and one for accounts payable.)
b Extract a trial balance as at 31 July 2023.
c Explain two advantages of perpetual inventory.

6 Identifying inventory loss or gain WB PAGE 125 SPREADSHEET X.XX

The following information relates to the business of Preston Paints on 31 December

2023.

Total sales for the period $142 000

GST on sales $14 200
Balance of the Inventory account in the $27 600
general ledger
Inventory on hand according to physical $26 700
stocktake

a Prepare a general journal entry to adjust the Inventory account for any inventory
losses or gains that may have occurred.
b Post the entry from part a to the Inventory account and balance the account.

7 Identifying inventory loss or gain WB PAGE 125 SPREADSHEET X.XX

The owner of Classic Trophies provides the following information about her business.

Balance of inventory as at 1 July 2022 $17 500

Credit purchases made during the year $52 000
GST on purchases $5 200
Total sales for the year – selling price $95 000
– cost price $43 600
GST on sales $9 500
Total of physical stocktake on 30 June 2023 $25 700

a Prepare the Inventory account as it would appear in the general ledger of Classic
Trophies. Your account should show all relevant entries, including adjustments for
inventory losses or gains, and a final balance for inventory on hand at the end of
the period.
b Inventory losses may cost retail business thousands of dollars each year. Suggest
two different strategies the management of a retail store can adopt to reduce
inventory losses.

978 1 4202 3962 1 [CHAPTER 7] THE PERPETUAL INVENTORY SYSTEM 147

 8 Recording in the general ledger
SPREADSHEET X.XX WB PAGE 126

The information listed below relates to the business of Sneakerboy.

Balance of inventory as at 1 November 2023 $34 200

Total of inventory sheets completed on 31 October 2023 $39 980
Credit purchases made during the year $62 000
GST on credit purchases $6 200
Cash purchases made during the year $23 400
GST on cash purchases $2 340
Cash sales for the year – selling price $125 000
– GST collected $12 500
– cost price $63 600
Credit sales for the year – selling price $32 890
– GST charged $3 289
– cost price $16 240

a Prepare the following general ledger accounts: Inventory, Cost of Sales, GST
Clearing, and Inventory Loss (or Gain).
b Show how the adjustment for the inventory loss (or gain) would appear in the
general journal.
c Give two possible reasons for the inventory loss (or gain).

9 Identified cost v FIFO

SPREADSHEET X.XX WB PAGE 127

The manager of Third Dimension Print Supplies uses the FIFO method of valuing
inventory. The following details relate to one inventory item, the AP540 printer.

Jul 1 Six printers in inventory with a cost price of $300

3 Sold for cash two printers for $540 each, plus GST of $54 (Receipt 65)
6 Purchased on credit 10 printers for $3200, plus GST of $320 (Invoice
9211)
8 Sold one printer on credit for $560, plus GST of $56 (cost price $320)
(Invoice 321) and one for $540 cash, plus GST of $54 (cost price
$300) (Receipt 66)
11 Sold three printers for cash for $550 each, plus GST of $55 (cost price
$320) (Receipt 67)
12 Sold one printer on credit for $560, plus GST of $56 (cost price $300)
(Invoice 322)
15 Purchased on credit eight printers for $335 each, plus GST of $33
(Invoice 9222)
17 Donated a printer to the local school and received publicity in the
school newsletter (cost price $335) (Memo 32)
18 Cash sales: four printers for $560 each, plus GST of $56 (Receipts
68–71). Two printers cost $320 each; the other two cost $335 each.
22 Sold one printer for cash $540, plus GST of $54 (cost price $300)
(Receipt 72)
24 Sold two printers that had cost $335 for $560 cash, plus GST of $56
each (Receipts 73–74)
28 Purchased on credit 10 printers for $3400, plus GST of $340 (Invoice
9231)

148 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 30 Sold two printers on credit for $560, plus GST of $56 (cost price
$340) (Invoice 323)
31 Physical stocktake identified 15 printers on hand, consisting of 5 with
a cost price of $320, 4 @$335 and 8@$340 (Memo 33)

a Prepare an inventory card for the AP540 printer using the identified cost method.
b Assuming that the information relating to cost prices wasn’t available, prepare the
inventory card using the FIFO assumption.
c Using the identified cost system, prepare the following general ledger accounts
using the transactions above: Inventory, Cost of Sales, and Sales.
d Explain why the management of some trading businesses may decide to adopt
FIFO to value inventory, rather than using the identified cost method.

10 Identified cost v FIFO WB PAGE 130 SPREADSHEET X.XX

The following information relates to the purchases and sales of product number
UZ927 during June 2023. On 1 June there were 10 units of UZ927 on hand with a
cost price of $14 each.
Purchases Sales
Invoice 64 2 Jun 50 units 3 Jun 40 units @ Invoice 132
@ $14 each $28 each (cost price $14)
Invoice 69 4 Jun 40 units 5 Jun 15 units @ Invoice 135
@ $15 each $28 each (cost price 5 @ $14, 10
@ $15)
Invoice 84 9 Jun 50 units 12 Jun 30 units @ Invoice 142
@ $15 each $30 each (cost price $15)
Invoice 98 24 Jun 50 units 19 Jun 50 units @ Invoice 150
@ $16 each $30 each (cost price 10 @ $14, 40
@ $15)
27 Jun 20 units @ Invoice 164
$30 each (cost price 10 @ $15, 10
@ $16)
29 Jun 20 units @ Invoice 168
$32 each (cost price $16)

On 30 June a physical stocktake reveals 22 units on hand (Memo 12). Five of these units
were coded as having a cost price of $14, with the remainder having a cost of $16.
a Using identified cost, prepare an inventory card for product UZ927 for June.
b The manager asks you to redraft the inventory card using the FIFO inventory
assumption to show the differences in valuation methods.
c Explain to the owner the effect on profit for June if the FIFO method is used instead
of identified cost.
d Using the transactions listed and your inventory card from part b, prepare the
following general ledger accounts: Inventory, Cost of Sales, and Sales.

978 1 4202 3962 1 [CHAPTER 7] THE PERPETUAL INVENTORY SYSTEM 149

 11 Inventory card: FIFO WB PAGE 132

The following information was extracted from an inventory card prepared under
the FIFO assumption. The inventory card includes all transactions in relation to this
inventory item for April 2023.
INVENTORY CARD
IN OUT Balance
Date Details Qty Cost Value Qty Cost Value Qty Cost Value
9 Apr Receipt 121 4 50 200 9 50 450
20 52 1040
26 Apr Invoice 812 5 50 250 4 50 200
20 52 1040
a Explain the difference between the transactions that have been recorded on 9 April
and 26 April.
b If there were no more transactions during April, how many units should be on hand
as at 30 April?
c If a physical stocktake completed on 30 April revealed that there were 22 units
in inventory, what is the value of the inventory loss or gain experienced by this
business?
d Justify why an adjustment for inventory loss/gain should be made on 30 April, with
reference to one qualitative characteristic and one accounting assumption.

12 Inventory card: FIFO

SPREADSHEET X.XX WB PAGE 133

Lisa Grass is the owner of Perfumes Online. She provides the following extract from
one of her inventory cards. It relates to a product named Temptation, which sells for
$70 per bottle.

INVENTORY CARD: TEMPTATION PERFUME

IN OUT Balance
Date Details Qty Cost Value Qty Cost Value Qty Cost Value
22 May Invoice 2919 3 35 105 2 35 70
27 May Invoice 31456 50 37 1850 2 35 70
50 37 1920

a On 30 May, Grass sold five bottles of Temptation perfume for cash at $70 per bottle
(Receipt 143). Record this transaction in the inventory card, using the FIFO method
of cost allocation.
b A physical count of inventory conducted on 31 May showed that 49 bottles of
Temptation were still in inventory. Record the necessary adjustment in the inventory
card, with reference to Memo 314.
c In light of the transaction recorded on 27 May, should Grass adjust her selling price
of Temptation? Explain your answer fully, and suggest a new recommended selling
price for this product.

150 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
13 Multiple inventory cards WB PAGE 134 SPREADSHEET X.XX

Barsco’s Barbequing sells two different models of gas grill, the Standard and the
Deluxe. An inventory card is maintained for each model, using the FIFO method. On
1 July 2023 the general ledger included the following balances.

Cash at bank 1 280 Accounts payable 3 000

Accounts receivable 3 000 GST clearing 2 000
Inventory 5 720 Mortgage loan 100 000
Premises 250 000 Capital 155 000
260 000 260 000

The transactions for August 2023 are listed below:

Aug 1 Inventory on hand – Deluxe 10 @ $380, Standard six @ $320

2 Cash sales of two Deluxe models for $650 each, plus GST of $65
(Receipts 101– 102)
4 Cash sales of three Standard models for $620 each, plus GST of $62
(Receipts 103–105)
7 Sold for cash three Deluxe models for $650 each, plus GST of $65
(Receipts 106–108)
9 Purchased on credit eight Standard models at $340 per unit, plus
GST of $34 (Invoice 535) from BBQs Plus
11 Sold for cash three Deluxe models at $650 each, plus GST of $65
(Receipts 109–111)
14 Sold for cash four Standard models at $620 each, plus GST of $62
(Receipts 112–115)
17 Purchased 10 Deluxe models on credit for a total of $3900, plus GST
of $390 (Invoice 919) from BBQs ‘R’ Us
20 Sold for cash two Standard models for $620 each (plus GST of $62)
(Receipts 116–117) and four Deluxe models at $660 each (plus GST
of $66) (Receipts 118–121)
22 Cash sales of one Standard model for $630 (plus GST of $63) and
one Deluxe model for $660 (plus GST of $66) (Receipts 122–123)
26 Cash sales of three Standard models at $693 each (including GST of
$63) (Receipts 124–126)
29 Purchased five Standard models on credit for $350 each (plus GST of
$35) (Invoice 560) from BBQs Plus
31 A physical stocktake showed that five Standard models and six
Deluxe models were on hand (Memo 92)

a Prepare the individual inventory cards for the two models being sold.
b Adjust the inventory cards for any inventory losses or gains revealed by the
stocktake.
c Prepare the following general ledger accounts for August 2023: Inventory, Cash at
Bank, and Inventory Loss (or Gain).
d Balance the Inventory account and reconcile it with the two inventory cards
prepared in part a.

978 1 4202 3962 1 [CHAPTER 7] THE PERPETUAL INVENTORY SYSTEM 151

 WB PAGE 136
14 Multiple inventory cards
SPREADSHEET X.XX

Optima Action Cameras sells two models of professional DV cameras, the All-Pro
8 and the All-Pro 9. The perpetual inventory system is used to record all inventory
movements.
Cash at bank 2 350 Accounts payable 6 000
Accounts receivable 4 000 GST clearing 2 500
Inventory 63 650 Bank loan 18 000
Shop fittings 35 000 Capital 78 500
105 000 105 000
620 000

The transactions for July 2023 are listed below.

Jul 1 Inventory on hand: All-Pro 8: five units in inventory; three with a cost
price of $1150 and two with a cost of $1100; All-Pro 9: five units with
a cost of $1600
3 Sold for cash one All-Pro 9 camera for $2900, plus GST of $290
(Receipt 633) and two All-Pro 8 cameras for $2100 each, plus GST of
$210 (Receipt 634)
4 Purchased on credit six All-Pro 8 cameras for $1180 each, plus GST
of $118 (Invoice 838) from Ace Cameras
5 Cash sales of two All-Pro 8 cameras for $2200 each, plus GST of $220
Receipt 635) and one All-Pro 9 camera for $2900, plus GST of $290
(Receipt 636)
8 Purchased on credit six All-Pro 9 cameras for $1870 each, including
GST of $170 (Invoice 923) (Ace Cameras)
10 Sold for cash two All-Pro 9 cameras at $2900 each, plus GST of $290
(Receipt 637)
16 Sold for cash three All-Pro 8 cameras for $2200 each, plus GST of
$220 (Receipts 638–640) and two All-Pro 9 cameras for $3200 each,
plus GST of $320 (Receipts 641–642)
19 Sold for cash two All-Pro 8 cameras, one for $2200 and the other for
$2000 (plus GST of $220 and $200, respectively) (Receipts 643–644)
21 Purchased on credit 10 All-Pro 8 cameras for $1210, including GST of
$110 (Invoice 852) (Ace Cameras)
24 Sold one All-Pro 9 and one All-Pro 8 camera for cash: $3100, plus
GST of $310 and $2100, plus GST of $210, respectively (Receipts
645–646)
26 Sold three All-Pro 8 cameras: one for $2200 plus GST of $220; and
the other two for $2150 each, plus GST of $215 (Receipts 647–649)
28 Purchased eight All-Pro 9 cameras on credit for $13 200, plus GST of
$1320. Total of Invoice 932: $14 520 (Ace Cameras)
31 A physical stocktake showed that six All-Pro 8 cameras and 11 All-Pro
9 models were in inventory (Memo A21)

a Using the FIFO method, prepare the individual inventory cards for the two models
being sold, including any adjustments required for inventory losses or gains.
b Prepare the following general ledger accounts: Inventory and GST Clearing.
c Balance the Inventory account and reconcile it with the two inventory cards
prepared in part a.
d Balance the GST Clearing account. Under what classification would you report this
account? Explain your answer fully.

152 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
15 Multiple inventory cards WB PAGE 138 SPREADSHEET X.XX

Jacq Wade, the owner of Western Blinds, runs a small business that sells two sizes
of venetian blinds as part of its range of products. The smaller size is designed for a
single window and usually sells for $250 per unit, plus GST. The larger size is suitable
for a double window and usually sells for $450 per unit, plus GST. Wade applies
the FIFO method to all inventory cards maintained for her business. The following
transactions occur during June 2023.

Jun 1 Inventory on hand: Singles: 25 blinds, 10 with a cost price of $120

and 15 with a cost price of $125. Doubles: 15 blinds, all costing
$230 each
3 Sold six single blinds for $250 each (cash) (Receipt 139
5 Sold three double blinds for $450 each (cash) (Receipt 140)
7 Sold five double blinds for $450 each (cash) (Receipt 141)
9 Purchased 25 more double blinds at a cost of $240 each (Invoice
7546)
11 Sold six single blinds for $260 each (cash) (Receipt 142)
14 Sold 10 single blinds for $2400 and five double blinds for $2150 to
Carlton College (Invoice 1333)
17 Purchased 30 single blinds for $127 each (Invoice 7566)
19 Wade donated two single blinds to the local cricket club. The club
secretary has agreed to hang a sign in the clubrooms to advertise
Wade’s business (Memo 82)
20 Sold four single blinds for $250 each (cash) (Receipt 143)
23 Sold six double blinds for $450 each (cash) (Receipt 144)
25 Sold one single and one double blind for a total of $700 (Receipt 145)
28 Sold three double blinds for $1300 in total (Invoice 1334)
30 A physical stocktake revealed the following quantities on hand at the
end of the month: single blinds: 24, double blinds: 16 (Memo 83)

a Prepare an inventory card for each of the two types of blinds sold by Western Blinds.
b Adjust your inventory cards for any inventory losses or gains revealed by the
30 June stocktake.
c If Western Blinds only sold these two inventory items, what should the balance of
the Inventory account be as at 30 June 2023?

978 1 4202 3962 1 [CHAPTER 7] THE PERPETUAL INVENTORY SYSTEM 153

 WB PAGE 139
16 Multiple inventory cards
SPREADSHEET X.XX

Collingwood Cases sells a range of briefcases to corporate clients. Its inventory

includes both a vinyl briefcase and a leather version. On 1 June 2023 the business had
the following inventory on hand: 24 vinyl cases and 50 leather cases. The inventory
cards for these two items included the following details at the start of the month.
Vinyl cases: 4 @ $30 $120 Leather cases: 20 @ $60 $1200
20 @ $32 $640 30 @ $64 $1920
24 $760 50 $3120

The following transactions occur during June 2023. Note: GST has not been included in
the prices stated below.

Jun 2 Sold six vinyl cases for $60 each (cash) (Receipt 593)
3 Purchased on credit 20 vinyl cases at a cost of $33 each (Invoice 132)
4 Sold eight leather cases for $99 each (cash) (Receipt 594)
5 Sold 14 leather cases for $99 each (cash) (Receipt 595)
7 Sold 10 vinyl cases for $62 each (Receipt 596)
9 Sold two leather cases for $105 each (Receipt 597)
11 Sold 10 vinyl cases for $62 each (Receipt 598)
14 Purchased on credit 20 leather cases @ $65 each (Invoice 142)
16 Sold 10 leather cases and five vinyl cases for $102 and $65 each,
respectively (cash) (Receipt 599)
18 Sold four vinyl cases for a total of $260 (Receipt 600)
20 Sold eight leather cases for $105 each (cash) (Receipt 601)
23 Sold five vinyl cases for $65 each and 12 leather cases for $105 each
(cash) (Receipt 602)
24 Purchased on credit 20 vinyl cases for $33 each and 20 leather cases
for $64 each (Invoice 4324)
25 Sold five vinyl cases for $65 each (cash) (Receipt 603)
28 Sold three leather cases for $105 each (cash) (Receipt 604)
30 Physical stocktake completed. Quantities on hand: vinyl cases 15;
leather cases 28 (Memo 321)

a Prepare an inventory card for June for each of the two types of cases sold by the
business.
b Make any adjustments required as a result of the physical counting of inventory on
30 June.
c Comment on the owner’s level of control over his inventory, given the results of the
30 June stocktake.
d Identify one problem created by Collingwood Cases in relation to its buying of
inventory. Explain why this may affect its profit performance.

154 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 ETHICAL CONSIDERATIONS WB PAGE 141

Rosa Mondio is the owner of Phonelife, a small business that sells a range of smartphone
accessories. When she purchases inventory, Rosa usually applies a mark-up of 100%
on the cost price. She has just received a delivery from her main supplier, a very large
company. The invoice she received with the goods clearly states:
•• 5 phone cases @ $10.00 each, plus $1.00 GST
However, when Rosa opened the box, she discovered that there were five dozen phone
cases packed in the box! She found her copy of her order form and it clearly states 5 units,
not 60. She’s not sure what she should do. The following are her options:
a She could say nothing and make some extra money. Fifty-five free phone cases will
generate a tidy profit. Business has been slow recently and this would certainly help.
After all, the supplier is such a big company – they can afford it!
b She could keep some of the cases and advise the supplier that 25 extras were
delivered. This would allow her to make some extra profit, without being too greedy.
c She could notify the supplier immediately. Mistakes can be made when goods are
shipped out, and it isn’t right to keep the goods.
What would you do in this situation? Discuss the pros and cons of the various options, and
make a recommendation to Rosa as to what she should do.

978 1 4202 3962 1 [CHAPTER 7] THE PERPETUAL INVENTORY SYSTEM 155

 CHAPTER CHECKLIST
Now that you have finished Chapter 7, double-check your progress.
Are you ready for your Unit 3 assessment?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
completed all end-of-chapter activities
handed in my workbook for marking.

I understand …

the General Journal and General Ledger and their use in recording
transactions, both manually and using ICT, including:
– credit sales of inventory
– credit purchases of inventory
– inventory loss or gain
– inventory used for advertising purposes
inventory cards using the First-In, First-Out (FIFO)
and Identified Cost methods for:
– inventory sold
– inventory purchased
– inventory used for advertising
– inventory loss or gain.

I can …

identify and manually record financial data in the General Journal, General Ledger and
inventory cards
use ICT to record financial data in the General Journal, General Ledger and inventory
cards and to construct graphical representations.

© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_7

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

156 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 8 SALES RETURNS AND
PURCHASES RETURNS

In Chapter 7 you learnt about LEARNING OBJECTIVES

inventory, and how trading firms
function by buying and selling By the end of this chapter, you will be able to:
their inventory. Not all sales
•• explain the purpose of a credit note [8.1]
are final, though. Sometimes
customers return items, or firms •• describe when a credit note will be issued [8.1]
return stock to their suppliers. •• prepare general journal entries to record the return of
Those returns also need to be goods to suppliers [8.2]
recorded by the accounting •• post entries for the return of goods to the general
system. ledger [8.2]
In this chapter you will learn •• prepare general journal entries to record the return of
how to record returns in the goods by customers [8.3]
general journal and general ledger,
•• post entries for sales returns to the general ledger
and about the effect of returns on
[8.3]
inventory cards.
•• explain why two double entries are required when
recording sales returns under perpetual inventory [8.4]
•• record sales returns and purchases returns in inventory
cards, using the identified cost and FIFO methods [8.5]

UNIT 3 – PROGRESS 1 2 3 4 5 6 7 8 9 10 11 12 13

8.2 8.4

Recording
Purchases returns returns in Chapter review
8.1 8.3 inventory cards 8.5 and exercises

From inventory
Credit notes for
Sales returns cards to the
returns
general journal

978 1 4202 3962 1 157

 8.1 CREDIT NOTES FOR RETURNS
A trading firm may both purchase and sell goods on credit. It receives a purchase
invoice from a supplier when it buys goods on credit. It issues a sales invoice when it
provides goods to a customer on a credit basis.
In some circumstances, invoiced goods are considered unsatisfactory and are
returned to the supplier. They may be unsatisfactory because they are:
•• the wrong size
•• the wrong brand
•• the wrong colour or style
•• delivered late and are no longer required
•• damaged or faulty.
This may occur either when goods are bought from a supplier or when they are sold
to a customer. In either situation, the goods may be replaced, or a credit note may
be issued.
credit note A credit note is a business document used to acknowledge that goods have been
source document used
to acknowledge the returned. Figure 8.1 shows an example.
return of goods
FIGURE 8.1 A typical credit note

Wholesale Trading CREDIT NOTE no. 3389

123 Power Avenue Balwyn VIC 3103 Date: 10/7/22
Credit: Elsternwick Electricals
898 Nepean Highway 
Reason: Damaged in transit Elsternwick VIC 3185

Description Quantity Unit price Subtotal GST Total

Leadlight touch lamps 4 $42.50 $170.00 $17.00 $187.00

Totals $170.00 $17.00 $187.00

Approved: Ken Sparkie Total (excluding GST) $170.00

Wholesale Trading – for all things electrical Total GST payable $17.00
Total amount payable (including GST) $187.00

8.1 CHECK YOUR UNDERSTANDING WB PAGE 143

1 Explain the purpose of a credit note.

2 List four reasons why a credit note may be issued.

158 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
8.2 PURCHASES RETURNS
In the credit note in Figure 8.1, Elsternwick Electricals returned damaged goods (a
purchases return) to the supplier, Wholesale Trading. The effect of this document is purchases returns
that Elsternwick Electricals debits the Accounts Payable account of Wholesale Trading, return of goods by a
business to its supplier
reducing the amount owed to the supplier. The credit note reduces the debt of (accounts payable)
Elsternwick Electricals by $187, which is the amount the supplier charged the business
when the purchase invoice was originally issued for these goods.
In addition to the cost price, the GST charged on the credit purchase must be
recorded on the credit note.
The following general ledger entry shows a summary. On the left is the double
entry for the original credit purchase, with the return of the damaged goods shown on
the right.
Credit purchase (invoice) $ Purchases return (credit note) $
Inventory 170 Dr Accounts payable 187 Dr
GST clearing 17 Dr Inventory 170 Cr
Accounts payable 187 Cr GST clearing 17 Cr

The summary shows the entries required when all the goods purchased from
accounts payable are subsequently returned and a credit note is granted.
In some situations, only some of the goods are returned; for example, a business
purchases 10 items and only two of them need be returned. In this case, identify the
cost price of only the goods being returned, along with the relevant GST that was
charged on them at the time of purchase.
As with all business documents, credit notes must be entered in the general journal
before being posted to general ledger accounts. Using the details in Figure 8.1, the
return of goods by Elsternwick Electricals would be recorded in their general journal as
shown in Figure 8.2.

FIGURE 8.2 General journal entry to record purchases returns

GENERAL JOURNAL
Date Details Dr Cr
10 Jul Accounts payable – Wholesale Trading 187
Inventory 170
GST clearing 17
Return of damaged goods to supplier
(Credit note 3389)

Faulty stock is
returned to the
supplier and a
purchases return
is recorded.

978 1 4202 3962 1 [CHAPTER 8] SALES RETURNS AND PURCHASES RETURNS 159
 RECORDING CHANGES TO INVENTORY
A business using the perpetual inventory method must record all movements of
inventory account
general ledger account inventory via the Inventory account. When goods were first purchased from the
used to record wholesaler, the Inventory account would be debited, with the credit entry being made
a summary of all
transactions affecting
to the Accounts Payable account. If goods are returned, the opposite entry is made.
inventory The debit to the Accounts Payable account reduces the liability of the firm, while the
credit to Inventory reduces the cost of inventory on hand.
In the general ledger of Elsternwick Electricals, the outstanding debt to Wholesale
Trading as at 1 July was $3000, and the balance of inventory on 1 July was $25 000.
The posting of the return of damaged goods results in the ledger account entries
shown in Figure 8.3.

FIGURE 8.3 General ledger entries for a purchases return

Accounts payable – Wholesale trading

$ $
10 Jul Inventory/GST clearing 187 1 Jul Balance 3 000

Inventory
$ $
1 Jul Balance 25 000 10 Jul Accounts payable 170

GST clearing
$ $
10 Jul Accounts Payable 17

The Accounts Payable account shows the effect of the credit note received from the
supplier. The obligation to the account payable has been reduced by the debit entry, so
Elsternwick Electricals now owes $187 less to its supplier.
Similarly, inventory is reduced. The credit entry to the Inventory account reduces
the inventory on hand, as the firm no longer possesses the goods. The credit entry to
the GST Clearing account cancels out the debit entry that would have been made to
the GST Account at the time of purchase.

8.2 CHECK YOUR UNDERSTANDING WB PAGE 143

1 Explain why the GST Clearing account should be credited when goods are returned
to a supplier.
2 ‘If a credit note has to be issued by a supplier, you should change suppliers.’ Do you
agree? Discuss.
3 A business owner is unsure what to do with credit notes issued by their suppliers.
Explain how these documents could be used to evaluate satisfaction with the
inventory provided by accounts payable.

160 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
8.3 SALES RETURNS
In the previous example, a credit note was received by Elsternwick Electricals from
its supplier. Keep in mind that Elsternwick Electricals can also issue credit notes to its
accounts receivable.
Consider the following transactions between this business and one of its credit
customers:
•• 1 Aug: Sold goods on credit to Brimbank Grammar School, of four light fittings for
$80 each, plus GST of $8 each
•• 5 Aug: Brimbank Grammar School returned one light fitting because it was the
wrong size. The customer was allowed a full credit of $80 (plus GST of $8).
Note: Elsternwick Electricals applies a mark-up of 100% to all its inventory. Therefore,
the cost of sales on 1 August, using identified cost, would be $160 (4 × $40), and the
return on 5 August would have a cost price of $40.
When the return of goods occurs on 5 August, a credit note will be issued, and a
general journal entry will be made to record the sales returns (see Figure 8.4). sales returns
return of goods by a
customer (accounts
FIGURE 8.4 General journal entry to record a sales return
receivable) to a business
GENERAL JOURNAL
Date Details Dr Crl
5 Aug Sales returns 80
GST clearing 8
Accounts receivable – Brimbank Grammar 88
Inventory 40
Cost of sales 40
Return of damaged goods
(Credit note 3389)

RECORDING SALES RETURNS

When a customer returns goods for credit, two double entries are required.
Under perpetual inventory, two double entries are made when goods are sold: one
to record the selling price and the other to record the cost price. This is also the case
when goods are returned, as in the above example.
When the customer returned the light fitting because it was the wrong size, two
events had to be recorded.
•• The Accounts Receivable account had to be reduced by the amount the customer
was originally charged ($80 + $8 GST = $88). This results in debits to the Sales
Returns and GST Clearing accounts and a credit entry to the Accounts Receivable
account.
•• The goods returned by the customer become part of the firm’s inventory again.
To record this, the cost price entry made when the goods were sold has to be
reversed. Inventory is debited to increase the asset account, and Cost of Sales is
credited. This credit entry negates the debit to Cost of Sales that would have been
recorded when the sale took place.

978 1 4202 3962 1 [CHAPTER 8] SALES RETURNS AND PURCHASES RETURNS 161
 The following summary demonstrates these two events.

Credit sale of goods Sales returned by a accounts receivable

Accounts receivable Dr Sales returns Dr
Sales Cr GST clearing Dr
GST clearing Accounts receivable
(with selling price) Cr (with selling price) Cr
And And
Cost of sales Dr Inventory Dr
Inventory (with cost price) Cr Cost of sales (with cost price) Cr

The entries in the general ledger would appear as shown in Figure 8.5. (Note that four
units were sold on credit, but only one was returned.)

FIGURE 8.5 General ledger entries for a sales return

Inventory
$ $
1 Aug Balance 10 000 1 Aug Cost of sales 160
5 Aug Cost of sales 40

Cost of sales
$ $
1 Aug Inventory 160 5 Aug Inventory 40

Accounts receivable – Brimbank Grammar

$ $
1 Aug Sales/GST clearing 352 5 Aug Sales returns/GST 88
clearing

Credit sales
$ $
1 Aug Accounts receivable – 320
Brimbank Grammar

Sales returns
$ $
5 Aug Accounts receivable – 80
Brimbank Grammar

GST clearing
$ $
5 Aug Accounts receivable – 8 1 Aug Accounts receivable – 32
DON’T! Brimbank Grammar Brimbank Grammar
When recording a sales
return, do not debit the
sales account. Make sure The correct amount of GST must be recorded on all sales returns. When the four units
that you use the sales
returns account. were sold at $80 each, the GST charged to the accounts receivable would have been
$32 ($8 per unit × 4 = $32 GST). When one item was returned, the related GST was
the $8 per unit originally charged to the accounts receivable.

162 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 Two double
entries are
required to record
a sales return for
credit.

THE SALES RETURNS ACCOUNT

The selling price of the goods returned ($80) was debited to a Sales Returns account
in the general ledger. This entry could be debited to the Sales account instead, with
sales adjusted to equal the revenue earned after returns have been recorded.
However, best accounting practice is to create a separate account for sales
returns, which can then be deducted from sales revenue in the income statement.
This provides additional information for management about customer satisfaction. If
only a net sales figure was reported at the end of the period, the income statement
wouldn’t show any information about the level of returns by customers. By having
a separate account for sales returns, such as in the example below, this additional
information can also be reported.

INCOME STATEMENT (EXTRACT)

Revenues $ $
Sales 100 000
Less: Sales returns 5 000 95 000

The reporting of sales returns in this way allows the reader of the report to see the full
picture in terms of the firm’s sales performance. Although $100 000 worth of goods
was sold during the year, goods valued at $5000 were returned by customers.
This can be expressed as a percentage to gauge the level of customer
satisfaction. During this reporting period, 5% of all sales ($5000/$100 000) was
returned. If this percentage decreases over time, it may indicate that customer
satisfaction has improved. If it increases, it indicates that more customers were
unhappy with the business.

8.3 CHECK YOUR UNDERSTANDING WB PAGE 144

1 Explain why two double entries are required when a credit note is issued to
an accounts receivable by a trading firm using perpetual inventory.
2 State the two double entries required in the circumstances outlined in
Question 1.
3 When goods are returned by customers, a debit could be made to Sales
or to Sales Returns. Explain why the use of a Sales Returns account is
preferred.
4 Should a business owner be concerned if they have issued many credit
notes in one reporting period? Explain your answer fully.

978 1 4202 3962 1 [CHAPTER 8] SALES RETURNS AND PURCHASES RETURNS 163
 RECORDING RETURNS IN
8.4 INVENTORY CARDS
Returns affect the amount of inventory held by a business, so they must be recorded
in the inventory cards maintained by the firm. Returns of inventory to a supplier
decrease the inventory on hand, while sales returns increase the inventory held at a
given date.
To record returns, the two types of transactions can simply be related to the
headings used in inventory cards. As returns to suppliers mean that goods are leaving
the business, purchases returns will be recorded in the Out column. If accounts
receivable return goods to a business, this means that goods are coming back into the
firm and therefore should be recorded in the In column.
The other method is to show all debits to the Inventory Control account in the In
column of an inventory card, while credits to the Inventory Control account can be
traced to the entries in the Out column.

HOW TRANSACTIONS AFFECT INVENTORY CARDS

Table 8.1 shows the various transactions covered so far in this text. The entries on the
debit side relate to the In column of the inventory cards maintained by the business.
The credit entries in the Inventory Control account relate to the Out column of the
business’s inventory cards.
The two entries affected for returns of inventory (sales returns and purchases
returns) are numbers 4 and 7.

Inventory
1 Balance 6 Cost of sales
2 Cash at bank 7 Accounts payable
3 Accounts payable 8 Drawings
4 Cost of sales 9 Inventory loss
5 Inventory gain 10 Advertising
11 Balance

1 The opening balance of inventory is on the debit side because it is an asset account.
2 Cash at bank records the cash purchases of inventory made during the period.
3 Accounts payable is the cross-reference for the total credit purchases made during the period.
4 Cost of sales is the cost price of sales returns approved for the period. Goods are
coming back into the business, so inventory increases and a debit entry is made.
5 Inventory gain: if the physical stocktake reveals that an inventory gain has occurred, a
debit is made to Inventory to adjust the account up to the correct amount.
6 Cost of sales: if a business sells on credit in addition to cash sales, there may be
multiple entries named ‘Cost of sales’.
7 Accounts payable is used to record the returns of inventory to suppliers. Inventory
is leaving the business and being returned to the supplier, so Inventory must be
credited.
8 Drawings represents withdrawals of inventory by the proprietor.
9 Advertising represents inventory given to others for advertising purposes.
10 Inventory loss is a balance day adjustment for losses revealed by the stocktake.
11 Balance is the amount of inventory on hand at the end of the period.

164 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
RECORDING PURCHASES RETURNS IN INVENTORY CARDS
We have established how sales returns and purchases returns affect the Inventory
account. The final question now is what price to record in an inventory card when a
return occurs.
Consider the inventory card in Figure 8.6.

FIGURE 8.6 Inventory card showing a credit purchase

Inventory item: Valuation method: FIFO

Classic chairs
Date Details Qty Cost Value Qty Cost Value Qty Cost Value
1 Aug Balance 5 12 60
2 Aug Invoice 78 10 13 130 5 12 60
10 13 130
3 Aug Receipt 213 2 12 24 3 12 36
10 13 130

This inventory card includes an entry for a credit purchase on 2 August, when 10
chairs were purchased (Invoice 78).
On 3 August, two of these chairs are found to be damaged and are returned to the
supplier. The supplier approves the return and issues Credit note 12 for $26 (2 × $13).
The inventory card entry required is shown in Figure 8.7.

Return of
inventory must
be recorded in
inventory cards.

FIGURE 8.7 Inventory card showing a purchases return

Inventory item: Valuation method: FIFO

Classic chairs
Date Details Qty Cost Value Qty Cost Value Qty Cost Value
1 Aug Balance 5 12 60
2 Aug Invoice 78 10 13 130 5 12 60
10 13 130
3 Aug Receipt 213 2 12 24 3 12 36
10 13 130
3 Aug Credit note 12 2 13 26 3 12 36
8 13 104

It is important to note that purchases returns have nothing to do with the FIFO assumption.
This is because the supplier will always determine the actual value of any credit allowed
when goods are returned, which will be evidenced by the credit note they issue.
You should always record a purchases return at the value determined by the
supplier’s credit note, then adjust the Balance column as required. Once the inventory
card has been adjusted, you can use the FIFO assumption to determine the cost of
sales when goods are sold.

978 1 4202 3962 1 [CHAPTER 8] SALES RETURNS AND PURCHASES RETURNS 165
 RECORDING SALES RETURNS IN INVENTORY CARDS
The method of recording sales returns is different from that used to record purchases returns.
The earlier example showed how the dollar value of a purchases return is determined
by the supplier. However, when goods are sold, either the identified cost method or the
FIFO assumption is used to determine the cost of sales to be recorded. This is an internal
decision by management, and the dollar value isn’t included on any source document.
When goods are sold to a credit customer, the selling price is stated on the sales
invoice. The inventory card is used to record the cost price of the goods sold.
The question now is: what is the cost price of a sales return? If the identified cost
method is being used, the sales transaction would have to be identified in the inventory
card, so that the cost price of the sales return can also be identified.
Consider the inventory card in Figure 8.8.

FIGURE 8.8 Inventory card using identified cost

Inventory item: Valuation method: Identified cost

Office desks
Date Details Qty Cost Value Qty Cost Value Qty Cost Value
1 Aug Balance 2 100 200
5 120 600
2 Aug Invoice 201 2 120 240 2 100 200
3 120 360
3 Aug Invoice 202 2 100 200 3 120 360

One office desk was returned by an account receivable on 4 August, and the
customer was granted full credit. The original sale to this customer was made on 2
August. The identified cost method is being used, so the order of sales and sales
returns isn’t important because the actual cost of the items must be identified.
Therefore, if the sale was made on 2 August, the actual cost price of the sales return
will be $120.
The inventory card would be adjusted as shown in Figure 8.9.

FIGURE 8.9 Inventory card using identified cost

Inventory item: Office Valuation method: Identified cost

desks
Date Details Qty Cost Value Qty Cost Value Qty Cost Value
1 Aug Balance 2 100 200
5 120 600
2 Aug Invoice 201 2 120 240 2 100 200
3 120 360
3 Aug Invoice 202 2 100 200 3 120 360
4 Aug Credit note 32 1 120 120 4 120 480

SALES RETURNS AND THE FIFO METHOD

The process of recording a sales return at cost price is straightforward when using the
identified cost method. However, if the FIFO assumption is being applied, it’s a little
more difficult.
The inventory card in Figure 8.10 includes a credit sale of six office chairs for $65
each on 4 September.

166 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
FIGURE 8.10 Inventory card showing a credit sale

Inventory item: Valuation method: FIFO

Office chairs
Date Details Qty Cost Value Qty Cost Value Qty Cost Value
1 Sep Balance 4 30 120
10 32 320
4 Sep Invoice 23 4 30 120
2 32 64 8 32 256

This business sold six chairs on 4 September. Invoice 23 shows the selling price
as $65 per chair. The FIFO assumption has been applied in the inventory card and
has determined that four chairs had a cost price of $30 each, and two had a cost
price of $32 each.
The problem arises when some, but not all, of these chairs are returned.
For example, on 5 September one chair is returned and a full credit is provided
to the customer. Credit note 5 is issued, but this only shows the credit allowed to
the accounts receivable, which would be the selling price of $65. The problem is in
relation to the cost price and how to adjust the inventory card in Figure 8.10.
The correct approach is simply to reverse the FIFO approach in the inventory card;
that is, start at the last inventory issued and work backwards through the inventory card.
So, if one chair was returned, the entry would be as shown in Figure 8.11.

FIGURE 8.11 Inventory card showing a sales return

Inventory item: Valuation method: FIFO

Office chairs
Date Details Qty Cost Value Qty Cost Value Qty Cost Value
1 Sep Balance 4 30 120
10 32 320
4 Sep Invoice 23 4 30 120
2 32 64 8 32 256
5 Sep Credit note 5 1 32 32 9 32 288

As goods are coming back into the business, the required entry is made in the In
column. The cost price chosen was the last one issued in the Out column on 4
September ($32). This returns the last unit issued into the inventory card, with the
balance returning to nine units on hand valued at $32 each.
If two chairs were returned on 5 September, rather than just one, the same approach
is used; simply rebuild the inventory card as if the goods had never been sold. The
business would again have the 10 units on hand at $32 each, as shown in Figure 8.12.

FIGURE 8.12 Inventory card showing a sales return

Inventory item: Valuation method: FIFO

Office chairs
Date Details Qty Cost Value Qty Cost Value Qty Cost Value
1 Sep Balance 4 30 120
10 32 320
4 Sep Invoice 23 4 30 120
2 32 64 8 32 256
5 Sep Credit note 5 2 32 64 109 32 320

978 1 4202 3962 1 [CHAPTER 8] SALES RETURNS AND PURCHASES RETURNS 167
 Finally, if this business accepted a return of three chairs on 5 September, it is
important that the third chair is not recorded at $32.
The balance of the inventory card on 1 September showed that four chairs cost $30
each and 10 units cost $32 each. If a return of multiple units occurs, the balance of the
inventory card should be resurrected, but don’t create more units than was shown in
the inventory card on a previous date. Once the 10 units worth $32 have been returned,
the assumption is that the other goods returned must be from the $30 inventory.
Therefore, if three chairs were returned, the inventory card would be adjusted as
shown in Figure 8.13.

FIGURE 8.13 Inventory card showing a sales return

Inventory item: Valuation method: FIFO

Office chairs
Date Details Qty Cost Value Qty Cost Value Qty Cost Value
1 Sep Balance 4 30 120
10 32 320
4 Sep Invoice 23 4 30 120
2 32 64 8 32 256
5 Sep Credit note 5 1 30 30 1 30 30
2 32 64 10 32 320

If a sales return involves multiple cost prices, always return the cost prices to the
inventory card in their original order. From Figure 8.13, we can see that the business
now has one chair with a cost price of $30, while the other chairs all have a cost of
$32. When the next sale is made, and FIFO is applied, the first cost price to be used
again is $30.
The main difference between a sales return and a purchases return lies in how the
FIFO assumption is applied. If a purchase is returned, the supplier determines the
credit allowed. This is because the supplier also decided what price would be charged
when the invoice was issued.
However, when a sale is made and FIFO is applied, a business doesn’t really know
the actual cost price of the item being sold. As FIFO involves an assumption about
cost prices, when a purchase is returned the cost price entry in an inventory card is
also an assumption.
When a sale is made, FIFO assumes that the first goods bought are the first goods
sold. When a sales return occurs, work backwards through the FIFO assumption
and resurrect the inventory card as if the sale never took place. This method helps to
ensure that FIFO is applied properly at all times.

8.4 CHECK YOUR UNDERSTANDING WB PAGE 145

1 How is the value of a purchases return determined? Explain your answer fully.
2 How is the cost price of a sales return determined by a business that applies the
FIFO assumption of inventory flow?
3 ‘The cost price of a sales return under the identified cost method may be different
from the cost price determined under the FIFO method.’ Do you agree with this
statement? Explain your answer fully.

168 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 FROM INVENTORY CARDS TO THE
8.5 GENERAL JOURNAL
Under the FIFO system, the cost prices of all sales are determined within the
inventory cards. This amount is then recorded in the general journal when a sale
is made. When the cost price is recorded in the journal, the Inventory account will
decrease with the usual cost of sales entry.
The following extended example, using the inventory card for a Deluxe Bluetooth
party speaker shown in Figure 8.14, demonstrates this flow of information.

FIGURE 8.14 Inventory card data for Bluetooth speaker

Inventory item:
Deluxe Bluetooth Product code: Valuation: FIFO
party speaker DBS1320
Supplier:
IN OUT Balance
Modern Electrics
Date Details Qty Cost Value Qty Cost Value Qty Cost Value
1 Jun Balance 10 125 1 250
4 Jun Receipt 121 2 125 250 8 125 1 000
8 Jun Invoice 646 10 130 1 300 8 125 1 000
10 130 1 300
11 Jun Receipt 122 1 125 125 7 125 875
10 130 1 300
15 Jun Invoice 828 5 125 625 2 125 250
10 130 1 300
18 Jun Credit note 1 125 125 3 125 375
17
10 130 1 300
19 Jun Credit note 1 125 125 2 125 250
2252
10 130 1 300
25 Jun Invoice 830 2 125 250
2 130 260 8 130 1 040
30 Jun Memo 71 1 130 130 7 130 910
30 Jun Memo 72 2 130 260 5 130 650

The entries in this inventory card create the following general journal entries in June:
•• purchases of inventory on 8 June
•• credit sales of inventory on 15 June and 25 June EXAM
SUCCESS
•• cash sales of inventory on 4 June and 11 June When new inventory
•• sales return of one unit on 18 June is purchased, make
sure that the cost
•• purchases return of one unit on 19 June prices are kept in
•• drawings of inventory on 30 June the order they
were purchased.
•• inventory loss of two units on 30 June.
Note the connection between the inventory card and the general journal. The entries in
the In column on 8 June are noted with an invoice number. This number indicates that
the goods were purchased on credit. The credit sales made during the month are on

978 1 4202 3962 1 [CHAPTER 8] SALES RETURNS AND PURCHASES RETURNS 169
 All information
about the sales
of this speaker
should move from
the inventory card
to the general
journal.

15 and 25 June, and these entries appear in the Out column. According to the inventory
card, on 15 June there were five units sold at a cost of $125 each. The entry made in the
journal for this transaction would show a cost price entry of $625 (5 × $125).
We can see that this business also sells its inventory for cash. In June there were
two cash sales, as noted in the Out column. The cost prices of these sales can be
traced back to the inventory card for the Bluetooth speaker. For the entry on 11 June,
the firm has applied FIFO; one unit was sold and was allocated the cost of $125.
There are two entries towards the end of the month, evidenced by memo
numbers 71 and 72. Memos may be used to record drawings of inventory, inventory
used for advertising purposes, and inventory losses and gains. In this example, the
owner withdrew one unit for personal use (Memo 71) and then recorded an inventory
loss of two units at the end of the month (Memo 72).
A physical stocktake, done at the end of the month, revealed only five units on
hand. As the inventory card indicated that seven units should be in inventory, two
were found to be missing. The inventory card was then adjusted to equal the actual
amount on hand.
The final process is the posting of the journal to the general ledger accounts of the
business. As the general journal entries have been covered in detail already, only the
inventory account is presented here.

Inventory
$ $
1 Jun Balance 1250 4 Jun Cost of sales 250
8 Jun Accounts payable 1300 11 Jun Cost of sales 125
18 Jun Cost of sales 125 15 Jun Cost of sales 625
19 Jun Accounts payable 125
25 Jun Cost of sales 510
30 Jun Drawings 130
30 Jun Inventory loss 260
30 Jun Balance 650
2675 2675
1 Jul Balance 650

170 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
This ledger account completes the picture regarding the cost prices of inventory sold:
•• The FIFO assumption is used within inventory cards to determine the cost prices EXAM
at the time of sale. SUCCESS
Practise using a
•• These cost prices are recorded in the general journal, along with their selling template for the
prices. inventory account.
There are many
•• These selling prices are verified with the source documents used: invoices, transactions to
receipts or EFT documents. remember!
•• After the general journal entries are prepared, they can be posted to the general
ledger accounts.

8.5 CHECK YOUR UNDERSTANDING WB PAGE 146

1 ‘The cost price of a sales return isn’t shown on a source document.’ Do you agree
with this statement? Explain your answer fully.
2 A memo may be used to record a variety of transactions involving inventory. State
four examples of such transactions.
3 ‘It doesn’t matter if a business uses FIFO or Identified cost when it returns damaged
inventory to a supplier. The cost price to be recorded is exactly the same.’ Do you
agree? Explain fully.

978 1 4202 3962 1 [CHAPTER 8] SALES RETURNS AND PURCHASES RETURNS 171
 8 CHAPTER REVIEW

KEY CONTENT
•• [8.1] When unsatisfactory goods are returned, a business may issue a credit note. This is a
source document that records the financial data regarding the return.
•• [8.2] A purchases return is the return of goods by a business to its supplier (accounts
payable). The return must be recorded in the general journal as a debit to accounts
payable and a reduction to the Inventory account.
•• [8.3] A sales return is the return of goods by a customer (accounts receivable) to a business.
This again requires two entries in the general journal – a reduction to accounts
receivable and an increase in the sales return. A second entry decreases cost of sales
and increases the inventory account.
•• [8.4] Returns must also be recorded in inventory cards maintained by the firm. Returns
of inventory to a supplier decrease inventory on hand, while sales returns increase
inventory on hand.
•• [8.5] Sales returns reflect FIFO assumptions, if the firm uses that system. However,
purchases returns don’t reflect FIFO assumptions, as the supplier determines what
credit is returned.

CHAPTER 8 EXERCISES

1 Returns to a supplier WB PAGE 147

The owner of Fidget Factory was issued with the following document.

Wholesale Toy Company no. 3389

199 Barbie Road — Kensville 5025 Date: 28/6/23
Credit: Fidget Factory Reason: Incorrect colour

Description Quantity Unit price Subtotal GST Total

Fidget spinners 10 $12.00 $120.00 $12.00 $132.00

Totals $170.00 $17.00 $187.00

Total (excluding GST) $120.00

Total GST $12.00
Total credit approved (including GST) $132.00

a State the name of the above document.

b State the name of the business that issued this document.
c Explain the effect of the above document on the accounting equation of Fidget
Factory.

172 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
2 Returns by a customer WB PAGE 147

The following document was in the possession of Helen Betson, the owner of Betson’s
Wholesale Books, who applies a mark-up of 100% to all inventory sold.

Betson’s Wholesale Books no. 16

385 Williams Drive
Docklands 3008
Date: 4/7/23
Credit: The Corner Bookstore Reason: Damaged
12 Elizabeth Street
Melbourne 3000

Description Quantity Unit price Subtotal GST Total

Guinness Book of Records
6 $75.00 $450.00 $45.00 $495.00
2023 edition

Totals $450.00 $45.00 $495.00

Total (excluding GST) $450.00

Total GST $45.00
Total credit approved (including GST) $495.00

a State the name of the above document.

b State the name of the business that issued this document.
c Describe the transaction evidenced by this document.
d State the double entry that should result from the issuing of this document in the
general ledger of Betson’s Wholesale Books.
e State the double entry that would be recorded in the books of The Corner Bookstore
as a result of the above document.

3 Returns to a supplier WB PAGE 148 SPREADSHEET X.XX

On 1 July 2023, Azzopardi’s Auto Spares purchases inventory from Chrysler Australia
on credit for $2000 plus GST of $200. Some of the goods were the wrong specification
and Azzopardi returns them to Chrysler on 3 July 2023. Credit note no. 65 is sent to
his business. These goods originally cost Azzopardi $150, plus GST of $15. He intends
selling the items for $290, plus GST of $29.
a Prepare the general journal entry to record the return of goods by Azzopardi on
3 July 2023.
b Prepare the general ledger account for Chrysler Australia showing all entries for July.
c State the balance owing to Chrysler Australia as at 31 July 2023.

4 Returns by a customer WB PAGE 148 SPREADSHEET X.XX

Glynn’s Glassware sells goods on credit to Zaita & Zaita, CPAs for $600, plus GST of
$60, on 12 July 2023. On 13 July, Zaita complains to Glynn that three items have marks
on them and requests a credit. Glynn issues Credit note 241 to Zaita, stipulating that a
credit of $150 had been approved, along with a credit for GST of $15. The cost price of
the goods returned is $65.
a Prepare the general journal entry to record the details required as a result of credit
note 241.
b Prepare the Accounts Receivable account for Zaita & Zaita in the general ledger of
Glynn’s Glassware.

978 1 4202 3962 1 [CHAPTER 8] SALES RETURNS AND PURCHASES RETURNS 173
 5 Accounts payable
SPREADSHEET X.XX WB PAGE 149

The following events are reported by the management of Peninsula Auto Parts during
July 2023.

Jul 15 Spare parts were bought from Auto Spares on credit for $480, plus
GST of $48 (Invoice 2175)
28 Faulty parts costing $80, plus GST of $8, were returned to Auto
Spares (Credit note 127)
30 Statement of account received from Auto Spares with a balance of
$440
31 Made a payment via EFT to Auto Spares in full settlement of the
account

a Prepare the general journal entries for any of the relevant items from the above list.
b Prepare the Accounts Payable account for Auto Spares, showing all transactions
during July.

6 Accounts receivable
SPREADSHEET X.XX WB PAGE 150

The following transactions occur between Encore Music Store and one of its credit
customers, Jack Stewart.

Jul 3 Credit sale of musical instruments $4200, plus GST of $420 (cost
price $2150)
6 One guitar was returned as it was damaged (selling price $1200, GST
$120, cost price $500) (Credit note 92)
9 Credit sale of musical equipment $2700, plus GST of $270 (cost price
$1230)
5 Stewart made a payment on his account: $500

a Using the general journal, prepare the entries required for the four transactions
shown above.
b Prepare the Accounts Receivable – Jack Stewart account, showing all entries for the
month of July 2023.

7 Accounts payable
SPREADSHEET X.XX WB PAGE 151

The following details are provided by the owner of Hawthorn Sunglasses Store:
•• balance of inventory as at 1 August 2023: $52 900
•• balance of accounts payable as at 1 August 2023: $9300
•• credit purchases for August: $8400, plus GST of $840
•• cash sales for August: selling price $19 800, plus GST of $1980; cost price $9500
•• during August, damaged goods costing $650 were returned to a supplier (GST on
returned goods $65) (Credit note 128).
a Prepare the general journal entry to record the last item from the list above.
b Prepare the Inventory account and the Accounts Payable account, showing all
transactions for August 2023.
c Apart from goods being damaged, state two other reasons why a firm may return
goods to a supplier.

174 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
8 Accounts receivable WB PAGE 151 SPREADSHEET X.XX

A business has inventory on hand of $75 000 on 1 September 2023. The balance of
accounts receivable as at 1 September 2023 is $4000. The following events take place
during September:

Sep 4 Sold goods on credit for $500, plus GST of $50 (cost price $240)
6 Accounts receivable returned goods that were sold for $50, plus GST
of $5 (cost price $20), and was granted a full credit (Credit note 9)
12 Sold goods on credit for $400, plus GST of $40 (cost price $200)
13 Customer was issued a credit note for goods returned: selling price
$30, GST $3, cost price $15 (Credit note 12)
22 An EFT payment was received from accounts receivable for the full
amount owing

a Prepare the general journal entries required on 6 and 13 September.

b Prepare the following general ledger accounts: Inventory, Cost of Sales, Accounts
Receivable, Sales and Sales Returns. Assume that the transactions listed above
were the only events for the month of September.

9 Accounts payable and accounts receivable WB PAGE 153 SPREADSHEET X.XX

The management of Fitzroy Furniture provides the following information:

•• Balances as at 1 October 2023:
Inventory $46 200
Accounts receivable $ 8 400
Accounts payable $ 7 300
GST clearing $ 1 200 Cr

•• Credit purchases during October: $7200, plus GST of $720

•• cash purchases during October: $2100, plus GST of $210
•• cash sales for October: selling price $12 400, GST $1240, cost price $6600
•• credit sales for October: selling price $5460, GST $546, cost price $2560
•• during October, damaged goods costing $890, plus GST of $89, were returned to a
supplier (Credit note 104)
•• during October, accounts receivable returned unsatisfactory goods that were
originally sold for $680, plus GST of $68 (cost price $330) (Credit note 87).
a Prepare the general journal entry to record the last two items from the list above.
b Prepare the following general ledger accounts: Inventory, Cost of Sales, Accounts
Payable, Accounts Receivable, Sales, Sales Returns and GST Clearing. Show all
transactions for October 2023 and balance all accounts as at 31 October.

978 1 4202 3962 1 [CHAPTER 8] SALES RETURNS AND PURCHASES RETURNS 175
 10 Purchases returns
SPREADSHEET X.XX WB PAGE 155

The owner of Retro Game Gear receives a delivery from 8-Bit Incorporated and notices
that two of the game controllers delivered have scratches on them. The invoice that
came with the goods on 12 August 2023 contains the following details:

Invoice no. 612 10 units – retro Nintendo controller @ $36.00

Plus GST 10% @ $ 3.60

8-Bit Incorporated agrees to a full credit and issues credit note No. 33 on 13 August for
two controllers. On 11 August 2023, the owner already has four of these controllers in
inventory, at a cost price of $35 per unit.
a Prepare the general journal entry to record the return of goods on 13 August 2023.
b In the inventory card for the retro Nintendo controller, prepare all relevant entries for
August, including the opening balance, the purchase and the return of two units to
the supplier.

11 Purchases returns
SPREADSHEET X.XX WB PAGE 156

Hurstbridge Hardware maintains an inventory card for every product sold by the
business. The following extract comes from one of its inventory cards.

Inventory item: Valuation method: FIFO

Proline drills
Date Details Qty Cost Value Qty Cost Value Qty Cost Value
1 Jul Balance 4 50 200
3 Jul Invoice 731 10 52 520 4 50 200
10 52 520

On 5 July the owner of the business finds that three of the drills delivered on 3 July
weren’t Proline drills and were in fact an inferior brand. The supplier, Wholesale Tools,
explains that it ran out of Proline drills and substituted an alternative product. Steve
Holding, the owner of Hurstbridge Hardware, isn’t happy with this decision and
requests full credit for these three items. The supplier agrees to this, and on 6 July it
issues credit note no. B72 for the three drills.
a Prepare the general journal entry to record the purchases return on 6 July. (Hint:
don’t forget the 10% GST.)
b Enter the details of credit note No. B72 in the inventory card for the Proline drills.
c Prepare the Accounts Payable account for Wholesale Tools, showing both the
purchase and purchases returns entries.

176 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
12 Sales returns WB PAGE 157 SPREADSHEET X.XX

The owner of Seddon Streetwear uses coloured tags to denote his different batches of
inventory. When he experiences a price rise, he simply uses a different colour from the
previous purchases of his inventory items. This system allows him to identify the actual
cost of inventory quite easily. The following transactions took place during June 2023 in
relation to one product, a black leather jacket.

Jun 1 Inventory on hand: Green tags: 10 jackets @ $150 each

Yellow tags: 10 jackets @ $160 each
4 Sold 5 jackets for $325 each (3 green tags, 2 yellow tags) (Receipt 176)
11 Sold 2 jackets for $325 each (both with yellow tags) (Receipt 177)
18 Purchased 10 new jackets for $165 each (blue tags applied)
(Invoice 7161)
20 Two jackets with yellow tags were returned to the store and full credit
was granted (Credit note 16)
30 Physical stocktake (Memo 26): Green tags: 6 jackets
Yellow tags: 8 jackets
Blue tags: 9 jackets

a Prepare the inventory card for black leather jackets for the month of June using the
identified cost method.
b The owner is considering a change to the FIFO method but has been advised that
it’s not as accurate as identified cost. Do you agree? Explain your answer fully.

13 Sales returns WB PAGE 158 SPREADSHEET X.XX

Luke Garagozlo operates a small retail business selling laptop computers. Prices in this
industry can change very quickly, so Luke uses a system of coloured stickers on the
laptops to help him identify their actual cost price. The following transactions relate to
the X0 laptop.

Aug 1 Inventory on hand: Blue stickers: 5 laptops @ $850 each

Red stickers: 8 laptops @ $820 each
4 Cash sale of 2 laptops (red stickers) for $1550 each (Receipt 342)
8 Cash sale of 1 laptop (red sticker) for $1550 (Receipt 343)
12 Purchased 5 X0 laptops (purple stickers) for $840 each (Invoice 7172)
15 Cash sale of 2 laptops (blue stickers) for $1525 each (Receipt 362)
18 Cash sale of 3 laptops (1 blue, 2 purple) for $1500 each
22 Purchased 5 X0 laptops (purple stickers) for $840 each (Invoice 7182)
27 Sold on credit 8 laptops (5 purple and 3 blue stickers) to Essendon
FC for $1450 each (Invoice 657)
31 Physical stocktake (Memo 81): Blue stickers on hand: 1
Red stickers on hand: 1
Purple stickers on hand: 3

a Prepare the inventory card for the X0 laptop for the month of August using the
identified cost method.
b Redraft your inventory card prepared in part a, using the FIFO method of inventory
valuation.
c Compare the cost of sales figures for the two methods of inventory valuation.
Which method determines the most accurate cost of sales value? Explain your
answer fully.
d Outline two reasons why some small business owners use the FIFO method of
inventory valuation, rather than the identified cost method.

978 1 4202 3962 1 [CHAPTER 8] SALES RETURNS AND PURCHASES RETURNS 177
 14 Purchases returns
SPREADSHEET X.XX WB PAGE 160

The following details relate to the Kandy Bar Stool, one of the products sold by
Fitzroy Furniture.

Balance 1 July 3 @ $28

20 @ $27
Sales during July 5 July 10 @ $52, plus GST of $5.20 (Receipt 181)
14 July 8 @ $52, plus GST of $5.20 (Receipt 185)
25 July 10 @ $53, plus GST of $5.30 (Receipt 192)
Purchases during 17 July 20 @ $28, plus GST of $2.80 (Invoice 711)
July
Purchases returns 19 July 3 @ $28, plus GST of $2.80 (Credit note 88)
Physical stocktake 31 July 11 units on hand (Memo 312)

a Prepare all entries in the inventory card for the Kandy Bar Stool for the month of
July, using the FIFO assumption of inventory flow.
b Prepare general journal entries for the events that took place on 19 and 31 July.
c Complete the Accounts Payable account for Funky Furniture, the supplier of the
Kandy Bar Stool, given that Fitzroy Furniture owed this supplier $400 on 1 July.
Balance the account at the end of the month.
d Explain the role of the FIFO assumption in relation to determining the cost price of
purchases returns.

15 Sales returns: FIFO

SPREADSHEET X.XX WB PAGE 162

Consider the following inventory card.

Inventory item: Nail gun Valuation method: FIFO

Date Details Qty Cost Value Qty Cost Value Qty Cost Value
1 Sep Balance 5 35 175
15 38 570
5 Sep Invoice 73 5 35 175
2 38 76 13 38 494

The customer (I Whinge) who purchased the seven items on credit on 5 September
isn’t satisfied with one of them and has been approved for a credit of $70, plus GST of
$7 (Credit note No. 55, issued 6 September).
a Prepare the general journal entry for the sales return on 6 September.
b Justify the dollar values used in your answer to part a, and explain the source of
each of the two dollar values.
c Redraft your journal entry for 6 September if I Whinge returned:
i two items, rather than one
ii three items, rather than one
d Complete the entry in the inventory card for a sales return by I Whinge of three
items on 6 September.

178 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
16 Sales returns: FIFO WB PAGE 163 SPREADSHEET X.XX

The manager of Bundoora Beard Oils applies the FIFO assumption and provides the
following information in relation to one of his inventory items:

Balance as at 15 July 5 @ $6
25 @ $7
Credit sale on 16 July (Invoice 54) 8 units @ $12, plus GST
Sales return on 17 July (Credit note 19) 2 units: credit allowed $24, plus GST

a Prepare entries in the inventory card, showing the balance on 15 July, the sale on 16
July and the return on 17 July.
b Justify the cost price that you have applied to the return on 17 July.
c Using a general journal, prepare the entry required on 17 July.

17 Sales returns: FIFO WB PAGE 164 SPREADSHEET X.XX

Ian White is the owner of White Water Canoes. He uses the perpetual inventory
system and maintains inventory cards under the FIFO method of cost location. The
following information comes from one of these inventory cards.

Inventory item: Glide Valuation method: FIFO

paddle
Date Details Qty Cost Value Qty Cost Value Qty Cost Value
1 Aug Balance 2 75 150
3 Aug Invoice 329 8 78 624 2 75 150
8 78 624
4 Aug Invoice A92 2 75 150
1 78 78 7 78 546
1 Aug Balance 2

On 6 August, one of the Glide paddles sold on 4 August is returned by the accounts
receivable, T Lockery. The paddle had a large dent at one end. Lockery requests that her
account is credited for the returned item. White agree to this, and on 6 August issues
credit note 812 for $150, plus GST of $15.
a Prepare the general journal entry to record the sales return on 6 August.
b Enter the details of the sales return in the inventory card for the Glide paddle.
c Prepare the Accounts Receivables ledger account for T Lockery, showing both the
sales and sales returns entries. (Note: All three paddles were sold for $150, plus
GST of $15.) Balance the account as at 6 August.

978 1 4202 3962 1 [CHAPTER 8] SALES RETURNS AND PURCHASES RETURNS 179
 CHAPTER CHECKLIST
Now that you have finished Chapter 8, double-check your progress.
Are you ready for your Unit 3 assessment?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
handed in my workbook for marking.

I understand …

the General Journal and General Ledger and their use in recording transactions,
both manually and using ICT, including:
– sales returns from accounts receivable
– purchase returns to accounts payable
– correction of errors
inventory cards using the First-In, First-Out (FIFO) and Identified Cost methods for:
– inventory returned
– drawings of inventory by the owner.

I can …

identify and manually record financial data in the General Journal, General Ledger and
inventory cards
use ICT to record financial data in the General Journal, General Ledger and inventory
cards and to construct graphical representations.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_8

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

180 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 9 INVENTORY VALUATION

As a firm’s inventory continues LEARNING OBJECTIVES

to be bought, sold, stored and
returned, the accounting system By the end of this chapter, you will be able to:
needs to keep track of what
•• distinguish between a ‘product cost’ and a ‘period
all the items are worth. This
cost’ [9.1]
means calculating a cost for the
inventory – one that accurately •• apply the qualitative characteristic of relevance when
determines the value of each determining product costs [9.1]
item. •• explain the effect on profit of treating an expense as a
In this chapter you will learn product cost rather than a period cost [9.1]
how to determine inventory •• explain the meaning of the term ‘net realisable value’
value in line with the qualitative (NRV) [9.2]
characteristics of accounting, •• value inventory at the lower of cost and NRV [9.2]
and how to record and adjust
•• record an inventory write-down in the general journal
inventory value in the double
and in inventory cards [9.3]
entry system.
•• explain the effect of an inventory write-down on an
income statement [9.3]
•• explain the two-fold effect of an inventory write-down
on a balance sheet [9.3].

UNIT 3 – PROGRESS 1 2 3 4 5 6 7 8 9 10 11 12 13

9.2

Cost price
versus net Chapter review
91 realisable value 9.3 and exercises

Product costs and Determining

period costs an item’s NRV

978 1 4202 3962 1 181

 9.1 PRODUCT COSTS AND PERIOD COSTS
The term ‘cost of inventory’ means the purchase price of an item, plus any other
costs directly related to that item. The purchase price is normally stated on a purchase
invoice. The other costs may include customs duty or cartage (shipping fees), if they
can be isolated to a particular item of inventory.
For example, if five items are purchased and the cartage paid was $15, it’s clear
that $3 cartage has been incurred per unit. Under these circumstances, cartage
product cost can be charged to the individual items of inventory as a product cost. It becomes
cost added to the
cost price of a unit of
part of the cost of a product or item of inventory, and is recorded on that item’s
inventory inventory card.
However, it’s not possible to do this when a delivery of inventory involves several
different items. For example, consider a delivery for a sports store of 20 footballs,
30 football jumpers, 12 soccer balls and 3 trampolines, with a cartage fee of $55 for
the entire delivery. It’s not possible to isolate the cartage per inventory item for this
delivery in a logical manner.
period cost In cases like this, the cartage is treated as a period cost instead of a product
cost written off as cost. This means that it’s written off as an expense for the reporting period, and isn’t
an expense for the
reporting period recorded as part of the cost of a particular inventory item.

Cartage (shipping
fees) can be recorded
as either a product or
period cost.

THE RELEVANCE TEST

When considering the cost of an item of inventory, the qualitative characteristic of
relevance should be taken into account.
The question of whether a cost is relevant may be decided by its significance.
Accounting information is usually viewed as relevant if its omission is likely to affect
decision making. This decision doesn’t consider the nature of the item; it’s simply
concerned with the dollar value paid and its relative importance.
Let’s look at two examples to illustrate this test.

182 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 EXAMPLE 9.1

Perfect Props purchases one replica shield at a cost of $300, plus a delivery fee of $10.
How should the $10 be treated – as part of the cost of the item or as a separate expense?
The answer lies in the interpretation of relevance and the dollar value.
• If the $10 is viewed as a relevant amount, it should be added to the cost of the item
of inventory. The item would be entered on the inventory card at a cost price of $310
($300 + $10 delivery).
• If the $10 isn’t seen as relevant to decision making, it wouldn’t be added to the cost
price. The delivery fee would be treated as a period cost in the usual fashion
(probably as ‘cartage inwards’).
Most small businesses would treat $10 cartage as a product cost. It’s a significant
dollar amount on a per item basis, and it would impact on decision making when
determining the selling price of the shield. Also, it’s easily identifiable on a per-unit
basis, making it more likely to be treated as a product cost.
This decision is a matter of opinion, and some businesses may choose differently.
However, if a cost can be traced to an individual unit in a logical way, and is a
reasonably significant dollar value, it should be treated as part of the cost of the item.

EXAMPLE 9.2

Perfect Props also purchases 10 replica WWII helmets with a cost price of $75, plus a
delivery fee of $10. How should the $10 be treated in this situation?
The $10 equates to a delivery fee of $1 per helmet, which each have a cost price of
$75. The delivery fee can still be logically traced to an individual inventory item, but is a
cost of $1 significant in this case?
If the owners of Perfect Props think the $1 cost isn’t significant, it wouldn’t be added
to the item’s inventory card. Instead, the $10 is treated as a period cost and debited to
the Cartage Inwards account, which would be closed off to the Profit and Loss Summary
account at the end of the period.
Again, this decision is a matter of opinion. Some business owners may feel that a $1
cost would affect their decision making when pricing the goods, and that it should be
treated as a product cost. Others might argue that it’s not significant, and can simply
be written off as a period cost.
There is no definitive percentage or dollar amount that states whether or not an
item should be treated as a product cost or a period cost. The two tests that need to
be satisfied are:
•• Can the cost be logically traced to an individual inventory item?
•• Is the amount per item significant enough to affect decision making?

Relevance and decision-making

One of the basic roles of accounting is to provide financial information for decision
making. The purpose of the characteristic of relevance is to ensure that all significant,
material information is available so that decision makers are fully informed.
An item may not be considered relevant if it has a small, insignificant value. As items
grow in value, they become more likely to be relevant to decision making. The question
is: what dollar value does an item need to be before it’s relevant to decision makers?
If in doubt as to whether an item’s omission would affect decision making, it’s
safer to classify the item as relevant and to let those making the decisions have the
final verdict. When dealing with the cost of an item of inventory, exclude only very
small, insignificant amounts from the definition of the cost of a particular item.

978 1 4202 3962 1 [ C H A P T E R 9 ] I N V E N TO R Y VA L U AT I O N 183

 THE EFFECT ON PROFIT
The decision as to whether to treat an item as a product cost or a period cost may affect
the profit result for a particular period.
For example, when cartage inwards is treated as a product cost, it becomes part of
the cost of the inventory item and is treated as part of the current asset called inventory.
It’s not written off as an expense until this inventory is actually sold. Therefore, product
costs become part of the cost of sales expense when inventory is actually sold.
However, if cartage is treated as a period cost, the amount incurred is written off
as an expense for the current period, regardless of how many units of inventory are
actually sold.
The decision to treat an item as a product or period cost may therefore mean that a
different profit figure will be determined, depending on how the item is treated.

EXAMPLE 9.3

1 Jun 200 units are purchased at a cost of $40 each; the delivery fee paid is $400.
30 Jun Of the 200 units purchased, only 30 have been sold by the end of June.
As the delivery fee amounts to a cost of $2 per unit, the following choices are available:

Product cost Period cost

Cost price $40 Cost price $40
+ delivery $2 Cartage in expense $200
Total cost $42

Since only 30 units were sold by 30 June, the expenses would be reported under the two
alternatives:

Product cost Period cost

Cost of sales (30 x $42) $1260 Cost of sales (30 x $40) $1200
Cartage in $400
Total expenses $1260 Total expenses $1600

This shows that if the cost of delivery is treated as a period cost, expenses are $340
higher and profit is $340 less. The difference occurs because under product costing, the
delivery fee of $2 per unit remains as part of inventory for the 170 units that haven’t yet
sold ($170 x $2 = $340).
Profit will always be lower if expenses are written off as period costs, unless all units
of inventory are sold by the end of the period. If this occurs, profit will be exactly the
same, regardless of whether an item is treated as a product cost or a period cost.
If any goods remain unsold at the end of a period, product costing will always
result in a higher net profit, as some of the expense would still be part of inventory.

9.1 CHECK YOUR UNDERSTANDING WB PAGE 166

1 Explain the meaning of the term ‘cost’ as it relates to inventory.

2 Distinguish between a product cost and a period cost.
3 Explain the role of relevance in determining a product’s cost.
4 A small business owner says, ‘It doesn’t really matter if you treat an expense as a
product cost or a period cost. They’re both expenses, after all, so profit will still be the
same.’ Do you agree with this comment? Explain your answer fully.

184 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 COST PRICE VERSUS NET REALISABLE
9.2 VALUE
As a basic rule, inventory is always recorded at cost prices. This is the case for both
individual inventory cards and the double entries in the general ledger accounts.
However, when reporting inventory in the final accounting reports, there is an
exception to this general principle. In the balance sheet of a trading firm, inventory
should be valued at the lower of two alternatives. The first of these is cost price and
the second is net realisable value.
An item’s net realisable value (NRV) is the estimated selling price of the product net realisable
value (NRV)
minus any costs incurred in its marketing, selling and distribution. In other words, it’s estimated selling price of
the net amount the business expects to gain from the sale of the item. an item of inventory, less
Any costs incurred in selling must be traceable on an individual basis to the specific any costs incurred in its
selling, marketing
inventory item involved. For example, if a firm expects to sell an item for $18, but pays a or distribution
commission of $3 for each unit sold, the item’s net realisable value would be $15.

THE FUNCTION OF NRV

In some cases, inventory items may have an NRV that is actually lower than the cost
paid by the business. This situation occurs only in a minority of cases, but sometimes
a business will sell an item for less than it cost to purchase. This may occur because
the item of inventory:
•• has been superseded by a new model •• is out of fashion
•• has become obsolete •• is damaged
•• is out of season •• is shop-soiled.

The qualitative characteristic of faithful representation demands that financial reports

faithfully represent real economic events. Accountants must therefore recognise
losses on inventory if they occurred in the current reporting period. The characteristic
of relevance also demands that if a business decides to sell inventory for less than
it cost, it should recognise the loss in the current reporting period. If the loss isn’t
recognised, the profit for the period will be overstated and won’t faithfully represent
what has occurred.
Therefore, inventory should be valued at the lower of cost and NRV. If inventory
is expected to be sold for less than the firm paid for it, the NRV should be used
to value that line of inventory. This avoids overstating the value of inventory in the
balance sheet.
When this rule is applied, accounting standards demand that both the cost of
inventory and its NRV are stated on an individual product basis, rather than total
inventory. Of course, in the majority of businesses, the cost of total inventory is
usually much less than its NRV, as it’s normal to sell inventory at a profit.
In order to reveal products where the NRV may be lower than the item’s cost,
it’s necessary to apply the rule on an individual basis. This isn’t always possible, and
sometimes inventory items have to be considered in groups of inventory. This is
still acceptable according to the accounting standards, because examples of NRV
being below cost can still be identified. However, the preferred method is to consider
individual inventory items.

978 1 4202 3962 1 [ C H A P T E R 9 ] I N V E N TO R Y VA L U AT I O N 185

 APPLYING NRV IN FINANCIAL REPORTING
The management of Essendon Trading has just completed its physical stocktake and
determined inventory on hand.

Inventory item Cost $ Quantity Value $

A 10 400 4 000
B 10 200 2 000
C 20 200 4 000
D 30 300 9 000
Total cost of inventory 19 000

The value for inventory shown above only takes into account the cost of the firm’s
inventory. When the NRV of each item is taken into account, a different picture emerges.

