BQOEIII Fundamentals of Accounting & Finance

BQOE III FUNDAMENTALS OF ACCOUNTING AND FINANCE
Noor Asma Jamaludin Nor Asma Lode Junaidah Hanim Ahmad Azlan Zainol Abidin Amin Ali Norazita Marina Abd. Aziz
Project Directors:
Prof. Dr. Mansor Fadzil Prof. Dr. Shaari Abd. Hamid Open University Malaysia Noor Asma Jamaludin Nor Asma Lode Junaidah Hanim Ahmad Azlan Zainol Abidin Amin Ali Norazita Marina Abd. Aziz Universiti Utara Malaysia Assoc Prof. Dr. Arfah Salleh Assoc. Prof. Hashanah Ismail Universiti Putra Malaysia Azlina Abdul Aziz Loo Sze Wei Rosila Abu Zarin Open University Malaysia
Module Writers:
Moderators:
Translated & Edited: Pearson (M) Sdn. Bhd. Compiled by: Desktop Publishing: Printed by: Lilian Kek Siew Yick Open University Malaysia Centre for Instructional Design and Technology Open University Malaysia Meteor Doc. Sdn. Bhd. Lot 47-48, Jalan SR 1/9, Seksyen 9, Jalan Serdang Raya, Taman Serdang Raya, 43300 Seri Kembangan, Selangor Darul Ehsan
First Printing, January 2009 Copyright @ Open University Malaysia (OUM), BQOE III All rights reserved. No part of this work may be reproduced in any form or by any means without the written permission of the President, Open University Malaysia (OUM). Version January 2009
Table of Contents
Course Guide Topic 1 Accounting Environment 1.1 Introduction to Accounting 1.1.1 Definition of Accounting 1.1.2 Users of Accounting Information 1.1.3 Branches of Accounting 1.1.4 Professional Accounting Bodies in Malaysia 1.2 Fundamental Accounting Concepts 1.2.1 Qualitative Characteristics of Accounting Information 1.2.2 Accounting Assumptions 1.2.3 Basic Principles of Accounting 1.2.4 Accounting Constraints 1.3 Accounting Equation 1.3.1 Analysis of Transaction 1.3.2 Summary of Analysis 1.4 Types and Objectives of Financial Statements 1.4.1 Income Statement 1.4.2 Statement of Changes in Owner's Equity 1.4.3 Balance Sheet 1.4.4 Cash Flow Statement Summary ix-xi 1 2 2 2 3 4 6 6 10 13 16 17 17 22 24 25 25 26 27 33
Topic 2
Recording Process 2.1 Chart of Accounts 2.2 Format of Account 2.3 Rules of Debit and Credit 2.3.1 Normal Balance 2.4 Steps in Recording Process 2.4.1 Journal 2.4.2 Journalising and Posting of Entry 2.4.3 Example of Analysis and Summary Transactions 2.4.4 Trial Balance Summary Tutorial Question
34 35 37 38 39 41 41 42 49 73 77 78
iv
TABLE OF CONTENTS
Topic 3
Financial Statements 3.1 Annual Report and Users of Financial Statements 3.2 Income Statement 3.3 Balance Sheet 3.3.1 Assets 3.3.2 Liabilities 3.3.3 Owners Equity or Shareholders Equity 3.3.4 Summary of Basic Accounting 3.4 Statement of Retained Earnings 3.5 Cash Flow Statement 3.5.1 Preparing Cash Flow Statement 3.5.2 Differentiating Cash Resources and Usage Summary Financial Statement Analysis 4.1 Financial Ratio Analysis 4.1.1 Income Statement 4.1.2 Balance Sheet 4.2 Liquidity Ratio 4.2.1 Net Working Capital 4.2.2 Current Ratio 4.2.3 Quick Ratio 4.3 Asset Management Ratio 4.3.1 Account Receivable Turnover 4.3.2 Average Collection Period 4.3.3 Inventory Turnover 4.3.4 Average Inventory Sales Period 4.3.5 Fixed Asset Turnover 4.3.6 Total Asset Turnover 4.4 Leverage Ratio 4.4.1 Debt Ratio 4.4.2 Debt-Equity Ratio 4.4.3 Equity Multiplier 4.4.4 Interest Coverage Ratio 4.5 Profitability Ratio 4.5.1 Gross Profit Margin 4.5.2 Net Profit Margin 4.5.3 Operating Profit Margin 4.5.4 Return on Asset 4.5.5 Return on Equity 4.5.6 Earnings Per Share
79 80 82 85 87 88 89 90 94 94 95 98 104 105 106 108 108 110 110 111 112 113 114 115 116 117 118 118 120 121 121 122 123 124 125 126 126 127 127 128
Topic 4
TABLE OF CONTENTS
Market Value Ratio 4.6.1 Price Earnings Ratio 4.6.2 Dividend Yield Ratio 4.7 Conducting A Complete Ratio Analysis 4.7.1 DuPont Analysis 4.7.2 Summarising All Financial Ratios 4.8 Weakness in Financial Ratio Summary Tutorial Question
4.6
128 129 130 132 132 134 136 141 142
Topic 5
Time Value of Money 5.1 Concept of Compounding and Future Value 5.1.1 Time Line 5.1.2 Compounding Interest 5.1.3 Calculation of Future Value Using Schedule 5.1.4 Graphical Illustration of Future Value 5.2 Concept of Discounting and Present Value 5.2.1 Calculation of Present Value 5.2.2 Calculation of Present Value (Principal) Using Schedule 5.2.3 Graphical Illustration of Present Value 5.3 Single Cash Flow Money Value 5.4 Series Cash Flow Money Value 5.4.1 Annuity 5.4.2 Derivation Cash Flow 5.4.3 Perpetuity 5.5 Compounding and Discounting More Than Once a Year 5.6 Continuous Compounding and Discounting Summary Tutorial Question
144 145 145 146 148 149 151 152 154 156 157 158 158 166 170 172 173 176 176 178
Answers
COURSE GUIDE
INTRODUCTION
Fundamentals of Accounting and Finance is a preparatory course for open entry learners who intend to pursue postgraduate programmes in Masters in Management (MM) and Masters of Business Administration (MBA). This course provides learners with fundamental knowledge in the area of accounting and finance.
COURSE OBJECTIVES
This course integrates the fundamental concepts of Financial Accounting and Financial Management. The first section of this course handles the introduction to the fundamental accounting concepts. This section will also elaborate on the process of preparing accounting information starting from the journal entries to the preparation of financial statement or report. Students will then be taught on how to evaluate, use and apply the financial information provided. At the end of this course, you should be able to: 1. 2. 3. 4. 5. 6. understand the fundamental concepts of accounting; describe the meaning of accounting information, its role as well as its importance; elaborate the process of preparing accounting information from beginning until the completion of the accounting cycle; discuss the functions and information contained in financial statements; analyse the financial performance of a company using financial ratio analysis; and apply the concept of the time value of money in computing cash flows.
COURSE SYNOPSIS
Topic 1 discusses the Accounting Environment. It introduces you to accounting fundamentals, involving the definition of accounting, users of accounting information, branches of accounting, professional accounting bodies in Malaysia as well as the fundamental concepts found in accounting. Also discussed are the accounting assumptions and the four main types of financial statements in financial reporting, namely Income Statement, Statement of Changes in Equity, Balance Sheet and Cash Flow Statement.
COURSE GUIDE
Topic 2 discusses the Recording Process. It revolves around the usage of accounts as well as the rules of debit and credit for each type of accounts (asset, liability and owner equity accounts). The rule of debit and credit will also include the normal balance for each type of accounts. This topic also tracks the steps taken in the recording process, which include the journal entry, transfer of entries to ledger and consequently the preparation of balance sheet. A complete example of the whole process is included to provide better understanding. Topic 3 discusses on the different types of financial statements used in business such as the income statement, balance sheet, statement of retained earnings and cash flow statement. You will get to understand the functions well as the information contained in the financial statements. Topic 4 discusses the usage of financial ratio analysis such as the liquidity ratio, asset management, leverage, profitability, and market value ratio. Besides that, this topic also discuss on the DuPont analysis and the overall financial analysis. Topic 5 exposes students to the basic concept for time value of money, which is the concept of present value and future value. You will learn the application and formula for the time value of money for single cash flow and net cash flow, annuity, perpetuity and derivation cash flow. The discussion will also include compounding and discounting methods that occurs more than once a year and compounding and discounting that occurs continuously.
REFERENCES
Emery, D.R., et. al. (1997). Principles of Financial Management. (1st ed.). Prentice Hall. Gitman, L.J. (2005). Principles of Managerial Finance, (11th ed.). Addison Wesley. Horngren C. T., Harrison W. T. Jr. and Bamber L. S. (2002), Accounting (5th ed.), Prentice Hall, New Jersey. Larson Kermit D., Wild John J., Chiappetta Barbara, (2004) Fundamentals Accounting Principles, (17th ed.), McGraw Hill. Lasher, W.R. (2005). Practical Financial Management, (4th ed.). South-Western Thomson Learning. Roger, H.H et al. (1997), Accounting: A Business Perspective, (7th ed.), Irwin US.
COURSE GUIDE
xi
Scott, D.F. Jr., et. al. (1998). Basic Financial Management (8th ed.). Prentice Hall. Warren C.S., Reeve J. M. and Fess P. E. (2004), Accounting (21st ed.), International Thompson Publishing, Ohio, USA. Warren et. Al (2001), Accounting: Customized by School Of Accountancy UUM for Business Accounting Students, Thompson Learning. Weygandt Jerry J., Keiso Donald E., Kimmel Paul D., (2004) Accounting Principles, (7th ed.), John Wiley & Sons, Inc.
EVALUATION
Refer to the CAPL website at http://capl.oum.edu.my for the evaluation method for this course.
Topic1 Accounting
LEARNING OUTCOMES
Environment
At the end of this topic, you should be able to: 1. explain the meaning, role and importance of accounting; 2. state the users and branches of accounting; 3. describe the main functions of professional accounting bodies in Malaysia; 4. describe the qualitative characteristics of financial information, assumptions, principles and constraints in accounting; 5. explain the accounting equation; 6. analyse transactions based on the accounting equation; and 7. list 4 main financial statements in financial reporting.
INTRODUCTION
Accounting plays an important role in our daily lives without us realising it. Accounting is a financial information system that helps us make better economic decisions. We might assume that accounting is only important to businessmen or accountants. In fact, we also need accounting in our daily lives. We need financial information to make economic decisions. For example, when making a decision on buying a new car, we need to know the total net revenue in a month (gross revenues minus all expenses) to know whether we can afford to buy the car. We also need to estimate other costs that might be involved in having a car.
TOPIC 1 ACCOUNTING ENVIRONMENT
The above example is only a decision at an individual level. For a business entity, it might need to make a decision on whether to buy a new building or just rent it for operational purposes. Even though it is a higher level decision, the decisionmaker still requires the necessary financial information. In this topic, you will be introduced to the basics of accounting. Among them are the definition and branches of accounting, users of accounting information, professional accounting bodies in Malaysia as well as the fundamental concepts in accounting.
1.1
INTRODUCTION TO ACCOUNTING
You often heard the word accounts in your daily lives. However, have you ever thought about the meaning of accounts or accounting? What do you understand about accounting?
1.1.1
Definition of Accounting
Accounting is an information system that prepares reports on the economic activities of an entity for users to help them make better decisions. More accurately, accounting is: A process to identify, measure, record and present the economic information of an entity to the users in order to help them make evaluations or economic decisions. Economic information are information related to economic activities; whereas an entity refers to a business unit.
1.1.2
Users of Accounting Information
Users of accounting information are parties that use the accounting information for specific purposes. The information required by the users might differ between one group and another. Users of accounting information can be divided into two groups - internal users and external users. Internal users are parties that have direct access to the resources of an entity and usually involved in the management of the entity, for example the management
of the company. Meanwhile, external users would be the parties who do not have direct access to the resources of the company and do not involved in the management of the company. The other differences between these two groups are summarised in Table 1.1.
Table 1.1: Differences between Internal Users and External Users Internal Users Types of information required Information that can help them make planning and exercise control over the entity. External Users Information required are different depending on the type of decisions made. Example: Investor: Require information on the profitability of the company before making decision to invest. Loan providers: Require information on the stability and liquidity of the company before making decision on giving out credit. How does the information been obtained Using the status or position in the company. Limited to what is made available by the company. Example Annual report published by the company.
1.1.3
Branches of Accounting
Accounting is divided into several different branches or other specialised fields. Among them are: (i) (ii) Financial Accounting; Management Accounting;
(iii) Taxation; and (iv) Auditing. These branches are not static as they evolving in time and requirement. This financial accounting course will combine two of the most basic and important accounting branches; that are financial accounting and management accounting.
Therefore, it is important for you to know some of the differences between these two branches, as shown in Figure 1.2.
Table 1.2: Differences between Financial Accounting and Management Accounting Financial Accounting Preparation of report Preparation of financial reports of an entity for external and internal users but focus is given to the external users. Management Accounting Preparation of financial and non-financial information that are required by parties in the company for planning, evaluating and controlling purposes of the operations of an entity. Report is produced at any time based on requirement and is not subject to any standard or format.
Standard or Format
Financial reports produced are periodically and in accordance to specified standard or format.
1.1.4
Professional Accounting Bodies in Malaysia
We also need to familiarise ourselves with the organisations that are involved in the accounting profession in Malaysia. The organisations are: (a) Malaysian Institute of Accountants (MIA) MIA was established under the Accountants Act 1967 as the main accounting body in the country. Overall, it functions as the core body in regulating the accounting profession. Other major functions of MIA as discussed in the Accountants Act 1967 are: (i) to set the required qualification in order to become a member; (ii) to provide training and education for practitioners or those who are interested in becoming accounting practitioners; (iii) to control the accounting practices in Malaysia; and (iv) to protect the accounting interest in Malaysia. The Malaysian Institute of Certified Public Accountants (MICPA) MICPA, formally known as The Malayan Association of Certified Public Accountants, was established in 1958 under the Companies Ordinances. On 6 July 1964, the name was changed to The Malaysian Association of Certified Public Accountants to reflect the change of name from Malaya to Malaysia. Since February 2002, it is known as The Malaysian Institute of Certified Public Accountants. Among the main objectives and functions of MICPA are:
(b)
(i) (ii) (iii) (iv) (c)
to advance the accounting theories and practices in all aspects; to train and evaluate the competent members; to ensure the independence of professional accountants; and to oversee the practices and professional conducts of its members.
Malaysian Accounting Standards Board (MASB) MASB was established under the Financial Reporting Act 1997. Among the main functions of MASB are: (i) to set and approve new accounting standards; (ii) to revise or accept the usage of existing standards as approved accounting standards; and (iii) to develop the conceptual accounting framework. Financial Reporting Foundation (FRF) FRF was established under the Financial Reporting Act 1997 together with MASB. Among the main functions of FRF are: (i) to provide opinion to MASB on matters to be implemented; (ii) to evaluate the performance of MASB; and (iii) to be responsible for the overall funding of the operation of MASB, including to approve its budget.
(d)
EXERCISE 1.1
1. Provide examples of common decisions made by both internal and external users. 2. How does Financial Accounting and Management Accounting assist users in making decision?
1.2
FUNDAMENTAL ACCOUNTING CONCEPTS
What are the important qualitative characteristics of accounting information?
1.2.1
Qualitative Characteristics of Accounting Information
In this section, you will be exposed to the qualitative characteristics of accounting information. Qualitative characteristics of accounting information refer to the characteristics that must be present in the accounting information to make it useful. These characteristics are divided into two categories; primary and secondary qualities. The primary qualities of accounting information are relevant and reliability, while the secondary qualities are comparability and consistency. In summary, accounting information is only useful if it has relevant, reliability, comparability and consistency qualities. Figure 1.1 shows the summary for qualitative characteristics of accounting information.
Figure 1.1: Qualitative characteristics of accounting information
(a)
Relevant In everyday terms, we might describe relevant as important or being related. In accounting, relevant is described as something that makes a
difference in arriving at a decision. In other words, something is said to be relevant if it influences or affects the decision being made. The extent to which information is considered relevant depends on its importance in decision making and may differ between one decision maker to another. Information that is relevant to you might not be relevant to another person and vice versa. For example, suppose you are an investor and you intend to buy shares of a public listed company. What kind of information might be relevant to your needs? You might want to know the profitability and performance of the said company for the past five years, including new projects or products for the company that will be profitable in the future. This information is relevant as it will influence your decision. Suppose the information that you obtained showed that the company is experiencing continuous losses for the past five years and it does not have any new projects. Will you still proceed with the proposal to invest in the company? Probably not. Figure 1.2 shows an example of performance information of a company in order to assist investors in decision making.
Figure 1.2: Performance information of a company to assist investor in decision making.
After knowing the meaning of relevant, you must also know how certain information are said to be relevant. To become relevant, the information must have three characteristics, namely feedback value, forecast value and timeliness.
Feedback Value Relevant information must be able to assist users in substantiating or correcting early expectations matters at hand. (ii) Forecast Value Relevant information must be able to assist users in forecasting. (iii) Timeliness Relevant information must be obtained before it becomes obsolete or unusable. (b) Reliability Reliability means that users can rely or depend on the said information to make good decisions. This characteristic is important because users might not have the time or expertise to evaluate some information. Generally, users simply depend on the information presented by the related entity and assume it to be true. This information is then used in decision making. Reliability does not mean that the said information must be precise. This is because in accounting there are a lot of information that involves estimation and approximation that might not be precise. What is important is that the estimation and approximation made must be reliable. Reliable information must have the following characteristics: (i) Verifiable This means that the accounting information could be verified objectively by another person using the same method. (ii) Objective Objective in this case means that the information is not biased. Information contained in the financial statements must be able to fulfil the requirements of various users and not concentrating on certain groups only. (iii) Trustworthy Information presented is based on the actual result of economic activities using specified methods. (c) Comparability Comparability means that the information can be compared whether among companies, industries or different periods. This will enable users to identify the similarities or differences that might exist in the said information. This characteristic is important because information that can be compared is more useful. This example might help you to understand comparability. Let us assume that you were told that the net profit of a business in the year 2000 was RM5 million. Is this information useful? This information would only be
(i)
meaningful if you can compare it with the net profit of the business in the year 1999 or the net profit of other businesses in the same industry as shown in Figure 1.3. Thus, financial statements contained in the Annual Report also include information on the previous year in addition to the current year for comparison purposes.
Figure 1.3: Profitability comparison
(d)
Consistency Consistency means that an entity must use the same accounting procedures in every period. It is for the purpose of enabling comparison to be made more effectively. In other words, a company cannot change their accounting procedure every year. This does not mean that the company cannot change the accounting procedure at all. Changes can still be made, but the company must make complete disclosure in the financial statement to explain to the users why they are making the changes and the effect of the changes towards the financial statements.
In your opinion, what will happen to a business entity if it only presents the qualitative characteristics of main accounting information in its annual report?
EXERCISE 1.2
1. State the qualitative characteristics of accounting information. 2. Explain the meaning of comparability provide an example to show its role in making accounting information useful.
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1.2.2
Accounting Assumptions
In this section you will be exposed to accounting assumptions. There are four accounting assumptions, created to aid the reporting entity and the users, which are generally accepted. They are: (a) Assumption of Separate Entity For the purpose of accounting, an entity is assumed to be separate from its owner and also other entities. An accounting entity is an economic entity in its own right which controls resources involving economic activities. All activities relating to the accounting entity must be separated from the owners activities or other accounting entities activities. The examples below should explain this concept clearly. Example 1: Assume that you own a business, your personal economic activities must be kept separate from the business economic activities. If you wish to buy products for personal use, you cannot take the business money and assume that as part of the business activities. Instead, you must record it as drawings. The Drawings Account shows the money or products from the business taken by the owner for personal use. Example 2: Supposing you have just set up a business which offers computer repair services. As it is a small business and you are the sole proprietor, the business cash is deposited into your private account. Assume that on 31 December 2003, the bank balance of your account is RM5,000. Based on your record, RM1,000 is the money from your business and the balance of RM4,000 is funds for your studies. If you did not comply with the assumption of separate entity and assume RM5,000 is the money from your business, you might make an inaccurate business decision. You might feel that your business has adequate funds while in fact only RM1,000 is the business cash. Although all the money belongs to you, from the accounting perspective, RM1,000 is for the business funds and the balance of RM4,000 is the money for your education purposes. Segregation would enable you to evaluate the financial status of the business much better and to make accurate decisions to enhance the performance of the business. If an owner has more than one business entity, each entity must be assumed as separate entity from the others. Please refer to the example below.
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Assuming that Mr. Ali owns three different businesses, all three are considered to be separate from accounting perspective. Accounting records must be maintained separately; assets and liabilities for each business cannot be mixed together. Segregation would enable the owner to know the performance for each business. As a simple example, suppose that Mr. Alis businesses show the following result on 31 December 2003:
Business Business 1 Business 2 Business 3 Transaction Profit Loss Profit (RM) 6,000 8,000 12,000
If the assumption of separate entity is not complied with and all the entities are assumed as one, Mr. Ali will have an overall business profit of RM10,000 [RM6,000 + (-8,000) + RM12,000]. Based on this result, Mr. Ali might be satisfied and might not take any measures for improvement. However, by preparing separate accounts, Mr. Ali will know that Business 2 is facing problems as it is suffering a loss of RM8,000, while Business 3 is performing very well with a profit of RM12,000. (b) Assumption of Going Concern According to this assumption, an entity is assumed to continue to exist and in operation in the future. This assumption is important because it enables the principle of historical cost to be applied. According to the historical cost principle, all assets and liabilities must be recorded at the purchase price (original cost). For most assets, this cost would be depreciated throughout the life span of the assets to depict its usage. However, asset of property would not be depreciated as its value would always appreciate. As an example, a machine with a life span of 25 years will be depreciated for 25 years based on the assumption of going concern. With this assumption, the entity would continue to exist for a period of more than 25 years. If we assume that the entity would exist only for another 10 years in absence of this assumption, we obviously cannot use 25 years as the basis for calculating the depreciation. The assumption also enables users to make decisions without any doubt or worries. Suppose you are interested to invest in a company that has consistently achieved high profits in the past few years. However, you were
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informed that the company would exist only for another five years. Would you still continue with your plan to invest in the said company? Generally, we will only invest when we believe the company will continue to exist in the future. (c) Assumption of Monetary Unit According to this assumption, all economic activities are measured and valued in currency unit. In Malaysia, the currency unit used is Malaysian Ringgit (RM). Only transactions that can be stated in currency unit will be recorded for accounting purposes. Currency unit enables the transactions to be summarised, reported and compared. Before the existence of currency, transactions were conducted by way of exchanging goods (barter system). The non-existence of currency unit had created difficulties in ascertaining the value of transactions. With a countrys standard currency unit, we would be able to value every product. However, this assumption has two weaknesses, that are: (i) It restricts the scope of accounting. Only transactions that can be measured in monetary terms will be taken into account, neglecting other factors that have impact on the business. (ii) It assumes that the value of currency is constantly stable, whereas we know that the currency value is always changing. (d) Assumption of Accounting Period In the assumption of going concern, we assumed that the entity will continue to operate for an unlimited period. However, users (whether manager, shareholders, loan providers or other parties) require periodical measurements to help them making decisions. With this assumption, the lifetime of the entity is divided into a certain period for the purpose of reporting its economic activities. Normally the period selected is one year. Financial reports must be produced every accounting year. The selected accounting period can start from 1 January and ends on 31 December, or starts from 1 July and ends on 30 June the following year, and so on depending on the operation of the company. For example, if an entity is established on 1 March, it might choose an accounting period that starts from 1 March and ends on 28 February of the following year. This accounting period can be changed if the entity feels that there is a need to do so.
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Figure 1.4 shows examples of accounting period.

Starting Date 1 January 2001 1 July 2002 1 March 2002 Ending Date 30 December 2001 30 June 2003 28 February 2003
Figure 1.4: Examples of accounting period
There are also companies which produce reports within a period of less than a year, for example monthly, quarterly or half yearly. These reports are known as interim reports. Interim report is normally produced to fulfil the requirement of users that might need a more up-to-date report.
There is a company that has obtained high profits consistently for the past 5 years and would exist for a period of another 10 years. Would you invest in the company? Explain your decision.
1.2.3
Basic Principles of Accounting
The word income is used daily especially in relation to business. However, do you know what is meant by income?
After understanding the qualitative characteristics of information and accounting assumptions, you will be exposed to the basic principles of accounting, which are the principles used in the process to identify, measure, evaluate and report financial information. There are four basic principles that you must know: (a) Principle of Historical Cost According to this principle, all business resources will be recorded based on historical cost, which is the original cost at time of purchase. Although the value of the resources might change in the future, no adjustment will be made to recognise the changes in the value.
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For example, you want to buy a piece of land for your business site. The seller set the price at RM80,000. You do not agree with the price and ask the seller to sell it RM70,000. After negotiation, the seller agreed with the price of RM72,000. In this case, the land would be recorded at the value of RM72,000 in your financial statement. Five years later, you wish to revalue the land. The assessor informed you that the value of the land had appreciated to RM120,000. Although there is a high appreciation in value, you must still record it at the value of RM72,000, which is the original cost of the land during the purchase. The principle of historical cost is justified by its high reliability. The value recorded in the financial statement is based on the original cost at the time of purchase supported by documentation. This advantage is also a weakness for certain parties. These parties criticised the failure of the principle to recognise any possible changes in asset value. Regardless, this principle is still adopted. (b) Principle of Income Recognition Principle of income recognition provides guidance regarding when and how to recognise income. The three conditions that must be complied with before income is recognised are: The seller had performed the necessary actions to obtain the income (for example, providing the goods for trade or rendering services); The amount of income can be measured objectively; and The income can be collected. Normally, income is recognised at the point of sale. The point of sale refers to a situation whereby ownership has been transferred from the seller to the buyer, notwithstanding whether the cash has been received or not. For an entity that offers services, the point of sale is when the service has been provided to the customer. However, in certain cases, the point of sale method is inappropriate. There are several different methods that can be used, for instance the percentage of completion and cash basis methods. (i) Percentage of Completion Method is normally used by companies involved in the construction industry which takes a long time to complete. For example, a housing project might take three years to complete. It would be inappropriate to recognise the revenue only after the project is completed. This is because revenue and expenses accrued throughout the duration of the project that could be determined periodically based on the degree of completion. This method is more appropriate because it complies with the accounting
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(ii)
period principle and provides a true picture of the project development. Cash Basis Method complies with the basis of cash accounting. According to this method, revenue is only recognised when cash is received. This method is applied in credit transactions when cash receipts are not assured.
(c)
Principle of Matching This principle matches the expense (effort) with the revenue (benefit obtained from the effort). The matching of the revenue with the expense will be done when the transaction has completed. To comply with this principle, two steps will be involved, which are: (i) First Step Recognition of the revenue for a specific period. (ii) Second Step Recognition of all the expenses involved in ascertaining the revenue. For example, when we provide services to customers, we will recognise the revenue according to the principle of income recognition. Then, we will recognise all the expenses involved in generating the revenue and match them with the revenue. The difference between the revenue and the expense will be either profit or loss. If revenue is more than expense, the difference will be net profit. However, if the revenue is less than expenses, the difference will be recognised as net loss. Figure 1.5 summarises the concept of profit and loss.
Figure 1.5: The relationship between revenue and expense
(d)
Principle of Full Disclosure The principle stresses for the full disclosure of all relevant information and material in the financial statement whether in the statement itself or in the notes to the accounts. This is to ensure that the users can make proper decisions. The disclosure of financial statements will be explained in detail in Unit 2.
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ACTIVITY 1.3
1. Explain the weaknesses exist in the assumption of monetary unit. 2. Describe THREE conditions that must be fulfilled before revenue can be recognised.
1.2.4
Accounting Constraints
We have seen the principles that must be complied with in accounting. However, there are constraints or obstructions that might result in these principles not being complied with. The main constraints in accounting are: (a) Cost-Benefit Relationship Before deciding on obtaining specific information, a company would normally analyse the cost involved and the benefit that may be gained from the information. If the cost of obtaining the information is very high but the benefit generated is not so much, the company might not reveal the information even though all information must be completely disclosed in accordance with the principle of full disclosure. Materiality Materiality refers to the effect of an item towards the overall operation of the entity. An item is considered immaterial if it does not affect the decision that will be made. Materiality is often measured based on size. A transaction that involves a huge amount is normally treated as material. A material transaction must be disclosed in detail, while immaterial transactions are sometimes combined or not disclosed in detail. For example, a small amount of expense like a purchase of stamps and fares are combined into one account known as sundry expenses. Another example will be the practice of approximation. You can see examples in the annual report published by companies. Generally, companies would not record the cents value, but instead will round the figures up to the nearest ringgit (example: RM471.20 is recorded as RM471). For larger companies, it might make the approximation to the nearest hundred ringgit (example: RM525,795 is recorded as 525,800).
(b)
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1.3
ACCOUNTING EQUATION
A business has assets valued at RM120,000. RM50,000 is the owners capital and the balance is bank loan. What is the accounting equation?
Accounting equation is the basis of accounting that will always be used each time we record a transaction. It consists of three components or basic elements, which are asset, liability and owners equity. What is meant by asset? Asset is the resources that can bring economic benefit, owned by the entity. For example, cash, building and fittings. For each resource, there must be a claim or rights on it. A simple example, if you own some money, the money belongs to you. If you buy a vehicle with bank loan, the ownership of the vehicle is claimed by the bank until you have settled your loan. In other words, the vehicle is not owned by you (but is owned by the bank) until you have settled your entire loan. It is the same in business. Every asset owned by the business can be claimed either by the owner itself, or loan providers. Rights or claims made by the loan providers are known as liabilities, whereas the rights or claims made by the owner itself are known as equities. Loan providers have priority over the rights to the business assets. If the entity is facing problems, it must first settle its loans. The owner can only claim his rights if there are assets left. Therefore, liability is put ahead of owners equity in the accounting equation as shown below: Accounting Equation: ASSET = LIABILITY + OWNERS EQUITY
1.3.1
Analysis of Transaction
You must always remember that the accounting equation is always equal regardless of the transaction that has transpired. All transactions can be stated by changes in the three components of the accounting equation. Now we will look at a few common transactions and analyse the results on the accounting equation.
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We will use the example of a sole proprietor business owned by Reen. Reen, who is skilled in the computer field, has established her own company on 1 November 2000. For a start, the business (Reen Cyber Service) offers services in computer consultancy. If successful, Reen intends to expand her business to selling computers. The following is a list of transactions incurred by Reen Cyber Service throughout the month of November 2000:
Table 1.3: List of Transactions for Reen Cyber Service, November 2000 No. 1 2 3 4 5 6 7 8 Date (Nov) 1 2 4 15 30 30 30 30 Transactions Reen invested cash of RM30,000 into Reen Cyber Service. Purchased a piece of land valued at RM20,000. The business paid cash RM5,000 and the balance is financed by bank loan. Purchased office supplies valued at RM2,700 on credit. Received revenue from consultancy services provided to customer. The customer paid RM15,000 cash. Paid staff salary expense RM4,250; rental expense RM1,600; utility expense RM900 and other expenses RM550. Made payment for account payable of RM1,900. Unused office supplies valued at RM1,100. Reen withdrew money from the business amounting to RM4,000 for her personal use.
All the transactions above are pertaining to Reen Cyber Service. The personal transactions of the owner (Reen) will not be taken into account if it does not involve the business. Now we have to analyse each transaction to see their effects on the accounting equation. Transaction 1: Reen invested cash of RM30,000 into Reen Cyber Service. Again, it needs to be emphasised that we are only interested in transactions involving Reen Cyber Service, and not Reens personal transactions. Therefore, even though the cash owned by Reen was reduced by RM30,000, the cash owned by Reen Cyber Service has increased by RM30,000. This capital was contributed by Reen. Therefore, owners equity will increase by RM30,000. Transaction 1 ASSET Cash 30,000 = = LIABILITY + OWNERS EQUITY Capital, Reen 30,000
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Transaction 2: The business entity purchased a piece of land valued at RM20,000, paying RM5,000 by cash and the balance of RM15,000 being financed by bank loan. From this transaction, the business will have a new asset (land) valued at RM20,000. The business cash is reduced by RM5,000 while a new liability of RM15,000 is created. Bank loan is always represented by the account Notes Payable (NP). Note that the equation still holds true. The asset section increased by RM15,000 and the liability section also increased by RM15,000. Balance shows the final balance for each item after every transaction. Transaction Balance 2 Balance ASSET Cash + Land 30,000 -5,000 + 20,000 25,000 20,000 = = = = LIABILITY NP 15,000 15,000 + OWNERS EQUITY Capital, Reen 30,000 30,000
Transaction 3: Purchased office supplies valued at RM2,700 on credit. The asset will increase by RM2,700. The purchase by credit will create a new liability, which is Account Payable (AP).
Transaction Cash Balance 3 Balance 25,000 25,000 + ASSET Land + Supplies 2,700 2,700 = = = = LIABILITY NP 15,000 15,000 2,700 2,700 + AP + + OWNERS EQUITY Capital, Reen 30,000 30,000
+ 20,000 20,000
Normally, office supplies bought are not only used in the current accounting period. The purchase of office supplies are prepaid expenses. The usage of office supplies for the specific period is recorded by using the account Supplies Expenses. Transaction 4: Received revenue from consultancy services provided to customer. The customer paid RM15,000 cash.
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Transaction Cash Balance 4 25,000 +15,000 + +
ASSET Land 20,000 + + Supplies 2,700
LIABILITY NP + + AP 2,700
= =
15,000
Balance
40,000
20,000
2,700
15,000
2,700
OWNERS EQUITY Capital, Reen 30,000 15,000 service revenue 45,000
Service revenue is one of the components in owners equity. The other components are expenses and drawings. Revenue will increase the owners equity while expenses and drawings will reduce it. Figure 1.6 shows the effect of revenue, capital, expenses and drawings on owners equity. Revenue Capital Expenses Drawings = = = = Owners equity Owners equity Owners equity Owners equity
Figure 1.6: Analysis of transaction
Transaction 5: Paid salary expense RM4,250; rental expense RM1,600; utility expense RM900 and other expenses RM550.
Transaction Cash Balance 5 40,000 4,250 1,600 -900 -550 Balance 32,700 + 20,000 + 2,700 = 15,000 + 2,700 + ASSET + Land + 20,000 + Supplies + 2,700 = = = NP 15,000 LIABILITY + + AP 2,700 + + OWNERS EQUITY Capital, Reen 45,000 -4,250 paid salary 1,600 paid rental -900 paid utility -550 paid sundry 37,700
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In this transaction, all the expenses were paid by cash. Therefore, cash will decrease according to the amount involved. Each expense item has to be recorded separately and cannot be combined. As explained in transaction 4, expenses will reduce owners equity. Transaction 6: Made payment for account payable of RM1,900. When the business paid RM1,900, cash will decrease by RM1,900 and liability will also decrease by RM1,900.
Transaction Cash Balance 6 Balance 32,700 1,900 30,800 ASSET + Land + 20,000 + 20,000 + Supplies + + 2,700 2,700 = NP LIABILITY + AP 2,700 + -1,900 800 + + OWNERS EQUITY Capital, Reen 37,700 37,700
= 15,000 + = = 15,000 +
Transaction 7: At the end of the month, the unused office supplies were valued at RM1,100. The office supplies was originally bought for RM2,700. The value of office supplies used up during the period is RM1,600 (RM2,700 RM1,100)
Transaction Cash Balance 7 + ASSET Land 20,000 + Supplies + 2,700 -1,600 = LIABILITY NP = 15,000 = + + AP 800 + + OWNERS EQUITY Capital, Reen 37,700 -1,600 Supplies expenses 36,100
30,800 + -1,600
Balance
30,800 +
20,000
1,100
= 15,000
800 +
Transaction 8: Reen took RM4,000 of the business cash for personal use.
Transaction Cash Balance 8 Balance + ASSET Land 20,000 + Supplies + 1,100 = LIABILITY NP = 15,000 = = 15,000 + + AP 800 + + OWNERS EQUITY Capital, Reen 36,100 -4,000 cash drawings 32,100
30,800 + 4,000 26,800 +
20,000
1,100
800
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Drawings is the reverse of capital investment. Capital investment will increase the capital (example in the form of cash) of the business. Drawings will reduce the capital. At the end of the accounting period, the drawings account will be closed and the balance will be transferred to the capital account. Therefore, drawings will be recorded as a reduction in capital account. Although both drawings and expenses reduced capital, there is a clear difference between these two types of accounts. Drawings are not for the purpose of generating revenue, but for the owners personal use.
1.3.2
Summary of Analysis
Some important items that we must be aware of during the analysis of transaction: (a) Each transaction will affect, either as an increase or decrease, one or more components in the accounting equation. However, each transaction will definitely involve more than one item in the financial statements; The accounting equation explained at the earlier stage will always be equal. You can examine this yourself by looking into the Balance section after every transaction analysis; and Owners equity will increase with investment from the owner and revenue, while drawings by the owner and expenses will reduce owners equity.
(b)
(c)
Table 1.4 is a summary of analysis for all the transactions of Reen Cyber Service. After all the transactions have been recorded, we will discover that the accounting equation will still be equal.
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Table 1.4: Analysis of Transaction for R.C.S, November 2000