Item Cost $ NRV $ Lower of cost and NRV $ Quantity Value $

A 10 18 10 400 4 000
B 10 7 7 200 1 400
C 20 25 20 200 4 000
D 30 22 22 300 6 600
16 000

Item A cost the firm $10 each and is expected to realise $18 per unit. The lower of
these two figures is the cost of $10, so this figure is adopted. The same situation
exists for item C, which cost $20 and is expected to sell for $25.
However, items B and D both have an NRV that is lower than their cost prices.
The rule of using the lower of cost and NRV means that, for these two items, the NRV
must be used.
The effect of this is that the cost of inventory was $19 000 but, because some
items won’t realise their cost prices, this value must be reduced to $16 000. This is
inventory write-down done via a general journal entry recording an inventory write-down (Figure 9.1).
general journal entry used
to reduce the value of an FIGURE 9.1 General journal entry to record an inventory write-down
item of inventory from its
cost price
GENERAL JOURNAL
Date Details Dr Cr
31 Dec Inventory write-down 3 000
Inventory 3 000
Adjusting entry for inventory write-down
(Memo 45)

RECORDING AN INVENTORY WRITE-DOWN

As well as the general journal entry, the item’s inventory card is affected by the
adjustment for an inventory write-down, due to its NRV being lower than its cost
price. As usual, any entry in the Inventory account must also be recorded in the
relevant inventory card.
Looking at inventory item B for Essendon Trading, there were 200 units on hand
with a cost price of $10. However, the NRV of item B was stated as only $7. Therefore,
an inventory write-down of $3 must be recorded on the inventory card of item B, as
shown in Figure 9.2.

186 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
FIGURE 9.2 Inventory card showing an inventory write-down

Inventory item: Item B

Date Details Qty Cost Value Qty Cost Value Qty Cost Value
31 Dec Balance 200 10 2 000
31 Dec Memo 45 200 3 600 200 7 1 400

The other item with an NRV lower than its cost price is item D. The cost of this product
was $30, but it’s expected to realise only $22 when sold. As there are 300 units of
item D on hand, the write-down required is 300 × $8 ($30 – $22 = $8 per unit).

FIGURE 9.3 Inventory card showing an inventory write-down

Inventory item: Item D

Date Details Qty Cost Value Qty Cost Value Qty Cost Value
31 Dec Balance 300 30 9 000
31 Dec Memo 45 300 8 2 400 300 22 6 600

The general journal entry in Figure 9.1 recorded a total inventory write-down of $3000.
This can be reconciled with the entries in the inventory cards above. Item B was
written down by $600, while item D had a write-down of $2400, for a total adjustment
of $3000.
In the general ledger, the Inventory Write-down account is classified as an expense.
It’s shown in the income statement, along with any inventory losses identified by
the physical stocktake. Both of these items are deducted from the gross profit to
determine the adjusted gross profit for the period.
$ $
Sales 100 000
Less: Cost of sales 40 000
Gross profit 60 000
Less: Inventory loss 2 000
Inventory write-down 3 000 5 000
Adjusted gross profit 55 000

As shown below, the Inventory account is written down to the lower value, taking into
account the rule of lower of cost and NRV.
INVENTORY
$ $
31 Dec Balance 19 000 31 Dec Inventory write-down 3 000
Balance 16 000
19 000 19 000
1 Jan Balance 16 000

The balance of inventory would then be reported in the balance sheet, once the
adjustment has been made to the books.

ESSENDON TRADING: BALANCE SHEET (EXTRACT) AS

AT 31 DECEMBER 2023
Current assets $
Inventory 16 000

978 1 4202 3962 1 [ C H A P T E R 9 ] I N V E N TO R Y VA L U AT I O N 187

 Faithfully
adjusting for
write-downs
avoids profits
being overstated.

QUALITATIVE CHARACTERISTICS AND THE NRV

Both the income statement and the balance sheet are affected by the adjustment for
inventory write-downs.
•• The income statement is affected by an adjustment to the gross profit for the period.
•• The balance sheet is affected through the reduction in the Inventory account
(matched with a reduction in owner’s equity, due to a lower profit figure).
Both final reports are adjusted by the application of the lower of cost and NRV rule,
so there is less likelihood that the profit for the period, or the assets of the business
at the end of the period, have been overstated. This complies with the qualitative
characteristic of faithful representation, which is the main aim of this rule when
valuing inventory.
The disclosure of such details is also necessary under the qualitative characteristic
of relevance. If a trading firm has units of inventory that will realise less than they
cost, this information is clearly relevant to the users of the final reports. The dollar
value of such expected losses should be reported, so that individual users can
evaluate the extent of the problem.

9.2 CHECK YOUR UNDERSTANDING WB PAGE 167

1 What does ‘net realisable value’ mean, in terms of inventory?

2 List four reasons why an item of inventory may have an NRV lower than its cost
price.
3 Explain why the lower of cost and NRV should be applied to individual inventory
items, or groups of items, rather than total inventory.
4 Explain the link between the qualitative characteristic of faithful representation and
the rule of lower of cost and NRV.
5 Explain the link between the concept of relevance and the application of the NRV rule.

188 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
9.3 DETERMINING AN ITEM’S NRV
Net realisable value is the estimated selling price of a product, less any costs incurred
in marketing, selling and distributing the item. In our previous examples, the NRV was
conveniently stated so that it could be compared with cost prices. This won’t always
be the case, and you may need to calculate an appropriate NRV.

EXAMPLE 9.4

Sunshine Products records the following inventory at the end of 2023.

Quantity Cost Selling Selling cost

price
Item A 100 $5 $9 $2 per unit
Item B 200 $7 $8 $2 per unit

Item B previously sold for $14, but has been replaced by a new model that has just been
released. Management has decided to cut the selling price to $8 in order to clear all
inventory held.
When the selling costs are taken into account, the NRV of the inventory can be
determined.
Item Estimated selling Selling costs NRV $
price
Item A $9 $2 $9 less $2 = $7
Item B $8 $2 $8 less $2 = $6

Item A hasn’t had its selling price reduced, and its NRV ($7) is greater than its cost price
($5). Therefore, it’s not affected by the application of the NRV rule.
However, item B, which costs $7 each, has an NRV of only $6. This is despite the fact
that its selling price ($8) is slightly higher than cost ($7). When the anticipated selling
costs are taken into account, the NRV of item B falls below cost.
This table shows a summary of this application of the NRV rule.

Item Estimated Selling NRV $ Cost Lower of Qty Value

selling price costs price CP and
NRV
Item A $9 $2 $7 $5 $5 100 $ 500
Item B $8 $2 $6 $7 $6 200 $1 200
Total value for inventory $1 700

An inventory write-down will be required in the general journal on balance day. The
amount of the write-down is determined by the difference between the cost of item B
($7) and the NRV of the item ($6), multiplied by the number of units on hand (200).
The write-down would be $1 × 200 units = $200.
The following general journal shows the entry required to record an inventory
write-down, including the memo number in the narration.
GENERAL JOURNAL
Date Details Dr Cr
31 Dec Inventory write-down 200
Inventory 200
Adjusting entry for inventory write-down
(Memo 67)

978 1 4202 3962 1 [ C H A P T E R 9 ] I N V E N TO R Y VA L U AT I O N 189

 Sometimes a
business will
sell items at less
than they cost to
purchase.

9.3 CHECK YOUR UNDERSTANDING WB PAGE 168

1 State the double entry to record an inventory write-down.

2 ‘NRV is basically the same as the selling price of an inventory item.’ Do you agree?
Explain your answer.
3 The owner of a small business values inventory on hand at cost at $63 000. When
the lower of cost and NRV rule was applied, she finds that the value of inventory
was only $59 000 and that an inventory write-down should be recorded. Using the
following table, show the two-fold effect of this inventory write-down on the firm’s
balance sheet. (Show dollar amounts where applicable.)

Increase/Decrease/No effect $
Assets
Liabilities
Owner’s equity

190 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 9 CHAPTER REVIEW

KEY CONTENT
•• [9.1] The cost of inventory includes both the purchase price of an item and any other costs
directly related to that item.
•• [9.1] Product costs are related directly to an inventory item and recorded on its inventory
card. Period costs aren’t related directly to an inventory item; they are written off as an
expense for the current reporting period.
•• [9.1] When deciding to treat a cost as a product or period cost, a business should consider
whether the cost can be logically traced to an individual inventory item, and whether
the amount per item is significant enough to affect decision making. This satisfies the
demands of the qualitative characteristic of relevance.
•• [9.2] In the balance sheet of a trading firm, inventory should be valued at the lower of either
cost price or net realisable value (NRV), the estimated selling price minus any costs
incurred. NRV will be lower than cost price in situations where goods are sold at a loss.
•• [9.3] When NRV is lower than cost price, this is recorded in the general ledger as an
inventory write-down. The item’s inventory card must also be adjusted.

CHAPTER 9 EXERCISES

WB PAGE 169
1 Product or period cost?
During the month of July 2023 the owner of Westside Sports, Stan Poppleton, makes
the following purchases.
Jul 6 Bought on credit five bikes at a cost of $240 each. The bikes were
modified before delivery with a computerised speedometer/
odometer. The modifications cost $25 per bike.
14 Purchased two dozen Sherrin footballs at a cost of $70 each. The
courier that delivered the footballs charged Poppleton a delivery fee
of $12.
22 Received a special delivery of 12 soccer balls from Good Sports.
These balls usually cost $38 but have been repackaged in special
boxes featuring the flags of the nations that compete in the World
Cup. This was done as a marketing strategy by Good Sports and the
repackaging cost Poppleton $4 per ball.

a For each of the three items Poppleton purchases during July, state the cost price
that you would recommend should be recorded on the item’s inventory card. Justify
your answer in each case.
b Explain the difference between a product cost and a period cost. Use examples
from Westside Sports to help clarify your answer.

978 1 4202 3962 1 [ C H A P T E R 9 ] I N V E N TO R Y VA L U AT I O N 191

 2 Product or period cost? WB PAGE 170

Rosa Mondio is the owner of Phonelife, a small business that sells smartphone
accessories. On 1 October 2023, Rosa receives a delivery of iPhone cases from one of
her suppliers. The invoice includes the following details:

10 Perfecta iPhone cases @ $25 $250

plus: cartage 30
Invoice sub-total 280
plus GST 28
Invoice total $308

On 1 November 2023, Rosa receives another delivery. The invoice sent with the goods
on this occasion includes the information below.
10 crystal screen protectors @ $40 $400
10 leather tablet wallets @ $28 280
15 Bluetooth speaker sets @ $40 600
plus cartage 30
Invoice sub-total 1 310
plus GST 131
Invoice total $1 441

a At what cost should the iPhone cases purchased in October be recorded in the
inventory card? Explain your answer fully, including your treatment of the cartage
fee and the GST.
b At what cost would you record the screen protectors that were delivered in
November? Justify your answer.
c Is there any difference in your treatment of the cartage in October compared with
that paid in November? Explain your answer fully, with reference to a qualitative
characteristic of accounting.

WB PAGE 170
3 Product costing
Echuca Electrical is a retail store that sells the Deluxe 500 L refrigerator. The following
financial details have been provided for your information.
Invoice price of the Deluxe 500 L $800
refrigerator
Advertising $4 800 per annum
Customs duty payable 10% of purchase price
Insurance of inventory $1 500 per annum
Cartage in expenses $40 per refrigerator
Cartage out expenses $20 per refrigerator
Average mark-up on refrigerators 75%
Commission paid on sales 5%
a Select the relevant details from above and calculate the dollar amount that should
be recorded as the cost of one Deluxe 500 L (500 litre) refrigerator.
b Explain your treatment of the items ‘cartage in’ and ‘cartage out’.
c Explain the difference between a product cost and a period cost. Use examples
from the above information in your answer.
d During August 2023 the business sold 10 Deluxe 500 L refrigerators. Prepare an
income statement to show the net result of selling 10 fridges. (Note: the 75%
mark-up is applied to the total product cost of each fridge.)

192 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
4 Product costing WB PAGE 172

Skipper’s Office Supplies decides to sell a new line of inventory, the Pro-plus printer,
which will be purchased in lots of 10 units at a time. As a special promotion, the owner
of the business, Toni Skipper, includes an extra printer cartridge with each printer.
She also has the printers repackaged in an attempt to promote sales. All printers are
delivered once a month by the supplier, the Global Printer Company. Details of the price
structure for this inventory line are as below.

Supplier’s price $90 GST $9

Extra cartridge $20 GST $2
Packaging costs $10 GST $1
Estimated selling price $140 GST $14
Delivery costs per month $100 (covers all inventory) GST $10

a What cost price would you record in the inventory card for the Pro-plus printer?
(Show all workings.)
b Explain your treatment of the GST payable on the inventory purchased.
c Distinguish between product and period costs, with reference to an example of
each from the above information.

5 Net realisable value WB PAGE 172 SPREADSHEET X.XX

The following information relates to three different inventory items in a trading business.

Item Quantity Cost price Estimated

$ selling price $
101 2000 8 12.50
102 1000 7 11.00
103 3000 12 10.00

a Determine the cost of inventory that should be determined as a result of a physical

stocktake.
b Copy and complete the following table, using the lower of cost and NRV rule.

Item Cost price NRV $ Lower of cost and Quantity Value $

$ NRV $
101
102
103
Total

c Prepare the general journal entry to adjust the books of the business for an
inventory write-down, as noted by Memo 47.
d State the value that would be reported for inventory in the balance sheet of the firm
on 30 June 2023.
e Show how the inventory write-down would be recorded in the inventory card of
item 103.
f Explain the effect of the inventory write-down on the income statement.

978 1 4202 3962 1 [ C H A P T E R 9 ] I N V E N TO R Y VA L U AT I O N 193

 6 Net realisable value
SPREADSHEET X.XX WB PAGE 174

The information listed below relates to the inventory of Better Products on

30 September 2023.
Item Quantity Cost price $ Estimated selling Marketing costs
price $ per unit $
A 800 5 9 2.00
B 600 4 4 2.00
C 1000 9 16 3.00
D 1800 8 14 2.50

a Calculate the value of inventory on hand at cost price.

b Determine the NRV for each line of inventory.
c Prepare a table to show the application of the lower of cost and NRV rule.
d Prepare the general journal entry to record the adjustment for an inventory write-
down, evidenced by Memo 33.
e Show how the inventory write-down would be recorded in the inventory card of item B.
f Show how inventory would be reported in the balance sheet of Better Products on
30 September 2023.

WB PAGE 175
7 Net realisable value
SPREADSHEET X.XX

Joe Lanzon is the owner of Newport Kitchen Supplies, a small business that sells a variety of
kitchen products, including a range of coffee percolators in different sizes. He has provided
the following information as at 30 June 2023 in relation to his inventory of percolators.

Size Quantity as per Quantity as per Cost Normal selling Estimated

inventory card stocktake price $ price $ NRV $
4 cup 100 100 12 19 19
6 cup 120 115 18 28 25
8 cup 80 82 20 29 29
10 cup 160 150 25 35 32
12 cup 180 180 28 39 25

a Using the relevant information from the above table, calculate the value of the
overall inventory loss or gain to be recognised on 30 June 2023.
b The recognition of an inventory loss or gain can be justified by two different
qualitative characteristics of accounting. Name these characteristics. Explain how
they justify the recording of an inventory loss or gain.
c Calculate the value of the inventory write-down required on 30 June 2023.
d Explain why an inventory write-down should be recorded on balance day, with
reference to the relevant accounting assumption.
e Prepare the general journal entry to record the inventory write-down required.
f Taking into account all relevant information from that stated above, determine the
balance of inventory reported in the balance sheet for Newport Kitchen Supplies as
at 30 June 2023. (Show all workings.)

194 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 CASE STUDY WB PAGE 176 SPREADSHEET X.XX

Shane Noonan is the owner of Wallan Wares, a retail outlet that sells a range of household
appliances. Noonan closes his books annually on 31 August. The following extracts have
been provided from some of the inventory cards used in his business.
Inventory item: Premier 120 cm television Identified cost
Date Details Qty Cost Value Qty Cost Value Qty Cost Value
23 Aug Receipt 4334 2 250 500 6 250 1 500
26 Aug Receipt 4342 1 250 250 5 250 1 250
28 Aug Receipt 4351 2 250 500 3 250 750

Inventory item: Series X laptop Identified cost

Date Details Qty Cost Value Qty Cost Value Qty Cost Value
25 Aug Invoice 2132 2 1 200 2 400 5 1 200 6 000
8 1 300 10 400
27 Aug Receipt 2136 1 1 200 1 200 4 1 200 4 800
8 1 300 10 400
30 Aug Invoice 2138 2 1 300 2 400 4 1 200 4 800
6 1 300 7 800

Inventory item: Deluxe freezer Identified cost

Date Details Qty Cost Value Qty Cost Value Qty Cost Value
22 Aug Receipt 4332 1 800 800 1 800 800
3 850 2 550
26 Aug Receipt 4344 2 850 1 700 1 800 800
1 850 850
30 Aug Invoice 32193 6 850 5 100 1 800 800
7 850 5 950

Additional information
•• A stocktake performed on 31 August 2023 revealed that only two Premier televisions
were in inventory (Memo 21).
•• A new model of laptop computer has just hit the market. Noonan has reviewed his
computer inventory and decided that his units of the Series X laptops will be sold for
$1100 each in a clearance sale, starting in early September 2023 (Memo 22).
•• The customer who purchased the two freezers on 26 August was charged $1300 per
unit, plus GST of $130. Unfortunately, he has decided that he now only needs one of
them. Noonan decides to give him a credit note for the full price charged for the item. This
decision is made and carried out on 31 August (Credit note 112 issued to A Leishman).

1 Prepare the relevant general journal entries on 31 August to account for all of the
above events.
2 Justify your treatment of the value of the computers. Refer to one accounting
assumption and one qualitative characteristic in your answer.
3 What cost price did you use for the return of the freezer? Justify your choice.
4 State the value of inventory on hand for each of the three inventory items after the
adjustments you have made via the general journal in Question 1. State the quantity,
value and total value on hand for each item.
5 Noonan is getting tired of having to write his cost prices in code on all of his inventory
items. He is now thinking of adopting the FIFO method of inventory valuation. Should
he continue using identified cost or change to FIFO? Discuss.

978 1 4202 3962 1 [ C H A P T E R 9 ] I N V E N TO R Y VA L U AT I O N 195

 CHAPTER CHECKLIST
Now that you have finished Chapter 9, double-check your progress.
Are you ready for your Unit 3 assessment?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
completed all end-of-chapter activities
handed in my workbook for marking.

I understand …

the General Journal and General Ledger and their use in recording transactions, both
manually and using ICT, including inventory write-down
inventory cards using the First-In, First-Out (FIFO) and Identified Cost methods for
inventory write-down
inventory valuation:
– product and period costs
– the lower of cost and net realisable value (NRV).

I can …

distinguish between product and period costs in relation to inventory valuation

use ICT, including spreadsheets, to model and analyse the effect of alternative
inventory valuation methods and cost assignment methods.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_9

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

196 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
10 CLOSING THE GENERAL LEDGER

Once a trial balance has LEARNING OBJECTIVES

been prepared, you must still
determine the profit earned by By the end of this chapter, you will be able to:
the firm during the reporting •• describe what is involved in closing the general ledger
period, and prepare the ledger [10.1]
accounts for the new reporting •• prepare a Profit and Loss Summary account in the
period. This is done by closing off general ledger [10.1]
the accounts used to prepare the •• distinguish between closing an account and balancing
income statement an account [10.2]
In this chapter, you will learn
•• state which accounts are closed and which are
what is involved in closing the
balanced [10.2]
general ledger at the end of a
reporting period, and how to report •• prepare general journal entries to close the relevant
on a business’s profit or loss. accounts [10.3]
•• prepare a general journal entry to transfer a net profit
or loss to the owner’s Capital account [10.4 & 10.5]
•• prepare a general journal entry to close the owner’s
drawings account to the Capital account [10.6].

UNIT 3 – PROGRESS 1 2 3 4 5 6 7 8 9 10 11 12 13

10.2 10.4
10.3 10.6

Closing a ledger Transfer of Closing the Sales Chapter review

10.1 account 10.3 net profit 10.5 Returns account 10.7 and exercises

The general Closing entries:

Closing the general Extended example:
journal and closing accounting
ledger closing the ledger
entries for a net loss

978 1 4202 3962 1 197

 10.1 CLOSING THE GENERAL LEDGER
Profit is the excess of revenue over expenses for a given period of time. We use the
revenue and expense accounts in the general ledger to calculate a profit. This leaves
the account classifications of assets, liabilities and owner’s equity, which make up the
accounting equation.
This is an important distinction, because revenue and expense accounts must
be closed off on balance day. The accounts reported as assets, liabilities or owner’s
equity are formally balanced in the usual way.
The other procedure is to return the balance of all revenues and expenses to
zero. It is vitally important to the accounting system not to mix one period’s revenue
and expenses with those of the following period. If this happened, it would become
practically impossible to determine profit for a given period.
Therefore, on balance day of every period, all revenue and expense accounts
are closed off and have a zero balance in preparation for the new reporting period.
This exercise is commonly referred to as closing the general ledger, or simply
closing the ledger.

On balance day, all

revenue and expense
accounts must be
returned to a zero
balance.

THE PROFIT AND LOSS SUMMARY ACCOUNT

profit and loss The Profit and Loss Summary account (also called the P&L Summary account)
(P&L) summary is a general ledger account used to gather the totals of all revenue and expense
account
general ledger accounts in order to calculate the net profit of a business. It’s classified as a profit
account that determination account, which is a temporary owner’s equity account.
summarises all
revenues and When accounts are closed off, their balances are transferred to the P&L Summary
expenses for a account. The account is only used on balance day.
reporting period, Figure 10.1 shows an example of a P&L Summary account.
leaving the profit
or loss
FIGURE 10.1 Profit and Loss Summary account showing a net profit
net profit
when revenues
exceed expenses for a Profit and Loss Summary
reporting period 2023 $ 2023 $
31 Mar Expense accounts 55 000 31 Mar Revenue accounts 70 000
Capital (net profit) 15 000
70 000 70 000

198 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
P&L Summary accounts have three key features:
•• the total of all revenue accounts appears on the credit side of the P&L Summary
account.
•• the total of all expense accounts appears on the debit side of the P&L Summary
account.
•• Profit equals revenue less expenses ($70 000 – $55 000), so the net profit of the
firm (in this example) is $15 000.
The calculated profit is entered in the P&L Summary account as capital, since the
profit for a period increases the owner’s Capital account. The $15 000 profit in this
example is transferred to the Capital account of the owner.

10.1 CHECK YOUR UNDERSTANDING WB PAGE 180

1 Explain what ‘closing the ledger’ means.

2 State and explain two reasons why ledger accounts must be closed.
3 What types of ledger accounts are closed? Why are some accounts not
closed?
4 Describe the purpose of the P&L Summary account.

10.2 CLOSING A LEDGER ACCOUNT

The closing of a ledger account involves making an entry in the account opposite to
the balance. In a revenue account, which usually has a credit balance, the closing closing entry
entry is made on the debit side. As expense accounts usually have debit balances, general journal entry used
the closing entries would be made on the credit side of the accounts. to close off a revenue or
expense account
Consider the accounts below, which were used to determine the totals of
revenues and expenses in the P&L Summary account in Figure 10.1.

Cash sales
$ $
8 Mar Cash at bank 60 000
Capital (net profit)

Credit Sales
$ $
16 Mar Accounts receivable 10 000

Cost of sales
$ $
8 Mar Inventory 31 000
16 Mar Inventory 4 000

978 1 4202 3962 1 [CHAPTER 10] CLOSING THE GENER AL LEDGER 199
 Wages
$ $
31 Mar Cash at bank 15 000

Advertising
$ $
11 Mar Cash at bank 5 000

These accounts reflect transactions for the month ended 31 March 2023. We can
see that the balances of the revenue accounts are $60 000 in the Cash Sales account
and $10 000 in Credit Sales. The expenses include cost of sales of $35 000, wages of
$15 000 and $5000 of advertising.
When the closing entries are posted to these ledger accounts, they appear as
shown below.

GENERAL LEDGER Cash sales

$ $
31 Mar P&L summary 60 000 8 Mar Cash at bank 60 000

Credit Sales
$ $
31 Mar P&L summary 10 000 16 Mar Accounts receivable 10 000

Cost of sales
$ $
8 Mar Inventory 31 000
16 Mar Inventory 4 000 31 Mar P&L summary 35 000
35 000 35 000

Wages
$ $
31 Mar Cash at bank 15 000 31 Mar P&L summary 15 000

Advertising
$ $
11 Mar Cash at bank 5 000 31 Mar P&L summary 5 000

DON’T! Note how the closing entries are on the opposite side to the balances of the
Do not ever close off accounts. When the closing entries are made, the account balances are brought back
assets and liabilities!
to zero. As with all entries in double entry accounting, every debit must be paired with
Only revenue and
expense accounts are a credit, and vice versa.
closed off. The other account affected in the double entry is the P&L Summary account,
which gathers together all of the revenue and expense account balances.

200 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 Profit and Loss Summary
$ $
31 Mar Expense accounts 55 000 31 Mar Revenue accounts 70 000

Capital 15 000

70 000 70 000

It’s not necessary to individually list the revenue and expense items in the P&L
Summary account. As it’s a summary of a firm’s revenues and expenses for a
reporting period, the only detail required is a total figure for both revenues and
expenses.

Each revenue
and expense
account must be
closed off to the
P&L Summary
account at the
end of the period.

However, it’s vital to close off each individual revenue and expense account to the
P&L Summary account so that, at the start of the next reporting period, all such
accounts begin with a zero balance.

10.2 CHECK YOUR UNDERSTANDING WB PAGE 181

1 Distinguish between closing and balancing a ledger account.

2 Is there a link between the going concern assumption and the balancing of
accounts? Explain fully.
3 Explain why individual accounts are not listed in a P&L Summary account.

978 1 4202 3962 1 [CHAPTER 10] CLOSING THE GENER AL LEDGER 201
 THE GENERAL JOURNAL AND
10.3 CLOSING ENTRIES
As with any entry in the general ledger, closing entries must first be recorded in the
general journal. The general journal entries for the accounts discussed so far would be
prepared as shown in Figure 10.2.

FIGURE 10.2 General journal closing entries

GENERAL JOURNAL
Date Details Dr Cr
31 Mar Cash sales 60 000
Credit sales 10 000
P&L summary 70 000
Closing entries
31 Mar P&L Summary 55 000
Cost of sales 35 000
Wages 15 000
Advertising 5 000
Closing entries

As one purpose of closing entries is to reset all revenue and expense accounts to
zero, every account in these categories must be named in the general journal as part
of the closing process.
When the expenses of a firm are being closed to the P&L Summary account, they
can be grouped into one entry. When there are multiple revenue accounts, these can
also be grouped together in one general journal entry.
This means that there will usually be three general journal entries made to
complete the closing of the ledger:
•• One journal entry is used to close all revenues.
•• One journal entry closes all expenses.
•• The final entry closes the P&L Summary account by transferring the net profit to
the Capital account.

Employee wages
are entered in the
general journal.

202 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
10.4 TRANSFER OF NET PROFIT
Once all the balances of revenues and expenses have been transferred to the P&L
Summary account, the final task is to calculate the profit (or loss) earned for the
period.
This final step also closes off the P&L Summary account, because the difference
between revenues and expenses is the profit figure. When the profit figure is entered
in the P&L Summary account, both sides of the account become equal and the P&L
Summary account is closed. The profit figure is transferred to the owner’s Capital
account and the closing process is concluded.
Using the data from Figure 10.2, the transfer of net profit is shown in Figure 10.3.

FIGURE 10.3 General journal entry to transfer net profit

GENERAL JOURNAL
Date Details Dr Cr
31 Mar P&L Summary 15 000
Capital 15 000
Transfer of net profit

DRAWINGS
In addition to the transfer of net profit to the Capital account, the drawings of the
owner must also be closed at the end of the period. As Drawings is a negative
owner’s equity account, it decreases the owner’s capital.
If the owner in our example had drawings of $10 000 for the quarter, the general
journal entry required is as shown in Figure 10.4.

FIGURE 10.4 General journal entry to transfer drawings

GENERAL JOURNAL
Date Details Dr Cr
31 Mar Capital 10 000
Drawings 10 000
Transfer of owner’s drawings

Posting the two journal entries shown in Figures 10.3 and 10.4 results in the following
entries in the general ledger. (Note that there was an opening balance of $200 000 in
the Capital account.)
Drawings
$ $
31 Mar Cash at bank 10 000 31 Mar Capital 10 000

Capital
$ $
31 Mar Drawings 10 000 1 Mar Balance 200 000
31 Mar Balance 205 000 31 Mar P&L summary 15 000
215 000 215 000
1 Apr Balance 205 000

978 1 4202 3962 1 [CHAPTER 10] CLOSING THE GENER AL LEDGER 203
 The first entry (on 1 March) represents the balance of the owner’s capital at the start
of the period. The result from the P&L Summary account (a profit of $15 000) has
been transferred to the Capital account and causes an increase in the owner’s equity.
The drawings by the owner have the opposite effect on the Capital account. The
debit to Capital reduces the owner’s equity, while returning the Drawings account to
zero for the new period.
A summary of such information is usually presented as part of the firm’s balance
sheet on balance day.
BALANCE SHEET (EXTRACT) AS AT 31 MARCH 2023
Owner’s equity $ $ $
Capital 200 000
Net profit 15 000 215 000
Less: Drawings 10 000 205 000

THE NEED FOR REPORTING

Remember that the general ledger is a formal accounting record used by accountants.
From time to time, information from ledger accounts is reported to other users, some
of them non-accountants. The report extract above repeats exactly what has been
recorded in the owner’s Capital account. It becomes part of an overall report that can
be easily read by individuals without a thorough accounting background. (This is in line
with one of the qualitative characteristics of accounting – understandability.)

Report extracts
may be easier
for users to
understand than
the entire ledger.

While this may appear to be an unnecessary duplication of a task, it fulfils a key

function of the accounting system. The system needs to present information for
a variety of purposes and to a wide range of users. Accountants need to extract
information from ledger accounts and use it to compile reports for others.

10.4 CHECK YOUR UNDERSTANDING WB PAGE 182

1 What is the nature of the P&L Summary account? Explain your answer fully.
2 Determine which side (debit or credit) of the P&L Summary account you would find:
a revenue accounts
b expense accounts
c a net profit.
2 State the double entry required to transfer a net profit to a Capital account.

204 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
10.5 OTHER TYPES OF CLOSING ENTRIES

ACCOUNTING FOR A NET LOSS

The closing entries so far have all involved a firm earning a profit. Unfortunately, this net loss
result when the
may not always be the case. When a business earns a net loss, a slight adjustment expenses for a period
has to be made in the closing process. exceed the revenue
for the same period
A loss occurs when the expenses closed off to the P&L Summary account exceed
the revenues. This means that the debit entries to P&L Summary exceed the credits.
To close off such a P&L Summary account, a credit entry is required. The
corresponding debit is made in the Capital account, reducing the owner’s equity.
Figure 10.5 shows a P&L Summary account when a business incurs a loss.

FIGURE 10.5 Profit and Loss Summary account showing a net loss

Profit and Loss Summary

2023 $ 2023 $
30 Jun Expense accounts 500 000 30 Jun Revenue accounts 450 000
Capital (net loss) 50 000
500 000 500 000

The general journal entry required to transfer a net loss to the owner’s Capital account
is shown in Figure 10.6.

FIGURE 10.6 General journal entry showing transfer of a net loss

GENERAL JOURNAL
Date Details Dr Cr
30 Jun Capital 50 000
P&L Summary 50 000
Transfer of net loss

The journal entry to transfer a profit or a loss must transfer the final figure to the Capital
account and also close off the P&L Summary account itself. Make sure that the total
debits made to the P&L Summary account are equal to the total credit entries made.
Remember: a profit will always increase owner’s equity and must be a credit to the
Capital account. If a loss is made, this will decrease owner’s equity and must result in a
debit entry to Capital.

978 1 4202 3962 1 [CHAPTER 10] CLOSING THE GENER AL LEDGER 205
 CLOSING THE SALES RETURNS ACCOUNT
Another complication in the closing process is when a trading business experiences
sales returns (see chapter 8) from some of its accounts receivable. Sales Returns acts
like a negative revenue account, and reduces the net sales reported for a given period.
Consider the following ledger accounts.
Credit sales
$ $
1–31 Jul Accounts receivable 11 000

Sales returns
$ $
1–31 Jul Accounts receivable 1 000

As both of the above are classified as revenue accounts (sales returns being negative
revenue), they can both be closed off in the one closing entry (Figure 10.7).

FIGURE 10.7 General journal Closing entry for sales and sales returns

GENERAL JOURNAL
Date Details Dr Cr
31 Jul Credit sales 11 000
Sales returns 1 000
P&L Summary 10 000
Closing entries

The amount transferred to the P&L Summary account is the net sales for the period.
As the business sold goods on credit for $11 000 and had sales returns of $1000, the
net sales for the period would be $10 000. This entry still returns the two revenue
accounts back to zero balances, ready for the subsequent period.
Despite the fact that Sales Returns is netted off against the total sales made for
the period, you should still report both items in the income statement for the period.
Revenue
Credit sales $11 000
Less: Sales returns $1 000 $10 000

10.5 CHECK YOUR UNDERSTANDING WB PAGE 182

1 State the double entry required to transfer drawings to a Capital account.

2 Explain why the Drawings account is closed off to Capital and not to the P&L
Summary account.
3 State the double entry required to transfer a net loss to a Capital account.

206 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 EXTENDED EXAMPLE: CLOSING
10.6 THE LEDGER
You have examined all the steps involved in closing the ledger, but the process really
starts with the preparation of the trial balance. Once a trial balance is prepared at the end
of the period, and no recording errors are detected, the closing of the ledger can begin.
This extended example examines the entire closing process, from the trial balance
through to the transfer of net profit and drawings. It shows the closing procedures
from start to finish, so that you can follow the entries from the general journal through
to the general ledger.
The information in this example relates to Sustainable Sunshine, a small business
owned and managed by Simon Cartwright that sells solar panels and related
technologies.

Sustainable
Sunshine must
close the ledger
at the end of the
financial year.

TRIAL BALANCE
SUSTAINABLE SUNSHINE: ADJUSTED TRIAL BALANCE AS
AT 30 JUNE 2023
$ $
Cash at bank 8 500 GST clearing 1 000
Accounts 5 000 Accounts 1 500
receivable payable
Inventory 65 000 Loan – NAB 5 000
Cost of sales 24 000 Cash sales 55 000
Inventory loss 1 000 Credit sales 17 500
Insurance 2 000 Capital 80 000
Advertising 1 000
Wages 20 000
Sales returns 2 500
Vehicle 22 000
Vehicle expenses 2 000
Drawings 7 000
160 000 160 000

978 1 4202 3962 1 [CHAPTER 10] CLOSING THE GENER AL LEDGER 207
 GENERAL JOURNAL
In order to prepare the entries in the general journal, the revenue and expense
accounts in the trial balance must first be identified. Having done this, the entries can
be completed.
SUSTAINABLE SUNSHINE: GENERAL JOURNAL
Date Details Dr Cr
30 Jun Cash sales 55 000
Credit sales 17 500
Sales returns 2 500
P&L Summary 70 000
Closing entries
30 Jun P&L Summary 50 000
Cost of sales 24 000
Inventory loss 1 000
Advertising 1 000
Insurance 2 000
Wages 20 000
Vehicle expenses 2 000
Closing entries
30 Jun P&L Summary 20 000
Capital 20 000
Transfer of net profit
30 Jun Capital 7 000
Drawings 7 000
Transfer of owner’s drawings

The net profit is calculated from the first two journal entries.

GENERAL LEDGER
As total revenue closed to the P&L Summary account was $70 000 and total
expenses closed off were $50 000, the net profit must be $20 000. These closing
entries are then posted to the general ledger.

SUSTAINABLE SUNSHINE: GENERAL LEDGER

Cash at bank
$ $
30 Jun Balance 8 500

Accounts receivable
$ $
30 Jun Balance 5 000

Inventory
$ $
30 Jun Balance 65 000

208 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 Cost of sales
$ $
30 Jun Inventory 24 000 30 Jun P&L summary 24 000

Inventory loss
$ $
30 Jun Inventory 1 000 30 Jun P&L summary 1 000

Insurance
$ $
30 Jun Cash at bank 2 000 30 Jun P&L summary 2 000

Advertising
$ $
30 Jun Cash at bank 1 000 30 Jun P&L summary 1 000

Wages
$ $
30 Jun Cash at bank 20 000 30 Jun P&L summary 20 000

Sales returns
$ $
30 Jun Accounts receivable 2 500 30 Jun P&L summary 2 5000

Vehicle
$ $
30 Jun Balance 22 000

Vehicle expenses
$ $
30 Jun Cash at bank 2 000 30 Jun P&L summary 2 000

Drawings
$ $
30 Jun Cash at bank 7 000 30 Jun Capital 7 000

GST clearing
$ $
30 Jun Balance 1 000

Accounts payable
$ $
30 Jun Balance 1 500

Loan – NAB
$ $
30 Jun Balance 5 000

978 1 4202 3962 1 [CHAPTER 10] CLOSING THE GENER AL LEDGER 209
 Cash sales
$ $
30 Jun P&L summary 55 000 30 Jun Cash at bank 55 000

Credit sales
$ $
30 Jun P&L summary 17 500 30 Jun Accounts receivable 17 500

BALANCE SHEET
Once the closing entries are completed, the final accounting reports for the period
can be prepared. The accounts used to determine profit (revenues and expenses)
are reported in the income statement. The balance sheet is then prepared using the
remaining accounts (assets, liabilities and owner’s equity).
Chapter 11 provides a detailed examination of the income statement. At this stage,
it’s enough to know that a balance sheet may be prepared once the P&L Summary
account has been finalised.
Having completed the accounts for Sustainable Sunshine, the balance sheet can
be prepared.

SUSTAINABLE SUNSHINE: BALANCE SHEET AS AT 30 JUNE 2023

Assets $ $ Liabilities $
Current assets Current liabilities
Cash at bank 8 500 GST clearing 1 000
Accounts receivable 5 000 Accounts payable 1 500
Inventory 65 000 78 500 Loan – NAB 5 000 7 500
Owner’s equity
Non-current assets Capital 80 000
Vehicle 22 000 Net profit 20 000 100 000
Less: Drawings 7 000 93 000
100 500 100 500

210 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 10 CHAPTER REVIEW

KEY CONTENT
•• [10.1] On balance day of a reporting period, all revenue and expense accounts are closed
off and have a zero balance, so that one period’s revenue and expenses aren’t mixed
up with those of the following period. This is called closing the general ledger, or just
closing the ledger.
•• [10.2] The Profit and Loss (P&L) Summary account is a general ledger account used to gather
the balances of all revenue and expense accounts in order to calculate the net profit of
a business. When accounts are closed off on balance day, their balances are transferred
to the P&L Summary account.
•• [10.3] Closing a ledger account involves making an entry in the account opposite to the
balance. In a revenue account, entry is made on the debit side. In an expense account,
entry is made on the credit side.
•• [10.4] Three general journal entries are made to close the ledger: one to close all revenues,
one to close all expenses, and one to close the P&L Summary account by transferring
the net profit to the Capital account.
•• [10.5] When the profit figure is entered in the P&L Summary account, both sides of the
account become equal and the P&L Summary account is closed. The profit figure is
transferred to the owner’s Capital account.
•• [10.5] The drawings of the owner must also be closed at the end of the period. As Drawings
is a negative owner’s equity account, it decreases the owner’s Capital.
•• [10.6] A net loss occurs when the expenses closed off to the P&L Summary account exceed
the revenues. This means that the debit entries to P&L Summary exceed the credits.
To close off the account, a credit entry is needed, and a corresponding debit is made in
the Capital account.
•• [10.7] A trading business may have sales returns, which reduce the net sales reported for
a given period. They are classified as revenue accounts and are included in the same
closing entry.

CHAPTER 10 EXERCISES

1 Closing entries: basic WB PAGE 183 SPREADSHEET X.XX

The following information relates to Prahran Pottery Products.

GENERAL LEDGER
Cash sales
$ $
31 Jan Cash at bank 30 000

Cost of sales
$ $
31 Jan Inventory 16 200

978 1 4202 3962 1 [CHAPTER 10] CLOSING THE GENER AL LEDGER 211
 Vehicle expenses
$ $
31 Jan Cash at bank 2 800

Capital
$ $
1 Jan Balance 40 000

a Prepare the general journal entry to close the Cash Sales revenue account.
b Prepare the general journal entry to close the two expense accounts.
c Prepare the general journal entry to transfer the net profit (or loss) to the owner’s
Capital account.
d Prepare the P&L Summary account and the Capital account for the month of
January 2023.

2 Closing entries: advanced

SPREADSHEET X.XX WB PAGE 184

The following ledger accounts were found in the general ledger of Tee Total, a pop-up
shop selling novelty T-shirts.
Cash at bank
$ $
1 Feb Balance 18 000 28 Feb Cash payments 5 455
28 Feb Cash receipts 5 060

Inventory
$ $
28 Feb Balance 10 000 28 Feb Cost of sales 2 560

Cost of sales
$ $
28 Feb Inventory 2 560

Capital
$ $
1 Feb Balance 23 000

Equipment
$ $
1 Feb Balance 5 000
28 Feb Cash at bank 2 000

Advertising
$ $
28 Feb Cash at bank 500

Insurance
$ $
28 Feb Cash at bank 400

212 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 Drawings
$ $
28 Feb Cash at bank 500

Wages
$ $
28 Feb Cash at bank 1 600

Stationery
$ $
28 Feb Cash at bank 150

Cash sales
$ $
28 Feb Cash at bank 4 600

Credit sales
$ $
28 Feb Accounts receivable 8 000

Accounts receivable
$ $
28 Feb Sales/GST clearing 8 800

GST clearing
$ $
28 Feb Cash at bank 305 28 Feb Cash at bank 460
Accounts receivable 800

a Prepare the required general journal entries to close off the relevant ledger accounts
to the P&L Summary account.
b Prepare general journal entries to transfer the net profit (or loss) and drawings to the
Capital account of the owner.
c Copy the revenue and expense accounts and post the closing entries to these
accounts.
d Prepare the P&L Summary account, the Capital account and the Drawings account
as they would appear in the general ledger for February 2023.
e Show how the owner’s equity section of the balance sheet would be prepared as at
28 February 2023.

978 1 4202 3962 1 [CHAPTER 10] CLOSING THE GENER AL LEDGER 213
 3 Closing entries from trial balance data
SPREADSHEET X.XX WB PAGE 186

Greg Smyth is the owner of Trailblazer Quad Bikes and has supplied the following trial
balance at the end of the yearly reporting period.
TRAILBLAZER QUAD BIKES: TRIAL BALANCE AS AT 30 APRIL 2023
$ $
Accounts receivable 3 200 Accounts payable 7 700
Advertising 3 500 Capital 93 350
Cash at bank 3 000 Cash sales 94 600
Cost of sales 42 500 Credit sales 14 470
Drawings 14 000 GST clearing 480
Electricity 760 Loan – GM Finance 36 000
Insurance 1 100 Mortgage loan 420 000
Interest on loan 4 700
Office furniture 900
Postage 120
Premises 500 000
Rates 1 000
Sales returns 600
Shop fittings 12 000
Stationery 240
Inventory 44 480
Inventory loss 500
Sales returns 3 000
Telephone expense 640
Vehicle 12 000
Vehicle expenses 1 360
Wages 17 000
666 600 666 600

a Prepare all relevant closing entries in the general journal, including the transfer of
profit and drawings.
b Prepare the P&L Summary account and Capital account in the general ledger.
c Prepare the owner’s equity section of the balance sheet as at 30 April 2023.

214 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
4 From trial balance to balance sheet WB PAGE 188 SPREADSHEET X.XX

The following information relates to the business of Lloyd’s Landscaping Supplies.

LLOYD’S LANDSCAPING SUPPLIES: TRIAL BALANCE AS AT 31 MAY 2023

$ $
Cash at bank 3 200
GST clearing 4 020
Telephone expense 740
Electricity 530
Inventory 59 000
Discount revenue 680
Investment account 8 600
Advertising 1 680
Loan – Handy Finance 142 500
Accounts receivable 2 870
Repairs to premises 1 040
Capital – Lloyd 286 000
Assistant’s wages 22 180
Sales – cash 74 600
Sales – credit 38 700
Interest expense 1 470
Sales returns 500
Drawings – Lloyd 9 720
Stationery 245
Accounts payable 6 800
Cost of sales 53 200
Commission 1 800
Accountant’s fees 600
Premises 385 000
Inventory gain 400
Discount expense 325
Cleaning of premises 4 600
555 500 555 500

a Prepare the general journal entries required to complete the closing of the general
ledger, including the transfer of the net profit (or loss) and the owner’s drawings.
b Prepare the following general ledger accounts: Profit and Loss Summary, Drawings
and Capital.
c Prepare a classified balance sheet as at 31 May 2023.
d Explain why closing entries should be done. Your answer should refer to the relevant
accounting assumption.
e Consider the level of sales returns experienced by this business. Should the owner
be concerned? Explain your answer fully.

978 1 4202 3962 1 [CHAPTER 10] CLOSING THE GENER AL LEDGER 215
 5 From trial balance to balance sheet
SPREADSHEET X.XX WB PAGE 190

Carly Hughes is the owner of Higher & Higher, a paragliding equipment company, and
has provided the following information in relation to her business.

HIGHER & HIGHER: ADJUSTED TRIAL BALANCE AS AT 30 JUNE 2023

$ $
Accounts payable 5750
Accounts receivable 3 870
Advertising 1 640
Bank 1710
Capital – Hughes 75 740
Carry bags 1 420
Cash sales 93 000
Cleaning of shop 1 260
Computer equipment 8 500
Cost of sales 47 300
Credit sales 29 700
Delivery van 26 000
Discount expense 100
Drawings 18 500
Electricity 490
General office expenses 2 100
GST clearing 2600
Interest on loan 1 200
Interest on term deposit 600
Inventory 32 500
Inventory loss 2 100
Legal expenses 430
Loan – Auto Finance (due 1/3/23) 13 400
Loan – NAB (repayable over four years) 12 000
Maintenance – computers 920
Office stationery expense 430
Rent of shop 32 400
Sales returns 1 500
Telephone expense 740
Term deposit 14 500
Wages – sales staff 36 600
234 500 234 500

a Prepare the general journal entries required to complete the closing of the general
ledger, including the transfer of the net profit (or loss) and the owner’s drawings.
b Prepare the following general ledger accounts: Profit and Loss Summary, Drawings
and Capital.
c Prepare a classified balance sheet as at 30 June 2023.

216 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
6 From trial balance sheet to balance sheet WB PAGE 192 SPREADSHEET X.XX

Aiko Nelson owns and manages Shokunin, a store selling Japanese artwork and
decorations. She has provided the following information at the end of her yearly
reporting period.
SHOKUNIN: ADJUSTED TRIAL BALANCE AS AT 31 MARCH 2023
$ $
Accounts receivable 3 200 Accounts payable 25 000
Cash at bank 2 200 Capital 352 600
Computer maintenance 700 Discount revenue 140
Computer system 5 400 Finance Co. loan 22 000
Cost of sales 81 400 GST clearing 4 320
Courier charges 980 Mortgage loan 314 000
Discount expense 300 Sales – cash 122 100
Display equipment 25 000 Sales – credit 43 880
Drawings 18 600
Heating and lighting 1 240
Insurance expense 3 000
Interest 6 400
Inventory 56 350
Inventory loss 800
Land and buildings 642 000
Office expenses 1 900
Postage expense 650
Promotion costs 3 120
Rates 2 400
Salaries 26 000
Sales returns 1 440
Telephone expense 920
884 000 884 000

Additional information
The Finance Co. loan is repayable at the rate of $200 per week.
The mortgage loan requires monthly repayments of $650.
a Prepare all relevant closing entries in the general journal, including the transfer of
profit and drawings.
b Prepare the P&L Summary account, the Drawings account and the Capital account
in the general ledger.
c Prepare a fully classified balance sheet as at 31 March 2023.
d Explain how your balance sheet helps satisfy the demands of the characteristic of
understandability.

978 1 4202 3962 1 [CHAPTER 10] CLOSING THE GENER AL LEDGER 217
 CHAPTER CHECKLIST
Now that you have finished Chapter 10, double-check your progress.
Are you ready for your Unit 3 assessment?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
handed in my workbook for marking.

I understand …

the recording of closing entries for revenue and expenses in the General Journal and in
the General Ledger
the preparation of the Profit and Loss Summary account in the General Ledger with
transfer of profit or loss to the Capital account in the General Journal and the General
Ledger.

I can …

identify and record financial data manually in the General Journal and the General
Ledger and manually prepare accounting reports
use ICT, including spreadsheets, to record transactions in the General Journal and the
General Ledger and prepare accounting reports.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_10

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

218 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
11 INCOME STATEMENTS

In Chapter 10 you learnt how to LEARNING OBJECTIVES

close the general ledger at the
end of each reporting period. By the end of this chapter, you should be able to:
As part of this process, the P&L •• explain the purpose of an income statement [11.1]
summary works out the profit (or •• prepare an income statement from general journal
loss) for the period and shows it closing entries [11.1]
in the general ledger. But how can •• prepare an income statement from a trial balance
that information be summarised [11.1]
more effectively?
•• evaluate a profit figure using a variety of benchmarks
In this chapter you will learn
[11.2]
how to create income statements,
which provide information about a •• explain the classification title ‘cost of goods sold’
business’s revenue, expenses and [11.3]
profit for a particular period. •• distinguish between cost of sales and cost of goods
sold [11.3]
•• distinguish between gross profit and adjusted gross
profit [11.3]
•• explain how to report discount expense and discount
revenue [11.4].

UNIT 3 – PROGRESS 1 2 3 4 5 6 7 8 9 10 11 12 13

11.2 11.4
10.3

Evaluating a net Reporting

11.1 profit figure 11.3 discounts

Preparing an Cost of goods sold Chapter review

income statement and gross profit and exercises

978 1 4202 3962 1 219

 11.1 PREPARING AN INCOME STATEMENT
The Profit and Loss (P&L) Summary account in the general ledger closes off revenue
and expense accounts on balance day. This closing-off procedure is necessary because
the balances in those accounts aren’t relevant to the following reporting period.
income The income statement is a key accounting report. Prepared at the end of each
statement period, it provides information about a business’s revenue, expenses and profit (or
accounting report
used to show a loss). It includes the same information as the P&L Summary account, but sets it out in
business’s revenue, a more informative manner.
expenses and net
profit (or loss)
When creating income statements, two of the qualitative characteristics of
accounting reports need to be considered:
•• Relevance: the income statement should convey meaningful information to its users.
•• Understandability: it should have a simple, clear format that non-accountants can
easily understand.

PURPOSE OF AN INCOME STATEMENT

The basic purpose of the income statement is to report on a business’s profit performance
over a given period. In order to do so, the report states the business’s revenue for the
period and deducts its expenses. The difference is the net profit (or loss).
Consider the general journal shown below, which includes the closing entries
made on 31 December 2023 in the books of Sparx Surfboards.

SPARX SURFBOARDS: GENERAL JOURNAL CLOSING ENTRIES

Date Details Dr Cr
31 Dec Cash sales 90 000
Credit sales 40 000
P&L summary 130 000
Closing entries
P&L summary 105 000
Cost of sales 55 000
Advertising 5 000
Wages 19 500
Telephone 600
Stationery 400
Office rent 24 000
Delivery expenses 500
Closing entries
P&L summary 25 000
Capital 25 000
Transfer of net profit

The general journal entries are posted to the P&L Summary account as shown below.

P&L summary
$ $
31 Dec Expense accounts 105 000 31 Dec Revenue accounts 130 000
Capital 25 000
130 000 130 000

220 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
The P&L Summary account shows the net profit figure, and all revenue and expense
accounts have been closed. However, there is still a need to provide information about
the revenue and expenses of a business in a clear, informative manner.

Sparx Surfboards’
income statement
allows its
profitability to be
understood.

DESIGNING AN INCOME STATEMENT

Using the information provided above, a formal income statement can be prepared for
Sparx Surfboards. Figure 11.1 shows a typical layout.

FIGURE 11.1 Income statement

SPARX SURFBOARDS: INCOME STATEMENT FOR THE YEAR ENDED

31 DECEMBER 2023
$ $
Revenue
Cash sales 90 000
Credit sales 40 000 130 000
Less: Cost of sales 55 000
Gross profit 75 000
Less: Expenses
Advertising 5 000
Wages 19 500
Telephone 600
Stationery 400
Office rent 24 000
Delivery expenses 500 50 000
Net profit 25 000

Headings and labels are used to highlight the key areas of the report. For example, the
gross profit made on the sales is clearly labelled, as is the net profit.
The title of the report indicates the reporting period. This is vital when evaluating
the performance of a business. For example, Figure 11.1 shows a profit of $25 000 for
the reporting period – this amount of profit might be satisfactory over six months, or
exceptional over a quarter (three months), but very poor for an entire year.
The period covered is also important when comparing results. There is little point in
comparing profit for six months with a weekly result.

978 1 4202 3962 1 [ C H A P T E R 11] I N C O M E S TAT E M E N T S 221

 THE LINK BETWEEN PROFIT AND THE BALANCE SHEET
As you saw in Chapter 10, the net profit or loss earned by a business affects the
owner’s equity as reported in the balance sheet. As the owner is entitled to all profits
earned by the business, the net profit becomes part of the owner’s equity. If the
business suffers a loss, this causes a decrease in the owner’s equity, which is also
reported in the balance sheet.
Once a trial balance has been finalised, the income statement and balance sheet
can be prepared. These two reports take care of the five basic classifications of
accounts that we looked at in Chapter 1, as shown in Figure 11.2.

FIGURE 11.2 The link between the income statement and the balance sheet

INCOME
STATEMENT REVENUE − EXPENSES = PROFIT

BALANCE
SHEET ASSETS = LIABILITIES + OWNER’S EQUITY

Remember: owner’s equity = capital + profit – drawings

At this point, the basic accounting system has been used from start to finish:
•• Source documents have been gathered.
•• Transactions from those documents have been entered in the general journal.
•• The general journal has been posted to ledger accounts.
•• A trial balance has been used to check the accounts.
•• The information in the trial balance has been used to prepare the two main
financial statements.
This system allows a business owner to determine a net profit result for a period, and
to state the accounting equation of the business at the end of that period.

11.1 CHECK YOUR UNDERSTANDING WB PAGE 195

1 Explain the basic function of an income statement.

2 Should a business owner have to prepare an income statement if they have already
completed a P&L Summary account? Explain your answer fully.
3 Outline the link between the income statement and the balance sheet of a business.

222 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
11.2 EVALUATING A NET PROFIT FIGURE
When an income statement has been completed, it’s not the end of the accounting
process. Management needs to be able to assess the profit figure, in order to tell how
the business is performing.
The period covered is a basic consideration when evaluating the profit earned, but
several other measures are also commonly used to evaluate profit (see Figure 11.3).

FIGURE 11.3 Measures for evaluating net profit

Profit trend

Budgeted profit

EVALUATING
NET PROFIT

Industry averages

Financial indicators

PROFIT TREND
Comparing the profit earned in the current period with that earned in previous
periods provides management with a profit trend over time. This could indicate an
improvement or a decline in the profit performance. Two or three consecutive profit
figures provide much more information than one isolated period.

EXAMPLE 11.1

Consider the profit figures of the two businesses shown below.

Profits earned in 2019 2020 2021 2022 2023

$ $ $ $ $
Business A 1 000 5 000 20 000 40 000 45 000
Business B 90 000 80 000 70 000 60 000 45 000

If you viewed 2023 in isolation, the only statement you could make would be that both
businesses earned a profit of $45 000. However, the performance of the two businesses
is very different when the five-year trend is taken into account.

978 1 4202 3962 1 [ C H A P T E R 11] I N C O M E S TAT E M E N T S 223

 BUDGETED (OR EXPECTED) PROFIT
Regardless of the trend in a business’s profit figures, the profit earned may not be
acceptable if it doesn’t meet management’s expectations.

EXAMPLE 11.2

Looking back to Business A in Example 11.1, the budgeted profit for 2023 was $50 000.

Profits earned in 2019 2020 2021 2022 2023 2023

Budget Actual
$ $ $ $ $ $
Business A 1 000 5 000 20 000 40 000 50 000 45 000

While there is a favourable trend when the 2023 profit is compared with the profit in
previous years, management wouldn’t be as pleased, because the business didn’t
achieve its profit target of $50 000.

INDUSTRY AVERAGES
Information may be available to indicate whether or not the business performed as
well as similar businesses. In the case of public companies, detailed statistics are
available regarding profit performance. In the case of smaller businesses, a public
accountant may be able to indicate whether or not the business is performing above
or below the typical level for that type of business.

FINANCIAL INDICATORS
profitability
a comparison of the Several indicators can be used to evaluate the profitability of a business. Profitability
profit earned with an compares the profit earned with an investment made.
investment made
While profit is simply the excess of revenue over expenses, profitability measures
return on assets
a financial indicator the net profit earned against the resources available to earn the profit.
that compares net One financial indicator used to measure profitability is return on assets. This
profit with the total indicator compares the net profit for a period with the average total assets under the
assets of the business
control of the business (net profit/average assets) to show how effectively the assets
return on owner’s
investment have been used to earn a profit.
a financial indicator A second profitability ratio is return on owner’s investment. This indicator
that compares net compares the net profit with the average capital of the owner (net profit/average capital).
profit with the capital
invested by the owner These indicators will be examined in detail in Unit 4.

11.2 CHECK YOUR UNDERSTANDING WB PAGE 196

1 Describe four different measures that can be used to evaluate the profit performance
of a small business.
2 Explain how ‘trend analysis’ can assist management when they are evaluating a
profit result.
3 ‘Industry averages are not valid as my business is unique.’ Do you agree with this
business owner? Discuss.

224 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
11.3 COST OF GOODS SOLD AND GROSS
PROFIT
An income statement is prepared to determine the net profit of a business over a
period of time. It can also show the gross profit for a trading business.
cost of goods sold
In Figure 11.1, gross profit was shown as the result of deducting cost of sales from subheading in an income
sales revenue. The figure shows the difference between the selling price of inventory statement that includes all
(sales) and the cost price of inventory sold (cost of sales). This definition of gross expenses incurred
in purchasing inventory
profit may be expanded further to include other expenses incurred in the buying of and getting items
inventory for resale. ready for sale
Cost of goods sold includes any expenses incurred in the purchasing of inventory
and preparing it for sale. It includes items such as cost of sales, cartage inwards,
buying expenses, customs duty on imports, and packaging costs. All expenses that
are involved with getting inventory on display and ready for sale are included in cost of
goods sold. Figure 11.4 shows some of these expenses.

FIGURE 11.4 Cost of goods sold in an income statement

CHEFMASTER CATERING SUPPLIES: INCOME STATEMENT FOR THE YEAR

ENDED 30 JUNE 2023
$ $
Revenue
Cash sales 150 000
Credit sales 120 000 270 000
Less: Cost of goods sold
Cost of sales 135 000 EXAM SUCCESS
Make sure that you
Cartage inward 2 000
follow this format for the
Buying expenses 3 000 140 000 income statement. Marks
Gross profit 130 000 may be deducted if this
format is not followed
Less: Inventory loss 2 000
Adjusted gross profit 128 000
Other revenue
Interest revenue 1 000
129 000
Less: Other expenses
Cartage outward 1 000
Advertising 14 000
Office expenses 12 000
Interest 2 000 29 000
Net profit 100 000

RECORDING REVENUE AND EXPENSES

Inventory losses or gains should be reported as an adjustment to the gross profit
figure for the period. This produces an adjusted gross profit, which is simply gross adjusted gross profit
profit less any inventory losses (or plus any inventory gains) that may have occurred. result of adjusting
gross profit for either
This allows comparisons of gross profit without other data, such as inventory losses. an inventory loss
If a trading business earns revenue in addition to its cash and credit sales, such or inventory gain
items may be added to the adjusted gross profit. An alternative is simply to list

978 1 4202 3962 1 [ C H A P T E R 11] I N C O M E S TAT E M E N T S 225

 all revenue items together in the revenue section of the report. However, some
managers prefer to keep minor items such as interest and commission revenue
separate, as they can make comparisons of gross profit results difficult to interpret if
they are bundled up with the normal sales revenue.
cartage inward
expense incurred when ‘Cartage’ is the cost of postage, handling and transporting inventory. In Figure
inventory is delivered 11.4, cartage inward is listed under ‘Cost of goods’, as it’s a cost incurred in bringing
into a business inventory into the business.
cartage outward Cartage outward, on the other hand, is the cost of delivering inventory to
expense incurred when
inventory is delivered to customers once it has been sold. It’s listed with all the other expenses that aren’t
a customer involved with buying and preparing goods for sale.

Cartage is the
cost of delivering
inventory to or
from a business.

CALCULATING NET PROFIT

EXAM Items such as cartage inward and buying expenses are included as cost of goods sold
SUCCESS
In your exam, other
because they are indirectly part of the cost of inventory – that is, they must be paid
revenue should be in order to get inventory ready for sale. They are reported in the top section of the
reported as a distinct income statement and are taken into account when determining the gross profit for
item, as shown in
the period.
Figure 11.4.
Having determined this figure, the other expenses are deducted to calculate the
final net profit figure.

11.3 CHECK YOUR UNDERSTANDING WB PAGE 197

1 Distinguish between the terms ‘cost of sales’ and ‘cost of goods sold’.
2 Name three different items that may appear in an income statement under the
heading ‘Cost of goods sold’.
3 A decrease in net profit indicates poor expense control by the management of the
business. Do you agree? Discuss.

226 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
11.4 REPORTING DISCOUNTS
All revenues and expenses should be reported in the income statement at the end of
a reporting period. A business that both buys and sells on credit may have recorded
discount expense or revenue during any given period. How should these discounts be EXAM SUCCESS
reported? While there are
Discount revenue, as the name implies, is a revenue item because it occurs as a several ways to report
discounts, this is the
result of a reduction in the outflows payable to liabilities, which leads to an increase in method preferred for
owner’s equity (through an increase in net profit). However, discount revenue is never VCE exams.
the main source of revenue for a trading business, so it should be reported under the
heading of ‘Other revenue’.
Discount expense is listed with all other normal expense items. Discounts granted
to credit customers represent a reduction in the inflows from accounts receivable,
which lead to a decrease in owner’s equity (through a decrease in net profit).
The business is sacrificing some of the money that is owed to it by its accounts
receivable. Figure 11.5 shows this treatment of discounts.

FIGURE 11.5 Reporting discounts in the income statement

Revenue $ $
Sales 88 000
Less: Cost of goods sold
Cost of sales 42 000
Gross profit 46 000
Other revenue
Discount revenue 1 000
47 000
Less: Other expenses
Wages 5 000
Discount expense 2 000 7 000
Net profit 40 000

Reporting discounts this way ensures that the gross profit reported for the period
isn’t distorted by any discounts granted by suppliers or allowed to customers. This is
important when assessing the performance of a business.

11.4 CHECK YOUR UNDERSTANDING WB PAGE 197

1 Where should discounts be reported in an income statement? Describe the

correct method of reporting both discount expense and discount revenue.
2 Explain why revenue items such as interest revenue and discount revenue
shouldn’t be added to sales revenue in an income statement.
3 A business owner has collected GST of $500 during the month. As the
business has experienced an inflow of resources, the owner intends
to report the $500 as revenue for the month. Is this correct accounting
treatment? Explain your answer fully.
4 Explain why discount revenue is classified as a revenue item. Refer to the
definition of revenue in your answer.

978 1 4202 3962 1 [ C H A P T E R 11] I N C O M E S TAT E M E N T S 227

 11 CHAPTER REVIEW

KEY CONTENT
•• [11.1] The income statement is a key accounting report that provides information about
a business’s revenue, expenses and profit. Its purpose is to report on the profit
performance of the business over a given period.
•• [11.2] Once a trial balance has been finalised, the income statement and balance sheet can
be prepared. These two reports take care of the five basic classifications of accounts.
•• [11.3] Several measures can be used to evaluate net profit, such as the length of the
reporting period, the profit trends, whether the budgeted profit was achieved, or
comparison against industry averages.
•• [11.4] An income statement can also show the gross profit for a trading business. This
figure shows the difference between the selling price of inventory and the cost price
of inventory sold. The heading ‘Cost of goods sold’ is used to include any expenses
incurred in purchasing inventory.
•• [11.5] Businesses should record any discount expense and/or revenue during any given
period. Discount revenue should be reported under the heading of ‘Other revenue’.
Discount expense is listed with all other normal expense items.

CHAPTER 11 EXERCISES WB PAGE 199

1 Income statement from closing entries

SPREADSHEET X.XX

Matthew Sauro is the proprietor of Mediterranean Herb Wholesalers. On 1 March 2023,

Sauro’s Capital account has a balance of $65 000. The following closing entries are
extracted from the books of the business at the end of March 2023.

MEDITERRANEAN HERB WHOLESALERS: GENERAL JOURNAL

Date Details Dr Cr
31 Mar Cash sales 24 000
Credit sales 26 000
P&L summary 50 000
Closing entries
P&L summary 26 600
Cost of sales 23 400
Advertising 1 200
Postage 200
Office expenses 600
Assistant’s wages 1 200
Closing entries
P&L summary 23 400
Capital 23 400
Transfer of net profit

228 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 a Prepare an income statement for the month ended 31 March 2023.
b Prepare an extract from the balance sheet as at 31 March 2023 to show the
owner’s equity section, including the additional detail that Sauro had drawings of
$10 700 during March.

2 Income statement from closing entries WB PAGE 200 SPREADSHEET X.XX

Wilson’s Winterwear is owned and managed by Therese Wilson. She has just
completed her closing entries for the year ended 30 June 2023. On 1 July 2022,
Wilson’s Capital account had a credit balance of $87 600. The closing entries prepared
by Wilson are listed below.

WILSON’S WINTERWEAR: GENERAL JOURNAL

Date Details Dr Cr
31 Mar Cash sales 125 000
Credit sales 35 000
Discount revenue 500
Sales returns 1 500
P&L summary 159 000
Closing entries
P&L summary 103 000
Part-time wages 25 700
Carry bags 620
Courier expenses 280
Stationery expenses 770
Insurance 3 400
Discount expense 230
Cost of sales 72 000
Closing entries
P&L summary 56 000
Capital 56 000
Transfer of net profit
Capital 10 600
Drawings 10 600
Transfer of owner’s drawings

a Prepare an income statement for the year ended 30 June 2023.

b Prepare the owner’s equity section of the balance sheet as at 30 June 2023.

3 Income statement from trial balance WB PAGE 201 SPREADSHEET X.XX

The following trial balance is provided at the end of a quarterly reporting period.

MECHA-KAIJU MODELS: TRIAL BALANCE AS AT 31 MARCH 2023

$ $
Cash at bank 5 200 Loan – NAB 2 000
Rent 16 600 Sales revenue 71 900
Accounts receivable 5 500 Accounts payable 1 000
Stationery expense 100 Capital 59 000
Telephone expenses 350 GST clearing 1 100
Cleaning 440

978 1 4202 3962 1 [ C H A P T E R 11] I N C O M E S TAT E M E N T S 229

 Inventory 59 400
Interest expense 480
Drawings 3 400
Sales returns 5 100
Cost of sales 36 400
Discount expense 130
Office furniture 1 900
135 000 135 000

a Prepare an income statement for the quarter ended 31 March 2023.

b Prepare a balance sheet as at 31 March 2023.

4 Income statement from trial balance

SPREADSHEET X.XX WB PAGE 202

Jack Chrystie is the proprietor of Chapel Street Formal Wear. He has provided the
following trial balance at the end of the business’s reporting period.

CHAPEL STREET FORMAL WEAR: ADJUSTED TRIAL BALANCE AS AT

31 JULY 2023
$ $
Accounts receivable 11 500 Accounts payable 6 200
Advertising 1 600
Capital 56 580
Carry bags 360 Cash sales 52 000
Cartage inward 180 Credit sales 53 000
Cash at bank 880 Discount revenue 210
Cleaning 1 200 GST clearing 3 000
Computer 3 200 Loan (due 31/7/24) 29 000
Cost of sales 48 000
Discount expense 150
Electricity 1 400
Furniture 12 300
Insurance 500
Interest 230
Inventory 53 700
Rent 12 400
Security expenses 1 500
Stationery expense 430
Telephone expenses 560
Vehicle 36 500
Vehicle expenses 1 600
Wages – assistant 11 800
199 990 199 990

a Prepare an income statement for the year ended 31 July 2023.

b Prepare a classified balance sheet as at 31 July 2023.

230 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
5 Income statement with inventory loss WB PAGE 203

The following balances are extracted from the trial balance of Costello’s Auto Shop as
at 30 June 2023.

$ $ $
Advertising 1 600 Cash sales 35 000 Accounts payable 2 300
Wrappings 1 080 Cost of sales 28 500 Telephone 170
Accounts receivable 430 Buying expenses 300 Interest expense 400
Equipment 14 000 Accounting fees 200 Inventory 32 000
Legal fees 270 Stationery expense 140 Bank overdraft 1 100
GST clearing 100 Sales returns 1 000 Credit sales 32 000
Inventory loss 2 000 Cartage inwards 500

a Select the relevant information from above and prepare an income statement for
the quarter ended 30 June 2023.
b Suggest three different ways of evaluating the net profit you determined in part a.

6 Full income statement WB PAGE 204 SPREADSHEET X.XX

The proprietor of Bayswater Boutique has supplied the following information about her
business for the year ended 30 April 2023.

$ $ $
Wages – assistant 36 000 Shop fittings 19 400 Accounts receivable 2 200
Cost of sales 45 300 Telephone expense 940 Cleaning 2 400
Loan (due 2023) 4 000 Interest on loan 440 Legal fees 600
Accounts payable 1 900 Discount expense 180 Electricity 2 280
Sales 98 150 Cash at bank 800 Advertising 800
Cartage inward 450 Office equipment 9 400 Debt agency fees 600

Using the relevant information from the list above, prepare an income statement for
Bayswater Boutique for the year ended 30 April 2023. Your report should highlight figures
for both gross and net profit, as well as the total expenses incurred by the business.

978 1 4202 3962 1 [ C H A P T E R 11] I N C O M E S TAT E M E N T S 231

 7 Income statement and balance sheet
SPREADSHEET X.XX WB PAGE 205

The following information relates to a comic shop owned and operated by Carolyn McCarthy.
FIVE-STAR COMICS & GRAPHIC NOVELS: ADJUSTED TRIAL
BALANCE AS AT 31 MARCH 2023
$ $
Premises 850 000
Term deposit account (matures 2026) 14 000
Mortgage loan 535 000
Newspaper advertisements 1 050
Cleaning of shop 5 200
Office equipment 4 200
Interest on loan 7 200
Accounting fees 1 600
Accounts payable 7 700
Cash at bank 13 850
Sales assistant’s wages 22 000
Drawings 2 340
Cost of sales 47 320
GST clearing 2 900
Accounts receivable 1 830
Shop fittings 19 300
Telephone expense 810
Pharmacy equipment 9 000
Rates 1 200
Inventory 74 600
Cash sales 109 720
Electricity 660
Inventory loss 800
Interest revenue 370
Capital – McCarthy 393 570
1 063 110 1 063 110

a Prepare an income statement for the year ended 31 March 2023.

b Prepare a classified balance sheet as at 31 March 2023.

232 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 CASE STUDY WB PAGE 206 SPREADSHEET X.XX

The owner of Calder Car Parts isn’t sure how to prepare accounting reports. The following
account balances were extracted from the trial balance of the business.
CALDER CAR PARTS: ACCOUNT BALANCES AS AT 31 MARCH 2023
$ $
Cost of sales 86 500 Cash at bank 3 200
Shop shelving 10 200 Advertising 8 600
Delivery vehicle 32 000 Accounts receivable 4 300
Shop wages 32 000 Cash sales 93 200
Interest on loans 8 700 Accounts payable 5 040
Loan from NAB 82 000 Discount expense 1 240
Drawings 20 000 Credit sales 84 800
Premises 232 000 Vehicle expenses 4 400
Office expenses 10 200 Inventory 58 700
GST clearing 1 300 Sales returns 2 400
Capital ?

Additional information
•• Two of the business’s inventory cards didn’t reconcile with a physical stocktake
completed on 31 March 2023. One inventory card revealed an inventory gain of one
set of car seat covers, which costs $30 and sells for $59. The other had an inventory
loss of 18 sets of wheel trims. These units sell for $49 each and were originally
purchased for $35 each. All other inventory cards were reconciled with the units
identified in the stocktake.
•• The loan from NAB is repayable at $145 per week.

1 Prepare an income statement for the year ended 31 March 2023. Your statement
should be prepared to highlight both gross and net profit results.
2 Prepare a classified balance sheet as at 31 March 2023.
3 Explain how the value reported for vehicles in your balance sheet would have been
determined. Refer to a qualitative characteristic that is relevant to the value being
reported.
4 Give two reasons to explain your classification of the GST Clearing account.

978 1 4202 3962 1 [ C H A P T E R 11] I N C O M E S TAT E M E N T S 233

 CHAPTER CHECKLIST
Now that you have finished Chapter 11, double-check your progress.
Are you ready for your Unit 3 assessment?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
completed the end-of-chapter activities
handed in my workbook for marking.

I understand …

characteristics and use of classified accounting reports: Income Statement

the effect of transactions on the accounting reports
financial indicators and non-financial information used to measure business performance
the distinction between cash and profit.

I can …

analyse the effect of financial transactions on the accounting equation

identify and record financial data manually in the General Journal and the General Ledger
and manually prepare accounting reports
use ICT, including spreadsheets, to record transactions in the General Journal and the
General Ledger and prepare accounting reports.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_11

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

234 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
12 CASH FLOW STATEMENTS

Chapter 11 explained how the LEARNING OBJECTIVES

balance sheet and income
statement report on the main By the end of this chapter, you will be able to:
components of the accounting •• describe the role played by a cash flow statement
system. However, these two [12.1]
statements aren’t the only •• outline the additional information revealed by a cash
necessary or useful accounting flow statement [12.1]
reports. •• classify cash flows into the areas of operating,
In this chapter, you will learn investing and financing activities [12.2]
about cash flow statements,
•• describe the basic format of a cash flow statement
which provide information about
[12.3]
the movement of cash into and
out of a business. •• prepare a cash flow statement [12.3]
•• analyse and interpret results as stated in a cash flow
statement [12.4]
•• explain how a cash flow statement can assist
management decision making [12.4].