Transaction Cash 1 30,000 + ASSET Land + Supplies = = LIABILITY NP + AP + OWNER EQUITY Capital, Reen 30,000 investment by Reen 30,000 30,000 30,000 15,000 service revenue 45,000 -4,250 paid salary -1,600 paid rental -900 paid utility -550 paid sundry 37,700 37,700 -1,600 bought supplies 36,100 -4,000 cash drawings 32,100
Balance 2 Balance 3 Balance 4
30,000 -5,000 25,000 25,000 15,000 + +
20,000 20,000 20,000 + 2,700 2,700
= = = = = =
15,000 15,000 15,000 + 2,700 2,700
+ +
Balance 5
40,000 4,250
20,000
2,700
= =
15,000
2,700
-1,600
-900
-550
Balance 6 Balance 7
32,700 1,900 30,800
+ +
20,000 20,000
+ +
2,700 2,700 1,600
= = = =
15,000 15,000
+ +
2,700 -1,900 800
+ +
Balance 8
30,800 4,000
20,000
1,100
= =
15,000
800
Balance
26,800
20,000
1,100
15,000
800
ASSET 47,900 47,900
= = =
LIABILITY 15,800 47,900
+ +
OWNERS EQUITY 32,100
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1.4
TYPES AND OBJECTIVES OF FINANCIAL STATEMENT
After the transactions have been identified, analysed and recorded, we need to prepare a report for the users. This report is the final product of the accounting process and is known as financial statement. There are four types of financial statement that you need to know: (a) (b) (c) (d) Income Statement; Statement of Changes in Owners Equity; Balance Sheet; and Cash Flow Statement.
These statements are interconnected with one another. The title for each statement must contain the reporting entitys name, type of statement and the reporting period covered. In this section, we will see in summary, the format for each of the four statements based on the transactions for Reen Cyber Service. We will learn about the preparation of each statement in detail in Unit 2.
Figure 1.7: Types of business
Let us take a look at Figure 1.7. Generally, businesses are divided into three types, which are sole proprietorship, partnership and company. Sole proprietorship is owned by a single owner while partnership is owned by 2 to 20 owners. Financial statements for these two types of business are not subject to the standards released by MASB. Therefore, there might be several formats used by these two types of business. Companies are divided into private limited and public listed companies. Private limited companies can be owned by 2 to 50 owners. However, there are unlimited number of owners for public listed companies. The preparation of financial
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statements for companies is subject to the standards released by MASB, whether in the form of accounting method, disclosure and reporting format.
1.4.1
Income Statement
This statement is also known as Profit and Loss statement which lists all the revenues and expenses incurred by the entity for a specific period. The difference between the revenue and expense will result in either net profit or net loss. Excess of revenue over expense will give us net profit, while expense in excess of revenue will give us net loss. Figure 1.8 shows the income statement for Reen Cyber Service for the month ended 30 November 2000. Reen Cyber Service Income Statement for the month ended 30 November 2000 RM Service revenue Expenses: Salary expenses Rental expenses Utility expenses Supplies expenses Sundry expenses Net profit
Figure 1.8: Income statement/Profit and loss statement
RM 15,000
4,250 1,600 900 1,600 550
(8,900) 6,100
1.4.2
Statement of Changes in Owners Equity
This statement shows the changes in owners equity for a specific accounting period. Owners equity will increase when the owner makes a capital investment or when the entity gains net profit. Owners equity will decrease when the owner makes drawings or when the entity incurs net loss. Figure 1.9 shows the statement of changes in owners equity for Reen Cyber Services.
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Reen Cyber Service Statement of Changes in Owners Equity for the month ended 30 November 2000 Opening Capital 1 November (+) Net profit (-) Drawings RM 30,000 6,100 36,100 (4,000) 32,100
Closing Capital 30 November
Figure 1.9: Statement of changes in owners equity
1.4.3
Balance Sheet
This statement is also known as the financial position statement, listing all the assets, liabilities and owners equity of the entity on a specific date. The purpose of this statement is to show the financial status of the entity on a specific date. There are two formats normally used, which are the statement format and accounts format. The accounts format places the asset on the left side with liability and owners equity on the right side (refer to Figure 1.10 and Figure 1.11) Reen Cyber Service Balance Sheet as at 30 November 2000 ASSETS Current Assets: Cash Supplies Fixed Assets: Land 1,100 RM LIABILITIES AND OWNERS EQUITY Liabilities: 26,800 Current Liabilities: Account payable Notes payable 20,000 Total liabilities Owner Equity: Capital TOTAL LIABILITIES AND TOTAL ASSETS 47,900 OWNERS EQUITY
Figure 1.10: Balance Sheet in accounts format
RM
800 15,000 15,800 32,100 47,900
27,900 Long-term liabilities:
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In the statement format, the asset, liability and owners equity are listed vertically. Reen Cyber Service Balance Sheet as at 30 November 2000 RM Fixed Assets: Land Current Assets: Cash Supplies () Current liabilities: Account payable Net current assets Financed by: Owners equity: Capital, Reen Long term liabilities: Notes payable 15,000 47,100
Figure 1.11: Balance Sheet in statement format
RM 20,000
26,800 1,100 27,900 (800) 27,100 47,100
32,100
1.4.4
Cash Flow Statement
This statement reports all the cash receipts and payments of the entity in a specific period. Through this statement, the users will know the sources of cash received and why cash is paid. The difference between cash inflows and outflows will provide the final cash account balance of the entity. This balance will be the same as the cash amount shown in the Balance Sheet. In the cash flow statement, cash transactions are divided according to the type of activities, which are operating, investing and financing activities. Figure 1.12 shows the cash flow statement for Reen Cyber Services.
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Reen Cyber Services Cash Flow Statement for the month ended 30 November 2000 RM Cash from operating activities: Cash received from customers () Expenditure paid Payment to supplier Net cash flow from operating activities Cash from investing activities: Payment for purchase of land Net cash flow from investing activities 15,000 7,300 1,900 (9,200) 5,800 RM RM
(5,000) (5,000)
Cash flow from financing activities: Investment by owner 30,000 () Drawings by owner (4,000) Net cash flow from financing activities Net cash flow for entity and cash account balance as at 30 November
Figure 1.12: Cash flow statement
26,000 26,800
Discuss the issues that might arise if a business entity did not disclose the relevant information in its financial statement.
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Further information regarding the professional accounting bodies in Malaysia can be obtained from the following websites: Malaysian Institute of Accountants (MIA) www.mia.org.my The Malaysian Institute of Certified Public www.micpa.com.my Accountants (MICPA) Malaysian Accounting Standards Board (MASB) Financial Reporting Foundation (FRF) www.masb.org.my www.masb.org.my
EXERCISE 1.4
1. Fill the blanks with the most accurate answer: (a) Financial statement prepared on a yearly basis complies with the assumption of ______________. (b) The principle that requires the economic resources of the entity to be recorded at the original cost at time of purchase is the principle of ___________. (c) _____________ information must have feedback value, forecast value and is presented on a timely basis. (d) The professional body responsible for setting the accounting standards in Malaysia is _______________________________. (e) The qualitative characteristic that enables users to depend or rely on the information presented is _____________. (f) The principle that matches the revenue with the expenses in the specific accounting period is ___________________. (g) Not all accounting information can be disclosed in detail due to constraints of ___________________ and __________________. (h) The branch of accounting that prepares specialised information for internal users and not subject to specified standard or format is ______________. (i) According to the assumption of _____________, the entity is assumed to continue to exist and in operation in the future. (j) Revenue is normally recognised when ________________. (k) The statement that shows the cash flow of an entity for a specific period is _______________. (l) ____________________ lists all the assets, liabilities and owners equity of an entity in a specific period.
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2. If revenue = RM12,000; expense = RM8,400 and drawings by owner = RM2,000; how much is the net profit or net loss for that period? A. Net profit RM5,600 B. Net loss RM3,600 C. Net profit RM1,600 D. Net profit RM3,600 3. Which of these is NOT a qualitative characteristic of accounting information? A. Materiality B. Reliability C. Relevant D. Comparability 4. One example of internal user is: A. Inland Revenue Board B. Investor C. Creditors D. Management 5. If the total assets increased by RM15,000 and the total liabilities decreased by RM10,000; owners equity had: A. increased by RM5,000 B. decreased by RM5,000 C. increased by RM25,000 D. decreased by RM25,000 6. For the purpose of simplifying accounting, the business owner and business entity are assumed as the same. True False
7. The accounting period for all businesses must start from 1 January and ends at 31 December each year. True False
8. Income statement shows the net profit or loss of a business entity at a specific date. True False
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9.
Determine the appropriate amount in the spaces marked ? ASSET (a) (b) (c) 84,000 ? 125,000 = = = = LIABILITY ? 72,000 50,000 + + + + OWNERS EQUITY 38,000 28,000 ?
10.
State the effects of the following transactions on the asset, liability and owners equity. An example is shown in transaction (a): Transaction (a) (b) (c) (d) (e) (f) Paid debts to supplier. Purchased office equipment by cash. Owner took cash from the business for personal use. Paid staff salary current period. for the Effect Asset decreased, Liability decreased.
Received cash from customer to settle his account receivable. Owner contributed office equipment for business use.
11.
Mr. Ashwin established a tour agency on 1 June 2001. The transactions for the month are as follows: (a) Deposited cash into the business account totalling RM20,000. (b) Purchased supplies on credit for RM800. (c) Made payment to supplier for RM620. (d) Received cash on the services provided for RM4,200. (e) Paid staff salary of RM1,000. (f) Paid transportation of RM700 and sundry expenses of RM150. (g) Paid office rental of RM1,200. (h) Charged customer RM2,500 for services provided. (i) Supplies unused at the end of the period is valued at RM250. (j) Mr. Ashwin took cash from the business totalling RM750 for his personal use.
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Required: (a) State the effect of each transaction and the balance after each transaction using the accounting equation format that you have learned. (b) Create the accounting equation for Mr. Ashwin business after the last transaction for that month. 12. Below are the assets and liabilities accounts balances for Seri Consultation Services as at 31 December 2000 including the revenue and expense incurred throughout the year 2000. On 1 January 2000, the capital of Miss Seri Devi (the owner) is RM22,200. Throughout the year, she made a cash drawings of RM6,000 but no records of it has been made. Account Accounts payable Accounts receivable Supplies Supplies expenses Tax expenses Salary expenses Sundry expenses Rental expenses Utility expenses Service income Cash Amount (RM) 1,200 18,755 8,480 6,300 4,200 18,000 1,265 14,400 7,350 78,750 23,300
Required: Based on the information given, prepare: (a) Income statement for the year ended 31 December 2000. (b) Statement of Changes in Owners Equity for the year ended 31 December 2000. (c) Balance Sheet as at 31 December 2000.
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In this topic, you have learned and discovered: 1. The users of accounting information consist of internal users and external users. The difference between financial accounting and management accounting are: Financial accounting prepares the financial report for external users while management accounting prepares the monetary and non-financial information for internal users. The financial reports in financial accounting is produced periodically and subject to specified format while the report for management accounting is produced according to specific needs and not subject to specified standards. The professional bodies involved in the accounting profession are Malaysian Institute of Accountants (MIA), The Malaysian Institute of Certified Public Accountants (MICPA), Malaysian Accounting Standards Board (MASB) and Financial Reporting Foundation (FRF). The assumptions and fundamental principles of accounting consist of: assumption of separate entity; assumption of going concern; assumption of monetary unit; assumption of accounting period; principle of historical cost; principle of income recognition; principle of matching; and principle of full disclosure. The accounting equation is fundamental in accounting and it consists of three components, namely asset, liability and owners equity. Financial statement is the final product of the accounting process and it consists of Income Statement, Statement of Changes in Owners Equity, Balance Sheet and Cash Flow Statement.
2.
3.
4.
5.
6.
Topic2 Recording
Process
LEARNING OUTCOMES
At the end of this topic, you should be able to: 1. describe the chart of accounts for recording and summarise the effect of transactions on financial statement; 2. explain the format of accounts used; 3. list the rule of debit and credit for each type of accounts; 4. prepare journal entries; 5. transfer entries to ledger; and 6. prepare trial balance.
INTRODUCTION
After studying how to analyse transactions, we will now learn about recording. Recording is the most important step in accounting for a business entity. However, before recording, we must identify the event that had occurred. Only events that occur to the business entity will be recorded in the entitys book. Not all events are transactions, for example, recruitment of staff. Although it will affect the entity economically, this event is not considered a transaction.
TOPIC 2 RECORDING PROCESS
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2.1
CHART OF ACCOUNTS
Why must transactions be recorded in accounts and not some other format?
When we analysed the transactions in the example of Reen Cyber Service, we have recorded and summarised the transactions that occurred using the accounting equation format. Although this format is easy to understand, it will become difficult to use when there are a lot of transactions to be recorded daily. In the example, we have analysed 8 transactions in a period of one month. In an actual situation, a medium-sized service firm may have several transactions in a day. If we use that accounting equation format, we will need a huge amount of space. Whenever there is a new item, we must add it into the limited columns available. We need to reshuffle the whole original format to accommodate this change. This also applies if errors are detected. It would be difficult for us to make any alteration without re-arranging the whole original format. As a result, the accounting system was created to show the increase or decrease of each item in the financial statement separately. The separate recording of each item is known as account. As an example, cash account is a separate recording especially to show the increase or decrease in the cash item. This also applies to other items like account payable, service revenue and salary expense. The group of accounts in a business entity is known as ledger. The list of accounts in the ledger is known as a chart of accounts. Chart of accounts was created particularly to enable the users of financial statements to refer to specific accounts. Each account is given a special number as reference. These accounts are normally listed systematically in the financial statement. Normally in the chart of accounts, balance sheet items (asset, liability and owners equity) are put in front, followed by income statement items (revenue and expense). Figure 2.1 summarises the concept of ledger and chart of accounts.
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Figure 2.1: Ledger and chart of accounts
Figure 2.1 explains the chart of accounts clearly. This chart will be used as an example in this topic. New accounts will be introduced in the following units when the entity increases its business scope. The chart is created by the entity itself. Therefore, the chart of accounts between one entity and another entity might be different. For Reen Cyber Service, its chart of accounts consists of only two digits. The first digit will show the type of account (example: 1 for asset account, 2 for liability account, 3 for owners equity account, 4 for revenue account and 5 for expense account). The second digit will show the account itself. For larger businesses, the chart might consist of three to four digits. If the entity has a branch at different location, the first digit might be used to show the branch location.
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Table 2.1: Chart of Accounts for Reen Cyber Service Accounts in Balance Sheet 1 ASSETS 11 Cash 12 Account receivable 14 Supplies 15 Insurance prepayment 17 Land 18 Office equipment LIABILITIES 21 Account payable 22 Notes Payable 23 Deferred Rental OWNERS EQUITY 31 Capital, Reen 32 Drawings, Reen 4 Accounts in Income Statement REVENUE 41 Service revenue
EXPENSES 51 Salary expenses 52 Rental expenses 53 Utility expenses 54 Supplies expenses 55 Sundry expenses
EXERCISE 2.1
Which of these events can be considered as a transaction and must be recorded? Please discuss. (a) The death of a branch manager.
(b)
The capital contribution of the owner into the business.
2.2
FORMAT OF ACCOUNT
Each account has three sections: (a) Title or name of the account, which is the name of the items recorded in that particular account. (b) Debit section on the left side. (c) Credit section on the right side. The debit and credit section are used to record either the increase or decrease in the specific account. However, do remember that, debit does not necessarily show an increase and that credit does not necessarily show a reduction. It depends on the type of account. This subject will be explained in detail later under the rule of debit and credit.
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Accounts are also known as T-accounts due to their shapes that look like the letter T. Account Title Debit (left) Credit (right)
Figure 2.2: T-Account (simple format )
Each section of the T-account should have four columns in the debit section and four columns in the credit section.
Debit Date Description Reference Account Title Amount Date Description Reference Credit Amount
Figure 2.3: T-Account (detailed format )
There is another format of account known as the three column account. Although in fact there are actually six columns in this accounts format, the three columns refer to the debit, credit and balance columns. An advantage of this format is that it can show the latest account balance at any particular time.
Date Description Reference Debit Credit Balance
Figure 2.4: Three column account format
2.3
RULES OF DEBIT AND CREDIT
What will happen if the rule of debit and credit are not complied with while recording the business transaction?
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We have previously stated that asset, liability and owners equity are the three main components in the accounting equation. Other items that are involved include drawings, revenue and expense. Every transaction that occurs will involve debit and credit and every transaction will affect at least two accounts. For every transaction, the total debit must be equal to the total credit. This is the basis of the double entry system. This rule of debit and credit is important to ensure that we make accurate recording. Table 2.2 shows the rules of debit and credit for each type of accounts.
Table 2.2: Rules of Debit and Credit Type of Account Asset Liability Capital Drawings Revenue Expense Increase Debit Credit Credit Debit Credit Debit Decrease Credit Debit Debit Credit Debit Credit
Do you understand the rules listed in Table 2.2? Table 2.2 shows that when the asset account increases, we will debit the said account. For example, when the entity receives cash, we will debit cash account. When the asset account decreases, we will credit the said account. For example, when the entity made cash payment, we will credit the entitys cash account. Referring to Table 2.2, we will discover that the nature of the asset account is opposite to that of the liability and owners equity accounts. To observe this more clearly, please refer back to the accounting equation we had learned: ASSET = LIABILITY + OWNERS EQUITY The asset item is on the left side while the liability and owners equity are on the right side. Asset is the economic resources owned by the entity while liability and owner equity are parties claiming ownership on the asset. Therefore, asset is the opposite of liability and owners equity.
2.3.1
Normal Balance
Normal balance is included in the rule of debit and credit. This refers to the balance ordinarily shown in the account.
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Let us take the asset account as an example. When asset increases, the account is debited. When asset decreases, the account is credited. Therefore, the normal balance for asset account is debit. This is because the reduction in asset normally would not exceed the increase that had occurred. As a simple example, if we have cash of RM1,000 in the bank, normally we cannot withdraw more than the said value. Table 2.3 shows the rules of debit and credit including the normal balances for each type of accounts.
Table 2.3: The Rules of Debit and Credit Including Normal Balances Type of Account Asset Liability Capital Drawings Revenue Expense Increase Debit Credit Credit Debit Credit Debit Decrease Credit Debit Debit Credit Debit Credit Normal Balance Debit Credit Credit Debit Credit Debit
Note that the normal balance for each account is the same as the increase in the said account. The rule of normal balance is important as it may help you to identify errors. For example, if the land account has a credit balance, you might have made a mistake in recording. However, you must also remember that normal balance is the balance that is ordinarily shown. The cash account that normally has a debit balance can also have a credit balance. This occurs when a company has withdrawn more cash than what is available. This might occur if the company has an overdraft agreement with the bank. When an entity has an overdraft agreement with the bank, it will be allowed to withdraw more money than what it is available in its account. The amount that can be withdrawn is subject to agreement.
Identify the characteristics that allow an event to be viewed as a transaction and therefore must be recorded?
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2.4
STEPS IN RECORDING PROCESS
Once the entitys transactions are identified, they must be recorded according to the accounting procedure specified. Recording begins with journal entry, then post to ledger and finally preparation of trial balance. This process can be illustrated in Figure 2.5.
Figure 2.5: Steps in recording process
2.4.1
Journal
Journal is the first book to be used in the recording process. Recording in journals (journalising) is the first process of recording. Transactions are recorded chronologically in the journal before been transferred to ledger. There are two main types of journal, the general journal and special journal. (a) General Journal General journal is the journal normally owned by all entities. This journal can be used to record all kinds of transaction like sales, purchases, cash receipts and cash payments. Special Journal Large businesses normally have many transactions. Special journals are created to avoid confusion due to many entries made in the general journal. The type of special journal created depends on the needs of the entity. For example, an entity that have numerous cash transactions might want to create Cash Receipts Journal and Cash Payment Journal that will be specially used for cash transactions. All the other transactions can still be recorded in the General Journal. This segregation will simplify recording and control. Among the special journals that are commonly used are:
(b)
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(i)
Purchase Journal: particularly for recording purchases of goods on credit. (ii) Sales Journal: particularly for recording sales of goods on credit. (iii) Cash Receipt Journal: particularly for recording all cash received. (iv) Cash Payment Journal: particularly for recording all cash payment. However, this course will only emphasise to the general journal. The format of general journal is shown in Figure 2.6.
Figure 2.6: Format of general journal
It is important to ensure that journalising is done correctly. This is because these information will be transferred to ledger for the purpose of preparing the financial statement. Errors made in the journal will result in errors in the financial statement. The name of accounts used must be specified in the beginning and used consistently in order to avoid confusion.
In your opinion, what are the appropriate journals for a book shop in a school? Please discuss.
2.4.2
Journalising and Posting of Entry
After the transactions have been recorded in the journal, it will be posted to the ledger. This process is known as transfer of entry or posting. We will now record the transactions of Reen Cyber Service in the General Journal and then post them to the ledger using the T-account format.
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Transaction 1: On I November, Reen invested RM30,000 as capital for Reen Cyber Service business. From our analysis in Topic 1, we know that this transaction will increase the cash and owners equity by RM30,000. According to the rules of debit and credit, the increase in asset account (cash) will be debited and increase in owners equity account (capital) will be credited. When recording, note that the name of the account to be debited is listed first, followed by the name of account to be credited. The name of the credited account will be aligned slightly to the right to differentiate it from the account to be debited. Journal entry: General Journal Date Nov 1 Cash Capital, Reen (Cash invested by Reen)
Journal 1: General Journal for Transaction 1
pg 1 Debit 30,000 30,000 Credit
Description
Reference
Post to ledger: Cash Nov 1 Capital, Reen 30,000
Capital, Reen Nov 1 Cash 30,000
Ledger 1: Ledger for Transaction 1
Transaction 2: On 2 November, the business purchased a piece of land valued at RM20,000. A total of RM5,000 cash had been paid while the balance is financed by bank loan (notes payable). Note that even though this transaction involves more than two accounts, the total amount of debit is still equal to the total amount of credit.
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Journal entry: General Journal Date Nov 1 Land Cash Notespayable Description Reference Debit 20,000 5,000 15,000 pg 1 Credit
(Purchased land by cash and bank loan)