UNIT 3 – PROGRESS 1 2 3 4 5 6 7 8 9 10 11 12 13

12.2 12.4
10.3

Classification Cash flows and

12.1 of cash flows 12.3 decision making

The role of Designing and

the cash flow preparing a cash Chapter review
statement flow statement and exercises

978 1 4202 3962 1 235

 12.1 THE ROLE OF THE CASH FLOW
STATEMENT
An income statement is prepared at the end of a period to determine a business’s
profit or loss over that particular period of time. A balance sheet is also prepared
to provide a snapshot of the business on balance day. Although these are two of
the main accounting reports, they don’t satisfy all the demands for information
about a business.
cash flow Accounting standards also require the preparation of a report known as a cash
statement flow statement. This report concentrates solely on cash flows and is a valuable
an accounting
report used to show tool for parties wishing to evaluate a business’s operations. The use of this report is
all inflows and comparatively recent and reflects the importance now placed on cash management.
outflows of cash
during a reporting The role of the cash flow statement is to complete the picture provided by the
period, and the cash other two general accounting reports:
balance at the end
of that period •• The income statement reports on revenues earned and expenses incurred.
•• The balance sheet reports on the business’s financial position at a particular point
in time.
Together, the income statement, the balance sheet and the cash flow statement
provide a summary of a business’s operating performance and financial standing.
As the cash flow statement concentrates on movements of cash in and out of the
business, it offers insights into the business that the other two key accounting reports
don’t. Specifically, it provides information relating to areas such as:
•• the net cash inflows generated by trading operations
•• the business’s ability to meet obligations to accounts payable and its bankers
•• the business’s long-term capital and debt arrangements
•• cash flows resulting from investing activities.
In order to survive, a business must manage its cash resources. A business may
earn a substantial profit, but this will be of little use if it doesn’t result in cash inflows.
Expenses have to be paid, and loans repaid, and the owner may have their own
demands for personal drawings. Therefore, the cash flow statement isn’t simply a
valuable report for external users. Management should regularly prepare such a report
in order to gain all the relevant information about their business’s activities.

Cash includes all

cash on hand and
any other cash
equivalents held
by a business.

236 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
THE CONCEPT OF CASH
In the cash flow statement, cash includes all cash on hand and any other cash cash
equivalents held by a business. The definition of cash means cash on hand, cash at all money on
hand plus cash
bank and cash held with non-banking financial institutions on an at-call basis. equivalents
Cash equivalents extends this definition to include items such as short-term cash equivalents
cash deposits, bills receivable created by promissory notes, and other short-term short-term liquid
investments such as bank bills and treasury bills. Such short-term items can include assets that can be
converted into cash
investments with a maturity date ranging from at-call up to two or three months into quickly
the future. Therefore, cash equivalents relate to liquid short-term assets. Figure 12.1
shows a number of possible cash equivalents.

FIGURE 12.1 Cash equivalents

Bank bills

Short-term Treasure bills

investments

CASH
EQUIVALENTS

Promissory notes Government bonds

Securities

As the cash flow statement examines changes in a business’s cash position, it also
takes into account short-term borrowings such as bank overdrafts. A business may
have a fluctuating bank balance that drops into an overdraft position several times
during a given period. Any review of a business’s cash position should reflect the use
of such short-term arrangements.
If a business has an overdraft reported on balance day, it should also be included
under the definition of cash and cash equivalents. The only difference is that an overdraft
would be treated as a negative item when determining the total of cash held.

12.1 CHECK YOUR UNDERSTANDING WB PAGE 209

1 Outline the general purpose of a cash flow statement.

2 A cash flow statement provides additional information to that of other
accounting reports. Suggest three questions to which management can
find answers in a cash flow statement.
3 Explain what ‘cash’ means when it is used in relation to a cash flow
statement.

978 1 4202 3962 1 [ C H A P T E R 12 ] C A S H F LO W S TAT E M E N T S 237

 12.2 CLASSIFICATION OF CASH FLOWS
The accounting standards require the reporting of cash flows under three main
classifications – operating activities, investing activities and financing activities.

CASH FLOWS FROM OPERATING ACTIVITIES

Cash flows from operating activities are cash flows that result from the provision
cash flows from of goods and services in the day-to-day business operations of a business. Operating
operating activities
cash flows that result activities include many of the receipts and payments that would normally appear in a
from the day-to-day business’s income statement. Examples are payments to suppliers and employees,
operations of a business
payments for goods and services, and receipts from customers that result from the
business supplying goods or providing services.
Keep in mind that there will be some items in an income statement that don’t relate
directly to cash flows. For example, depreciation of non-current assets doesn’t involve
a movement of cash, and shouldn’t be included in a cash flow statement. Furthermore,
an income statement prepared using the accrual method of accounting states revenues
and expenses for a period, and these items don’t necessarily relate to cash flows.
The existence of credit transactions, accrued expenses and prepaid expenses means
that items listed as revenue earned or expenses incurred are different from the actual
cash flows that occurred during the period. Therefore, when a cash flow statement is
prepared, the only relevant information regarding operating activities is the actual cash
inflows and outflows that resulted from such revenue and expense items.
Cash flows from operating activities will include both the collection and payment
of the Goods and Services Tax. The GST collected on cash sales is thus reported as
an operating cash flow. Similarly, the GST paid on cash purchases and other payments
is reported under the heading of ‘Operating cash flows’. If a business owner settles
a GST liability owing from a previous month, or receives a GST refund from the ATO,
these items should also be reported in the operating activities section of the report.

CASH FLOWS FROM INVESTING ACTIVITIES

cash flows Cash flows from investing activities are the cash flows that result from the purchase
from investing
activities
or sale of non-current assets. Investing activities would include the purchase or sale of
cash flows that assets such as land and buildings, factory equipment and vehicles. It may also include
relate to the sale or long-term investments that don’t qualify under the definition of cash or cash equivalents.
purchase of non-
current assets Once again, the important point to keep in mind is that actual cash flows must
be reported. When non-current assets are disposed of, book profits or losses aren’t
relevant. However, the value realised in cash upon disposal represents a cash inflow
and is therefore reported. When preparing a cash flow statement for a company, other
long-term assets such as shares in other companies and debentures are also reported
under the category of investing activities.

Buying a non-
current asset is
considered an
investing activity.

238 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
CASH FLOWS FROM FINANCING ACTIVITIES
Cash flows from financing activities are cash flows that have occurred as a result of cash flows from
financing activities
changes in a business’s financial structure. When evaluating the financial stability of a cash flows that occur
business, it’s vitally important to consider how it is financed, and the balance between as a result of changes
the owner’s funds and borrowed funds. A report on changes in financial structure will in the financial
structure of
usually be of great interest to a business’s prospective owners and lenders. Financing a business
activities include capital contributions by the owner, the owner’s withdrawals of cash,
the taking out of loans from external parties, and repayments of such loans.

REPORTING AGAINST CASH FLOW CLASSIFICATIONS

The use of these three broad categories – operating activities, investing activities and
financing activities – allows users of the cash flow statement to focus on specific
areas within a business. Operating activities mainly focus on cash flows resulting
from revenues and expenses, while the other two classifications study the changes in
items reported in the balance sheet. Investing activities highlight changes in the area
of non-current assets, and financing activities look at how such assets were financed.
Table 12.1 summarises the types of cash flows that may be reported under each
classification.

TABLE 12.1 Classifications of cash flows

Operating activities Investing activities Financing activities

Cash inflows from: Cash inflows from: Cash inflows from:

• selling goods for cash • proceeds from the sale of • capital injections of cash
• cash collected from non-current assets • taking out loans
accounts receivable
• commission received
• interest received
• GST received
• GST refunds

Cash outflows from: Cash outflows from: Cash outflows from:

• cash purchases of stock • purchase of non-current • owner’s cash drawings
• payments to accounts assets for cash • loan repayments
payable
• expenses paid
• GST paid
• GST settlements

12.2 CHECK YOUR UNDERSTANDING WB PAGE 210

1 Describe the three classifications used within a cash flow statement.

2 Using the headings from your answer to Question 1, classify each of the following
items into the three types of cash flows, or as a non-cash item where appropriate:
a cash purchase of furniture g loss on sale of vehicle
b wages paid h proceeds from sale of vehicle
c depreciation of furniture i withdrawals of cash
d cash sale of goods j cash purchase of inventory
e loan repayments k rent expense paid
f GST collected on cash sales l GST paid on purchases.

978 1 4202 3962 1 [ C H A P T E R 12 ] C A S H F LO W S TAT E M E N T S 239

 DESIGNING AND PREPARING A CASH
12.3 FLOW STATEMENT
The basic format of the cash flow statement is outlined by the accounting standards.
Figure 12.2 demonstrates the format of the report, which is based on the use of
the three classifications of cash flows: operating activities, investing activities and
financing activities.
A sub-total is determined for each of these classifications. These sub-totals are
used to highlight the net cash inflow or outflow that occurred within each activity
during the reporting period. The overall result of such cash flows is then shown in
terms of an increase or decrease in cash held over the period. This can be reconciled
with the two cash balances as reported in the business’s consecutive balance sheets.

FIGURE 12.2 Cash flow statement: basic format

KILMORE ACTION SPORTS: CASH FLOW STATEMENT FOR THE YEAR ENDED
31 DECEMBER 2023
[1] $  $
Cash flows from operating activities
Cash sales 150 000
Collections from accounts receivable 45 000
GST collected 15 000
Payments to accounts payable (73 500)
Rent (25 000)
Wages (35 000)
GST paid (2 500)
Net cash provided by operating activities [2]  74 000
Cash flows from investing activities
Sale of shop fittings 1 000
Purchase of shop fittings (5 000)
Net cash used in investing activities [2]  (4 000)
Cash flows from financing activities
Loan from bank 10 000
Loan repayments (5 500)
Drawings (29 500)
Net cash used in financing activities [2]  (25 000)
Net increase (decrease) in cash held [3]  45 000
Cash held at the beginning of the year (12 000)
Cash held at the end of the year [4]  33 000

•• [1]  Cash inflows are shown as positive amounts and cash outflows are shown as
negative amounts, indicated by brackets.
•• [2]  A summary (total) is shown for each of the three categories – operating,
investing and financing cash flows.
•• [3]  The overall increase or decrease in the cash held by the business is calculated
by adding up the three sub-totals.
•• [4]  The final step is to include the cash held by the business at the start and end
of the period.

240 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
PREPARING A CASH FLOW STATEMENT
A cash flow statement can be prepared from either a summary of cash transactions
or the statement of receipts and payments. Both the journals and the statement of
receipts and payments provide a summary of all cash flow transactions for a period.
Therefore, it’s simply a matter of classifying these cash flows under the headings of
operating, investing and financing activities. Consider the statement of receipts and
payments shown below.

YURTS R US: STATEMENT OF RECEIPTS AND PAYMENTS FOR THE YEAR ENDED
30 JUNE 2023
DON’T!
$ $ Never include
Cash receipts non-cash items in
a cash flow statement.
Capital contribution 20 000 Discounts, credit sales and
Cash sales 50 000 inventory losses should
never be part of this
Collections from accounts receivable 10 000
statement.
Sale of office equipment 2 000
GST collected 5 000 87 000
Less: Cash payments
Payments to accounts payable 30 000
Advertising 3 000
Wages 14 000
Cleaning 3 000
Drawings 10 000
Purchase of computer 4 000
Loan repayments 11 000
GST paid 4 000 79 000
Excess of receipts over payments 8 000
Bank balance as at 1 July 2022 3 000
Bank balance as at 30 June 2023 11 000

Using the information in the above report, a formal cash flow statement can be
prepared as follows:
CASH FLOW STATEMENT FOR THE YEAR ENDED 30 JUNE 2023
$ $
Cash flows from operating activities
Cash sales 50 000
Collections from accounts receivable 10 000
GST received 5 000
Payments to accounts payable (30 000)
Advertising ( 3 000)
Wages (14 000)
Cleaning (3 000)
GST paid (4 000)
Net cash provided by operating activities 11 000
Cash flows from investing activities
Sale of office equipment 2 000

978 1 4202 3962 1 [ C H A P T E R 12 ] C A S H F LO W S TAT E M E N T S 241

 Purchase of computer (4 000)
Net cash used in investing activities (2 000)
Cash flows from financing activities
Capital contribution 20 000
Drawings 10 000
Loan repayments (11 000)
Net cash used in financing activities (1 000)
Net increase (decrease) in cash held 8 000
Cash held at the beginning of the year 3 000
Cash held at the end of the year 11 000

Comparing these two accounting reports shows that a cash flow statement is simply
a statement of receipts and payments where all the cash flows have been classified
into the three distinct areas of operating, investing and financing.
The cash flow statement has the advantage of providing additional information
about a business. For example, management can determine the extent of cash, if
any, being generated by operating activities. An owner can see how much cash has
been used up in financing the business, or how much cash has been invested into the
assets of the business.
The cash flow statement is a valuable addition to the income statement and
balance sheet, as it provides information not highlighted in the other general purpose
financial reports.

12.3 CHECK YOUR UNDERSTANDING WB PAGE 211

1 Are all revenue items in an income statement reported in a cash flow statement?
Explain your answer fully, using an appropriate example.
2 Are all expense items in an income statement reported in a cash flow statement?
Explain your answer fully, using an appropriate example.
3 A cash flow statement may report four different types of cash flows in relation to the
GST. Describe the nature of these four different cash flows.
4 Describe the basic format of a cash flow statement, highlighting the key areas within
the report.

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12.4 CASH FLOWS AND DECISION MAKING
There isn’t much point in preparing a cash flow statement if it can’t be analysed fully and
its results taken into account when making decisions about the future of a business.
As with other accounting reports, a cash flow statement can be compared with
previous results. Such comparisons allow users of the report to detect changes in the
various activities and identify trends. For example, management should investigate
any significant change in the cash provided by operating activities. Changes in financial
structure can be highlighted over consecutive reporting periods. Similarly, if a business
is expanding over several years, the additional investment in non-current assets will
be reflected in the cash flow statements prepared each period.
In general, the cash flow statement provides management with information that
demonstrates the effects of its decision making on cash resources. For this reason,
cash flow statements for consecutive reporting periods are often prepared within the
one report. This allows for easy comparison and highlights changes that have occurred
within the business over time.
The following cash flow statements shows how reporting periods can be compared.

FORWARD FASHIONS: CASH FLOW STATEMENT FOR THE YEAR

ENDED 31 DECEMBER
2022 2023
$ $ $ $
Cash flows from operating activities
Cash sales 200 000 240 000
GST collected 20 000 24 000
Cash purchases of inventory (100 000) (120 000)
GST paid (14 000) (13 000)
Net cash provided by operating activities 106 000 131 000
Cash flows from investing activities
Sale of non-current assets 6 000
Purchase of non-current assets (40 000) (10 000)
Net cash used in investing activities (34 000) (10 000)
Cash flows from financing activities
Loan repayments (22 000) (18 000)
Proprietor’s drawings (40 000) (50 000)
Net cash used in financing activities (62 000) (78 000)
Net increase (decrease) in cash held 10 000 43 000
Cash held at the beginning of the year 3 000 13 000
Cash held at the end of the year 13 000 56 000

These cash flow statements provide a quick comparison of the changes in this
business over a two-year period. The business increased its cash held from $3 000 at
the beginning of 2022 to $56 000 at the end of 2023, a very pleasing result!

978 1 4202 3962 1 [ C H A P T E R 12 ] C A S H F LO W S TAT E M E N T S 243

 The report can be used to explain how this improvement happened.
•• Operating activities have provided an additional $25 000 of cash inflows. This is a
favourable result, and the causes of such improvement should be investigated and
noted for the future.
•• Management has continued the expansion in its non-current assets. Having
committed $40 000 to non-current assets in 2022, it allocated a further $10 000
investing activities in 2023.
•• In the area of financing, the owner has increased the cash outflows for personal
drawings, but reduced the outflows for loan repayments.
Key changes such as these provide management with a range of information not
provided by its income statements or balance sheets.
The cash flow statement gives an additional insight into the workings of the
business and should be an integral part of an overall cash management strategy.

12.4 CHECK YOUR UNDERSTANDING WB PAGE 212

1 Explain why cash flow statements are often prepared for consecutive reporting
periods within the one report.
2 Outline the link between preparing a cash flow statement and management
decision making.
3 A business owner bought a new computer for cash for $3630, including GST.
Show how to report this transaction in a cash flow statement by completing the
following table.

Item Operating/investing/ financing Inflow or outflow $

4 A trading business sold stock for cash for $5000, plus GST. The goods sold had a cost
price of $3500. On the same day the owner withdrew $1000 in cash and stock that
had a cost price of $600. Complete the following table to show how to report these
events in a cash flow statement.

Item Operating/investing/ financing Inflow or outflow $

244 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 12 CHAPTER REVIEW

KEY CONTENT
•• [12.1] A cash flow statement provides information on the movement of cash in and out of a
business during the reporting period. ‘Cash’ includes all cash on hand and any other
cash equivalents (liquid short-term assets) held by a business.
•• [12.2] Cash flows are reported under three main classifications: Operating activities, investing
activities and financing activities.
•• [12.3] A standard cash flow statement reports against the three classifications, with a sub-
total provided for each.
•• [12.3] A cash flow statement can be prepared from either a summary of cash transactions or
a statement of receipts and payments.
•• [12.4] Cash flow statements can be analysed by management, who take the results into
account when making decisions about the future of the business.

CHAPTER 12 EXERCISES

WB PAGE 213
1 Cash flows from operating activities
The owner of Star of Istanbul provides the following information about his Islamic
clothing business.

Receipts $ Payments $
Cash sales 60 000 Cash purchases of inventory 32 000
Collections – accounts receivable 20 000 Wages 19 000
Loan – Easy Bank 30 000 Advertising 5 000
GST collected 6 000 Drawings 16 000
GST paid 3 700

a Using the relevant information from above, calculate the net cash provided by
operating activities for the year ended 28 February 2023.
b Explain your treatment of drawings in your answer to part a.

WB PAGE 213
2 Cash flows from operating activities
Alan Bennetts extracts the following information from the books of his business, which
trades under the name of Fishing World.

$
Cash sales 60 000
Cash paid to accounts payable 25 000
Cost of sales 27 000
Wages 12 000
Advertising 3 000
Cash drawings 5 000
GST received from customers 6 000
GST paid to suppliers 2 800

978 1 4202 3962 1 [ C H A P T E R 12 ] C A S H F LO W S TAT E M E N T S 245

 a Using the relevant information from that listed above, calculate the net cash
provided by operating activities for the year ended 31 March 2023.
b Explain your treatment of ‘cost of sales’ in your answer to part a.
c Explain why management should determine the net cash generated by operating
activities in addition to calculating the net profit for a period.

3 Cash flows from investing activities WB PAGE 214

The owner of McNamara’s Music provides the following information about her
business for the year ended 31 May 2023.

Receipts $ Payments $
Cash sales 62 000 Cash purchases of inventory 29 800
Sale of van 5 000 Purchase of computer 3 800
Sale of furniture 2 000 Purchase of fittings 4 900
GST collected 6 200 Drawings 9 700
GST paid 3 870

a Using the relevant information from above, calculate the net cash provided (or used)
by investing activities for the year ended 31 May 2023.
b Justify your treatment of the purchases of inventory in your answer to part a.

4 Cash flows from investing activities WB PAGE 214

The following transactions occurred in the business of Lancefield Tractor Parts during
the year ended 31 March 2023.

$
Cash collected from accounts receivable 32 400
Purchase of office equipment for cash 6 700
Profit on sale of computer 200
Cash purchase of fittings 5 400
Loss on sale of office furniture 300
Proceeds from sale of non-current assets 2 000
GST paid during the period 1 550
Purchase of furniture for cash 3 400
Cash drawings by the owner 5 600

Extract the relevant information from that listed above and determine the net cash flow
provided (or used) by investing activities.

5 Cash flows from financing activities

SPREADSHEET X.XX WB PAGE 214

The following cash flows relate to the business of Wrestle-Maniac Ring Gear.
$
Profit earned for the year 40 000
Drawings made during the year 10 000
Cash sales for the year 36 700
Loan repayments made during the year 13 000
Credit sales for the year 34 300
a Prepare a schedule to determine the net cash provided (or used) by financing activities.
b Make a brief comment on the financing activities of Wrestle-Maniac Ring Gear in
light of your answer to question a.

246 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
6 Cash flows: full statement WB PAGE 215 SPREADSHEET X.XX

The following is a summary of the cash transactions for March 2023 for the business of
Drummond Street Drapery.

Receipts
Cash sales: selling price $ 5 030
Cash sales: cost price $ 2 585
Receipts from accounts receivable $ 5 280
Capital contribution $ 8 000
Loan – NAB $ 9 000
Disposal of computer $ 1 600
GST collected $ 503
Total cash banked $29 413
Payments
Payments to accounts payable $ 2 300
Cash purchases of inventory $ 2 200
Advertising $ 400
Purchase of equipment $ 4 500
Wages $ 2 000
Drawings $ 1 350
Insurance $ 370
Loan repayment $ 200
GST paid $ 747
Total cash paid $14 067

Additional information
The Cash at Bank account balance as at 1 March 2023 was $2510.
a Prepare a cash flow statement for Drummond Street Drapery for the month ended
31 March 2023.
b The cash flow statement can provide information not revealed by other accounting
reports. What additional information is available to the owner of Drummond Street
Drapery? Refer to details from part a in your answer.

7 Cash flows: full statement WB PAGE 216 SPREADSHEET X.XX

The owner of Dylan’s Disposal Store, which doesn’t sell on credit, provides the
following summary for his business for June 2023.

Cost of sales $ 2 685

(Note: all inventory sold at 100% mark-up)
Receipts from accounts receivable $ 880
(Note: includes discounts of $30)
Loan – EZ Finance $16 000
GST receipts $ 568
Commission revenue $ 310
Capital injection $ 5 000
Sale of van $ 5 600

Purchase of shop fittings $ 5 600

Cash purchases of inventory $ 1 850
Wages $ 2 540
GST settlement $ 2 100
Payments to accounts payable $ 1 650
(Note: includes discounts of $50)

978 1 4202 3962 1 [ C H A P T E R 12 ] C A S H F LO W S TAT E M E N T S 247

 Drawings by the owner $ 1 720
(Note: includes drawings of inventory that
cost the business $520)
Loan repayment $ 1 760
Purchase of computer $ 2 500
Advertising $ 1 900
GST payments $ 1 345
Cleaning expenses $ 1 600

Additional information
On 1 June 2023 the business had an overdraft of $1340.
a Prepare a cash flow statement for the month of June 2023, showing clearly the
cash flows from operating, investing and financing activities.
b Comment on:
i the business’s overall cash ii the level of cash generated by
position operating activities.

WB PAGE 218
8 Cash flows: full statement
SPREADSHEET X.XX

The following report is submitted by Glenys Dellamarta, the owner of Pulsar Jetskis.

STATEMENT OF RECEIPTS AND PAYMENTS FOR THE YEAR ENDED

31 MARCH 2023
$ $
Cash receipts
Cash sales 90 000
Collections from accounts receivable 32 000
Sale of delivery truck 5 500
Capital 5 000
Commission revenue 1 000
Loan – K.S. Finance 13 000
GST collected 9 100 155 600
Less: Cash payments
Cash purchases of inventory 54 040
Interest 1 660
Advertising 6 450
Cartage inward 1 150
Purchase of office equipment 12 300
Wages – sales staff 32 060
Loan repayments 4 700
Drawings 17 900
Purchase of delivery truck 23 000
GST paid 9 694 162 954
Excess (deficit) of receipts over payments (7 354)
Bank balance as at 1 April 2022 9 245
Bank balance as at 31 March 2023 $1 891

a Prepare a cash flow statement for Pulsar Jetskis for the year ended 31 March 2023.
b The owner is concerned about the cash flows of her business. Comment on the
results revealed by your cash flow statement.

248 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
9 Cash flows: full statement WB PAGE 219 SPREADSHEET X.XX

Scott Woodman, the owner of Specialist Computers, provided the following information
in relation to his business.
STATEMENT OF RECEIPTS AND PAYMENTS FOR THE YEAR ENDED
30 JUNE 2023
$ $
Cash receipts
Additional capital 12 000
Proceeds from sale of office furniture 3 500
Interest on government bonds 3 200
Sales 65 200
Accounts receivable 53 950
NAB – loan 22 600
GST received 6 520 166 970
Less: Cash payments
Proprietor’s drawings 23 400
Cartage outward 1 150
Accounts payable 62 330
Interest expense 2 360
Office salaries 15 600
Cash purchases of inventory 8 500
Repayments to NAB 4 650
Advertising 2 100
Shop wages 18 200
Insurance 1 350
Purchase of shop fittings 12 600
GST paid 2 570 154 810
Excess (deficit) of receipts over payments 12 160
Bank balance as at 1 July 2022 4 860
Bank balance as at 30 June 2023 17 020

Additional information
Stock loss for the year was $2100.
a Prepare a cash flow statement for Specialist Computers for the year ended 30 June 2023.
b Comment briefly on what is shown by your cash flow statement.

978 1 4202 3962 1 [ C H A P T E R 12 ] C A S H F LO W S TAT E M E N T S 249

 10 Consecutive cash flow statements WB PAGE 220

The owner of Lightbox Lasers prepares the following cash flow statements.

LIGHTBOX LASERS: CASH FLOW STATEMENTS FOR THE YEARS ENDED

31 DECEMBER
2022 2023
$ $ $ $
Cash flows from operating activities
Cash sales 140 000 150 000
GST received 14 000 15 000
Cash purchases (60 000) (50 000)
Cash expense (40 000) (40 000)
GST paid (11 500) (9 800)
Net cash provided by operating activities 42 500 65 200
Cash flows from investing activities
Proceeds from sale of non-current assets 8 000 –
Purchase of non-current assets (15 000) (8 000)
Net cash used in investing activities (7 000) (8 000)
Cash flows from financing activities
Repayments of loan (10 000) (10 000)
Proprietor withdrawals (22 000) (22 000)
Net cash used in financing activities (32 000) (32 000)
Net increase (decrease) in cash held 3 500 25 200
Cash held at the beginning of the year 7 000 10 500
Cash held at the end of the year 10 500 35 700

Comment on the changes that have occurred in the business of Lightbox Lasers as
revealed in the above cash flow statements. Your comments should consider the
changes in the cash flows from operating, investing and financing activities.

250 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 CASE STUDY WB PAGE 221 SPREADSHEET X.XX

Kerry Norton, the owner of Norton’s Bookshop, provides the following information for
your consideration.
BALANCE SHEET AS AT 30 APRIL 2023
Assets $ Liabilities $
Cash at bank 3 240 Creditor – Bestsellers P/L 540
Inventory 45 400
Display fittings 15 260 Owner’s equity
GST clearing 100 Capital 63 460
64 000 64 000

The following is a summary of the key transactions for Norton’s Bookshop in May 2023.

Summary of credit purchases Summary of credit sales

Inventory bought on credit $1 840 Inventory sold on credit $2 290
GST charged by suppliers $ 184 GST charged to clients $ 229
Total of invoices received $2 024 Total of invoices issued $2 519

Cost of sales $1 050

Summary of cash receipts Summary of cash payments
Receipts from accounts $ 1 725 Payments to accounts $ 1 146
receivable payable
Cash sales $ 1 460 Cash purchases of $ 1 200
inventory
Capital contribution $ 8 000 Drawings $ 1 150
Bank loan $ 5 000 Wages $ 1 840
GST received on sales $ 146 Computer system $ 8 000
Total cash received $16 331 Loan repayment $ 550
GST paid $ 920
Total cash paid $14 806
Other information Other information
Cost of sales $ 730 Discounts from accounts $ 45
payable
Discounts to accounts $ 95
receivable

In addition to the above information, the owner reports that a stock loss of $190 was
identified on 31 May.
•• Prepare general ledger accounts for the month of May 2023. (Use one accounts
receivable account for all credit customers and one accounts payable account for
suppliers providing credit to Norton.)
•• Balance all accounts and prepare a trial balance as at 31 May 2023.
•• Prepare the following general purpose accounting reports:
i income statement for May 2023
ii cash flow statement for May 2023
iii balance sheet as at 31 May 2023.

978 1 4202 3962 1 [ C H A P T E R 12 ] C A S H F LO W S TAT E M E N T S 251

 CHAPTER CHECKLIST
Now that you have finished Chapter 12, double-check your progress.
Are you ready for your Unit 3 assessment?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
completed the end-of-chapter activities
handed in my workbook for marking.

I understand …

characteristics and use of classified accounting reports: Cash Flow Statement

the distinction between cash and profit
the effect of transactions on the accounting reports.

I can …

identify and record financial data manually in the General Journal and the General
Ledger and manually prepare accounting reports
use ICT, including spreadsheets, to record transactions in the General Journal and the
General Ledger and prepare accounting reports
distinguish between cash and profit
analyse the effect of financial transactions on the accounting reports.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_12

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

252 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
13 MANAGEMENT AND
ACCOUNTING REPORTS

The purpose of accounting LEARNING OBJECTIVES

reports such as the balance sheet
and cash flow statement is to By the end of this chapter, you will be able to:
provide financial data to users. •• explain the importance of managing accounts receivable,
Management uses these reports accounts payable and inventory [13.1–13.6]
to make financial decisions and to •• describe some basic control mechanisms for
run their business. controlling accounts receivable, accounts payable and
In this chapter you will learn inventory [13.1, 13.3 & 13.5]
about three areas of management •• calculate an inventory turnover rate (in days) [13.2]
decision making, and explore
•• prepare an age analysis of accounts receivable [13.3]
how accounting reports are used
to manage and control business •• calculate an accounts receivable turnover rate (in
activities. days) [13.4]
•• determine the length of the cash cycle for a trading
business [13.5]
•• calculate an accounts payable turnover rate (in days) [13.6]
•• suggest ways to improve a business’s performance in
relation to controlling its accounts receivable, accounts
payable and inventory [13.1–13.6].

UNIT 3 – PROGRESS 1 2 3 4 5 6 7 8 9 10 11 12 13

13.2 13.4
10.3 13.6
10.3

Evaluating Evaluating
Evaluating
accounts receivable accounts payable
13.1 inventory turnover 13.3 13.5
turnover turnover

Controlling Controlling Evaluating Chapter review

inventory accounts receivable the cash cycle and exercises

978 1 4202 3962 1 253

 13.1 CONTROLLING INVENTORY
One of the most important parts of managing a trading business is controlling
inventory. The buying and selling of inventory is the lifeblood of a trading business.
Management’s decisions about inventory often determine the success or failure of a
trading business – and these decisions don’t go away after a period of time.
Questions managers face on a daily basis include:
•• What inventory should we buy?
•• How many of each item?
•• What size range (e.g. for a clothing business)?
•• What colour range?
•• Which brand names should be part of our inventory?
In many small businesses, inventory is the most valuable asset reported in the
balance sheet (especially when the business rents its premises, instead of owning
land and buildings). It’s therefore a key investment for a business owner and one that
demands a lot of attention throughout a reporting period.
Under the perpetual inventory system, the goods purchased for resale are
represented in the general ledger by the Inventory account. As you’ve already seen,
the Inventory account has a key role in helping management control the business’s
inventory. The Inventory account is represented by a system of numerous inventory
cards. These two types of records should be reconciled on a regular basis.

INVENTORY CONTROL PROCEDURES

In order to control a business’s inventory, there are many more procedures that
management can adopt, as summarised in Figure 13.1.

FIGURE 13.1 Inventory control procedures

INVENTORY CONTROL
Minimum and Monitoring
PROCEDURES
maximum processes
levels
Removing Introducing
slow-moving complementary
lines items
Removing
Rotating Improving
obsolete items
inventory security

Monitoring Changing
seasonal with the times
products

Setting minimum and maximum levels of inventory

Management should consider every type of inventory separately, decide an ideal
quantity for each line and set minimum and maximum levels. A business that carries
too little inventory is likely to miss out on potential sales. A business that carries too

254 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
much inventory may suffer from ‘dead inventory’ – goods that it can no longer sell.
This may occur because of changes in fashion or in season, or through technological
change. Deciding what is too little and too much inventory is often difficult, and is a
matter of personal judgment.
In a perfect situation, the minimum quantity should be just enough to satisfy sales
until a new order is delivered. Many small business owners try to follow the principle
of just in time ordering. With this system of ordering, replacement orders of just in time
inventory arrive just as the last few numbers of the current inventory are used up. Of ordering
purchasing
course, this doesn’t always happen in practice, as customers aren’t always predictable inventory so that the
in their behaviour. new order of goods
arrives just before
Physically rotating inventory on hand the business runs
out of inventory
When a new delivery of inventory arrives at a store, it shouldn’t simply be stacked
on top of existing inventory. The older units on hand should be placed on prominent
display, so that are sold first, with the new units placed out of sight or reach.
This is particularly important for perishable items. Many items – food, batteries,
medicines – carry use-by dates, and such items are difficult to sell if these dates
have almost expired. Other types of inventory should also be rotated, because the
longer an item sits in a shop or on a shelf the more likely it is to become dirty, dusty
or damaged. Inventory affected like this is referred to as ‘shop-soiled’. It’s difficult to
sell shop-soiled inventory, so management should always look after the business’s
inventory and present it in the best possible way. Rotating inventory is one way of DON’T!
doing this. Do not ever suggest
that FIFO makes sure that
Note: the rotation of inventory is based on the physical movement of goods,
your oldest inventory
and is different from the assumption of first in, first out (FIFO) inventory valuation. is sold first. This is
Even when inventory is regularly rotated, there is still a possibility that customers will simply not true!
select an item from the bottom of a stack or the back of a shelf. For example, many
customers will take milk from the back of the fridge, even if it means moving a few
cartons first!
Remember, FIFO is an assumed inventory flow. Although management might
hope that inventory moves on a first in, first out basis, this probably won’t be what
actually happens on the shop floor.

Rotating inventory
helps to minimise
shop-soiled items
that are harder to
sell.

978 1 4202 3962 1 [CHAP TER 13] M ANAGEMENT AND ACCOUNTING REPORTS 255
 Inventory cards must be regularly reviewed, and slow-moving lines identified and
dealt with. Perhaps a clearance sale is required; management may decide not to sell a
particular line anymore, or look for a replacement product that will sell at a faster rate.
The worst thing management can do is to do nothing. Slow-moving inventory has
the potential to ruin a trading business. Once goods have been paid for, they need to be
sold to generate a cash inflow. Inventory is the key to success in a trading business; if
it’s not selling fast enough, it may also be the cause of business failure.
The definition of ‘slow-moving’ inventory depends on the nature of the goods. Some
inventory may be slow-moving compared to other goods on sale, but the slower-selling
items are highly profitable. For example, a department store sells both clothing and
furniture, and inventory in the clothing area sells at a much faster rate than inventory in
the furniture department. Management tolerates this because furniture sales, although
slower than clothing sales, are much more profitable. Therefore, when identifying slow-
moving lines, always consider the nature of the inventory.

Monitoring seasonal products

If a trading business has products that are subject to seasonal demand, management
must pay special attention to these items. Towards the end of the ‘season’, such
inventory must be run down to a very low level or cleared out completely. Otherwise,
the business is left with items that cannot be sold for another year.
For example, in Victoria there is a huge industry in sporting apparel, particularly
football clothing. However, there is little point in purchasing lots of football jumpers in
October. Most sports stores have clearance sales in August or September, so that all
football inventory is sold before the end of the season. This ensures that there is little
or no dead inventory sitting in the shop from October to February each year. Once the
summer season has passed, management may stock a fresh range of merchandise in
anticipation of the new winter season.

Monitoring technological obsolescence

Some trading businesses are affected by rapid technological change, such as those
selling televisions, computers and mobile phones. It may be unwise to buy a particular
model in bulk just because a supplier is offering a good price. If customers aren’t
going to buy the product because there is a new and improved model on the market,
the business may again be left with dead inventory.
Therefore, management in such industries must be careful not to over-commit
to inventory purchases. They must always be aware of the latest trends in product
development in order to maximise sales from the inventory held.

Introducing complementary products

One way of improving the turnover of inventory is to have a range of complementary
products available for customers. An increased range of inventory may attract additional
customers and improve the chances of selling the established lines of inventory.
Management should consider what products it could sell to complement the
products already available. For example, a menswear store will usually sell belts and
ties as well as shirts and trousers. A mobile phone store will also sell battery packs,
phone cases and covers, headphones and so on.

Changing with the times

Regardless of the nature of the inventory a business sells, management must always
be prepared to change, because markets, competitors and customers all change.
A business that does the same thing year after year will often fail.

256 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 Managing inventory is a dynamic process. A top seller one year may become a
slow mover in another year. Management must monitor all its inventory lines and be
ready to react to changing demand.
The amount and speed of change will depend on the nature of the business.
However, those business owners who refuse to change will often find themselves
losing their place in the market, and may even be forced out of business.

Monitoring selling prices

One factor that management should never underestimate is the setting of selling
prices. Some markets are more reactive to changes in selling prices than others,
but all businesses need to constantly review their selling prices to ensure that profit
margins cover their expenses. Inventory can be sold very quickly if selling prices are
slashed, but there’s no point in selling thousands of items if the product isn’t going to
produce a profit.
Cost prices must be also monitored closely, as an increase in costs is a threat to a
business’s profit margin. An increase in cost prices will usually require an increase in
selling prices. However, a business facing intense competition may be limited in how
much it can raise its selling prices before this has a significant impact on turnover.

Ensuring adequate security

An important part of managing the inventory of a business is security. After cash,
inventory is the asset most likely to be targeted for theft. Inventory may be stolen by
customers if adequate security isn’t in place.
Inventory losses don’t occur only from shoplifting. There are numerous recorded
cases of fraud and/or theft in business situations that involve staff. Inventory control
procedures should tackle potential problem areas.
The manager of a small business should consider what security is required for
their particular store and respond on that basis.

ONGOING MANAGEMENT OF INVENTORY

Managing inventory is an ongoing responsibility. Inventory must be constantly
reviewed in terms of its security, its turnover and its general performance. If a trading
business fails to manage its inventory effectively, its overall performance will suffer
and so too will the returns to the owner in terms of profit. As the success of a trading
business is based on the buying and selling of goods, the management and control of
inventory is crucial.

13.1 CHECK YOUR UNDERSTANDING WB PAGE 230

1 Explain why a trading business owner must constantly monitor the

business’s inventory.
2 Describe the role played by the setting of minimum and maximum levels of
inventory.
3 Explain why all forms of inventory should be rotated when new inventory
arrives in a store.
4 Identify five different security measures a trading business may have in
place to protect inventory.

978 1 4202 3962 1 [CHAP TER 13] M ANAGEMENT AND ACCOUNTING REPORTS 257
 13.2 EVALUATING INVENTORY TURNOVER
It’s important that inventory is turned into sales, and therefore into cash, within a
reasonable time. This allows a trading business to function on a day-to-day basis.
Inventory can be paid for, expenses can be met and, hopefully, a profit can be earned.
But how long should a business take to turn its inventory into sales? What is an
acceptable period of time for a trading business to sell all its inventory?
There are no simple answers to these questions. All businesses are different, and
different industries will have different factors to take into account. However, a good
inventory starting point is the inventory turnover rate, which can be used to evaluate the
turnover success or otherwise of management’s investment in its inventory.
a financial indicator
that determines
how quickly a Inventory turnover = Average inventory x 365
business can turn
Cost of goods sold
its inventory into
sales This ratio compares the level of inventory held by a business during a period to the
sales made in the period, at cost price.
Consider the following example, based on end-of-year data for three consecutive
periods for Blackrazor Skate Shop.

2021 2022 2023

$ $ $
Inventory on hand 55 000 57 000 59 000
Cost of goods sold 240 000 274 000

The first step is to determine the average level of inventory held by the business.
Using an average figure helps prevent the rate from being distorted by any significant
increase or decrease in inventory levels during a particular reporting period.
•• At the end of 2021 the business had inventory valued at $55 000, and this grew
to $57 000 by the end of 2022. Over 2022, the average inventory is $55 000 +
$57 000 / 2 = $56 000.
•• Similarly, the average inventory level for 2023 is $57 000 + $59 000 / 2 = $58 000.
Once the average inventory figures for both periods are known, the inventory turnover
can then be calculated.

For the year 2022: $56 000 x 365 = 20 440 000 = 85.16 or 85 days
$240 000 240 000

For the year 2023: $58 000 x 365 = 21 170 000 = 77.26 or 77 days
$274 000 274 000

Note: if average inventory figures are unavailable, inventory turnover may be

calculated using data for inventory at the end of the period.
The ratios calculated for Blackrazor Skate Shop indicate that in 2022, this business
turned its inventory into sales every 85 days. In the following reporting period (2023)
the inventory turnover was faster, taking only 77 days to turn its inventory into sales.
This means that the inventory has been moving out of the business at a faster rate in
2023 than in 2022. It also means that the likelihood of having idle inventory in 2023 is
lower than it was in 2022.
These results indicate that management has been more efficient in controlling
its inventory. Although this could be the result of a variety of decisions made by
management, it’s generally viewed as a positive result.

258 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
EXAMINING TURNOVER
How do we know if inventory turnover is favourable? There are three ways in which
inventory turnover is commonly evaluated.
•• Comparison with inventory turnover in previous reporting periods. This is an
ideal starting point, as it gives management a historical perspective and allows
comparisons to be made easily with the current period.
•• Comparison with expectations of management. With Blackrazor, an
improvement was noted because inventory turnover was faster in 2023. However,
EXAM SUCCESS
if management had set a target of 70 days in 2023, the turnover rate – although When making a
faster than that achieved in 2022 – wouldn’t have met expectations. Therefore, comment about
both the change in the turnover rate and management’s goals should be inventory turnover,
always state if it is faster
considered when evaluating inventory turnover. or slower. Do not state
•• Consideration of the type of inventory. This is possibly the most important factor that it has increased
or decreased.
to consider when deciding if a particular turnover rate is good or not. A bakery will
have a much higher rate of inventory turnover than a used car yard, and a milk bar has
a much higher rate of turnover than a hardware store. There’s no such thing as an ideal
inventory turnover rate; it’s highly dependent on the type of inventory being sold.
Having determined an acceptable rate of turnover, management should try to
maintain or improve it to ensure that their investment in inventory is producing
revenue at a satisfactory rate.
When examining inventory turnover, bear in mind that the rate determined is an
average for a period. Many businesses sell a range of inventory, not just one type
of product. Some of these items may turn over quickly, while other products may
experience a much slower turnover rate.
For example, a typical supermarket sells milk, fresh bread, pasta sauces, mineral
turpentine and mouse traps (among other items).
•• The fresh milk and bread sections need to be sold out on a daily basis. These two
areas each have a turnover rate of one day.
•• The inventory of pasta sauces takes several days to sell out.
•• Mineral turpentine takes two weeks to clear the shelves.
•• Mouse traps may take a month to sell out.
When inventory turnover is determined for this supermarket, it may be as low as
8–10 days, which is the average turnover rate based on its investment in inventory.
This average reflects the great range of products that the business sells, and so
management needs to be careful when interpreting results.

A typical
supermarket
needs to sell out
its milk section in
one day.

978 1 4202 3962 1 [CHAP TER 13] M ANAGEMENT AND ACCOUNTING REPORTS 259
 MANAGING TURNOVER RATE
Every business is unique, which means that comparisons with turnover rates achieved
in a business’s previous reporting periods are more relevant than comparisons with
rates in other businesses. Differences between businesses may render comparisons
EXAM of turnover rates meaningless.
SUCCESS Factors that can influence the turnover rates of different businesses within an
If accounts payable industry include:
turnover increases, you
may be asked to state •• the range of products being sold
one positive and one
•• the length of time a business has been operating
negative in relation to
this change. Revise •• the size of a business
answers for both
•• competition in the local area.
possibilities.
If management detects a problem with its inventory turnover, it should act to improve
the situation and shorten the time taken to turn inventory into sales. Some possible
tactics are:
•• reducing the selling price of slow-moving items
•• relocating inventory within the store to highlight particular goods
•• running special promotions of targeted inventory lines
•• combining items to promote particular products (e.g. ice cream and drink combos).
To succeed in managing and controlling inventory, a business must also continuously
review the performance of all items being sold. Checking movements of inventory
through a regular review of inventory cards should provide management with enough
information to make decisions that allow it not only to control inventory, but to
improve performance where necessary.

13.2 CHECK YOUR UNDERSTANDING WB PAGE 231

1 Explain what ‘inventory turnover’ means.

2 ‘All trading businesses should aim for an inventory turnover of 30 days or less.’ Do
you agree with this statement? Justify your answer.
3 A trading business increased its cost of goods sold from $80 000 in 2022 to $88 000
in 2023. The owner of the business claims that this indicates an increase in inventory
turnover of 10%. Is this necessarily correct? Explain your answer.

260 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 CONTROLLING ACCOUNTS
13.3 RECEIVABLE
Once management has addressed the issue of controlling and turning over its
inventory, it needs to consider how it manages sales. If goods are always sold for
cash, management can focus solely on the turnover of inventory, but a business that
makes credit sales must evaluate how it manages its accounts receivable.
Selling on credit may increase inventory turnover, as new clients are attracted by
the credit facility, but there’s little benefit in providing credit if the business’s accounts
receivable cannot be controlled and kept within certain limits. Ultimately, accounts
receivable aren’t valuable assets if the business can’t turn them into cash at some point.

GRANTING CREDIT TO CUSTOMERS

All credit sales have an element of risk, with the ultimate one being non-payment.
Before granting credit to a customer, management should perform a credit check to
determine if the potential debtor is an acceptable risk.
In larger businesses, a credit check may be extensive, including items such as the
customer’s:
•• banking history
•• loans and/or credit card history
•• references from other businesses
•• references from financial institutions
•• cash forecasts and/or budgets
•• income statements
•• balance sheets.

A credit check
helps determine
whether a
customer is an
acceptable risk.

Smaller businesses often use agencies that conduct credit checks on behalf of
business owners. They charge a fee for their services, but the fee is small compared
with the potential cost of selling on credit to a customer with a poor credit history.
It’s unusual in the small business sector to ask for a full set of accounting reports
from a potential customer. However, it’s common to ask for references from other

978 1 4202 3962 1 [CHAP TER 13] M ANAGEMENT AND ACCOUNTING REPORTS 261
 businesses that have provided credit in the past. If a potential client cannot furnish
such references, a small business owner may insist on cash sales until a relationship
is established.
Many small businesses now use EFTPOS rather than offering credit to customers.
Sales made via debit or credit cards are virtually cash sales to a business owner,
as they don’t take the risk of non-collection. Instead, banks provide credit to their
customers when a credit card is used in a business situation; this means the bank,
rather than the business owner, has the problem of following up with a slow payer or
a non-payer in the future.

MANAGING CREDIT CUSTOMERS

Once a business has an established list of credit customers (accounts receivable), it
must monitor them to make sure they pay on time. If it grants credit terms of 30 days
to customers, for example, it’s reasonable for the business owner to expect to receive
cash about a month after sale. If this doesn’t occur, the owner should take action.
If using a computerised accounting system, it’s easy to keep track of accounts
receivable; programs issue reminders when accounts become overdue. In a manual
system, managers have to be more vigilant to ensure that overdue accounts aren’t
overlooked.
If a business sells on credit, management may adopt a range of tactics to get
payment, such as:
•• offering discounts for prompt payment
•• sending reminder emails to accounts receivable
•• reminding accounts receivable via the telephone, so as to make personal contact
•• sending regular statements, with stamps or stickers if accounts are overdue
•• threatening not to provide credit in the future
•• threatening the customer with legal action
•• employing a debt collector
•• taking legal action to recover the debt.
This list includes a wide range of tactics, from the relatively mild (sending an email) to
DON’T! the extreme (taking legal action).
If asked how to improve
Some accounts receivable may take offence at being chased for money. While a
accounts receivable turnover,
always check if the business business owner has a legal right to pursue slow payers or non-payers, it should be
offers discounts. If they done tactfully, or the business owner may lose a good customer forever. Some
do, don’t suggest that they
accounts receivable may be slow payers, but big or reliable clients; the value of
introduce discounts for prompt
payment. This future sales could easily outweigh the value of one delayed payment.
would be assessed as Small business owners need to know their credit customers well, and how to
an incorrect
encourage them to pay overdue accounts without undue embarrassment. Some
response..
slow payers will always wait for an overdue account reminder; others customers
will always pay as soon as they receive an invoice. Knowing the business’s accounts
receivable is always a challenge, but it’s vital when chasing up overdue accounts.

262 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
CONDUCTING AN AGE ANALYSIS
To gain a greater insight into a business’s accounts receivable, it’s possible to analyse
them in terms of the time that’s passed since the credit sales were originally made.
An age analysis of accounts receivable classifies Accounts Receivable accounts age analysis of
according to the age of their debt. That is, it shows how much time has elapsed since accounts receivable
a table that classifies
the credit sales were actually made. This is vital information because the older a debt Accounts Receivable
becomes, the more likely it is to turn into a bad debt. Figure 13.2 provides an example accounts according to
the age of their debt
of an age analysis of accounts receivable.

FIGURE 13.2 Age analysis of accounts receivable

Total accounts receivable 0–30 days 31–60 days 61–90 days 91 days and over
$14 000 $10 500 $2 000 $1 000 $500
100% 75.0% 14.3% 7.1% 3.6%

This age analysis shows that the total accounts receivable of the business add up
to $14 000. It then breaks this $14 000 into categories, based on how long the debt
has been unpaid. Such an analysis enables management to evaluate its collection
procedures.
For example, if accounts receivable were allowed 30 days’ credit, the majority of
the accounts receivable balances should be in the first section of the age analysis
table. If this isn’t the case, it indicates that the credit terms offered are being abused.
This may lead to cash flow problems for the business, as cash may not be coming into
the business quickly enough.
Although 75% of the accounts receivable in this example are in the 0–30 days
category, a problem may still exist. A total of 10.7% of accounts have gone beyond
two months, and 3.6% of total debts outstanding are over the 90-day mark. Such
accounts receivable would have been issued with several reminders over the three-
month period, but their accounts are still not settled. The longer these accounts
remain unpaid, the more likely they are to turn into bad debts.
An age analysis of accounts receivable should be prepared on a regular basis
(preferably monthly) and compared with previous analyses so that management
can see any trends emerging. If the comparison shows that a higher percentage
of accounts receivable have moved into the 0–30 days category, this indicates that
management has gained better control over its accounts receivable. On the other
hand, if management isn’t following up effectively, more accounts receivable may be
slipping into the lower groups. This indicates a real problem in terms of credit control, and
there may be serious consequences if the situation isn’t corrected in the near future.

13.3 CHECK YOUR UNDERSTANDING WB PAGE 232

1 Explain the procedures management should follow before granting credit

to customers.
2 If 30 days’ credit is offered to accounts receivable, would you expect all
debts to be paid within 30 days? Explain why this may not happen.
3 What is an age analysis of accounts receivable? What is its purpose?

978 1 4202 3962 1 [CHAP TER 13] M ANAGEMENT AND ACCOUNTING REPORTS 263
 EVALUATING ACCOUNTS RECEIVABLE
13.4 TURNOVER
In addition to preparing an age analysis, management may choose to calculate the
accounts
receivable accounts receivable turnover to help assess the level of control the business has
turnover over its accounts receivable. This compares the average amount owing by accounts
a financial indicator
that determines the receivable over a year with the credit sales made during this period. This figure must
average time taken by also include the 10% GST added to all sales. Therefore, the formula is:
accounts receivable
to settle their Accounts receivable turnover = Average accounts receivable x 365
accounts Net credit sales (plus GST)

Note that this formula only applies to those sales made on credit, as cash sales don’t
affect accounts receivable.
Consider the following example, based on end-of-year data for three consecutive
reporting periods for Blackrazor Skate Shop.

2021 2022 2023

$ $ $
Balance of accounts receivable 8 000 10 000 7 000
Credit sales 80 000 100 000
GST charged 8 000 10 000

The first step is to determine the average amount owed by accounts receivable to the
business.
•• At the end of 2021 the accounts receivable of Blackrazor owed $8000, and this
increased to $10 000 by the end of 2022. Over the year, the average accounts
receivable would be ($8000 + $10 000) / 2 = $9000.
•• Similarly, the average accounts receivable for 2023 is ($10 000 + $7000)/2= $8500.
As with inventory turnover, using an average figure helps prevent the rate being distorted.
Having determined average accounts receivable for both periods, the accounts
receivable turnover can be calculated.

For the year 2022: $9000 x 365 = $3 285 000 = 37.3 or 37 days
$88 000 $88 000

For the year 2023: $8 500 x 365 = $3 102 500 = 28.2 or 28 days
$110 000 $110 000

Note: if average accounts receivable figures are unavailable, the accounts receivable
turnover may be calculated using data for end-of-period accounts receivable.
The result for Blackrazor Skate Shop are favourable: the credit sales figures have
increased over time, while the amount owed by accounts receivable decreased during
2023. It’s a positive outcome when a business can sell more on credit while keeping
control over its accounts receivable. This indicates that, even with a greater amount of
credit sales, the Accounts Receivable accounts are being collected at a fast rate and are
under control.
Perhaps the management of Blackrazor tightened its follow-up procedures once
goods have been sold on credit. Or it may have decided to offer incentives for
early payments (such as discounts), which its customers have accepted. Whatever
was done, it appears to have improved its performance in terms of controlling its
accounts receivable.

264 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
COMPARING TURNOVER WITH CREDIT TERMS
The accounts receivable turnover, expressed in days, can be compared with the credit
terms granted to accounts receivable at the point of sale.
For Blackrazor Skate Shop, the business’s accounts receivable took an average of
37 days to settle their accounts in 2022, but only 28 days in 2023. The reduction in
time taken is favourable, because the business is receiving cash at a faster rate. This is
particularly important for the business’s liquidity: the less time taken to collect debts, the
sooner it gains the cash it needs to meet its own obligations.
If a business trades on 30 days’ credit, an average collection period of 28 days would
usually be seen as acceptable. As 28 days is an average, this means that some accounts
receivable took less than 30 days to settle their accounts, while others may have taken
much longer before paying their debts.
In 2022, Blackrazor’s accounts receivable were taking an average of 37 days. This
indicated to management that accounts receivable repayments were taking longer than
expected, and they responded in 2023 by improving follow-up procedures. The figures
appear to support the notion that management took corrective action during 2023 and
reduced the time taken to collect debts.
Note the assumption that this business trades on 30 days’ credit. If it sold on 60 days’
credit, for example, the turnover rates would be seen in a different light, and the results
would be viewed as highly satisfactory. This shows the importance of comparing
accounts receivable turnover with the actual credit terms offered. The control of accounts
receivable is dependent on the credit terms on offer, and management’s ability to enforce
those terms.

MANAGING ACCOUNTS RECEIVABLE TURNOVER

Once the credit terms and the accounts receivable turnover are compared, the
ratio should be compared with ratios from previous reporting periods. This allows
management to identify any noticeable trends. Management should also set targets
for such ratios, and measure turnover results against these predetermined rates.
If accounts receivable turnover has been a problem in the past, management may
set a standard of performance that has to be met within a set period. This provides a
target for measuring success or failure at the end of the reporting period.
The results of the accounts receivable turnover are mostly dependent on internal
factors, and comparisons with other businesses are of little value.

13.4 CHECK YOUR UNDERSTANDING WB PAGE 233

1 What does accounts receivable turnover evaluate? Explain how it is

calculated.
2 Spotswood Sports has accounts receivable turnover of 24 days. It allows its
accounts receivable a maximum of 30 days’ credit. Comment on the results
achieved by this business in relation to its accounts receivable accounts.
3 Describe three different tactics that management may use to try to speed up
a business’s accounts receivable turnover.

978 1 4202 3962 1 [CHAP TER 13] M ANAGEMENT AND ACCOUNTING REPORTS 265
 13.5 EVALUATING THE CASH CYCLE
Inventory turnover and accounts receivable turnover play important roles in the
success of trading businesses. These two ratios have a close relationship. A trading
business is involved in a continuous process of buying goods, turning these goods
into sales, and then turning these sales into cash.
cash cycle This whole process is known as the cash cycle of business, which is the time a
the process of business takes to collect cash from the inventory it bought for resale. The cash cycle
turning inventory
into sales, and then is therefore the sum of the inventory turnover and accounts receivable turnover.
turning these sales Figure 13.3 shows the cash cycle as a flow diagram.
into cash

FIGURE 13.3 The cash cycle of a trading business selling on credit

Inventory turnover

PURCHASE
INVENTORY

SELL
INVENTORY

COLLECT CASH
FROM
ACCOUNTS
RECEIVABLE
Accounts
receivable turnover

Using the ratios calculated for Blackrazor Skate Shop, the business’s cash cycle can be
determined.
2022 2023
Inventory turnover (in days) 85 77
+ Accounts receivable turnover (in days) 37 28
= Cash cycle 122 105

Combining the two turnover rates gives management a complete summary of what
has happened in the business in terms of these crucial current assets.
For Blackrazor Skate Shop, improvements have been achieved in both turnover
rates. These improvements mean that, on average, the cash cycle of the business has
improved by 17 days. The business is therefore receiving cash from its investment in
inventory 17 days faster than it did in the previous year.
This is very positive, because the cash is available at an earlier date and can
therefore be used by management as it sees fit. For example, it may gain discounts
because it can settle accounts payable sooner. Interest on the business’s overdraft
may be reduced because it can decrease or even eliminate the overdraft. It’s always
an advantage to have the cash cycle happening at a faster rate.

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 Improving
accounts
receivable
turnover
contributes to
business success.

INTERPRETING THE CASH CYCLE

The cash cycle is made up of two components, so movements in one component
may be offset by opposite movements in the other component. For example,
inventory turnover may increase by five days, while accounts receivable turnover
decreases by five days. This makes it appear as if the cash cycle hasn’t changed,
because the overall figure may be consistent from one period to the next.
This means that both components of the cash cycle need to be monitored. If
one turnover rate improves, it may be time to concentrate on the other so that the
business’s overall performance still improves over time.
As with all analytical tools, the cash cycle examines relationships between
different items, so it can be used to inform management of perceived problems. How
management reacts to these problems has a major impact on the success or failure of
a business.
Turnover rates are just another source of financial information to be used by
owners and managers. Ultimately, these people need to make decisions that lead to
changes in the cash cycle that strengthen the business and make it perform better in
future periods.

13.5 CHECK YOUR UNDERSTANDING WB PAGE 234

1 Explain what the term ‘cash cycle’ means. How is it calculated?

2 What problems may exist in a trading business that experiences an
increasing cash cycle? Explain your answer fully.
3 ‘If a business improves their accounts receivable turnover from 37 days to
29 days, their cash cycle must also improve.’ Do you agree? Explain fully.

978 1 4202 3962 1 [CHAP TER 13] M ANAGEMENT AND ACCOUNTING REPORTS 267
 EVALUATING ACCOUNTS PAYABLE
13.6 TURNOVER
A business doesn’t need to control accounts payable so much as manage them in a
way that helps satisfy its needs.
Accounts payable are a useful source of credit. Many trading businesses purchase
their inventory requirements from accounts payable (known as trade credit) for two
basic reasons:
1 trade credit gives a business time to sell its inventory and turn it into cash.
2 trade credit is basically interest-free finance: a short-term credit arrangement that
doesn’t involve interest (except in a small number of arrangements).
For example, in retail it’s common practice to purchase inventory on 30 days’ credit. The
objective of retailers is then to have a cash cycle fast enough to cope with demands for
payment at the end of this 30-day period. This isn’t always possible, but the concept of
working with accounts payable in line with the business’s cash cycle is useful.
The cash cycle flow diagram in Figure 13.3 can be modified to represent this
concept.

FIGURE 13.4 The cash cycle of a trading business buying and selling on credit

Inventory turnover

PURCHASE
INVENTORY

PAY CASH
TO SELL
ACCOUNTS INVENTORY
PAYABLE
COLLECT CASH
FROM
ACCOUNTS
RECEIVABLE

Accounts payable Accounts

turnover receivable turnover

Figure 13.4 represents the ideal situation for a trading business. It shows a cycle
of buying goods, selling goods, collecting cash, and then ultimately paying cash to
accounts payable at the end of the cycle.
Unfortunately, things don’t always happen in this order; the payment of accounts
payable can become a balancing act for management. A business owner doesn’t set
out to upset anyone who provides inventory on credit, but suppliers expect to be paid
on time, and it’s a dangerous practice to always pay late. The old ‘the cheque is in
the mail’ routine doesn’t hold up with many suppliers – especially now that cheques
are largely a thing of the past. If it’s used repeatedly, suppliers may refuse to supply
goods on credit to the business in future.

268 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 However, when a business owner experiences problems with slow inventory
turnover, or has problems with slow-paying accounts receivable, payments to accounts
payable may be deliberately delayed. If a business is experiencing a severe cash
shortage, there may be little choice but to put off accounts payable for a few weeks. At
other times a business may have excess cash, allowing it to settle accounts promptly.
Therefore, when evaluating accounts payable turnover, keep in mind that other accounts
factors within the business may determine when accounts payable are settled. payable turnover
a financial indicator
that determines the
CALCULATING ACCOUNTS PAYABLE TURNOVER average time taken
by a business to
pay its accounts
Accounts payable turnover is calculated in a similar fashion to that of the accounts payable
receivable turnover. Instead of credit sales, credit purchases for the period are used,
and this figure is compared to the average amount owed to accounts payable.

Accounts payable turnover = Average accounts payable x 365

Net credit purchases (plus GST)

Note: This ratio only considers purchases made on credit, as cash purchases don’t
affect accounts payable.
Consider the end-of-year data for three consecutive reporting periods for Blackrazor
Skate Shop.

2021 2022 2023

$ $ $
Balance of accounts payable 4 000 6 000 5 000
Credit purchases 40 000 50 000
GST charged 4 000 5 000

For the year 2022: $5000 x 365 = $1 825 000 = 41.1 or 41 days
$44 000 $44 000

For the year 2023: $5 500 x 365 = $2 007 500 = 36.5 or 37 days
$55 000 $55 000

The trend in this ratio is favourable: credit purchases have increased over time, yet the
average repayment period has decreased by four days (from 41 to 37).
The reason for such a change may be difficult to identify, although it could be linked
to improved accounts receivable turnover. You saw in section 13.4 that Blackrazor
reduced the average collection period from accounts receivable from 37 days to
28 days over this two-year period. As the business was receiving cash at an earlier
time from its accounts receivable, this may have allowed it to settle accounts with
suppliers at a faster rate.

MANAGING TURNOVER RATE

The accounts payable turnover rate should be compared to the credit terms offered
by suppliers. Some suppliers may tolerate an occasional late payment, but they won’t
be happy if their credit terms are continually abused. A creditor may cut off supply
to a business if it is always late with its payments. This may be a hefty price to pay,
particularly if the supplier’s products are a fast-moving inventory item.

978 1 4202 3962 1 [CHAP TER 13] M ANAGEMENT AND ACCOUNTING REPORTS 269
 The accounts payable turnover should also be compared with previous reporting
EXAM periods, so that any significant trends can be identified. The budget expectations of
SUCCESS management may also be used as criteria for measurement. Always keep in mind that
If accounts payable
turnover increases, you the accounts payable turnover may change because of the needs of management at a
may be asked to state particular time.
one positive and one The ability to repay accounts payable may reflect the current liquidity of the
negative in relation to
this change. Revise business – its ability to meets its debts as they fall due. For example, if ample cash
answers for both resources are available, the accounts payable turnover may fall sharply. At other times,
possibilities. cash reserves may be low, perhaps because of seasonal variations or because the
economy has slowed down. If consumers aren’t spending, inventory turnover will fall,
and accounts receivable turnover may also slow down as money becomes tight.
The tasks of managing and controlling inventory, accounts receivable and accounts
payable must not be viewed as isolated activities. They are the most crucial tasks
faced by any manager of a small business that is involved in trading activities. A
manager who doesn’t give these areas sufficient attention is risking failure. The ability
to buy and sell inventory at a fast enough rate, coupled with the demands of collecting
cash from accounts receivable and paying cash to accounts payable, determines how
successful a business will be. A trading business is all about managing the balancing
act between its cash cycle and its accounts payable turnover.

Late payments
can damage your
business in many
ways.

13.6 CHECK YOUR UNDERSTANDING WB PAGE 235

1 ‘Accounts payable turnover shouldn’t be predetermined, as it depends on other

factors.’ Describe two factors that should be taken into account when evaluating
accounts payable turnover.
2 What are the possible implications of having a very fast accounts payable turnover?
Explain your answer fully.
3 What is a possible implication of a slow accounts payable turnover? Explain your
answer fully.

270 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
 13 CHAPTER REVIEW

KEY CONTENT
•• [13.1] One of the most important aspects of managing a trading business is controlling
inventory. The Inventory account, and the use of inventory cards, are key tools in inventory
control, although there are many other procedures than can also be used to assist.
•• [13.2] The inventory turnover rate is a financial indicator that shows how quickly a business
can turn its inventory into sales. Faster turnover is generally better, but each business
and industry will have different criteria for the ideal rate.
•• [13.3] Businesses that make credit sales must monitor and evaluate how they manage
accounts receivable and avoid bad debts. A key tool for this is an age analysis of
accounts receivable, which classifies Accounts Receivable accounts according to the
age of their debt.
•• [13.4] The accounts receivable turnover rate is a financial indicator that shows the average
time taken by accounts receivable to settle their accounts.
•• [13.5] The cash cycle is the time taken to collect cash from the inventory bought for resale by
the business. It’s the sum of the inventory turnover and accounts receivable turnover.
•• [13.6] The accounts payable turnover rate is a financial indicator that shows the average time
taken by a business to pay its accounts payable.

CHAPTER 13 EXERCISES

WB PAGE 236
1 Inventory turnover
On 1 January 2023, Total Turntables had inventory on hand of $46 400. During 2023
the business sold goods for a total of $294 000. The cost price of goods sold totalled
$206 480 and inventory as at 31 December 2023 is valued at $42 200. The management
of the business states that the inventory turnover in 2022 was 87 days.
a Calculate inventory turnover for 2023 for Total Turntables.
b Compare the results of 2023 to those achieved in 2022. Comment briefly on the
trend in the inventory turnover rate.

2 Comparing inventory turnovers WB PAGE 236

The following information relates to two similar businesses.

Ballarat Books Bendigo Books

$ $
Inventory as at 1 January 2023 54 200 51 600
Inventory as at 31 December 2023 52 800 54 200
Cost of goods sold for 2023 307 625 280 370

a Calculate the inventory turnover in days for each of these businesses for 2023.
b Which business managed its investment in inventory more efficiently during 2023?
Explain your answer fully.

978 1 4202 3962 1 [CHAP TER 13] M ANAGEMENT AND ACCOUNTING REPORTS 271
 c What other information could you use to evaluate the success or otherwise of the
inventory turnover rates determined in part a?
d ‘If the inventory turnover is faster, it means the business has sold more goods.’ Do
you agree with this statement? Explain your answer fully.

WB PAGE 237
3 Trend in inventory turnover
Pat Carrier is the owner of Carrier’s Camping Gear. He provides the following financial
data from his business records.

2020 2021 2022 2023

$ $ $ $
Cost of goods sold 122 000 124 000 128 000 134 000
Balance of inventory 35 600 36 000 38 500 44 500

Carrier is quite happy with the business’s performance over the last few years, as he
has noted that the cost of goods sold has increased every year.
a Calculate the inventory turnover for Carrier’s business for the years 2021, 2022
and 2023.
b Comment on Carrier’s observations about the business’s performance, taking into
account your turnover calculations.
c Explain how inventory cards can assist an owner of a trading business to improve
inventory turnover results.

4 Accounts receivable turnover WB PAGE 238

Fakhri’s Fabrics had total accounts receivable of $12 400 on 1 January 2023, while
on 31 December 2023 accounts receivable were $11 600. Credit sales for the year
were $174 000, plus GST. The business offers credit customers 30 days to settle their
accounts.
a Calculate the accounts receivable turnover in days to show the average time taken
for settlement of accounts.
b Comment on the performance of the business in controlling its accounts receivable.
c Explain how an age analysis of accounts receivable may help management to
control its accounts receivable.
d If this business has inventory turnover of 73 days, calculate the length of the cash
cycle. Explain the significance of this result.

5 Comparing accounts receivable turnovers WB PAGE 239

The following information is provided by the management of two smartphone retailers.

Both businesses supply goods on 30 days’ credit to regular customers.

Android Unlimited Smartphone Plus

$ $
Accounts receivable balance as at 30 June 2022 16 500 22 800
Accounts receivable balance as at 30 June 2023 18 300 19 400
Cash sales for the year (excluding GST) 204 600 225 600
Credit sales for the year (excluding GST) 187 920 247 925

a Calculate the accounts receivable turnover in days, and write a brief comment on
the businesses’ collection procedures.
b Describe four steps management could take to improve accounts receivable
turnover.

272 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
6 Age analysis of debts WB PAGE 240

The manager of Skyranger Drones asks for your help with the accounts receivable
of the business. The invoices sent to accounts receivable clearly state that the credit
terms are 60 days. No discounts are offered for early payment. The following summary
of the business’s accounts receivable was drawn up at the end of October 2023.
AGE ANALYSIS OF ACCOUNTS RECEIVABLE
Total accounts 31–60 61–90 91–120 121 days
0–30 days
receivable days days days and over
$42 500 $3 400 $29 750 $4 250 $2 975 $2 125

The manager isn’t overly concerned, because he’s been told that most accounts
receivable should be in the top of the age analysis table. As the business sells on 60
days’ credit, he’s happy that most accounts receivable are in the 0–60 days categories.
a Redraft the age analysis table by adding a percentage breakdown of each category.
b Comment on your percentage analysis, particularly in light of the manager’s
statement. Highlight any major concerns you have about the results.
c Recommend at least three changes this manager could make in terms of the
way the business deals with accounts receivable. Explain the reasons for your
recommendations fully.

WB PAGE 241
7 Comparing age analyses
The following age analyses of accounts receivable are supplied by the management of
Trachan’s Tractor Parts.
AGE ANALYSIS OF ACCOUNTS RECEIVABLE AS AT 31 DECEMBER 2022
Total accounts 91 days and
0–30 days 31–60 days 61–90 days
receivable over
$17 800 $12 460 $3 560 $1 246 $534

AGE ANALYSIS OF ACCOUNTS RECEIVABLE AS AT 31 DECEMBER 2023

Total accounts 91 days and
0–30 days 31–60 days 61–90 days
receivable over
$19 600 $14 700 $4 312 $392 $196

Additional information
•• The business allows 30 days’ credit to its customers.
•• Credit sales for 2023 totalled $220 000, including GST
•• Accounts receivable turnover was 43 days in 2022 and 41 days in 2021.
a Prepare an age analysis of accounts receivable for 2023 in percentage terms.
b Calculate the accounts receivable turnover for 2023.
c Referring to your answers to part a and b, comment on management’s
effectiveness in collecting debts during the 2023 reporting period.

978 1 4202 3962 1 [CHAP TER 13] M ANAGEMENT AND ACCOUNTING REPORTS 273
 8 Age analysis and turnover rates WB PAGE 241

Parlato’s Printing Supplies allows 60 days’ credit to its regular customers. During 2023
the business sold $285 000 worth of goods on credit, plus GST. The management of
the business provides the following details relating to accounts receivable at the end of
the year, along with the equivalent details from the previous year.

AGE ANALYSIS OF ACCOUNTS RECEIVABLE AS AT 31 DECEMBER 2023

Total accounts 91 days and
0–30 days 31–60 days 61–90 days
receivable over
$44 800 $23 000 $16 200 $5 150 $450

AGE ANALYSIS OF ACCOUNTS RECEIVABLE AS AT 31 DECEMBER 2022

Total accounts 91 days and
0–30 days 31–60 days 61–90 days
receivable over
$49 200 $23 500 $12 400 $10 960 $2 340

The accounts receivable turnover rate for 2022 was 68 days.

a Calculate the accounts receivable turnover for 2023.
b Calculate an age analysis of accounts receivable for 2022 and 2023 to show the
percentage of accounts receivable in each category.
c Comment on the success or otherwise of management’s collection of debts over
the last 12 months.

9 Accounts payable turnover WB PAGE 242

Bairnsdale Book Store had accounts payable of $12 800 on 1 October 2022, while on
30 September 2023 accounts payable totalled $14 400. Credit purchases for the year
were $156 000, plus GST. The business purchases its inventory on credit terms of
30 days.
a Calculate the accounts payable turnover.
b Comment on the performance of the business in meeting its commitments to its
suppliers.

10 Comparing accounts payable turnovers WB PAGE 242

The owners of two mag wheel retailers provide the following information.

Mags & Rims Lowriders

$ $
Accounts payable balance as at 31 December 2022 31 400 23 400
Accounts payable balance as at 31 December 2023 36 800 26 200
Cash purchases for the year (excluding GST) 123 400 112 800
Credit purchases for the year (excluding GST) 320 000 383 750
Credit terms of suppliers 30 days 30 days

a Calculate the accounts payable turnover for both businesses for 2023.
b Suggest two reasons why accounts payable turnover may not be in compliance with
the credit terms offered by suppliers.

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11 Trends in accounts payable turnover WB PAGE 243

Tony Arthurson, the owner of Footy Fever Superstore, is concerned about how long
he’s taking to repay some of his suppliers. Arthurson purchases all the inventory for his
business on credit. He sometimes gets reminders about his credit accounts, but needs
actual data in order to understand what is happening in his business.
The following information is extracted from his final accounting reports for the last
three years.

2021 2022 2023

$ $ $
From the income statements:
Cost of goods sold 88 000 92 000
From the balance sheets:
Balance of inventory 25 400 28 300 32 200
Balance of accounts payable 4 900 5 900 7 100

a Reconstruct the Inventory Control account to determine the credit purchases the
business made during 2022 and 2023.
b Calculate the accounts payable turnover for 2022 and 2023.
c Comment on the turnover results you have calculated in part b. Should Arthurson be
concerned? Give reasons for your answer.

WB PAGE 244
12 Managing the cash cycle
The following information relates to Dalrymple Timber Supplies.

31 December
1 January 2023
2023
$ $
Inventory on hand 24 600 25 800
Accounts receivable balance 11 900 13 100
Accounts payable balance 12 500 14 400
Credit sales for the year (including GST) 181 500
Cost of goods sold for the year 131 040
Budgeted inventory turnover 60 days
Inventory turnover in 2022 72 days
Standard credit terms for accounts receivable 30 days
Accounts receivable turnover in 2022 32 days
Credit terms of suppliers 30 days

Note: all inventory purchases are made on credit.

a Calculate the inventory turnover and accounts receivable turnover for 2023.
b Determine the length of the cash cycle.
c Reconstruct the Inventory account to determine the credit purchases for the year.
d Calculate the accounts payable turnover for 2023.
e Comment on the trend in the cash cycle and the success of the business in meeting
its objectives with regard to the turnover of inventory and accounts receivable.
f Compare the cash cycle to the accounts payable turnover rate. Are there any dangers
in what is happening in this business at the moment? Explain your answer fully.

978 1 4202 3962 1 [CHAP TER 13] M ANAGEMENT AND ACCOUNTING REPORTS 275
 CHAPTER CHECKLIST
Now that you have finished Chapter 13, double-check your progress.
Are you ready for your Unit 3 assessment?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
handed in my workbook for marking.

I understand …

internal control procedures to safeguard resources against theft and fraud

financial indicators: inventory turnover, accounts payable turnover, accounts receivable turnover
non-financial information available to assist analysis and decision-making in relation to inventory,
accounts receivable and accounts payable.
strategies to improve the management of inventory, accounts receivable and accounts payable
strategies to improve business performance.