Post to ledger: Land Nov 2 Cash Notes Payable 5,000 15,000 Cash Nov 1 Capital, Reen 30,000 Nov 2 Land 5,000
Notes Payable Nov 2 Land 15,000
Transaction 3: On 4 November, the business bought office supplies valued at RM2,700 on credit.
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Journal entry: General Journal Date Nov 4 Supplies AccountsPayable Description Reference Debit 2,700 2,700 pg 1 Credit
(Purchased office supplies by credit)

Post to ledger: Supplies Nov 4 AP 2,700
Accounts Payable Nov 4 Supplies 2,700
Transaction 4: On 15 November, the business received revenue from consultancy services provided to a customer. The customer paid cash of RM15,000. Journal entry: General Journal Date Nov 15 Cash Service revenue (Cash received for services provided)
pg 1 Debit 15,000 Credit 15,000
Description
Reference
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Post to ledger: Cash Nov 1 Capital, Reen 15 Service revenue 30,000 Nov 2 15,000 Service revenue Nov 15 Cash 15,000 Land 5,000
Transaction 5: On 30 November, the business paid salary expenses (RM4,250), rental expenses (RM1,600), utility expenses (RM900) and sundry expenses (RM550). Journal entry: General Journal Date Nov 30 Description Salary expenses Rentalexpenses Utilityexpenses Sundryexpenses Reference Debit 4,250 1,600 900 550 7,300 pg 1 Credit
Cash
(Cash payment for the said expenses)
Post to ledger: Cash Nov 1 Capital, Reen 15 Service revenue 30,000 15,000 Nov 2 Land 30 Salary expenses Rental expenses Utility expenses Sundry expenses 5,000 4,250 1,600 900 550
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Salary expenses Nov 30 Cash 4,250 Nov 30 Cash
Rental expenses 1,600
Utility expenses Nov 30 Cash 900 Nov 30 Cash
Sundry expenses 550
Transaction 6: On 30 November, the business paid its debt to the supplier of supplies purchased on 4 November for RM1,900. Journal entry: General Journal Date Nov 30 Description Accounts Payable Reference 1,900 1,900 Debit pg 1 Credit
Cash
(Payment to accounts payable)
Post to ledger: Cash Nov 1 Capital, Reen 15 Service revenue 30,000 15,000 Nov 2 Land 30 Salary expenses Rental expenses Utility expenses Sundry expenses 30 Accounts payable 5,000 4,250 1,600 900 550 1,900
Accounts Payable Nov 30 Cash 1,900 Nov 4 Supplies 2,700
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Transaction 7: Unused office supplies on 30 November were valued at RM1,100. Journal entry: General Journal Date Nov 30 Description Supplies expenses Supplies (Recording usage of supplies)
pg 1 Debit 1,600 Credit
Reference
1,600
Post to ledger: Supplies Nov 4 Accounts payable 2,700 Nov 30 Supplies 1,600
Supplies expenses Nov 30 Supplies 1,600

Transaction 8: On 30 November, Reen took RM4,000 cash from the business for her personal use. Journal entry: General Journal Date Description Reference Debit 4,000 4,000 pg 1 Credit
Nov 30 Drawings, Reen Cash (Cash drawings by owner)

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Post to ledger: Cash Nov 1 Capital, Reen 15 Service revenue 30,000 15,000 Nov 2 Land 30 Salary expenses Rental expenses Utility expenses Sundry expenses 30 Accounts payable 30 Drawings, Reen 5,000 4,250 1,600 900 550 1,900 4,000
Drawings, Reen Nov 30 Cash 4,000

How are you doing so far? Can you understand the recording process at this stage? By using the same transactions, we have prepared the journal entries and transferred them to ledger. The journalising and posting process that we have done is a very simple example for you to better understand the basic process, emphasising only on the date, accounts and amounts involved. In the next example, we will perform postings in detail involving reference column.
2.4.3
Example of Analysis and Summary of Transaction
The double entry system is very useful for analysing the effects of transactions. According to the system, every transaction will affect at least two items in the financial statements. In analysing the transactions, three important things that must be dealt with: (a) (b) (c) Determine whether the transaction will affect the asset, liability, owners equity, revenue or expense accounts. For every account involved, determine whether the account will increase or decrease. Decide whether the increase or decrease should be recorded as debit or credit.
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You might feel difficult at this stage to make an analysis, or feel there are too many things to remember. However, with familiarisation and frequent practice, you will find that these three things can be done simultaneously. We will now continue with the example of Reen Cyber Service by extending the transactions to December. In December, we will see more transactions. We will analyse the transactions one by one with emphasis given on the types of transaction that have not been analysed before. The transactions throughout December are listed in Table 2.4.
Table 2.4: Transactions for the month of December No. 1 2 3 Date (Dec 2000) 1 1 1 Transactions Paid insurance premium of RM4,800 for coverage against losses due to fire and burglary for a period of 24 months. Paid office rental for the month of December of RM1,600. A company planned to rent the land owned by Reen Cyber Service. The business rented the land for three months for RM720. The tenant paid the amount in cash. Purchased office equipment by credit from Office Equipment Sdn. Bhd. totalling RM3,600. Paid RM360 to advertise the business in the newspaper. Paid RM800 for the transaction on 4 December. Paid salary of temporary staff for RM1,900 for the first two weeks of December. Received RM6,200 cash from customer for services provided. Provided services valued at RM3,500 to a customer. The customer promised to pay next month. Made another payment of RM1,800 for transaction on 4 December. Customer made payment for account receivable of RM1,300. Purchased supplies by cash for RM2,900. Paid salary of temporary staff for RM2,400 for the last two weeks of December. Paid telephone and electricity bill for the month December for RM620 and RM450 respectively. Received cash of RM5,740 from customer on the services provided. Billed customer for the services provided of RM2,240. Reen made cash drawings of RM4,000.
4 5 6 7 8 9 10 11 12 13 14 15 16 17
4 6 11 13 16 16 20 21 23 27 31 31 31 31
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Transaction 1: Paid insurance premium for 24 months totalling RM4,800. Have you ever paid insurance premium? If you own a vehicle, you will be familiar with paying insurance premium. Insurance premium must be paid at the beginning of the coverage period. Payment made in advance is known as prepaid expenses and it is an asset. The asset you get is the insurance coverage for 24 months starting from 1 December 2000.
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Prepaid insurance account (asset) increased by RM4,800. Cash account (asset) reduced by RM4,800.
Prepaid insurance account (asset) increased: debit Cash account (asset) reduced: credit
Journal entry: General Journal Date Description Reference L15 L11 Debit 4,800 4,800 pg 1 Credit
Dec 1 Prepaid insurance Cash (Paid insurance premium for 24 months)
Post to ledger: Prepaid Insurance Account Date Dec 1 Cash Description Reference J2 Debit 4,800 Credit No: 15 Balance
Cash Account Date Description Reference J2 Debit Credit 4,800
No: 11 Balance
Dec 1 Prepaid insurance
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In this example, we did not use the T-account format. Instead, we used the three column account format to make you more familiar with the different types of accounting format available. This format is better as it can show the balance after each transaction. The balance column is supposed to show final balance after each transaction including the previous transactions in November. However, in this section, the column is left blank to avoid confusion. After completing all the transactions, we will combine all the processes of journal entries and entry post to ledger. After that, you will be able to understand better the function of the balance column in this three column account format. Note that for reference purposes, the account number (refer to the chart of accounts in section 1) must be recorded in the Reference column in the journal, while the page of general journal is recorded in the Reference column in the accounts. Transaction 2: Paid RM1,600 rental for the month of December . This transaction is prepaid expense as the rental expenses was paid at the beginning of December. However, it is different from transaction 1 in terms of the coverage period. In transaction 1, the premium paid was for a period of 24 months. In this transaction, the rental paid was only for one month. For such a short period, we normally do not use the prepaid rental account. This is easier as we need not make any adjustments at the end of the period.
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Rental expenses account (expense) increased by RM1,600. Cash account (asset) reduced by RM1,600.
Rental expenses account (expense) increased: debit Cash account (asset) reduced: credit
Dec 1 Rental expenses Cash (Paid rental expenses for December month)
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Post to ledger: Rental expenses Account Date Dec 1 Cash Description Reference J2 Debit 1,600 No: 11 Description Rental expenses Reference J2 Debit Credit 1,600 Balance Credit No: 52 Balance
Cash Account Date Dec 1
Do you still remember the accounting constraints on materiality that we had studied earlier? Can you relate it to the recording of transaction 2?
Transaction 3: Received RM720 from the lands tenant for rental of three months. In this transaction, the business received payment in advance of the specific period. This created an obligation or commitment on the business. By receiving three months rental in advance, Reen Cyber Service is responsible to supply land for rental in that three month period. This is a liability (the business owes services to the tenant) and the account created is deferred rental account. The deferred rental will be recognised as rental revenue at the end of the period when the services have been provided.
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Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit
Cash account (asset) increased by RM720. Deferred rental account (liability) increased by RM720.
Cash account (asset) increased: debit Deferred rental account (liability) increased: credit
Journal entry: General Journal Date Dec 1 Cash Deferred rental (Cash received for three months rental)
pg 1 Reference L11 L23 Debit 720 720 Credit
Description
Post to ledger: Cash Account Date Dec 1 Description Deferred rental Reference J2 Debit 720 No: 23 Reference J2 Debit Credit 720 Balance Credit No: 11 Balance
Deferred rental Account Date Dec 1 Description Rental expenses
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Transaction 4: Purchased office equipment on credit for RM3,600.

Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Office equipment account (asset) increased by RM3,600. Accounts payable (liability) increased by RM3,600.
Office equipment account (asset) increased: debit Accounts payable (liability) increased: credit
Dec 1 Office equipment Accounts payable (Purchased office equipment on credit) Post to ledger: Office Equipment Account Date Dec 4 Description Accounts payable Reference J2
No: 18 Debit 3,600 No: 15 Reference J2 Debit Credit 3,600 Balance Credit Balance
Account Payable Date Dec 1 Description Office equipment
Transaction 5: Paid RM360 for advertisement in newspaper. For large businesses that always advertise their products or services. For advertisement that involves large sums, a specific account (Advertisement expenses) will be created for this purpose. However, if the advertisement expenses seldom occur and immaterial, it is often recorded as sundry expenses. In the example of Reen Cyber Service, we will use the sundry expenses account to record this expense.
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Sundry expenses account (expense) increased by RM360. Cash account (asset) decreased by RM360 Sundry expenses account (expense) increased: debit Cash account (asset) decreased: credit
Journal entry: General Journal Date Description Reference L55 L11 Debit 360 360 pg 2 Credit
Dec 6 Sundry expenses Cash (Payment for advertisement expenses)
Post to ledger: Sundry Expenses Account Date Dec 6 Cash Description Reference J2 Debit 360 No: 11 Description Sundry expenses Reference J2 Debit Credit 360 Balance Credit No: 55 Balance
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Transaction 6 : Paid supplier (for transaction on 4 December) amounting to RM800.

Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Accounts payable (liability) decreased by RM800. Cash account (asset) decreased by RM800.
Accounts payable (liability) decreased: debit Cash account (asset) decreased: credit
Journal entry: General Journal Date Description Reference L21 L11 Debit 800 800 pg 2 Credit
Dec 11 Accounts payable Cash (Payment for accounts payable)
Post to ledger: Accounts payable Date Dec 11 Cash Description Reference J2 Debit 800 No: 11 Description Account payable Reference J2 Debit Credit 800 Balance Credit No: 21 Balance
Transaction 7: Paid salary of temporary staff for the first two weeks of December totalling RM1,900.
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Salary expenses account (expense) increased by RM1,900. Cash account (asset) decreased by RM1,900.
Salary expenses account (expense) increased: debit Cash account (asset) decreased: credit
Dec 13 Salary expenses Cash (Salary payment for temporary staff)
Post to ledger: Salary expense Account Date Dec 13 Cash Description Reference J2 Debit 1,900 No: 11 Description Salary expenses Reference J2 Debit Credit 1,900 Balance Credit No: 51 Balance
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Transaction 8: Received cash for services provided for RM6,200:

Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Cash account (asset) increased by RM6,200. Service revenue account (revenue) increased by RM6,200. Cash account (asset) increased: debit Service revenue account (revenue) increased: credit
Journal entry: General Journal Date Dec 16 Cash Service revenue (Received cash for services provided)
pg 2 Reference L11 L41 Debit 6,200 6,200 Credit
Description
Post to ledger: Cash Account Date Dec 16 Description Service revenue Reference J2 Debit 6,200 No: 41 Reference J2
No: 51 Credit Balance
Service revenue Account Date Dec 16 Cash Description Debit Credit 6,200
Balance
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Transaction 9: Billed customer for RM3,500 for services provided.

Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Accounts receivable (asset) increased by RM3,500. Service revenue account (revenue) increased by RM3,500. Accounts receivable (asset) increased: debit Service revenue account (revenue) increased: credit
Dec 16 Accounts receivable Service revenue (Billed customer for services provided)
Post to ledger: Accounts receivable Date Dec 16 Description Service revenue Reference J2 Debit 3,500 No: 41 Reference J2 Debit Credit 3,500 Balance Credit No: 12 Balance
Service revenue Account Date Dec 16 Description Accounts receivable
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Transaction 10: Payment of RM1,800 to supplier (for transaction on 4 December).

Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Accounts payable (liability) decreased by RM1,800. Cash account (asset) decreased by RM1,800. Accounts payable (liability) decreased: debit Cash account (asset) decreased: credit
Journal entry: General Journal Date Dec 20 Description Accounts payable Cash (Payment to accounts payable)
Post to ledger: Accounts payable Date Dec 20 Cash Description Reference J3 Debit 1,800 No: 11 Description Accounts payable Reference J3 Debit Credit 1,800 Balance Credit No: 12 Balance
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Transaction 11: Customer paid cash RM1,300 as payment on its accounts receivable.
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Cash account (asset) increased by RM1,300 Accounts receivable (asset) decreased by RM1,300 Cash account (asset) increased: debit Accounts receivable (asset) decreased: credit
Journal entry: General Journal Date Dec 21 Cash Accounts receivable (Payment received for accounts receivable)
Description
Post to ledger: Cash Account Date Dec 21 Description Accounts receivable Reference J3 Debit 1,300 No: 12 Reference J3
No: 11 Credit Balance
Accounts Receivable Date Dec 21 Cash Description Debit Credit 1,300
Balance
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Transaction 12: Purchased supplies by cash for RM2,900.

Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Supplies account (asset) increased by RM2,900. Cash account (asset) decreased by RM2,900. Supplies account (asset) increased: debit Cash account (asset) decreased: credit
Journal entry: General Journal Date Dec 23 Account and Description Supplies Cash (Purchased supplies by cash) Reference L14 L11 Debit 2,900 pg 3 Credit 2,900
Post to ledger: Supplies Account Date Dec 23 Description Cash Reference J3 Debit 2,900 Credit No: 14 Balance No: 11 Reference J3 Debit Credit 2,900 Balance
Cash Account Date Dec 23 Description Supplies
Transaction 13: Paid salary of temporary staff for the last two weeks of December totalling RM2,400.
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Salary expenses account (expense) increased by RM2,400. Cash account (asset) decreased by RM2,400. Salary expenses account (expense) increased: debit Cash account (asset) decreased: credit
Journal entry: General Journal Date Dec 27 Description Salary expenses Cash (Payment for salary of temporary staff) Reference L51 L11 Debit 2,400 pg 3 Credit 2,400
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Post to ledger: Salary expenses Account

Date Dec 27 Cash Description Reference J3 Reference J3 Debit 2,400 Credit
No: 51 Balance No: 11
Cash Account
Date Dec 27 Description Salary expenses Debit Credit 2,400
Balance
Transaction 14: Made payment for telephone and electricity bill for December, RM620 and RM450, respectively. The payment of bills like electricity, water and telephone are normally grouped into the utility expenses account. This is because the expenses incurred are normally immaterial in terms of amount and significance until the entity has to open a separate account for each type of bill. Therefore, the total utility expenses paid on this date is RM1,070.
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Utility expenses account (expense) increased by RM1,070. Cash account (asset) decreased by RM1,070. Utility expenses account (expense) increased: debit Cash account (asset) decreased: credit
Journal entry: General Journal

Date Dec 31 Description Utility expenses Cash (Payment for telephone and electricity bill for December) Reference L53 L11 Debit 1,070
pg 3
Credit 1,070
Post to ledger: Utility expenses Account

Date Dec 31 Date Dec 31 Description Cash Reference J3 Debit 1,070 Credit
No: 53
Balance
Cash Account
Description Reference Debit Utility expenses J3 Ledger 22: Ledger for Transaction 14 Credit 1,070
No: 11
Balance
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Transaction 15: Received cash RM5,740 for services provided.

Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Cash account (asset) increased by RM5,740. Service revenue account (revenue) increased by RM5,740. Cash account (asset) increased: debit Service revenue account (revenue) increased: credit
Journal entry: General Journal Date Dec 31 Description Cash Service revenue (Received cash for services provided) Reference L11 L41 Debit 5,740 pg 3 Credit 5,740
Post to ledger: Cash Account Date Description Dec 31 Service revenue Service revenue Account Date Description Dec 31 Cash Reference J3 Reference J3 Debit 5,740 Debit Credit No: 11 Balance No: 41 Balance
Credit 5,740
Transaction 16: Billed customer for RM2,240 for services provided.

Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Accounts receivable (asset) increased by RM2,240 Service revenue account (revenue) increased by RM2,240 Accounts receivable (asset) increased: debit Service revenue account (revenue) increased: credit

Date Dec 31 Description Reference Accounts receivable L12 Service revenue L41 (Billed customer for services provided) Journal 24: General Journal for Transaction 16 Debit 2,240
pg 3
Credit 2,240
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Post to ledger: Account Receivable Date Description Dec 31 Service revenue Service revenue Account Date Description Dec 31 Accounts receivable
Reference J3 Debit 2,240 Credit
No: 12 Balance No: 41 Balance
Reference Debit J3 Ledger 24: Ledger for Transaction 16
Credit 2,240
Transaction 17: Owner made cash drawings of RM4,000.

Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Drawings account (contra owner equity) increased by RM4,000 Cash account (asset) decreased by RM4,000. Drawings account (contra owner equity) increased: debit Cash account (asset) decreased: credit
Notes: Although the drawings account is a type of owner equity account, it has an opposite feature against the owners equity. Therefore, we will put the word contra to show the difference.

Date Dec 31 Description Drawings, Reen Cash (Cash drawings by Reen). Reference L32 L11 Debit 4,000
pg 3
Credit 4,000
Post to ledger: Drawings, Reen Account Date Description Dec 31 Cash Cash Account Date Description Dec 31 Drawings, Reen
Reference J3 Reference J3
Debit 4,000 Debit
Credit
No: 32 Balance No: 11 Balance
Credit 4,000
After analysing all the transactions one by one, we will now combine all the journal entries and entries posting involved throughout the month of November and December 2000.
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The following are the general journal entries and postings throughout November and December 2000. GENERAL JOURNAL Date Nov 1 Account and Description Cash Capital, Reen (Investment by Reen) Land Cash Notes payable (Purchase of land by cash and bank loan) Supplies Accounts payable (Purchase of supplies on credit) Cash Service revenue (Received cash for services provided) Salary expenses Rental expenses Utility expenses Sundry expenses Cash (Payment of expenses by cash) Account payable Cash (Payment to accounts payable) Supplies expenses Supplies (Recording of supplies usage) Drawings, Reen Cash (Cash drawings by owner) Reference L11 L31 L17 L11 L22 Debit 30,000 pg 1 Credit 30,000 20,000 5,000 15,000
L14 L21 L11 L41
2,700 2,700 15,000 15,000
15
30
L51 L52 L53 L55 L11 L21 L11 L54 L14 L32 L11
4,250 1,600 900 550 7,300 1,900 1,900 1,600 1,600 4,000 4,000
30
30
30
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GENERAL JOURNAL Date Dec 1 Account and Description Prepaid Insurance Cash (Paid insurance premium for 24 months) Rental expenses Cash (Paid rental for December) Cash Deferred rental (Cash received for three months rental) Office equipment Accounts payable (Purchased office equipment by credit) Sundry expenses Cash (Payment for advertisement expenses) Accounts payable Cash (Payment to accounts payable) Salary expenses Cash (Payment for salary of temporary staff) Cash Service revenue (Received cash for services provided) Accounts receivable Service revenue (Billed customer for services provided) Reference L15 L11 Debit 4,800
pg 2 Credit 4,800
L52 L11 L11 L23
1,600 1,600 720 720
L18 L21
3,600 3,600
L55 L11
360 360
11
L21 L11 L54 L11
800 800 1,900 1,900
13
16
L11 L41
6,200 6,200
16
L11 L41
3,500 3,500
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GENERAL JOURNAL Date Dec 20 Account and Description Accounts payable Cash (Payment to accounts payable) Cash Accounts receivable (Received payment for accounts receivable) Supplies Cash (Purchased of supplies by cash) Salary expenses Cash (Payment for salary of temporary staff) Utility expenses Cash (Payment of telephone and electricity bill) Cash Service revenue (Received cash for services provided) Accounts receivable Service revenue (Billed customer for services provided) Drawings, Reen Cash (Cash drawings by owner) Reference L12 L11 L11 L12 Debit 1,800
pg 3 Credit 1,800 1,300 1,300
21
23
L14 L11 L54 L11 L53 L11
2,900 2,900 2,400 2,400 1,070 1,070
27
31
31
L11 L41 L12 L41 L32 L11
5,740 5,740 2,240 2,240 4,000 4,000
31
31
Journal 26: General Journal for Reen Cyber Service for the month of November and December 2000.
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GENERAL LEDGER Cash Account Date Nov 1 2 15 30 Description Capital, Reen Land Service revenue Salary expenses Rental expenses Utility expenses Sundry expenses Accounts payable Drawings, Reen Prepaid insurance Rental expenses Deferred rental Sundry expenses Accounts payable Salary expenses Service revenue Accounts payable Accounts receivable Supplies Salary expenses Utility expenses Service revenue Drawings, Reen Reference J1 J1 J1 J1 J1 J1 J1 J1 J1 J2 J2 J2 J2 J2 J2 J2 J3 J3 J3 J3 J3 J3 J3 Debit 30,000 15,000 4,250 1,600 900 550 1,900 4,000 4,800 1,600 720 360 800 1,900 6,200 1,800 1,300 2,900 2,400 1,070 5,740 4,000 Credit 5,000 No: 11 Balance 30,000 25,000 40,000 35,750 34,150 33,250 32,700 30,800 26,800 22,000 20,400 21,120 20,760 19,960 18,060 24,260 22,460 23,760 20,860 18,460 17,390 23,130 19,130
30 30 Dec 1
6 11 13 16 20 21 23 27 31 31 31 *
It was previously explained that the Balance column will show the updated balance after each transaction. Can you relate to it now? No: 12 Reference J2 J3 J3 Debit 3,500 2,240 Credit 1,300 Balance 3,500 1,100 4,440
Accounts Receivable Date Dec 16 21 31 Description Service revenue Cash Service revenue
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Supplies Account Date Nov 4 30 Dec 23 Description Accounts payable Supplies expenses Cash Reference J1 J1 J3 Debit 2,700 2,900 Credit 1,600
No: 14 Balance 2,700 1,100 4,000 No: 15 Reference J2 Debit 4,800 Credit Balance 4,800 No: 17 Description Reference J1 J1 Debit 5,000 15,000 Credit Balance 5,000 20,000 No: 18 Reference J2 Debit 3,600 Credit Balance 3,600 No: 22 Description Reference J1 J1 J2 J2 J3 Debit 1,900 3,600 800 1,800 Credit 2,700 Balance 2,700 800 4,400 3,600 1,800 No: 22 Reference J1 Debit Credit 15,000 Balance 15,000 No: 23 Reference J2 Debit Credit 720 Balance 720
Prepaid insurance Account Date Dec 1 Description Cash
Land Account Date Nov 2 Cash Notes payable
Office Equipment Account Date Dec 4 Description Accounts payable
Accounts Payable Date Nov 4 30 Dec 4 11 20 Supplies Cash Supplies Cash Cash
Notes Payable Account Date Nov 2 Description Land
Deferred Rental Account Date Dec 1 Description Cash
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Capital, Reen Account Date Nov 1 Description Cash Reference J1 Debit Credit 30,000
No: 31 Balance 30,000 No: 32 Reference J1 J3 Debit 4,000 4,000 Credit Balance 4,000 8,000 No: 41 Reference J1 J2 J2 J3 J3 Debit Credit 15,000 6,200 3,500 5,740 2,240 Balance 15,000 21,200 24,700 30,440 32,680 No: 51 Reference J1 J2 J3 Debit 4,250 1,900 2,400 Credit Balance 4,250 6,150 8,550 No: 52 Reference J1 J2 Debit 1,600 1,600 Credit Balance 1,600 3,200 No: 53 Reference J1 J3 Debit 900 1,070 Credit Balance 900 1,970 No: 54 Reference J1 Debit 1,600 Credit Balance 1,600
Drawings, Reen Account Date Nov 30 Dec 31 Description Cash Cash
Service Revenue Account Date Nov 15 Dec 16 31 Description Cash Cash Accounts receivable Cash Accounts receivable
Salary Expenses Account Date Nov 30 Cash Dec 13 Cash 27 Cash Description
Rental Expenses Account Date Nov 30 Dec 1 Description Cash Cash
Utility Expenses Account Date Nov 30 Dec 31 Description Cash Cash
Supplies Expenses Account Date Nov 30 Description Supplies
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Sundry Expenses Account Date Nov 30 Dec 6 Description Cash Cash Reference J1 J2 Debit 550 360 Credit
No: 55 Balance 550 910
2.4.4
Trial Balance
Trial balance is a list of all the accounts used including the corresponding balances at a specific date. Normally the trial balance would be prepared at the end of the specific accounting period and the debit and credit totals need to be equal. The main purpose of preparing the trial balance is to ensure that the total debit and credit balances are the same. Unequal amount of total balances indicate that errors had happened in any one of the stages in the recording process, whether during the journal entry, posting to ledger or the preparation of the trial balance itself. However, it must always be kept in mind that a balanced trial balance does not necessarily mean that there are no errors. Examples of errors that can occur even though the trial balance is balanced are: (a) the transaction has not been recorded at all in the journal; (b) the transaction entry has not been posted to the ledger; (c) the transaction of entry posted to ledger had been done twice; and (d) the usage of wrong account during journalising or posting. In the first case, the transaction was not recorded at all. Both the debit and credit sections were not affected. Therefore, the trial balance will be balanced, only the total would be less than what it should have been. In the second case, the transaction had been recorded in the journal without being posted to ledger. The result is the same as with the first case because the trial balance is prepared based on the ledger balance. In the third case, the entry was posted correctly, but twice. The trial balance will be balanced, only the total would be more than what it should have been. In the final case, the debit and credit amount is equal, only that they have been recorded on the wrong side of the accounts. The final balance of the trial balance would be the same as it should be, but there will be errors in the last balance of the individual accounts. For example, when a business purchased supplies by cash, the correct entry should be to debit the supplies account and to credit the
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cash account. However, a mistake was made by debiting cash and crediting supplies. Although the accounts have been recorded wrongly, the trial balance will still be balanced. Only the individual balances in the cash account and supplies account will be incorrect. This error is quite difficult to detect as the final amount in the trial balance is still equal.
EXERCISE 2.2
1. 2. What is meant by account, ledger and chart of accounts? State TWO account format of that you have learned. Which is the easier format? Which format will show the latest balance after each transaction? Drawings and expense will reduce owners equity. Discuss the difference between these two terms. Which of the following accounts have a normal debit balance? A. Owners capital B. Deferred rental C. Prepaid expense D. Service revenue A credit balance in which account might indicate an error? A. Rental revenue B. Accounts payable C. Drawings D. Capital Group the following accounts according to its type (asset, liability, owners equity, revenue or expense): (a) Vehicle (b) Insurance expenses (c) Prepaid insurance (d) Rental revenue (e) Deferred rental (f) Supplies (g) Supplies expenses (h) Accounts receivable
3.
4.
5.
6.
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7.
Cindy established Cindy Insurance Agency on 1 April 2001. The effects of all transactions throughout April 2001 are summarised in the following schedule:
Asset Trans. a. Cash +5,000 + AR + Supplies = = Liability AP + + Owners Equity Capital, Cindy +5,000 Capital, Cindy +3,250 Service revenue -750 Paid rental expense -125 +1,875 +1,875 Service revenue -390 Paid utility expense -187 Paid sundry expense -1,250 Paid salary expense -162 Paid supplies expenses -550 Drawings, Cindy
b. c.
+275 +3,250
+275
d.
750
e. f.
-125
g.
-577
h.
-1,250
i.
-162
j.
-500
-50
Required: (a) Prepare the journal entries for all the above transactions. (b) Transfer the entries to ledger using the 3 column account format. (c) Prepare the trial balance as at 30 April 2001.
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8.
The following are the chart of accounts and accounts balances for Edlin Enterprise on 1 February 2001:
Account No 101 102 104 108 201 301 302 401 501 502 503 509 Cash Accounts receivable Supplies Office equipment Accounts payable Capital, Edlin Drawings, Edlin Service revenue Rental expenses Advertisement expenses Utility expenses Sundry expenses Accounts Balance as at 1/2/01 (RM) 15,238 4,575 427 8,400 1,730 26,910
Transactions involving Edlin Enterprise throughout the month of February 2001 are:
Date Feb 1 2 5 9 15 18 25 28 Transaction Purchased office supplies by cash RM274. Edlin withdrew cash from business totalling RM2,000 for personal use. Received RM2,740 cash from customer for payment on accounts receivable. Purchased office equipment valued at RM4,000 on credit. The seller agreed to give a discount of RM150 from the amount. Made payment to accounts payable for RM1,200. Received cash for services provided for RM580. Paid RM420 to advertise its business in the newspaper. Paid telephone bills (RM75 for Edlins house and RM135 for business) and electricity bills (RM42 for Edlins house and RM80 for business). All the payments had been made using money from his savings. Paid RM1,200 for rental of business premises. Paid RM220 to repair the office equipment.
29 30
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Required: (a) Prepare the journal entries to record all the above transactions by using the accounts listed in the chart of accounts for Edlin Enterprise. (b) Post the entries to ledger by using the three column account format. (c) Prepare the trial balance as at 28 February 2001.
The important matters discussed in this topic were: 1. 2. 3. 4. The chart and format of accounts used to present the financial report of an organisation. The rules of debit and credit are fundamental to the double entry system. The rules of normal balance for each type of account are used to assist in identifying errors in recording. Steps in recording beginning from journal entry, posting entries to ledger and preparation of the trial balance.
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TUTORIAL QUESTION INTRODUCTION