I can …

discuss strategies to improve the management of inventory, accounts receivable and accounts
payable
construct appropriate graphical representations to assist with the analysis of classified accounting
reports and other information to evaluate the performance of a business
explain and apply appropriate internal control procedures.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_13

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

276 [UNIT 3] FINANCIAL ACCOUNTING FOR A TRADING BUSINESS 978 1 4202 3962 1
4 UNIT
RECORDING, REPORTING,
EVALUATING AND
PLANNING ACCOUNTING
INFORMATION
Accounting systems do more
than record numbers – they
are information systems that
provide decision makers with
vital financial data. Accountants
Area of Study 1:
Extension of recording and reporting

On completion of this unit the student should

be able to record financial data and balance

© VCAA; by permission.
work with managers and day adjustments using a double-entry system,
report accounting information using an accrual-
business owners to create and
based system and evaluate the effect of balance
interpret financial reports, and
day adjustments and alternative methods of
analyse the results to suggest
depreciation on accounting reports.
strategies for improving the
performance of a business.
Area of Study 2:
In this unit you will learn about: Budgeting and decision-making

•• the purposes of accounting On completion of this unit the student should

systems be able to prepare budgeted accounting
•• the role of accounting as an reports and variance reports for a trading
information system
business using financial and other relevant
information, and model, analyse and discuss
•• how to use the accrual basis the effect of alternative strategies on the
of accounting to prepare performance of a business.
reports
•• the role and importance CHAPTERS
of budgeting in decision 14 15 16 17 18
making in a business
19 20 21 22 23
•• how to interpret accounting
information from reports and
graphical representations.

278 978 1 4202 3962 1

14 BAD AND DOUBTFUL DEBTS

In Unit 3 you focused on learning LEARNING OBJECTIVES

how to record the transactions
of a small trading business. But By the end of this chapter, you will be able to:
it’s not enough just to record •• distinguish between bad debts and doubtful debts
data; it’s an accountant’s job [14.1]
to create reports using that •• explain the need to account for doubtful debts [14.1]
data. Management needs to •• prepare a general journal to create an allowance for
be able to understand what the doubtful debts [14.1]
business’s financial data means
•• prepare a general journal entry to write off a bad debt
in order to make decisions, and
[14.2]
that understanding comes from
effective reports. •• prepare an adjusting entry to record bad debts
In this chapter you begin the expense for a period [14.3]
reporting process by looking at •• explain the link between the accounting assumptions
the bad and doubtful debts that and qualitative characteristics of accounting and bad
a business may accumulate from and doubtful debts [14.3].
its credit customers, and learning
how to report those debts
accurately.

UNIT 4 – PROGRESS 14 15 16 17 18 19 20 21 22 23

14.2

Writing off debts Chapter review

14.1 14.3 and exercises

Adjusting the
What are bad and allowance for
doubtful debts? doubtful debts
account

978 1 4202 3962 1 279

 14.1 WHAT ARE BAD AND DOUBTFUL
DEBTS?
Whenever a trading business provides goods to a customer on credit, there is the
risk of non-payment. A business may investigate a customer’s background and credit
rating, but sometimes what looks like a reasonable risk becomes a problem.

BAD DEBTS
Slow-paying accounts receivable should be reminded of their obligations via email,
telephone calls and reminder letters. Sometimes legal action may be used as a threat
to get customers to pay. However, these tactics don’t always succeed, and many
bad debt businesses eventually face what is known as a bad debt. A bad debt is an account
expense account
created when an
receivable that management accepts cannot (or won’t) pay the amount outstanding.
accounts receivable This management decision may be due to legal advice from a lawyer representing
is written off as the customer, possibly advising that they are bankrupt. Another possibility is when a
irrecoverable
customer cannot be located; people may move interstate (or overseas) to avoid their
debts. Rather than spend hundreds or thousands of dollars chasing someone around
the country (or the world), a business may choose to write off a relatively small debt
as uncollectable.

A bankrupt credit
customer is likely
to become a bad
debt.

DOUBTFUL DEBTS
Under accrual accounting, profit is defined as revenue earned less expenses incurred.
When an income statement is prepared, revenue earned may include both cash and
credit sales. Credit sales are usually recognised when goods have been provided to
the customer and an invoice has been issued.
As you have seen, there is a risk that some of these credit sales may not be
collected in the future. This raises the question of whether or not to report all credit
sales in an income statement. As accountants are required to represent financial
data faithfully, it would be wrong not to report the total credit sales earned in a given
period. However, to acknowledge that there is some risk in relation to all the sales
being collected in credit, it’s common practice to create an allowance for doubtful
allowance for
doubtful debts debts at the end of a reporting period. This allowance is made in recognition of the
a negative asset risk attached to selling goods on credit.
account based on Once a business has been trading for a period of time, it may be able to identify
predictions of future
bad debts a pattern of non-payment. For example, perhaps 5% of all credit sales are never
collected from accounts receivable. If this pattern is established, management may
apply this percentage at the end of each period to allow for some accounts to turn
into bad debts in the future.

280 [ U N I T 4 ]  R E C O R D I N G , R E P O R T I N G , E VA L U AT I N G A N D P L A N N I N G A C C O U N T I N G 978 1 4202 3962 1

I N F O R M A T I O N
RECORDING BAD AND DOUBTFUL DEBTS
If bad debts are expected by a business, this should be recognised on balance day
as it would more faithfully represent the true financial situation. It also creates an
expense for the current reporting period, which acknowledges that management
doesn’t expect to collect all amounts owing by accounts receivable.

EXAMPLE 14.1

The management of Tullamarine Trailers discusses bad debts at its monthly meeting.
Credit sales made during 2023 $100 000
Percentage of credit sales not usually collected 5%
Management believes that this trend of uncollected accounts will continue, so an
allowance for doubtful debts is created with the following general journal entry.
GENERAL JOURNAL
Date Details Dr Cr
31 Dec Bad debts expense 5 000
Allowance for doubtful debts 5 000
Adjusting entry to create allowance for doubtful
debts at 5% of credit sales (Memo 76)

The double entry to create an allowance for doubtful debts has a two-fold effect on
the final accounting reports:
•• It creates a bad debts expense, which decreases the net profit for the period.
Owner’s equity thus also decreases in the balance sheet.
•• The current assets of the business are indirectly decreased in the balance sheet,
as the allowance for doubtful debts is deducted from accounts receivable.
If accounts receivable had a total amount owing of $65 000 as at 31 December,
it would be reported as shown below.
Current assets
Accounts receivable 65 000
Less: Allowance for doubtful debts 5 000
60 000
When an allowance for doubtful debts is created, individual accounts receivable aren’t
named. The allowance is simply based on a percentage of credit sales made during a
period. The amount recognised should be as accurate as possible, in order to be true
to the demands of faithful representation.
Bad debts are a fact of life for many businesses, so it’s sensible to allow for this
possibility in the period in which credit sales are reported. The potential losses created
by future bad debts are a relevant expense to the users of accounting reports, and
they should be reported at the end of each reporting period.

14.1 CHECK YOUR UNDERSTANDING WB PAGE 246

1 Explain the circumstances in which management may decide to create an

allowance for doubtful debts.
2 State the double entry to create an allowance for doubtful debts.
3 Explain why an allowance for doubtful debts is reported in a balance sheet.
4 Distinguish between doubtful debts and bad debts.

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 14.2 WRITING OFF DEBTS
Having established an allowance for doubtful debts at the end of a reporting period,
the next step in the process is to write off a credit customer when they actually
become a bad debt.
Example 14.1 showed that Tullamarine Trailers anticipates about $5000 in bad
debts in the next period. To demonstrate the complete process, the following two
transactions have been provided for the subsequent reporting period.

EXAMPLE 14.2

31 Mar Accounts receivable – Y Settle owes the business $2200 and hasn’t responded to
countless emails and reminder letters. A debt collector attempted to collect the debt, but
the business has now been advised that this customer has disappeared interstate.
Management decides to write the account off as a bad debt, without any cash being
received.
GENERAL JOURNAL
Date Details Dr Cr
31 Mar Allowance for doubtful debts 2 000
GST clearing 200
Accounts receivable – Y Settle 2 200
Account written off as bad debt (Memo 81)

There are three components to this entry:

•• The first step is to identify the GST component of the debt. As the total debt was
$2200, dividing this amount by 11 determines the GST amount charged at the time
of sale: $2200/11 = $200. As the business will collect the GST charged on this
sale, it must be cancelled so that the business doesn’t overpay the ATO. A debit to
the GST Clearing account is made to counteract the credit made to GST Clearing at
the time of the sale.
•• The remainder of the debt (i.e. $2000) is debited against the balance of the
Allowance for Doubtful Debts account. The business allowed for $5000 in bad
debts; this is its first bad debt for the period, but management’s predictions are
starting to come true!
•• The third entry is the credit to Accounts Receivable. As the account had a balance
of $2200, this entry closes the account completely and Y Settle has now been
removed from the books of this business.

Debt collectors
may be necessary
to try to collect
overdue accounts.

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 EXAMPLE 14.3

15 Jun Legal advice is received that one of Tullamarine Trailers’ customers, IM Shiftee,
has been declared bankrupt and is only paying 30 cents in the dollar on all his debts. The
Accounts Receivable account for IM Shiftee shows that he still owes the business $2750.
The remainder of this account is to be written off as irrecoverable.
This results in the following general journal entries.

GENERAL JOURNAL
Date Details Dr Cr
15 Jun Cash at bank 825
Allowance for doubtful debts 1 750
GST clearing 175
Accounts receivable – Y Settle 2 750
Account written off as bad debt (Memo 81)

This journal entry is similar to the one in Example 14.3, with one exception. As the
customer is paying all debts at the rate of 30 cents in the dollar, the business will
receive $825 (30% of $2750). Once the cash received is recorded, the rest of the EXAM
process is exactly the same. SUCCESS
When writing
•• The amount that remains owing is $2750 – $825 = $1925. Divide this amount by off an accounts
11 to determine the GST still owing: $1925 ÷ 11 = $175. receivable, always
check that the three
•• Deduct the GST from the total still owing to determine the amount to be written
debit entries equal
off against the allowance for doubtful debts (i.e. $1925 – $175 = $1750). the balance of
•• By recording the cash received and making the adjustment to the GST Clearing the account.

account, the business achieves its goal of writing off the customer’s account.
Add up the three entries on the debit side to ensure that the total amount owing has
now been taken care of – in this case, $825 + $1750 + $175 = $2750.

14.2 CHECK YOUR UNDERSTANDING WB PAGE 247

1 Explain the link between faithful representation and the creation of an

allowance for doubtful debts.
2 State the double entry to write off an accounts receivable as irrecoverable.
3 If some cash is received from an accounts receivable that has been declared
bankrupt, how should you modify the double entry you stated in Question 2?

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 ADJUSTING THE ALLOWANCE FOR
14.3 DOUBTFUL DEBTS ACCOUNT
Having written off accounts receivable against the Allowance for Doubtful Debts
account, the final step is to prepare this account for the subsequent period.
Continuing with Tullamarine Trailers, the allowance for doubtful debts account
would appear as shown below.

Allowance for doubtful debts

$ $
31 Mar Accounts receivable 2 000 31 Jan Balance 5 000
15 Jun Accounts receivable 1 750

The original estimate of future bad debts was $5000, and this appears on the credit
side of the account. Two different accounts became bad debts during the period, so
the two amounts that were written off appear on the debit side.
We can now compare the estimate of bad debts and the actual bad debts incurred.
The ledger account shows that, in this case, management’s estimate of bad debts
was a little high:
Prediction of future bad debts $5000
Actual bad debts written off $3750 (2000 + 1750)

The allowance is based on an estimated figure, so it’s not expected to be perfect. Still,
it’s important to make as accurate an estimate as possible, because it has an impact
on the profit reported for a given period.
If an estimate was high in one period, the adjustment made on balance day will
automatically be adjusted for the following period. For example, if management
wanted the allowance for doubtful debts to be maintained with a balance of $5000,
the account would look like the example below.

Allowance for doubtful debts

$ $
31 Mar Accounts receivable 2 000 1 Jan Balance 5 000
15 Jun Accounts receivable 1 750 31 Dec Bad debts expense 3 750
31 Dec Balance 5 000
8 750 8 750
1 Jan Balance 5 000

Bad debts expense

$ $
31 Dec Allowance for 3 750
doubtful debts

Despite the Allowance for Doubtful Debts account having a balance of $5000, the
actual expense for this period for bad debts is only $3750. This is because in the
previous year, the estimate was $1250 too high. The anticipated bad debts were
$5000, yet the accounts written off were for only $3750. Therefore, this is the amount
that would be reported in the income statement at the end of the period.

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 When management’s prediction of bad debts is too high, they may decrease the
balance of the Allowance for Doubtful Debts account. For example, if management
decided to decrease the allowance to only $4000, the accounts would be entered
as below.
Allowance for doubtful debts
$ $
31 Mar Accounts receivable 2 000 1 Jan Balance 5 000
15 Jun Accounts receivable 1 750 31 Dec Bad debts expense 2 750
31 Dec Balance 4 000
7 750 7 750
1 Jan Balance 4 000

Bad debts expense

$ $
31 Dec Allowance for doubtful 2 750
debts

The figure reported for bad debts expense in this case is again $1250 lower than the
balance of the Allowance for Doubtful Debts account. This reflects the high estimate
from the year before.
The Allowance for Doubtful Debts account adjusts itself automatically, depending
on whether a high or low estimate was made in the previous period.

An allowance for
doubtful debts is
only an estimate.

Keep in mind that the allowance for doubtful debts cannot satisfy the demands of
verifiability. It’s simply an estimate of future events. However, it does comply with
relevance, because it recognises the potential for credit sales not being collected. This
may more faithfully represent the situation faced by a business, especially if it has a
history of bad debts over a number of consecutive periods.

14.3 CHECK YOUR UNDERSTANDING WB PAGE 248

1 ‘The allowance for doubtful debts is only an estimate and therefore distorts
the profit reported by management.’ Comment on this statement.
2 Explain the link between the period assumption and the creation of an
allowance for doubtful debts.
3 ‘The creation of an allowance for doubtful debts causes a conflict between
the demands of verifiability and faithful representation.’ Do you agree?
Discuss.

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 14 CHAPTER REVIEW

KEY CONTENT
•• [14.1] Whenever a trading business provides goods to a customer on credit, there is a risk
of non-payment. A bad debt is an account receivable that cannot (or won’t) pay the
amount outstanding.
•• [14.2] An Allowance for Doubtful Debts account is created to reflect the possibility of bad
debts. It provides an allowance based on estimates of the likely level of bad debts in
a reporting period. Individual accounts receivable aren’t named when an allowance for
doubtful debts is created.
•• [14.3] The double entry to create an allowance for doubtful debts creates a bad debts
expense, which leads to a decrease in net profit and owner’s equity. The current assets
of the business are indirectly decreased, as the allowance is deducted from accounts
receivable.
•• [14.3] The allowance is based on an estimated figure, and doesn’t need to be perfect. It’s still
important to make as accurate an estimate as possible.

CHAPTER 14 EXERCISES

SPREADSHEET X.XX1 Creating an allowance for doubtful debts WB PAGE 249

Jacob Hutchinson is the owner of Hutchie’s Horse Gear, a small business that sells
saddles, bridles and other horse-riding equipment. He has sold over $20 000 worth
of goods in the last 12 months but isn’t certain that all of his credit customers will
pay their accounts. His accountant has advised that he should create an allowance
for doubtful debts of about 3% of his credit sales. This was noted on Memo 34. Total
accounts receivable at the end of the period were $5600.
a Prepare the general journal entry required on 30 June 2023 to create an allowance
for doubtful debts.
b Show how accounts receivable, with the allowance for doubtful debts, would be
reported in the balance sheet as at 30 June 2023.

SPREADSHEET X.XX2 Creating an allowance for doubtful debts WB PAGE 249

Sullivan’s Shoes is owned and operated by Brooke Sullivan. She has provided the
information below from her records at 31 May 2023.
Cash sales for the year: $63 000
Credit sales for the year: $25 500
Sales returns from accounts receivable: $2 500
a Prepare the general journal entry to create an allowance for doubtful debts equal to
2.5% of net credit sales (noted on Memo 87).
b Prepare a balance sheet extract to show how accounts receivable would be
reported as at 31 May 2023.

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3 Writing off a bad debt WB PAGE 250 SPREADSHEET X.XX

Eva Harrington is a credit customer of Northside Music & Beats. The business sold
goods to her on 7 September 2022 for $200, plus GST. No payment has ever been
made on her account. The management of the business has tried to locate Harrington
for several months, but without success. On 30 June 2023, management decides to
write off the debt as irrecoverable and this is noted on Memo 23. On balance day of
the previous period, an allowance for doubtful debts of $300 was created.
a Prepare the general journal entry to write off Harrington’s debt.
b Prepare the following general ledger accounts: Accounts Receivable – Harrington,
and Allowance for Doubtful Debts. Balance these accounts.

4 Writing off a bad debt WB PAGE 251 SPREADSHEET X.XX

A credit sale of $480, plus GST, was made 18 months ago to a company named
Cheetem Pty Ltd. The customer has made no payment since that time. At the end of
the previous period, a decision was made to create an allowance for doubtful debts of
$600. Management has been informed by Cheetem’s bank that the firm has collapsed
and the owner can’t be located. It’s believed that he has disappeared interstate. All
details were noted on Memo 121.
a Prepare the general journal entry to write off Cheetem’s debt on 10 October 2023.
b Post your general journal entry to both the Accounts Receivable account and the
Allowance for Doubtful Debts account in the general ledger.
c Outline the steps a business should follow before granting credit to customers.

5 Bad debt with a cash receipt WB PAGE 252 SPREADSHEET X.XX

The general ledger of Fitzroy Furniture included the following account.

Accounts receivable – D Pendable
$ $
31 Mar Balance 770

The owner of Fitzroy Furniture has just received legal advice that D Pendable has been
declared bankrupt. The correspondence received also indicates that only 40 cents in the
dollar will be paid and a cheque has been enclosed for this amount. Memo 312 notes
all details regarding this payment. Total cash received from accounts receivable during
March was $14 000. The balance of the Accounts Receivable account at the start of
March was $21 000 and the Allowance for Doubtful Debts account had a credit balance
of $1000.
a Prepare the general journal entry to write off the D Pendable account, including the
receipt of cash representing the payment of 40 cents in the dollar.
b Prepare the following general ledger accounts to show the receipt of cash from
D Pendable and the bad debts entry: Accounts Receivable – D Pendable, Bad Debts
and Allowance for Doubtful Debts.
c State three tactics management may choose to adopt when an accounts receivable
is overdue with a payment.

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 SPREADSHEET X.XX6 Accounts receivable written off WB PAGE 253

The following information relates to S Case, a credit customer of Perfect Props.

12 July 2022 Credit sale of $380, plus GST of $38
14 August 2022 Credit sale of $820, plus GST of $82
31 December 2022 An allowance for doubtful debts of $200 was created
17 April 2023 Cash receipt of $100
31 December 2023 Legal advice received to the effect that S Case has been
declared bankrupt. All debts are to be paid 20 cents in
the dollar. A payment was received for 20% of Case’s
balance. The remainder of the account is to be written
off as a bad debt (Memo 34).
a Prepare the Accounts Receivable – S Case account as it would appear in the general
ledger of Perfect Props. The account should include all relevant entries from 12 July
2022 to 31 December 2023.
b In light of the above information concerning the S Case account, comment on the
accuracy of the income statement that was prepared for Domestic Appliances for
the year ended 31 December 2022.

SPREADSHEET X.XX
7 Adjusting the allowance for doubtful debt WB PAGE 254

The following transactions occurred between Encore Music Store and one of its credit
customers, N Kelly. The business has allowed for future bad debts by establishing an
allowance for doubtful debts of $2500 on 30 June 2022.

2022
Jul 3 Credit sale of musical instruments $4200, plus GST of $420 (cost
price $2150)
9 Credit sale of musical equipment $2700, plus GST of $270 (cost price
$1230)
15 Kelly made a payment on his account of $500
31 Legal advice was received from Kelly’s solicitor advising Encore Music
that its client has been declared bankrupt. All creditors of Kelly are
to be paid 35 cents in the dollar. Memo 97 was completed to record
all such details.

a Using the general journal, prepare the entry required to write off Kelly as a bad debt
on 31 July 2022.
b Given that the Allowance for Doubtful Debts account has a balance of $3500 on
30 June 2022, show how the account would look after Kelly’s account was
written off.
c No other bad debts were experienced by the business in the year ended 30
June 2023. The business had net credit sales of $250 000 in this period, and
management has decided to adjust the allowance for doubtful debts to equal 2.5%
of net credit sales. Prepare the adjusting entry required on 30 June 2023.
d The accountant has stated that an allowance for doubtful debts should be
maintained in order to comply with the demands of faithful representation. Do you
agree? Explain your answer fully.

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8 Adjusting the allowance for doubtful debt WB PAGE 255 SPREADSHEET X.XX

Montrose Exports has an accounts receivable on its books who has recently
disappeared without trace. Memo 37 relates to this customer (named Scott Nodo) and
gives the amount owing as $660. Montrose Exports currently has an allowance for
doubtful debts of $500 in the general ledger, but has decided to increase it to $700 on
30 June 2023.
a Using the general journal, prepare the entry required on 30 June 2023 to write off
the amount owing by Scott Nodo as a bad debt.
b Prepare the Allowance for Doubtful Debts account, including the entry to write off
Nodo and the adjusting entry to increase the allowance to $700.
c Prepare the following general ledger accounts: Accounts Receivable – S Nodo and
Bad Debts.

9 Bad and doubtful debts WB PAGE 256 SPREADSHEET X.XX

Geelong Scooterworld has just completed its first year of trading on 31 December
2022. During the year the firm earned credit sales of $102 000, with $19 200 remaining
unpaid on 31 December. It was decided to create an allowance for doubtful debts equal
to 2% of credit sales.
On 30 November 2023 a credit customer, Kaput Ltd, was written off as a bad debt. This
account had a balance of $550 at the time. No other accounts receivable were written
off during the year.
During 2023 the business had credit sales of $120 000, and an allowance for doubtful
debts of 1.5% of credit sales was required at the end of the period.
a Prepare the adjusting entry to create the allowance for doubtful debts on
31 December 2022 and the relevant closing entry on that date.
b Prepare a balance sheet extract to show how accounts receivable would be
reported at 31 December 2022.
c Prepare the Allowance for Doubtful Debts account, including entries for:
i the creation of the allowance on iii the adjustment to the allowance
31 December 2022 for doubtful debts on 31
ii the writing off of the bad debt on December 2023
30 November 2023
d Comment briefly on the accuracy of the allowance for doubtful debts created on
31 December 2022.

10 Bad and doubtful debts WB PAGE 257 SPREADSHEET X.XX

The following information relates to the business of OK Go-Pro. The balance of the
Accounts Receivable account at 31 December 2022 was $25 000, and the balance
of the Allowance for Doubtful Debts account was $1200. During the year ended
31 December 2023 the following events are noted.
•• Credit sales for the year amount to $110 000.
•• Accounts receivable is expected to be about $18 000.
•• Bad debts to be written off total $1320.
•• The allowance for doubtful debts is to be 1% of credit sales.
a Prepare the Allowance for Doubtful Debts account as it would appear in the general
ledger from 31 December 2022 to 31 December 2023.
b Prepare all relevant general journal entries in relation to bad debts and the allowance
for doubtful debts during 2023.
c Explain how accounting for an allowance for doubtful debts complies with the
demands of the qualitative characteristic of relevance.

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 SPREADSHEET X.XX11 Bad and doubtful debts WB PAGE 258

The management of All Things Analog has provided the following information.

BALANCE SHEET (EXTRACT) AS AT 30 JUNE 2022

Current assets $ $
Accounts receivable 18 500
Less: Allowance for doubtful debts 925 17 575

a On 8 March 2023 a credit customer, F Chislett, was declared bankrupt. Prepare the
general journal to write off the account balance of $440.
b On 18 June 2023, legal advice was received in relation to the account of Larry
Lightfingers, who owed the business $1210. A cheque for $484 was enclosed
as final payment, as only 40 cents in the dollar was going to be paid. Prepare the
general journal entry to write off the account.
c Management has decided to increase the allowance for doubtful debts to 1% of
credit sales for the year ended 30 June 2023. Total credit sales amounted to
$164 000, with sales returns made by accounts receivable being $2000 for the year.
Prepare the adjusting entry required for this to take effect.
d The business received notification that on 17 August 2023 accounts receivable –
S Banks has been declared bankrupt. The account, which had a balance of $660, is
to be written off. Prepare the appropriate journal entry.
e Prepare a general journal entry to write off the account of B Nevan on 15 December
2023. The account had a balance of $1650, and a payment of 30 cents in the dollar
was received from Nevan’s solicitor.
f On 30 June 2024 it was decided to have an allowance for doubtful debts of $1750.
Prepare the adjusting entry required on this date.
g Prepare the Allowance for Doubtful Debts account as it would appear in the general
ledger of All Things Analog for the period 30 June 2022 to 30 June 2024.
h State the amount that would be reported as bad debts expense for each of the
years ended 30 June 2023 and 2024.
i The owner of the business is concerned that that the allowance for doubtful debts
cannot satisfy verifiability, and perhaps he shouldn’t be including it in his balance
sheet. Do you agree? Discuss.

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 ETHICAL CONSIDERATIONS WB PAGE 261

Lee King is the owner of LK Tools, a trading business that provides tools and equipment to
carpenters, plumbers and electricians. King provides credit to many of his customers, as
most of his competitors also do the same and he doesn’t want to miss out on sales.
Unfortunately, some of his biggest customers owe him a lot of money. He has
employed a debt collection agency in the past, with mixed results. They have been
successful in some cases, and King has paid them a fee of 2.5% of the debts collected.
Other cases have been unsuccessful, and several accounts receivable have been written
off as bad debts over the last few years.
Last weekend King was at a social event, discussing this issue with a few friends. One
friend, who runs a panel-beating business, said that he has no problem collecting money
from slow payers. The local motorcycle club runs a debt collection service that, according
to King’s friend, has a 100% success rate. The only issue is that their fee is 50% of the
amount owing.

As LK Tools currently has overdue debts totalling $120 000, these comments have
made King give some serious thought to using alternative methods of debt collection.
a Suggest three strategies that King could use to try to collect his outstanding debts
before referring the matter to a debt collection agency.
b 
Calculate the collection fees payable to the debt collection agency and the motorcycle
club, given that $120 000 is currently owed by accounts receivable.
c Consider the alternatives available to King, and take into account the social, ethical
and financial considerations of your decision. What would you do if you were in King’s
position? Explain your answer fully.

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 CHAPTER CHECKLIST
Now that you have finished Chapter 14, double-check your progress.
Are you ready for your Unit 4 exam?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
completed all end-of-chapter activities
handed in my workbook for marking.

I understand …

the creation of an allowance for doubtful debts using the Income Statement approach
the writing off of bad debts using the allowance method in the subsequent period
characteristics and use of classified accounting reports:
– Income Statement
– Balance Sheet.

I can …

use correct accounting terminology

identify and record financial data and report accounting information
manually record transactions in the General Journal and General Ledger and prepare accounting
reports
use ICT, including spreadsheets, to record transactions, prepare accounting reports and construct
graphical representations.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_14

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

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15 STRAIGHT-LINE DEPRECIATION

Every trading business uses non- LEARNING OBJECTIVES

current assets (e.g. vehicles or
furniture) that are under its control By the end of this chapter, you will be able to:
for more than 12 months. These •• define ‘depreciation’ [15.1]
assets become less effective or
•• explain how depreciation complies with the period and
useful over time.
accrual accounting assumptions [15.1]
In this chapter you will learn
•• explain the meaning of the term ‘cost’ as it applies to
about depreciation and how it is
non-current assets [15.1]
calculated and applied. You will
also prepare journal entries to •• calculate depreciation expense under the straight-line
record depreciation of non-current method [15.2]
assets. •• prepare a general journal entry to record the balance
day adjustment for depreciation [15.3]
•• prepare a general journal entry to close Depreciation
expense accounts to the Profit and Loss Summary
account [15.3]
•• explain the function of the Depreciation account and
the Accumulated Depreciation account [15.3]
•• describe the effect that depreciation has on an income
statement and a balance sheet [15.4].

UNIT 4 – PROGRESS 14 15 16 17 18 19 20 21 22 23

15.2 15.4

The straight-
Depreciation and
line method of
15.1 15.3 the balance sheet
depreciation

The meaning of The adjusting entry Chapter review

depreciation for depreciation and exercises

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 15.1 THE MEANING OF DEPRECIATION
An asset’s effectiveness gradually diminishes. At the end of its useful working life
it may be scrapped, sold or traded in on a newer model. Because an asset suffers
wear and tear from being used, and may have become obsolete by the time it’s
disposed of, it’s unlikely to return its original purchase price to the owner.
depreciation Depreciation is the allocation of the cost of a non-current asset over its effective
allocation of the cost working life. Non-current assets are those assets expected to be under the control of
of a non-current asset
over its life a business for more than 12 months for the purpose of earning revenue. Depreciation
spreads the cost of an asset over the period of time it’s used to generate revenue.
The purpose of depreciation is to allocate as an expense the difference between
the original cost of the asset and the amount it’s likely to achieve at the end of its
effective working life. This process may take several years, since only a portion of the
cost is allocated during each year of the asset’s life.
In compliance with the period assumption, the life of a business is divided into
time periods. Revenue earned for a period is matched against the expenses incurred
in that same period, so that an accurate profit can be determined. Non-current assets
are used to generate revenue, but they also create some expenses for a business
(e.g. repairs, registration and insurance). In order to determine an accurate profit
figure for any given period, all relevant expenses should be included.
depreciation Depreciation expense is created to account for a portion of the cost of an asset
expense
the amount of
in each reporting period. In this way, the revenue earned by an asset is considered in
depreciation written the same period as depreciation expense is recognised. This ensures that the profit
off as an expense for recognised under accrual accounting is reasonably accurate.
one particular period

Depreciation
involves
allocating the
cost of an asset,
such as a vehicle,
over multiple
periods.

THE COST OF AN ASSET

There are two elements to identify when measuring the cost of a non-current asset:
•• the purchase price of the asset
•• all other costs incurred to get the asset into a revenue-earning capacity.
Faithful representation requires that the information presented in relation to a non-
current asset is complete and without bias. Relevance requires that all information
that can affect managers’ decision making be reported.

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 The purchase price of a non-current asset can usually be verified by documentary
evidence such as an invoice, an EFT transaction or a written contract. However,
the other costs relating to the purchase of an asset aren’t always easy to identify.
Sometimes a business has to pay for one-off expenses, such as the delivery or
installation of an asset, before it’s ready to earn revenue. In this case, the delivery and
installation costs become part of the actual asset and the total amount is considered
for depreciation.
The following examples illustrate this situation.

EXAMPLE 15.1

A business buys a new vehicle for $20 000 cash and pays the items listed in the
table below.

Government stamp duty $1000

Dealer’s charges $500
Insurance and registration $800 per annum

The cost of the vehicle consists of the purchase price of $20 000, plus the stamp duty
of $1000 and the dealer’s charge of $500: a total of $21 500.
All of these items become part of the cost of the vehicle because they must be paid in
order to get the vehicle in a position to earn revenue. Once these items have been paid,
they don’t occur again – proof that they are related to the actual purchase of the asset.
However, the insurance and registration cost is a different matter. This amount isn’t
included in the cost of the vehicle, because it isn’t paid to get the asset into a revenue-
earning capacity. Furthermore, it’s payable every year if the business owner chooses to
renew the insurance policy and registration. Therefore, it’s seen as a separate expense
item.

EXAMPLE 15.2

A business buys a new computer for $10 000 and pays for the items listed in the
table below.
Installation $2000
Service contract $200 per annum

In this example the cost of the computer is $12 000. The installation cost must be paid
in order to get the asset into a revenue-earning capacity, so it becomes part of the cost
of the asset.
The service contract doesn’t have to be paid before the asset is usable. It’s payable
each year, and it’s the choice of management as to whether or not it should be
continued.

15.1 CHECK YOUR UNDERSTANDING WB PAGE 263

1 What is depreciation?
2 Explain how depreciation is part of accrual accounting and complies with the
period assumption.
3 Depreciation is based on the cost of an asset. Outline the items that should be
included in this definition of ‘cost’.

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 THE STRAIGHT-LINE METHOD OF
15.2 DEPRECIATION
There are several different ways of calculating depreciation but the VCE course only
requires you to have a knowledge of two methods. The first of these is known as the
straight-line depreciation method, which is the simplest. The second is the reducing
balance method, which you’ll learn about in chapter 16.
straight-line The straight-line method of depreciation allocates the same amount of an asset’s
method
cost each period. It’s also called the fixed instalment method because the amount of
a method of
depreciation that depreciation is fixed, regardless of whether the asset is in its first or final year of use.
allocates the Consider the details in the table below, which relate to a vehicle bought by
same amount of
depreciation every Faulkner’s Fine Foods on 1 July 2023.
reporting period,
regardless of the age Purchase price of van $32 000
of the asset Estimated useful life 4 years
Estimated residual (scrap) value $12 800
The formula to calculate depreciation under the straight-line method is:

Depreciation per annum = Cost – Residual value

Useful life

In the example of Faulkner’s Fine Foods, the equation becomes:

Depreciation per annum = ($32 000 – $12 800)

4
= $19 200
4
= $4800

This calculation indicates that $4800 of the cost of the vehicle will be written off as
depreciation in each of the four years the van is used in the business. Over the four
years a total of $19 200 will be written off, leaving only the expected ‘scrap value’ of
$12 800 (i.e. $32 000 – $19 200 = $12 800).
The depreciation expense can also be expressed as a percentage rate per annum.
In this case, the depreciation rate is calculated as follows:

Depreciation per annum = $4800 = 0.15 or 15%

Cost of the asset $32 000

This percentage rate indicates that 15% of the cost of the asset will be written off
each year throughout its expected life.

15.2 CHECK YOUR UNDERSTANDING WB PAGE 264

1 What does the term ‘scrap value’ mean? Why is it important when calculating
depreciation of an asset?
2 Explain what is meant by the straight-line method of depreciation.
3 A business bought an asset for $10 000 on 1 July 2023 and it is to be depreciated
by 15% on cost per annum. If the accounting period ends on 31 December, how
much depreciation should be written off for the 6 months ended 31 December 2023?
Justify your answer fully.

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15.3 THE ADJUSTING ENTRY FOR
DEPRECIATION
Depreciation is usually allocated on the last day of each period, and is therefore
called a balance day adjustment. (Balance day adjustments are covered in detail in
Chapter 18.) Each period, an adjusting entry is required to introduce the amount of
depreciation to be written off.
Looking back to Faulkner’s Fine Foods, the vehicle was purchased on 1 July 2022.
If the reporting period ends on 30 June each year, the first adjusting entry to record
the depreciation of the van is shown in Figure 15.1.

FIGURE 15.1 General journal entry to record depreciation

GENERAL JOURNAL
Date Details Dr Cr
30 Jun Depreciation of vehicle 4 800

Accumulated depreciation of vehicle 4 800

Adjustment for depreciation of vehicle at 15%

p.a. straight-line method (Memo 56)

The debit entry to the Depreciation of Vehicle account is required because depreciation is an
expense item. Therefore, the above entry increases the expense account for depreciation.
The credit entry to Accumulated Depreciation of Vehicle is an increase in a negative
asset account. As its name suggests, the accumulated depreciation account is used
accumulated
to accumulate or add up the total depreciation written off an asset so far. It’s known
depreciation
as a negative asset account, because it’s deducted from the related asset account (i.e. the total amount of
Vehicle) in the balance sheet. depreciation that
has been written off
When posted to the general ledger accounts, this journal entry results in the entries from the date the
shown below. asset came under the
control of the business
Depreciation of vehicle until the present time
2023 $ $
30 Jun Accumulated dep’n of 4 800
vehicle

Accumulated depreciation of vehicle

$ 2023 $
30 Jun Depreciation of 4 800
vehicle

As the Depreciation of Vehicle account is an expense, it’s closed off to the Profit and
Loss Summary account on balance day along with all other expenses.
Using this data, the related closing entry would be recorded in the general journal
as shown in Figure 15.2.

FIGURE 15.2 General journal entry to close a depreciation account

GENERAL JOURNAL
Date Details Dr Cr
30 Jun P&L summary 4 800
Depreciation of vehicle 4 800
Closing entry

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 When the closing entry is posted to the general ledger, the accounts appear as
follows.
Depreciation of vehicle
2023 $ 2023 $
30 Jun Accumulated dep’n of 4 800 30 Jun P&L summary 4 800
vehicle

Accumulated depreciation of vehicle

$ 2023 $
30 Jun Depreciation of 4 800
vehicle

Note that the Depreciation and Accumulated Depreciation accounts are totally
different in nature. As the Depreciation account is an expense account, it’s closed
off at the end of each period and returned to a zero balance on balance day. The
Accumulated Depreciation account, being a negative asset account, is balanced each
period, with the balance carried forward to the following period.
Continuing with this, the accounts have been redrafted to illustrate the ledger
entries after two periods have passed.

Depreciation of vehicle
2023 $ 2023 $
30 Jun Accum. dep’n vehicle 4 800 30 Jun P&L summary 4 800
2024 2024
30 Jun Accum. dep’n vehicle 4 800 30 Jun P&L summary 4 800

Accumulated depreciation of vehicle

$ 2023 $
30 Jun Depreciation of 4 800
vehicle
2024 2024
30 Jun Balance 9 600 30 Jun Depreciation of 4 800
vehicle
9 600 9 600
1 Jul Balance 9 600

EXCEPTIONS TO THE DEPRECIATION RULE

Under the straight-line method, the amount recorded as depreciation is the same
each period. The depreciation expense is closed off to the Profit and Loss Summary
account each year. The Accumulated Depreciation account simply adds on the period’s
depreciation to that amount already depreciated in previous reporting periods.
However, there are two circumstances where the amount of depreciation entered on
balance day may vary.
The first exception is when the reporting period is less than a year. For example, a
business owner may report monthly or quarterly. As straight-line depreciation is based
on the actual time expired, it’s a matter of simply dividing the annual depreciation
expense into smaller periods.

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 For Faulkner’s Fine Foods, the vehicle was being depreciated at the rate of $4800
per year. If the reporting period was half a year, the depreciation to be allocated
should be half of this amount, so $2400 would be allocated. If the business reported
quarterly, only $1200 would be allocated each quarter ($4800/4); for monthly
reporting, it would be $400 ($4800/12).
DON’T!
The second complication may be that a business purchases an asset during the Do not automatically
reporting period, rather than right at the start of the period. Once again, it’s simply allocate 12 months
a case of working out how long the asset has been under the control of the depreciation every time.
Always check when the
entity, and how much depreciation is relevant to that time period. business purchased the
In the case of the Faulkner’s Fine Foods’ van, it was purchased on 1 July asset and when the
and balance day was 30 June, so a full year’s depreciation was allocated. reporting period ends.
However, if the vehicle was purchased on 1 April, only three months would have
expired by balance day. Thus, depreciation would only be for three months, or a
quarter of the full year’s amount.
Therefore, when calculating depreciation, always check two details:
•• the length of the reporting period
•• how long the asset has actually been under the control of the entity.
Determine the annual depreciation expense, then adjust this amount for either of
these two circumstances if necessary.

Check how long

an asset has been
under the control
of the entity
before calculating
depreciation.

15.3 CHECK YOUR UNDERSTANDING WB PAGE 264

1 Describe the double entry necessary to record the balance day adjustment for
depreciation of a computer of $2000.
2 Explain the closing entry that would result from the adjusting entry in Question 1.
3 Describe the nature and function of the following general ledger accounts.
a Depreciation of Equipment
b Accumulated Depreciation of Equipment

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 15.4 DEPRECIATION AND THE BALANCE
SHEET
Depreciation has a two-fold effect on the balance sheet of a business:
•• As depreciation is an expense item, it decreases profit and therefore reduces the
owner’s equity at the end of the period.
•• It reduces the amount shown for the asset in the balance sheet on balance day.
Figure 15.3 demonstrates the presentation of the details relating to the vehicle owned
by Faulkner’s Fine Foods.

FIGURE 15.3 Balance sheet (extract) as at 30 June 2023

Non-current assets
Vehicle $32 000
Less: Accumulated 4 800
depreciation
27 200

The three dollar values shown in Figure 15.3 represent the following details:
•• The $32 000 is the purchase price of the asset, plus any other costs incurred in
getting the asset into a revenue-earning capacity, such as stamp duty and dealer’s
delivery charges. Therefore, the total of $32 000 faithfully represents the cost of
the vehicle to the entity. This figure is always shown in the balance sheet as long
as the asset is under the control of the business.
•• The $4800 shown as accumulated depreciation is the total amount of depreciation
allocated from the day the asset was first purchased up until the date of the report.
This figure increases each reporting period. Another term used to describe this
expired cost figure is the expired cost of the asset.
the value of a non-
current asset that has •• The $27 200 is made up of two components: the value of the asset yet to be
already been written off depreciated and the estimated residual value of the asset. Popular terms used to
as depreciation
describe this amount are ‘book value’ or ‘carrying value’; carrying value is preferred,
carrying value as it indicates the cost of the asset still being carried by the business, as distinct
the value of a non-
current asset yet from the asset’s original cost. It may also be referred to as the written-down value or
to be depreciated unexpired cost of the asset. As more depreciation is written off over the years, the
(calculated by
deducting accumulated
accumulated depreciation of an asset increases and its carrying value decreases.
depreciation from an Over the useful life of the asset, Faulkner’s vehicle would be reported in the balance
asset’s historical cost)
sheets as follows:
BALANCE SHEETS (EXTRACTS) AS AT 30 JUNE
2023 2024 2025 2026
Non-current assets $ $ $ $
Vehicle 32 000 32 000 32 000 32 000
Less: Accumulated depreciation 4 800 9 600 14 400 19 200
27 200 22 400 17 600 12 800

Note that the original cost of the vehicle is reported in each balance sheet throughout
the asset’s life. Rather than adjust the cost price of the asset, the accumulated
depreciation increases by the amount of depreciation charged each year ($4800). This
causes a corresponding decrease in the carrying value of the asset as each year passes.

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DEPRECIATION AND THE INCOME STATEMENT
As depreciation is an expense item, it’s closed off to the Profit and Loss Summary
account in the general ledger. It’s also reported in the income statement when final
reports are being prepared. As depreciation is an expense, it’s clearly a relevant item
in relation to the demand for an accurate profit being determined for the period.
However, there is also the demand for all information to be verifiable – information
should be supported by evidence. This creates the possibility of a conflict between
residual value
these two qualitative characteristics. As depreciation is based on two estimates (an the amount an asset is
estimate is made for both residual value and useful life), the amount written off expected to realise at the
each year may be questionable, as it cannot be verified by documentary evidence. end of its useful life when
it is sold, traded in or
However, this is usually considered acceptable, because it’s outweighed by the scrapped
demand that all relevant expenses be included in the income statement. useful life
While it’s often difficult to predict future residual values after years of use, it’s the period of time that a
better to have an estimated amount written off as depreciation, rather than not include business expects to use
a non-current asset for
depreciation in the income statement at all. The demands of relevance outweigh the the purpose of earning
concern of not being able to satisfy verifiability. revenue

An asset will
have residual
NO PIC
value when it is
sold, traded in or
scrapped.

EXAM SUCCESS
Always remember,
depreciation is based
on estimates, so it can
never satisfy verifiability.
However, it is highly
relevant to the income
statement as it helps
determine an
accurate profit.

15.4 CHECK YOUR UNDERSTANDING WB PAGE 265

1 Explain what the ‘carrying value’ of an asset is.

2 Describe the two-fold effect that depreciation has on the accounting reports of a
business.
3 The information below was extracted from a balance sheet.
Vehicle $45 000
Less: Accumulated depreciation $14 000 $31 000

Explain what each of the following dollar values represents in the above extract.
a $45 000
b $14 000
c $31 000
4 Explain how the allocation of depreciation causes a conflict between the demands of
two qualitative characteristics of accounting – relevance and verifiability.

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 15 CHAPTER REVIEW

KEY CONTENT
•• [15.1] Depreciation is the allocation of the cost of a non-current asset over its effective
working life. The cost is spread over the period of time the asset is used to generate
revenue.
•• [15.1] Depreciation follows the period assumption, as the life of a business is divided into
periods of time, and the asset’s value is spread across those periods. It also follows the
accrual accounting assumption, in that the depreciation incurred for a period is matched
against the revenue earned in that same period.
•• [15.1] The cost measured for a non-current asset includes both the asset’s purchase price
and all other costs incurred in getting the asset into a revenue earning position.
•• [15.2] The straight-line method of depreciation allocates the same amount of an asset’s
cost each period. It is also called the fixed instalment method because the amount of
depreciation is fixed, regardless of whether the asset is in its first or final year of use.
•• [15.3] Depreciation is recorded in the Depreciation account as an expense. It’s closed off to
the Profit and Loss Summary account on balance day.
•• [15.3] The Accumulated Depreciation account is used to accumulate or add up the total
depreciation written off an asset so far. As a negative asset account, it’s balanced each
period, with the balance carried forward to the following period.
•• [15.4] As depreciation is an expense item, it decreases profit and owner’s equity at the end
of the period. The effect on balance day is to reduce the amount shown for the asset
in the balance sheet. The expense is also reported in the income statement when final
reports are prepared.

CHAPTER 15 EXERCISES

SPREADSHEET X.XX1 Calculating depreciation WB PAGE 266

Ben Wilson is the owner of Wilson’s Wheels, a small business that specialises in tyres
and alloy wheels. On 1 July 2023 he purchases a photocopier for his business office at
a cost of $15 000. The manufacturer also charges Wilson $1000 for installing and setting
up the machine. The accounting period for Wilson’s Wheels ends on 31 December each
year. Wilson estimates that the photocopier will have a useful life of about three years,
after which he expects to sell it for approximately $4000.
a Calculate the depreciation expense to be charged per annum under the straight-line
method of depreciation.
b How much depreciation expense would be written off for the years ended
31 December 2023, 2024 and 2025?
c Prepare balance sheet extracts to show how the photocopier would be reported as
at 31 December 2023, 2024 and 2025.

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2 Determining the cost of a non-current asset WB PAGE 267 SPREADSHEET X.XX

Collingwood Cactus World purchases a new computer system on 1 April 2023. The
following information relates to this computer:
Purchase price $4920
Maintenance contract $120 per annum
Insurance $50 per annum
Installation $80

The owner estimates that she will use the computer in the business for three years
and then sell it for about $1100.
a Calculate the total cost of the asset that should be considered for depreciation.
b In your answer to part a, did you exclude any items from the list of payments stated
above? If so, explain how you would treat these items in the accounting reports of
the business.
c Using the straight-line method of depreciation, calculate the depreciation expense
per annum.
d Express the depreciation per annum as a percentage of the cost of the asset.
e Prepare the adjusting entry for depreciation in the general journal on 31 March 2024.

3 Journal entries for depreciation WB PAGE 268 SPREADSHEET X.XX

Footscray Fireplaces purchases a new delivery van on 1 June 2023 for $19 000.
Dealer’s charges and stamp duty totalling $2000 are also paid, along with registration
and insurance of $900 for 12 months’ cover. The estimated useful life of the van is four
years and its estimated residual value is $6600.
a Calculate the annual depreciation expense to be written off under the straight-line
method.
b Prepare the general journal entry to record the depreciation expense on the balance
days of 30 June 2023 and 30 June 2024.
c Prepare the closing entries relevant to depreciation on 30 June 2023 and 2024.
d Post the entries prepared in parts b and c to the relevant general ledger accounts.
e Prepare an extract of the balance sheet to show the reporting of the delivery van as
at 30 June 2023 and 2024.

4 Journal entries for depreciation WB PAGE 270 SPREADSHEET X.XX

Rex Payne is the proprietor of Terrarium Rex, a store selling terrariums and associated
gear. On 1 July 2023 he purchases new shop fittings for $12 000 cash. He decides to
depreciate the fittings at 20% per annum, using the straight-line method. The books of
the business are closed on 31 December each year.
a Prepare the necessary adjusting and closing entries for depreciation of the shop
fittings for the years ended 31 December 2023, 2024 and 2025.
b Prepare the following general ledger accounts for the period 1 July 2023 to
31 December 2025.
i Shop Fittings
ii Depreciation of Shop Fittings
iii Accumulated Depreciation of Shop Fittings
c Show how the shop fittings would be shown in the balance sheet as at
31 December 2023, 2024 and 2025.
d Explain how depreciation ties in with the demands of the qualitative characteristic
of relevance.

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 SPREADSHEET X.XX5 Ledger accounts for depreciation WB PAGE 274

Louise Kurkowski is the proprietor of LK’s Pinball Tables. On 1 November 2023 she
purchases $6520 of new office equipment. The equipment has an expected useful life
of four years, after which it will be sold. The anticipated residual value is $2200. The
business closes its books on 30 June each year.
a Using the straight-line method of depreciation, calculate the annual depreciation
expense.
b What is the expense for depreciation of office equipment for the year ended
30 June 2024?
c Prepare the following general ledger accounts for the period 1 November 2023 to
30 June 2025.
i Office Equipment
ii Depreciation of Office Equipment
iii Accumulated Depreciation of Office Equipment
d Show how the asset office equipment would be reported in the business’s balance
sheet on 30 June 2024, 2025 and 2026.

SPREADSHEET X.XX6 Depreciations and reports WB PAGE 276

Bellarine Bedding purchases a new delivery van on 1 April 2023 for $18 600. To improve
the van’s handling on dirt roads, an improved suspension system is installed as a
permanent fixture in the vehicle. The suspension system and its installation cost a total
of $2400. The business uses the straight-line method to depreciate its assets. It plans
to use the van for three years and then trade it in on a newer model. The anticipated
trade-in allowance is expected to be approximately $6000.
a Explain, and justify, how you would treat the cost of $2400 for the suspension system.
b Calculate the annual depreciation expense of the delivery van.
c In relation to the van, how much depreciation expense should appear in the income
statement for the year ended 30 June 2023?
d Prepare the required adjusting and closing entries for the depreciation of the van for
the years ended 30 June 2023, 2024 and 2025.
e Prepare extracts of the business’s balance sheet to show how the delivery van
would be reported as at 30 June 2023, 2024 and 2025.

SPREADSHEET X.XX7 Interpreting depreciation entries WB PAGE 277

Tom Smyth is the owner of Gippsland Salami Merchants. He uses the straight-line
method of depreciation and has provided the following accounts from his general ledger:

Vehicle
$
1/3/23 Cash at bank 42 000

Depreciation of vehicle
$ $
30/6/23 Accum. dep’n vehicle 2 240 30/6/23 P&L summary 2 240

Accumulated depreciation of vehicle

$ $
30/6/23 Dep’n of vehicle 2 240

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 a What is the annual depreciation expense being allocated from the cost of this
vehicle?
b What percentage of the asset’s cost is being written off per annum?
c What will be the balance of accumulated depreciation on 30 June 2025?
d Prepare balance sheet extracts to show how the vehicle would be reported as at
30 June 2024, 2025 and 2026.
e Smyth plans on using the vehicle in his business for four years. What was his
original estimate of the vehicle’s scrap value?

WB PAGE 278
8 Interpreting depreciation entries
The following information is extracted from the books of Fanboy Frenzy Collectables.

GENERAL LEDGER
Shop fittings
$
1/7/23 Cash at bank 16 000

Depreciation of shop fittings

$ $
31/12/22 Accum. dep’n of shop 1 400 31/12/22 P&L summary 1 400
fittings
31/12/23 Accum. dep’n of shop 2 800 31/12/23 P&L summary 2 800
fittings

Accumulated depreciation of shop fittings

$ $
31/12/22 Dep’n of shop fittings 1 400
31/12/23 Balance 4 200 31/12/23 Dep’n of shop fittings 2 800
4 200 4 200

a What is the historical cost of the shop fittings owned by Fanboy Frenzy?
b What is the annual depreciation expense in relation to the business’s shop fittings?
c What percentage of the asset’s cost is written off per annum?
d What will be the carrying value of the shop fittings on 31 December 2025?
e If the estimated residual value of the shop fittings is $2000, what is the estimated
useful life of the asset?
f On what date does the business plan on disposing of the asset?
g Consider the following: ‘Depreciation is based on estimates. It is therefore
unreliable, and should not be included in an income statement.’ Do you agree
with this statement? Your answer should consider the demands of relevance and
verifiability, and refer to financial data provided for Fanboy Frenzy.

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 SPREADSHEET X.XX
CASE STUDY WB PAGE 280

Bernadette Kirkwood is the owner of Hightail Hammocks, a retail business that specialises
in hammocks and outdoor furniture. As the business grew over the years, Kirkwood
discovered that free delivery was one way of attracting additional customers. She now
delivers most of the goods sold by her business, but new vehicles had to be purchased to
keep up with demand.
The following information has been provided in relation to the delivery vehicles. Note: it’s
the business’s policy to keep all its vehicles for three years before selling them or trading
them in for new vehicles.
•• Vehicle 1: Purchased on 1 January 2021 for $28 000, plus modifications that cost
$1000. The vehicle is insured at a cost of $500, and registration costs $450 each year.
Estimated residual value is $9800.
•• Vehicle 2: Bought as a new vehicle for $32 000 on 28 February 2022. Dealer’s delivery
fee was $1100. Insurance of $600 and registration of $450 were also paid on 28
February. Predicted scrap value is $11 400.
•• Vehicle 3: Cost of the new vehicle on 1 September 2023 was $36 400, including 12
months’ insurance of $600 and registration of $480. Dealer’s delivery fee of $1200
was paid in cash. A GPS tracking and security system was installed in this vehicle as a
permanent fixture on 1 September 2023 at a cost of $1460. Expected residual value in
three years’ time is $19 200.
•• Vehicle 4: This vehicle was bought as a second-hand model for $16 000 on 31 January
2024. Registration was arranged at an annual cost of $480. The vehicle hasn’t been
insured. Estimated residual value when useful life has expired is about $8400.

1 Calculate the amount of depreciation expense that would be shown in the income
statements for the years ended 30 June 2023, 2024 and 2025 (show all workings).
2 Prepare extracts from the balance sheets as at 30 June 2023, 2024 and 2025, to show
how the asset vehicles would be reported in each of these three years.
3 Explain the link (if any) that exists between the qualitative characteristic of verifiability
and your calculations for depreciation of vehicles.
4 Consider the following statement: ‘Depreciation is based on estimates of residual
value, not on the cost of an asset.’ Do you agree with this statement? Give reasons to
justify your answer.

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 ETHICAL CONSIDERATIONS WB PAGE 282

Darryl Cruse is the owner of a landscaping business. He has six vehicles on the road on a
regular basis, driving to various jobs around Melbourne. He drives one of the vehicles, with
the other five being driven by his employees. As his employees start work at 7 a.m. each
day, Cruse lets them use the business vehicles to drive home at the end of the day. This
allows his workers to get to jobs quickly each morning, rather than having to report to the
head office first.
However, in recent weeks Cruse has noticed a significant increase in his petrol
expenses. He suspects that some of his employees are using the business vehicles after
hours for personal use. He also noticed a couple of his vehicles parked at a local
take-away restaurant at 2 p.m. on Friday afternoon.
Acting on his suspicions of inappropriate use of his vehicles, Cruse has asked for
quotes to install GPS tracking devices in all his vehicles. This will allow him to determine
when the vehicles are being used and where they have been. He will be able to do so 24
hours a day, thus keeping a watchful eye on his employees.
A simpler solution might be to instruct all five workers to return the vehicles to head
office every day once their jobs are completed. This may save some petrol, but it could
cost valuable time, which is a concern.

What would you do if you were asked to provide advice to Cruse? Discuss fully, with
reference to the following ethical issues:
•• Should Cruse install GPS tracking in his vehicles?
•• Would this represent an invasion of the privacy of his employees?
•• S
 hould he inform his employees, or simply go ahead with the installation? After all, the
vehicles are owned by his business.
•• What other alternatives may be appropriate in this situation?

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 CHAPTER CHECKLIST
Now that you have finished Chapter 15, double-check your progress.
Are you ready for your Unit 4 exam?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
completed the end-of-chapter activities
handed in my workbook for marking.

I understand …

accounting assumptions and qualitative characteristics as applicable

methods of depreciation: straight-line
ethical considerations in relation to business decision-making and the recording and reporting of
financial information.

I can …

explain and apply relevant qualitative characteristics and accounting assumptions

apply theoretical knowledge to simulated situations.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_15

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

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16 THE REDUCING BALANCE
METHOD OF DEPRECIATION

In Chapter 15 you learnt about the LEARNING OBJECTIVES

concept of depreciation, and how
to use the straight-line method By the end of this chapter, you will be able to:
to allocate an asset’s cost over •• describe the reducing balance method of depreciation
time. But some assets earn more [16.1]
revenue in their early years. For
•• explain why the reducing balance method of
these assets the reducing balance
depreciation may be used for some assets [16.1]
method of depreciation is more
•• compare the straight-line and reducing balance
suitable than the straight-line
methods [16.2]
method.
In this chapter you will learn •• prepare a graph showing the differences between the
about the reducing balance two methods [16.2]
method and how it’s calculated •• explain the effect that a change in depreciation method
and applied. may have on accounting reports [16.2]
•• justify depreciation methods for a variety of assets
[16.3]
•• explain the role played by accounting assumptions and
the qualitative characteristics of accounting in relation
to changing depreciation methods [16.3].

UNIT 4 – PROGRESS 14 15 16 17 18 19 20 21 22 23

16.2

Comparing
depreciation Chapter review
16.1 methods 16.3 and exercises

The reducing Choosing a

balance method of depreciation
depreciation method

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 16.1 THE REDUCING BALANCE METHOD OF
DEPRECIATION
Depreciation is the allocation of a cost of a non-current asset over its useful working
life. The allocation of depreciation as an expense is in line with the demands of both
relevance and the period assumption, as it helps to determine an accurate profit by
matching all revenues earned with all expenses incurred. Depreciation is an expense
that should be matched against the revenue actually produced by the asset being
depreciated.

THE NEED FOR AN ALTERNATIVE METHOD

Some assets earn a constant amount of revenue throughout their lives, regardless of
their age. Shop fittings, display equipment and office furniture are all similar assets
in terms of producing revenue. Such assets are just as efficient in helping a business
earn revenue in the first year as they will be in the last year of their useful lives.
Other assets tend to be more efficient when they are new and therefore produce
most of their revenue in their first years of use. Their efficiency in producing revenue
decreases as they get older. For example, the more that a drill press is used, the more
likely it is to break down and to spend time being repaired. This means it’s less likely
to earn as much revenue for the business as when it was first purchased.
It’s logical, therefore, to allocate less depreciation when the asset is likely to be
producing less revenue for the business. This is in line with the demands of accrual
accounting, as it strives to determine an accurate profit for the current period. As a
general rule, when an asset is likely to generate more revenue, it should have more
of its cost allocated as an expense. When its revenue-earning capacity diminishes, so
should the amount of depreciation being written off as an expense. To represent this,
reducing balance accountants use the reducing balance method of depreciation.
method
a method of depreciation
that allocates more CALCULATING REDUCING BALANCE DEPRECIATION
depreciation in the early
years of an asset’s life, When an asset has a constant revenue-earning capacity over its useful life, the
and less depreciation in its
later years amount of depreciation being allocated should also be constant. The straight-line
method of depreciation follows this principle.

EXAMPLE 16.1

Segway Solutions purchases a delivery vehicle on 1 July 2023 and provides the
following details.

Purchase price of van $32 000

Estimated useful life 4 years
Estimated residual (scrap) value $12 800

The calculation of depreciation expense under the straight-line method is

(32 000 – $12 800) = $4800 per annum

4

The percentage rate of depreciation is $4800 = $15% per annum

$32 000

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As discussed on the previous page, though, some assets’ revenue-earning capacity
changes over time, so a fixed rate of depreciation may not be the most appropriate
method. In line with the period assumption and, to comply with relevance, it’s
important that revenue earned in a particular period is matched with the expenses
incurred over that same time period. If an asset earns more revenue in a particular
year, it’s logical to allocate a greater amount of depreciation in that year.
The reducing balance method of depreciation (also known as the diminishing balance
method) follows the general principle that an asset produces more revenue in its early
life and less in its later years. If an asset is expected to earn more in a particular period,
relevance demands that more depreciation should be allocated.
The formula to calculate the depreciation expense under the reducing balance method is:

s
Depreciation percentage rate = 100 (1 – n √ )
c
where n = estimated useful life (expressed as a number of years)
s = estimated scrap value (or residual value)
c = the cost of the asset

VCE Accounting students are not required to use this formula to determine the exact rate.
Usually, it is simply calculated at 1.5 times the rate used under the straight-line method.

EXAMPLE 16.2

As seen in Example 16.1, Segway Solutions purchases a delivery vehicle on 1 July 2023
with the details below.

Purchase price of van $32 000

Estimated useful life 4 years
Estimated residual (scrap) value $12 800

Since the vehicle will become less efficient over time, it’s more appropriate to
calculate depreciation using the reducing balance method.
Putting the details of the vehicle into the formula for the reducing balance method
gives the following result:

Depreciation percentage rate = 100 (1 – 4

√ 12 800
32 300
)

= 100 (1 – 4 √0.4 )
= 100 (1 – 0.7953)
= 20.47%

APPLYING THE DEPRECIATION RATE

Once the percentage rate of depreciation has been calculated, it is applied to the
carrying value of the asset at the end of each period. carrying value
You can see that the reducing balance method doesn’t use the residual value (or book value)
historical cost
(scrap value) of an asset in the yearly calculation of depreciation. The residual value is of an asset less
considered in the formula to determine the annual percentage rate, but then the rate accumulated
is simply applied to the reducing carrying value of the asset over its useful life. depreciation

This is very different from the calculation of annual depreciation under the straight-
line method, where the residual value is a vital factor in determining the expense to
be allocated – that is, (cost – residual value)/useful life.
Table 16.1 shows the depreciation calculation for each year under the reducing
balance method.

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 TABLE 16.1 Calculation of depreciation using the reducing balance method*

Year Depreciation expense Accumulated

Carrying value
ended depreciation
30/6/24 20.47% of $32 000 = $6550 $6550 $32 000 – $6550 =
$25 450
30/6/25 20.47% of $25 450 = $5210 $6550 + $5210 = $32 000 – $11 760 =
$11 760 $20 240
30/6/26 20.47% of $20 240 = $4143 $11 760 + $4143 = $32 000 – $15 903 =
$15 903 $16 097
30/6/27 20.47% of $16 097 = $3297 $15 903 + $3297 = $32 000 – $19 200 =
$19 200 $12 800

* adjusted to eliminate rounding off errors

The depreciation rate used under the reducing balance method is a fixed percentage
each year. However, the amount of depreciation expense each year still decreases,
because the percentage rate is applied to the carrying value of the asset. As the
asset’s carrying value decreases, so does the depreciation expense in each of the
following years.
Table 16.1 highlights how the reducing balance method allocates more
depreciation expense in the earlier years of an asset’s life. The calculations made
earlier under the straight-line method determined a rate of $4800 per annum for the
same vehicle. Under the reducing balance method, depreciation was greater than
$4800 in the first two years and then lower than $4800 in the last two years.
There are two further points to keep in mind when calculating depreciation expense:
•• When calculating the depreciation rate under the reducing balance method, an
approximation is often used of 1.5 times the rate used under the straight-line
method. In the example of Segway Solutions, the rate under the straight-line method
was 15% per annum, which provides a rate of 22.5% (15% × 1.5) for the reducing
balance method. According to the formula, the actual rate was found to be 20.47%,
which shows how accurate (or inaccurate) the approximation method can be.
•• The qualitative characteristic of relevance demands that all important information
be reported, but it also allows for insignificant values to be omitted from accounting
reports. Therefore, it’s common practice to omit cents in financial reports.

Remember, depreciation is based on estimates of useful life and residual value,

so it isn’t expected to be exact. These approximations and omissions are usually
considered acceptable.

16.1 CHECK YOUR UNDERSTANDING WB PAGE 284

1 Outline the features of the straight-line method of depreciation.

2 Explain the workings of the reducing balance method of depreciation.
3 Outline the differences in cost allocation between the straight-line and reducing
balance methods of depreciation.
4 On what basis should a depreciation method be selected? Explain your answer fully.
5 Explain the link between depreciation methods and the period assumption.
6 Explain the link between depreciation methods and the qualitative characteristic of
relevance.

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 Depreciation expense
6000

16.2 COMPARING DEPRECIATION METHODS

5000

4000

The following
3000 table, prepared for the vehicle owned by Segway Solutions, highlights
the differences between the two methods of depreciation.
2000

Year Straight-line
1000 method Reducing balance method
2024 0
$4 800 $6 550
2025 2024 $4 800 2025 2026 $5 210 2027

2026 $4 800 $4 143

2027 $4 800 $3 297
Total $19 200 Depreciation expense $19 200
7000

As you can6000see, the total amount of depreciation allocated over the life of the asset is
exactly the same under both methods.
5000
The straight-line method allocates a fixed amount of depreciation each year, while
4000
the reducing balance method allocates more in the early years and less in the later
3000
years. However, over the life of the asset, both methods allocate the same amount of
cost and 2000
end up with the original estimate of residual value as the carrying value of
the asset1000
after its four-year life.
The graph in Figure 16.1 based on the above data, clearly shows the differences
0
in cost allocation between
2024 the two
2025depreciation methods. As2027
2026 the years pass, the
amount of depreciation allocated under the reducing balance method decreases.
Depreciation under the straight-line method will be at a constant rate throughout the
asset’s life. This fundamental difference will always exist between these two methods
of depreciation, regardless of the type of asset involved and its estimated useful life.

FIGURE 16.1 Graph showing both straight-line and reducing balance methods

Straight-line method Reducing balance method

7000

6000

5000

4000

3000

2000

1000

0
2024 2025 2026 2027

Remember, the only difference between the two depreciation methods is the amount
of cost to be allocated in a particular period. The amount of depreciation, once
determined, is recorded by exactly the same general journal entry on balance day.
Only the amount will vary, depending on the method chosen.
The general journal entries in Figures 16.2 and 16.3 allow a comparison of the two
methods over the life of the Segway Solutions vehicle. (The narration for each entry
specifies the depreciation method used.)

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 FIGURE 16.2 General journal entries: straight-line depreciation

GENERAL JOURNAL
Date Details Dr Cr
30/6/24 Depreciation of vehicle 4 800
Accumulated depreciation of vehicle 4 800
Adjustment for depreciation of vehicle at 15%
p.a. straight-line method
30/6/25 Depreciation of vehicle 4 800
Accumulated depreciation of vehicle 4 800
Adjustment for depreciation of vehicle at 15%
p.a. straight-line method
30/6/26 Depreciation of vehicle 4 800
Accumulated depreciation of vehicle 4 800
Adjustment for depreciation of vehicle at 15%
p.a. straight-line method
30/6/27 Depreciation of vehicle 4 800
Accumulated depreciation of vehicle 4 800
Adjustment for depreciation of vehicle at 15%
p.a. straight-line method

FIGURE 16.3 General journal entries: reducing balance depreciation

GENERAL JOURNAL
Date Details Dr Cr
30/6/24 Depreciation of vehicle 6 550
Accumulated depreciation of vehicle 6 550
Adjustment for depreciation of vehicle at
20.47% p.a. reducing balance method
30/6/25 Depreciation of vehicle 5 210
Accumulated depreciation of vehicle 5 210
Adjustment for depreciation of vehicle at
20.47% p.a. reducing balances method
30/6/26 Depreciation of vehicle 4 143
Accumulated depreciation of vehicle 4 143
Adjustment for depreciation of vehicle at
20.47% p.a. reducing balance method
30/6/27 Depreciation of vehicle 3 297
Accumulated depreciation of vehicle 3 927
Adjustment for depreciation of vehicle at
20.47% p.a. reducing balance method

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DEPRECIATION IN THE BALANCE SHEET
The presentation of non-current assets in a balance sheet is also unaffected by the
choice of depreciation method. The cost of each asset is still shown, and accumulated
depreciation is deducted from this figure to determine the carrying value on balance
day. Once again, the only difference between the two methods is that the amount of
accumulated depreciation will change depending on which is used.
The following balance sheet extracts show how Segway Solutions’ vehicle would
be reported under each of the two methods.

STRAIGHT-LINE METHOD
Balance sheet extracts as at 30 June: 2024 2025 2026 2027
Non-current assets
Vehicle 32 000 32 000 32 000 32 000
Less: Accumulated depreciation 4 800 9 600 14 400 19 200
27 200 22 400 17 600 12 800

REDUCING BALANCE METHOD

Balance sheet extracts as at 30 June: 2024 2025 2026 2027
Non-current assets
Vehicle 32 000 32 000 32 000 32 000
Less: Accumulated depreciation 6 550 11 760 15 903 19 200
25 450 20 240 16 097 12 800

16.2 CHECK YOUR UNDERSTANDING WB PAGE 286

1 Compare the general journal entries for depreciation under the straight-line
method and the reducing balance method.
2 Describe the types of assets to which the straight-line depreciation method
should be applied.
3 Describe the types of assets to which the reducing balance depreciation
method should be applied.

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 16.3 CHOOSING A DEPRECIATION METHOD
Which depreciation method should a business use?
There’s no single answer to this question. The appropriate method to select is the
one that best satisfies the demands of relevance and the period assumption.
In order to do this, management needs to identify the revenue-earning pattern of
the asset.
EXAM
SUCCESS •• If it’s expected to earn more revenue in its earlier years than later in its life, then
Always remember: the reducing balance method is most appropriate.
depreciation does
not attempt to estimate •• If the asset usually has the same revenue-earning capacity regardless of its age,
market value. It is then the straight-line method should be adopted.
allocated to try to
get an accurate The choice of depreciation method should always be linked to the nature of the asset
assessment of being considered. A business that has numerous non-current assets may use both
profit.
methods, since the various assets may have different revenue-earning patterns.
The following examples illustrate where one or other method may be more
appropriate than the alternative.
Asset Depreciation method suggested

Shop fittings Straight-line

Office furniture Straight-line

Machinery Reducing balance

Vehicles Reducing balance

The different
methods of
depreciation are
best suited for
different types of
asset

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Both shop fittings and office furniture are usually just as efficient in their later years
as when they are first purchased. Therefore, a fixed amount of depreciation should be
allocated using the straight-line method.
Assets such as machinery and vehicles are usually more efficient when they are
new, so there is a reasonable expectation that they will earn more revenue in these
early years. Following the period assumption, it’s desirable to match this greater amount
of revenue with a higher allocation of depreciation expense. Therefore, the reducing
balance method will more accurately reflect the revenue-earning pattern of the assets.
Once the most appropriate depreciation method is selected, it should be applied
consistently over the asset’s life in order to meet the qualitative characteristic
of comparability. (Comparisons are difficult to make if accounting methods are
constantly changing over several consecutive periods.)

16.3 CHECK YOUR UNDERSTANDING WB PAGE 286

1 For each of the following assets, state the depreciation method that you
would recommend to allocate costs over their useful lives. Justify your
answer for each asset.
a Computers
b Sales manager’s vehicle
c Office equipment
d Machinery
e Display equipment
f Forklifts
2 A business owner is advised that she shouldn’t change depreciation
methods once she commences writing off her assets. Do you agree with
this advice? Discuss this issue, with reference to accounting assumptions
and the qualitative characteristics of accounting.

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 16 CHAPTER REVIEW

KEY CONTENT
• [16.1] Reducing balance is a method of depreciation that allocates more depreciation in the
early years of an asset’s life, and less in its later years. It may be used with assets that
become less useful or effective over time, such as vehicles.
• [16.2] Depreciation under the straight-line method is at a constant rate throughout the asset’s
life. Over the same period, the amount of depreciation allocated under the reducing
balance method decreases. The only difference between the straight-line and reducing
balance methods is the amount of cost to be allocated in a particular period.
• [16.3] The depreciation method used should be based on the grounds of best satisfying the
demands of relevance and the period assumption.

CHAPTER 16 EXERCISES

SPREADSHEET X.XX1 Depreciation: comparing methods WB PAGE 288

Kevin Riley’s Equestrian Centre purchases office equipment at a cost of $12 000, plus
$1200 GST. Kevin is considering whether to use the straight-line or the reducing balance
method of depreciation. The equipment is expected to be used for four years before it’s
sold. You have been asked to supply information regarding straight-line depreciation at the
rate of 20% per annum or reducing balance depreciation at 30% per annum.
Prepare tables as shown below and complete the details for each of these two
depreciation methods to assist Kevin with his decision.
Note: this question may be completed using a spreadsheet.
METHOD OF DEPRECIATION: STRAIGHT-LINE
Year Depreciation Accumulated depreciation Carrying value
1
2
3

METHOD OF DEPRECIATION: REDUCING BALANCE

Year Depreciation Accumulated depreciation Carrying value
1
2
3

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2 Depreciation: comparing methods WB PAGE 288 SPREADSHEET X.XX

Castlemaine Cladding purchases a new vehicle at a cost of $24 000, plus GST of $2400.
The vehicle is expected to be used in the business for five years. Its residual value is
estimated to be about $5700.
Note: this question may be completed using a spreadsheet.
a Prepare tables as shown below and complete the details for each of the two
depreciation methods. (For the reducing balance method, simply apply depreciation
at 25% per annum.)

METHOD OF DEPRECIATION: STRAIGHT-LINE

Year Depreciation Accumulated depreciation Carrying value
1
2
3

METHOD OF DEPRECIATION: REDUCING BALANCE

Year Depreciation Accumulated depreciation Carrying value
1
2
3

b Prepare a line graph to highlight the differences between the two depreciation
methods. Using one line for each method, show the depreciation expense
each year.
c In what years does the reducing balance method allocate:
i more depreciation than the straight-line method?
ii less depreciation than the straight-line method?
d Prepare a line graph showing the balance of accumulated depreciation each year
under each of the two depreciation methods.

3 Reducing balance depreciation WB PAGE 289 SPREADSHEET X.XX

Five Star Comics & Graphic Novels buys a new photocopier for its office on 1 February
2023 for $14 000, plus GST of $1400. The machine is to be used until it’s four years old,
after which it’s expected to be traded in for a new model. Balance day for the business
is 31 July each year. The photocopier is to be depreciated by the reducing balance
method at the rate of 20% per annum.
a Calculate the depreciation expense to be allocated on 31 July 2023, 2024 and 2025.
b Prepare the necessary adjusting and closing entries for depreciation of the
photocopier for each of the three years.
c Prepare the following general ledger accounts: Photocopier, Depreciation of the
Photocopier, and Accumulated Depreciation of the Photocopier.
d Prepare a balance sheet extract to show how the photocopier would be reported as
at 31 July 2023, 2024 and 2025.
e Do you think the reducing balance method is appropriate for depreciating a
photocopier? Explain your answer fully.

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 SPREADSHEET X.XX4 Depreciation entries: reducing balance method WB PAGE 292

Connie Grant is the owner of Warrnambool Wigs & Hair Extensions. On 1 October 2023
she purchases display equipment for $35 200, including GST. She decides to depreciate
the equipment at 25% per annum on the reducing balance method. The books of the
business are closed on 31 December each year.
a Prepare the necessary adjusting and closing entries for depreciation of the display
equipment for the years ended 31 December 2023, 2024 and 2025. (Narrations are
not required.)
b Prepare the following general ledger accounts: Display Equipment, Depreciation of
Display Equipment, and Accumulated Depreciation of Display Equipment.
c Prepare a balance sheet extract to show how the display equipment would be
reported as at 31 December 2023, 2024 and 2025.
d A friend of Corrine’s suggests that she should use the straight-line method to
depreciate the equipment, as it will result in a more consistent profit over the years.
Do you agree? Explain your answer.
e Corrine may breach a qualitative characteristic of accounting if she changes
depreciation methods. Explain the possible implications of this change, with
reference to the relevant qualitative characteristic.