The main purpose of this activity is to enable you to understand the analysis of transactions and recording process. The comprehensive question that follows will cover this entire unit.
QUESTION
The balances of assets and liabilities accounts for the business of Anggun Rias as at 1 January 2001 are: Accounts Cash Accounts receivable Supplies Land Accounts payable Balance (RM) 2,500 4,780 980 30,000 2,350
Anggun Rias is owned by Mrs. Disdi and operated as a sole proprietor business offering services in image consultancy. The transactions incurred by the business throughout the month of January 2001 are as follows: (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) Mrs. Disdi made a cash investment of RM5,000 for market expansion. Received RM2,920 in cash from customers for services provided. Paid creditors RM1,350. Paid RM2,000 office rental for the month of January. Billed customers for RM4,245 for services provided. Purchased supplies valued at RM280 on credit. Sent staff to attend beautification course, the fees of RM500 was paid by cash. Mrs. Disdi has a special allocation for staff training. Received cash from customer for RM2,000 as payment on accounts receivable. The value of the balance of supplies at the end of the month was calculated at RM750. Paid staff salary amounting to RM2,000, utility expenses of RM800 and RM155 in expenses. Mrs. Disdi took supplies valued at RM100 for personal use.
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QUESTION
1. 2. Determine the amount of asset, liability and owners equity for the business of Anggun Rias as at 1 January 2001. Analyse each transaction using the accounting equation format that you have learned. For each transaction, show the increase or decrease that has occurred. Also show the balance after each transaction. Prepare: (a) Income Statement for the month of January 2001. (b) Statement of Changes in Owners Equity for the month of January 2001. (c) Balance Sheet as at 31 January 2001. (d) Cash Flow Statement for the month of January 2001.
3.
To resolve this problem, you must: 1. understand what is meant by asset, liability and owners equity. You must also be familiar with several examples of the common accounts used for each type of account. know the structure of the accounting equation and the effect of transactions on the components in the equation. be familiar with the formats of the four main financial statements in financial reporting.
2. 3.
Topic
3 Financial
Statements
LEARNING OUTCOMES
At the end of this topic, you should able to: 1. 2. 3. identify the accounts contained in the income statement and in the balance sheet; prepare the statement of retained earnings and cash flow statement; and interpret the financial statements prepared.
INTRODUCTION
Financial statement is a summary data on asset, liability and equity as well as income and expenditure of a business for a specific period. Financial statement is used by financial managers to evaluate the companys status and for making the companys future planning. In this chapter, you will learn about the four main financial statements, which are the income statement, balance sheet, statement of retained earnings and cash flow statement. In the beginning, you will be exposed to the basic format of each financial statement. Subsequently, you will learn how to prepare each of the financial statement. Understanding of the financial statements are important as these financial statements will assist in evaluating the companys performance.
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FINANCIAL STATEMENTS
3.1
ANNUAL REPORT AND USERS OF FINANCIAL STATEMENTS
Who are the users of financial statements? What sort or type of information is required by them?
Figure 3.1: Information in the annual report
Companies are required to report their businesss financial status at the end of each accounting period in the annual report. Annual reports usually contain messages from the chairman, financial statements and notes explaining the practices and policies adopted in reporting the companys accounts. There are two types of information in an annual report. The first section is the message from the chairman. It reports the companys achievement throughout that year and discusses on new developments that will affect the companys future operations. The second section will report on the basic financial statements such as the income statement, balance sheet, statement of retained earnings and cash flow statement. Financial statements illustrate the operations and financial status of a company. Detailed data are prepared for past two or three years together with a summary
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of the main statistics for the past five or ten years. Normally, financial statements are followed by notes explaining in detail the items found in the statements. These notes explain the policies or accounting practices that were used in the preparation of the financial statements. For example, further notes on inventory might explain the method of inventory recording being adopted by the company. Several groups of users are interested in the information contained in the financial statements. They examine the statements in detail and interpret the information according to their own interests. The objective of the analysis is the evaluation on the specific aspect of the companys performance. The information required by the user depends on the type of intended decision. We can divide the users of financial statements into two groups:
Figure 3.2 Two groups of users of financial statements
(a)
Internal users include the manager and other officers that operate the business. They are responsible in planning the strategies and operations of the company. Therefore, they use the financial statements to obtain information on the overall companys performance. External users of the company are not directly involved in the operations of the company. They comprise of users whom have direct interest in the company (such as shareholders, investors and creditors) and users whom have indirect interest in the company (such as customers, tax agent and labour organisations).
(b)
Shareholders and potential investors use financial statements to help them to interpret what will happen to the company in the future. Short-term creditors will look at the companys liquidity while long-term creditors look at the ability of the company to settle the interests and payment of the long-term principal debts.
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The Companies Act 1965 stipulates that at least four of the following financial statements must to be included in the annual reports, which are: income statements; balance sheet; statement of retained earnings; and cash flow statement
Let us look at these financial statements and the relationship between each of them by basing on the financial statements of Company FAZ as an example.
3.2
INCOME STATEMENT
What are the usages of income statement to the financial operations of a company?
Income statement measures the operating performance of a company for a specific period, normally for a period of one year ending at a specific date, usually at 31 December. Monthly statements are also prepared for the usage of the management who required more frequent information to enable more prudent decisions to be made. Yearly quarter statements are also prepared for shareholders of public companies. Income statements provide information to evaluate the firms performances. To measure a firms performance, several important aspects in the income statement must be given priority: Sales figure can be compared with the firms sales for the previous year and the expected sales in the future. This information can be used for the firms future planning. Gross profit/gross loss can be compared with the sales figure to show profit from the products/services sold. Firm expenditures can be compared with the firms expenditures for the previous year to see which policy can be adopted to reduce costs.
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Table 3.1 is the income statement of Company FAZ for year ended 31 December 2002. This statement starts with sales revenue that is the sales value in ringgit throughout the accounting period. Cost of goods sold is deducted from the sales revenue to obtain gross profit of RM70,000. This total is the amount obtained from sales to cover the financial operating costs and tax. All the operating expenditures such as sales expenses, general and administrative expenses and depreciation expenses will be listed and totalled to obtain the total operating expenditure. This total will then be deducted from the gross profit to obtain profit from operations of RM37,000. Profit from operations is the profit obtained from activities of manufacturing and selling of products; it does not take into account the financial costs and tax. Profit from operations is also known as profit before interest and tax. Thereafter, the financial cost that is the interest expenses of RM7,000 will be deducted from the profit from operations to obtain the profit before tax of RM30,000. After deducting tax, we will obtain profit after tax (or profit before preference shares) of RM18,000. Any dividends for preference shares must be deducted from the profit after tax to obtain net profit. This total is also known as profit available to the ordinary shareholders and is the total obtained by the company on behalf of ordinary shareholders throughout the specific period. Normally, reports on earnings per share are provided at the last section of the income statement. Earnings per share show the total obtained by the company throughout the specific period for each ordinary share. In year 2002, Company FAZ obtained RM17,000 for the ordinary shareholders or RM0.17 for each share issued (total ordinary shares is 100,000). Earnings per share are often referred as the bottom line to show that earnings per share are the most important item in the income statement compared to the other items.
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Figure 3.3: Companys objectives are to increase earnings and maximise profit
If you are one of the preference shareholders in Company FAZ, how would the information contained in the companys financial statements be useful to you?
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Table 3.1: Income Statement
Company FAZ Income Statement for the Year Ended 31 December 2002
Sales Less: Cost of goods sold Gross profit Less: Operating expenditure Sales expenses Administrative and general expenses Depreciation expenses Total operating expenditure Profit before interest and tax Interest Profit before tax Tax (40%) Profit after tax Less: Dividend for preference shares Net profit (or profit available for ordinary shareholders) Earnings per share = Net profit/ total ordinary shares RM 170,000 100,000 70,000 8,000 15,000 10,000 33,000 37,000 7,000 30,000 12,000 18,000 1,000 17,000 0.17
3.3 BALANCE SHEET
Explain in further detail the difference between asset, liability and equity.
Balance sheet is a statement that summarises the status of a company at a specific point of time. Balance sheet shows the accounts for assets, liabilities and equities. It balances the companys assets (what it owns) with its financing, either debts
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Table 3.2: Balance Sheet
Company FAZ
Balance Sheet As at 31 December 2002 and 2001 31-12-2002 RM Assets Current assets Cash Marketable securities Account receivables Inventory 31-12-2001 RM
Total current assets

Long-term assets Land and building Machines and equipment Fixtures and fittings Vehicles Others (including lease)
40,000 60,000 40,000 60,000 200,000 120,000 85,000 30,000 10,000 5,000 250,000 130,000 120,000 320,000
30,000 20,000 50,000 90,000 190,000 105,000 80,000 22,000 8,000 5,000 220,000 120,000 100,000 290,000
Total fixed assets

Less: Accumulated depreciation Fixed assets, net TOTAL ASSETS Liabilities and Equities Current liabilities Account payable Notes payable Tax accrual
Total current liabilities

Long-term debts
Total liabilities
Equities Preference shares Ordinary shares, RM10 par value, 4,500 shares Paid-up capital above par Retained earnings
70,000 60,000 10,000 140,000 60,000 200,000 10,000 12,000 38,000 60,000 120,000 320,000
50,000 70,000 20,000 140,000 40,000 180,000 10,000 12,000 38,000 50,000 110,000 290,000
Total equities
TOTAL LIABILITIES AND EQUITIES
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3.3.1
Assets
Assets are valuable economy resources owned by the business. It can be used in several activities such as manufacturing, usage and exchange. Assets have service potential or will bring economic benefit in the future. Assets have the capability to provide services or generate benefit to the business entity that owns it. In businesses, services or economic benefit will generate cash inflow (receiving cash) to the business. Assets can be categorised into current assets and long-term assets. Assets are listed in the balance sheet according to its liquidity level from the most liquid to the less liquid. Therefore, current assets are arranged first, followed by fixed assets. (a) Current Assets Current assets are assets that can be converted into cash in the shortest period, which is within a year or less. The current assets for Company FAZ comprised of: Cash Marketable securities Account receivables Inventory
Cash is the most liquid of current assets. Marketable securities such as government bills or deposit certificates are short-term investments that are highly liquid. Marketable securities can sometimes be seen as a form of cash due to its high liquidity. Account receivables are debts owed by customers who bought goods by credit from the company. Inventory comprised of raw materials, work in process and finished goods held by the company. Other current assets which are not in Company FAZs balance sheet are prepaid expenses (prepayment). Prepaid expenses are expenses that have been paid in advance by cash but the benefits from the expenses have not been received. Examples of prepaid expenses are prepaid rental, prepaid insurance and office supplies. (b) Long-Term Assets Long-term assets are assets that are held by the company for a rather long period, which is more than a year. Long-term assets are categorised into fixed assets, other long-term assets and intangible assets. The long-term assets of Company FAZ only comprised of fixed assets.
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Fixed assets are land and buildings, machines and equipment, fixtures and fittings and vehicles. Usually, a company will report the total fixed asset that is the original cost of all the fixed assets owned by the company. From that total, the company will deduct the accumulated depreciation for all fixed assets to obtain net fixed assets. All fixed assets must be depreciated except for land. This is because the value of land will always increase while the values of other fixed assets such as machines and equipment, as well as vehicles will decrease when the life span of the asset increases. Other long-term assets comprise of long-term investments (such as bonds and shares) prepaid expenses and account receivables that involve a period of more than a year. Besides current assets and fixed assets, a business might show intangible assets in its balance sheet. Intangible assets are long-term assets that cannot be physically seen and usually provides a competitive advantage compared to the competitors. Examples of intangible assets are patents, franchise licences, licences, trademarks, copyrights and goodwill. Although these assets cannot be physically seen, it is recorded using the same method as the other fixed assets. This means that the assets will be recorded at its original cost and this cost will be amortised throughout its lifetime. Among the intangible assets that are famous are the patent of Polaroid, the franchise of McDonald and the trademark of Colonel Sanders Kentucky Fried Chicken.
If you used a private vehicle to conduct the companys business, would that vehicle be considered a companys asset?
3.3.2
Liabilities
Most businesses have been in situations where they need to take loans to finance the businesss assets or to buy assets such as raw materials on credit. Liabilities are claims made by creditors on the company assets. In other words, liabilities are debts and obligations of a company. Liabilities comprise of current liabilities and long-term liabilities. If a situation occurs where the company is unable to pay its business liabilities, the creditors can force the company to be liquidated. In this situation, the
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creditors claims must be settled first before the company can settle the claims of the shareholders. (a) Current Liabilities Current liabilities are short-term debts, or debts that will mature within the period of one year or less. Company FAZs current liabilities are: Account payable; Notes payable; and Tax accrual
Account payable is the obligation of the company towards its suppliers when the company purchases raw materials and finished goods on credit. Notes payable is a written obligation of Company FAZ. The obligation is with the Bank for the loan to purchase vehicles for the usage of the company. The company also has tax accrual, that is the tax that must be paid to the government but still outstanding. Other current liability that is not in the balance sheet of Company FAZ is deferred income. Deferred income is cash that had been received from customers but the services or products paid had not been provided. Examples of deferred income are deferred rental and deposit from customers. (b) Long-Term Liabilities Long-term liabilities are the responsibilities or obligations that mature in a period of more than a year. These claims might be in the type of bonds, long-term notes payable and lease. Bonds are a type of fixed income securities that are issued by companies. Notes payables are a type of credit transaction that involves a written agreement between the company and creditors. Mortgage loans are longterm loan that use the assets (such as land and buildings) as a mortgage for the loan. Notes payable can also be mortgaged with the other assets as a security for the loan. A lease is a contractual agreement between the lessor and the lessee. The lessor gives the right to the lessee to use the asset for a specific period and will impose charges for usage of the asset.
3.3.3
Owners Equity or Shareholders Equity
Owners or shareholders claim towards the assets are known as owners equity or shareholders equity. In the balance sheet of Company FAZ, the owners equity comprised of:
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(a) (b) (c) (d)
preference shares; ordinary shares; paid up capital above par; and retained earnings
Preference shares are securities that provide fixed return dividend to its holders. Preference shareholders do not have ownership in the company. Ordinary shares are securities that reflect the ownership of the company. Ordinary shareholders are the real owners of the company. They will receive returns in dividends that will be paid to them in cash or shares (bonus issues). There will be situations where the par value (stated value) is not equal to the market price of the ordinary shares at the time of issue. Cash earnings from the issuance of shares might be equal, more or less from the par value. When this situation occurs, the company will record the issuance of shares at the par value in the Ordinary Shares account and the difference between the par value and the shares selling price (surplus earnings) will be recorded in a separate account known as Paid Up Capital Above Par. Retained earnings are the total accumulated earnings since incorporation that had not been distributed to the shareholders as dividend but was re-invested into the company. It is important to remember that retained earnings are not cash but are earnings that have been used to finance the companys assets.
3.3.4
Summary of Basic Accounting
Assuming that a newly started business was self financed by the businesss owner. This means that all the companys assets belongs or claimable by the businesss owner. This relationship can be shown by the equation below: Assets = Owners Equity However, businesses are normally financed by the businesses owners and creditors. Therefore, claims on the assets are equal to the claims by the creditors (liabilities) added with the claims by the owner of the business (owners equity) towards the assets. This relationship can be shown in the equation below: Assets = Liabilities + Owners Equity
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The equation above is known as the summary of basic accounting where the total assets must be equal to the total liabilities plus owner's equity. Owner's equity is equal to total assets less total liabilities. This is because the assets of a business are financed by either the creditors or the owner. To determine the owner's portion (owner's equity), we must deduct the creditors' portion (liabilities) from the assets. The balance will be the claim of the owner on the business's assets. As the creditors' claims would be given priority over the owner's claims upon liquidation, the owner's claims are also known as residual equity.
By using the summary of basic accounting, connect the relationship between cash, account payable, account receivable, retained earnings, marketable securities and ordinary shares.
EXERCISE 3.1
1. Balance sheet is the statement on the financial status of a company for a specific period. (a) True (b) False Income statement is the statement that attempts to measure the result of a company's operating decisions at specific point of time. (a) True (b) False Fixed assets are items would not be converted into cash within a period of one year. (a) True (b) False Investments in financial securities are considered as current assets (a) True (b) False Which is FALSE? A. Assets = Liabilities + Owner's Equity B. Assets Liabilities = Owner's Equity C. Assets + Liabilities = Owner's Equity D. Assets Owner's Equity = Liabilities
2.
3.
4.
5.
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6.
Mark on each of the accounts listed below as follows: (a) In column (1), state the appropriate statement whether the account is in the Income Statement (IS) or the Balance Sheet (BS) (b) In column (2), state whether the account is a current asset (CA), fixed asset (FA), current liabilities (CL), long term liabilities (LTL), shareholder's equity (SE), income (I) or expenditure (EX).
(1) Statement _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ _______________ (2) Type of Account ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ ___________________
Account Account payable Account receivable Accrual Building General expenses Interest expenses Sales expenses Operating expenses Administrative expenses Tax Preference shares dividends Sales revenue Long-term debts Inventory Cost of goods sold Paid up capital above par Notes payable Retained earnings Equipments Ordinary shares Preference share Marketable securities Depreciation Accumulated depreciation Land Cash
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7.
Use the relevant items listed below to prepare the income statement for Company PC for period ending 31 December 2001.
Value as at 31 December 2001 (RM 000) 3,500 2,050 2,850 550 600 250 100 5,250 350 2,650
Items Account receivable Accumulated depreciation Cost of goods sold Depreciation expenses General and administrative expenses Interest expenses Preference shares dividends Sales revenue Sales expenses Shareholders equity Tax Rate = 30%
8.
Use the relevant items from the list below to prepare the balance sheet for Company ODC as at 31 December 2001.
Item Account payable Account receivable Accrual Building General expenses Depreciation expenses Sales revenue Long-term loans Inventory Equipments Cost of goods sold Machines Paid up capital above par Note payable Retained earnings Ordinary shares (at par) Preference shares Marketable securities Accumulated depreciation Land Cash Value at 31 December 2001 (RM 000) 2,200 4,500 550 2,250 3,200 450 3,600 4,200 3,750 2,350 25,000 4,200 3,600 4,750 2,100 900 1,000 750 2,650 2,000 2,150
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3.4
STATEMENT OF RETAINED EARNINGS
Statement of retained earnings showed how the retained earnings account in the balance sheet is adjusted between two dates of the balance sheet. Statement of retained earnings will adjust the net profit generated throughout the period and any dividends paid, with the changes in the retained earnings in the beginning and ending of the year. Table 3.3 showed the statement of retained earnings for Company FAZ for year ended 31 December 2002. The statement showed that the company started with a retained earnings of RM50,000 on 31 December 2001 or 1 January 2002 and profit after tax of RM18,000 (data obtained from the income statement). From this total, the company had paid dividends for preference shares of RM1,000 and dividends for ordinary shares of RM7,000. Therefore, the retained earnings had increased by RM10,000 from RM50,000 as at 1 January 2002 to RM60,000 as at 31 December 2002.
Table 3.3: Statement of Retained Earnings Company FAZ Statement of Retained Earnings for the Year Ended 31 December 2002 Retained earnings, 1 January 2002 + Net profit (throughout year 2002) Dividends paid (throughout year 2002) Preference shares Ordinary shares Retained earnings, 31 December 2002 RM50,000 18,000 RM1,000 7,000
8,000 RM60,000
3.5
CASH FLOW STATEMENT
What will affect the status of cash and marketable securities of a company?
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Cash flow statement shows how the activities in a company such as operating, investing and financing activity that can influence the status of cash and marketable securities. Cash flow statement is the statement that summarises the cash flow throughout a specific period, normally for the current year ended. Data from the balance sheet and income statement are used to prepare the cash flow statements. Cash flow statement can assist the finance manager to: evaluate the companys capability to generate positive cash flow in the future; and evaluate the companys capability to settle debts, pay dividends and provide loans. Operating Activities Operating activities refer to the activities that are directly related to the production of products, sales and services of the company such as the sales and purchases of goods/services, rental income, fees income, wages and salaries of employees, utility expenses and rental expenses. Investing Activities Investing activities refer to the activities that are related with the buying and selling of long-term assets such as the sale and purchase of fixed assets, selling of investments, buying of stocks and bonds (investing) and loans to other entities. Financing Activities Financing activities refer to the activities that are related to the current liabilities and long-term liabilities as well as owners equity such as repayment of loans, short-term and long-term loans and shares buyback.
(a)
(b)
(c)
3.5.1
Preparing Cash Flow Statement
Data obtained from the balance sheet together with the net profit, depreciation and dividends obtained from the income statement can be used to prepare the cash flow statement. You can do this by using the three steps below: Step 1 Classify the data into one of these three components: (a) (b) (c) Cash flow from operating activities Cash flow from investing activities Cash flow from financing activities
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Step 2
List the data according to the arrangement in Table 2.4. All resources and net profit including depreciation are positive cash flow, which is the cash flowing in; while all usages, any losses and dividends payable are negative cash flow, which is the cash flowing out. Obtain the total for the items in each component. Add the total from each component to obtain the Increase (or decrease) of net cash and marketable securities. To check whether you had prepared the statement correctly, ensure that the value is equal to the changes in cash and marketable securities for the relevant year by looking at the opening and closing balances of cash and marketable securities in the balance sheet.
Table 3.4: Components and Data Sources that Must be Included into the Cash Flow Statement RM
Step 3
Cash Flow from Operating Activities Net profit (Net loss) Depreciation and other non-cash charges Changes in all current assets (except cash and marketable securities) Changes in all current liabilities (except notes payable)
IS IS BS BS xx
Cash flow from operating activities

Cash Flow from Investing Activities Changes in total fixed assets Changes in the companys interest
BS BS xx
Cash flow from investing activities

Cash Flow from Financing Activities Changes in notes payable Changes in long-term loans Changes in shareholders equity (other than retained earnings)
BS BS BS xx ___ XX
Cash flow from financing activities

Increase (or decrease) in cash and marketable securities
Data Sources BS = Balance Sheet IS = Income Statement
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Example of Cash Flow Statement: Company FAZ The cash flow statement of Company FAZ for year ended 31 December 2002 is shown in Table 2.5. Based on this cash flow statement, the company had enjoyed an increase of RM50,000 in cash and marketable securities for the year 2002 (refer to Table 3.5). The cash of the company increased by RM10,000 while the marketable securities increased by RM40,000 between the two dates.
Table 3.5: Cash Flow Statement of Company FAZ Company FAZ Cash Flow Statement as at 31 December 2002 RM Cash Flow from Operating Activities Net Profit Depreciation Decrease in account receivable Decrease in inventory Increase in account payable Decrease in tax accrual 18,000 10,000 10,000 30,000 20,000 (10,000) 78,000 RM
Cash flow from operating services
Cash Flow from Investing Activities Increase in total fixed assets
(30,000) (30,000)

Cash Flow from Financing Activities Decrease in short term notes payable Increase in long term loan Changes in shareholders' equity Dividends paid
(10,000) 20,000 (8,000) 2,000 50,000

Net increase in cash and marketable securities
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(a)
Cash Flow from Operating Activities The operating activities in the cash flow statements showed that the profit after tax of Company FAZ is RM18,000 for year 2002. Depreciation expenses of RM10,000 deducted from the income statement had been added back into the cash flow statement as it is not cash outflow. Account receivable had decreased by RM10,000 which means that the company had collected credit accounts from its customers. Inventory had also decreased from RM90,000 in year 2001 to RM60,000 in year 2002, representing cash resources of RM30,000 to the company. In the liabilities section, notice that the account payable had increased by RM20,000. This means that the company had increase its debts from the suppliers and this represents cash inflow. Tax accrual had decreased by RM10,000 indicating that the company had used RM10,000 cash to pay tax.
(b)
Cash Flow from Investing Activities Fixed assets of Company FAZ had increased by RM30,000 between 31 December 2001 and 31 December 2002. This increment reflected in the cash outflow used to by additional assets. Cash Flow from Financing Activities Notes payable of Company FAZ has decreased by RM10,000 indicating cash outflow as the company paid its shor-term loans. Long-term liabilities increased by RM20,000 indicating cash inflow. The company obtained loans to acquire additional cash.
(c)
3.5.2
Differentiating Cash Resources and Usage
Before we can prepare the cash flow, we must classify the cash flow from operating, investing and financing activities into cash resources or usage. Table 2.6 lists the basic cash resources and usage. Several issues that can help you to classify between cash resources and usage:
Table 3.6: Cash Resources and Usage Cash Resources Decrease in asset Increase in liability Net profit Cash Usage Increase in asset Decrease in liability Net loss
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Depreciation Sale of shares
Payment of dividends Shares Buyback
(a)
Decrease in the asset account is a cash inflow resource while increase in the asset account is a cash usage or cash outflow. Company bought new assets by cash. Therefore, any increase in the asset items between the two dates of the balance sheets will indicate that cash outflow had occurred. Any decrease in the asset items will indicate cash inflow as the company had sold the assets to obtain cash.
(b)
Increase in the liability account and owners equity is a cash inflow resources and a decrease in the liability account is cash usage. The company might use cash to settle its liability and claims on the assets. Therefore, any decrease in the liability items, preference shares or ordinary shares between the two dates of balance sheets indicates cash outflow. To obtain additional cash, the company can make loans. Therefore, any increase in the liability items, preference shares or ordinary shares indicated cash inflow.
(c)
Depreciation is a cash flow resource as is not cash expenses (non-cash charges). Non-cash expenditures are all expenses deducted from sales in the income statement but actually do not involve any cash outflow throughout the period. Depreciation and amortisation are examples of noncash expenses. Direct changes in the retained earnings are not included in the cash flow statement as these items affects the retained earnings and are shown as profit after tax (or loss after tax) and cash dividends.
(d)
100 TOPIC 3 FINANCIAL STATEMENTS
Table 3.7 shows changes in the balance sheet items of Company FAZ between 31 December 2001 and 31 December 2002.
Table 3.7: Changes in the Balance Sheet Items Company FAZ Changes in the Balance Sheet Items between 31 December 2001 and 31 December 2002 Classification 31-12-01 31-12-02 Changes Resource Usage Assets RM Cash 30,000 Marketable securities 20,000 Account Receivable 50,000 Inventory 90,000 Total fixed assets 220,000 Less: Accumulated Depreciation (120,000) Liabilities Account payable 50,000 Notes payable 70,000 Tax accrual 20,000 Long-term loan 40,000 Equities Preference shares 10,000 Original shares at par 12,000 Paid-up capital 38,000 Retained earnings 50,000 TOTAL RM 40,000 60,000 40,000 60,000 250,000 RM +10,000 +40,000 10,000 30,000 +30,000 RM RM 10,000 40,000
10,000 30,000 30,000
(130,000) 70,000 60,000 10,000 60,000 10,000 12,000 38,000 60,000
10,000 +20,000 10,000 10,000 +20,000 0 0 0 +10,000
10,000 20,000 10,000 10,000 20,000
10,000 100,000
100,000
From Table 3.7, we found that: Account receivable decreased by RM10,000 and this is considered as a cash resource as when debts are collected, the company obtain cash. Inventory decreased by RM30,000 and this is considered a cash resource as the company obtained cash from the product sold. Total fixed assets increased by RM30,000 and this is considered as cash usage as the company uses the cash to buy fixed assets. Increased in account payable and long-term loans of RM20,000 are considered cash sources as the company increased its debt with suppliers.
TOPIC 3
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Notes payable and tax accrual decreased by RM10,000 and this are considered as cash usage as the cash was used to settle debts to the creditors and tax to the government.
These types of classifications (based on Table 2.6) are made on every item in the balance sheet. The result of these classifications will be totalled to obtain the total cash resources and total cash usage. If these classifications are done correctly, the total cash resources will be equal to the total cash usages.
YOUR IDEA
All sorts of support and loan assistance had been provided by the government through organisations such as the Perbadanan Usahawan Nasional Berhad (PUNB) to encourage the participation of bumiputera in the area of entrepreneurship. Many have grabbed this opportunity to be involved in their own businesses covering various economic sectors but not all of them succeeded. What is your opinion on this matter?
EXERCISE 3.2
1. In the Cash Flow Statement, you will see that both interest expenses and dividends paid in the section of financing activities. (a) True (b) False Depreciation expense is one of the items that will be deducted from the net profit to determine the cash flow from operating activities. (a) True (b) False Profit from the sale of fixed assets will be deducted from the net profit to ascertain the cash flow from operating activities. (a) True (b) False Payment to suppliers for the purchase of materials will be included into the cash flow statement in the section of cash from financing activities. (a) True (b) False Information included in the cash flow statement are obtained from _______________. A. B. C. 6. income statement balance sheet income statement and balance sheet
2.
3.
4.
5.
Interest expenses are regarded as _________________ in the income statement and ___________ in the cash flow statement. A. B. C. D. operating expenses; item from operating activity financing expenses; item from financing activity operating expenses; item from financing activity financing expenses; item from operating activity
TOPIC 3
103
7.
Hugo Enterprise begun the year 2000 with retained earnings of RM92,800. Throughout year 2000, the company obtained RM37,700 after tax. From this amount, preference shareholders were paid dividends of RM4,700. At the end of year 2000, retained earnings of the company total RM104,800. 14,000 units of ordinary shares were issued throughout year 2000. (a) Prepare the retained earnings statement for the year ended 31 December 2000 (ensure that you calculate and include the total dividends of ordinary shares paid in the year 2000). Calculate the earnings per share for year 2000. How much dividend per share was paid by the company to the ordinary shareholders for the year 2000?
(b) (c)
8.
Profit after tax of year 2001 for Company Ceria is RM186,000. The closing balance for retained earnings for year 2001 and 2000 were RM812,000 and RM736,000 accordingly. How much dividend did the company paid in the year 2000? Classify each of the following items as funds resource (R) or usage (U), or neither (N) both.
Item Cash Account payable Notes payable Long term loans Inventory Fixed assets Account receivable Net profit Depreciation Share buyback Cash dividend Sale of Share Changes (RM) + 1,000 - 10,000 + 5,000 - 20,000 + 2,000 + 4,000 - 7,000 + 6,000 + 1,000 + 6,000 + 8,000 +10,000 Cash Flow ________________ ________________ ________________ ________________ ________________ ________________ ________________ ________________ ________________ ________________ ________________ ________________
9.
Financial statements represents the financial outlook of a company. Information from the income statements; balance sheet; statement of retained earning and cash flow statement are used to measure the companys current financial status as well as financial planning for the future. Having a clear understanding of financial statements will prepare you to analyse the financial ratio in the next topic.
Topic4 Financial
LEARNING OUTCOMES
Statement Analysis
At the end of this topic, you should able to: 1. calculate and define three liquidity ratios, which are the net working capital, current ratio and quick ratio; 2. calculate and explain the six asset management ratios, which are the account receivable turnover ratio, average collection period, inventory turnover, average inventory sales period, fixed assets turnover and total assets turnover; 3. calculate and explain the three financial leverage ratios, which are the debt ratio, debt equity ratio, equity multiplier and interest coverage ratio; 4. calculate and explain the four profitability ratios, which are the gross profit margin, net profit margin, return on asset and return on equity; 5. calculate and explain the two market value ratios which are price earnings ratio and dividend yield ratio; and 6. calculate the DuPont analysis and explaining its advantages to the finance managers.
INTRODUCTION
Financial analysis is an evaluation of the companys financial achievement for the previous years and its prospect in the future. Normally the evaluation will involve analysis of the companys financial statement. Information from the financial statement is used to identify the relative strengths and weaknesses of the company compared to its competitor and providing indication on areas that needs to be investigated and improved.
106 TOPIC 4 FINANCIAL STATEMENT ANALYSIS
Finance manager use the financial analysis for the companys future planning. For example, shareholders and potential investors are interested in the level of returns and risks of the company. Creditors are interested in the short-term liquidity level and the ability of the company to settle its interests and debts. They will also emphasis on the profitability of the company as they want to ensure that the companys performance is good and will be successful. Therefore, the finance manager must know the entire aspects of the financial analysis that are being focused by several parties having their own interests in evaluating the company. Beside the finance manager, the management also uses the financial analysis to monitor the companys achievement from time to time. Any unexpected changes will be examined to identify the problems that need to be dealt with.
4.1
FINANCIAL RATIO ANALYSIS
What is the relevance in calculating the financial ratios for short term and long term operations? Should its value be in accordance with the average performance of the industry? Please explain. Financial ratio analysis involves the calculation of several ratios that will enable the manager to evaluate the performance and financial status of the company by comparing its financial ratios with the financial ratios of other companies. These ratios are divided into five groups or categories, which are: (a) Liquidity Ratio Liquidity ratio refers to the companys ability to fulfil its short-term maturity claims or obligations. Asset Management Ratio Asset management ratio refers to the efficiency of the company to use its assets and how fast specific accounts can be converted into sales or cash. Leverage Ratio Leverage ratio refers to the level of debt usage or the ability of the company to fulfil its financial claims such as interest claims. Profitability Ratio Profitability ratio refers to the effectiveness of the company in generating returns from investments and sales, for example, gross profit margin, net profit margin, operating profit margin, return from assets and returns from equity.
(b)
(c)
(d)
TOPIC 4 FINANCIAL STATEMENT ANALYSIS
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(e)
Market value Ratio Market value ratio refers to the ability of the company to create market values in excess of its investment costs. Liquidity, asset management and leverage ratios measure the companys risk while the profitability ratio measures the companys returns.
Within the short-term period, liquidity, asset management and profitability ratios are important to the management of the company as these ratios provide critical information on the companys short-term operations. If a business is unable to sustain within the short-term period, it would be irrelevant to discuss its longterm prospects. Before preparing the ratio analysis, the finance manager must have consideration to the following issues: One ratio is unable to give complete information on the status of the company. This means that several categories of ratios must be looked at simultaneously before any conclusion can be made. Comparisons between the financial ratios for one company with other companies in the industry must be made at the same point of time. Industry average is not a figure that must be achieved by a company. There are many companies that had been managed efficiently but the performance of their financial ratios is much higher or lower than the performance of the industry average. The obvious difference between the financial ratios of the company and the industry average is an indication to the analysers to check on the ratio further. Use the financial statements that have been audited. This will show the actual status of the company. Use the same method to evaluate items in the financial statement that will be compared. For example, to record inventory, a company might use different accounting methods such as the first-in-first-out, first-in-last-out or moving average method. Choose only one of these methods for comparison purposes. Different methods will provide different ratio values. Therefore, actual evaluation cannot be done.
Financial statements of the company are the main input for the manager who intend to prepare the ratio analysis for its company. Each example of the ratios that will be discussed in the next section will be using the financial information extracted from the income statement and balance sheet of Company ABC (refer to Table 4.1 and Table 4.2).
4.1.1
Income Statement
The income statement for Company ABC for the year ended 31 December 2001 and 31 December 2002 are shown in Table 2.8. The income statement shows the operating performance of the company for a specific period.
Table 4.1: Income Statement for Company ABC
Company ABC Income Statement for the Year Ended 31 December 2001 and 2000 2001 RM 307,400 208,800 98,600 10,000 19,400 3,500 23,900 56,800 41,800 9,300 32,500 9,400 23,100 1,000 22,100 0.29 2000 RM 256,700 171,000 85,600 10,800 18,700 3,500 22,300 55,300 30,300 9,100 21,200 6,100 15,100 1,000 14,100 0.18
Sales Less: Cost of goods sold Gross profit Less: Operating expenses Sales expenses Administrative and general expenses Lease expenses Depreciation expenses Total operating expenses Profit before interest and tax (operating profit) Less: Interest expense Profit before tax Less: Tax (29%) Profit after tax Less: Preference shares dividend Profit available for ordinary shareholders Earnings per share
4.1.2
Balance Sheet
Balance sheet shows the overall value of various assets and claims on these assets at a specific point of time. For Company ABC, the balance sheet shows the assets, liabilities and equities as at 31 December 2001 and 31 December 2000 as shown in Table 4.2.
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Table 4.2: Balance Sheet Company ABC Balance Sheet as at 31 December 2001 and 31 December 2000 2001 RM Assets Current Assets Cash Marketable securities Account receivable Inventory 2000 RM