SPREADSHEET X.XX5 Depreciation: comparing methods WB PAGE 294

Rewind Retro Furnishings is a small business situated in Strathmore, owned and

operated by Russell Cosgriff. The business purchases a vehicle on 1 July 2023 for
$28 000, plus GST. Cosgriff expects to own the vehicle for about four years. He’s
unsure whether to depreciate the asset under the straight-line method at 20% per
annum, or under the reducing balance method at 30% per annum. The business closes
its books on 31 December each year.
a Using a spreadsheet, calculate depreciation under the two methods for the years
ended 31 December 2023, 2024, 2025 and 2026.
b Explain fully the difference in profit for each of the four years if the vehicle is
depreciated using the reducing balance method.
c Which method would you recommend Cosgriff use to depreciate the vehicle?
Explain your answer fully, with reference to an accounting principle.

WB PAGE 295
6 Depreciation: comparing methods
Makeup 2 Your Door purchased a vehicle on 1 April 2020 for $24 000, including GST.
The owner of the business estimated that the vehicle would have a useful life of five
years and then be sold for approximately $9600. The vehicle was depreciated using the
straight-line method on 31 March 2021 and 2022.
However, the owner has been told that reducing balance depreciation is a more
appropriate method for depreciating a vehicle. She calculates that the rate to be
charged would be 20% of the asset’s carrying value.
a If the straight-line method was used again in 2023, what would be the depreciation
expense allocated for the year?
b If the vehicle was depreciated using the reducing balance method at 20% per
annum, what would be the depreciation expense for the year ended 31 March
2023?
c Explain the effect the change of accounting method would have on the net profit
figure reported for the year ended 31 March 2023.
d Do you think the owner should change the method used? Explain your answer fully.

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 CASE STUDY WB PAGE 296 SPREADSHEET X.XX

Costa Kriezis is the owner of GET SWOLE!, a business selling bodybuilding and gym
equipment. He needs your advice regarding the depreciation of a fleet of delivery vehicles
owned by the business, which offers free delivery. The vehicles have just been updated by
the business, at a cost of $250 000. This was done in week one of the new period, which
runs for 12 months.
The vehicles are estimated to have a useful life of four to five years. Therefore, Costa is
considering straight-line depreciation at 25% (over a useful life of four years) or 20% (over
five years). Residual value isn’t allowed for, as the vehicles are constantly being used and
he doesn’t think this is necessary.
Costa has also heard that if he applies reducing balance depreciation, profit will be
lower and he may pay less taxation. He is now also considering using the reducing balance
method, at 1.5 times the rate of the straight-line method. This would mean that depreciation
would be applied at 37.5% per annum (over four years) or 30% over five years.
In each of the past three years, the business has earned a profit, before considering
depreciation expense, of $200 000.
a Prepare a spreadsheet to show Costa the effect on profit over the next four years under
each of the four possible alternatives:
i straight-line at 25% per annum
ii straight-line at 20% per annum
iii reducing balance at 37.5% per annum
iv reducing balance at 30% per annum.
Your spreadsheet should show clearly the depreciation expense for each of the four years
and the net profit (after depreciation) for each of the four scenarios.
b With reference to the results shown in your spreadsheet, advise Costa which scenario he
should adopt. Your advice should consider the requirements of accrual accounting, faithful
representation, relevance and verifiability.
c Costa clearly believes that residual values shouldn’t be applied in this case, and that the
most important thing is to minimise profit so that less tax is payable. Discuss the ethics of
such decision making, taking into consideration the effect on net profit (after depreciation).

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 CHAPTER CHECKLIST
Now that you have finished Chapter 16, double-check your progress.
Are you ready for your Unit 4 exam?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
completed the end-of-chapter activities
handed in my workbook for marking.

I understand …

methods of depreciation: straight-line and reducing balance

the implications of alternative methods of depreciation on accounting reports.

I can …

use ICT, including spreadsheets, to model and analyse alternative depreciation

methods
compare alternative methods of depreciating non-current assets and justify the
method selected
evaluate the effect of alternative methods of depreciating non-current assets on
accounting reports.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_16

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

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I N F O R M A T I O N
17 BUYING AND SELLING
NON-CURRENT ASSETS

As discussed in Chapters 15 LEARNING OBJECTIVES

and 16, non-current assets are
depreciated over time. You should By the end of this chapter, you will be able to:
know how to record the purchase •• prepare a general journal entry to record a purchase
of non-current assets and how of a non-current asset for cash or financed by a loan
they are recorder when sold, [17.1]
traded-in or otherwise disposed of.
•• record a purchase of a non-current asset in the general
In this chapter you will learn
ledger [17.1]
how to record purchases and
•• prepare general journal entries to record the disposal
sales of non-current assets in
of a non-current asset for cash or as a trade-in [17.2]
the general journal, including
determining the profit or loss •• calculate a profit or loss on disposal of an asset [17.2]
made on disposal. •• prepare a Disposal of Asset account in the general
ledger [17.2]
•• classify profits and losses on disposal in an income
statement [17.3]
•• explain how a profit or loss on disposal occurs in
relation to the allocation of depreciation [17.3]
•• explain how depreciation method affects the profit or
loss on disposal of a non-current asset [17.3].

UNIT 4 – PROGRESS 14 15 16 17 18 19 20 21 22 23

17.2

Disposal of Chapter review

17.1 non-current assets 17.3 and exercises

Recording the
Trading in
purchases of non-
non-current assets
current assets

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 17.1 RECORDING THE PURCHASES OF
NON-CURRENT ASSETS
When a business purchases a non-current asset, there are two basic scenarios to
consider. The asset may be purchased for cash (often done for small items such
as computers); in the case of larger purchases, a loan may be used to finance the
purchase. Trade credit isn’t usually used to buy long-term assets, as it’s unrealistic to
pay for large purchases using credit terms of, say, 30 days.
If a non-current asset is bought for cash, the entry in the general journal is
straightforward, as Figure 17.1 shows.

FIGURE 17.1 General journal entry for the purchase of a non-current asset for cash

GENERAL JOURNAL
Date Details Dr Cr
1 Jul Laptop computer 2 000
GST clearing 200
Cash at bank 2 200
Purchase of computer from Officeworks via EFT

This journal entry establishes the Laptop Computer ledger account, adjusts the GST
Clearing account for the GST paid, and decreases the Cash at Bank account with the
total amount of $2200.

RECORDING PURCHASES USING BORROWED FUNDS

The purchase of a non-current asset using borrowed funds is a little different. There
are actually two transactions taking place. Once the finance has been arranged, the
business will receive the amount borrowed. Management can shop around for the
best deal and purchase the asset in the usual manner.
Consider the purchase of machinery for $55 000, including $5000 GST. The journal
entries shown in Figure 17.2 would be the result of taking out a loan and purchasing
the machinery.

FIGURE 17.2 General journal entry for the purchase of a non-current asset using
borrowed funds

GENERAL JOURNAL
Date Details Dr Cr
1 Jul Cash at bank 55 000
Loan – NAB Finance 55 000
Borrowed $55 000 for the purchase of
machinery (EFT transfer)
1 Jul Machinery 50 000
GST clearing 5 000
Cash at bank 55 000
Purchase of machinery from Ace Manufacturing
via EFT

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The double entries in the general ledger when these journal entries are posted are
shown below.
Cash at bank
$ $
1 Jul Loan – NAB Finance 55 000 1 Jul Machinery/GST 55 000
clearing

Loan – NAB Finance

$ $
1 Jul Cash at bank 55 000

Machinery
$ $
1 Jul Cash at bank 50 000

GST clearing
$ $
1 Jul Cash at bank 5 000

The only difference in the above transaction is that the Cash at Bank account is
affected by two entries:
•• When the loan is approved and the cash is received, the Cash at Bank account is
increased by the debit entry shown.
•• When the non-current asset is purchased (which could be at a later date), the cash
outflow is recorded in the usual manner.
The liability account for the loan has been established and this will now have to be
repaid over a specified period of time.
Sometimes the loan amount won’t be the same as the purchase price of the asset.
If the purchase of the non-current asset is funded partly by cash from the business,
the amount borrowed will be lower than the amount paid for the asset. This can
simply be adjusted in the general journal to reflect the transactions taking place.

17.1 CHECK YOUR UNDERSTANDING WB PAGE 298

1 State the double entry required when office furniture is purchased for cash from Ace
Office Supplies for $2000, plus GST of $200.
2 State the double entries required when $22 000 is borrowed from the United Bank
and the cash is used to buy shop fittings for $20 000, plus GST.
3 Describe an advantage and a disadvantage of purchasing non-current assets
financed by a loan.

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 17.2 DISPOSAL OF NON-CURRENT ASSETS
When a business purchases a non-current asset, it debits the total cost to an
asset account. Then, on every balance day throughout the asset’s useful life, it is
depreciated using one of two methods of depreciation (see Chapters 15 and 16). The
final process in regard to a non-current asset is the recording of its disposal.
An asset may be scrapped for no return, be sold for cash, or be traded in on a
replacement asset. Regardless of what happens to a non-current asset when it’s
disposed of, it must be removed from the books of the business, as it’s no longer
under the control of the entity.
The necessary steps to record the disposal of an asset for cash are:
•• transfer the cost of the asset to the Disposal of Asset account.
•• transfer the accumulated depreciation of the asset to the Disposal of Asset
account.
•• record the proceeds gained from the sale of the asset in the Disposal of Asset
account. That is, record the amount received for the asset, or the amount granted
as a trade-in.
•• close off the Disposal of Asset account by recording the profit or loss on the sale
of the asset. This entry will also have the effect of closing off the Disposal of
Asset account.

Non-current
assets are
disposed of at
their end of their
useful life.

EXAMPLE 17.1

Fanboy Frenzy Collectables purchases a store-wide computer system, with barcode

scanners and integrated EFTPOS.

1 July 2023: Purchased the computer system for $10 000 cash
Estimated useful life: 2 years
Estimated scrap value: $4000
Depreciation method: straight-line
30 June 2025: Sold the computer system for $3800 cash.

Therefore, depreciation = ($32 000 – $12 800) = $3000 per annum

2

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I N F O R M A T I O N
The entries relating to the purchase of the computer system, its depreciation each loss on
year and the loss on disposal of asset (disposal of the system) on 30 June 2025 are disposal of asset
the difference
all shown in the following general ledger accounts. (Note: this business closes its between the
books on 30 June each year.) carrying value of
an asset and the
proceeds from the
GENERAL LEDGER disposal of the asset,
Computer where the proceeds
are less than the
$ $ carrying value
1/7/23 Cash at bank 10 000 30/6/25 Disposal of computer 10 000

Depreciation of computer
$ $
30/6/24 Accum. dep’n 3 000 30/6/24 P&L summary 3 000
computer
30/6/25 Accum. dep’n 3 000 30/6/25 P&L summary 3 000
computer

Accumulated depreciation of computer

$ $
30/6/24 Dep’n of computer 3 000
30/6/25 Disposal of computer 6 000 30/6/25 Dep’n of computer 3 000
6 000 6 000

Disposal of computer
$ $
30/6/25 Computer 10 000 30/6/25 Accum. dep’n 6 000
computer
Cash at bank 3 800
Loss on disposal of 200
computer
10 000 10 000

Loss on disposal of computer

$ $
30/6/25 Disposal of computer 200 30/6/25 P&L summary 200

In Example 17.1, the computer has been sold at the end of its predicted useful life.
Its carrying value (or book value) at this time will equal its estimated scrap value of carrying value
(or book value)
$4000 ($10 000 – $6000). This $4000 represents the economic sacrifice made by the historical cost
business on 30 June 2025. It can be compared against the actual cash generated by of an asset less
the disposal of the asset. accumulated
depreciation
When the asset was disposed of, the business received $3800; this amount has been
recorded on the credit side of the Disposal of Computer account. To close off the Disposal
of Computer account, the loss on sale of $200 has been recorded on the credit side. This
makes both sides equal, so the Disposal of Computer account is now closed off.
The corresponding debit entry of $200 has been made to the Loss on Disposal of
Computer account. This is logical, as the asset was sold for $200 less than its carrying
value, which was $4000 at the time it was sold.

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 LOSS FROM ASSET DISPOSAL
Fanboy Frenzy made a loss on the disposal of their computer system. This occurred
either because the depreciation rate was too low over the life of the asset, or because
the original estimate of scrap value was too high.
Other reasons for an asset being sold for less than its carrying value include:
•• the item is no longer popular, and there isn’t much demand in the second-hand market.
•• an asset may become technologically obsolete. For example, it’s difficult to sell
second-hand computers for much return, as new, advanced models are developed
very quickly.
•• the asset may be severely marked or damaged from its business use.
It’s important to remember that depreciation isn’t a valuation tool. Depreciation is
allocated in order to match an appropriate amount of depreciation expense against the
revenues generated by the asset. It’s not recorded in order to make predictions about
market value at a particular point in time.
Also, it’s unrealistic to expect depreciation to be perfectly accurate, as scrap values
are predicted for years in advance in the case of some assets. The entries required
over-depreciation on the disposal of an asset simply adjust the firm’s books for any over- or under-
a situation where a
non-current asset has
depreciation that has occurred over the life of the asset.
been depreciated too Using the above data, the following item would be reported in Fanboy Frenzy’s
much due to under- income statement under the heading ‘Other expenses’.
estimation of either
its useful life or its Other expenses:
residual value, leading
to a profit on disposal Loss on disposal of computer $200
under-depreciation
a situation where This one item provides a neat summary of the events that have taken place. The
a non-current
asset hasn’t been Computer account has been eliminated, as has the Accumulated Depreciation of
depreciated enough Computer account. The proceeds from the sale have been recorded in the Cash at
due to over-estimation
of either its useful life Bank account. The end result of all the transactions is that the business has suffered a
or its residual value, loss of $200, and this has been reported as an expense for the reporting period.
leading to a loss on
disposal
PROCEEDS FROM ASSET DISPOSAL
An asset may sometimes be sold for more than its carrying value when it has
been depreciated too much. In this case, the firm recovers an amount in excess of
proceeds its carrying value. The difference between carrying value and the proceeds from
from disposal
of asset disposal will simply be reported in the firm’s income statement under the heading
the amount of ‘Other revenue’.
cash received, or For example, if the computer was sold for $4100, this indicates that it was sold
the trade-in value
granted, on the for $100 higher than its carrying value. That is, the business has made a profit of $100
disposal of a non- on the disposal of the computer. As this $100 hasn’t been earned in the ordinary
current asset
course of business, the profit on disposal of the computer shouldn’t be listed in the
top section of the report with the firm’s sales. Such profits should always be reported
separately under the heading of ‘Other revenue’.
As is the case with all ledger entries, the transactions must first be recorded in
the general journal. The ledger entries shown above for the disposal of the computer
system have been prepared in the general journal in Figure 17.3. Note that these
entries are based on the original data. That is, the computer was sold for $3800.

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FIGURE 17.3 General journal entries for the disposal of a non-current asset
GENERAL JOURNAL
Date Details Dr Cr
30 Jun Disposal of computer 10 000
Computer 10 000
Transfer of cost of computer sold
Accumulated depreciation of computer 6 000
Disposal of computer 6 000
Transfer of accumulated depreciation on
computer sold
Cash at bank 3 800
Disposal of computer 3 800
Cash received on disposal of computer
Loss on disposal of computer 200
Disposal of computer 200
Transfer of loss on disposal of computer

The totals of the debit entries to the Disposal of Computer account should equal the
total credit entries made to that account. That is, the Disposal of Computer account
must be closed off once all entries have been completed.
The purpose of the disposal account is two-fold:
•• It removes all balances in relation to the asset being sold, as it closes off the asset
account itself, along with its Accumulated Depreciation of Computer account.
•• It also determines the profit or loss made on the disposal, which at the same time
closes off the Disposal of Computer account itself.
When completing a Disposal of Asset account, always check that the debits equal the
credits and that no balance is left remaining in the account.

17.2 CHECK YOUR UNDERSTANDING WB PAGE 298

1 State the names of the two ledger accounts that must be closed off to the Disposal
of Vehicle account when a vehicle is sold.
2 Explain the circumstances when:
a a loss is made on the disposal of a non-current asset
b a profit is made on the disposal of a non-current asset.
3 ‘A loss on disposal of a non-current asset simply means that too much depreciation
has been written off during the asset’s life.’ Do you agree with this statement?
Explain your answer fully.

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 17.3 TRADING IN NON-CURRENT ASSETS
The journal entries shown above cover the situation where an asset is sold for cash. If
an asset is traded in, the entries required will vary slightly.

EXAMPLE 17.2
As before, Fanboy Frenzy Collectables purchased a store-wide computer system.
However, rather than selling it for $3800 at the end of its useful life, it trades it in for
$3800 against the cost of a new system. The cost of the new asset is $12 000, and the
purchase is financed by a loan from GE Finance Company.

1 July 2023: Purchased the computer system for $10 000 cash
Estimated useful life: 2 years
Estimated scrap value: $4000
Depreciation method: straight-line
30 June 2025: Traded in the computer system for $3800 on a new model
financed by a loan from GE Finance of $9400 – total cost
$12 000, plus GST of $1200.

Depreciation = ($10 000 – $4 000) = $3000 per annum

2

As the asset was traded in and not sold for cash, the entry shown previously as
a cash receipt in the general journal won’t exist, as no cash has changed hands.
However, the trade-in allowance must now be recognised and recorded.
The appropriate entries under this new situation are shown in Figure 17.4.

FIGURE 17.4 General journal entries for the disposal of a non-current asset via a trade-in

GENERAL JOURNAL
Date Details Dr Cr
30 Jun Disposal of computer 10 000
Computer 10 000
Transfer of cost of computer sold
Accumulated depreciation of computer 6 000
Disposal of computer 6 000
Transfer of accumulated depreciation on
computer sold
Computer 3 800
Disposal of computer 3 800
Trade-in of computer
Loss on disposal of computer 200
Disposal of computer 200
Transfer of loss on disposal of computer

Having recorded the disposal of the computer as a trade-in, the purchase of the new
computer would be recorded as in the following entry. (Note the amount borrowed to
finance the purchase.)

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 30 Jun Cash at bank 9 400 [3]
Loan – GE Finance 9 400
Borrowed funds to purchase new computer
Computer [1] 8 200
GST clearing [2] 1 200
Cash at bank 9 400
Purchase of computer after trade-in of $3800 allowed.

Trade-in of $3800 has been debited to the Computer account, so amount to be

•• [1] 
paid in cash is $8200 ( $12 000 – $3800).
Actual purchase price was $12 000, so GST payable to the supplier is still
•• [2] 
$1200. If a trade-in allowance is granted, this is deducted from the total
purchase price.
New computer cost $12 000, plus $1200 GST, so total outlay equals $13 200.
•• [3] 
As the trade-in allowance was $3800, the amount borrowed from the finance
company would be $9400 ($13 200 – $3800).
The following ledger accounts show the full picture of the disposal of the computer,
the trade-in on the new computer, the creation of the loan of $9400, and the cash
payment for the computer.

GENERAL LEDGER
Computer
$ $
1/7/23 Cash at bank 10 000 30/6/25 Disposal of computer 10 000
30/6/25 Disposal of computer 3 800
30/6/25 Cash at bank 8 200

Depreciation of computer
$ $
30/6/24 Accum. dep’n 3 000 30/6/24 P&L summary 3 000
computer
30/6/25 Accum. dep’n 3 000 30/6/25 P&L summary 3 000
computer

Accumulated depreciation of computer

$ $
30/6/24 Dep’n of computer 3 000
30/6/25 Disposal of computer 6 000 30/6/25 Dep’n of computer 3 000
6 000 6 000

Disposal of computer
$ $
30/6/25 Computer 10 000 30/6/25 Accum. dep’n 6 000
computer
Computer 3 800
Loss on disposal of 200
computer
10 000 10 000

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 Loss on disposal of computer
$ $
30/6/25 Disposal of computer 200 30/6/25 P&L summary 200

Loan – GE Finance
$ $
30/6/25 Cash at bank 9 400

Cash at bank
$ $
30/6/25 Loan – GE Finance 9 400 30/6/25 Computer 8 200
EXAM GST clearing 1 200
SUCCESS
When an asset is GST clearing
traded-in, cash at bank is
$ $
not affected. Make sure
that the trade-in value 30/6/25 Cash at bank 1 200
is debited to the non-
current asset being
purchased. Compare the above entries with those for Example 17.1 (p.326):
•• The cost is transferred in exactly the same way.
•• The accumulated depreciation on the asset being disposed of is transferred in the
same way.
•• Rather than an entry being made for a receipt of cash, the trade-in allowance
results in a debit to the non-current asset account, as the trade-in value is
deducted from the cost price of the new computer being purchased.
•• The loss on disposal is recorded in the same way; it closes off the Disposal of
Computer account and creates the expense account for the loss on disposal.
•• The final general ledger entries record the borrowing of cash from the finance
company and the purchase of the new computer (including GST).

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CLOSING ENTRIES
The final step when the asset is disposed of is to close off the Loss on Disposal of
Computer account to the Profit and Loss Summary account.
As a loss on disposal is an expense item, it will be closed off along with all other
expenses and then reported under ‘Other expenses’ in the income statement. The
general journal closing entry is shown in Figure 17.5.

FIGURE 17.5 Closing entry for a loss on disposal of an asset

GENERAL JOURNAL
30 Jun P&L summary 200
Loss on disposal of computer 200
Closing entry

If an asset is disposed of at a profit – that is, at a value greater than its carrying
value – the closing entry is simply the other way around.
As a profit on disposal of asset represents a revenue item, the Profit and Loss profit on
disposal of
Summary account must be credited, with the debit entry being recorded in the
asset
revenue account to bring its balance back to zero. The closing entry for a profit of $100 the difference
on the sale of a computer would be as shown in Figure 17.6. between the
carrying value of
an asset and the
FIGURE 17.6 Closing entry for a profit on disposal of an asset proceeds from its
disposal, where
the proceeds are
GENERAL JOURNAL
greater than the
30 Jun Profit on disposal of computer 100 carrying value
P&L summary 100
Closing entry

17.3 CHECK YOUR UNDERSTANDING WB PAGE 299

1 A vehicle was sold for $5000 when its carrying value was $5500. State the
double entry to record the profit or loss on disposal of the vehicle.
2 Explain the difference in recording procedures when an asset is traded in,
rather than sold for cash.
3 A photocopier has been traded in for $6000 on a new machine that was
bought from Classic Copiers for $25 000, plus GST. To assist the business
with this purchase, West Bank allowed the business to borrow $20 000. State
the double entries required for:
a the trade-in allowance
b taking out the loan of $20 000
c the cash payment for the new photocopier.

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 17 CHAPTER REVIEW

KEY CONTENT
•• [17.1] If a non-current asset is bought for cash, the general journal is straightforward. If it is
purchased using borrowed funds, such as finance or a loan, the funds must first be
recorded as a cash inflow or credit, then the purchase recorded as a debit.
•• [17.2] When a non-current asset is disposed of, it must be removed from the books of the
business, as it is no longer under the control of the entity. The cost of the asset, and its
accumulated depreciation, must be transferred to the Disposal of Asset account. This
account is also used to record any proceeds from the sale of the asset.
•• [17.2] A business may make a profit or a loss when disposing of an asset, depending on how
the item has depreciated and how that depreciation has been recorded.
•• [17.3] If a non-current asset is traded in, rather than being sold for cash, no cash receipt entry
is made in the general journal, as no cash has changed hands. However, the trade-in
allowance must be recognised and recorded.

CHAPTER 17 EXERCISES

WB PAGE 300
SPREADSHEET X.XX1 General journal entries revisited
Prepare the required general journal entries to ensure the correct recording of the
following information in the books of Galaxy Games during November 2023.

Nov 4: A
 mobile phone was purchased for cash from Mobiles ‘R’ Us for
$700, plus GST of $70.
Nov 10: A
 n office desk was purchased for $440, including GST of $40, from
Frankie Cotso Furniture.
Nov 18: T
 he owner transferred $330 to Furniture Galore for the purchase of a
new office chair.
Nov 22: A
 n accounts receivable, S. Claus, returned goods that were originally
sold for $220, including GST of $20. Credit note no. 54 was issued
and full credit was granted. The cost price of the goods returned was
$100.
Nov 27: T
 he owner was dissatisfied with some products in the store and
returned them to Works Gameshop, the original supplier, who sent
credit note no. 72. The original charge was $300, plus GST of $30,
when the purchase was initially made.

Note: this business makes all payments by electronic funds transfer (EFT).

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2 Purchase of non-current assets WB PAGE 301 SPREADSHEET X.XX

On 5 September 2023, Krusty Products purchases a new computer for cash from
PC Computers for $2400, plus GST of $240. On 12 September the firm took out a
loan from CBA Finance for $15 400. On 15 September it bought a photocopier costing
$14 000, plus GST of $1400, from Kanen Co. Ltd (EFT transfer).
a Show the general journal entries to record these transactions.
b Post the general journal to the relevant general ledger accounts.

3 Disposal of a non-current asset for cash WB PAGE 303 SPREADSHEET X.XX

The following ledger accounts are extracted from the books of Brunswick Barbecues at
the end of 2023.

Vehicle
$ $
31 Dec Balance 18 000

Accumulated depreciation of vehicle

$ $
31 Dec Balance 13 000

On 31 December 2023 the vehicle was sold for $3700 cash.

a Prepare the general journal entries necessary to record the disposal of the vehicle.
b Prepare the closing entries required on 31 December 2023 in relation to the profit or
loss on the disposal of the vehicle.
c Prepare the following general ledger accounts.
i Vehicle
ii Accumulated Depreciation of Vehicle
iii Disposal of Vehicle
iv Profit (or Loss) on Disposal of Vehicle
d State the item that would be reported in the firm’s income statement as a result of
the disposal of the vehicle.

4 Disposal for cash: straight-line depreciation WB PAGE 304 SPREADSHEET X.XX

Ezard’s Electricals closes its books on 30 June each year. The business purchased
storage equipment on 1 July 2023 for $8000, plus GST. The equipment had an
estimated life of five years, after which time it was expected to be sold for $1000.
Management decided to depreciate the asset using the straight-line method.
On 30 June 2025 the owner decided to sell the equipment for $5500 cash.
a Prepare the general journal entries required to record the disposal of the equipment
on 30 June 2025.
b Prepare the following general ledger accounts for the period 1 July 2023 to 30 June 2025.
i Storage Equipment
ii Depreciation of Storage Equipment
iii Accumulated Depreciation of Storage Equipment
iv Disposal of Storage Equipment
c Was a profit or a loss made on the disposal of the equipment? If so, how much?
d Explain why the profit or loss identified in part c occurred.

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 SPREADSHEET X.XX5 Disposal for cash: reducing balance depreciation WB PAGE 306

Dragonforge Replica Armour purchases a delivery van for $28 000, plus GST, on 1 July
2023. The owner decides to depreciate the van at the rate of 25% per annum using the
reducing balance method. The business has a reporting period of 12 months and the
balance day is 31 December. Due to its poor performance, the owner sells the van for
$14 800 cash on 31 December 2025.
a Prepare the general journal entries required to record the disposal of the vehicle on
31 December 2025.
b Prepare the closing entries required in relation to the disposal of the asset.
c Prepare the following general ledger accounts for the period 1 July 2023 to
31 December 2025.
i Delivery Van
ii Accumulated Depreciation of Delivery Van
iii Disposal of Delivery Van
iv Profit (or Loss) on Disposal of Delivery Van.

WB PAGE 308
SPREADSHEET X.XX
6 Trade-in with new asset financed by a loan
The following accounts are found in the general ledger of Port Melbourne Import & Export.

Photocopier
2023 $ $
31 Aug Balance 32 000

Accumulated depreciation of photocopier

$ 2023 $
31 Aug Balance 14 000

On 31 August 2023 the photocopier is traded in on a new model. The trade-in

allowance was $16 500 towards the cost of the new photocopier, which was $35 000,
plus GST of $3500. The owner decides to borrow the required amount of funds from
EZ Finance Company to pay for the rest of the cost of the new photocopier. This loan is
approved on 31 August and the funds are transferred to the business bank account.
a Prepare the general journal entries necessary to record the disposal of the
photocopier.
b Prepare the general journal entry to record the loan from EZ Finance and the
purchase of the new photocopier.
c Prepare the following general ledger accounts with all relevant entries.
i Photocopier
ii Accumulated Depreciation of Photocopier
iii Disposal of Photocopier
iv Loan from EZ Finance and GST Clearing

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I N F O R M A T I O N
7 Trade-in of an asset: reducing balance WB PAGE 310 SPREADSHEET X.XX

depreciation method
Garra’s Gift Shop closes its reporting period on 30 September each year. The owner
of the business, Jon Garra, buys a computer system from MBI Computers on 31 July
2023 for $16 000, plus GST of $1600. He decides to depreciate the computer using the
reducing balance method at 30% per annum, and to keep it for a few years. However,
after discovering a new, improved model, Garra decides to trade in his old computer
system and upgrade to the new one.
The supplier of the new system, Computer Solutions, gives Garra a trade-in allowance
of $2100 on 31 March 2025. The price of the new system is $20 000, plus GST of
$2000. To assist with this purchase, Garra decides to borrow $12 000 from ANZ Bank.
a Prepare the general journal entry to record the purchase of the asset on 31 July 2023.
b Prepare any necessary adjusting and closing entries on 30 September 2023 and 2024.
c Prepare the general journal entries required to record the disposal of the computer
on 31 March 2025.
d Prepare the following general ledger accounts for the period 31 July 2023 to
31 March 2025.
i Computer System
ii Depreciation of Computer System
iii Accumulated Depreciation of Computer System
iv Disposal of Computer System
v Profit (or Loss) on Disposal of Computer System
vi Loan – ANZ Bank
e Was a profit or a loss made on the disposal of the computer system? If so, how much?
f Explain how a profit or loss on disposal occurs.

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 SPREADSHEET X.XX8 Trade-in of an asset using business document WB PAGE 313

Katrina Williams is the proprietor of Kat’s Boutique. On 1 September 2023, Williams

purchases a sound system for her shop at a cost of $8000, plus GST of $800. It was
bought from DJ Hi-Fi Store, which charged an additional $600 to install the system
(plus GST of $60). These costs were confirmed in writing by tax invoice 32. This amount
is paid on 30 September 2023.
Williams thinks the sound system should be useful for about five years, after which she
will trade it in. She anticipates that it will have a trade-in value of about $1200. Balance
day is 30 June and straight-line depreciation is applied.
However, on 30 September 2025, Williams decides that she’s dissatisfied with the
sound system and arranges to replace it. DJ Hi-Fi is again the supplier and provides the
following document.

DJ Hi-Fi Tax invoice 65

8121 Highpoint Road Date: 30/9/25
Maidstone VIC 3012 ABN 31 101 232 948
Account: Kat’s Boutique
27 Palm Beach Avenue
Brighton VIC 3186
Item Qty Cost GST Total
Megablast system 1 $9 000 $900 $9 900
Installation charge $1 000 $100 $1 100

Sub-total $11 000

Less: Trade-in allowance $4 000
Paid in full – thank you for your business! Amount owing $7 000

Williams thinks the new Megablast system will be much better than the previous one.
She expects to use it for five years, before selling it for about $1500. She pays the
amount outstanding to DJ Hi-Fi on 30 September 2025.
a Prepare the general journal entries required to record the disposal of the sound
system on 30 September 2025.
b Prepare the following general ledger accounts for the period 1 September 2023 to
30 September 2026, including details of both assets.
i Sound System
ii Accumulated Depreciation of Sound System
iii Disposal of Sound System
iv Profit (or Loss) on Disposal of Sound System

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I N F O R M A T I O N
 CASE STUDY WB PAGE 315

Greensborough Garden Supplies is a small business owned and managed by Matthew

Decker. In order to move heavy items around his storage yard, Decker has purchased a
number of forklifts over the years. His policy is to depreciate the business’s forklifts at the
rate of 25% per annum, using the reducing balance method of depreciation. If the forklifts
become unreliable, Decker doesn’t hesitate to replace them, because they are crucial to
the running of his business.
The following is a summary of the purchases and sales of Decker’s forklifts over the years:
•• Forklift #1: Purchased on 1 April 2023 for $15 000 cash, plus GST of $1500. Insurance
cost is $200 per annum.
•• Forklift #2: Purchased on 31 October 2023 for $19 800 cash (including GST). Insurance
cost is $250 per annum.
•• Forklift #3: Purchased on 30 June 2024 as a replacement for forklift #1, which keeps
breaking down. A trade-in allowance of $9000 is granted by the supplier, Dynamic
Forklifts. The purchase price of the new forklift is $19 000 (plus GST), but modifications
are required and these cost an additional $1500 (plus GST). Insurance cost is $300 per
annum. The new forklift is bought for cash via EFT.
•• Forklift #4: Forklift #2 is now becoming unreliable, so it is traded in for $13 500 on
forklift #4 on 1 September 2025. Dynamic Forklifts issues a receipt with a cost price of
$22 000, plus GST of $2200, less the agreed trade-in. Insurance is arranged at a cost
of $400 per annum. Due to previous problems with his forklifts, Decker arranges a
maintenance contract at a cost of $500 per year. A loan of $7000 is taken out from
EZ Bank to help with the purchase of the latest forklift.

1 Using a spreadsheet, prepare a table to calculate the amount of depreciation expense SPREADSHEET X.XX

that would be shown in the income statements for the years ended 31 December
2023, 2024 and 2025. An example layout is provided below.

2023 2024 2025

Forklift #1
Forklift #2
Forklift #3
Forklift #4
Total depreciation expense for the year

2 On your spreadsheet, prepare extracts from the balance sheets prepared as at 30 June
2023, 2024 and 2025 to show how the asset Forklifts would be reported in each of
these three years.
3 Prepare the Disposal of Forklift account with all entries in relation to:
i forklift #1
ii forklift #2.
4 Depreciation and disposal of non-current assets are both affected by several accounting
assumptions and/or qualitative characteristics. State, and explain, the assumptions and
characteristics that are related to this area over the life of a non-current asset.

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 CHAPTER CHECKLIST
Now that you have finished Chapter 17, double-check your progress.
Are you ready for your Unit 4 exam?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
completed the end-of-chapter activities
handed in my workbook for marking.

I understand …

the purchase of non-current depreciable assets for cash and financed by a loan
the recording and reporting on the disposal of a non-current depreciable asset.

I can …

analyse the effect of financial transactions on the accounting reports.

© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_17

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

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I N F O R M A T I O N
18 PROFIT DETERMINATION AND
BALANCE DAY ADJUSTMENTS

The ultimate goal of every trading LEARNING OBJECTIVES

business is to make a profit –
that is, to earn more revenue By the end of this chapter, you will be able to:
than it incurs in expenses. But •• outline the period assumption and its relationship with
determining whether a business balance day adjustments [18.1]
has made a profit can be a
•• explain the need for balance day adjustments under
complex task, involving many
the accrual method of accounting [18.1]
elements of the accounting
•• describe the role of adjusting and closing entries [18.1]
process.
In this chapter and Chapter 19, •• record entries in the general journal for prepaid
you will learn how to determine expenses using the asset approach [18.2]
profit, and to adjust and update •• record entries in the general journal for accrued
ledger accounts on balance day. expenses [18.3]
•• describe the treatment of accrued expenses in a
subsequent period when payment is made [18.3]
•• record adjustments for inventory losses and inventory
gains [18.4]
•• prepare ledger accounts incorporating balance day
adjustments [18.6]
•• describe the two-fold effect that balance day
adjustments have on final accounting reports [18.6]
•• calculate profit under the accrual method of
accounting [18.6].

UNIT 4 – PROGRESS 14 15 16 17 18 19 20 21 22 23

18.2 18.4 18.6

Inventory losses The adjusted trial

Prepaid expenses
18.1 18.3 and gains 18.5 balance

Profit Extended
determination: example: Chapter review
Accrued expenses
underlying Adjusting and and exercises
assumptions closing entries

978 1 4202 3962 1 341

 18.1 PROFIT DETERMINATION: UNDERLYING
ASSUMPTIONS
Before you learn about the various problems involved in attempting to determine
profit, it’s important to understand the accounting rules and assumptions on which
profit determination is based. (You’ll already know about some of these from earlier in
this book.)
The first of these is the going concern assumption, which assumes that the
business will continue to operate as a going concern for an indefinite period into
the future. The going concern assumption allows accountants to report non-current
assets in a balance sheet in the belief that they will have some future economic
value to the business.
However, there’s little value in waiting until a business is wound up before
reporting on its activities. Performance needs to be reported on a periodic basis. In
response to this need, the period assumption was created. This assumption divides
the indefinite life of a business into periods of time over which its performance (i.e.
profit or loss) can be measured. The maximum period of time is one year, due to
taxation requirements. The last day of the period is referred to as balance day.
After the period is decided, the qualitative characteristic of relevance is applied to
determine which revenue and expenses will be included in calculating an accurate
profit or loss figure.

ACCRUAL ACCOUNTING
accrual This chapter is based on accrual accounting, where profit is defined as revenue
accounting earned less the expenses incurred in earning that revenue. This method recognises
a system of
determining profit that a business can earn revenue in one period but actually receive the cash in a
where revenue previous or subsequent period. It also recognises that some cash payments relate to
earned is matched
items owing from a previous period, or are paid in advance for a future period.
with expenses
incurred; any The accrual method of accounting attempts to measure the revenue and expenses
difference is the that belong to the same period of time.
profit for the period
The following transactions highlight the application of accrual accounting to
practical examples. All the examples are for Artisan Jeans, a business that uses
31 December as its balance day.

EXAMPLE 18.1

Sales invoices for goods sold during December totalled $10 000. On 31 December, only
$2000 of this amount had been received in cash.
Under accrual accounting: Sales revenue = $10 000, as this amount was earned in the
current period. The whole $10 000 is recognised as revenue, regardless of the fact that
$8000 hasn’t yet been received. This is because the revenue-earning process has been
completed and there’s objective evidence of the amount of revenue earned (the
invoices). As long as these two requirements are satisfied, revenue may be recognised
as being earned under accrual accounting.

EXAMPLE 18.2

On 1 July a yearly insurance premium of $2000 was paid.

Under accrual accounting: Insurance expense = $1000, as only half of the insurance
payment has been incurred (or expired) during the current period. The other $1000 will
be recognised as an expense in the following period.

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I N F O R M A T I O N
 EXAMPLE 18.3

Advertising paid this year totalled $4000, with $1000 of this amount relating to advertis-
ing that was done during the previous period.
Under accrual accounting: Advertising expense = $3000, as this is the amount of ex-
pense that belongs to the current period. It ignores the other $1000, as that amount
relates to the previous year and therefore wasn’t incurred during the current period.

BALANCE DAY ADJUSTMENTS

At the end of a period, a trial balance (p.88) should be prepared to check the accuracy
of the double entries made during the period. When this process is completed,
accounting reports can then be prepared. In order to comply with the demands of
accrual accounting, the figures in the trial balance must equal the revenue earned and
the expenses incurred. balance day
However, often the accounts will only reflect the cash flows that took place adjustments
adjustments made to
during the period. Some of these cash flows may relate to revenues and expenses revenue and expense
associated with the previous or subsequent periods. Balance day adjustments are accounts at the end of a
period so that they equal
used to adjust the balances of revenue and expense accounts so that they equal the revenue earned and
amounts of revenue earned and expenses incurred. expenses incurred
Before exploring various examples of balance day adjustments, it’s important to adjusting entry
understand the differences between two types of entries made in general ledger a general journal entry
used to adjust revenue
accounts via the general journal. and expense accounts
•• Adjusting entries are used in revenue and expense accounts to make them equal (see balance day
adjustments)
to revenue earned and expenses incurred. Adjusting entries are made on the last
closing entry
day of the period – that is, on balance day. a general journal entry
•• Closing entries are used to close off the adjusted revenue and expense accounts to used to close off a
revenue or expense
the Profit and Loss Summary account. Closing entries are also made on balance day. account

18.1 CHECK YOUR UNDERSTANDING WB PAGE 318

1 Explain the going concern assumption.

2 What is the purpose of the period assumption? Why do accountants follow this
assumption?
3 What are balance day adjustments? What is the purpose of such adjustments?
4 Explain the role of each of the following types of general journal entries:
a adjusting entries
b closing entries.

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 18.2 PREPAID EXPENSES
An asset is a resource under the control of an entity that has future economic
benefits. An expense is the consumption or loss of economic benefits, which leads to
a decrease in owner’s equity. When a business pays for an item in advance, it poses
the question: does the item represent an asset or an expense?
Consider the case of Preston Pet-Smart, which pays a $480 12-month insurance
premium in advance on 1 October 2023. What is the double entry for such a
transaction?
•• The credit entry is clear: as Cash at Bank has decreased, it must be credited.
•• There are two possibilities for the debit entry: the initial payment can be treated as
an asset or as an expense.
This $480 insurance premium appears to qualify under the definition of an asset – it’s
controlled by the entity and has future economic benefits. Therefore, it should be
recorded as an asset when the transaction occurs on 1 October 2023.
However, insurance is normally referred to as an expense in accounting – but when
an expense is paid in advance, it hasn’t yet been consumed and therefore doesn’t
satisfy the definition of an expense. To avoid confusion, an expense paid in advance is
prepaid referred to as a prepaid expense.
expenses
A prepaid expense exists when a payment relates to a future economic benefit
expenses paid
during a period because the item hasn’t yet been consumed. For example, if wages are paid at the
but not yet used end of the working week, they’re treated as an expense because the economic
sacrifice has been fully consumed. If insurance (or any other expense) is paid in
advance, the economic benefit is yet to be used, so an asset has been created.

PREPAID EXPENSES ON BALANCE DAY

Having decided to record the insurance payment in an asset account (prepaid
insurance), the problem then switches to balance day. If Preston Pet-Smart closes its
books on 31 December, how much insurance should it take into account?
Accrual accounting requires that only the relevant amount of insurance expense is
deducted from the period’s revenue in order to determine an accurate profit, but the
insurance payment was debited to an asset account.
The next step is to transfer out of the asset account the amount of expense that
has been used up or has expired.
Using the details of Preston Pet-Smart’s $480 insurance payment, the following
summary can be prepared.

1 October 2023 Insurance paid: $480 (which equals a cost of $40 per month)
31 December 2023 Insurance expense incurred in 2023 (three months used): 3 × $40 =
$120
31 December 2023 Prepaid insurance for 2024 (nine months not used): 9 × $40 = $360

As the insurance was paid on 1 October for 12 months in advance, only three months
has expired before balance day (31 December). Therefore, only one quarter ($120) of
the total payment should be treated as an expense. The other $360 remains as an
asset, as it still has future economic benefit for the business.

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I N F O R M A T I O N
 The prepaid insurance account is shown as follows, with both the original cash
payment and the necessary adjusting entry to insurance expense on 31 December.

Prepaid insurance expense

$ $
2023 2023 EXAM SUCCESS
1 Oct Cash at bank 480 31 Dec Insurance expense 120 When adjusting a
prepaid expense item,
Insurance expense always debit the
expense.
$ $
2023
31 Dec Prepaid insurance 120
expense

As some of the insurance paid has now been used, it’s removed from the asset
account by the credit entry and transferred to the expense account (Insurance
Expense) on balance day. The balance of the Prepaid Insurance account is now $360
($480 – $120), which is the economic benefit remaining as at 31 December 2023.
The Insurance Expense account is now ready for closing to the Profit and Loss
Summary account. As the Prepaid Insurance account is an asset, it’s balanced in the usual
way. The closing and balancing of these two accounts results in the entries shown below.

Prepaid insurance expense

$ $
2023 2023
1 Oct Cash at bank 480 31 Dec Insurance expense 120
31 Dec Balance 360
480 480
2024
1 Jan Balance 360

Insurance expense
$ $
2023 2023
31 Dec Prepaid insurance 120 31 Dec P&L summary 120
expense

The expense account is now closed and the amount of expense incurred in the
current period ($120) has been transferred to the Profit and Loss Summary account.
The amount of insurance not yet used ($360) remains in the Prepaid Insurance
account and will be reported in the balance sheet as a current asset.
As with all general ledger recordings, the adjusting and closing entries are all
recorded in the general journal first, before being entered in the general ledger. Using
the data from the above example, the general journal entries would be prepared as
shown in Figure 18.1.

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 FIGURE 18.1 Adjusting and closing entries for a prepaid expense

GENERAL JOURNAL
Date Details Dr Cr
31 Dec 2023 Insurance expense 120
Prepaid insurance expense 120
Adjusting entry for three months’ insurance
incurred
31 Dec P&L summary 120
Insurance expense 120
Closing entry

Keep in mind that when a business pays expenses (including prepaid expenses),
it may also have to pay GST. Expenses such as wages don’t attract GST, but other
expenses may.
In the case of Preston Pet-Smart, the annual insurance premium paid was $480.
Applying the 10% GST to this amount would mean that the business would actually
pay a total of $528 ($480 for the expense, plus $48 GST).
The payment for prepaid insurance, as demonstrated above, would be recorded in
the general journal as shown in Figure 18.2.

FIGURE 18.2 Journal entry to record the payment of a prepaid expense

GENERAL JOURNAL
Date Details Dr Cr
1 Oct 2023 Prepaid insurance expense 480
GST clearing 48
Cash at bank 528
Payment of 12 months’ insurance in advance via EFT

18.2 CHECK YOUR UNDERSTANDING WB PAGE 319

1 Outline the circumstances that exist when an adjustment for prepaid expenses is required.
2 A business paid for a 12-month insurance policy on 1 February 2023. The amount
paid was $660 (including GST). No other insurance policies were taken out. The
owner determines profit annually, with balance day being on 30 September each
year. How much should be reported for insurance expense for the year ended 30
September 2023?
3 At the end of a period, a business had a Prepaid Insurance account with a balance
of $4000. On balance day the insurance expired for the period was determined to
be $3400. If the adjusting entry wasn’t made, what would be the effect on the firm’s
balance sheet? Copy and complete the following table to show the effect of this
omission. (Show dollar amounts where applicable.)

Item Overstated/understated/no effect $

Assets
Liabilities
Owner’s equity

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I N F O R M A T I O N
18.3 ACCRUED EXPENSES
An expense account may include several cash payments for costs paid during the
period, but there may be additional outstanding accounts on balance day. If these
costs were incurred in the current period, they should also be included in profit
calculations for the current period.
Consider the case of Abbotsford Archery Supplies, which paid $800 for advertising
during 2023. On 31 December the business owes another $200 for advertising
completed during December. In this case, the cost incurred for advertising during
2023 is $1000, yet the balance of the Advertising Expense account in the trial balance
would only be $800 before adjustments have been entered.
The Advertising Expense account has been prepared below and includes the
necessary balance day adjustment.
Advertising expense
2023 $ $
Jan–Dec Cash at bank 800
31 Dec Accrued advert expense 200

Accrued advertising expense

$ 2023 $
31 Dec Advertising expense 200

The adjusting entry for the accrued expense has the following features: accrued
expenses
•• The debit entry increases the expense account so that it equals the total cost expenses that
incurred for the period (i.e. $1000). have been
incurred during a
•• It creates a liability on balance day in the form of the Accrued Advertising Expense period but not yet
account. paid, remaining
as liabilities on
balance day
RECORDING ACCRUED EXPENSES
In the above case, Abbotsford Archery Supplies owes $200 as at 31 December. As
this $200 is a present obligation resulting from a past event, it should be reported
as a liability. As this type of debt would usually be paid within a short period of time
(perhaps 30 or 60 days), it’s classified as a current liability.
The closing entry is entered as usual on the credit side of the expense account.
This closing entry transfers the advertising expense for the period ($1000) to the Profit
and Loss Summary account on balance day.

Advertising expense
2023 $ 2023 $
Jan–Dec Cash at bank 800
31 Dec Accrued advertising 200 31 Dec P&L summary 1 000
expense
1 000 1 000

The general journal entries required for the adjusting and closing entries for accrued
advertising are shown in Figure 18.3.

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 FIGURE 18.3 Adjusting and closing entries for an accrued expense

GENERAL JOURNAL
Date Details Dr Cr
31 Dec 2023 Advertising expense 200
Accrued advertising expense 200
31 Dec Adjusting entry for advertising owing
P&L summary 1 000
Advertising expense 1 000
Closing entry

ACCRUED EXPENSES IN SUBSEQUENT PERIODS

It’s important to consider the treatment of accrued expenses in the subsequent
period. For Abbotsford Archery Supplies, an Accrued Advertising Expense account
was created for advertising owing on balance day. The $200 listed as owing at that
time would be reported in the balance sheet as a current liability. This item would be
paid sometime in the early stages of the next period (e.g. 5 January).
When the amount owing is paid off, it should not be recorded as an expense in the
new period. The double entry shown in Figure 18.4 will ensure that this is achieved.
(The related GST payment has also been included.)

FIGURE 18.4 Payment of an accrued expense in the subsequent period

GENERAL JOURNAL
Date Details Dr Cr
5 Jan 2024 Accrued advertising expense 200
GST clearing 20
Cash at bank 220
Payment of accrued advertising from previous
period via EFT

It’s vital that the payment of $200 is debited to accrued advertising, and not to advertising
expense. This will avoid counting the advertising payment as an expense twice.
When creating the account on balance day, a specific title such as ‘Accrued
Advertising Expense’ should be used, rather than the generic term ‘Accrued
Expenses’. This allows the expense that’s owing to be easily identified; when it is paid
off in the new period, the accrued account can be eliminated.
When the cash payment is made, the Accrued Advertising Expense account will
appear as follows.
Accrued advertising expense
$ $
5 Jan Cash at bank 200 31 Dec Advertising expense 200

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SPLITTING UP ACCRUED EXPENSES IN SUBSEQUENT PERIODS
In the previous example, $200 was owing for advertising from the previous period.
This amount was then paid off during January. However, what happens if $500 (plus
GST of $50) was paid for advertising on 5 January, including the $200 owing as at DON’T!
When paying
31 December? accrued expenses in the
This $500 can be broken down into two parts: next period, make sure you
don’t debit the expense
•• The amount owing from last period is $200.
account with the total
•• The remaining $300 relates to advertising expense for the new period. amount paid.

It’s important to record the two amounts accurately. First, the $200 owing should be
closed off in the liability account. The second part of the transaction is to record the
other $300 in the Advertising Expense account as usual; see Figure 18.5.

FIGURE 18.5 Payment of an accrued expense in the subsequent period, with an

additional expense also being paid

GENERAL JOURNAL
Date Details Dr Cr
31 Dec 2023 Accrued advertising expense 200
Advertising expense 300
GST clearing 50
Cash at bank 550
Payment of $200 accrued advertising from
previous period, plus $300 for the current
period (EFT payment)

When the one payment of $500 is paid for advertising (plus GST), it’s important
to record this payment correctly in the journal. The total amount must be split
between the payment of the liability and the payment of the expense. The end
result is that the liability owing from the previous period (i.e. $200) has been
eliminated, and the expense incurred in relation to the new period is also recorded
($300 in the expense account).

Payment of
liability and
expense must
be recorded
separately.

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 Note also that the total amount of GST paid, which is $50, is recorded at this time.

Accrued advertising expense

$ $
31 Jan Cash at bank 200 31 Dec Advertising expense 200

Advertising expense
$ $
31 Jan Cash at bank 300

GST clearing
$ $
31 Jan Cash at bank 50

18.3 CHECK YOUR UNDERSTANDING WB PAGE 320

1 What is an accrued expense? Explain the effect of an adjusting entry for an accrued
expense on both the income statement and the balance sheet.
2 A business had accrued advertising of $250 on balance day of 30 June 2023. State
the double entry required when the advertising is paid on 2 July 2023 (including the
GST payment of $25).
3 If a business had accrued wages of $400 on balance day of 31 December 2023, state
the double entry required when wages of $500 are paid on 2 January 2024.
4 Copy and complete the following table to show the effect of an adjusting entry for an
accrued expense of $400 on the accounting equation. (Show dollar amounts where
applicable.)

Item Increase Decrease No effect

Assets
Liabilities
Owner’s equity

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18.4 INVENTORY LOSSES AND GAINS
While accounting for inventory losses and gains was covered earlier in Chapter 7, it’s
important to realise that such entries are also balance day adjustments.

ADJUSTMENT FOR AN INVENTORY LOSS

Physical stocktakes are carried out on balance day. If necessary, an adjustment for an
inventory loss is also done at this time. Consider the following details.

31 Dec Balance of the Inventory account $45 000

Value determined by the physical stocktake $42 500

In this situation, an inventory loss of $2500 has occurred. A balance day adjustment
is required to decrease the balance of the Inventory account to its correct figure.
The adjustment also creates an expense account in the form of Inventory Loss,
as the business has experienced a consumption of economic benefits (although
unintentionally) to the value of $2500.
The adjusting entry required is shown in Figure 18.6.

FIGURE 18.6 Adjusting entry for an inventory loss

GENERAL JOURNAL
Date Details Dr Cr
31 Dec Inventory loss 2 500
Inventory 2 500
Adjusting entry for inventory loss revealed by
physical stocktake (Memo 76)

ADJUSTMENT FOR AN INVENTORY GAIN

The other possible balance day adjustment required is to account for an inventory
gain. Consider the following details.

31 Dec Balance of the Inventory account $45 000

Value determined by the physical stocktake $46 000

In this situation, an inventory gain of $1000 has occurred. A balance day adjustment
is required to increase the balance of the Inventory account to its correct figure.
The adjustment also creates a revenue account in the form of Inventory Gain, as the
business has had an inflow of resources to the value of $1000.
It could be argued that inventory gains are merely an adjustment to expenses,
because this type of gain often occurs because of recording or stocktaking errors.
However, an inventory gain may also occur through oversupply by a supplier. Although
such an event should be detected when goods are delivered, it’s possible that it may
go undetected throughout the period.
The effect of oversupply is that the business has (accidentally) experienced an
inflow of economic resources, which qualifies as a revenue item. Thus, inventory gains
should be recognised as revenue and must be adjusted for on balance day.
The adjusting entry to record an inventory gain of $1000 is shown in Figure 18.7.

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 FIGURE 18.7 Adjusting entry for an inventory gain

GENERAL JOURNAL
Date Details Dr Cr
31 Dec Inventory 1 000
Inventory gain 1 000
Adjusting entry for inventory gain revealed by
physical stocktake (Memo 76)

18.4 CHECK YOUR UNDERSTANDING WB PAGE 320

1 What is the double entry required to account for an inventory loss? Explain the two-
fold effect an inventory loss has on a balance sheet.
2 Explain how a physical stocktake can help satisfy reliability.
3 Explain two possible causes of an inventory gain.

18.5 EXTENDED EXAMPLE: ADJUSTING AND

CLOSING ENTRIES
The following extended example demonstrates the processes involved in recording
adjusting and closing entries for a small business. A trial balance has been prepared
for the business of Supreme Trading Store, and this is followed by a series of balance
day adjustments to be recorded on 30 June 2023.

SUPREME TRADING STORE: TRIAL BALANCE AS AT 30 JUNE 2023

$ $
Prepaid insurance expense 2 280 Sales revenue 121 000
Interest expense 9 000 Accumulated depreciation – 540
office furniture
Inventory 55 000 Loan – NAB 183 000
Advertising expense 2 600 Capital 676 120
Telephone expense 780 Interest revenue 200
Drawings 8 000 Accounts payable 12 000
Wages 48 000 GST clearing 2 000
Term deposit (maturing 30/6/24) 6 000 Allowance for doubtful debts 1 000
Cash at bank 2 500
Accounts receivable 10 100
Cost of sales 47 000
Sales returns 1 000
Office furniture 3 600
Premises 800 000
995 860 995 860

Adjustments required:
•• insurance expense for the year: $2000
•• inventory on hand as at 30 June 2023: $54 600 (Memo 36)

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•• B Broak, an accounts receivable who owes $1000, to be written off as a bad debt;
the allowance for doubtful debts to be increased to $1200
•• advertising owing: $300
•• depreciation – office furniture: 10% per annum on cost.

GENERAL JOURNAL
The following adjusting and closing entries to account for the balance day adjustments
are recorded in the general journal.

Date Details Dr Cr
30 June 2023 Insurance expense 2 000
Prepaid insurance expense 2 000
Adjusting entry for insurance incurred
Inventory loss 400
Inventory 400
Adjusting entry for inventory loss identified by
physical stocktake (Memo 36)
Allowance for doubtful debts 1 000
Accounts receivable 1 000
Account: B Broak written off as bad debt
Bad debts 1 200
Allowance for doubtful debts 1 200
Adjusting entry to increase allowance for
doubtful debts to $1200
Advertising expense 300
Accrued advertising expense 300
Adjusting entry for advertising owing EXAM SUCCESS
Depreciation – office furniture 360 Always remember:
one closing entry for
Accumulated depreciation – office furniture 360
all revenues and one
Adjusting entry for depreciation: 10% on cost closing entry for all
Sales 121 000 expenses.

Interest revenue 200

Sales returns 1 000
P&L summary 120 200
Closing entries
P&L summary 111 640
Insurance 2 000
Interest expense 9 000
Advertising expense 2 900
Telephone expense 780
Wages 48 000
Cost of sales 47 000
Inventory loss 400
Bad debts 1 200
Depreciation of office furniture 360
Closing entries
P&L summary 8 560

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 Capital 8 560
Transfer of net profit
Capital 8 000
Drawings 8 000
Transfer of owner’s drawings

GENERAL LEDGER
These general journal entries must now be posted to general ledger accounts.
The accounts involved in the profit determination process are shown below, along
with the items from the balance sheet that are affected by the adjusting entries.

Sales revenue
$ $
30 Jun P&L summary 121 000 Jul–Jun Cash at bank 121 000

Prepaid insurance
$ $
Jul–Jun Cash at bank 2 280 30 Jun Insurance expense 2 000
Balance 280
2 280 2 280
1 Jul Balance 280

Insurance expense
$ $
30 Jun Prepaid insurance 2 000 30 Jun P&L summary 2 000
expense

Interest expense
$ $
Jul–Jun Cash at bank 9 000 30 Jun P&L summary 9 000

Inventory
$ $
30 Jun Balance 55 000 30 Jun Inventory loss 400
Balance 54 600
55 000 55 000
1 Jul Balance 54 600

Inventory loss
$ $
30 Jun Inventory 400 30 Jun P&L summary 400

Advertising expense
$ $
Jul–Jun Cash at bank 2 600
30 Jun Accrued advertising 300 30 Jun P&L summary 2 900
expense
2 900 2 900

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 Accrued advertising expense
$ $
30 Jun Advertising expense 300

Wages
$ $
Jul–Jun Cash at bank 48 000 30 Jun P&L summary 48 000

Telephone expense
$ $
Jul–Jun Cash at bank 780 30 Jun P&L summary 780

Cost of sales
$ $
Jul–Jun Inventory control 47 000 30 Jun P&L summary 47 000

Interest revenue
$ $
Jul–Jun P&L summary 200 Jul–Jun Cash at bank 200

Accounts receivable
$ $
30 Jun Balance 10 100 30 Jun Allowance for 1 000
doubtful debts
Balance 9 100
10 100 10 100
1 Jul Balance 9 100

Allowance for doubtful debts

$ $
30 Jun Accounts receivable 1 000 30 Jun Balance 1 000
30 Jun Doubtful debts 1 200
expense

Bad debts
$ $
30 Jun Allowance for doubtful 1 200 30 Jun P&L summary 1 200
debts

Depreciation – office furniture

$ $
30 Jun Accumulated 360 30 Jun P&L summary 360
depreciation – office
furniture

Accumulated depreciation – office furniture

$ $
30 Jun Balance 540
30 Jun Balance 900 Depreciation – office 360
furniture

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 900 900
1 Jul Balance 900

Profit and loss summary

$ $
30 Jun Expense accounts 111 640 30 Jun Revenue accounts 120 200
Capital 8 560
120 200 120 200

Capital
$ $
30 Jun Drawings 8 000 30 Jun Balance 676 120
Balance 676 680 P&L summary 8 560
684 680 684 680
1 Jul Balance 676 680

Drawings
$ $
Jul–Jun Cash at bank 8 000 30 Jun Capital 8 000

INCOME STATEMENT AND BALANCE SHEET

The ledger accounts above include the adjusting and closing entries for all of the
balance day adjustments. It’s important to be able to trace the double entry for each of
the adjustments through to the preparation of the Profit and Loss Summary account.
Once all the processes required on balance day have been completed, the financial
reports can be prepared in the usual way. The income statement and the balance
sheet for Supreme Trading are shown below.

SUPREME TRADING STORE: INCOME STATEMENT FOR THE YEAR ENDED 30 JUNE 2023
$ $
Revenue
Sales revenue 121 000
Less: Sales returns 1 000 120 000
Less: Cost of sales 47 000
Gross profit 73 000
Less: Inventory loss 400
Adjusted gross profit 72 600
Other revenue
Interest revenue 200
72 800
Less: Other expenses
Insurance 2 000
Interest expense 9 000
Advertising 2 900
Telephone 780
Wages 48 000
Bad debts 1 200
Depreciation – office furniture 360 64 240
Net profit 8 560

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SUPREME TRADING STORE: BALANCE SHEET AS AT 30 JUNE 2023
Current assets Current
$ $ $ $ $ $
Liabilities
Cash at bank Accounts
2 500 12 000
payable
Accounts 9 100 Accrued 300
receivable advertising
Less: Allowance 1 200 7 900 GST clearing 2 000 14 300
for doubtful
debts
Inventory 54 600 Non-current
Liabilities
Term deposit 6 000 Loan – Nab 183 000
Prepaid 280 71 280
insurance
Non-current Owner’s equity
assets
Office furniture 3 600 Capital 676 120
Less: 900 2 700 Net profit 8 560 684 680
Accumulated
depreciation
Premises 800 000 802 700 Less: Drawings 8 000 676 680
873 980 873 980

PREPARING AN INCOME STATEMENT

These two accounting reports have been prepared under the accrual method of
accounting. The revenues and expenses reported in the income statement represent
the revenues earned and expenses incurred during the period. This also means that
EXAM SUCCESS
the dollar values shown are after adjustments have been made to the accounts. This report has been
Inventory losses or gains should be listed immediately after gross profit has been prepared in line with the
recommended format
determined. The resultant figure is labelled as adjusted gross profit. If the business
for VCE exams.
has earned revenue in addition to its cash and credit sales of inventory items, this
should be listed after the adjusted gross profit figure. From this new sub-total, the
other expenses of the business are deducted to determine the final net profit figure.
The balance sheet states the assets and liabilities after the adjustments have been
made. Accrued expenses represent obligations of the business as at 30 June 2023,
and are therefore reported as liabilities. Note that the Inventory account has been
adjusted for the inventory loss revealed by the physical stocktake. The term deposit

Recording
adjustments
makes for a more
accurate profit
figure.

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 (maturing 30 June 2024) has been classified as a current asset, because it’s expected
to be turned into cash within the next 12 months.
Note that every balance day adjustment in this case study affected an item in both
financial reports. This situation will always occur because an adjustment must affect
a revenue or expense account as well as an asset or liability. Such adjustments are
necessary under accrual accounting in order to meet the demands of both relevance
and the period assumption.
When all adjustments have been recorded, the result is a more accurate profit
figure as well as a more accurate statement of a firm’s financial position.

18.5 CHECK YOUR UNDERSTANDING WB PAGE 321

1 State the double entry to (a) write off a bad debt, and (b) increase the allowance for
doubtful debts.
2 It could be claimed that doubtful debts create a conflict between relevance and
verifiability. Do you agree? Justify your answer.
3 Does writing off a debtor as irrecoverable satisfy the demands of faithful
representation? Explain your answer fully.

18.6 THE ADJUSTED TRIAL BALANCE

A trial balance should be prepared at the end of a period to ensure that the double
entries made during the period are accurate. Once this has been checked, balance
day adjustments may be entered into the books. To ensure that this process has been
done correctly, a second trial balance may be prepared.
adjusted trial An adjusted trial balance is prepared after balance day adjustments have been
balance
a trial balance entered in the accounts. As all adjustments are included, the same data that is used
prepared after to prepare the final reports is used in an adjusted trial balance.
the recording
of balance day
Using the data as stated previously for Supreme Trading Store, the adjusted trial
adjustments has balance would be prepared as shown below.
been completed
SUPREME TRADING STORE: ADJUSTED TRIAL BALANCE AS AT 30 JUNE 2023
$ $
Prepaid insurance expense 280 Sales revenue 121 000
Interest expense 9 000 Accumulated depreciation – 900
office furniture
Inventory 54 600 Loan – NAB 183 000
Advertising 2 900 Capital 676 120
Telephone expense 780 Interest revenue 200
Wages 48 000 Accrued advertising expense 300
Term deposit 6 000 GST clearing 2 000
Cash at bank 2 500 Accounts payable 12 000
Accounts receivable 9 100 Allowance for doubtful debts 1 200
Cost of sales 47 000
Sales returns 1 000
Office furniture 3 600

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 Drawings 8 000
Premises 800 000
Insurance expense 2 000
Inventory loss 400
Bad debts 1 200
Depreciation – office furniture 360
996 720 996 720

Always check the data presented for report presentation, as a trial balance contains
completely different data from that used for an adjusted trial balance.
An income statement should be based on adjusted revenue and expense
accounts. Therefore, an adjusted trial balance provides the required information.
However, if a pre-adjustment trial balance is the only information available, always
ensure that the appropriate balance day adjustments are processed first.
Once those adjustments are made, the final accounting reports may then be
prepared to determine an accurate profit figure for the period.

18.6 CHECK YOUR UNDERSTANDING WB PAGE 322

1 Distinguish between a trial balance and an adjusted trial balance.

2 ‘If an adjusted trial balance balances, the net profit of a business will be calculated
accurately.’ Do you agree? Explain your answer.
3 The accounting system includes many different processes in both the recording and
reporting phases. Rewrite the following list in sequential order, as they would occur
in a double entry system.
•• Balance sheet
•• General ledger
•• Business documents
•• Trial balance
•• Income statement
•• General journal
•• Adjusted trial balance
•• Balance day adjustments

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 18 CHAPTER REVIEW

KEY CONTENT
• [18.1] Balance day adjustments adjust the balances of revenue and expense accounts so
that they equal the revenue earned and expenses incurred. Such adjustments make it
possible to create an accurate trial balance that reflects more than just cash flows.
• [18.1] Adjusting entries are made in revenue and expense accounts to make them equal
to revenue earned and expenses incurred. Closing entries are used to close off the
adjusted revenue and expense accounts to the Profit and Loss Summary account.
• [18.2] A prepaid expense exists when a payment relates to a future economic benefit
because the item hasn’t yet been consumed. On balance day, the relevant amount
of expense is deducted from the period’s revenue in order to determine an accurate
profit. The remaining amount is retained as an asset.
• [18.3] Accrued expenses are those that have been incurred during a period but not yet paid.
They remain as liabilities on balance day and must be recorded as such. When the
amount owing is paid off, it should not be recorded as an expense in the new period.
• [18.4] Physical stocktakes are carried out on balance day. If necessary, an adjustment for an
inventory loss or gain is also done at this time.
• [18.6] At the end of a period, a trial balance is prepared to ensure the accuracy of the double
entries made. Once this is checked, balance day adjustments may be entered into the
books. An adjusted trial balance is prepared after balance day adjustments have been
entered in the accounts.

CHAPTER 18 EXERCISES

WB PAGE 323
SPREADSHEET X.XX1 Preparation of an income statement
Ben Nguyen is the proprietor of Nguyen Robotics. He commenced business on 1 July
2022 and supplies the following information regarding his first year of business.
• Sales charged to customers totalled $120 000. Of this amount, all but $15 000 was
received prior to 30 June 2023.
• Cost of sales for the year was $54 000.
• Advertising paid was $4000. An account for $1000 for advertising completed during
June 2023 hasn’t yet been paid.
• Insurance paid during the year was $3600, of which $400 relates to the period July–
September 2023.
• Office expenses for the year were $8000, and were all paid by 30 June 2023.
• The business premises were rented at a cost of $4000 per month. A total of
$52 000 was paid during the year for rent.
a Prepare an income statement under the accrual method of accounting for the year
ended 30 June 2023.
b Prepare an extract from the firm’s balance sheet, showing the current assets that
would be reported on 30 June 2023 under accrual accounting as a result of the
above information.

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2 Preparation of an income statement WB PAGE 324 SPREADSHEET X.XX

Melissa Mercuri, owner of Northcote Theatrical Lighting, supplies the following

information relating to the quarter ended 31 March 2023.
• Cost of sales for the quarter was $22 000.
• Inventory loss amounted to $300.
• A three-month advertising contract costing $6000 was paid on 1 February 2023.
• Wages paid for the quarter totalled $9000.
• A total of $1000 of vehicle expenses was paid during the quarter. Included in this
was a yearly insurance premium of $480 paid on 1 March 2023.
• Depreciation of equipment for the quarter was $2000.
• Sales revenue earned was $46 000, including $5000 yet to be received.
Prepare an income statement for the quarter ended 31 March 2023 using the accrual
method of accounting.

3 Preparation of an income statement WB PAGE 325 SPREADSHEET X.XX

The manager of Dickenson’s Books provides the following summary of the firm’s
transactions during 2023.
• Sales received totalled $88 000.
• Cost of sales for the year totalled $42 000.
• Wages paid to an assistant during the year were $29 000. A bonus of $1000 was
earned by the employee during December but hadn’t been paid by balance day.
• Depreciation of equipment for the year was $1200.
• Depreciation of office furniture was $800.
• Inventory as per stocktake was $22 000; balance of Inventory account: $19 800.
• Insurance paid was $1100. Prepaid insurance was $300 at 1 January 2023 and $400
at 31 December 2023.
• Cleaning expenses paid totalled $5200. On 31 December an amount of $300 was
owing for cleaning.
a Prepare an income statement under the accrual method of accounting for the year
ended 31 December 2023.
b List the items that would appear in the firm’s balance sheet under the headings of
‘Current assets’ and ‘Current liabilities’.

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 SPREADSHEET X.XX4 Prepaid expenses: basic WB PAGE 325

The owner of Caserta’s Ice Skates paid $120 000, plus GST of $12 000, for six months’
rent in advance on 1 May 2023. Balance day is on 30 June each year.
a State the double entry that would be made when the payment occurred on 1 May 2023.
b Prepare the adjusting and closing entries in the general journal that relate to the
rent expense for the period that ends on 30 June 2023.
c Prepare the Prepaid Rent account and the Rent Expense account, with all relevant entries.
d Explain the purpose of the adjusting entry prepared in part b of this question.
e State and explain the effect on the firm’s accounting reports if the balance day
adjustment for rent wasn’t done.

SPREADSHEET X.XX5 Prepaid expenses: advanced WB PAGE 327

Max Kolbe is the proprietor of Splatter Paintball Supplies, a small business that owns
three vehicles. The following ledger account records the yearly insurance premiums
paid on these vehicles. The firm closes its books on 31 December each year.

Prepaid insurance
2023 $ $
1 Jan Balance 750
1 Apr Cash at bank 900
30 Jun Cash at bank 900
1 Nov Cash at bank 900

a Calculate the insurance expense that would be reported under accrual accounting
for the year ended 31 December 2023.
b Prepare the Prepaid Insurance account, and record the adjusting and closing entries
that would be made on 31 December 2023 if this firm used accrual accounting.
c Explain the link between the adjusting entry prepared in part b above and the
qualitative characteristic of relevance.
d How is the balance sheet affected by the adjusting entry prepared in part b?

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6 Accrued expenses: basic WB PAGE 328 SPREADSHEET X.XX

Rosehill Trading paid a total of $4200 for equipment repairs during 2023. On
31 December 2023, the business still has in its possession an account for repairs done
during December. This account was for $1300 and hasn’t been paid.
a Prepare the adjusting and closing entries in the general journal that relate to the
repairs expense.
b Prepare the Equipment Repairs Expense account and Accrued Equipment Repairs
account with all relevant entries on 31 December 2023.
c Explain how the adjusting entry prepared in part a helps satisfy the period assumption.
d State and explain the effect on the firm’s reports if the balance day adjustment
wasn’t recorded.
e On 31 January 2024, Rosehill Trading made a cash payment of $1430 in relation to
equipment repairs. This amount included the $1300 owing as at 31 December 2023,
plus the related amount of GST. Prepare the relevant entry in the general journal.
f Post the entry made in your general journal to the Accrued Equipment Repairs account.

7 Accrued expenses: advanced WB PAGE 330 SPREADSHEET X.XX

Alphington All-Sports has an advertising contract with the local newspaper for a cost of
$300 per month. During the year ended 30 September 2023, the business paid a total
of $3000. The accounts for August and September 2023 haven’t yet been settled. The
Advertising Expense account in the general ledger appears as shown below.

Advertising expense
2023 $ $
Oct–Sep Cash at bank 3 000

a State the amount of advertising expense that would be reported for the year ended
30 September 2023 under accrual accounting.
b Prepare the adjusting journal entry that would be made on 30 September 2023.
c Prepare the Advertising Expense account in the general ledger, including the
required adjusting and closing entries.
d State the two-fold effect of the adjusting entry on the balance sheet.
e On 31 October the business made a cash payment of $900, plus GST of $90. The
$900 relates to advertising for the months of August, September and October 2023.
Record this event in the relevant ledger accounts.
f Prepare the required entries in the cash payments journal for the payment of $990
on 31 October 2023.

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 SPREADSHEET X.XX8 Bad debts: basic WB PAGE 331

Highpoint Hardware made a credit sale to B Riskee on 15 November 2022. The invoice
price was $550, plus $55 GST, and this was entered into the Accounts Receivable
account on 30 November 2022. The owner of Highpoint Hardware has chased Riskee
for payment for several months, without success. On balance day, 30 June 2023, the
owner decides to write off the account as a bad debt.
a Prepare the general journal entry required on 30 June 2023 to write off Riskee’s
debt, given that the allowance for doubtful debts has a balance of $1000.
b Explain the effect on the income statement and the balance sheet of Highpoint
Hardware when the balance day adjustment is recorded.

SPREADSHEET X.XX9 Bad debts: advanced WB PAGE 332

The general ledger of Natural Nutrients included the accounts shown below.
After trying to track down I Nikov for almost two years, the owner of Natural Nutrients
has just received legal advice that Nikov has been declared bankrupt. All of Nikov’s
debts are to be paid at 12 cents for each dollar owed, and a bank cheque was enclosed
as a final payment. The business owner has decided to write off the remainder of
Nikov’s balance as irrecoverable.
a Prepare the adjusting entry required on 30 June 2023 to write off the Nikov account.
b Prepare the Nikov account to show both the receipt of cash from Nikov and the
writing off of the account.

Accounts receivable – I Nikov

2021 $ $
31 Mar Credit sales/GST 1 260
clearing

Allowance for doubtful debts

$ 2023 $
30 Jun Balance 1 000

c The owner of Natural Nutrients decides to increase the allowance for doubtful debts
to $1500. Complete the Allowance for Doubtful Debts account, including the writing
off of Nikov’s account and the adjusting entry required to increase the allowance.

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I N F O R M A T I O N
10 From trial balance to balance sheet WB PAGE 332 SPREADSHEET X.XX

The following trial balance was supplied by the owner of Shot Callers Streetwear.

SHOT CALLERS STREETWEAR: TRIAL BALANCE AS AT 31 DECEMBER 2023

$ $
Cash at bank 2 500 Capital 68 000
Advertising 3 300 Sales 132 400
Inventory 51 000 Accounts payable 1 000
Term deposit (30/6/25) 26 000 Accumulated depreciation – 800
office furniture
Office furniture 4 000 Accumulated depreciation – 6 000
vehicle
Vehicle 32 000 Loan – DBC Finance 74 000
Prepaid insurance expense 3 400 GST clearing 1 000
Interest 6 400
Cost of sales 65 800
Drawings 6 400
Rent 75 000
Accounts receivable 6 000
Telephone expense 740
Stationery expense 660
283 200 283 200

Adjustments required
• Inventory as per stocktake as at 31 December 2023 was $50 000
• Prepaid insurance as at 31 December 2023 was $100
• Telephone expenses owing: $120
• Depreciation – vehicle: 25% per annum on cost
• Office furniture: 20% per annum, reducing balance method

a Prepare all adjusting and closing entries for the general journal on 31 December
2023.
b Prepare the following general ledger accounts, including any necessary adjusting
and closing entries: Prepaid Insurance Expense, Telephone Expense, and Inventory.
c Prepare an adjusted trial balance as at 31 December 2023.
d Prepare an income statement for the year ended 31 December 2023 and a
classified balance sheet at that date.
e The business paid $300, plus GST of $30, for telephone expenses on 15 January
2024, which included the $120 owing from December 2023. Prepare the required
entry in the general journal on 15 January 2024.

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 SPREADSHEET X.XX11 Reports with adjustments, including doubtful debts WB PAGE 336

The following trial balance relates to the business of Prints Charming, a small business
owned and managed by Alanah Douglas.

PRINTS CHARMING: TRIAL BALANCE AS AT 30 SEPTEMBER 2023

$ $
Cash at bank 5 200 Capital 112 000
Advertising 1 200 Cash sales 54 000
Accounts receivable 12 700 Credit sales 35 500
Cost of sales 49 600 Accumulated 6 600
depreciation –
equipment
Equipment 22 000 Accumulated 12 000
depreciation – vehicle
Assistant’s wages 23 000 Loan – MT Finance 38 000
Interest on loan 1 880 Accounts payable 10 000
Inventory 44 500 Commission revenue 200
Drawings 14 600 GST clearing 3 500
Telephone expense 680 Allowance for 1 500
doubtful debts
Rent 44 600
Stationery expense 500
Vehicle 48 000
Electricity 850
Prepaid insurance 2 750
expense
Equipment repairs 1 240
273 300 273 300

Adjustments required
• One of the credit clients of the business has been declared bankrupt. The total
amount of $1700 owing by D Crepit is to be written off.
• After writing off D Crepit’s account, the owner of Prints Charming has decided to
increase the allowance for doubtful debts to $2000.
• Insurance paid in advance as at 30 September 2023: $150.
• Interest owing on loan: $120.
• The owner gave some colour prints to the local kindergarten for a fundraising
auction and received some advertising during the event. The goods provided had a
cost price of $500 and a selling price of $950. As yet, no entry had been made to
record this event.
• Depreciation of equipment: 15% per annum on cost.
• Depreciation of vehicles: 25% per annum reducing balance method.
• Physical stocktake as at 30 September: $42 900.
• On 30 September 2023 the owner realised that a payment of $200 for wages was
accidentally debited to advertising.

a Prepare an income statement, taking into account all adjustments required.

b Prepare a classified balance sheet as at 30 September 2023.
c State the double entry that results when the interest owing is paid on 3 October
2023.

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I N F O R M A T I O N
12 Reports with adjustments, including doubtful debts WB PAGE 337

The proprietor of One Stop Geocaching Supplies the following information relating to
her business.

ONE STOP GEOCACHING: TRIAL BALANCE AS AT 30 JUNE 2023

$ $
Accounts receivable 23 850 Accumulated depreciation –
580
office equipment
Advertising 3 200 Accumulated depreciation – 1 760
shop fittings
Cleaning expenses 4 060 Allowance for doubtful debts 2 800
Cost of sales 75 800 Bank 14 370
Drawings 10 900 Capital 304 600
Interest expense 31 300 GST clearing 6 000
Inventory 48 520 Interest revenue 1 560
Investment account 15 700 Mortgage loan 670 000
Office equipment 5 800 Sales revenue 121 780
Office expenses 3 140
Premises 852 000
Prepaid insurance expense 3 800
Rates 2 600
Salaries 31 240
Sales returns 1 280
Shop fittings 8 800
Stationery expense 580
Telephone expense 880
1 123 450 1 123 450

Adjustments required
• Depreciation – office equipment: 20% per annum, reducing balance method.
• Depreciation – shop fittings: 20% per annum on cost.
• Insurance expired during period: $3200.
• An account for $800 for cleaning done during June 2023 hasn’t yet been paid and is
not included in the above accounts.
• It’s been discovered that $200 of advertising has been incorrectly debited to the
Interest Expense account.
• The physical stocktake conducted on 30 June 2023 showed total inventory on hand
of $49 200.
• One debtor, who owes $3600, has to be written off as irrecoverable.
• The allowance for doubtful debts is to be increased to 3% of net sales.

a Prepare an income statement for the year ended 30 June 2023, showing clearly the
gross and net profit earned by the business.
b Prepare a classified balance sheet as at 30 June 2023.
c Prepare the required entry in the cash payments journal on 28 July 2023 when $264
is paid in relation to cleaning expenses. This included a GST payment of $24.

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 CASE STUDY WB PAGE 339

Nigella Cook is the owner of Chefmaestro Kitchen Products. The trial balance of her
general ledger accounts at the end of a year’s trading is shown below.

CHEFMAESTRO KITCHEN PRODUCTS: TRIAL BALANCE AS AT 30 JUNE 2023

$ $
Accounts receivable 4 420 Accounts payable 12 500
Advertising 2 280 Accumulated depreciation
– display equipment 1 460
Bank 2 130
Carriage inward 2 010 Accumulated depreciation
– office furniture 480
Carriage outward 2 620
Carry bags expense 1 920 Allowance for doubtful debts 1 600
Cleaning of shop 2 020 Bank loan 223 000
Cost of sales 58 200 Capital 193 560
Council rates 2 400 Cash sales 86 100
Discount expense 1 020 Credit sales 32 100
Display equipment 14 600 Discount revenue 1 200
Drawings 17 000 GST clearing 3 500
Electricity 1 420
Interest expense 18 000
Inventory 52 800
Office expenses 1 500
Office furniture 1 600
Postage 1 030
Premises 340 000
Prepaid insurance expense 3 600
Telephone expenses 1 430
Wages 23 500
555 500 555 500

Additional information
• The insurance premium was for 12 months’ coverage and was taken out on 1 August
2022.
• An account for $120 for electricity for the month of June has been received but not yet
paid. It will be paid on 4 July 2023.
• A physical stocktake performed on 30 June 2023 was checked against the firm’s
inventory cards. Discrepancies were found to exist on three different inventory cards:

Item Inventory card balance: FIFO Stocktake

Digital scales 11 @ $28 30 on hand (selling price
25 @ $29 $59.95)
Electric frypans 6 @ $68 14 on hand (selling price
10 @ $72 $139.50)
Three-litre 30 @ $24 31 on hand (selling price
saucepans $45.00)

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I N F O R M A T I O N
• It was discovered that the owner had withdrawn $640 from the business on 26 June.
No entry has been made to account for this transaction.
• A review of the cheque book of the business has revealed that $40 paid for postage on
2 June 2023 has been incorrectly recorded in the firm’s journal as a telephone account.
• The bank loan is repayable at the rate of $400 per week.
• Depreciation is required as follows: display equipment 20% on cost; office furniture
15% on cost.
• One of the firm’s accounts receivable, Con Spiracee, is to be written off as a bad debt.
He owed $1000.
• The allowance for doubtful debts is to be decreased to $1200.

1 Prepare general journal entries for all adjustments required on 30 June 2023.
2 Prepare closing entries in the general journal on 30 June 2023.
3 Complete the following general ledger accounts, including all relevant entries to
account for the stated information: Prepaid Insurance Expense, Insurance Expense,
Accrued Electricity, Electricity Expense, and Inventory.
4 Complete the Profit and Loss Summary account as it would appear in the general
ledger.
5 Prepare the first section of the income statement to determine the gross profit and the
adjusted gross profit of the business for the year. (The full report isn’t required.)
6 Prepare a balance sheet as at 30 June 2023.
7 Explain your treatment of the insurance premium, with reference to one qualitative
characteristic of accounting.
8 Refer to the item regarding the withdrawal of cash by the owner. Justify your treatment
of this item, with reference to one accounting assumption.
9 Taking into account the information regarding the physical stocktake, comment on the
management of the inventory held by the business.
10 Comment on the level of profit earned by the business over the last 12 months.

978 1 4202 3962 1 [ C H A P T E R 18 ] P R O F I T D E T E R M I N AT I O N A N D B A L A N C E DAY A D J U S T M E N T S 369

 CHAPTER CHECKLIST
Now that you have finished Chapter 18, double-check your progress.
Are you ready for your Unit 4 exam?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
completed the end-of-chapter activities
handed in my workbook for marking.

I understand …

the recording of transactions in the General Journal and General Ledger and
preparation of classified accounting reports using manual methods and ICT
the recording and reporting of balance day adjustments:
– prepaid expenses (asset approach) with GST being recorded at the time of payment
– accrued expenses with GST being recorded at the time of payment
– the payment of accrued expenses in the subsequent reporting period
the purpose and preparation of an adjusted Trial Balance
characteristics and use of classified accounting reports: Cash Flow Statement.

I can …

prepare an adjusted Trial Balance

analyse the effect of financial transactions on the accounting reports
analyse the effect of balance day adjustments on accounting reports.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_18

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

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I N F O R M A T I O N
19 UNEARNED AND ACCRUED
REVENUE

In Chapter 18 you looked at the LEARNING OBJECTIVES

process of determining whether
a business has made a profit. This By the end of this chapter, you will be able to:
process is made harder when •• outline the meaning of the terms ‘unearned revenue’
revenue is earned in one reporting and ‘accrued revenue’ [19.1]
period but isn’t actually obtained
•• prepare balance day adjustments in the general journal
until the next period.
for both unearned revenue and accrued revenue [19.1]
In this chapter you will look
•• prepare entries in the general ledger for unearned
at how unearned and accrued
revenue using the liability approach [19.1]
revenue affects how we
determine profit, and how to •• describe the two-fold effect that adjustments for
adjust the general ledger and unearned revenue and accrued revenue have on the
general journal to account for such balance sheet [19.2 & 19.3]
revenue. •• explain the effect that balance day adjustments for
unearned revenue and accrued revenue have on the
income statement [19.2 & 19.3]
•• describe the treatment of accrued revenue in a
subsequent period when the revenue is actually
received [19.3]
•• prepare accounting reports, taking into account
balance day adjustments for unearned revenue and
accrued revenue [19.3].

UNIT 4 – PROGRESS 14 15 16 17 18 19 20 21 22 23

19.2

Unearned sales Chapter review

19.1 revenue 19.3 and exercises

Accrued revenue
Unearned revenue
(revenue owing)

978 1 4202 3962 1 371

 19.1 UNEARNED REVENUE

WHAT IS ‘REVENUE EARNED FOR A PERIOD’?

In Chapter 18, you learnt about balance day adjustments for expenses. Adjustments
were made for expenses paid in advance (prepaid expenses), expenses not yet
paid (accrued expenses), depreciation of non-current assets, and stock losses or
gains. The adjustments were made so that the account balances were equal to the
amounts incurred during a period, rather than simply reflecting the amounts paid
during that period.
The same scenario exists regarding the revenue of a business. When a trial balance
is prepared, the accounts usually reflect the cash transactions that took place during
the reporting period. Some small businesses only sell for cash, so their situation is
straightforward: they provide goods and then receive cash in return. The balance of their
Cash Sales account will likely equal the revenue they earned for the period.
However, this isn’t always the case. Take the example of an airline. Passengers make
bookings well in advance for trips they plan to take in the future. They pay cash up-
front, which the airline accepts for a future booking – so cash is paid in advance on the
promise of something in the future. At any point in time, this type of business may hold
large amounts of cash that it hasn’t yet earned. Should this cash be treated as revenue?
The principle of accrual accounting says ‘no’, as the business hasn’t yet fulfilled its
obligation to provide the goods or services customers have paid for. In other words,
the business hasn’t yet earned its revenue.

Businesses like
airlines are paid
in advance before
providing goods
or services.

A second scenario occurs when a business has earned revenue but hasn’t yet
received it. If a business has cash invested in a term deposit, but doesn’t receive
interest until the maturity date, no interest revenue will be received during the period.
Should this revenue be ignored simply because it hasn’t yet been received?
Accrual accounting requires all revenue earned to be reported in the income
statement. But revenue that hasn’t yet been received won’t show up in a trial balance
when the accounts are checked at the end of the period. This situation also needs to
be taken into account when determining a business’s profit.
As you can see, it’s possible that, in a given period, some revenue will be received
in advance and some may not be received at all. It may therefore be necessary to
make adjustments on balance day in order to determine revenue earned for that
period. This follows the qualitative characteristic of relevance, as revenue earned is
relevant to decision making for the current period.

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THE LIABILITY APPROACH
A business may receive revenue before it has performed services or supplied goods
to its customers. That is, the revenue it receives during one reporting period may
include amounts that have been paid in advance for a subsequent period.
The liability approach to unearned revenue says that revenue received that liability approach
a method of accounting
relates to a future period shouldn’t be included in the current period’s profit
where the initial receipt
calculation. Although this inflow of resources may appear to meet the definition of of revenue is treated
revenue, if it has been received in advance, the firm has actually created an obligation as a liability, with a
subsequent transfer of
of future economic sacrifice – that is, it fits the definition of a liability. the amount earned to a
The liability may be in the form of goods or services to be provided in the future. revenue account
However, if the business is unable to fulfil its obligations, it may take the form of a
cash refund.
This problem is similar to the question of whether prepaid insurance is an asset or
an expense. As you saw in Chapter 18, it’s all a matter of timing. An asset becomes
an expense when it’s used up or consumed. Insurance paid in advance is treated
as an asset (Prepaid Insurance) because it has future economic value. As it’s used
up, the asset Prepaid Insurance is eliminated and the amount is transferred to the
expense account Insurance, because it’s now viewed as a sacrifice of resources
during the period.
In the case of revenue received in advance, a future commitment is created and
therefore a liability exists. As this commitment is fulfilled, the liability is eliminated and
the revenue can then be recognised as being earned.

UNEARNED REVENUE
Unearned revenue is simply revenue received but not yet earned. Unearned revenue, unearned revenue
revenue that has been
or revenue received in advance, may be unusual for many small businesses, but some
received in advance but
do receive their money in advance of goods or services being provided. not yet earned
Consider the case of East Coast Coaches, a bus company that offers prepaid
interstate fares. As the prepaid fares represent a liability to the business, it credits
them to a liability account when it receives the cash. This account should have a
descriptive title, such as ‘Unearned Bus Fares Revenue’, to indicate the nature of what
it has received.
The focus then switches to the adjustment required on balance day. Accrual
accounting requires that revenue earned is matched with expenses incurred, but the
bus fares were credited to a liability account when they were received. The next step
is to transfer out of the liability account the amount of revenue that has been earned
during the current period.

Payments
received in
advance, such
as prepaid
fares, should
be credited to a
liability account.

978 1 4202 3962 1 [CHAP TER 19] UNE A RNED A ND ACCRUED RE V ENUE S 373
 East Coast Coaches has the following financial records at the end of 2023.

Total bus fares received during 2023 $90 000

Bus fares paid in advance for trips in 2024 $10 000

Using these details, the situation on balance day is as follows.

Total bus fares received $90 000

Bus fares revenue earned in 2023 $80 000
Unearned bus fares for 2024 $10 000

Only $80 000 of the $90 000 is recognised as revenue for 2023. The other $10 000
remains as a liability, because it represents a future commitment or obligation of the
business.
The Unearned Bus Fares Revenue account below has entries for both the original
cash receipts and the necessary adjusting entry on 31 December 2023.
Unearned bus fares revenue
2023 $ 2023 $
1 Dec Bus fares revenue 80 000 Jan–Dec Cash at bank 90 000

Bus fares revenue

2023
1 Dec Unearned bus 80 000
fares revenue

The adjusting entry transfers the amount of revenue earned from the liability account
(Unearned Bus Fares Revenue) to the revenue account (Bus Fares Revenue).
The revenue account now has the revenue earned for the period, ready to be
closed off to the Profit and Loss Summary account. The liability account can then be
balanced, ready to be reported in the firm’s balance sheet.
The closing of the revenue account and the balancing of the Unearned Bus Fares
Revenue account are shown below.
Unearned bus fares revenue
$ $
2023 2023
31 Dec Bus fares revenue 80 000 Jan–Dec Cash at bank 90 000
Balance 10 000
90 000 90 000
2024
1 Jan Balance 10 000

Bus fares revenue

$ $
2023 2023
31 Dec P&L summary 80 000 31 Dec Unearned bus 80 000
fares revenue

As usual, all general ledger entries must be journalised before being posted to ledger
accounts. Figure 19.1 shows the adjusting and closing entries for the example of
unearned revenue.

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FIGURE 19.1 General journal adjusting and closing entries for unearned revenue
GENERAL JOURNAL
Date Details Dr Cr
31 Dec 2023 Unearned bus fares revenue 80 000
Bus fares revenue 80 000
Adjusting entry for bus fares earned during the
period
31 Dec Bus fares revenue 80 000
P&L summary 80 000
Closing entry

This treatment of unearned revenue responds to the demands of relevance. Under

accrual accounting, the fares received in advance for 2024 ($10 000) aren’t relevant to
the period that concludes on 31 December 2023. They should therefore be excluded
from the income statement for that period. Such fares will remain in the liability
account until the firm has fulfilled its obligations.
When the prepaid customers take their trip, the revenue is transferred from
the liability account to the revenue account. This means that the revenue will be
recognised in the same period as when the expenses of the bus trips are incurred,
which satisfies the demands of accrual accounting.
This practice of not recognising revenue until it’s earned, as well as matching
revenue against the relevant expenses, allows for profit for a period to be measured
accurately. It thus meets the requirements of the period assumption.

UNEARNED REVENUE AND GST

The previous example showed how unearned revenue should be treated on balance
day. However, keep in mind that when a business receives revenue (including
unearned revenue), it may also receive an amount of GST.
In the example, the unearned bus fares received were $90 000. When we apply
the 10% GST to this amount, we see that the business would have actually received
$99 000 – that is, $90 000 for the actual bus fares, plus GST of $9000.
The GST should be recorded in the general journal at the time the cash is received –
see Figure 19.2.

FIGURE 19.2 General journal entry to record the receipt of unearned revenue, including GST

GENERAL JOURNAL
Date Details Dr Cr
31 Dec 2023 Cash at bank 99 000
Unearned bus fares revenue 90 000
GST clearing 9 000
Bus fares revenue received in advance

19.1 CHECK YOUR UNDERSTANDING WB PAGE 347

1 Explain what the term ‘unearned revenue’ means.

2 How is unearned revenue classified in a balance sheet? Justify this treatment.
3 Explain the ‘liability approach’ that is used to record unearned revenue.

978 1 4202 3962 1 [CHAP TER 19] UNE A RNED A ND ACCRUED RE V ENUE S 375
 19.2 UNEARNED SALES REVENUE
Most trading businesses don’t receive a great deal of their revenue in advance, as
customers usually prefer to receive goods at the time they pay for them.
However, in some industries a customer may pay a deposit to secure an order. If a
business receives a deposit from a customer before supplying the goods to them, it
represents a liability to the business at that time. It may issue a receipt on receiving the
deposit and then a sales invoice when the goods are delivered. These source documents
are important, as they help to determine how such financial events will be recorded.
For instance, Cara Johnston owns Peninsula Furniture, a small business that makes a
range of furniture to the specifications of the customer. The following events take place.

1 June: Hillside Motel placed an order for 20 coffee tables at a price of

$200 each, plus $20 GST. Total of the order: $4000, plus $400 GST.
Johnston required a deposit of 20% of the selling price to secure the
order, and wrote receipt no. 43 for $800 (20% of $4000 = $800).
30 June: Johnston delivered the 20 coffee tables to Hillside Motel, along with
invoice no. 160 for the amount owing, as shown below. (The cost of
the sale was determined to be $1800.)
20 coffee tables @ $200 each $4 000
Plus 10% GST $  400
Total of order $4 400
Less deposit $  800
Total now due $3 600
15 July: Hillside Motel made a payment of $3600 via EFT (Receipt 56).

This series of events are recorded in the books of Peninsula Furniture.

DON’T! RECORDING UNEARNED SALES REVENUE

When recording a
deposit, do not record The first step is to record the receipt of the deposit, as shown in Figure 19.3.
any GST received.

FIGURE 19.3 General journal entry to record a deposit on unearned sales

GENERAL JOURNAL
Date Details Dr Cr
1 Jun 2023 Cash at bank 800
Unearned sales revenue 800
Deposit of 20% on 20 coffee tables received from
Hillside Motel (Receipt 43)

Note that there is no GST recorded in this entry. The $800 received from Hillside
Motel is simply to secure the order. At this point, no goods have been provided and
no revenue has been earned.
The entry in the general journal creates the liability account Unearned Sales
Revenue. Having received $800 in advance from the customer, Peninsula Furniture
now has an obligation to provide goods to Hillside Motel. If it can’t fulfil the order, a
cash refund may be due to the customer.

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I N F O R M A T I O N
 A deposit paid
before delivery
is considered
unearned sales
revenue.

On 30 June the goods are delivered to Hillside Motel, along with a sales invoice. This
creates the need for another journal entry. Assuming that this date is also the end of
the reporting period, a balance day adjustment is required to transfer the unearned
sales revenue (the deposit) to the Sales Revenue account. Figure 19.4 shows the
adjusting entry required on 30 June.

FIGURE 19.4 General journal entry to adjust for unearned revenue now earned

GENERAL JOURNAL
Date Details Dr Cr
30 Jun 2023 Unearned sales revenue 800
Sales revenue 800
Adjusting entry for sales revenue earned this
period

As the coffee tables have now been provided to the customer, Peninsula Furniture’s
liability to Hillside Motel no longer exists and the $800 can now be recognised as
revenue earned for the period.
However, this entry doesn’t complete the full series of events, as the customer
was also issued with an invoice on 30 June. This document specified the full charge
to the customer ($4000, plus GST of $400), the deposit already paid ($800) and the
amount that remains outstanding ($4400 – $800 = $3600).
Figure 19.5 shows the final entry required to complete the sale made to Hillside Motel.

FIGURE 19.5 General journal entry to record a credit sale

GENERAL JOURNAL
Date Details Dr Cr
30 Jun 2023 Accounts receivable 3 600
Sales revenue 3 200
GST clearing 400
Cost of sales 1 800
Inventory 1 800
Credit sale made to Hillside Motel, after
deducting deposit of $800 (Invoice 160)

978 1 4202 3962 1 [CHAP TER 19] UNE A RNED A ND ACCRUED RE V ENUE S 377
 This may look like a standard entry for a credit sale, but there is one noticeable
difference. Usually in such an entry, the GST amount is a dollar value equal to 10% of
the Sales Revenue entry. This isn’t the case here, because Peninsula Furniture already
received $800 of sales revenue in the form of the deposit made on 1 June. As shown
in the previous calculation, the customer owes a total of $3600 to Peninsula Furniture,
and this amount is reflected in the entry.
Having recorded the credit sale and the balance day adjustment for the unearned
revenue (the deposit), the final transaction to be recorded is the cash receipt on 15
July. As Hillside Motel became an accounts receivable of Peninsula Furniture on 30
June (when the invoice was issued), the final payment of $3600 is recorded in the
usual way, as shown in Figure 19.6.

FIGURE 19.6 General journal entry to record the receipt of cash from an accounts
receivable
GENERAL JOURNAL
Date Details Dr Cr
15 Jul 2023 Cash at bank 3 600
Accounts receivable 3 600
Received cash from Hillside Motel (Receipt 56)

19.2 CHECK YOUR UNDERSTANDING WB PAGE 348

1 If a business involved in publishing magazines uses the liability approach to record

unearned subscriptions revenue, state the double entry required on balance day to
adjust for revenue earned.
2 If no adjusting entry is made on balance day for unearned revenue, would profit be
overstated or understated? Explain your answer fully.
3 When a deposit is received by a trading business, what double entry should it make
in the general ledger?

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19.3 ACCRUED REVENUE (REVENUE OWING)
Another situation that may exist on balance day is when a business earned revenue
during the reporting period but hasn’t yet received it. If the revenue-earning process
has ended, the principles of accrual accounting require that the revenue be recognised
as earned.
Consider the case of Dinosaur Direct, a business that invests $20 000 for six
months on 1 July 2023 at 10% per annum, payable on 2 January 2024. If Dinosaur
Direct has its balance day on 31 December 2023, the trial balance won’t show
a balance in the Interest Revenue account because interest won’t be received
during 2023.
However, Dinosaur Direct has earned $1000 of interest in the 2023 reporting
period (10% of $20 000 = $2000 interest per annum, or $1000 interest for six
months). The double entry for the balance day adjustment would be as follows.
Interest revenue
$ 2023 $
31 Dec Accrued interest 1 000
revenue

Accrued interest revenue

2023 $ $
31 Dec Interest revenue 1 000

This adjusting entry has two functions:

•• it increases the revenue account so that the revenue equals the amount earned for
the period
•• it creates a temporary asset account for the purposes of reporting in the balance sheet.
Accrued revenue represents revenue that has been earned but hasn’t yet been
received. Therefore, it’s a future economic benefit to Dinosaur Direct and should be accrued revenue
revenue that has been
reported as a current asset in the balance sheet. The Interest Revenue account would earned but not yet
then be closed off to the Profit and Loss Summary account: received

Interest revenue
2023 $ 2023 $
31 Dec P&L summary 1 000 31 Dec Accrued interest 1 000
revenue

After the balance day adjustment has been entered in the Interest Revenue account,
the balance of the account represents the interest revenue earned for the period.
This is closed off to the Profit and Loss Summary account as part of the profit-
determination process.
This completes the process for the current reporting period.
The adjusting and closing entries are shown in the general journal in Figure 19.7.

FIGURE 19.7 General journal adjusting and closing entries for accrued revenue

GENERAL JOURNAL
Date Details Dr Cr
31 Dec 2023 Accrued interest revenue 1 000
Interest revenue 1 000

978 1 4202 3962 1 [CHAP TER 19] UNE A RNED A ND ACCRUED RE V ENUE S 379
 Adjusting entry for six months’ interest earned
but not received
31 Dec Interest revenue 1 000
P&L summary 1 000
Closing entry

ACCRUED REVENUE IN SUBSEQUENT PERIODS

An Accrued Interest Revenue account was created for Dinosaur Direct for the interest
earned during 2023. The $1000 listed at that time would be reported in the balance
sheet as a current asset. This revenue would actually be received in the next period
(i.e. 2 January 2024).
When the revenue owing is received, it must not be recorded as revenue in the
new period. Figure 19.8 shows how the revenue would be correctly recorded and
reported for both 2023 and 2024.

FIGURE 19.8 General journal entry to record the receipt of accrued revenue

GENERAL JOURNAL
Date Details Dr Cr
2 Jan 2024 Cash at bank 1 000
Accrued interest revenue 1 000
Receipt of accrued interest revenue earned in
the previous period

The receipt of $1000 must not be credited to Interest Revenue, as it belongs

to the 2023 period. To help ensure this, use an account with a descriptive title
such as ‘Accrued Interest Revenue’, rather than a generic title such as ‘Accrued
Revenue’. This allows for the revenue still owing to be easily determined. When
it’s received in the subsequent reporting period, the Accrued Interest Revenue
account can be eliminated.
When the cash receipt of the interest occurs, the Accrued Interest Revenue
account appears as below.

Accrued interest revenue

2023 $ 2024 $
31 Dec Interest revenue 1 000 2 Jan Cash at bank 1 000

ACCRUED REVENUE WITHIN A RECEIPT

Sometimes, when accrued revenue is received in a subsequent reporting period, it
may be part of a larger cash receipt. This payment may include revenue that relates to
the new period, in addition to the amount owing from the previous period.
In the Dinosaur Direct example, $1000 was the interest owing from the previous
period. This amount was then received in the subsequent reporting period. However,
you should also be prepared to record the receipt of revenue in excess of this amount.
The following example demonstrates this situation.
Commission earned during June 2023 but not received $500
Commission received on 31 July 2023 (including the $500 owing) $600 (plus $60 GST)

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I N F O R M A T I O N
The $600 received on 31 July can be broken into two parts: $500 is the amount
owing from the previous period, while $100 relates to commission earned during
the new period.
In this case, it’s important to record the two amounts separately:
•• The $500 owing is closed off in the asset account (Accrued Commission Revenue).
•• The other $100 is recorded in the Commission Revenue account for the new period.
The GST received should be recorded in the usual way.
The entries are as follows.

Accrued commission revenue

$ $
30 Jun Commission revenue 500 31 Jul Cash at bank 500

Commission revenue
$ $
31 Jul Cash at bank 100

GST clearing
$
31 Jul Cash at bank 60

The Accrued Interest Revenue account that was created on balance day must be
closed off when the cash is received. The remainder of the cash received by the
business is then recorded in the relevant revenue account for the new period, with
the GST (if applicable) recorded in the usual fashion.
The journal entry for this example is shown in Figure 19.9.

FIGURE 19.9 General journal entry to record the receipt of accrued interest revenue

GENERAL JOURNAL
Date Details Dr Cr
31 Jul 2023 Cash at bank 660
Accrued interest revenue 500
Commission revenue 100
GST clearing 60
Receipt of accrued interest revenue earned in
the previous period

19.3 CHECK YOUR UNDERSTANDING WB PAGE 348

1 What is accrued revenue? How is it classified in a balance sheet?

2 A business has earned commission revenue during a period but hasn’t received
it by balance day. State the double entry required as a balance day adjustment to
account for this item.
3 The commission earned in Question 2 was received in the first week of the
subsequent reporting period. State the double entry that will be made when the
commission is received by the business.

978 1 4202 3962 1 [CHAP TER 19] UNE A RNED A ND ACCRUED RE V ENUE S 381
 19 CHAPTER REVIEW

KEY CONTENT
• [19.1] In a given reporting period, some revenue may be received in advance; this is called
unearned revenue. Other revenue may not be received at all, but will be in the next
reporting period; this is called accrued revenue. Balance day adjustments are needed
to account for such revenue.
• [19.1] The liability approach to unearned revenue holds that any revenue received that relates
to a future period should not be included in the current period’s profit calculation.
Instead, it should be recorded as a liability.
• [19.2] Deposits are the most common form of unearned revenue for a trading business.
These should also be recorded as liabilities. If the customer doesn’t receive their item,
the business must return the deposit.
• [19.3] Accrued revenue that has yet to be received is a future economic benefit for a
business. It should therefore be reported as a current asset in the balance sheet.

CHAPTER 19 EXERCISES

SPREADSHEET X.XX1 Unearned revenue – amount unearned provided WB PAGE 349

Marble Memorials sells custom-made headstones to cemeteries on a prepaid basis. In

the quarter ended 31 March 2023, the business receives $42 000 in advance payments for
headstones. Of this amount, $4000 relates to headstones to be delivered in the month of
April 2023. The business uses the liability approach to record revenues received in advance.
a State the amount of revenue that would be reported for the quarter ended
31 March 2023 under accrual accounting.
b Prepare the general journal entries required to record the adjusting and closing
entries relating to the sales revenue for the quarter.
c Prepare all the relevant entries for the quarter ended 31 March 2023 that would be
made to the Unearned Sales Revenue and Sales Revenue accounts.
d State and explain the effect on the firm’s reports if the balance day adjustment
wasn’t recorded.

SPREADSHEET X.XX2 Unearned revenue – amount unearned provided WB PAGE 350

The following account appeared in the general ledger of City Real Estate.

Unearned rental revenue

$ $
2022
1 Jul Balance 5 000
2023
Jul–Jun Cash at bank 90 000

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I N F O R M A T I O N
 On 30 June 2023 the manager determined that the unearned revenue totalled $8000.
a Explain what the $5000 balance shown in the above account represents on 1 July 2022.
b Prepare the adjusting and closing entries in the general journal on 30 June 2023.
c Prepare the Unearned Rental Revenue account and post all general journal entries
prepared in part a.

3 Unearned revenue – amount earned provided WB PAGE 351 SPREADSHEET X.XX

Custom Canopies sells custom-made modifications for utility vehicles. Because of

the nature of the business, it requires customers to prepay all orders. During the
year ended 30 September 2023, the business received a total of $234 000 from its
customers. The manager determined that $222 000 of this amount had been earned by
the end of the period.
a Prepare the relevant adjusting and closing general journal entries on 30 September 2023.
b Prepare the two accounts affected by your adjusting entry in part a, showing all
relevant entries.
c Is the balance sheet affected by your adjusting entry in part a? If so, state the two-
fold effect of the adjusting entry.
d State the effect of your adjusting entry in part a on the firm’s income statement.

4 Unearned revenue – amount earned provided WB PAGE 352 SPREADSHEET X.XX

Dani Dothraki owns Cosmeti-Crate, a business that sends out monthly curated
packages of makeup and beauty materials. Subscribers must pay $120 per year, plus
GST of $12, for 12 packages. During the year ended 30 June 2023, Dothraki received a
total of $52 800, consisting of subscriptions of $48 000, plus GST. On balance day, she
establishes that $36 000 of the revenue received has been earned.
a Prepare the entry in the general journal to show how the $52 800 would have been
recorded when the cash was received.
b Complete the necessary adjusting and closing entries in the general journal on
30 June 2023.
c Prepare the Unearned Subscriptions Revenue and Subscriptions Revenue accounts,
showing all entries for the period ending 30 June 2023.
d How should the amount not yet earned be reported on 30 June 2023? Explain your
answer fully, with reference to the relevant definitions of balance sheet terms.

5 Unearned revenue – deposit received WB PAGE 353 SPREADSHEET X.XX

Beds ‘R Us received an order for 10 single beds at a price of $450 each, plus GST, from
Downtime Holiday Resort on 11 November 2023. The customer paid a deposit of $500 on
this date to confirm the order. Receipt no. 53 was issued to the customer. No GST was
received at the time the order was confirmed. The cost price of the beds was $250 each.
On 28 December 2023, Beds ‘R Us delivers the 10 beds to Downtime Holiday Resort and
issues invoice no. 726 for $4500, plus GST of $450, less the deposit already received in
November. The reporting period for this business ends on 31 December each year.
a Prepare the journal entry required on 11 November 2023 to record the deposit
received from Downtime Holiday Resort.
b Record the relevant entry in the journal on 28 December 2023 when the delivery
was made to the customer.
c Prepare the required balance day adjustment in the general journal on 31 December
2023 in relation to the unearned revenue received by Beds ‘R Us.

978 1 4202 3962 1 [CHAP TER 19] UNE A RNED A ND ACCRUED RE V ENUE S 383
 SPREADSHEET X.XX6 Unearned revenue – deposit received WB PAGE 354

Peter Mitchell is the owner of Mitchell Education, a small business that provides a
range of educational teaching aids. The reporting period for Mitchell’s business runs
from 1 July to 30 June each year.
Moonga College recently ordered 20 whiteboards from Mitchell Education. The order
was placed, along with a deposit of $2000, on 14 April 2023. The selling price of the
whiteboards was $800 each (plus GST), while the cost price was $370 each (plus GST).
On 24 June 2023, the 20 whiteboards are delivered to Moonga College, and Mitchell
Education issues invoice no. 1763.
a Prepare the journal entry required to record the deposit received from Moonga
College.
b Prepare the adjusting entry required on 30 June to transfer unearned revenue to the
Sales Revenue account.
c Record the relevant entry in the general journal on 24 June when Invoice 1763
was issued.

SPREADSHEET X.XX7 Unearned revenue – deposit received, order partially WB PAGE 354

completed
The owner of Pearson Electronics, Belinda Pearson, asks you to help her record some
recent transactions with one of her customers.
On 12 August 2023, Pearson accepted an order to provide 10 data projectors to Kolbe
University at a price of $3200 per projector, plus $320 GST. Pearson agreed to provide
the goods, but required a payment of 10% of the selling price to secure the order. She
received this deposit from Kolbe University on 14 August 2023 and sent Receipt 97 to
the customer. The reporting period for Pearson Electronics ends on 30 September each
year. The business applies a mark-up of 100% to all goods sold.
The data projectors required by Kolbe University are in short supply, but by
30 September Pearson managed to obtain six units and these were delivered to Kolbe
on that date, along with the following document.

Pearson Electronics ABN: 31 789 756 433

9189 Bell Street Date: 30/9/2023
Coburg VIC 3058 Tax Invoice no: 746
Charge: Kolbe University

For: 6 deluxe data projectors @ $3200 per unit $19 200

Plus: GST $1 920
Sub-total $21 120
Less: deposit received $3 200
Amount now due $17 920

The other four data projectors were finally delivered to Kolbe on 21 October 2023, and
Invoice 756 was issued on that date.
a Prepare the general journal entry required to record the deposit received from Kolbe
University.
b Prepare the general journal adjusting entry required on 30 September in relation to
unearned sales revenue.
c Record the credit sale made on 30 September 2023 in the general journal.
d Record the credit sale evidenced by Invoice 756 on 21 October 2023.

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I N F O R M A T I O N
8 Accrued revenue WB PAGE 355 SPREADSHEET X.XX

On 1 April 2023, Brooklyn Bicycles invests $8000 in 6% state government bonds for
three years. The business will receive interest on 31 March each year. Balance day is
31 December. The owner of the business asks for your help in calculating interest
revenue earned for 2023.
a Prepare the adjusting entry required in the general journal on 31 December 2023
and the closing entry that would follow.
b Post the general journal entries from part a to the Interest Revenue and Accrued
Interest Revenue accounts.
c State the two-fold effect of the adjusting entry in part a on the balance sheet of the
business.
d Prepare the general journal entry on 31 March 2024 when the business receives the
annual interest from the bank.

9 Accrued revenue WB PAGE 356

Deborah Barker invests excess cash from her business in a term deposit paying
5% per annum. She invested $10 000 on 1 July 2023 for two years. Her balance day
each year is 31 December, and interest is paid on 30 June.
a How much interest has been earned in the year ending 31 December 2023?
b How much interest has been received in the year ended 31 December 2023?
c Explain how these events should be treated in the income statement and balance
sheet at the end of 2023.

10 Accrued revenue – effect on reports WB PAGE 357

The owner of Emjay Salon, Maree Johnson, decides to take out a term deposit for
four years, starting on 1 November 2020. The bank has agreed to pay her 4.5% for
a minimum investment of $30 000. Its policy is to pay interest on all term deposit
accounts on 31 March, 30 June, 30 September and 31 December each year. Johnson
agreed to these terms and invested $30 000. Her reporting period ends on 30 June
each year.
a Calculate how much interest would be received in the yearly period that ends on
30 June 2023.
b Does your answer to part a represent the interest earned for the period? Explain
your answer fully.
c Using the above information, state the item, its classification and its dollar value,
which would be reported in the following accounting reports.
i cash flow statement for the year ended 30 June 2023
ii income statement for the year ended 30 June 2023
iii balance sheet as at 30 June 2023

978 1 4202 3962 1 [CHAP TER 19] UNE A RNED A ND ACCRUED RE V ENUE S 385
 SPREADSHEET X.XX11 Accrued revenue – receipt in the subsequent period WB PAGE 358

During the year ended 31 December 2023 the owner of Geelong Art Supplies, Tony
Paatsch, recorded receipts of commission revenue of $21 000. However, when Paatsch
checks the sales figures for December, he finds that additional commission of $4000
had been earned but not yet received.
a Prepare the adjusting entry required on 31 December 2023 and the closing entry on
that date.
b Prepare the two ledger accounts affected by your adjusting entry from part a.
c Is the balance sheet affected by your adjusting entry in part a? If so, state the two-
fold effect of the adjusting entry on the balance sheet.
d The commission owing was received on 17 January 2024, along with $2000
commission for the new period and GST of $600. State the double entry required
when the commission owing is received.
e Explain the impact on the accounting reports prepared for the year ended
31 December 2024 if the commission received on 17 January was credited to the
Commission Revenue account.

SPREADSHEET X.XX12 Accrued revenue – receipt in the subsequent period WB PAGE 359

Adam Taylor, owner of Taylor’s Beehives, invests $16 000 in a four-year term deposit
at 5.5% per annum. The investment is made on 1 November 2022 and the business
closes its books on 30 June each year. Interest on the investment is paid twice a year,
on 30 April and 31 October.
a Prepare the relevant general ledger accounts to show all transactions relating to the
investment from 1 November 2022 to 31 October 2023. Your entries should include
all cash transactions, as well as adjusting and closing entries.
b Prepare the adjusting and closing entries that would be made in the general journal
on 30 June 2023.
c State, and explain, the effect on the firm’s reports if the balance day adjustment
wasn’t recorded on 30 June 2023.
d Show how the receipt of interest on 31 October 2023 would be recorded in the
general journal of Taylor’s Beehives.

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I N F O R M A T I O N
 CASE STUDY WB PAGE 361 SPREADSHEET X.XX

John McConville is the proprietor of Carlton Trophies, a small business that makes trophies
and medallions for individuals, schools and businesses. Because of the nature of the work,
the firm requires cash up-front from all customers. Unearned revenue is recorded using
the liability approach.

The following trial balance provides information about the business and its records for
the current year.

CARLTON TROPHIES: TRIAL BALANCE AS AT 31 AUGUST 2023

$ $
Cost of sales 37 000 Unearned sales revenue 92 000
Cash at bank 12 000 Capital 321 800
Display equipment 11 000 Accounts payable 12 400
Cleaning of premises 4 200 Interest revenue 200
Stationery expense 1 740 Loan – TY Finance 13 750
Prepaid insurance 1 800 Mortgage loan 328 000
Term deposit 5 000 Accumulated depreciation – 7 000
display equipment
Drawings 16 000 GST clearing 3 200
Inventory 40 150
Advertising 500
Wages 22 160
Interest expense 16 800
Premises 610 000
778 350 778 350

Additional information
• Of the unearned sales revenue, $8400 relates to orders that will be completed during
September and October 2023.
• An account for advertising done during August 2023 hasn’t yet been paid. The invoice
from Northern Newspapers is for $100.
• The insurance policy of $1800 was taken out on 1 December 2022 for 12 months’ cover.
• Interest on the term deposit is payable at 4% per annum. The investment was made on
30 April 2022 for a three-year period.

978 1 4202 3962 1 [CHAP TER 19] UNE A RNED A ND ACCRUED RE V ENUE S 387
 • The firm’s receipts show that McConville withdrew $2000 cash in June, but this was
accidentally debited to wages.
• Commission revenue earned by the business during the period was $500. None of this
commission has yet been received.
• A bank statement received on 31 August 2023 showed that interest was charged on
the mortgage loan for the last month of the period. The amount was $1200, and this
payment wasn’t taken into account before the above trial balance was prepared.
• A stocktake done on 31 August revealed stock on hand costing $40 500.
• Depreciation of display equipment is to be recorded at 10% per annum, using the
reducing balance method.

1 Prepare all the required adjusting entries in the general journal on 31 August 2023.
2 Prepare an income statement for the year ended 31 August 2023, showing both the
gross profit and net profit for the period.
3 Taking into account all the adjustments required, prepare extracts from the balance
sheet to show the current assets and current liabilities as at 31 August 2023.
4 Commission received on 5 September 2023 totalled $700, plus GST of $70. Prepare
the accrued commission revenue account, including the balance day adjustment and
the subsequent receipt of cash in the new reporting period.
5 Prepare the relevant entry in the firm’s general journal when the commission was
received on 5 September 2023.
6 McConville says he’ll settle the account for the outstanding advertising expense on
7 September 2023. Prepare the Accrued Advertising Expense account, including the
balance day adjustment and the subsequent payment of cash.
7 Prepare the following general ledger accounts, including all relevant entries: Unearned
Sales Revenue, Prepaid Insurance Expense, Capital, and Drawings.

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I N F O R M A T I O N
 ETHICAL CONSIDERATIONS WB PAGE 366

Jenny Atsakaris has been operating a small business for a number of years, trading as
Designer Diaries. Customers are expected to pay up-front when placing an order with the
business for its custom-designed personal or business diaries.
During the year ended 30 June 2023, the business received a total of $260 000 in
orders. When Atsakaris checks at the end of the current period how many orders haven’t
been filled, she’s surprised to find that only $5000 remains as unearned revenue. This
means that the business has earned $255 000 in revenue for the year and will show a
significant profit for the period. While pleased about the profit, she’s now worried about
how much tax she’ll have to pay.
Her husband suggests that she can delay recognising some of the sales by shifting
them to the next period, and therefore show a smaller profit for the current period. After
all, he says, the tax will be paid, whether this year or next, so it doesn’t make much
difference.
They agree that the adjusting entry for the current period would be as follows.

GENERAL JOURNAL
Date Details Dr Cr
30 Jun 2023 Unearned sales revenue 200 000
Sales revenue 200 000
Adjusting entry for sales revenue earned this
period

Atsakaris asks for your professional opinion on this issue. Prepare a report for her, making
reference to the following items:
• the potential financial benefit of the decision to the business (if any)
• the potential financial costs of the decision (if any)
• the period assumption
• the qualitative characteristic of relevance
• the meaning of accrual accounting
• any ethical considerations of the decision.

978 1 4202 3962 1 [CHAP TER 19] UNE A RNED A ND ACCRUED RE V ENUE S 389
 CHAPTER CHECKLIST
Now that you have finished Chapter 19, double-check your progress.
Are you ready for your Unit 4 exam?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
completed the end-of-chapter activities
handed in my workbook for marking.

I understand …

documents used by a business to record financial transactions

the recording and reporting of balance day adjustments:
– unearned revenue (liability approach) with a GST being recorded at the time revenue
is earned
– accrued revenue with GST being recorded at the time of receipt
– receipt of accrued revenue in the subsequent reporting period
the effect of transactions on the accounting reports.

I can …

use ICT, including spreadsheets, to record transactions, prepare accounting reports and
construct graphical representations
prepare an adjusted Trial Balance
analyse the effect of balance day adjustments on accounting reports
discuss and evaluate ethical considerations in relation to business decision-making and
the strategies used to improve business performance.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_19

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

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I N F O R M A T I O N
20 BUDGETING

The owner of a business must LEARNING OBJECTIVES

be able to plan and control the
business’s activities. The most By the end of this chapter, you will be able to:
important accounting tools for this •• explain the need for budgeting in small businesses
planning are the budget, and the [20.1]
reports that are used to create
•• outline the role played by a variety of budgets [20.1]
and shape that budget.
•• identify relevant items used in the different types of
In this chapter, you will learn
budgets [20.1]
why budgeting is so vital for a
successful business, and how •• reconstruct ledger accounts to find information
to create a variety of budgeting relevant to budgeting [20.2]
reports. •• prepare budgeted cash flow statements [20.3]
•• prepare budgeted income statements [20.4]
•• prepare budgeted balance sheets [20.5].

UNIT 4 – PROGRESS 14 15 16 17 18 19 20
20 21 22 23

20.2 20.4

Cash budgeting Budgeted income Chapter review

20.1 20.3 statements 20.5 and exercises

Preparing a
The need for Budgeted balance
budgeted cash flow
budgeting sheets
statement

978 1 4202 3962 1 391

 20.1 THE NEED FOR BUDGETING
budgeting Budgeting is a means of planning and controlling a business’s future financial
the process of transactions. The budgeting process involves making estimates of what is expected to
preparing a financial
plan for a business happen in the future.
All businesses need to prepare a budget, because all managers should have a
basic financial plan. Those plans might include making sales of a particular value,
increasing market share to a specific percentage, or generating a certain rate of return
on investment.
A financial plan can be prepared and then modified as necessary to improve
performance of the business. A business that doesn’t have a financial plan will operate
haphazardly, without effective control or oversight.
Some budgets set achievement targets, while others set expenditure limits.
sales budget For example, a business can use its sales budget to estimate future revenue. This
a report that includes provides a target for management and employees to aim for in a future reporting
estimates of all sales
for a future reporting period. It might also provide incentives for staff to improve their performance; if
period every employee improved, the overall business would benefit in terms of sales and,
probably, profits.
Other budgets simply aim to control a business’s costs. Sometimes expenses
are grouped together to identify cost centres within a business. Budgets can be
based on these cost centres, helping to restrict the business’s spending and improve
expense budget accountability. Therefore, an expense budget is used to plan a business’s future
a list of predicted expenses and, hopefully, to put a ceiling on spending within particular segments of
expense items for a
future reporting period the business.

DIFFERENT TYPES OF BUDGET

Management may develop a very complex budget plan, or it may adopt the more
commonly used budget tools. Table 20.1 lists some of the types of budgets that small
business owners and/or managers might use.

TABLE 20.1 Types of budgets and their purposes

Sets out the overall planning strategy of the business; made up of

Master budget
information from many of the other types of budgets

Predicts the future sales revenue expected to be earned by the business

Sales budget Usually includes quantities of products expected to be sold and their
anticipated selling prices

Estimates the cost of purchases required to meet the anticipated sales of

Purchases budget
the business

Labour budget Predicts the staff required and the cost of wages and salaries for a given period

Expense budget Outlines the cost of all expenses necessary to meet the business’s plans

Budgeted cash Predicts the future cash inflows and cash outflows of the business, with the
flow statement final figure being the predicted cash balance at one point in time

Budgeted income Provides a summary of all revenues and expenses expected for a period,
statement with the final figure being the predicted net profit or loss for the period

Budgeted balance Estimates the future financial position of the business; includes predictions
sheet of assets, liabilities and owner’s equity at a particular time in the future

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Perhaps the most important budget for many small trading businesses is the sales
budget, which involves estimating the future sales of the business. The sales budget
is crucial to the overall budgeting process, as the forecasts have a direct link with
many other types of budgets:
•• The sales made by a business will hopefully lead to an inflow of cash in the future,
so the sales forecast has a direct impact on the business’s estimated cash flows.
•• The sales not expected to be collected in a given period lead to an estimated
Accounts Receivable balance, which becomes part of the budgeted balance sheet.
•• As both cash and credit sales are usually recognised as revenue earned during
a period, the sales forecast also has a direct link with the budgeted income
statement.
The estimate of sales also leads to other predictions, such as inventory requirements,
estimated purchases and staffing needs. The sales budget is therefore the
cornerstone of the budgeting process.
There are other types of budgets that can be prepared by small business owners.
For example, a capital budget is used to plan the replacement of assets (also known
as capital items) in the future. Assets such as equipment, shop fittings and computers
involve a considerable capital outlay, but businesses rarely have cash available at short
notice to replace them. Management must plan how such assets will be replaced
when they reach the end of their useful working lives.
The capital budget also has an impact on several other budgets:
•• As non-current assets are involved, the budgeted balance sheet is directly affected.
•• If cash is paid for assets, the budgeted cash flow statement must reflect the cash
outflow expected to occur for purchases.
•• Once assets are purchased, their depreciation will be shown in a budgeted income
statement.
Depending on the size of the business, other budgets may also be prepared.
Although it’s important to have an overview of the complete budgeting process, EXAM SUCCESS
Accounting exams
this chapter focuses on three key types of budgeting – budgeted cash flow
focus on these three
statements, budgeted income statements and budgeted balance sheets. types of budgets.

20.1 CHECK YOUR UNDERSTANDING WB PAGE 369

1 Explain how a budget helps in planning the future operations of a business.

2 A budget is said to assist in controlling expenses. Describe how it does this.
3 ‘The sales budget is the cornerstone of the budgeting process for a trading
business.’ Comment on this statement.
4 Describe the two processes involved in the preparation of a sales budget.

978 1 4202 3962 1 [CHAPTER 20] BUDGETING 393

 20.2 CASH BUDGETING
budgeted cash A budgeted cash flow statement looks at the future cash inflows and outflows of a
flow statement business. It’s particularly important for trading businesses because of the significant
accounting report
that shows estimates investment in the inventory sold by the business.
of cash receipts The success of a trading business is largely determined by management’s ability
and payments, and
to turn inventory into cash on a regular basis. As many businesses purchase inventory
bank balance, at
a particular future on credit over 30 or 60 days, it’s crucial to know the expected cash situation of the
period business in the forthcoming months.
The preparation of a budgeted cash flow statement must take into account all
future inflows and outflows of cash. Typical items that are reported in a budgeted cash
flow statement for a trading business are shown below, using the usual classifications
of in a cash flow statement.

Anticipated cash inflows (receipts)

Operating activities Investing activities Financing activities

• cash sales of inventory • cash receipts from the • cash contributions

• collections from disposal of non-current by the proprietor (i.e.
accounts receivable assets additional capital)
(from credit sales made • loans (e.g. from banks,
previously) finance companies)
• other revenues (e.g.
interest revenue,
commissions)
• GST collected from
customers

Anticipated cash outflows (payments)

Operating activities Investing activities Financing activities

• cash purchases of • cash payments for non- • cash withdrawals by the

inventory current assets (buying proprietor
• payments to accounts new assets • repayments of loans
payable (from credit
purchases made
previously)
• cash payments of
expense items
• GST paid to suppliers

MAKING ESTIMATES
As with any form of budgeting, the most difficult task is making an estimate of a
future event. Some cash flows are fairly constant, while others fluctuate wildly.
For example, an expense such as rent, which is specified in a contract, is easy
to estimate for a certain period into the future. Cash outflows for items such as
telephone, internet and electricity are also usually stable. The amounts paid in
previous periods can be checked, and estimates of future outflows are easy.

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I N F O R M A T I O N
 Regular, periodic
expenses such
as rent are easy
to estimate for a
budget.

Other predictions are very difficult to make. Perhaps the most difficult one is the
sales forecast and the cash flows that result from such sales. The accounting records
from the same period last year may provide a starting point, but management should
conduct market research on a periodic basis to help plan the future of the business.
Market research can take into consideration questions such as:
•• Is the business likely to continue to trade as successfully as it did last year?
•• Is the business planning on a major change in the way it operates? For example,
should it offer goods online?
•• Does the business plan to sell the same inventory lines, or will it experiment with
an expanded range of products?
•• Does the business plan to eliminate some slow-moving inventory lines?
•• Are there new competitors in the market – either generally or in the local area?
•• Are there any external factors that are likely to affect the business (e.g.
government decisions, the state of the economy, environmental factors)?
Once a business has taken these and other factors into account, it should be able
to make an informed estimate of sales. Like any form of budgeting, it’s still only an
estimate and isn’t expected to be perfectly accurate. However, as the sales forecast
is used in other forms of budgeting, management should ensure that all relevant
information is available before sales estimates are finalised. An informed decision is
more likely to result in an accurate budget than one based on guesswork because of a
lack of information.

20.2 CHECK YOUR UNDERSTANDING WB PAGE 370

1 What is a budgeted cash flow statement? What does it show?

2 State four items you could expect to find under the heading of ‘operating activities’
that are:
a estimated inflows of cash
b estimated outflows of cash.
3 State and describe four different factors management might consider when making
estimates of future sales turnover.

978 1 4202 3962 1 [CHAPTER 20] BUDGETING 395

 PREPARING A BUDGETED CASH FLOW
20.3 STATEMENT
If a trading business buys and sells on credit, sales and purchases won’t automatically
equate to cash flows. As a budgeted cash flow statement predicts future inflows and
outflows of cash, management not only predict future sales and purchases, but also
when those transactions will result in a movement of cash.
The following extended example examines the processes involved in determining
cash flows from future transactions.
Tina Davis is the owner of Smart Screen, a small business that sells smartphone
cases and screen protectors. Davis is thinking of purchasing a new computer system
for her business at a cost of about $2000. On 1 July 2023 the business’s bank account
has a debit balance of $250. Davis needs a quarterly budget (July–September) to be
prepared to help her determine when she can buy the computer.
After extensive market research and studying last year’s figures, Davis believes
that the following sales estimates will be reasonably accurate.

Sales information (including 10% GST)

Actual – April $10 450
– May $10 450
– June $11 000
Estimated – July $11 000
– August $13 200
– September $15 400

Based on past experience, 70% of total sales are made on a cash basis, with the
other 30% of sales being made on credit. When sales are made on credit, 60% of
accounts receivable pay in the month after the sale has occurred, 25% pay in the second
month after sale, and the remaining 15% usually pay in the third month after sale.
In order to satisfy the above sales requirements, Davis estimates that the following
purchases will be required.

Purchases information (including 10% GST)

Actual – May $6 600
– June $6 600
Estimated – July $7 700
– August $8 800
– September $9 900

Davis normally purchases all her inventory requirements on 30 days’ credit. Of

these credit accounts, 90% are usually settled in the month after purchase to take
advantage of a 2% discount. The remaining 10% are usually paid in the second month
after purchase.
When questioned about other regular cash payments, Davis supplies the following list.

Wages paid to an assistant $380 per week

Advertising $200 per month, plus GST of $20
Window cleaning $60 per week, plus GST of $6
Cash drawings $500 per week

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In addition to the regular payments, the insurance on the shop is due for payment on
1 July and is expected to be $600, plus GST of $60. Davis also has a telephone bill for
$180 (plus GST of $18), which is due on 27 June. She intends to pay the account in
the first week of July. The business also owes the Australian Taxation Office $500 for
GST, and this is due by 28 July.

EXPECTED CASH INFLOWS

The first step in preparing a budgeted cash flow statement for Smart Screen is to
determine the cash flows that are expected as a result of sales. As both cash and credit
sales are made, it’s important to calculate the dollar value for each of these items.
Table 20.2 should be prepared./credit sales analysis table

TABLE 20.2 Smart Screen’s expected cash inflows

Month Total sales Cash sales 70% Credit sales 30%
$ $ $
April 10 450 7 315 3 135
May 10 450 7 315 3 135
June 11 000 7 700 3 300
July 11 000 7 700 3 300
August 13 200 9 240 3 960
September 15 400 10 780 4 620

The cash sales figures for July, August and September in Table 20.2 will go directly
into the budgeted cash flow statement, as this is the period under examination.
Note, however, that the figures for cash sales include the GST collected by the
business. When preparing a cash budget, you should ensure that the GST collected is
shown separately from the cash sales figures.
The GST and the cash sales for July, August and September would be determined
as follows.

Month Cash sales (including GST collected Sales per month

GST) $ (sales/11) $ (excluding GST) $
July 7 700 700 7 000
August 9 240 840 8 400
September 10 780 980 9 800

As credit sales aren’t a cash flow, a further step is required to determine when
accounts receivable are likely to pay their accounts. A schedule of collections from schedule of
collections
accounts receivable solves this problem, and is shown in Figure 20.1.
a table used by
businesses that sell on
FIGURE 20.1 Schedule of collections from accounts receivable credit to predict cash
inflows from accounts
receivable
Credit sales Collections in:
Month
$ July $ August $ September $
April 3 135 470
May 3 135 784 470
June 3 300 1 980 825 495
July 3 300 1 980 825
August 3 960 2 376
Total to be received 3 234 3 275 3 696

978 1 4202 3962 1 [CHAPTER 20] BUDGETING 397

 This collections schedule is used to calculate the expected cash flow resulting
from credit sales. Using the past history of the business, the pattern of collections has
been used to stagger the expected cash receipts over a three-month period.
Looking at June as an example, the $3300 worth of credit sales are expected to be
collected as follows:
•• 60% in July ($1980)
•• 25% in August ($825)
•• the remaining 15% in September ($495).
The credit sales of April are relevant to the collections schedule because 15% of
April’s sales are expected to be collected during July, which is part of the quarterly
budget period.
Note that as 60% of April’s sales are collected in May and 25% in June, the
amounts received in these months aren’t relevant to the July–September period. Only
those receipts expected in July (i.e. 15% of April’s sales) have been recorded in the
schedule because they will result in cash flows during the budget period.
The credit sales of September are also irrelevant to the collections schedule
because they are expected to result in cash receipts during October, November
and December.

EXPECTED CASH OUTFLOWS

Having determined the anticipated cash receipts, the next step is to find the expected
cash outflows that result from the business’s credit purchases. A schedule showing
anticipated payments to accounts payable should be prepared using the data given
earlier, as shown in Figure 20.2.

FIGURE 20.2 Schedule of payments to accounts payable

Credit Payments in:

Month
purchases $ July $ August $ September $
May 6 600 660
June 6 600 5 821 660
July 7 700 6 791 770
August 8 800 7 762
Total to be paid 6 481 7 451 8 532

schedule of The schedule of payments to accounts payable is based on the usual pattern
payments of payments by the management of Smart Screen. Note that when the payment
a table used by
businesses that occurs in the month after purchase, the 2% discount has been deducted as this isn’t
purchase inventory a cash outflow.
on credit to help
predict cash outflows Using the month of June as an example, 90% of the credit purchases are expected
to accounts payable to be paid in July, when the discount will be received.

Accounts to be paid are: 90% of $6600 = $5 940

Less the discount available: 2% of $5940 = $119
Actual cash payment anticipated =$5 821

The purchases in May are relevant to the budget period because 10% of May’s
purchases are expected to be paid in July (i.e. two months after purchase). As all
purchases are made on a credit basis, the schedule doesn’t include purchases expected
to be made in September, which are expected to be paid in October and November.

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THE BUDGETED CASH FLOW STATEMENT
Having completed schedules to determine the cash flows involving both accounts
receivable and accounts payable, the budgeted cash flow statement can now be
prepared, as shown in Figure 20.3. Note that the GST collected as part of cash sales
has been reported separately.

FIGURE 20.3 Quarterly budgeted cash flow statement

SMART SCREEN: BUDGETED CASH FLOW STATEMENT FOR QUARTER ENDING

30 SEPTEMBER 2023
July August September
$ $ $
Cash flows from operating activities
Cash sales 7 000 8 400 9 800
Collections from accounts receivable 3 234 3 275 3 696
GST received 700 840 980
Payments to accounts payable (6 481) (7 451) (8 532)
Wages – assistant (1 520) (1 520) (1 520)
Advertising (200) (200) (200)
Window cleaning (240) (240) (240)
Insurance (600) EXAM SUCCESS
When preparing a
Telephone (180)
budgeted cash flow
GST settlement (500) statement, make sure
that you only include
GST paid (122) (44) (44) cash flow items.
Net cash provided by operating activities 1 091 3 060 3 940
Cash flows from investing activities
Nil – – –
Cash flows from financing activities
Cash drawings (2 000) (2 000) (2 000)
Net cash used by financing activities (2 000) (2 000) (2 000)
Net increase (decrease) in cash held (909) 1 060 1 940
Cash held at beginning of month 250 (659) 401
Cash held at end of month (659) 401 2 341

The format of this budgeted cash flow statement is preferable to just adding up all receipts
and payments for the quarter and presenting them as one figure. Instead, this report allows
management to calculate an estimated cash balance at the end of each month.
It also provides information in relation to the three areas of cash flows. The increase
in cash flows from operations is clearly a positive trend. It’s also clear that the bank
account is expected to move from an opening balance of $250 at the start of July to an
estimated overdraft of $659 by the end of July. This is then expected to improve to a
positive balance of about $400 by 31 August and to $2341 by 30 September.
In relation to Smart Screen, the answer to Davis’ question is that she should buy
the computer system in September. As the system is expected to cost about $2000,
there won’t be sufficient cash during July or August if the budget is accurate.

978 1 4202 3962 1 [CHAPTER 20] BUDGETING 399

 BUDGETING FOR GST LIABILITY
Remember that when a business collects GST on its sales, it must send this money
(less any GST it has paid) to the Australian Taxation Office (ATO) at some point. All
business owners must ensure that they keep sufficient cash in their accounts to be
able to meet their GST liability.
In the case of Smart Screen, the business will have a GST liability after the
transactions of July, August and September. Davis must decide whether to wait until
after September to buy the computer or, if this isn’t satisfactory, alter her plans after
considering the information revealed by the budgeted cash flow statement. This may
lead her to decide to:
•• make an additional capital contribution
•• cut back on the level of personal drawings
•• reduce and/or postpone the payment of expenses
•• borrow the required cash from an outside party (e.g. a bank)
•• lease, rather than purchase, a computer.

SURPLUS CASH BALANCES

A budgeted cash flow statement might indicate that a business will have surplus cash
available in future reporting periods. In this case, management has to decide how best
to use the cash. It might:
•• reduce debt by paying off some liabilities
•• purchase non-current assets
•• purchase inventory for cash, taking advantage of discounts that may be available
•• take the opportunity, while the business can afford it, to withdraw cash for
personal use.
The basic role of a budgeted cash flow statement is to determine if, at the end of a
given period, a business is likely to have a shortage or a surplus of cash. Management
must then respond to ensure that the business’s plans won’t fail simply because of a
shortage of cash when it’s required.
The budgeted cash flow statement also has links with the budgeted income
statement and the budgeted balance sheet. Many cash flows are also revenues or
expenses and will appear in a budgeted income statement as well. (For example, a
cash sale is also a revenue item, and wages is also an expense item.)
The estimated cash balance, as determined by the budgeted cash flow statement,
goes straight into the budgeted balance sheet since it represents the expected value
of a current asset in the future.

20.3 CHECK YOUR UNDERSTANDING WB PAGE 371

1 Outline the importance of budgeted cash flow statements when accounting for a
trading business.
2 State and explain three decisions management may make when a budgeted cash
flow statement predicts a shortfall of cash.
3 If a budgeted cash flow statement predicts a surplus of cash, what should
management do? Discuss the options that management may consider.

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20.4 BUDGETED INCOME STATEMENTS
A budgeted income statement is used to examine the predicted revenues and budgeted income
expenses of a business over a given period of time. While the budgeted cash statement
accounting
flow statement looks at the business’s future cash position, the budgeted income report that shows
statement allows management to investigate the likely profitability of the business. estimates of
revenues, expenses
Earning a profit is a basic objective for most small businesses, so management must and profit over
have information about future earning potential. a specific future
The format of the budgeted income statement is exactly the same as the historical period

type of profit report. The only difference is that the dollar values in the budgeted report
are predicted results, rather than historical fact.
It’s important to distinguish between the items relevant to a budgeted cash flow
statement and those used to prepare a budgeted income statement:
•• The budgeted income statement reports on future estimates of revenue to be
earned and expenses to be incurred.
•• The budgeted cash flow statement reports on all expected cash inflows and
outflows, whether or not the items involve revenues or expenses.
Table 20.3 highlights the differences between the two types of reports.

TABLE 20.3 Comparison of the items relevant to a budgeted cash flow statement and
a budgeted income statement

Included in a budgeted income statement Included in a budgeted cash flow

statement
Revenue earned Revenue received
Expenses incurred Expenses paid
Credit sales Collections from accounts receivable
Cost of sales Payments to accounts payable/suppliers
Depreciation of non-current assets Cash paid for new assets
Inventory losses/gains Cash from disposal of assets
Cash from new loans
Cash paid for loan repayments
Capital contributions by owner
Cash withdrawals by the owner

A budgeted
income statement
is used to help
set goals for a
business.

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 MANAGEMENT AND THE BUDGETED INCOME STATEMENT
When a budgeted income statement has been prepared, management is provided
with a plan of its future trading activities. The plan consists of several smaller
budgets – usually a sales budget, a cost of sales budget and an expense budget.
If the budget plan isn’t to the satisfaction of management (e.g. if it predicts a net
loss), changes should be made to improve the situation before the budget period
commences. Management may have to re-examine the expense structure of the
business and consider alternatives:
•• Should assets be leased, rather than purchased?
•• Is there a more efficient way to advertise the business’s products?
Or management may have to re-evaluate the inventory the business sells:
•• Are all departments or all lines of inventory profitable?
•• Can some new lines be introduced to improve profitability?
•• Should some lines be eliminated?
Ideally, management should consider these sorts of questions on a continuous basis
in an effort to improve the performance of the business.
The value of a budgeted income statement is that it forces management to
consider the future of the business. Goals can then be set for the business, and
for departments and individuals within the business. Having set budget targets,
management can then measure how well the business is performing in terms of
achieving its objectives.

PREPARING A BUDGETED INCOME STATEMENT

To demonstrate the preparation of a budgeted income statement, let’s again consider
the example of Smart Screen. Some of the relevant information was already provided
for the budgeted cash flow statement:
•• Estimated sales for July were $11 000: $7700 cash sales and $3300 credit sales.
•• By removing the GST from these figures, the actual revenue to the business would
be cash sales of $7000 and credit sales of $3000.
•• Ninety per cent of June purchases are expected to be paid in July, to take
advantage of a 2% discount.
•• Wages paid to an assistant are $380 per week.
•• Advertising is $200 per month (plus GST of $20).
•• Window cleaning costs $60 per week (plus GST of $6).
•• Cash drawings are $500 per week.
•• Insurance on the shop is due for payment on 1 July and is expected to be $600 for
a one-year premium (plus GST of $60).
•• A telephone bill for $180 (plus GST of $18), due on 27 June, will be paid in the first
week of July. The amount of this bill is a typical quarterly bill.
Additional information not used for the budgeted cash flow statement:
•• Cost of sales is usually 50% of sales revenue, as the business applies a standard
mark-up of 100% to its inventory in order to determine its selling prices.
•• Depreciation on shop fittings is charged at the rate of 20% per annum, using the
straight-line method. On 30 June 2023 the balance of the Shop Fittings account
was $12 000.

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Figure 20.4 uses this information to show the estimated revenues and expenses for
the month of July.

FIGURE 20.4 Budgeted income statement

SMART SCREEN: BUDGETED INCOME STATEMENT FOR THE MONTH ENDING
31 JULY 2023
Revenue $ $

Credit sales 3 000

Cash sales 7 000 10 000
Less: Cost of sales 5 000
Estimated gross profit 5 000
EXAM SUCCESS
Other revenue A budgeted income
Discount revenue 119 statement follows
the same format
5 119 as a normal income
statement, except
Less: Other expenses
that the values are
Wages 1 520 all estimates.

Advertising 200
Window cleaning 240
Insurance 50
Telephone 60
Depreciation of shop fittings 200 2 270
Estimated net profit 2 849

How the estimates were calculated:

•• Wages, advertising and window cleaning are exactly the same as the figures in the
budgeted cash flow statement because they’re paid as they’re incurred.
•• Insurance expense is $50, as the $600 premium is for one year; the expense for
July is $600 ÷ 12 = $50.
•• The quarterly telephone bill is usually $180; the estimated expense for one month
is $180 ÷ 3 = $60.
•• Depreciation of shop fittings is 20% per annum on a cost of $12 000. The cost
for one year is $12 000 × 0.20 = $2400, and for one month it would be
$2400 ÷ 12 = $200.
•• The discount revenue comes from the settlement of 90% of June’s credit purchases.
That is, $600 × 0.90 = $5940 to be settled. Therefore, a discount of 2% of $5940
= $118.80 will be granted by the business’s suppliers (rounded off to $119). This
amount wasn’t reported in the statement as it doesn’t represent a cash flow.

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 REVIEWING THE BUDGETED INCOME STATEMENT
Once the budgeted income statement is prepared, management should review it in
terms of the business’s desired profit level.
If the results fit with management’s overall objectives, the budget should be
adopted and put into action. If it’s unsatisfactory, it needs to be reviewed and
amended until management is happy with the goals in the budget. There is little use
in preparing a budget if staff working within the organisation won’t accept it. A budget
must be a workable document that is based on attainable goals.
The budgeted income statement is a plan for the future profitability of a business.
Once finalised, it should be viewed as providing a target that specifies a high level of
performance.

Wages,
advertising and
window cleaning
are regular and
predictable
expenses.

20.4 CHECK YOUR UNDERSTANDING WB PAGE 372

1 Explain why the management of a trading business should prepare a budgeted

income statement on a regular basis.
2 Distinguish between the items that are used to prepare a budgeted cash flow
statement and those that are used to prepare a budgeted income statement.
3 Name four items that could appear in a budgeted cash flow statement that wouldn’t
appear in a budgeted income statement.
4 Name four items that could appear in a budgeted income statement that wouldn’t
appear in a budgeted cash flow statement.

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20.5 BUDGETED BALANCE SHEETS
The budgeted balance sheet is a statement of a firm’s predicted financial position at budgeted balance
a particular date in the future. This statement can be used for a variety of purposes, sheet
accounting report that
such as: shows estimates of
•• reporting on the future situation of a firm’s non-current assets (i.e. capital assets, liabilities and
owner’s equity at a
spending) specific future date
•• examining the future liquidity position of the business
•• evaluating the gearing of the business in the future (i.e. the extent to which it relies
on borrowed funds)
•• showing the future details of the owner’s equity in the business, including details
of future profits and drawings.
The format of a budgeted balance sheet is virtually the same as that of the traditional
report. The only difference is that the dollar values are based on estimates of future
events, rather than being a report on historical results.
If a business plans to expand, the expected changes in assets can be clearly
shown in a budgeted statement. There would also be changes expected in the
equities side of the report. Additional liabilities may be created, or the owner’s equity
may be increased in order to fund the purchase of the new assets.
The budgeted balance sheet can be classified in the usual way, allowing
management to examine changes in liquidity. The estimated future current assets can
be compared with the expected current liabilities. This helps management ensure that
the future plans won’t adversely affect the business.
The results of liquidity analysis from a budgeted balance sheet should be read
together with a budgeted cash flow statement to ensure the firm’s liquidity will be
sufficient to meet its needs into the future.

A budgeted
balance sheet
helps predict
the effects of
expanding and
buying more
assets.

PREPARING A BUDGETED BALANCE SHEET

In order to demonstrate the preparation of a budgeted balance sheet, Smart Screen
will again be used as an example.
When preparing a budgeted balance sheet, a logical starting point is the most
recent historical statement. This report provides factual data about the business at
one point in time.

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 Having established the actual financial position of the business, management
can then use this data to make predictions for the future. These predictions take into
account what is likely – or expected – to happen to the business.
The historical report is provided in Figure 20.5.

FIGURE 20.5 Historical balance sheet

SMART SHEET: BALANCE SHEET AS AT 30 JUNE 2023
Current assets $ $ Current liabilities $ $ $
Cash at bank 250 Accounts payable 7 260
Accounts receivable 5 024 GST clearing 500
Inventory 21 000 26 274 Accrued telephone 180 7 940
expense
Non-current assets Owner’s equity
Shop fittings 12 000 Capital 25 000
Less: Accumulated 2 400 9 600 Net profit 4 934 29 934
depreciation
Less: Drawings 2 000 27 934
35 874 35 874

The preparation of the budgeted cash flow statement and budgeted income
statement for Smart Sheet also includes much of the work required for the budgeted
balance sheet.
The following information has been extracted from the previous two budgets.

Accounts receivable
The budgeted cash flow statement states that the Cash at Bank account balance as
at 31 July is expected to be $659 overdrawn. Accounts Receivable at the beginning of
July were $5024.
The budgeted income statement states that credit sales during July are expected
to be $3000. GST charged to accounts receivable will therefore be $300.
The budgeted cash flow statement states that receipts from accounts receivable
during July are estimated to be $3234. Thus the final accounts receivable balance is
expected to be $5024 + $3000 + $300 – $3234 = $5090.
This figure may be found through a reconstruction of the Accounts Receivable account:
Accounts receivable
$ $
1 Jul Balance 5 024 31 Jul Cash at Bank 3234
31 Sales/GST clearing 3 300 Balance 5090
8 324 8324
Aug 1 Balance 5 090

Inventory
Inventory at the start of July was $21 000.
Purchases during July are expected to be $7000 (original data provided for the
budgeted cash flow statement) and cost of sales for July is predicted as $5000
(budgeted income statement).
Therefore, inventory as at 31 July can be determined as $21 000 + $7000 – $5000 =
$23 000.

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 An Inventory account may be used to determine this final balance, as shown below.

Inventory
$ $
1 Jul Balance 21 000 31 Jul Cost of sales 5 000
31 Accounts payable 7 000 Balance 23 000
28 000 28 000
Aug 1 Balance 23 000

Accounts payable
Accounts payable as at 30 June were $7260.
During July, credit purchases are expected to be $7000, plus GST of $700, and
payments to accounts payable are estimated as $6481. (Discount revenue on these
payments totalled $119.)
The balance of accounts payable can be estimated as $7260 + $7000 + $700 –
$6481 – $118 = $8360.
The Accounts Payable ledger account may also be used to find this final balance:
Accounts payable
$ $
31 Jul Cash at bank 6 481 1 Jul Balance 7 260
Discount revenue 119 31 Inventory/GST 7 700
clearing
Balance 8 360
14 960 14 960
1 Aug Balance 8 360

GST liability
The GST liability as at 30 June was $500, and was expected to be paid in July. The
GST events expected in July are:
•• GST received on cash sales: $700
•• GST charged on credit sales: $300
•• GST charged on credit purchases: $700
•• GST paid on expenses: $122.
This information can all be reconstructed in a GST Clearing account to determine the
final GST liability or refund due at the end of July 2023, as shown below.
GST clearing
$ $
31 Jul Accounts payable 700 1 Jul Balance 500
Cash at bank 122 31 Cash at bank 700
Cash at bank 500 Accounts 300
receivable
Balance 178 1 500
1 500 1 Aug Balance 178

Other estimates
•• Accumulated depreciation of shop fittings is to increase by $200 (from the
budgeted income statement).

978 1 4202 3962 1 [CHAPTER 20] BUDGETING 407

 •• Prepaid insurance will be created during July. The insurance payment of $600 is for
a one-year premium. $50 will be written off as an expense for July, with the other
$550 being a prepaid expense as at 31 July.
•• The Telephone account is paid quarterly, so one month’s expense will be owing at
the end of July. A current liability of $60 ($180/3) will be created on 31 July.
•• In relation to the owner’s equity, the estimated profit for July is $2849 and her
drawings are expected to be $2000 during the month of July.
Taking into account all the above budget estimates, the budgeted balance sheet for
Smart Screen can be prepared as shown in Figure 20.6.

FIGURE 20.6 Budgeted balance sheet

SMART SCREEN: BUDGETED BALANCE SHEET AS AT 31 JULY 2023

Current assets $ $ Current liabilities $ $ $

Accounts 5 090 Bank overdraft 659

receivable
Inventory 23 000 Accounts payable 8 360
Prepaid insurance 550 28 640 GST clearing 178
EXAM SUCCESS A
budgeted balance sheet Accrued telephone 60 9 257
is still based on the expense
standard accounting Non-current
equation A = L +OE. assets
Shop fittings 12 000 Owner’s equity
Less: 2 600 9 400 Capital 27 934
Accumulated
depreciation
Net profit 2 849 30 783
Less: Drawings 2 000 28 783
38040 38 040

REVIEWING THE BUDGETED BALANCE SHEET

Once a budgeted balance sheet has been prepared, it should be compared with the
latest historical report. This allows management to identify the key changes expected
to occur in the budget period.
For example, changes in the liquidity or the gearing of the firm can be highlighted.
If necessary, management can take appropriate action, such as making changes to
the budget plan. Or, if the problems aren’t seen as serious, management may simply
monitor the situation in the future to make sure it meets expectations.

20.5 CHECK YOUR UNDERSTANDING WB PAGE 373

1 What is the function of a budgeted balance sheet?

2 State and describe three different uses management may make of a budgeted
balance sheet.
3 A budgeted balance sheet is said to have links to both the budgeted cash flow
statement and the budgeted income statement. Describe three such links, and
explain how the various reports relate to one another.

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20 CHAPTER REVIEW

KEY CONTENT
• [20.1] Budgeting is a means of planning and controlling the future financial transactions of
a business. All businesses have a need for budgeting, because all managers should
have a basic financial plan. There are multiple different types of budget, with different
purposes.
• [20.3] A budgeted cash flow statement looks at the future cash inflows and outflows of a
business. This statement is particularly important for trading businesses because of the
significant investment made in inventory.
• [20.4] A budgeted income statement is used to examine predicted revenues and expenses
over a period of time. This statement allows management to investigate the likely
profitability of the business.
• [20.5] A budgeted balance sheet is a statement of a firm’s predicted financial position at a
particular date in the future. It’s used to help management ensure that future plans
won’t adversely affect the business.

CHAPTER 20 EXERCISES

1 Schedule of collections from accounts receivable WB PAGE 374 SPREADSHEET X.XX

Paul Goss is the owner of Box Hill Gym Equipment. He wants to prepare a budgeted
cash flow statement for his business but isn’t sure how to estimate the cash
collections from his credit sales. He supplies the following information and asks for
your help.

Credit sales for the previous two months May $9 000

(including GST) June $10 000
Estimated future sales July $11 000
(including GST) August $11 000
September $13 000

The past history of the business’s accounts receivable shows that 80% of accounts are
usually settled in the month after sale and 18% usually pay in the second month after
sale. The business has had a problem with bad debts, and the remaining 2% is unlikely
to be collected.
Prepare a schedule of collections from accounts receivable to show the estimated cash
flows for the quarter ending 30 September 2023.

978 1 4202 3962 1 [CHAPTER 20] BUDGETING 409

 SPREADSHEET X.XX2 Schedule of collections from accounts receivable WB PAGE 374

The owner of Capri Jewellery, Cecilia Mandanici, asks you to prepare estimates of the
future cash inflows for her business. The shop sells on both a cash and a credit basis,
with cash sales usually being 60% of total sales. Based on her experience in running
the business, Mandanici informs you that accounts receivable usually pay as follows:
• 70% of accounts receivable pay in the month following sale and are allowed a
discount of 2% on their accounts
• 20% of accounts receivable pay in the second month after sale
• 10% of accounts receivable pay in the third month after sale.
Cecilia also supplies the following sales data, which includes GST.

Actual sales: July $12 000

August $12 000
September $14 000
Estimated sales: October $15 000
November $16 000
December $20 000

a Prepare a table showing the breakdown between credit and cash sales for the six
months July–December.
b Prepare a schedule of collections from accounts receivable for the quarter ending
31 December. (Round off amounts to the nearest dollar.)
c Using your calculations from parts a and b, prepare a budgeted cash flow statement
extract showing the estimated cash receipts for Capri Jewellery for the months of
October, November and December. (Round off all amounts to the nearest dollar.)
d Explain the role market research should play in the preparation of a budgeted cash
flow statement.

SPREADSHEET X.XX3 Schedule of payments to accounts payable WB PAGE 376

Bait-Up Fishing and Tackle usually purchases 80% of its inventory requirements on
credit, with the other 20% of inventory being bought on a cash basis. When goods are
purchased on credit, 90% of debts are settled in the month after purchase, with the
other 10% usually being paid in the second month.
The following data relates to the purchases over the last two months and the budget
estimates for the next two months. Note: all amounts include 10% GST.

Actual purchases: May $8 450

June $8 260
Budgeted purchases: July $8 500
August $9 200

a Prepare a schedule showing the breakdown of total purchases into cash and credit
purchases for the months May–August.
b Prepare a schedule of payments to accounts payable for the two-month budget
period of July and August.
c Draw up a budgeted cash flow statement extract for July–August to show the
estimated payments that will result from your answers to parts a and b.

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4 Schedules for collections and payments WB PAGE 377 SPREADSHEET X.XX

The following information relates to Colasurdo’s Carriers, a retail store that sells a range of
pet carriers and kennels. Note that GST has been included in all sales and purchases data.
Sales Purchases
$ $
Historical data: January 12 000 6 000
February 15 000 8 000
March 16 000 7 500
Projected data: April 14 000 7 000
May 13 000 6 500
June 12 000 6 200

The owner provides additional information:

• Colasurdo buys 90% of the shop’s inventory on credit and pays all accounts payable
in the month after purchase to take advantage of a 2.5% discount.
• Cash sales usually make up about 65% of total sales.
• Of the credit sales made by the shop, 50% are usually collected in the month after
sale. Accounts receivable who pay within this time are allowed a 3% discount on
their accounts.
• Normally, 40% of accounts receivable accounts are collected in the second month
after sale, and 9% pay three months after the sale has occurred.
• The business suffers bad debts of around 1% of total credit sales.
a Prepare appropriate schedules to determine the expected cash flows for
Colasurdo’s Carriers for the period April–June.
b Using the schedules from part a, state the relevant entries that would appear in a
budgeted cash flow statement for the quarter ending 30 June.
c Are bad debts reported in a budgeted cash flow statement? Explain your answer fully.

5 Reconstruction of accounts receivable WB PAGE 378 SPREADSHEET X.XX

Toorak Turbochargers has accounts receivable of $5400 on 1 October 2023. The total
sales made during October 2022 were $6200, plus GST of $620. So far, the sales made
in 2023 have been consistently 15% up on the sales made in the same month the
previous year.
The credit sales made by Toorak Turbochargers make up about 40% of their total
sales. Management is concerned about a number of slow-paying customers and has
decided to crack down on slow payers during October. As a result, the amount owing
by accounts receivable by the end of October is expected to be only $3200. Discounts
allowed to accounts receivable during October are expected to total $82.
a Prepare the Accounts Receivable account for the month of October 2023 to find the
estimated cash collections from accounts receivable during that month.
b Explain how an age analysis of accounts receivable may assist the management of
Toorak Turbochargers.

978 1 4202 3962 1 [CHAPTER 20] BUDGETING 411

 SPREADSHEET X.XX6 Budgeted cash flow statement WB PAGE 378

Lee Herbert is the proprietor of Southern Scuba Supplies. He supplies the following
information about his business.
On 1 July 2023 the balance of the bank account was $3400.
Revenue over the last two months was as follows (including GST).
May Cash sales $24 000 Credit sales $12 000
June Cash sales $28 000 Credit sales $10 000

During July, all sales are expected to be 8% higher than the June sales figures. Based
on the past experience of the business, 60% of credit customers pay in the month
after sale, with the other 40% paying in the second month.
The shop had the following purchases during June (including GST):
• cash $6 000
• credit $16 000.
During July, Herbert expects to have cash purchases of $7000, plus GST of $700, and
credit purchases of $14 000 (plus GST). It’s the business’s policy to pay all accounts
payable in the month following the purchase of goods.
The business has the following regular payments each month.

Advertising $1 700 plus GST

Wages $3 200
Drawings $3 000
Loan repayments $2 200
Cleaning of premises $500 plus GST

The business pays its annual insurance premium of $3400, plus GST of $340, in two
instalments, one being due on 16 January and the other on 16 July each year.
Herbert has also decided to renovate the shop and must make a payment of $8000
(plus GST of $800) to the builder on 31 July 2023 and another payment of $6000 (plus
GST of $600) on 31 August 2023, when the job should be finished.
a Prepare a budgeted cash flow statement for Southern Scuba Supplies for the month
of July 2023.
b Comment on the business’s cash position, given the second payment for the
renovations is due in August 2023.

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7 Budgeted cash flow statement WB PAGE 380 SPREADSHEET X.XX

Hepburn Springs Hardware is a small business that sells hardware to the general
public. The owner is concerned about the liquidity of the business, as there’s only $230
in the bank on 30 September 2023, but she’s never prepared a formal budgeted cash
flow statement. You’ve been asked to provide assistance.
The following financial data is available.

Sales (incl. GST) Purchases (incl. GST)

$ $
Historical data: July 14 000 6 000
August 12 000 6 000
September 14 000 7 000
Budgeted data: October 18 000 9 000
November 18 000 10 000
December 20 000 10 000

The business purchases all its inventory on credit and usually pays for these goods in
the month after purchase to take advantage of a 2% discount. The business’s sales are
made on both a cash and a credit basis, with credit sales making up only about 20% of
the total sales.
The accounts receivable of the business usually pay in the following pattern:
• 60% in the month after sale
• 30% in the second month
• 10% in the third month.
The business has the following regular expenses:
• wages: $350 per week
• advertising: $800 per month (plus GST of $80)
• cleaning: $130 per week (plus GST of $13)
• office expenses: $50 per week (plus GST of $5)
• depreciation of shop fittings $300 a month.
The owner usually withdraws about $600 cash and $100 worth of inventory each week
for personal use.
In addition to the regular advertising, the owner plans on spending $1000 (plus GST of
$100) on additional advertising in the first week of December to try to boost the shop’s
share of Christmas trading.
During October the owner plans on buying a new computer for the business at a cost
of about $3000 (plus GST of $300).
Rates on the business property are due on 15 November and are expected to be $650.
The business also has monthly loan repayments of $800 per month.
a Prepare appropriate schedules, and calculate the anticipated payments to accounts
payable and estimated collections from accounts receivable.
b Prepare a budgeted cash flow statement for the quarter ending 31 December 2023.
Your budget should show the estimated bank balance at the end of each month.
(Note: GST isn’t payable on rates.)
c Comment on the business’s liquidity in light of the owner’s concerns.

978 1 4202 3962 1 [CHAPTER 20] BUDGETING 413

 SPREADSHEET X.XX8 Reconstruction of accounts receivable, inventory and WB PAGE 381

accounts payable
Penni Roe is the owner of Western Solar Panels. She wants to plan for the next
quarter’s trading activities and provides some financial data from the business.
The following information was extracted from the balance sheet as at 30 June 2023.
Balance of inventory $42 800
Balance of accounts receivable $6 400
Balance of accounts payable $4 600
During the quarter ending 30 September 2023, Roe estimates that the business will
have total sales of $86 000, plus GST of $8600. Cash sales usually make up 75% of the
total sales made. The business sells its inventory at a 100% mark-up. (That is, the cost
price of an item is doubled in order to determine its selling price.)
By the end of the September quarter, the following balances are expected to be
reported in the business’s balance sheet.

Balance of inventory $46 400

Balance of accounts receivable $5 800
Balance of accounts payable $5 200
a Prepare the Accounts Receivable account to calculate the estimated receipts
expected from accounts receivable for the quarter ending 30 September 2023.
b Complete the Inventory account to determine the credit purchases expected to be
made during the quarter.
c Prepare the Accounts Payable account to provide an estimate of the cash to be paid
to accounts payable during the quarter ending 30 September 2023.
d Using the above information, list all items relevant to the budgeted cash flow
statement of Western Solar Panels for the September quarter. State the dollar
amount for each item listed.
e Using the above information, list all items relevant to the budgeted income
statement for this business. State the dollar amount for each item for the
September quarter.

SPREADSHEET X.XX
9 Reconstruction of inventory and accounts payable WB PAGE 383

Tony Gleeson is the proprietor of Brunswick X-Sports. He needs to plan his future cash
flows but isn’t sure how to determine some of them.
The following information is available.
Balance of inventory 1 October 2023 $24 200
Balance of inventory 31 October 2023 $27 800
Balance of accounts payable 1 October 2023 $6 250
Balance of accounts payable 31 October 2023 $5 760
Returns of inventory to suppliers expected during October $250 (GST $25)
Discounts expected to be received from suppliers during October $150
Sales expected during October $12 600 (GST $1260)
Cost of sales expected during October $6 800

a Prepare the Inventory account, showing all expected entries for October 2023.
b State the value of credit purchases expected to be made during the month.
c Prepare the Accounts Payable account for October 2023, showing all anticipated
transactions that affect the business’s accounts payable.
d State the cash flow expected to be made to accounts payable during October 2023.

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10 Preparation of budgeted reports WB PAGE 383 SPREADSHEET X.XX

The following statement was supplied by Jeremy Corby, the owner of Highpoint Hi-Fi
Systems.
CITY HI-FI SYSTEMS: BALANCE SHEET AS AT 30 JUNE 2023
Assets $ $ Liabilities $ $

Cash at bank 2 000 Accrued advertising 200

Accounts receivable 4 800 Accounts payable 9 200
Inventory 32 000 GST clearing 1 000
Furniture 2 500 Loan 6 000 16 400
Shop fittings 15 000 Owner’s equity
Less: Accumulated 3 000 12 000 Capital 36 900
depreciation
53 300 53 300

Additional information
• Sales for the month of July are expected to be: cash $15 000 (plus GST of $1500)
and credit $5400 (plus GST of $540). All accounts receivable usually pay in the
month after sale and are granted a 2.5% discount.
• Purchases are all made on credit, and in July they are expected to be $11 200, plus
GST of $1120. All accounts payable are paid in the month after purchase.
• Inventory is expected to increase by $1000 during July 2023.
• The regular monthly expenses of the business include wages $1200, office
expenses $300 (plus GST of $30) and advertising $200 (plus GST of $20). All these
items will be paid on time during July, along with the $200 of advertising owing for
June (plus GST of $20).
• Rent is payable on the first day of each month at a cost of $3000 per month (plus
GST of $300 per month).
• Depreciation of shop fittings is charged at the rate of 20% per annum on cost.
• Interest on the loan is charged at the rate of 10% per annum and is payable on the
last day of March, June, September and December. The principal of the loan is due
for repayment in a lump sum on 30 June 2024.
• A delivery van will be purchased in the last week of July 2023. The van is expected
to cost $12 000. Half of the cost will be paid in July and the balance in August.
• The owner of the business usually withdraws $500 per week from the business for
personal use.
a Prepare a budgeted cash flow statement for the month of July 2023.
b Prepare a budgeted income statement for the month ending 31 July 2023. (Hint:
reconstruct the Inventory account to determine the cost of sales for the period.)
c Prepare a budgeted balance sheet as at 31 July 2023. (Hint: prepare the GST
Clearing account to determine its final balance.)
d ‘Profit isn’t cash.’ Comment on this statement and refer to examples from your
budgets prepared in parts a and b.

978 1 4202 3962 1 [CHAPTER 20] BUDGETING 415

 SPREADSHEET X.XX11 Preparation of budgeted reports WB PAGE 386

Annemarie Burgess is the owner of Kayaks Deluxe. She provides the following
information in relation to the business.
KAYAKS DELUXE: BALANCE SHEET AS AT 30 SEPTEMBER 2023
Assets $ $ Liabilities $ $

Accounts receivable 5 400 Cash at bank 620

Inventory 36 000 Accounts payable 6 000
Prepaid insurance 720 GST clearing 1 100 7 720
Term deposit (maturing 26 000
31/12/24)
Shop fittings 12 000 Owner’s equity
Less: Accumulated 3 600 8 400 Capital 86 800
depreciation
Delivery van 20 000
Less: Accumulated 2 000 18 000
depreciation
94 520 94 520

Additional information
• As the business has an overdraft on 30 September, the owner will contribute $2000
as additional capital on 2 October 2023.
• All of the business’s accounts receivable with accounts outstanding as at 30
September are expected to pay during October, with the exception of one account
for $500. This is expected to realise only $100, with the remainder being written off
as a bad debt.
• The accounts payable as at 30 September will all be paid during October. One
supplier with a balance of $2100 has agreed to accept $2000 in full payment of the
account.
• Sales during October are expected to be $13 200 cash (plus GST of $1320) and
$6800 on credit (plus GST of $680). Of the credit sales, about 10% is expected
to be collected during October (including the related GST). It’s hoped that the
remainder will be received in November, but anticipating bad debts in the future,
Burgess has decided to create an allowance for doubtful debts of $500 on 31
October.
• Burgess has stipulated that inventory levels are to increase 10% during October.
The purchases required to achieve this goal during October will all be made on
credit and will be paid during November.
• Management applies a fixed mark-up percentage of 100% to all inventory sold.
• The prepaid insurance of $720 is the result of a yearly premium of $960 paid on 1
July 2023.
• The term deposit was taken out on 1 January 2022 and is earning 4% per annum.
Interest is payable monthly.
• Depreciation is charged as follows: on the shop fittings 15% on cost per annum; on
the delivery van 25% per annum on the reducing balance method.
• Monthly expenses usually incurred by the business are: advertising $400 (plus GST
of $40), wages $2400, and rent $3600 (plus GST of $360).
• Rent is payable three months in advance on the first of January, April, July and
October.
• The wages are paid as incurred, but only half of the advertising cost is expected to
be paid during October.

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 • The owner expects to be granted a loan during October to purchase a computer
system for the business in November. Although she’s still shopping around for a
system, she estimates that she will apply for approximately $6000.
• Owner’s drawings are usually around $800 per week.
Using a spreadsheet, complete the following tasks:
a Prepare a budgeted income statement and a budgeted cash flow statement for the
month ending 31 October 2023.
b Prepare a budgeted balance sheet as at 31 October 2023.
c Comment on the future of the business using information from your budgets in parts
a and b. Outline any areas of concern or positive features from the three budgets.

WB PAGE 389
12 Preparation of budgeted reports SPREADSHEET X.XX

Sue McKenna is the proprietor of Flash Photography, a retail outlet selling cameras and
video equipment. She has supplied the following financial information and has asked
for assistance in preparing the business’s budgets.
FLASH PHOTOGRAPHY: BALANCE SHEET AS AT 30 JUNE 2023
Current assets $ $ $ Current liabilities $ $
Cash at bank 1 700 Accounts payable 8 200
Inventory 28 000 GST clearing 2 200
Accounts receivable 8 600 Loan 6 000 16 400
Prepaid rent 6 400 44 700 Owner’s equity
Capital 43 100
Non-current assets
Shop fittings 15 000
Less: Accumulated 5 000 10 000
depreciation
Office furniture 8 000
Less: Accumulated 3 200 4 800 14 800
depreciation
59 500 59 500

Additional information
• Sales for the month of July are estimated to be $16 200 (plus GST of $1620), of
which 75% will be for cash. None of the credit sales will be settled until August or
September.
• Accounts receivable as at 30 June 2023 are expected to pay as follows: 80% should
pay during July and will be allowed a 2% discount, and the other 20% are expected
to pay during August.
• The owner of the business maintains a fixed mark-up on goods sold to ensure that
gross profit is equal to one-third of sales revenue.
• Management expects inventory to be up to $30 000 by the end of July. Purchases
will be made on credit to achieve this goal. All credit purchases made by the
business are settled in the following month.
• The proprietor of the business has arranged for a bank overdraft and has a limit of
$10 000 approved by the bank.
• Rent on the shop is payable three months in advance. The last payment was made
on 1 June 2023.
• Wages of the shop are usually $650 per week.

978 1 4202 3962 1 [CHAPTER 20] BUDGETING 417

 • A quarterly electricity bill for the period July–September is due in the last week of
September. It’s usually about $240 per quarter, plus GST.
• Advertising handbills costing $600, plus GST of $60, will be purchased for cash on 2
July 2023. These handbills should all be used during July.
• Stationery will be purchased for cash during July for $150, plus GST of $15. All of
this stationery is expected to be used by the end of July.
• Shop fittings are depreciated at the rate of 20% per annum using the reducing
balance method, and office furniture at 10% per annum using the straight-line
method.
• A new computer is expected to be purchased on 31 July 2023 for $4800, plus GST
of $480. The total owing will be paid on this date.
• The computer is to be depreciated at the rate of 33.3% per annum, using the
reducing balance method.
• The loan is an interest-only loan due for repayment on 31 July 2023. Interest of 10%
per annum has been paid on the last day of every month for the past two years. The
principal must be paid in full on 31 July 2023.
• The owner plans to withdraw $600 per week in cash.
Complete the following tasks. You may use a spreadsheet.
a Prepare a budgeted cash flow statement for the month ending 31 July 2023.
b Prepare a budgeted income statement for the month ending 31 July 2023.
c Prepare a budgeted balance sheet as at 31 July 2023.
d Comment on the future liquidity position of the business and its future profitability.
e Identify three items that appear in the budgeted cash flow statement that don’t
appear in the business’s budgeted income statement.
f Identify three items that appear in the budgeted income statement that don’t
appear in the business’s budgeted cash flow statement.

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 CASE STUDY WB PAGE 391

Ben Doyle, the proprietor of Damascus Steel, makes the following predictions for his
revenues and expenses for the yearly budget period ending 30 June 2023. The business
specialises in high-quality knife sets, which sell for $200 each.

Revenues Expenses
Cash sales 350 units @ $200 = $70 000 Wages – casuals 34 000
Credit sales 200 units @ $200 = $40 000 Office expenses 2 500
Advertising 5 300
Insurance 2 200
Depreciation 4 000
Stock losses 5 000
Note: all goods in the business are usually marked up by 100% on cost price.
Doyle is concerned about the profitability of his business, and considering a range of
strategies to improve his situation. He makes the following list for you to consider:
1 Employ additional casual employees. This will increase wages by 10% but is expected
to increase cash sales by 8%.
2 Undertake a new advertising campaign at an additional cost of $1000 per month. The
market research shows that a 10% increase in all sales may be possible.
3 Increase the mark-up on all goods to 110%. This may cost the business some
customers, and volume (based on the original estimates) will probably fall by
approximately 2% on cash sales and 1% on credit sales.
4 Decrease the mark-up on all goods to 90%. This is designed to attract new customers,
and volume (based on the original estimates) is expected to increase both cash and
credit sales by 12%.

a Using a spreadsheet, prepare a budgeted income statement based on Doyle’s original

estimates and determine his budgeted net profit for the year. (Hint: include cells for
both the number of units sold and the dollar value. This will assist you when completing
part b. You should also use formulas, when necessary, to determine all values within
the spreadsheet.)
b Copy and paste your spreadsheet prepared in part a so that you have five versions
of the one spreadsheet. Consider each of Doyle’s strategies in turn, using a separate
spreadsheet for each. You should end up with one spreadsheet that reflects the original
situation, plus one for each of the four different strategies.
c Write a report, discussing the anticipated results of the four strategies. Recommend to
Doyle what he should do to improve his profit result.
d Doyle is also worried about the level of stock losses. He’s received quotes for a new
security system that would include installing cameras around his business. The cost
of the system is approximately $12 000, but Doyle expects his stock losses would
be reduced to about $500 per year. Should he go ahead with the installation of the
security system? Explain your answer fully.

978 1 4202 3962 1 [CHAPTER 20] BUDGETING 419

 CHAPTER CHECKLIST
Now that you have finished Chapter 20, double-check your progress.
Are you ready for your Unit 4 exam?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
completed the end-of-chapter activities
handed in my workbook for marking.

I understand …

the characteristics and use of classified budgeted accounting reports:

– Budgeted Cash Flow Statement
– Budgeted Income Statement
– Budgeted Balance Sheet
the analysis of historical and budgeted accounting reports, including a consideration of
the limitations of analysis, to develop strategies to improve business performance
the distinction between cash and profit.

I can …

manually prepare classified budgeted accounting reports and variance reports

use ICT, including spreadsheets, to prepare and analyse classified budgeted accounting
reports and variance reports, and construct graphical representations.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_20

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

420 [ U N I T 4 ]  R E C O R D I N G , R E P O R T I N G , E VA L U AT I N G A N D P L A N N I N G A C C O U N T I N G 978 1 4202 3962 1

I N F O R M A T I O N
 21 BUDGET VARIANCE REPORTS

Budgets are used to plan for LEARNING OBJECTIVES

the future, but they are always
based on estimates. A certain By the end of this chapter, you will be able to:
degree of variance from estimates
•• identify both favourable and unfavourable variances
is inevitable, even in the most
[21.1]
carefully prepared budget.
What’s more important is that •• suggest possible causes of variances [21.1]
management regularly reviews •• prepare budget variance reports [21.2].
that variance and adjusts its plans
accordingly.
In this chapter, you will learn
about possible variances in a
budget, and how to prepare
reports that identify the causes of
those variances.

UNIT 4 – PROGRESS 14 15 16 17 18 19 20 21 22 23

21.2

Preparing budget
21.1 variance reports

Chapter review
Reviewing budgets
and exercises

978 1 4202 3962 1 421

 21.1 REVIEWING BUDGETS
Budgeting is a tool that, if used properly, provides a plan for management to follow
into future periods. This plan should anticipate improvements in the performance
of the business. By developing a plan, management should be able to decide if it is
satisfactory or if changes need to be made. This is the essence of budgeting: to plan
and control future financial events expected by a business and its management.
Regardless of the type of budget being prepared, the budgeting process must
remain flexible. As budgets involve predictions of future events, they’re not expected
to be perfect. They’re simply a tool for planning future events and shouldn’t be locked
in indefinitely. Modifications should be made as more up-to-date information becomes
available or as the performance of a budget is evaluated.
After preparing the required budgets, a business must check its performance
against the budgets during the course of the budget period. Budgeting should be a
continuous process, involving constant review.
The complete budgeting process is shown in Figure 21.1.

FIGURE 21.1 The budgeting process

Budget preparation

Adjustments
to plan as outlined Recording of
in budgets actual results

Review of actual
results against
budget predictions

BUDGET VARIANCE REPORTS

Figure 21.1 emphasises that budgeting should be an ongoing, continuous process.
The biggest mistake management can make when preparing a budget is to follow the
‘set and forget’ approach. There’s no point in preparing a detailed budgeting strategy if
it’s simply going to be filed away somewhere.
It’s important, therefore, to develop a systematic approach to budget review to
ensure that a business continuously controls its operations and carries out follow-up
action as required.
variance report A budget variance report (also known as a budget performance report) is
(or performance prepared to show the differences between budget estimates and actual results. As a
report)
an accounting budget sets the expectations of management in terms of performance, it’s important
report that to review these results.
compares budget
predictions with
the actual results
achieved

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I N F O R M A T I O N
 A budget variance report can be prepared for any type of budget. This report
simply states the budgeted figure for an item, the actual results for that item and
the variance between the two. A variance is the difference between budgeted and variance
actual results: the difference
between a budget
•• A favourable (or positive) variance occurs when the result is better than prediction and an
management expected. actual result
favourable
•• An unfavourable (or negative) variance is a result that is worse than that
variance (or
predicted by the budget. positive variance)
a situation in which
For example, if sales were predicted as $8000, and $10 000 worth of sales was the actual result
achieved, this would be a favourable variance. If the sales achieved were only $7000, is better than the
result predicted in
it would be an unfavourable variance.
the budget
In the case of an expense item, if wages were budgeted at $3000 and only $2800
unfavourable
was incurred, this would also be seen as a favourable variance. If the wages expense variance (or
was instead $3500, it would be an unfavourable variance. negative
variance)
a situation in which
MANAGING BUDGET VARIANCE the actual result
is worse than the
It’s often valuable to express the variances in both dollar terms and percentages. This result predicted in
the budget
helps identify the more significant variances, as minor variances are always expected
to occur. A budget is based on estimates and will rarely be exact in its predictions.
Significant variances from budget should be investigated and any relevant notes
made for future reference. If a budget contains many variances, management should
attempt to find explanations for these and make adjustments in its future planning.
In large businesses, results above budget expectations are often rewarded. For
example, a business may offer incentives to department managers if they achieve
exceptional results. This helps to reinforce the concept of a budget setting goals for
the business.
A budget variance report may also identify areas of concern. There may be cases
of overspending where a manager hasn’t kept within budget limits. This also requires
a reaction from management, but in this case it would be a negative response.
Disciplinary action, or perhaps even a demotion, may be the result of not following the
objectives outlined in the budget.
If undesirable results are allowed to go on for too long, there’s little chance of a
budget being met. Therefore, even when a budget is prepared for a quarterly period, it
should be reviewed after each month. If results aren’t as expected, decisions must be
made to get the plan back in line with what’s outlined in the budget.

21.1 CHECK YOUR UNDERSTANDING WB PAGE 396

1 Explain the purpose of a budget variance report.

2 ‘The preparation of a budget is only one part of the budgeting process.’ Comment on
this statement.
3 What is a variance? Should all variances be investigated by management?
4 ‘Budgeting is a continuous process.’ Explain fully the meaning of this statement.

978 1 4202 3962 1 [CH A P TER 21] BU D GE T VA RI A N CE REPO R TS 423

 PREPARING BUDGET VARIANCE
21.2 REPORTS
Because budget variance reports are prepared using the information from budget
statements, we’ll look back to the business of Smart Screen from Chapter 20 and use
their budget statements to demonstrate a budget variance report.
Variance reports have been prepared to show the business’s results in the
month of July.

VARIANCE IN BUDGETED CASH FLOW STATEMENTS

The first variance report relates to Smart Screen’s budgeted cash flow statement
(p. 399).
Liquidity is vital to a trading business. In this case, the owner of Smart Screen is
concerned that, even though cash sales are up, the final overdrawn balance is an even
worse result than that anticipated in the budget.
The report in Figure 21.2 can help identify the reasons for this unexpected result.
The F/U column notes whether each variance is favourable or unfavourable.

FIGURE 21.2 Variance report for a budgeted cash flow statement

SMART SCREEN: CASH FLOW STATEMENT VARIANCE REPORT FOR MONTH ENDED
31 JULY 2023
Budget Actual Variance F/U % Comments
$ $ $
Cash flows from operating
budgeted cash
activities
flow statement
accounting report Cash sales 7 000 7 700 700 F 10.0 Sunday trading
that shows estimates
Collections from accounts 3 234 2 934 300 U   9.3 Bad debt
of cash receipts
receivable
and payments, and
bank balance, at GST received 700 770 70 F 10.0 Increased sales
a particular future
Payments to accounts (6 481) (6 481) Nil
period
payable
Wages – assistant (1 520) (1 840) 320 U 21.1 Sunday trading
Advertising (200) (200) Nil
Window cleaning (240) (240) Nil
Legal costs Nil (200) 200 U 100.0 Re: bad debt
Insurance (600) (660) 60 U 10.0 Premium increase
Telephone (180) (180) Nil
GST settlement (500) (500) Nil
GST paid (122) (128)   6 U   4.9 Insurance
increase
Net cash provided by 1 091 975 116 U 10.6
operating activities
Cash flows from investing
activities
Nil
Cash flows from financing
activities
Cash drawings (2 000) (2 400) 400 U 20.0 Car accident

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I N F O R M A T I O N
 Net cash used in financing (2 000) (2 400) 400 U 20.0
activities
Net increase (decrease) in (909) (1 425)
cash held
Cash held at beginning of 250 250
month
Cash held at end of month (659) (1 175)

Two items appear in this variance report that the management of Smart Screen
apparently ignored in their planning – bad debts and legal costs didn’t appear in any of
the budgets prepared previously. These items have now been identified as part of the
budget review and should become part of future planning.
On the positive side, management apparently decided to experiment with
Sunday trading during July and, as a consequence, cash sales increased.
(Unfortunately, this meant that the payment for wages also increased.) This has also
been highlighted in the variance report and should be considered by management
when preparing future budgets.
The budgeted cash flow statements for August and September, which were
originally part of a quarterly budgeted cash flow statement, may have to be adjusted
in light of July’s results.
Ideally, at the end of each month, a budget variance report should be prepared,
followed by a new quarterly report. This achieves the goal of budgeting as an ongoing
process involving future planning that’s continuously updated.

VARIANCE IN BUDGETED INCOME STATEMENTS

A budget variance report can also be prepared in relation to a budgeted income
statement. The report is used to examine the profit performance of the business
against the budget expectations set down at the start of the period. As the budget
specifies the predictions of all revenue and expense items, the variance report can be
used to highlight the major variations from this budget plan.
Figure 21.3 is the income statement variance report for Smart Screen for the
month of July.

FIGURE 21.3 Budget variance report for an income statement

SMART SCREEN: BUDGET VARIANCE REPORT FOR THE MONTH ENDED
31 JULY 2023
Budget Actual Variance F/U % Comments
$ $ $
Revenue
Credit sales 3 000 3 600 600 F 20.0 Sunday trading
Cash sales 7 000 7 700 700 F 10.0 Sunday trading
10 000 11 300 1 300 F 13.0
Less: Cost of sales 5 000 5 650 650 U 13.0 Increased sales
Gross profit 5 000 5 650 650 F 13.0 Increased
turnover
Other revenue

978 1 4202 3962 1 [CH A P TER 21] BU D GE T VA RI A N CE REPO R TS 425

 Discount revenue 119 119 Nil
5 119 5 769
Less: Other expenses
Wages 1 520 1 840 320 U 21.1 Overtime
Advertising 200 200 Nil
Window cleaning 240 240 Nil
Insurance 50 55 5 U 10.0 Premium increase
Telephone 60 60 Nil
Bad debts 0 300 300 U 100.0 I Shiftee
Legal costs 0 200 200 U 100.0 I Shiftee
Depreciation – shop fittings 200 200 Nil
Total expenses 2 270 3 095 825 U 36.3
Net profit 2 849 2 674 175 U 6.1

This variance report clearly shows the favourable variances achieved in the revenue
area. Management has noted the success of Sunday trading in achieving an increase
in sales. In contrast to this is the unfavourable result in several expense items such as
wages, bad debts and legal costs.
This shows how important it is to review every item individually, rather than simply
comparing predicted profit with the actual result achieved. Although the budgeted
profit figure was only $175 off the actual net profit for July, many different items
caused this variance.
The management of Smart Screen may be happy with this variance report, since
the experiment with Sunday trading appears to have produced additional revenue.
Unfortunately, this didn’t cause a substantial increase in profit, due to the business
suffering bad debts of $300 and incurring some unexpected legal costs. Given that
these events were probably unusual, though, management may look forward to
improved future trading.
As with all budgeting procedures, the budgeted statements for August and beyond
should take into consideration the information from the July variance report. For example:
•• The owner should consider making allowance for future bad debts, particularly if
the level of credit sales is likely to continue to increase.
•• Sales estimates may have to be reviewed if additional trading hours are going to be
maintained.

21.2 CHECK YOUR UNDERSTANDING WB PAGE 397

1 ‘Variances shouldn’t occur very often if budgets are done properly.’ Do you agree?
Explain your answer fully.
2 Explain the link between a variance report and management decision-making.
3 A favourable variance in sales revenue may cause some unfavourable variances in
an income statement. State and explain three items that could have unfavourable
variances as a result of a favourable variance in sales.

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I N F O R M A T I O N
21 CHAPTER REVIEW
GST collected 2 400 2 800

KEY CONTENT
•• [21.1] Budgeting should be a continuous process, involving constant review. A business’s
performance is compared with the budgets as the budget period passes.
•• [21.1] A variance report states the budgeted figure for an item, the actual results for that item
and the variance between the two.
•• [21.2] A budget variance report should be prepared at the end of every month, followed by
a new quarterly report. This achieves the goal of budgeting as an ongoing process
involving future planning that’s continuously updated.

CHAPTER 21 EXERCISES

1 Variance report – cash flows WB PAGE 398

The following comparison of budgeted cash flows and actual cash flows has been
prepared for Broadway Formal Wear for the quarter ended 31 December 2023.

Budget Actual
$ $
Operating activities
Cash sales 28 000 32 000
Collections from accounts receivable 10 000 12 000
GST received 2 800 3 200
Cash purchases (1 200) (800)
Payments to accounts payable (18 000) (22 000)
Wages (2 700) (2 500)
Insurance (600) (620)
Postage and telephone (250) (220)
Electricity (320) (340)
GST paid (587) (518)
Investing activities
Purchase of new computer (3 500) (3 200)
Financing activities
Additional capital 4 000 –
Drawings (6 000) (5 200)

The business had $840 in the bank on 1 October 2023.

a Using a spreadsheet, prepare a variance report for the quarter ended 31 December SPREADSHEET X.XX

2023 to reveal the significant differences between the budget and the actual
results. Your report should also show the difference in the estimated bank balance
and the actual bank balance as at 31 December 2023.
b State the main reasons that caused the difference between the budgeted and
actual bank balances. If possible, suggest reasons for these variances occurring.
c Do you think that a quarterly period is appropriate for budgeted cash flow
statements? Give reasons for your answer.

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 SPREADSHEET X.XX2 Variance report – cash flows WB PAGE 400

Graeme Dickenson, the owner of Moon-Fire New Age Books, prepares a budgeted
cash flow statement on a regular basis. However, he’s alarmed to see that his latest
bank statement shows an overdrawn balance, when his budget estimated a debit
balance of several thousand dollars.
Dickenson provides the following data and asks you to compare the budgeted and
actual figures for the month of July 2023.

Budget Actual
$ $
Operating activities
Cash sales 24 000 28 000
Collections from accounts receivable 12 000 10 600
GST collected 2 400 2 800
Wages (10 400) (12 200)
Advertising (2 200) (2 800)
Rent (4 800) (4 800)
Payments to accounts payable (13 200) (14 600)
Telephone (240) (200)
Office expenses (200) (240)
Cartage outwards (520) (600)
GST paid (796) (1 264)
Investing activities
Purchase of display equipment – (4 000)
Financing activities
Drawings (2 400) (3 600)
Bank balance start of month 440 440

a Using the data provided, prepare a budget variance report, including variances in
dollar amounts and percentages, for Moon-Fire New Age Books for July 2023. Your
report should be a full statement of cash flows, including the final cash balances.
b Write a report to Graeme Dickenson, explaining clearly why the projected cash
figure wasn’t achieved. Your report should mention the significant favourable and
unfavourable variances from the budget.
c Given the result of July, Dickenson is sceptical about preparing budgets in the
future. He suggests that, because of the inaccuracy of the July budget, budgeting
for his business is a waste of time. Comment on his reaction.

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I N F O R M A T I O N
3 Variance report – income statement WB PAGE 402

The following information relates to the business of Salm’s Disposal Store.

SALM’S DISPOSAL STORE: INCOME STATEMENT FOR MONTH ENDED
30 NOVEMBER 2023
Budgeted Actual
$ $
Revenue
Cash sales 10 500 8 400
Credit sales 8 000 7 800
18 500 16 200
Less: Cost of sales 9 000 10 500
Gross profit 9 500 5 700
Less: Other expenses
Wages – sales staff 2 800 2 900
Advertising 2 600 2 000
Postage and telephone 150 160
Wrappings 360 320
Insurance 430 440
Interest on overdraft 100 140
Depreciation of fittings 800 800
Total operating expenses 7 240 6 760
Net profit 2 260 (1 060)

a Using a spreadsheet, prepare a budget variance report using the budgeted and SPREADSHEET X.XX

actual data.
b Write a report to the owner of the business explaining why the predicted profit for
November wasn’t achieved.

4 Variance report – income statement WB PAGE 404

The management of Console Kingdom completes an income statement for the month
of August 2023 and is surprised by the results. The following comparison of budgeted
and actual results is available.

Budgeted $ Actual $
Sales 22 000 26 000
Cost of sales 11 000 13 000
Wages 4 000 6 000
Office expenses 800 850
Rent 2 400 3 200
Doubtful debts 500 1 000

a Using a spreadsheet, prepare a budget variance report that shows both the budgeted SPREADSHEET X.XX

and actual profit figures.

b Comment on the changes in the following items: sales, cost of sales, wages, rent, and
bad debts.
c Prepare two pie charts to break down the sales dollar into the various expenses and net
profit. In one chart show the budgeted data; the other should show the actual results.
d Comment on any significant differences between the two pie charts prepared in part c.

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 SPREADSHEET X.XX5 Budgeted cash flows with account reconstructions WB PAGE 405

The owner of Benalla Music, Erik Heyden, needs help in preparing his budgeted
reports. He’s gone through his past records thoroughly and prepared a summary
of what’s happened and what he expects to happen. However, he’s unsure how to
determine estimated cash receipts from accounts receivable and estimated cash
payments to accounts payable.
The following information is provided.
FROM THE BALANCE SHEET
Actual Predicted
31 July 2023 31 August 2023
$ $
Balance of inventory 26 000 36 400
Balance of accounts receivable 2 400 2 800
Balance of accounts payable 8 600 9 600
Balance of cash at bank 3 210 ?

FROM THE INCOME STATEMENT

Actual Predicted
July 2023 August 2023
$ $
Cash sales 6 500 6 800
Credit sales 2 750 2 800
Cost of sales 4 500 4 600
Inventory loss 800 500
Wages 1 600 1 800
Office expenses 200 200
Discount expense 110 120
Discount revenue 150 160

a Reconstruct the following general ledger accounts to help Heyden with the
preparation of his budgeted cash flow statement: Accounts Receivable, Inventory,
and Accounts Payable. (Don’t forget to allow for GST of 10% on all sales and
purchases.)
b Using the above information, plus your reconstructions from part a, prepare a
budgeted cash flow statement for Benalla Music for the month ending 31 August
2023. (Note: you may use a spreadsheet.)
c Taking into consideration your budgeted cash flow statement from part b, comment
on the likely future cash position of this business.
d Prepare a budgeted income statement for the month ending 31 August 2023.
(Note: you may use a spreadsheet.)
e Write a brief report on the future performance expectations of Benalla Music in
relation to the expected profit or loss.
f ‘Reliability cannot be satisfied in the process of budgeting and therefore the
budgeting process isn’t all that valuable.’ Comment on this statement.

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I N F O R M A T I O N
 WB PAGE 409
ACCOUNTING IN THE REAL WORLD
The process of budgeting for a small business involves making predictions and planning
the future activities of the entity. Part of this planning may require making financial
arrangements with a bank or other financial institution. Just as you might apply for a
personal loan, overdraft or term deposit at some point in the future, small businesses may
set up similar arrangements.

In this activity, you’ll explore the different types of finance available to small business
owners. Although not directly part of the VCE Accounting Unit 4 course, this task expands
your knowledge of accounting for a small business and the related financial issues.
Visit at least two of the following websites:

•• Commonwealth Bank
•• NAB
•• ANZ
•• Westpac
(You can research a different bank or financial institution with your teacher’s permission.)
Your task is to investigate what types of loans are available to business owners.
Prepare a summary of your findings that includes:
a the types of finance available
b a brief description of the nature of the finance
c any advantages of the type of finance being suggested (some may be provided on the site).

Commonwealth Bank mea.digital/commbank

NAB mea.digital/nab.com
ANZ mea.digital/anz.com
Westpac mea.digital/westpac

978 1 4202 3962 1 [CH A P TER 21] BU D GE T VA RI A N CE REPO R TS 431

 CHAPTER CHECKLIST
Now that you have finished Chapter 21, double-check your progress.
Are you ready for your Unit 4 exam?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
completed the end-of-chapter activities
handed in my workbook for marking.

I understand …

the characteristics and use of classified budgeted accounting reports:

– Budgeted Cash Flow Statement
– Budgeted Income Statement
– Budgeted Balance Sheet
the use of variance reports and trends for Cash Flow Statements and Income
Statements.

I can …

manually prepare classified budgeted accounting reports and variance reports

use ICT, including spreadsheets, to prepare and analyse classified budgeted accounting
reports and variance reports, and construct graphical representations.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_21

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

432 [ U N I T 4 ]  R E C O R D I N G , R E P O R T I N G , E VA L U AT I N G A N D P L A N N I N G A C C O U N T I N G 978 1 4202 3962 1

I N F O R M A T I O N
22 EVALUATION OF BUSINESS
PERFORMANCE

Throughout this year, you’ve LEARNING OBJECTIVES

studied different ways to measure
and report on the operations, By the end of this chapter, you will be able to:
transactions and requirements •• outline the meaning of vertical and horizontal analysis
of trading businesses. But [22.1]
what is the ultimate point of
•• explain the role of financial indicators, including ratios
these reports? It’s to evaluate
[22.2]
how effectively a business
is performing, and to help •• give examples of benchmarks that can be used to
management make decisions measure performance [22.2]
that (hopefully) improve that •• comment on the results of ratio analysis [22.2]
performance. •• prepare a variety of indicators to examine the areas of
In this chapter you’ll learn profitability and operating efficiency [22.3 & 22.4]
about key financial indicators for •• calculate changes in performance in both dollar and
a business, and how accounting percentage terms [22.3 & 22.4]
reports on these indicators are
•• evaluate the performance of a business using data
used to inform decisions.
from several reporting periods [22.3 & 22.4].

UNIT 4 – PROGRESS 14 15 16 17 18 19 20 21 22 23

22.2 22.4

Operating
Analytical ratios efficiency
22.1 22.3
indicators

The role of
financial evaluation Profitability Chapter review
indicators and exercises

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 22.1 THE ROLE OF FINANCIAL EVALUATION
The evaluation of reports is a vital part of the accounting process. As accounting
provides financial information for managers to use in making better decisions,
they must interpret the information correctly. If accounting reports aren’t analysed
correctly, any decisions based on that analysis could affect the future of a business.
Planning for the future operations of a business usually takes into account the
reporting of past results of the business. It’s important, therefore, that information is
reported in a clear, easily understood fashion that allows management to interpret the
results and make the right decisions. Figure 22.1 shows where evaluation fits in the
overall accounting process.

FIGURE 22.1 The place of evaluation in the accounting system

Recording Preparation of reports Evaluation of reports Budgeting (planning) Decision-making

of transactions

Evaluation provides additional information to that already available in financial

statements, such as the income statement and the balance sheet. The techniques of
evaluation should improve the quality of the information available to management. This
may be done using such tools as year-to-year comparisons, percentages as well as
dollar values, ratios, charts and graphs.
Evaluation of reports involves two distinct processes:
analysis •• analysis is breaking down something complex into simpler, smaller parts.
the process of breaking
down something •• interpretation is then explaining the meaning of the completed analysis.
complex into simpler,
smaller parts
VERTICAL ANALYSIS
interpretation
the process of A simple form of analysis is to present the income statement in both dollar terms and
explaining the meaning
of a financial item or percentages. This is known as vertical analysis, because the accounting report is
analytical ratio analysed in a vertical fashion.
vertical analysis The income statement based on dollar values provides limited information. When
breakdown of an the same report is analysed (or broken down) into percentages, additional information
accounting report
into percentages in a becomes available.
vertical fashion on the An example of a vertical analysis is shown in Figure 22.2. It shows the 2023
page
performance of the business Twitchstream Tees, which sells T-shirts based on popular
Twitch shows and performers.

FIGURE 22.2 Vertical analysis of an income statement

$ %
Sales 80 000 100.00
Less: Cost of goods sold 40 000 50.00
Gross profit 40 000 50.00

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 Less: Other expenses
Wages 15 000 18.75
Office expenses 5 000 6.25
Advertising 6 000 7.50
Interest 4 000 5.00
Total expenses 30 000 37.50
Net profit 10 000 12.50

Management can now interpret this report in terms of the percentage of the sales
dollar consumed by each expense. The percentage of the sales dollar earned as both
gross profit and net profit is also available. This information wasn’t readily available in
2021
the normal statement.
The vertical analysis
2% in Figure 22.2 shows that, on average, 50% of the sales dollar
11% Cost of goods sold
earned by Twitchstream Tees was consumed by its cost of sales. (This is an average
only, as the business varies8%its mark-up on the differentWages
T-shirts it sells.) Over the year,
half of its sales revenue was eaten away by cost prices,Office
thus leaving 50% of the sales
expenses
7%
dollar as gross profit. 55%
Advertising
Note that an increase in the business’s mark-up would lead to an increase in this
17%
gross profit margin (gross profit/sales). On the other hand,
Interest if cost prices increased gross profit margin
the percentage of the
and selling prices remained unchanged, the gross profitNet margin
profit would fall.
sales dollar remaining
Having established a gross profit percentage, it can also be seen that: after cost of goods
2022 sold has been taken
•• wages consumed 18.75% of the sales dollar into accounts
3% expenses
•• 6.25% went in office 10% Cost of goods sold

•• advertising used up 7.5% of sales Wages

8%
•• interest expense consumed 5% of the sales dollar. Office expenses
6%
56%
The end result is that 12.5% of total sales remained as net profit at the end of the
Advertising
period (net profit/sales). This type of data is often represented in pie chart form, which is
17% Interest
an excellent way of demonstrating changes that may occur from one period to the next.
Figure 22.3 shows a pie chart for the above income Net statement.
profit

FIGURE 22.3 Pie chart showing breakdown of sales dollar

2023
Cost of goods sold
5% 13%
Wages

7% Office expenses
50%
6% Advertising

Interest
19%
Net profit

common size
Vertical analysis allows statements to be presented as percentages for each reporting statements
period. Translating accounting reports from dollars to percentages provides a common reports that use
percentages rather
base, which allows comparisons to be made more easily. Common size statements than dollar values,
are reports based on percentages, rather than actual dollar amounts, to assist to allow easier
comparison of results. comparison of results

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 HORIZONTAL ANALYSIS
A second form of analysis uses horizontal comparisons of multiple trading periods.
horizontal analysis Continuing with the example of Twitchstream Tees, a horizontal analysis can be
comparison of financial performed as shown in Figure 22.4.
results across the page,
usually by reporting on
several consecutive FIGURE 22.4 Horizontal analysis of the income statement
trading periods
2021 2022 2023
$ % $ % $ %
Sales 60 000 100.00 80 000 100.00 80 000 100.00
Less: Cost of goods sold 33 000 55.00 45 000 56.25 40 000 50.00
Gross profit 27 000 45.00 35 000 43.75 40 000 50.00
Less: Wages 10 000 16.67 14 000 17.50 15 000 18.75
Office expenses 4 000 6.67 5 000 6.25 5 000 6.25
Advertising 5 000 8.33 6 000 7.50 6 000 7.50
Interest 1 000 1.67 2 000 2.50 4 000 5.00
Total expenses 20 000 33.33 27 000 33.75 30 000 37.50
Net profit 7 000 11.67 8 000 10.00 10 000 12.50

As all three reports express each item as a percentage of sales, they can now be
compared horizontally across the page. For example, although Twitchstream Tees’
net profit increased from $7000 to $8000, and then from $8000 to $10 000, it hasn’t
remained a constant percentage of sales:
•• 2021: net profit as a percentage of sales was 11.67%
•• 2022: net profit as a percentage of sales was only 10%
•• 2023: net profit as a percentage of sales increased to 12.5%
Vertical analysis can then be used to explain why certain changes have occurred over
time. For example, it looks like the 2022 fall in the net profit percentage was caused
by the fall in the gross profit rate.
Note that the percentage consumed by expenses was virtually constant in
2021 and 2022. However, a problem may be developing, as the total consumed by
expenses jumped from 33.75% in 2022 to 37.5% in 2023.
Management can use such analysis to pinpoint problems and make decisions to
correct the situation. For example, two expenses (wages and interest) have increased
as a percentage of sales each year. These two areas may need to be reviewed and
monitored carefully in the future to ensure they don’t reduce future profits.
The use of pie charts can also support horizontal analysis, as they allow for easy
comparisons over consecutive periods. The Twitchstream Tees horizontal analysis can
be presented as shown in Figure 22.5.
Pie charts provide an instant overview of major changes within a business. The
most obvious change shown in Figure 22.5 occurred with cost of goods sold, which
dropped from 56.25% in 2022 to only 50% in 2023. Net profit increased slightly over
the same period.
Some users of accounting reports prefer pie charts to pages of numerical data,
because of their visual impact. As long as the information they present is accurate, pie
charts can be a valuable tool for accountants.

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 2021
FIGURE 22.5 Comparative pie charts over consecutive reporting periods
2% 11%
2021 Cost of goods sold

8% Wages
2% 11% Cost of goods sold
7% Office expenses
55% Wages
8% Advertising

7% 17% Office expenses

Interest
55%
Advertising
Net profit
17% Interest
2022
Net profit
3% 10% Cost of goods sold
2022
Wages
8%
3% 10% Cost of goods sold
Office expenses
6%
56% Wages
8% Advertising
Office expenses
6% 17% Interest
56%
Advertising
Net profit

17% Interest

Net profit

2023
Cost of goods sold
5% 13%
2023 Wages
Cost of goods sold
5% 7% Office expenses
13%
50% Wages
6% Advertising
7% Office expenses
Interest
19% 50%
6% Advertising
Net profit
Interest
COMBINED ANALYSIS
19%
Net profit
A combination of vertical and horizontal analysis can be used to examine a business’s
performance over several reporting periods. Management can then identify changes in
revenues and expenses over time and take appropriate action.
It’s essential to use comparative data over time, as one year’s data may not
present the full picture. Vertical analysis can provide detailed information about the
current reporting period, but when this is compared with previous periods, it may be
seen differently.
Consider the following example, which compares the performance of two different
businesses.

2023
Business A Business B
$ $
Sales 50 000 50 000
Net profit 10 000 10 000

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 The above figures simply state that the sales and profit figures for both businesses
were the same in 2023. Both businesses earned a profit that was 20% of sales
revenue (10/50 = 0.20).
However, vertical analysis is limited, as it only considers the one period. If previous
years’ figures are also available, it might lead to a different opinion of the two
business’ performance.
The following shows a three-year comparison.

Business A Business B
2021 2022 2023 2021 2022 2023
$ $ $ $ $ $
Sales 30 000 40 000 50 000 70 000 60 000 50 000
Net profit 3 000 6 000 10 000 25 000 20 000 10 000

When the results of the three years are compared, Business A appears to have
performed much better in 2023 than Business B.
This horizontal analysis can be used to produce data relating to comparisons of one
year against another. For example, using the given data, you can see that:
•• during 2023, Business A increased sales revenue by 25% (an increase of $10 000
on the $40 000 earned in 2022)
•• Business A’s profit in 2023 was $10 000 – $6000 = $4000, or 66.7% ($4000/$6000)
above that achieved in 2022
•• in contrast to the results achieved by Business A, Business B experienced a drop
in sales of $60 000 – $50 000 = $10 000, or 16.7% ($10 000/$60 000), as well as a
50% decrease in profit.

trend analysis Comparing one year’s data to that of one or more previous years provide management
measuring the change with a trend of the business’s performance. Trend analysis involves measuring the
in a financial item or an
indicator over several
change in an item from one year to another. For example, 2023 may be compared
periods with 2022, or with 2021; we may even look at the trend over five or ten years.

22.1 CHECK YOUR UNDERSTANDING WB PAGE 411

1 Explain the role played by the evaluation of reports in the overall accounting system.
2 Distinguish between analysis and interpretation.
3 Explain why percentages are often used in the process of analysis and interpretation.
4 Describe the differences between vertical and horizontal analysis.
5 Explain why data from several periods is preferred to a single set of results when
evaluating the performance of a business.

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22.2 ANALYTICAL RATIOS
When final accounting reports have been prepared, they offer a wide range of financial
information to users. However, accountants will often extract and compare different pieces
of information to find out more about the business. This process creates an analytical ratio.
An analytical ratio is the mathematical comparison of two items that have a analytical ratio
a comparison of
particular relationship. For example, a comparison of current assets and current
two related items in
liabilities measures the liquidity of a business. Profit for a period can be compared order to analyse an
with the investment made in the business to measure its profitability. aspect of business
performance
Analytical ratios are also known as financial indicators, as management uses them
profitability
to measure financial performance over different periods. This is possible because
acomparison of
these indicators bring all figures back to a common base. profit with a base
For example, sales in one period may be $123 460, but increase to $125 870 in the figure, such as assets
employed, capital
following period. Such odd amounts make comparisons difficult. However, if sales for invested or sales
both periods are made to equal 100%, comparisons are possible, and expenses can made
all be expressed as a percentage of sales revenue.
The previous examples of income statements showed how the results of several
periods can be compared, and trends detected in particular areas within the business.
The vertical analysis in Figure 22.2 (p.434–5) is based on a collection of financial
indicators. Some examples contained in Figure 22.2 are:
•• gross profit margin, which is gross profit divided by net sales
•• expense ratios – for example, wages divided by net sales expense ratio
(expense/sales)
•• net profit margin, which is net profit divided by net sales. may also be used for
total expenses (total
These financial indicators are only one type of ratio, as they all relate to the income
expenses/sales)
statement and the profitability of the business.
net profit margin
Financial indicators are an important part of evaluation because they make it (net profit/sales)
possible to compare data from different periods. the percentage of
the sales dollar that
remains after all
FINANCIAL INDICATORS AND BENCHMARKS expenses have been
taken into account
When financial indicators are calculated, they’re usually compared to benchmarks of benchmarks
measurement or performance. These are used to measure the success (or otherwise) tools used
to measure
of business decision-making. performance by
Typical benchmarks include comparisons with the following: comparing financial
results against some
•• Previous periods’ results. These allow a trend in an indicator to be detected. established criteria
•• Industry averages, or comparisons with other similar businesses. Although such
information isn’t always publicly available, an accountant may be able to state if a
business’s performance is above or below that of similar businesses.
•• Budget estimates, or predicted results. Even if financial indicators reflect an
improved performance (compared to previous periods), they may not have
achieved the level of performance in management’s targets.
•• Alternative investments. Indicators that are used to examine profitability should be
compared against the rates of return available on other forms of investment. There
may be little value in investing in a business if a greater return is available in the
money market.
Whenever an indicator is calculated, it should be compared with one or more
benchmarks to give it some sort of meaning. The benchmarks used will vary
depending on the particular indicator.

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 As long as financial indicators are calculated in a consistent manner, they can
provide management with detailed information about the performance of the business
in a number of areas.

MAIN TYPES OF FINANCIAL INDICATORS

There are literally hundreds of financial indicators that can be calculated to measure
different aspects of a business’s performance. This text will only cover the most
important indicators that relate to the sole trader type of business.
While it’s important to appreciate that indicators interrelate with one another, they
can be grouped into four main areas:
1 Profitability indicators. These examine how profitable the business has been during
the period. Profitability may be measured by comparing profit with an investment, by
looking at what happened to the sales dollar during a period (see Figure 22.3), or by
other means.
2 Operating efficiency indicators. These look at how efficiently management uses the
assets available to them. Investment in inventory, accounts receivable, current assets
or non-current assets can all be examined in terms of how efficiently they have been
used and managed.
EXAM 3 Liquidity indicators. These investigate the ability of the business to meet its short-
SUCCESS term debts as they fall due. Liquidity indicators are usually based on short-term events,
You will not be asked and consider items relevant to the next 12 months of a business’s operations.
to calculate indicators
on the VCE exam, but 4 Stability indicators. These measure a business’s financial stability and reflect the
you must be able to financial risk being taken on by the business owners.
explain what each
indicator measures, These four types of financial indicators are explained in this and the next chapter.
and whether or not Remember that one indicator may have a direct impact on another indicator in a
it has improved or different area:
deteriorated.
•• An indicator that shows how efficiently assets have been used may affect one or
more profitability indicators.
•• Liquidity indicators take into consideration the current liabilities of a business. As
this may involve loans, and loans attract interest, this may also have an impact on
profitability.
Keep in mind the possible relationships between indicators as you study this topic.

22.2 CHECK YOUR UNDERSTANDING WB PAGE 412

1 Why do accountants prepare analytical ratios when a wide range of information is

already available in final accounting reports?
2 Explain the purpose of benchmarks in ratio analysis.
3 Name three benchmarks that can be used to evaluate the profit figure of a business.
4 Describe the different areas of a business that can be evaluated by financial
indicators.

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22.3 PROFITABILITY INDICATORS
Before we look at individual profitability indicators, it’s important to distinguish
between the terms ‘profit’ and ‘profitability’.
•• Profit is simply the dollar value determined when expenses incurred are deducted
from revenue earned over a given period.
•• Profitability is the comparison of a profit figure with a base figure, such as the
investment made.
When attempting to measure a business’s profitability, it’s necessary to go beyond
simply determining a net profit for a period. Profitability indicators not only examine
how profitable a business has been, but also look at the reasons for changes in its
profitability.
The most important profitability indicators are examined in detail below.

GROSS PROFIT MARGIN

Gross profit margin = Gross profit × 100
Net sales

One of the most important factors that influence the profit of a trading business is the
percentage of the sales dollar earned as gross profit. The relationship between the cost
price and the selling price of the goods sold by the business is crucial to profitability.
If cost prices increase over time, but selling prices remain constant, the gross
profit margin will fall. If management decides to increase the general mark-up on the
inventory sold, the gross profit margin will increase.
The following data demonstrates the gross profit margin for Twitchstream Tees.
2022 2023
$ $
Net sales 80 000 100 000
Less: Cost of goods sold 40 000 55 000
Gross profit 40 000 45 000

Gross profit margin $40 000 $45 000

$80 000 $100 000
= 0.50:1 = 0.45:1
or 50.0% or 45.0%

The gross profit margin for this business dropped from 50% in 2022 to 45% in 2023.
This indicator tells management that, although sales increased by $20 000 over the
year, the percentage of the sales dollar maintained as gross profit decreased.
This occurred because, on average, cost of goods sold consumed $0.50 out of
each sales dollar in 2022, and this increased to $0.55 cents in 2023. This may have
occurred because:
•• cost prices increased, while selling prices remained constant
•• cost prices remained constant, while selling prices were decreased
•• both cost prices and selling prices increased, but cost prices increased at a greater rate.
When evaluating a gross profit margin, it’s important to compare it against
benchmarks such as the previous periods’ gross profit margins and the budgeted
gross profit rate.

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 NET PROFIT MARGIN
Net profit margin = Net profit
× 100
Net sales

The net profit margin achieved by a business is the relationship between its total
revenues and total expenses. Once the gross profit rate has been calculated, the level
of the business’s operating expenses determines the percentage of the sales dollar
that remains as the net profit for the period.
The following shows data relating to Twitchstream Tees’ operating expenses.

2022 2023
$ $
Net sales 80 000 100 000
Less: Cost of goods sold 40 000 55 000
Gross profit 40 000 45 000
Less: Wages 10 000 15 000
Office expenses 5 000 5 000
Total expenses 15 000 20 000
Net profit 25 000 25 000

Net profit margin $25 000 $25 000

$80 000 $100 000
= 0.31:1 = 0.25:1
or 31.0% or 25.0%

An obvious question in relation to Twitchstream Tees is: why did their profit remain at
the level of $25 000 when sales increased by $20 000?
The net profit margin indicates that in 2022 about 31 cents in the dollar was earned
as profit, and that this figure has dropped to 25 cents in the dollar in 2023. This return
on sales should be compared with the rate achieved in past periods, the budgeted
rate and the rate achieved by similar businesses. Although each business is unique in
terms of its own revenues and expenses, if similar businesses earn a much higher net
profit margin, this can act as a warning signal that something may be wrong.
Having determined this result, the question then becomes: how did it occur?
One possible cause is the 5% drop in the gross profit margin, which flowed on to
affect the net profit margin. Another possible cause is the change in expenses.

EXPENSE RATIOS
Expense ratio = Expense item
Net sales

A percentage rate can be calculated for each individual expense item. Such expense ratios
inform management about the percentage of the sales dollar consumed by each expense.
For Twitchstream Tees, two calculations can be made, as shown on the next page.

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 2022 2023
$ $
Wages expense ratio 10 000 15 000
80 000 100 000
= 0.125:1 = 0.150:1
or 12.5% or 15.0%

Office expenses ratio $5 000 $5 000

$80 000 $100 000
= 0.0625:1 = 0.05:1
or 6.250% or 5.00%

These two expense ratios show contrasts in their trends.

The wages of the business consumed 12.5 cents of each sales dollar in 2022,
and this increased to 15 cents in 2023. This may be expected to occur because
sales increased by $20 000 over this time. However, the increase in selling expenses
occurred at a greater rate than the increase in sales (50%, compared with 25%). Thus,
in 2023 the business’s profitability was reduced by the large increase in wages expenses.
The office expenses ratio shows a drop from 6.25% to 5% over the two years.
In this case the expense in dollar terms didn’t change. As sales increased in 2023,
office expenses as a percentage of sales actually decreased. This could be because
the expenses incurred in running the office may be constant in nature. Items such as
postage, telephone and stationery may not vary much from one year to the next.
Expense ratios should be compared with previous periods’ results and the expense
budgets set down by management. Unexpected expense items and major changes
in expense ratios should always be investigated, as they have a direct impact on the
business’s net profit margin.

RETURN ON ASSETS
Net profit
Return on assets = × 100
Average total assets

The financial indicators demonstrated so far examined relationships that exist within
the income statement. Another way of measuring the profitability of a business is to
compare the net profit for the period with the amount invested in the business’ assets.
Rather than using the value of total assets at the beginning or end of the period,
an average of these two values is normally used. This removes any bias that may
exist if total assets change in a significant manner right near the end of the period.
By using an average of asset value, the profit can be compared with the average level
of investment. If the data is available, an average based on monthly figures would be
even more accurate.
Once the method of calculating the rate of return has been decided, it should be
consistently applied each reporting period (as required by the qualitative characteristic
of comparability). If this isn’t done, meaningful comparisons become more difficult, as
changes in the ratio may occur simply because of a change in the method of calculation.
The following information is used to calculate Twitchstream Tees’ return on assets. return on assets
how well
management
has used its
investment in assets
to earn profit

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 2021 2022 2023
$ $ $
Total assets 120 000 130 000 140 000
Net profit 25 000 25 000

For 2022:

Return on assets = Net profit

Average total assets

= $25 000 = $25 000 = 0.2 or 20% return

($120 000 + 130 000) ÷ 2 $125 000
For 2023:

Return on assets = $25 000 = $25 000 = 0.185 or 18.5% return

($130 000 + 140 000) ÷ 2 $135 000

The results of the return on assets can be interpreted in two different ways.
First, it can be expressed in terms of the profit earned for every dollar invested in the
business’s assets. In the above example, in 2022 Twitchstream Tees earned 20 cents of
profit for every dollar invested in assets. In 2023, an unfavourable trend was experienced
when the return on assets dropped to only 18.5 cents of profit for every dollar invested.
return on owner’s Second, it can be expressed in terms of the return on owner’s investment.
investment In 2022, Twitchstream Tees earned a return of 20% per annum on its investment,
the return earned
on the investment but only 18.5% in 2023. The return on assets is often expressed in these terms, as
of funds by the owners use this as a comparison with alternative investments. This is one of the
proprietor of a
business benchmarks that can be used to evaluate a rate of return.
The other usual benchmarks are still valid for this financial indicator since the
results can be compared with previous years, budget expectations and returns
achieved by similar businesses.

RETURN ON OWNER’S INVESTMENT

Return on investment = Net profit × 100
Average capital
A percentage return may also be calculated on the actual investment made by the
owner of the business.
An owner will usually be interested in the return being earned on the capital
they’ve invested in their business. As many small businesses fund some of their
assets through liabilities, there may be a significant difference between total assets
and owner’s equity.
The following details expand the Twitchstream Tees example:

2021 2022 2023

$ $ $
Capital 70 000 80 000 90 000
Total assets 120 000 130 000 140 000
Net profit 25 000 25 000

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For 2022:
Return on owner’s investment = Net profit
Average capital

= $25 000 = $25 000

($70 000 + 80 000) ÷ 2 $75 000

= 0.33 or 33% return

For 2023:
Return on owner’s investment = Net profit
Average capital

= $25 000 = $25 000

($80 000 + 90 000) ÷ 2 $85 000

= 0.294 or 29.4% return

The return on owner’s investment fell from 33% in 2022 to 29% in 2023. This is an
unfavourable trend, as the owner’s capital has earned a lower return on the average
level of investment.
As with the return on assets, an average of the owner’s capital is the preferred
figure to be used in this financial indicator. However, capital at the beginning or end
of the year may be used as alternatives. The important thing is always to calculate the
ratio using the same method consistently from one year to the next.
When evaluating an owner’s personal return on investment, the usual benchmarks
include comparisons with:
•• alternative investments in the money market
•• the budgeted, or expected, rate of return
•• previous periods’ rates of return.
When evaluating the return on an owner’s investment, remember that the desired
return may be based on a personal target. Many owners seek a return much higher
than that available in the commercial market, as a reward for their hours of work and
the financial risk.
Another factor to take into account is that an owner’s return on investment doesn’t
always equal the amount available for drawings. The return earned on alternative
investments may be paid in cash each year, but this isn’t always possible when
running a business. Funds may have to be retained to finance the future plans of the
business. For these reasons, an owner may want a much higher return on investment
compared with many other types of investments.

22.3 CHECK YOUR UNDERSTANDING WB PAGE 413

1 Business A earned a profit of $20 000, while Business B had a profit of

$30 000. Explain how it’s possible that Business A has a higher profitability.
2 The gross profit margin of a business was 50% in 2022 and 55% in 2023.
Explain how it may have achieved this increase.
3 How is the net profit margin calculated? What does this ratio indicate?
4 Explain why the average assets figure is preferable to assets at the end of a
period when calculating the return on assets ratio.
5 What is the purpose of calculating a return on owner’s investment if the
return on assets has already been determined?

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 22.4 OPERATING EFFICIENCY INDICATORS
A trading business purchases assets for the purpose of generating revenue. Money is
invested in assets such as fittings, delivery vehicles and inventory to help the business
earn a profit. If a business uses its assets to their maximum operating efficiency, the
result should be maximum profit.
The financial indicators in this section illustrate how efficiently a business uses its
various types of assets. However, always remember that efficiency indicators have a
direct impact on the profitability ratios covered earlier, as assets are used to generate
revenue, which ultimately determines the level of profit earned for the period.

ASSET TURNOVER
Asset turnover = Net sales
Average total assets

asset turnover Asset turnover compares sales revenue with the average investment in the
how well assets business’s total assets. By doing so, it gives management information about how well
have been used to
generate sales the assets of the business have been used to generate revenue.
The asset turnover for Twitchstream Tees is calculated as follows:

2021 $ 2022 $ 2023 $

Sales 80 000 100 000
Total assets 120 000 130 000 140 000

For 2022:

Asset turnover = Net Sales x 100

Average total assets

Asset turnover = $80 000 = $80 000 = 64%

($120 000 + 130 000) ÷ 2 $125 000
For 2023:

Asset turnover = $100 000 = $100 000 = 74%

($130 000 + $140 000) ÷ 2 $135 000

This trend is a favourable result, because the dollars invested in Twitchstream’s assets
have generated a higher rate of sales turnover. The more times the investment in
assets is turned into sales, the better it is for the business because this reflects a
more efficient use of the assets available to management.
Another way of looking at this ratio is that, for every dollar invested in assets,
64 cents of sales revenue was generated in 2022, which increased to 74 cents for
every dollar invested in 2023. Alternatively, the invested in assets generated a 64%
return in terms of sales, and this increased to 74% in 2023.
If the asset turnover rate decreased in a given period of time, it would mean that
assets aren’t generating the same amount of revenue. For example, if assets weren’t
used during the period, this would be reflected in the turnover rate.

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CLASSIFIED ASSET TURNOVER
Asset turnover rates may also be calculated for specific classifications of assets. That
is, a turnover rate may be calculated for current assets or non-current assets:

Current asset turnover rate = Net sales

Average current assets

Non-current asset turnover rate = Net sales

Average non-current assets

Asset turnover rates may be calculated on a classification basis to reveal problem

areas within the business.
If the overall asset turnover decreases each year, management may need further
information to locate the problem. For example, perhaps non-current assets have
maintained the same relationship with sales revenue for several periods, while the
current asset turnover rate shows a steady decrease. This identifies the problem area,
and management is then in a better position to correct it.
All turnover rates should be compared with some established benchmarks.
The usual ones used include previous periods’ figures, budget estimates and, if
appropriate, similar businesses or industry averages.
The last of these benchmarks isn’t always suitable for these indicators, as the
asset structure of businesses can vary greatly. If comparisons with other businesses
are to be made, management must first ensure that those comparisons are valid.
Otherwise, they should use internal benchmarks, such as last year’s results and the
budgeted rates.

OTHER ANALYSIS TOOLS

When analysing the operating efficiency of a business, the asset turnover rate
provides a general guide as to how well management has used its assets during a
reporting period. However, this rate is general in nature and takes into account all the
assets under the control of the entity.
More specific detail can be provided about the business’s assets by using several
tools of analysis that were covered in Chapter 14. These include:
•• inventory turnover
•• accounts receivable turnover
•• age analysis of accounts receivable
•• cash cycle
•• accounts payable turnover.
Since these items were explained in Chapter 14, it’s not necessary to cover them
again in detail. However, it’s important to keep them in mind as part of an overall
analysis of a business’s performance, so a brief summary of them is provided here.

Inventory turnover
Inventory turnover = Average inventory × 365
Cost of goods sold

This indicator determines the number of days a business takes to turn the average
level of inventory into sales. Inventory turnover is used to evaluate performance in
managing and controlling inventory.

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 When interpreting inventory turnover rates, consider:
•• the type of inventory being sold
•• previous periods’ results (i.e. the trend)
•• management’s expectations or budget objectives.

Accounts receivable turnover

Accounts receivable turnover = Average accounts receivable x 365
Net credit sales (plus GST)

The accounts receivable turnover examines the performance of management in

collecting its debts from credit customers. It’s expressed in days and is used to
assess the average time taken by accounts receivable to settle their accounts. The
accounts receivable turnover can be used to evaluate performance in relation to
controlling and managing credit accounts.
When interpreting accounts receivable turnover results, the usual benchmarks include:
•• the credit terms originally offered to accounts receivable
•• accounts receivable age analysis (see below)
•• previous periods’ results (i.e. the trend)
•• management’s expectations or budget objectives.

Age analysis of accounts receivable

This tool is another method for analysing the performance of management in relation
to accounts receivable. An age analysis can be prepared on a regular basis to provide
a breakdown of accounts receivable in relation to the age of their debts. It can
provide a business owner with regular feedback on the success or otherwise of their
collection procedures.
The results can also be measured by:
•• the credit terms originally offered to accounts receivable
•• previous periods’ results (i.e. the trend)
•• management’s expectations or budget objectives.

Cash cycle
Cash cycle = Inventory turnover + Accounts receivable turnover

The addition of the two turnover rates provides management with an assessment of
the time taken to turn inventory into sales, and then sales into cash.
For a trading business, the cash cycle is crucial. The cycle of buying inventory,
selling it, and then collecting cash from its sales is the reason trading businesses
exist. Ultimately, it’s the process that determines the success or failure of so many
Australian small businesses. If management can’t complete the cash cycle within a
certain time, it’s doomed to fail.
When evaluating the cash cycle, consider the following:
•• the performance of the individual turnover rates
•• previous periods’ results (i.e. the trend)
•• management’s expectations or budget objectives
•• accounts payable turnover rate.

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Accounts payable turnover
Accounts payable turnover = Average accounts payable × 365
Net credit purchases + GST

This indicator is used to evaluate the management of accounts payable. It’s expressed
in days, with the result being the average time taken to settle accounts with suppliers.
This indicator should be compared to the accounts receivable turnover and/or the
cash cycle of the business. Finding a balance between the time taken to complete
the cash cycle and the time taken to settle accounts payable is important in managing
cash within a small business. At times, management may have to extend the
accounts payable turnover rate simply because it’s unable to complete the cash cycle
at a fast enough rate.
Things to consider when interpreting results of the accounts payable turnover include:
•• cash cycle results
•• credit terms offered by suppliers
•• previous periods’ results (i.e. the trend)
•• management’s expectations or budget objectives.

EFFICIENCY RATIOS AND PROFITABILITY

The way management uses a business’s assets has a direct impact on the profitability
of the business.
Two key ratios already examined are the net profit margin and asset turnover.

Asset turnover = Net sales

Average total assets

Net profit margin = Net profit

Net sales
The return on assets is an indicator used to measure how efficiently the assets of
a business have been used to generate profit. If the two ratios stated above are
multiplied together, the result is the return on assets calculation:

Return on assets = Net sales Net profit = Net profit

x
Total assets Net sales Total assets
As the sales figure for the period appears in both financial indicators, when they are
multiplied together the sales figure is cancelled out. The return on assets calculation
remains as net profit divided by total assets.

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 Using the data from Twitchstream Tees, the ratios are calculated as follows:

2022 2023
Net profit margin $25 000 $25 000
$80 000 $100 000
= 31.25% = 25.0%
Asset turnover $80 000 $100 000
$125 000 $135 000
64% 74%
Return on assets $25 000 $25 000
$125 000 $135 000
= 20.0% = 18.52%

The net profit margin decreased from 2022 to 2023, while asset turnover increased
over the same period.
The return on assets showed a slight decrease over the year. This decrease was
the result of the changes in the other two ratios.

Net profit margin Asset turnover

2022: Return on assets = 31.25% × 64% = 20.0%
2023: Return on assets = 25.00% × 74% = 18.5%

Because the return on assets is actually affected by two other ratios, management
can dissect it to determine the full picture of events.
When the return on assets was calculated, it stated that a decrease occurred from
2022 to 2023. However, it’s now known that asset turnover actually increased during
this period. The problem for Twitchstream is that expenses consumed so much of the
sales dollar during 2023 that they eliminated the benefits achieved through the higher
asset turnover.
In summary, the return on assets actually reports on two aspects of a business’s
performance:
•• First, it examines how efficiently the business has used its assets to generate
revenue (i.e. asset turnover).
•• Second, the return is affected by the percentage of the sales revenue consumed
by the business’s expenses, which determines the business’s net profit margin.
The return on assets provides clear evidence that operating efficiency ratios have a
direct impact on a business’s profitability.
Keep in mind that efficiency ratios might also have an impact on other areas of a
business. The liquidity of a business is one such area, which will be examined in the
next chapter.

22.4 CHECK YOUR UNDERSTANDING WB PAGE 415

1 Describe what asset turnover tells a business owner.

2 What is liquidity? Explain why liquidity analysis is important to management.
3 Outline the link between the cash cycle and the liquidity of a business.
4 Describe the role an age analysis of accounts receivable can play in analysis and
interpretation.

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22 CHAPTER REVIEW

KEY CONTENT
• [22.1] Two common, simple forms of accounting analysis are vertical analysis (presenting
the income statement in both dollar terms and percentages) and horizontal analysis
(comparing reports on several consecutive trading periods).
• [22.2] Financial indicators are used by management to measure financial performance over
different periods. When financial indicators are calculated, they’re usually compared to
benchmarks of measurement or performance.
• [22.2] An analytical ratio is an indicator that is the mathematical comparison of two related
items, such as current assets and current liabilities. Many different types of ratios can
be calculated and analysed.
• [22.3] Profitability indicators examine how profitable the business has been during the period.
Profitability may be measured by comparing profit with an investment, by looking at
what happened to the sales dollar during a period, or by other means.
• [22.4] Operating efficiency indicators look at how efficiently management uses the assets available
to them. Investment in inventory, accounts receivable, current assets or non-current assets
can all be examined in terms of how efficiently they have been used and managed.

CHAPTER 22 EXERCISES

WB PAGE 416
1 Analysis by common size statements
The owner of Bashira’s Boutique supplies the following financial information.
2022 2023
$ $
Sales 136 000 149 600
Cost of goods sold 61 200 71 800
Wages 20 400 22 440
Office expenses 6 800 11 970

a Using a spreadsheet, prepare income statements for the two years in both dollar SPREADSHEET X.XX

and percentage terms.

b Write a brief comment explaining the change in the gross profit margin from 2022
to 2023.
c Prepare a pie chart for each of the two years, showing the breakdown of the sales
dollars into expenses and net profit.
d Explain what has happened to the net profit margin of the business over the
two years. Use data from your other answers to help explain the changes in the
profitability of the business.

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 2 Gross profit margin WB PAGE 417

The following information relates to the business of Lanting Computers, a small

business owned and managed by Jackson Lanting.
2022 2023
$ $
Sales 120 000 150 000
Cost of goods sold 66 000 89 100

a Calculate the gross profit margin for 2022 and 2023.

b Determine the percentage increase in both sales and cost of goods sold from 2022 to 2023.
c Referring to your answers in parts a and b, explain to Lanting what has happened in
his business over the last two years.

3 Analysis by common size statements WB PAGE 418

Luke Deering is the proprietor of Superior Sports and provides the following
information relating to his business.
2022 2023
$ $
Sales 192 000 215 040
Cost of goods sold 92 160 97 690
Wages 24 000 26 400
Advertising 3 840 4 200
SPREADSHEET X.XX a Using a spreadsheet, prepare income statements for the two years in both dollar
and percentage terms.
b Prepare a pie chart for each of the two periods to show the breakdown of the sales
dollars.
c Write a report explaining the changes that have occurred in the business of Superior
Sports from 2022 to 2023.

WB PAGE 419
4 Evaluation of profitability
The information provided below relates to Commercial Telephones, a business owned
and managed by Sue Dodd.

2021 2022 2023

$ $ $
Sales 160 000 165 000 185 000
Net profit 25 600 26 400 32 000
Total assets 90 000 100 000 100 000
Owner’s equity 60 000 65 000 65 000

a Calculate the following financial indicators for the years 2022 and 2023:
i net profit margin
ii return on assets
iii return on owner’s investment.
b Write a brief comment to Dodd on the performance of the business as revealed by
each of the indicators calculated in part a.
c Describe three different benchmarks that may be used to evaluate the owner’s
return on her investment.
d Compare the results of the return on assets and the return on owner’s investment
for 2022 and 2023. Explain how this is possible.

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5 Evaluation of profitability WB PAGE 420

Jacob Reid earns a profit of $46 200 in his small business after investing $99 000
capital. Robert Bartolo made an investment of $72 000 into his business and earns a
profit of $35 400.
a Calculate the return on owner’s investment for each of the two owners.
b Which owner has the higher profitability? Explain your answer.
c If both businesses had assets of $120 000, calculate the return on assets for each
business.
d Which business has used its assets most effectively in terms of earning profit?
Justify your answer.

6 Evaluation of profitability WB PAGE 421

The following information relates to two similar businesses.

High Street Hardware Hardware Emporium

$ $
Total assets 30/6/22 86 600 78 400
Total assets 30/6/23 83 400 85 600
Sales for the year 382 500 348 500
Net profit 45 900 48 790

a Using the above information, calculate the following financial indicators for each of
the businesses:
i the asset turnover
ii the return on assets
iii the net profit margin.
b Which business has used its assets most effectively to earn its sales revenue?
Explain your answer fully.
c Compare the results of the three ratios for the two businesses. Comment on the
differences between the two sets of results.

7 Evaluation of profitability WB PAGE 423

Consider the results of the two businesses presented below.

Victory Vespa Fitzroy Scooters

$ $
Total assets 31/12/22 120 000 96 000
Total assets 31/12/23 124 000 108 000
Sales for the year 457 500 326 400
Net profit 51 240 39 160

a Calculate return on assets, net profit margin and asset turnover for each of the two
businesses.
b Write a brief comment on the results revealed by each of the three ratios.
c ‘If a business increases its asset turnover, its net profit margin must also increase.’
Do you agree with this statement? Explain your answer fully.

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 CASE STUDY WB PAGE 424

Chockstone & Carabiner is a business that sells rock-climbing, abseiling and

mountaineering equipment, along with related accessories and clothing.
The following accounting reports have been provided for the most recent reporting periods.

CHOCKSTONE & CARABINER: INCOME STATEMENTS FOR THE YEARS ENDED

31 DECEMBER
2022 2023
$ $
Revenue
Credit sales 190 000 188 000
Cash sales 66 000 70 000
256 000 258 000
Less Sales returns 6 000 2 000
Net sales 250 000 256 000
Less Cost of sales 122 000 132 000
Gross profit 128 000 124 000
Less Expenses
Shop wages 22 000 26 000
Advertising 4 000 6 000
Depreciation of shop fittings 2 000 2 000
Depreciation of vehicle 6 000 6 000
Rent 48 000 48 000
Vehicle expenses 2 000 3 000
Interest 5 000 6 000
Total expenses 89 000 97 000
Net profit 39 000 27 000

CHOCKSTONE & CARABINER: BALANCE SHEETS AS AT 31 DECEMBER

2021 2022 2023
$ $ $
Cash at bank 1 500 4 400 1 500
Accounts receivable 9 600 10 600 12 000
Inventory 35 000 34 000 40 000

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 Computer – – 3 000
Shop fittings* 14 000 12 000 10 000
Delivery vehicle* 32 000 26 000 20 000
Premises 210 000 210 000 210 000
302 100 297 000 296 500
Accounts payable 14 000 15 000 16 500
Loan (interest-only loan: due 2024) 60 000 60 000 60 000
74 000 75 000 76 500
Capital – owner 228 100 228 100 222 000
Net profit 42 000 39 000 27 000
270 100 267 100 249 000
Less: Drawings 42 000 45 100 29 000
228 100 222 000 220 000
302 100 297 000 296 500
* Non-current assets have been reported at carrying value (i.e. historical cost less accumulated depreciation)

CHOCKSTONE & CARABINER: SUMMARIES OF CASH FLOWS FOR THE YEAR

ENDED 31 DECEMBER
2022 2023
$ $
Net cash provided (used) by operating activities 48 000 29 100
Net cash provided (used) by investing activities 0 (3 000)
Net cash provided (used) in financing activities (45 100) (29 000)
Net increase/decrease in cash held 2 900 (2 900)
Cash held at beginning of year 1 500 4 400
Cash held at end of year 4 400 1 500

The management of Chockstone & Carabiner stated the following business objectives for
the 2022 and 2023 reporting periods:
1 to increase sales by 10% above the previous year’s result
2 to increase net profit by 5% above the previous year’s result
3 to maintain a gross profit margin of at least 45%
4 to maintain a net profit margin of at least 15%
5 to achieve a return on owner’s investment of at least 20%
6 to achieve an inventory turnover of at least four times per annum
7 to maintain an average settlement period of less than 30 days for accounts receivable
8 to maintain an average settlement period of 30–45 days with the accounts payable
9 to keep the working capital ratio above 175%
10 to keep the quick asset ratio above 100%
11 to maintain a cash flow cover of at least four times
12 to keep the debt ratio under 25%.

a For each of the above objectives, state whether or not they were achieved in both 2022
and 2023.
b Where appropriate, suggest possible reasons if objectives weren’t achieved. Calculate
the appropriate financial indicator in each case and clearly identify the trend in the
indicators.

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 CHAPTER CHECKLIST
Now that you have finished Chapter 22, double-check your progress.
Are you ready for your Unit 4 exam?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
handed in my workbook for marking.

I understand …

indicators and other relevant information to measure business performance: financial

and non-financial
the analysis of historical and budgeted accounting reports, including a consideration of
the limitations of analysis, to develop strategies to improve business performance
graphical representations related to preparing and interpreting budgeted accounting
reports
strategies to improve business performance.

I can …

analyse and interpret classified accounting reports, graphical representations and other
information to evaluate the performance of a business
use ICT, including spreadsheets, to model and analyse the financial effects of
alternative strategies to improve business performance
analyse and interpret classified historical, budgeted and variance reports, graphical
representations and other information to evaluate the performance of a business
discuss strategies to improve the performance of a business.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_22

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

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 23 ADDITIONAL PERFORMANCE
INDICATORS

In the previous chapter you LEARNING OBJECTIVES

looked at how to analyse and
interpret accounting reports and By the end of this chapter, you will be able to:
information, in particular financial •• prepare a variety of indicators to examine the area of
indicators for two key areas of liquidity [23.1 & 23.2]
a business – profitability and
•• prepare a variety of indicators to examine the area of
operating efficiency. But there are
gearing [23.3]
more areas that inform decision
making than just those two. •• evaluate a business using both financial and non-
In this final chapter you will financial indicators [23.4 & 23.5]
look at two more financial •• describe some non-financial methods of analysis
indicators, liquidity and gearing, [23.5]
as well as non-financial tools and •• outline the limitations of ratio analysis [23.5].
factors for analysing a business’s
performance.

UNIT 4 – PROGRESS 14 15 16 17 18 19 20 21 22 23

23.2 23.4

Liquidity and Other evaluation Chapter review

23.1 cash flows 23.3 tools 23.5 and exercises

Gearing and Non-financial

Liquidity analysis
financial stabilty factors

978 1 4202 3962 1 457

 23.1 LIQUIDITY ANALYSIS
liquidity Liquidity is the ability of a business to meet its short-term debts as they fall due.
the ability of Liquidity indicators measure a business’s ability to meet debts in the short term,
a business to
meet its short-
which usually refers to the next 12 months in the life of a business.
term debts as For a trading business to survive, it must have sufficient ‘liquid’ funds available to
they fall due meet certain needs. These needs include meeting payments of expenses, accounts
payable, GST debts, loan repayments and proprietor’s drawings.
Efficiency ratios, such as inventory turnover and accounts receivable turnover, are
very important to liquidity. If a business takes a long time to turn its inventory into
sales, it puts more pressure on its liquid funds. So does a slower accounts receivable
turnover, as the business has to wait longer to collect its cash.
Unfortunately, many expenses incurred in running a business won’t wait –
employees and rent have to be paid. It’s important that management has information
relating to the business’s ability to meet these debts as required. Liquidity indicators
can provide some of this information.

'Liquid' funds are

those available
to pay short-term
expenses and
debts.

WORKING CAPITAL RATIO

Working capital = Current assets – Current liabilities

Working capital ratio = Current assets

Current liabilities

working capital Working capital is a dollar measure of the amount of liquid funds a business has.
the liquidity of a It’s based on the theory that if current assets are greater than current liabilities, a
business, expressed in
dollars business is likely to meet its debts in the next 12 months. If current liabilities exceed
current assets, the business may be facing a liquidity problem.
Remember the definition of the two classifications from the balance sheet:
•• Current assets are expected to be turned into cash within the next 12 months.
•• Current liabilities are obligations due for repayment within the same time period.
It’s logical to compare one group with the other to evaluate a business’s liquidity.

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 The working capital ratio examines the relationship between current assets and working
current liabilities in a different fashion. Rather than simply stating working capital as capital ratio
measure of the
a dollar value, the assets are divided by the liabilities and the result is expressed in a liquidity of a business,
ratio or as a percentage. expressed as a ratio or
percentage
Consider the example of Echuca Essential, a business selling essential oils and
natural fragrances.

2022 2023
Current assets $30 000 $28 000
Current liabilities $12 000 $14 000
Working capital (CA – CL) $18 000 $14 000
Working capital ratio CA $30 000 $28 000
CL $12 000 $14 000
= 2.5:1 2.0:1
or 250% 200%

Echuca Essential’s working capital ratio decreased from 2022 to 2023. This ratio
may be expressed as a percentage (as shown above), or stated in more comparative
terms:
•• At the end of 2022, the business had $2.50 of current assets for every $1.00 of
current liabilities.
•• On balance day of 2023, the business had $2.00 of current assets for every $1.00
of current liabilities.
These results indicate that Echuca Essential is unlikely to have any problems meeting
its short-term debts, even though liquidity fell in the second year.
There’s no ideal percentage for a working capital ratio. If the ratio is less than 1:1,
the business may have a liquidity problem in the forthcoming year. Some owners
prefer a ratio closer to 2:1, as it provides a safety margin for any unforeseen problems.
The trend in the ratio is also important. Changes in working capital should be
examined carefully, and ideally the ratio should be determined more than once a year.
A monthly or quarterly calculation gives management more up-to-date information in
relation to liquidity.

MANAGING WORKING CAPITAL

No matter how often working capital ratios are calculated, working capital
requirements will vary from business to business, and a preconceived figure shouldn’t
be set as a hard-and-fast rule. Some businesses trade successfully with low working
capital, while others require a higher percentage. The difference is in the cash cycle of
the businesses. Consider the following two businesses:
•• Echuca Essential: all purchases are on credit, all sales are made for cash,
inventory turnover is very fast.
•• Shepparton Antiques: all purchases are for cash, all sales are on credit, inventory
turnover is very slow.
Echuca Essential could trade successfully with much lower working capital than
Shepparton Antiques. This is possible because Echuca Essential buys its inventory
on credit (perhaps on terms of 30 days) and sells for cash. Depending on how fast its
inventory turnover rate actually is, the business may be able to sell all its inventory
before it has to pay its accounts payable. If so, it doesn’t require a large amount of
funds tied up in working capital.

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 On the other hand, Shepparton Antiques requires more working capital to cover
the time it takes to sell its goods and collect from accounts receivable. If a business
sells on credit, it must ensure that it has sufficient funds to meet operating costs
during its extended operating cycle.
Another consideration is whether the working capital ratio is too high. A ratio of 4:1
or 5:1 may indicate that the percentage of current assets to current liabilities is much
greater than the business’s requirements. This might not seem like a problem at first,
but it can indicate other issues, such as:
•• The business has over-invested in current assets, and has too much money tied
up in cash at bank, inventory or accounts receivable. A business should only
keep enough cash in a normal trading account to meet its needs. If excess cash
is available, it should be put to use – the business could pay off debts, buy non-
current assets or invest the excess cash.
•• The business has too much inventory. Excess inventory can cost a business
money in storage costs, insurance and a greater chance of damage, shoplifting and
obsolescence.
•• The business has an excessive balance in accounts receivable. Bad debts, debt
collection fees and legal costs all add up to be a costly exercise when credit
accounts aren’t collected over an extended period.
The working capital ratio must reflect a business’s needs. A suitable level of working
capital for one business may not be appropriate for another. Trends in the ratio should
be monitored, and significant changes should always be investigated.
As accounts receivable and inventory are major determinants of the working
capital ratio, their individual ratios should be closely examined whenever changes in
working capital are identified.

QUICK ASSET RATIO

Quick asset ratio = Current assets – (Inventory + Prepaid expenses)

Current liabilities

While the working capital ratio looks at the short-term liquidity of a business (the next
quick asset ratio 12 months), the quick asset ratio looks at the immediate liquidity of the business.
a measure of
The quick asset ratio has significant differences from the working capital ratio:
immediate liquidity
•• Prepaid expenses are removed from the total of current assets because
prepayments can’t usually be turned into cash if a business has an urgent need
for liquid funds.
•• Inventory is also removed from the total of current assets because a business
can’t completely liquidate its inventory in order to meet debts. Even if this could be
achieved by reducing selling prices to ridiculous levels, the goods sold would have
to be replaced if the business expects to continue trading.
When these items are removed from the totals of current assets, the quick asset ratio
basically becomes a comparison of cash at bank and accounts receivable with the
amount owing to current liabilities. It looks at the assets that can be turned into cash
urgently (i.e. quick assets) and the debts that must be met in the very near future (i.e.
urgent debts).

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 In order to compare this with the working capital ratio, let’s look at Echuca
Essential again.

2022 2023
$ $
Current assets 30 000 28 000
Inventory 17 000 19 000
Prepaid expenses 1 000 1 000
Current liabilities 12 000 14 000

For 2022:

Quick asset ratio = Current assets – (Prepaid expenses + Inventory)

Current liabilities
= $30 000 – ($1000 + $17 000)
$12 000
= $30 000 – $18 000
$12 000
= $12 000
$12 000
= 1:1 or 100%

For 2023:

Quick asset ratio = $28 000 – ($1000 + $19 000)

$14 000
= $ 8 000
$14 000
= 0.57:1 or 57%

These quick asset ratios show an unfavourable trend over the period 2022 to 2023:
•• On balance day of 2022, the business had $1.00 of quick assets to meet every
$1.00 of urgent liabilities.
•• In 2023, this relationship has deteriorated to the extent that the business now only
has $0.57 of quick assets for every $1.00 of urgent debts.
This ratio is evidence that the liquidity of the business has decreased. Although its
very fast cash cycle may allow Echuca Essential to operate with a low quick asset
ratio, such a change in the ratio over a 12-month period is a warning to management
to keep a close watch on future events. If the decline continued in the next period, the
business may simply run out of cash.

23.1 CHECK YOUR UNDERSTANDING WB PAGE 428

1 Distinguish between the working capital ratio and the quick asset ratio in terms of
what they evaluate.
2 ‘If management determines liquidity ratios on a constant basis, a cash budget is
no longer necessary.’ Do you agree with this statement? Explain your answer fully.
3 ‘If current assets increase, the working capital ratio must also increase.’ Do you
agree? Explain fully.

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 23.2 LIQUIDITY AND CASH FLOWS
Both the working capital and quick asset indicators provide management with useful
information on balance day. However, the data used to determine these two liquidity
ratios comes from the balance sheet. Since the cash flow statement should be
prepared at the end of every period, this report should also be considered when
evaluating liquidity.
There’s a logical connection between the cash flow statement and liquidity. The
focus of the entire report is inflows and outflows of cash, providing a summary of
what has happened to the cash resources of the business over time.
Consider the cash flow statement below, for a small business that sells
automotive parts.

G.P. AUTO PARTS: CASH FLOW STATEMENT FOR THE YEAR ENDED 30 JUNE 2023
$ $
Cash flows from operating activities
Cash sales 160 000
GST received 16 000 176 000
Cash purchases of stock (90 000)
Wages (49 000)
GST paid (9 000) (148 000)
Net cash from operating activities 28 000
Cash flows from investing activities
Purchase of shop fittings (6 000)
Net cash used in investing activities (6 000)
Cash flows from financing activities
Mortgage repayments (8 000)
Drawings (21 000)
Net cash used in financing activities (29 000)
Net increase (decrease) in cash held (7 000)
Cash held at beginning of year 2 000
Cash held at end of year (5 000)

This report may be very valuable when evaluating liquidity. For example, it shows that
the business started the period with $2000 in its bank account, but by the end of the
period, this had decreased to an overdraft of $5000. This in itself shows a significant
deterioration in the cash supplies of G.P. Auto Parts, and perhaps also in their liquidity.
However, this information should be read together with financial indicators, such as
those for working capital and quick assets. The shortage of cash may not be an issue
for management if there are large Accounts Receivable expected to be settled early in
July 2023, or a capital injection is planned by the owner.
Neither financial indicators nor the cash flow statement (or any other accounting
report) should be relied upon as the sole source of financial information. It’s important
to gather as much information as possible to get a full picture of a business’s liquidity
situation. This may include ratios, reports, vertical analyses, horizontal analyses and
trend analyses. Once management has all the relevant data, it should be in a better
position to interpret the results accurately.

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CASH FLOW COVER
In recent years there’s been more emphasis in the accounting profession on
cash management and liquidity analysis. Profitable businesses have had to cease
trading because of management’s inability to control cash. If cash isn’t managed
and expenses aren’t met on time, a business won't survive. Landlords become
uncooperative when rent isn’t paid on time. Telephone companies tend to cut off
services if bills aren’t paid. Employees won’t work if they’re not paid their wages!
Cash management is crucial to a business’s continued operations, and additional
indicators were created to look at this area of business. One such indicator is cash cash flow cover
flow cover, which examines the relationship between the cash flows generated by how many times net
cash flows can
the day-to-day business operations, compared to the current liabilities of the business. cover expected
accounts payable in a
Cash flow cover = Net cash flows from operating activities reporting period
Average current liabilities
For example, if the average current liabilities of GP Auto Parts were $2800, the ratio
would be:

Cash flow cover = $28 000 = 10 times per annum

$2800

This ratio shows that GP Auto Parts generated net operating cash flows equal to 10
times what it owed in current liabilities on balance day.
(As usual, keep in mind that average figures are subject to distortion. Seasonal
factors may mean that the average for accounts payable is either artificially high or
artificially low.)
The concept behind this ratio is that a business should have sufficient coverage of its
current obligations if it’s to survive. If the trend in this ratio is falling (e.g. from 10 times
to 8 times in the subsequent period), this may indicate a worsening liquidity position,
and management may have to take corrective action. On the other hand, if the ratio
increases from 10 times to 15 times, the business is unlikely to experience difficulty in
meeting its short-term debts.
For a business trading on 30-day terms, it’s logical to use 12 times as an acceptable
level of cash flow cover. In other words, a year’s cash flows can be expected to cover
the accounts payable owing at the end of a given month about 12 times. Otherwise, the
business is not producing enough cash over the year to meet its most urgent liabilities.
However, the Accounts Payable figure on balance day may vary greatly, depending
on when the report was prepared. Therefore, the more important point to keep in mind
is the trend in the ratio over several reporting periods. Valuable benchmarks include:
•• previous periods’ result (i.e. the trend)
•• management’s expectations or budget objectives.

23.2 CHECK YOUR UNDERSTANDING WB PAGE 429

1 Explain how a statement of cash flows can assist management when evaluating the
liquidity position of a business.
2 ‘If cash flows from operating activities have increased over time, a business
will have an improved liquidity.’ Do you agree with this statement? Explain your
answer fully.
3 ‘A business can have a negative result from operating activities and still survive.’ Is
this true? Discuss.

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 23.3 GEARING AND FINANCIAL STABILITY
While liquidity ratios examine the short-term future of a business entity, financial
stability looks at its long-term structure. A business may be financed using internal
gearing funds (owner’s equity) or external funds (liabilities). Gearing is the dependence of an
the dependence of a entity on outside funds, compared with those contributed by the proprietor.
business on borrowed
funds, compared to A business is described as highly geared when a high percentage of its assets are
funds contributed by financed by liabilities. A lowly geared business is one that is highly dependent on the
the business owner
proprietor’s funds and has borrowed very little from external sources.
A highly geared business is a higher financial risk, because there is a greater
pressure on the business’ resources to meet repayments of debts. If the expected
cash inflows don’t occur, the owner is still faced with the repayment of liabilities. The
ultimate result of this problem may be the collapse of the business. A lowly geared
business doesn’t have the same pressure, as multiple repayments aren’t constantly
draining its working capital.
Financial stability indicators are calculated to provide management with information
relating to changes in the gearing of a business. There are a number of ratios that may
be used to measure changes in gearing.

DEBT RATIO
debt ratio The debt ratio, also known as the gearing ratio, determines the percentage of assets
measure of the
actually funded by borrowed funds.
dependence of a
business on liabilities
to fund its assets Debt ratio = Total liabilities × 100
Total assets

Consider the following example for Castlemaine Furnishings.

2022 2023
$ $
Total assets 130 000 140 000
Liabilities 50 000 70 000
Owner’s equity 80 000 70 000
Debt ratio 50 000 70 000
130 000 140 000
= 0.38:1 = 0.50:1
or 38% or 50%

These ratios indicate that the gearing of this business increased over the two-year
period. Its assets increased from $130 000 to $140 000, which is positive, but this
increase in assets means that the owner has borrowed more funds from external
sources, causing the debt ratio to jump from 38% in 2022 to 50% in 2023.
This means that half of Castlemaine Furnishings’ assets are now financed by
external funds. The financial risk of the entity may increase as a result, as it’s under
greater pressure from its repayments of debts. For example, if this expansion was
funded by additional loans, more cash will have to be put aside for loan repayments
each month. This leads to greater pressure on the liquid resources of the business.
In simple terms, the more a business owner borrows, the higher the debt ratio and
the more financial pressure the business will face.

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GEARING AND RETURN ON INVESTMENT
The more a business borrows from outside sources, the more likely it is not to
survive. The obvious question is: why would an owner take on a risk that could lead to
total financial collapse?
Many small business owners simply don’t have enough personal wealth to
finance a business without borrowing money from others. A few others borrow
money through personal choice, and use these borrowed funds to increase their own
personal returns.
Consider the following information relating to two skateboard shops, Abbotsford
Boards and Brunswick Skate. Both businesses are of equal size in terms of total
assets; they are in the same industry, and are both owned by sole proprietors.
The only difference is that Abbotsford Boards is a highly geared business, whereas
Brunswick Skate is lowly geared.
Here are the financial details for the two businesses for the year ended
31 December 2023. Due to its heavy borrowing, Abbotsford Boards has a higher
interest expense and has therefore earned a profit $10 000 lower than that of
Brunswick Skate.

Abbotsford Boards Brunswick Skate

$ $
Total assets 100 000 100 000
Liabilities 80 000 10 000
Owner’s equity 20 000 90 000
Net profit 15 000 25 000

To further emphasise the differences between the two businesses, their debt ratios
have been calculated, along with two profitability ratios – the return on assets and the
return on owner’s investment.

Abbotsford Boards Brunswick Skate

$ $
Debt ratio Liabilities 80 000 10 000
Total assets 100 000 100 000
= 80% 10%
Return on assets Net profit 15 000 25 000
Total assets 100 000 100 000
= 15% 25%
Return on owner’s investment Net profit 15 000 25 000
Average capital 20 000 90 000
= 75% 28%

These figures highlight the positive outcomes that may be achieved through using
borrowed funds to finance a business:
•• Even though Abbotsford Boards achieved a return on assets of only 15%, the
owner’s personal return on their investment was 75%.
•• Brunswick Skate had a higher return on assets (25%), but only generated a return of
28% on the owner’s investment.

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 The owner of Abbotsford Boards has therefore used other people’s money to
generate a higher return on their personal funds invested in the business.
The two profitability ratios for Brunswick Skate are almost the same, due to the large
percentage of funds contributed by the owner and the very small amount borrowed
from outside sources.
Even though Abbotsford Boards has generated an incredibly high return on the
owner’s investment, there’s much greater financial risk involved. If sales turnover
declined in the next period, the management of Abbotsford Boards may struggle to
meet its high level of repayments. The opportunity to earn high returns on owner’s
funds also carries with it greater financial risk and the greater likelihood of financial
collapse.
The structure of Brunswick Skate is an example of a more conservative approach to
financing. The return on owner’s investment may be lower in the current year, but this
business has a greater chance of survival in difficult times.
Differences in financial structure are often affected by the personal choices of
business owners. Some proprietors are risk takers who are prepared to borrow large
sums of money to try to boost their own personal returns. Others are conservative
owners who only borrow through necessity and prefer a high equity component.
The ideal situation is a balanced approach between the two extremes. Borrowed
funds can be used to increase an owner’s personal returns, but liabilities shouldn’t
increase to such an extent that the repayment of such debts puts the business at risk.
There’s no set percentage of gearing that can be defined as totally secure. However,
as gearing increases, so too does financial risk, with the ultimate risk for an owner
being the loss of everything, including personal assets. This possible sacrifice must
be weighed up against the possible gains that may be achieved through the use of
borrowed funds.

23.3 CHECK YOUR UNDERSTANDING WB PAGE 430

1 What is the debt ratio? What is it used to measure?

2 State two reasons why business owners may borrow money to help finance the
purchase of business assets.
3 Explain the link between gearing and financial risk.
4 Explain how gearing may be used to increase the return on owner’s investment.

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23.4 OTHER EVALUATION TOOLS
Accountants, business owners and managers use financial indicators as a starting
point in their evaluation of performance. However, these indicators should never be
seen as the only relevant tools for evaluating business performance.
Chapter 20 outlined how budget expectations can be used as benchmarks to
measure performance, but there are many other tools that may be used at times,
which can be calculated as ratios or numerical results.

CUSTOMER SATISFACTION
Customer satisfaction surveys are an example of non-financial analysis that should be
used in conjunction with financial indicators. Many small businesses have customer
feedback forms, and many more gather feedback via their business website, social
media pages or online reviews.
A business’s customers can be an excellent source of information. Many will seize
the opportunity to tell management exactly what they think of them! Management
should review feedback periodically so that they’re in touch with customer concerns
and needs. If several customers identify a recurring theme, particularly if they are
important clients, management should take action.
It’s also possible to calculate a ratio to reflect the degree of customer satisfaction.
If a business has accepted returns of goods during a period, it’s common practice to
report this in the income statement:

Revenue $ $
Sales 50 000
Less: Sales returns 2 500 47 500

In this business, net sales reported for the period totalled $47 500. Management may
be interested in the fact that the business actually sold $50 000 worth of goods, but
$2500 of goods were subsequently returned.
A percentage is then calculated, which shows that customers returned 5% of total
sales during this period:

Sales returns ratio = Sales returns = $2500 = 0.05 or 5%

Total sales $50 000

This ratio can be used as a reflection of customer satisfaction (or dissatisfaction).

If the percentage of goods being returned increases, it would indicate customers’
greater dissatisfaction with the inventory being sold. This may lead management to
change some products, change some brands, or purchase inventory from different
suppliers.
If a problem is identified by an increase in the percentage of goods being
returned, management may decide that it’s time for another customer survey.
That is, a non-financial tool (a survey) may be used after financial analysis reveals a
particular problem.

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 QUALITY ASSURANCE
Just as customers can be surveyed about their satisfaction, business owners should
consider how satisfied they are with their own suppliers.
In a similar fashion to the sales returns percentage, management should calculate
the percentage of goods returned to suppliers. The number of returns made by
customers could also be analysed in terms of which suppliers are involved.

Customer
satisfaction
data is useful
for assessing
a business’s
performance.

Often a retail outlet may accept a sales return, only to then return the product to the
supplier because it’s faulty or doesn’t perform the task it was designed for. (Of course,
if an item is shop-soiled through the fault of the retailer, it shouldn’t be returned to the
original supplier.)
To ensure that customers are satisfied, the business owner must strive to find
suppliers who will provide reliable products.
Once again, a simple ratio can be used to quantify this information.

Purchases return ratio = Purchases returns

Total purchases

PROFIT COMPARED TO HOURS WORKED

Many small business owners go into business because they don’t want to work for
someone else. Being your own boss is attractive to many people. However, it often has
a major disadvantage: a business owner can’t simply clock off at the end of the day. They
have to complete many tasks, some of which may have to be done after hours, such as:
•• finalising inventory orders
•• completing stocktake
•• updating accounting records
•• calculating wages records
•• GST record keeping
•• emailing slow-paying accounts receivable.

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As a result of these demands, many business owners work 60 to 80 hours per
week. Some may question whether it’s worth it. That’s a difficult question to answer,
as making money isn’t the only reason why people go into business – although it’s
usually the main one! The feeling of being independent, the opportunity to achieve a
lifetime dream, and the chance to make something out of nothing, are all common
reasons for going into business.
An interesting consideration for some business owners is the following calculation.

Profit per hour = Net profit for the period

Hours worked by the owner

Imagine that a person resigned as an employee because their salary was only $62 400
(working a 40-hour week), and there was an opportunity to earn $78 000 working
75 hours per week as a small business owner. The two situations can be compared:
•• salary earner: $62 400 weeks = $1200 per week
52
•• business owner: $78 000 weeks = $1500 per week.
52

Salary earner:
Income per week = $1200 = $30 per hour
Hours worked per week 40 hours

Business owner:

Income per week = $1500 = $25 per hour

Hours worked per week 75 hours

Is this the right choice? There’s no simple answer. Many business owners are happy
to work extra hours because of the potential benefits. It’s a matter of personal choice,
and of whether an individual is self-motivated, organised and prepared to work hard to
establish a successful business venture.
The Australian economy needs people to take on the role of small business
owners. It also needs individuals to fill the wage and salary positions in those and
larger businesses. The decision to go into business will often be a personal one that
requires particular personality traits.
Accounting can play a small role in providing useful tools to assess the
performance of business owners. Some of these tools may help individuals decide
whether or not it’s worthwhile to remain a business owner.

23.4 CHECK YOUR UNDERSTANDING WB PAGE 430

1 What use can management make of customer surveys when evaluating business
performance?
2 Name one indicator that may be used to measure customer satisfaction. Explain
how this indicator can be used to reflect the satisfaction or otherwise of a business’s
customers.
3 A business owner should try to provide customers with quality merchandise.
Describe two methods of measuring the performance of a business in relation to the
quality of goods being purchased from suppliers.

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 23.5 NON-FINANCIAL FACTORS
There are a range of financial indicators that can be used to evaluate a business’s
performance. Although these indicators are important, there are also non-financial
factors that can assist a business owner when evaluating performance.
As a general rule, if an evaluation tool involves a dollar sign, it would be classified
as a financial indicator. A tool that doesn’t involve specific dollar figures is a non-
financial factor. For example:
•• calculating sales returns as a percentage of the total sales made is a financial indicator
•• the number of times goods had to be returned to suppliers is a non-financial factor.
This section looks at a few different non-financial factors, but there’s no limit to the
ways a business owner can evaluate the performance of their business. What’s
important is that meaningful data is collected, whether it’s financial or non-financial.
Once the data has been gathered, it needs to be analysed and interpreted so that
management can make sound decisions to ensure the future success of the business.

QUALITY OF MANAGEMENT
A small business owner needs a range of skills to be successful. Many small
businesses fail because of a weakness in management skills.
A successful business owner should have:
•• good communication skills: it’s crucial that an owner is able to deal with customers,
staff, suppliers, bankers and government agencies
•• adequate management skills: Chapter 14 covered the areas of managing and
controlling inventory, accounts receivable and accounts payable
•• the ability to adapt to change: business owners who refuse to change their
management practices may keep making the same mistakes. A vision for the future
is needed
•• the ability to develop or sell new products: successful owners quite often are ahead
of market changes because they anticipate what is likely to happen in the future
•• flexibility in responding to customers’ needs: all customers are different and should
be treated on an individual basis
•• the ability to recognise one’s own weaknesses.
Some business owners adopt an ‘I know it all’ approach and can’t critically evaluate the
performance of management – because they’re management. However, not all owners
are managers, and an owner may in fact conduct a review of their management team.
This should help identify weaknesses and allow problems to be addressed.
Staff are usually willing to participate in an appraisal of management performance.
In some businesses they may be asked to comment on a range of issues so that
the quality of management can be reviewed and improved. As the decisions of
management have a direct impact on the financial performance of a business, such
comments shouldn’t be ignored.

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ECONOMIC CLIMATE
The general state of the economy should be kept in mind when analysing the
performance of a business. The economic climate may cover a whole range of
possible events and factors, some of which impact on some businesses more than
others. These include:
•• consumer confidence
•• market competition
•• the actions of big business
•• government decision-making (e.g. the introduction of new taxes)
•• wage demands by unions
•• technological change
•• market trends.
One of the biggest challenges to management is staying flexible in a changing
economic climate. Business owners who become set in their ways, and refuse to
change usually won’t survive in the long term. When evaluating results, it can be
difficult to explain why things changed. It’s easy to calculate a ratio and to identify an
increase or a decrease; finding out why it’s happened is much harder.
Even if an owner knows why something happened, there is always the challenge
of deciding what to do next. What decisions should the owner take for the future of
the business? This is the basic challenge of being a business owner. A successful
business owner has a working knowledge of the economic climate and of how
changes in this climate affect their business.

OTHER NON-FINANCIAL FACTORS

While financial indicators are important, there are many non-financial factors that can
help a business owner to evaluate performance.
Meaningful non-financial factors may include:
•• the number of times goods are returned by customers in one period
•• the number of times goods are returned to suppliers in one period
•• customer satisfaction surveys
•• employee satisfaction surveys
•• the number of customers who visit the business in a given period
•• the number of hits on a business website
•• the number of sales made in a period (as distinct from the value of sales)
•• the number of repeat customers in a period
•• the postcodes of customers (showing the scope of the market)
There’s no limit to the ways a business owner can evaluate their business’s
performance. What is important is that meaningful data is collected, whether financial
or non-financial. Once that data has been gathered it needs to be analysed and
interpreted so that management can make sound decisions to ensure the future
success of the business.

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 LIMITATIONS OF FINANCIAL ANALYSIS
Although indicators can provide management with a vast array of financial information,
there are some inherent limitations of such analysis. Financial indicators can only be
as accurate as the information on which they are based.
The use of indicators may be questionable, or of limited value, for several reasons:
•• Financial indicators are based on historical data. Indicators may provide a historical
summary of a business’s operations, but there’s no guarantee that the past results
will correspond to the future results of the business.
•• Changes in the value of the dollar. Much of the information used in accounting is
based on dollar values. Sometimes items in reports may change, simply because
of the change in what a dollar represents. For example, in times of inflation, sales
revenue may increase over time, even though the same number of units has been
sold. This type of change should be taken into account when comparing indicators,
but is often difficult to identify.
•• Changes in accounting methods. Sometimes management may decide to change
accounting methods. The concept of relevance demands that the impact of any
such changes be identified as part of the annual reporting process. However,
once changes have been made, comparisons of financial indicators become more
difficult.
•• Inter-business differences. Many indicators lend themselves to comparisons with
the performance of other similar businesses. However, every business is unique in
terms of financial structure, assets, revenues and expenses, so comparisons with
other businesses must be made carefully. Industry averages are often suggested
as a means of comparison, but the business in question may not resemble the
typical or average business.
•• Frequency of reporting. Some forms of analysis are most useful when frequent
reporting allows regular comparisons of results to be made. Unfortunately, many
small trading businesses complete a minimal amount of reporting each period.
•• Limited information. Most proprietors have a limited accounting background (if
any), and many don’t use a comprehensive reporting system. Therefore, limited
information leads to limited analysis.

23.5 CHECK YOUR UNDERSTANDING WB PAGE 431

1 External factors may sometimes affect the performance of a business. Give three
examples of such factors, and explain how they may affect business performance.
2 Give three reasons why financial analysis may have limited value for some
businesses.
3 A small business owner has asked you to recommend three non-financial methods
of evaluating the performance of their business. State the three methods you would
recommend, and justify your choice.

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 23 CHAPTER REVIEW

KEY CONTENT
• [23.1] Liquidity is the ability of a business to meet its short-term debts as they fall due. For
a trading business to survive, it must have sufficient working capital available to meet
short-term and immediate financial needs.
• [23.2] Cash management is crucial to a business’s continued operations. A key indicator for
cash management is cash flow cover, or how many times net cash flows can cover
expected accounts payable in a reporting period.
• [23.3] Gearing is the dependence of a business on outside funds, compared with those
contributed by the proprietor. A highly geared business is dependent on loans and
financing from external sources, while a lowly geared business is highly dependent on
the proprietor’s funds and has borrowed very little from external sources.
• [23.4] Many financial indicators can be calculated as ratios or numerical results, based on
financial activity. These include sales returns ratios measuring customer satisfaction,
purchase returns ratios measuring quality assurance from suppliers, and comparisons
of profit to hours worked for the business owner.
• [23.5] Financial indicators are only as accurate as the information on which they’re based,
and cannot measure every aspect of a business’s performance. Non-financial factors,
such as the current economic climate or the quality of management, also need to be
considered.

CHAPTER 23 EXERCISES

WB PAGE 432
1 Evaluation of liquidity
Consider the following balance sheet information, which relates to two different
businesses as at 30 June 2023.

Collingwood Comic Greensborough

Store Graphic Novels
$ $
Current assets 41 500 47 700
Current liabilities 35 800 42 600

a Calculate the working capital for both businesses as at 30 June 2023.

b Determine the working capital ratio for both businesses.
c Which business has the better liquidity? Compare the liquidity of the two
businesses and comment on the differences between them.

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 2 Evaluation of liquidity WB PAGE 433

The following information is provided by the proprietor of Martello’s Menswear.

BALANCE SHEET DATA AS AT:
31/12/22 31/12/23
$ $
Cash at bank 3 400 Nil
Accounts receivable 5 200 4 800
Inventory 34 500 32 600
Bank overdraft Nil 1 200
Accounts payable 5 800 6 000
GST clearing 1 000 1 500
Accrued expenses 500 1 000

a Calculate the working capital ratio for Martello’s Menswear for 2022 and 2023.
b Comment on the business’s liquidity with reference to the ratios determined in part a.
c What other information would you recommend be made available to enable further
comment on the liquidity of the business?

WB PAGE 434
3 Evaluation of liquidity
Consider the following information, which relates to two different businesses as at
30 June 2023.

The Tool Shed Huntingdale Tools

$ $
Cash at bank 4 500 2 900
Accounts receivable 8 300 11 800
Inventory 32 400 38 200
Accounts payable 10 400 13 800
GST clearing 1 200 1 100

a For each of the two businesses, calculate a:

i working capital ratio
ii quick asset ratio.
b Comment on the differences in the liquidity structure of the two businesses,
including references to the ratios calculated in part a.

4 Evaluation of liquidity WB PAGE 434

The owner of Waverley Street Fashions reports that cash provided by operating
activities in the year ended 30 June 2023 was $82 400. Current liabilities as at that date
totalled $10 300. For the previous year, cash flows from operations were $71 900, with
current liabilities of $11 300.
a Calculate the cash flow cover for each of the two years.
b Has the liquidity of the business improved or deteriorated over the last two years?
Explain fully.
c What other information would assist you in commenting on this business’s liquidity?

474 [ U N I T 4 ]  R E C O R D I N G , R E P O R T I N G , E VA L U AT I N G A N D P L A N N I N G A C C O U N T I N G 978 1 4202 3962 1

I N F O R M A T I O N
5 Evaluation of liquidity WB PAGE 435

The following items were extracted from the balance sheets of Nicoletti’s Costuming
Supplies.

31/12/22 31/12/23
$ $
Cash at bank 3 900 4 400
Accounts receivable 11 200 15 500
Inventory 43 900 42 400
Prepaid expenses 1 500 2 000
Bank overdraft 2 800 Nil
Accounts payable 15 000 16 800
GST clearing 1 400 1 700
Accrued expenses 1 500 1 000

a Calculate a working capital ratio for both 2022 and 2023.

b Comment on the change in the working capital ratio over the two years.
c Calculate the quick asset ratio for 2022 and 2023, and comment on the change in
the ratio.
d Working capital and quick asset ratios both look at liquidity. Explain the difference
between these two forms of ratio analysis.
e Outline the role cash budgeting plays in evaluating a firm's liquidity.

6 Evaluation of reports WB PAGE 436

The management of Emerald Jewellers has completed final accounting reports for the
year ended 30 September 2023. The following information has been extracted from
these reports.
From the cash flow statement:
Net cash provided by operating activities $32 000
Net decrease in bank for the year $4 500
From the income statement:
Gross profit $43 000
Net profit $5 000
From the balance sheet:
Cash at bank balance $3 200
Current liabilities $8 400
Drawings for the year (all cash) $16 000

a State two possible reasons why cash at bank decreased over the period despite
$32 000 being provided by operating activities.
b Explain why this business has reported such a small net profit when it has such a
healthy gross profit.
c Give two reasons why net cash flow from operations was $32 000, but net profit
was only $5000.
d Calculate the net cash flow cover as at 30 September 2023.
e The cash flow cover as at 30 September 2022 was calculated as 6.5 times. Make a
brief comment on the current situation, taking into account last year’s result.

978 1 4202 3962 1 [ C H A P T E R 2 3 ] A D D I T I O N A L P E R F O R M A N C E I N D I C ATO R S 475

 WB PAGE 437
7 Evaluation of gearing
Western Trading has total assets of $220 000 and owner’s equity of $140 000. Northern
Trading has owner’s equity of $82 000 and total assets of $120 000.
a Calculate the debt ratio for each business.
b Which of the two businesses has the higher gearing? Explain your answer fully.
c Explain the link between gearing and financial risk.

WB PAGE 438
8 Evaluation of gearing and returns
The following information was extracted from the books of two similar businesses.

Mount Hotham Gifts Bairnsdale Gifts

$ $
Liabilities 32 600 46 800
Owner’s equity 64 400 56 200
Net profit 25 000 25 000

a Calculate the following financial indicators for each of the two businesses:
i debt ratio
ii return on assets
iii return on owner’s investment.
b Comment on the different financial structures of the two businesses.
c Compare the profitability ratios for the two businesses and explain the differences
between them.
d State one advantage and one disadvantage of being the owner of a highly geared
business.

9 Evaluation of gearing and returns WB PAGE 439

The following information has been provided by the proprietors of two similar-sized
businesses.

Superior Electricals Supreme Electricals

$ $
Liabilities 70 000 50 000
Owner’s equity 80 000 100 000
Net profit 22 000 26 000
Net cash from operating activities 28 000 32 000

a Calculate the following ratios for both businesses:

i debt ratio
ii return on assets
iii return on owner’s investment.
b Write a brief comment comparing the gearing of the two businesses.
c Comment on the profitability of the two businesses.
d Of the two businesses, which one has the greater capacity to borrow? Explain your
answer fully and refer to any relevant ratios.

476 [ U N I T 4 ]  R E C O R D I N G , R E P O R T I N G , E VA L U AT I N G A N D P L A N N I N G A C C O U N T I N G 978 1 4202 3962 1

I N F O R M A T I O N
10 Evaluation of customer satisfaction WB PAGE 440

The owner of Frankston Fashions has extracted the following information from the
business's last three income statements. She’s pleased about the trend in the results,
as total sales and net sales have increased every year. However, she’s concerned about
the number of returns.

2021 2022 2023

$ $ $
Revenue
Sales 86 900 92 400 98 600
Less: Sales returns 3 476 5 544 6 902
Net sales 83 424 86 856 91 698

a Calculate the sales returns ratio for each of the three reporting periods.
b Comment on your results from part a, in light of the owner’s concerns.

WB PAGE 440
11 Evaluation of quality of inventory
Mitchell Hill is the owner of Peninsula Puzzles, a small business that sells a range of
puzzles, games and entertainment products. He’s always emphasised good-quality
inventory, but lately some of his customers seem dissatisfied. He provides you with
the following details.

2022 2023
$ $
Total sales 86 000 84 200
Sales returns 1 720 2 100
Total purchases 42 300 42 600
Goods returned to suppliers 1 270 1 700

a Calculate the sales returns ratio and purchases returns ratios for 2022 and 2023.
b Comment on the results in part a. Does this business owner have a problem?
c Suggest a possible solution to the situation that you’ve identified in this business.

978 1 4202 3962 1 [ C H A P T E R 2 3 ] A D D I T I O N A L P E R F O R M A N C E I N D I C ATO R S 477

 12 Evaluation of performance – advanced WB PAGE 441

The following information relates to Tollitt Trading, an import-export business, and

covers three consecutive reporting periods.

INCOME STATEMENTS FOR THE YEARS ENDED 31 DECEMBER:

2021 2022 2023
$ $ $
Credit sales 92 000 98 000 94 000
Less: Cost of sales 55 200 53 900 54 050
Gross profit 36 800 44 100 39 950
Less: Wages 22 000 25 000 26 000
Office expenses 7 500 7 000 7 500
Interest 2 500 2 000 1 500
Total expenses 32 000 34 000 35 000
Net profit 4 800 10 100 4 950
From the cash flow statement: net cash provided by operating activities:
2021 $28 000; 2022 $20 000; 2023 $16 000.

BALANCE SHEETS AS AT 31 DECEMBER:

2021 2022 2023
$ $ $
Cash at bank 3 000 4 000 2 000
Accounts receivable 5 000 8 000 8 000
Inventory 14 000 14 000 16 000
Fittings (book value) 15 000 12 000 9 000
Premises 120 000 120 000 120 000
Total assets 157 000 158 000 155 000
Accounts payable 6 000 3 000 7 500
GST clearing 2 000 3 000 2 500
Loan from NAB 32 000 28 000 26 000
Capital – Tollitt 117 000 124 000 119 000
Total equities 157 000 158 000 155 000
* The owner of the business has stated that the 2020 figures were virtually
identical to the 2021 results.

a Calculate the following financial indicators for each of the three years:
•• gross profit margin •• inventory turnover
•• net profit margin •• accounts receivable turnover
•• expense ratios •• accounts payable turnover
•• return on owner’s investment •• cash flow cover
•• return on assets •• working capital ratio
•• asset turnover •• quick asset ratio debt ratio.

b Write a report on the trends revealed in the ratios calculated above. Your report
should be made up of separate sections that consider the profitability, efficiency,
liquidity and stability of the business.

478 [ U N I T 4 ]  R E C O R D I N G , R E P O R T I N G , E VA L U AT I N G A N D P L A N N I N G A C C O U N T I N G 978 1 4202 3962 1

I N F O R M A T I O N
 ACCOUNTING IN THE REAL WORLD WB PAGE 442

In Chapter 2, you researched a number of publicly traded retailers, located their online
balance sheets and commented on your findings (p.39). Now it’s time to look at those
companies again, and apply your full knowledge of accounting to the information they
provide.
(If you saved the spreadsheets from that activity, you may find them useful for this
activity as well.)
Visit the websites of at least three of these public companies in the retail sector:
• David Jones Ltd
• Harvey Norman Ltd
• JB Hi-Fi
• Woolworths Ltd.
Locate the balance sheet for each firm on their site, then create a spreadsheet with the
SPREADSHEET X.XX
following elements:
1 State the name of the company.
2 State the dollar amounts for the following items for both the current reporting period
and the previous period (all company reports must report for two periods):
• sales (may be listed as sales turnover or simply turnover)
• net profit (use operating profit before tax)
• net cash provided by operating activities
• current assets
• current liabilities
• owners’ equity (look for shareholders’ equity).
3 Calculate the following financial indicators for both the current reporting period and the
previous period:
• net profit margin (net profit/sales) or (operating profit/sales turnover)
• return on owner’s equity (net profit/owner’s equity) or (operating profit/shareholders’
equity)
• working capital (current assets/current liabilities)
• cash flow cover (net cash flows from operations/current liabilities)
• debt ratio (total liabilities/total assets).
4 Compare the results of the various companies selected and comment on your findings.
Your comments should address the areas of profitability, liquidity and gearing.

David Jones Ltd mea.digital/davidjones

Harvey Norman Ltd mea.digital/harveynorman
JB Hi-Fi mea.digital/jbhifi
Woolworths Ltd mea.digital/woolworths

978 1 4202 3962 1 [ C H A P T E R 2 3 ] A D D I T I O N A L P E R F O R M A N C E I N D I C ATO R S 479

 CHAPTER CHECKLIST
Now that you have finished Chapter 23, double-check your progress.
Are you ready for your Unit 4 exam?

I have …

completed all ‘Check Your Understanding’ questions

completed all exercises
completed the end-of-chapter activities
handed in my workbook for marking.

I understand …

indicators and other relevant information to measure business performance: financial

and non-financial
the analysis of historical and budgeted accounting reports, including a consideration of
the limitations of analysis, to develop strategies to improve business performance
graphical representations related to preparing and interpreting budgeted accounting
reports
strategies to improve business performance.

I can …

use ICT, including spreadsheets, to model and analyse the financial effects of
alternative strategies to improve business performance
analyse and interpret classified historical, budgeted and variance reports, graphical
representations and other information to evaluate the performance of a business
discuss strategies to improve the performance of a business.
© VCAA; by permission.

READ
Make sure you skim
this chapter one more
time when preparing for
the exam.

mea.digital/acc34_23

PREPARE WATCH
Read back over Watch the Mr Box on
the chapter now, then Demand video, then ask
complete the online your teacher if you need
revision activity. additional help.

480 [ U N I T 4 ]  R E C O R D I N G , R E P O R T I N G , E VA L U AT I N G A N D P L A N N I N G A C C O U N T I N G 978 1 4202 3962 1

I N F O R M A T I O N
 INDEX

academic accountants 5 in subsequent periods 348

accountants in subsequent periods, splitting up 349–50
role 4–5 accrued revenue
types 4–5 defined 379
accounting explained 378–9
five elements 6–8 within a receipt 380–1
importance 2–3 in subsequent periods 379–80
role 1–16 accumulated depreciation 297
accounting assumptions 11 adjusted gross profit 225, 357
Accounting Conceptual Framework 8 adjusted trial balance
accounting entity assumption 11 after adjusting and closing entries, worked
accounting equation 7 example 358–9
in a balance sheet 18, 29–32 adjusting and closing entries, worked exam-
and double entry accounting 66–70 ple 352–8
worksheet approach 28–9 adjusting entry 343
accounting process, basic 42 advertising 94–6, 115, 142–3
accounting reports 55 age analysis of accounts receivable 263, 448
characteristics 8–10 allowance for doubtful debs 278–9
evaluation of 434 Allowance for Doubtful Debts account 282–3
and management 253–71 analysis 434
purposes and users 204, 434 charts 69, 72
types 42 combined 437–8
accounting standards 8 financial, limitations 471–2
accounting system horizontal 436–7
and business documents 41–64 liquidity 458–61
computerised 56–7 trend 438
overview 54–5 vertical 434–5
place of evaluation in 434 analytical ratios 439–40
accounts payable 268–9 explained 439
Accounts Payable accounts 73, 74 asset turnover
accounts payable turnover 269, 448–9 defined 446
equation 269, 448 equation 446
managing 269–70 explained 446
accounts receivable assets
age analysis of 263, 448 in analysis chart 69
controlling 261–3 in balance sheets 18
Accounts Receivable accounts 73, 74 classifying 21
accounts receivable turnover 264, 448 contributing multiple 110–11
compared with credit terms 265 contribution or withdrawal of 113–14
equation 264, 448 defined 6, 344
managing 265 and drawings 97
accrual accounting 342 as expenses 7–8
accrual basis assumption 11, 26 fair value 113–14
accrued expenses Australian business number (ABN) 43
defined 372 Australian Society of Certified Practising
recording 347–8 Accountants (ASCPA) 4

INDEX 481
 bad debts 278–84 budgeting for GST liability 400
balance day 55, 198, 204 defined 394
balance day adjustments 55, 343 items relevant to 401
balance sheets 17–40 preparing 396–400
adjusting and closing entries, worked purpose 392
example 357 surplus cash balances 400
as an accounting report 42 worked example 399
on balance day 204, 210 budgeted income statement
classifying 21–3 defined 401
defined 18 example 403
and depreciation 300, 315 items relevant to 401
for every transaction 29–32 and management 401–2, 403–4
and financial transactions 26–32 preparing 402
and income statement link 222 purpose 392, 401–2
and inventory 187, 188 reviewing 403–4
owner’s equity narrative presentation 20, budgeted income statements
23 and budget variance reports 425–6
and profit link 222 budgeted profit 224
standard narrative presentation 19, 22 budgeting 391–409
T-form presentation 18, 22, 67 cash 394–5
typical headings 21 defined 392
using, for budgeted balance sheet 405–8 need for 392
bank statement 53 process 422
defined 47 business documents
benchmarks 439 and accounting systems 41–64
book value 310, 327 in an information flow example 53
budget credit notes as 158
reviewing 422 defined 42
types and their purposes 392–3 and the GST 43–4
variance, managing 423 business owner, desirable skills 470
budget variance reports business performance
for budgeted cash flow statements 424–5 and economic climate 470–1
for budgeted cash flow statements, exam- efficiency ratios 449–50
ple 424–5 evaluation 433–8
for budgeted income statements 425–6 indicators 439–51, 457–69, 471–2
for budgeted income statements, example non-financial factors 470–1
425–6
explained 422–3 capital 69, 73, 199, 203–4, 205
preparing 424–7 capital budget, purpose 393
budgeted balance sheet carrying value 300, 311, 327
defined 404 cartage 182, 226
example 407–8 inward 226
preparing 405–8 outward 226
purpose 392, 404 cash 44, 97
reviewing 408 concept 237
budgeted cash flow statement defined 237
and budget variance report 424–5 sales 44

482 INDEX
Cash at Bank account 69, 72, 73, 74 cost of goods sold 225
cash cycle 266, 448 cost of inventory 182
equation 448 Cost of Sales account 73, 74
interpreting 267 cost price
cash equivalents, defined 237 monitoring 257
cash flow cover recording methods 128–34
defined 463 CPA Australia 4, 5
equation 463 credit
explained 463 customers, managing 262
cash flow statement to customers, granting 261–2
basic format 240 transactions 48–9, 261
comparing 243–4 and trial balance 88–90
defined 236 understanding 69, 71, 72
formal format 241–2 credit check 261
and liquidity 462 credit note 158
preparing 241–2 cross-referencing accounts 69, 70, 72–3
role 236–7 current assets 6, 21
cash flows current liabilities 6, 21
classification 238–9 customer satisfaction 467
from financing activities 239 ratio equation 467
from investing activities 238, 239 customs duty 182
from operating activities 238, 239
data
reporting 238–9 collection 42, 57
cash inflows 45, 394 input 57
cash outflows 45, 394 processing 57
cash payments 47 recording 42
cash receipt source 45
defined 45 day book 54, 82
types 45–7 dead inventory 255
cash register receipt 44 debit
cash register rolls 53 and trial balance 88–90
cash transactions 45–7 understanding 69, 71, 72
cheques 47 debt ratio
classified asset turnover 447 defined 464
equations 447 equation 464
closing entries, worked example 352–8 explained 464
closing entry 199–200, 202, 343 debts
closing the general ledger 198 bad 278
closing the ledger 198 doubtful 278
combined analysis 437–8 and the next reporting period 282–3
common size statements 435 recording 279
comparability 9, 317 writing off 280–1
complementary products 256 decision making 243–4
computerised coding systems 131–2 delivery docket 52, 53
continuous inventory 125 depreciation
correcting entries 116–17 accumulated 297

INDEX 483
 adjusting entry for 297–9 expected profit 224
and the balance sheet 300, 315 expense budget
comparing methods 313–15 defined 392
comparing methods graphically 313–14 purpose 392
expense 294 expense ratios 439, 442–3
and the income statement 301 equation 442
meaning 294 expenses
method, choosing a 316–17 in analysis chart 72
reducing balance method 310–12 assets to 7–8
reducing balance method equation 311 defined 7, 26, 344
rule, exceptions to 298–9 in double entry system 71–4
straight-line method 296 recording 225–6
straight-line method equation 296, 310 expired cost 300
diminishing balance method 311
fair value 113–14
discount expense 227
faithful representation 9, 185, 188, 279, 283
discount revenue 227
favourable variance 423
document management
FIFO (first in, first out) method 128, 129,
physical and digital 42
132–4, 166–8, 255
double entry accounting 26, 54–5, 56
financial evaluation, role of 434–8
and the accounting equation 66–70
financial indicators 224 see also analytical
under the perpetual method 127 ratios; business performance, indicators
recording, first stages 82 and benchmarks 439
recording, rules 67 limitations of 471–2
for revenues and expenses 71–4 main types 440
system, establishing a new 112 financial questions, answering 2–3
system, managing 110–12 financial reports
doubtful debts 278–84 limitations of 470–1
drawings 97, 203–4, 445 six qualitative characteristics 8–10

economic climate 470–1 financial stability 464–6

EFT payments 47 financial transactions

EFT receipt 46 and balance sheets 26–32
EFTPOS (Electronic Funds Transfer at Point of fixed mark-up systems 131
Sale) 46
gearing
EFTPOS receipts 45–7
defined 464
electronic transfer of funds 45–7
explained 464, 465–6
employee pay slips 53
general journal 54, 82
entity 6
and accrued expense 348, 349
errors
and accrued revenue 379, 380, 381
common trial balance 89
adjusting and closing entries, worked
correcting entry 116–17 example 353–4
stocktake 138 to balance sheet 208–210
estimates, making 394–5 and closing entries 202
ethical compliance 3 closing entries for sales and sales returns
evaluation of reports 55 206
expected cash inflows 397–9 closing entry for loss on disposal of an
expected cash outflows 398 asset 332

484 INDEX
 closing entry for profit on disposal of an gross profit margin 435, 439, 441
asset 333 equation 441
correcting entries 116–17 GST Clearing account 68, 73, 74
and depreciation 297, 314–15 GST liability 26
and disposal of non-current assets 329 budgeting for 400
entry to transfer net loss 205 GST refund 26
entry to transfer net profit 203 GST to be recorded, no 68
and inventory for advertising 142–3
and inventory gain adjustment 352 handwritten receipts 45
and inventory loss adjustment 351 horizontal analysis 436–7
and inventory write-down 186, 187, 190
identified cost method 128, 129–32, 133–4,
non-current asset trade-in in 330–1 166
opening journal entry 112 income statement 26, 42, 163
and prepaid expenses 345–6 adjusting and closing entries, worked
recording in 84–5 example 356
recording purchases of non-current assets and balance sheet link 222
324 cost of goods sold in 225
recording purchases returns 159 defined 220
recording sales returns 161 and depreciation 301
transactions 109–22 designing 221
and unearned revenue 375 and inventory write-downs 188
and unearned revenue, including GST 375 preparing 357–8
and unearned sales revenue 376, 377, 378 purpose 220–1
general ledger 54, 66, 70, 72–3 and reporting discounts 227
adjusting and closing entries, worked individual accounts 32
example 354–6 industry averages 224
closing the 198, 208–10 information
and depreciation 297–8 financial 3
and disposal of non-current assets 327 flow 53
and inventory cards 136–7 output 57
and inventory write-down 187 instalment loans 24–5
non-current asset trade-in in 331–2 Institute of Chartered Accountants in Austra-
recording purchases of non-current assets lia (ICAA) 4, 5
325 insurance 344–6
recording purchases returns 160 interest-only loans 24
recording sales returns 162–3 internal transactions 49–50
from trial balance to balance sheet 207–10 International Accounting Standards Board
goal setting 402 (IASB) 8
going concern assumption 11, 342 interpretation 434
Goods and Services Tax (GST) 26 inventory
and business documents 43–4 and adjusted gross profit 225
and cash flows 238 and advertising 115, 142–3
and receipts 44 and cartage 226
and tax invoices 43–4 changing with the times 256–7
and unearned revenue 375 continuous 125
government accountants 5 control 73–4, 254–7
gross profit 225 cost of 182

INDEX 485
 the cost price of 128–34 invoices 42, 48–9
dead 255
just in time ordering 255
defined 124
gain adjustment 351–2 ledger 54
on hand, rotating 255–6 closing the 198
loss adjustment 351 ledger accounts 66–8, 81
minimum and maximum levels 254–5 balancing 86–7
ongoing management 257 closing 199–201
sheet 124 from source documents 82–5
shop-soiled 255
liabilities
slow-moving 256
in analysis chart 69
system, perpetual see perpetual inventory
in balance sheets 18
system
classifying 21
theft 257
contributing multiple 111
trading 124
defined 6
type 259
liability approach to unearned revenue 373
valuation 185, 186
LIFO (last in, first out) method 128, 129
withdrawal of 49, 50
liquidity 458
Inventory account 69, 73, 127
analysis 458–61
and inventory write-down 187
and cash flows 462–3
recording changes to 160, 170
defined 21
inventory cards 127, 134–7
indicators 440
to the general journal 169–71
loans, classifying 24–5
how transactions affect 164
loss on disposal of asset 327, 328
recording purchases returns in 165
recording returns in 164 management
recording sales returns in 166–8 and accounting reports 253–71
showing a credit purchase 165 and budgeted income statement 401–2,
showing an inventory write-down 187 403–4
showing donations for advertising 142–3 document 42
inventory gain inventory 257
adjusting for 140–1 quality of 470
causes 138 manual coding systems 129–30
defined 137 market research 395
responding to 141–2 memorandums 49
inventory loss memos 49–50, 143
adjusting for 138–40 merchandise see inventory
causes 137
defined 137 narrative reports 19–20
responding to 141–2 negative variance 423
inventory turnover 258, 447–8 net loss 205
equation 258, 447 net profit 26, 198
evaluating 259 calculating 226
managing 260 evaluating 223–4
inventory write-down transfer 203–4
defined 186 net profit margin 439, 442
recording 186–7, 190 equation 442

486 INDEX
net realisable value (NRV) on balance day 344–5
defined 185 defined 344, 372
determining 189–90 price, selling 257
in financial reporting 186 principal 24
function 185 private accountants 5
net worth of the owner 7 proceeds from disposal of asset 328
non-current assets 6, 21, 124 product costs 182, 184
buying and selling 323–34 profit 55, 198
cost 294–5 and balance sheet link 222
disposal 326–9 budgeted 224
recording cash purchases of 324 defined 441
recording loan purchases of 324–5 on disposal of asset 333
trading in 330–3 product cost and period cost effect on 184
non-current liabilities 6, 21–2, 24 trend 223
non-financial factors 470–2 Profit and Loss (P&L) Summary account
198–9, 200–6, 208, 210, 220–1
opening journal entry 112 profit compared to hours worked 468–9
operating efficiency indicators 440, 446–50 ratio equations 469
order form 51 profit determination
other expenses 225, 226, 227 assumptions 342
other revenue 225, 227 and balance day adjustments 341–60
over-depreciation 328 profitability 224, 439, 441, 449–50
overdraft 237 profitability indicators 440, 441–5
owner’s equity 7 public accountants 4
in analysis chart 69 purchase invoice 48, 158
in balance sheets 18, 204 purchases returns 159–60
defined 7, 26
quality assurance 468
payments 45, 47 ratio equation 468
paywave technology 46 quick asset ratio
performance indicators see business perfor- defined 460
mance, indicators
equation 460
performance reports see budget variance
explained 460–1
reports
quotation (quote) 51
period assumption 11, 310, 316, 342, 358
period costs 182, 184 raw data 42, 57
perpetual inventory system 123–44 see also receipts 42, 44, 45–7
inventory
reducing balance method of depreciation
advantages 125–6 310–12
defined 125 relevance 9, 185, 188, 220, 283, 301, 310,
disadvantages 125, 126 316, 342, 358, 373
petrol 95–6 test 182–4
physical stocktake 124 rent 94–6
planning for the future 55 reporting to a wide range of users 204
positive variance 423 reports 42
postage 95–6 evaluation 55
posting 83 residual value 301
prepaid expenses return on assets 224, 443–4

INDEX 487
 equation 443, 449 surplus cash balances 400
return on investment 465–6
tap and go technology 46
return on owner’s investment 224, 444–5
tax invoice 43–4
equation 444
technological obsolescence 256
returns see credit notes; inventory cards;
purchases returns; sales returns timeliness 10
revenue 7, 26, 55 trade credit 268
in analysis chart 72 trading inventory 124
in double entry system 71–4 transaction
earned for a period 372–3 to balance sheet, worked example 90
owing see accrued revenue worksheets 28–9
recording 225–6 trend analysis 438
trial balance 55
sales, cost price of 128–34 and adjusted trial balance 358–9
sales budget to balance sheet 207–10, 222
defined 392 errors 89
purpose 392, 393 to income statement 222
sales invoice 49, 158 role 88–90
sales returns 161–3 standard approach presentation 88, 90
recording 161–3 T-format presentation 90
recording in inventory cards 166–8 two-fold effect 26–7, 29
Sales Returns account 163, 206
schedule of collections 397–8 under-depreciation 328
schedule of payments 398 understandability 10, 204, 220
seasonal products 256 unearned revenue 373–4
security 257 and GST 375
selling price 257 liability approach 373
shipping confirmation 52 unearned sales revenue
shipping fees 182 explained 376
shoplifting 138, 257 recording 376–8
software, accounting 56–7 unfavourable variance 423
source documents useful value 301
for cash transactions 45–7
variance 422
credit notes as 158
variance reports see budget variance reports
for credit transactions 48–9
verifiability 10, 283, 301
defined 45
vertical analysis 434–5
in double entry accounting 54
and information flow 53 weighted average cost method 128, 129
to ledger accounts 82–5 working capital 23
stability indicators 440 defined 458
statements of account 50 equation 458
stock see inventory managing 459–60
stocktake working capital ratio
errors 138 defined 458
physical 124, 137 equation 458
straight-line method of depreciation 296, 310 explained 458–9, 460
summary accounts 32

488 INDEX
 NEVILLE
BOX BOX

MACMILLAN

FOR VCE
ACCOUNTING
MACMILLAN
ACCOUNTING
FOR VCE

Macmillan accounting for vce

units 3 & 4
first published 2019
author
neville box
3+4 3 4