Net Fixed Assets Total Assets Liabilities and Equities Current liabilities Account payable Notes payable Accruals
36,300 6,800 50,300 28,900 122,300 237,400 359,700
28,800 5,100 36,500 30,000 100,400 226,600 327,000

Long-term loans Total liabilities Equities Preference shares Ordinary shares, RM2.50 par value, 100,000 shares issued 2001: 76,262; 2000: 76,244 Paid-up capital above par Retained earnings
38,200 7,900 15,900 62,000 102,300 164,300
27,000 9,900 11,400 48,300 96,700 145,000
20,000 19,100
20,000 19,000
42,800 113,500 195,400 359,700
41,800 101,200 182,000 327,000
Total equities
Total liabilities and shareholders' equities
4.2
LIQUIDITY RATIO
What do you understand by the definition of liquidity?
Liquidity refers to the ability of asset to be converted easily into cash without affecting the value of the asset. Liquidity ratios refer to the ability of the company to discharge its claims or short-term obligations by cash and assets that can be converted into cash in a short period. Liquidity is important in operating the business activities. A poor liquidity status is an early indication that the company is facing fundamental problems. The liquidity ratios are shown in Figure 2.4.
Figure 4.1: Liquidity ratio
4.2.1
Net Working Capital
Net working capital is the difference between the total current assets with the total current liabilities. It measures the funds (cash and items that can be easily converted into cash) that are owned by the company in managing its daily operating activities. The higher the value of the working capital, the better as this shows that the company is able to settle its short-term debts with surplus funds for its daily operating activities.
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Net working capital of Company ABC for the year 2001 is calculated as follows: Net working capital = = = = Current assets Current liabilities RM122,300 RM62,000 RM60,300 RM42,700 (2.1)
Industry average
Based on the calculation above, the net working capital of Company ABC is higher than the industry average. This shows that Company ABC is able to settle its short-term debts and has higher surplus funds than the other companies in the industry to manage its daily operations.
4.2.2
Current Ratio
Current ratio measures the ability of the company to fulfil its long-term loans using its current assets. The higher the value of this ratio, the better the liquidity status of the company. This shows that the company is able to settle short-term debts using its current assets. Current ratio is obtained by dividing the current assets with the current liabilities. The current ratio of Company ABC is as follows:
Current ratio
= = =
Current Assets Current Liabilities RM122,300 RM 62,000 1.97 2.05
(2.2)
Industry average
The current ratio of Company ABC is 1.97 which is lower compared with the industry average of 2.05. This shows that for every ringgit of current liability, the company only has RM1.97 current assets for its payment compared to the other companies in the industry that has RM2.05 to settle their current liabilities. However, the current ratio of the company is not too low for concern. Current ratio of 2.0 times is acceptable; however, this acceptance depends on the type of industry. For example, current ratio of 1.0 is satisfactory for industries such as utilities that have a rather stable business but unsatisfactory for industries such as manufacturing due to business volatility.
The current ratio can be connected to the net working capital; If the current ratio is equal to 1.0, the net working capital is zero. If the current ratio is less than 1.0, then the net working capital is negative. If the current ratio is more than 1.0, the net working capital is positive.
4.2.3
Quick Ratio
Quick ratio measures the ability of the company to pay its short-term loans quickly. Quick ratio is a liquidity test that is more stringent compared to the net working capital and current ratio. This is because quick ratio only takes into consideration the cash and assets that can easily be converted into cash. Inventory is not included with the other liquid assets due to the longer period for the inventory to be converted into cash. Expenses prepaid are also not included as it cannot be converted into cash. Therefore, it cannot be used to settle the current liabilities. Quick ratio is obtained when the most liquid current assets (cash, marketable securities and account receivables) are divided with current liabilities. The higher the quick asset ratio compared with the current liabilities, the better the liquidity level of the company to settle its short-term loans quickly. The calculation of quick ratio for Company ABC is as follows: Quick ratio
= = =
Current Assets-(Inventory+ Prepayments) Current liability RM122,300 RM28,900 RM62,000 1.51 times 1.43 times
(2.3)
Industry average
The quick ratio of Company ABC is 1.51 times, it is higher compared to the industry average of 1.43 times. This means that the liquidity level of the company is better compared to the other companies in the industry. For every ringgit of current liability, the company has RM1.51 cash and assets that can easily converted into cash to pay its short-term debts immediately. This is better compared to other companies in the industry that only has RM1.43 to pay their short-term debts immediately.
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EXERCISE 4.1
1. The following data is taken from the financial statements of Company Fazrul
Sales Cost of sold goods Cash Marketable securities Account receivable Inventory Prepayment items Net fixed assets Current liabilities
1999 RM640,000 380,000 30,000 40,000 70,000 150,000 10,000 300,000 120,000
1998 RM560,000 360,000 26,000 52,000 62,000 140,000 10,000 260,000 140,000
Based on the data above, calculate the following liquidity ratios for the years 1998 and 1999: (a) (b) (c) Net working capital Current ratio Quick ratio
4.3
ASSET MANAGEMENT RATIO
Asset management ratio measures the efficiency of the management in using the assets and specific accounts to generate sales or cash. Ratios that can be used to measure the efficiency in asset management are shown in Figure 4.2.
Figure 4.2: Asset management ratio
4.3.1
Account Receivable Turnover
Account receivable turnover measures the ability of the company to collect debts from its customers. It provides the total of account receivables collected throughout the year. The higher the ratio, the better as it is an indication that: The company can collect debts from its customers quickly; The company has low bad debts; and The company can use the funds for the next investments
Account receivable turnover is the net credit sales revenue (if unavailable, use the total sales) divided by the account receivables (or average account receivable). Account receivable turnover
= = =
Credit sales Account receivable RM307,400 RM50,300 6.11 times 8.24 times
(2.4)
Industry average
The account receivable turnover for the company unsatisfactory compared to the industry average. This may indicate the inefficiency of the credit department in credit collection.
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4.3.2
Average Collection Period
Average collection period showed the average days taken by the company to collect the account receivable. Assuming there are 360 days in a year. The comparison between the average periods with the companys credit term could measure the efficiency of the company in collecting debts from its customers. Average collection period of Company ABC is as follows:
= = =
Industry average
360 Account Receivable Turnover 360 6.11 58.92 days 44.3 days
(2.5)
The average collection period of Company ABC are 58.92 days which is unsatisfactory compared with the performance of the industry average of 44.3 days. On average, Company ABC takes 58.92 days to collect its account receivables while other companies in the industry only takes an average of 44.3 days to collect debts from their customers. If the credit period for Company ABC is 30 days, the average collection period of 58.2 days is unsatisfactory. This means, on average, the customers did not settle their payments with the period specified. This could also indicate that the credit management or credit department is inefficient or both. If the collection period extends for several years without changes to the credit policy, the company must take action to expedite the collection of account receivables. However, if the companys credit period is 60 days and the average collection period is 58.92 days, this shows a practical collection period. The average collection period can also be calculated using formula 2.6. Average collection period
= =
=
Account receivables Yearly sales/360 RM50,300 RM307,400/360 58.92 days
(2.6)
4.3.3
Inventory Turnover
Inventory turnover measures the efficiency of inventory management. It shows the number of times the inventory can be sold in a year. The higher the inventory turnover, the better, as it is an indication that the company is able to sell its inventory quickly and reduce the chances of obsolete inventory. Inventory turnover is obtained by dividing the cost of goods sold with inventory. The calculation of inventory turnover for Company ABC is shown as follows:
Inventory turnover
= = =
Cost of goods sold Inventory RM208,800 RM28,900 7.22 times 6.6 times
(2.7)
Industry average
Inventory turnover for Company ABC of 7.22 times is mush better if it is compared with the industry average of 6.6 times. This means that the company can sell its inventory 7.22 times in a year compared to the other companies in the industry that can only sell their inventory 6.6 times in a year. This might be because the company does not keep surplus inventory. Surplus inventory is not productive and it is an investment that does not provides any return. If the company holds too high inventory, the funds that could be invested elsewhere would be held by the inventory. Furthermore, the transportation and holding cost of the inventory will be high and the company is at risk of damage or obsolete. However, the company might lose sales if it is unable to fulfil the customers demands due to low inventory keeping. Therefore, the manager must be efficient in managing its inventory. Several issues that must to be considered in calculating inventory turnover. (a) (b) (c) Notice that the cost of goods sold and not sales (as might be done by some companies) is used as the numeric figure as inventory is recorded at cost. The usage of sales as the numeric figure a number is not appropriate as it will increase the value of inventory turnover. Must remember that for comparison, the company must ensure that the method of inventory recording must be similar between the company and the industry.
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(d)
The inventory turnover can be changed into number of days when it is divided with 360 days (average number of days a year). This ratio is known as the average inventory sales period as discussed in the next section.
4.3.4
Average Inventory Sales Period
The average inventory sales period shows the number of days taken to make one round of inventory sales. The high average inventory sales period is less unsatisfactory as this indicates that the company took longer time to sell its inventory. For Company ABC, the average inventory sales period is 50 days as calculated below: Average inventory sales period Average inventory sales period Average inventory sales period Average inventory sales period
= =
360 Inventory turnover 360 7.22
(2.8)
= 49.86 days = 55.30 days
The average inventory sales period for Company ABC of 49.86 days is better compared to the performance for the industry of 55.30 days. This indicates that the company takes shorter time to sell its inventory compared to the other companies in the industry. This ratio can also be calculated using the following formula:
= = =
Industry average
Inventory Cost of goods sold/360 RM28,900 RM208,800/360 49.83days 55.30 days
(2.9)
4.3.5
Fixed Asset Turnover
Fixed asset turnover shows the efficiency of the company in using its fixed assets to generate sales. The higher this ratio, the better because it shows indicated efficient asset management. This ratio is obtained when the sales is divided by the net fixed assets. The calculation of fixed asset turnover for Company ABC is as follows: Fixed asset turnover
= = =
Sales Net Fixed assets RM307,400 RM237,400 1.29 times 1.35 times
(2.10)
Industry average
The fixed asset turnover ratio for Company ABC is lower compared to the other companies in the industry indicating that the asset management of the company in generating sales is less efficient compared to the other companies. This might be because the company has lots of fixed assets or unsatisfactory sales.
4.3.6
Total Asset Turnover
The total asset turnover shows the efficiency of the company in using all its assets to generate sales. Usually, the higher this ratio, the more efficient the usage of the assets. This ratio might be the most frequent ratio referred by management as it can show the overall efficiency of the companys operations. Total asset turnover of Company ABC is as follows:
= = = Industry average
=
Sales Total assets RM307,400 RM359,700 0.85 times 0.75 times
(2.11)
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This performance is more satisfactory compared to the industry in average. However, analysers must be careful in using the fixed asset turnover and total asset turnover ratio because the calculation of these ratios uses the history costs of the assets. Some companies may have old assets or new assets. Therefore, it might not be appropriate to compare the fixed asset ratio. Companies that owned new fixed assets normally will show lower fixed asset turnover. Therefore, the difference in the performance of the asset turnover might be due to the costs of the assets and not the efficiency of the managements operations.
The economic and technology status of the country will influence the operations of a business. To ensure that the company stays competitive and is expanding, what effective actions that can be taken?
EXERCISE 4.2
1. The following data was taken from the financial statements of Fazrul Company. Based on the data below, calculate the asset management ratios for the years 1998 and 1999. Assume that there are 365 days in a year.
Sales Cost of goods sold Cash Marketable securities Account receivables Inventory Prepayment items Net fixed assets Current liabilities 1999 RM640,000 380,000 30,000 40,000 70,000 150,000 10,000 300,000 120,000 1998 RM560,000 360,000 26,000 52,000 62,000 140,000 10,000 260,000 140,000
(a) (b) (c) (d) (e) (f)
Account receivables turnover Average collection period Inventory turnover Average inventory sales period Fixed asset turnover Total asset turnover
4.4 LEVERAGE RATIO

Leverage ratio measures a company' level of debt funding and the ability of the company to fulfil its financial demands such as interest claim. Leverage ratios are shown in Figure 4.3.
Figure 4.3: Leverage ratio
Leverage occurs when a company is being funded by debt. Debts include all current liabilities and long-term liabilities. Debt is one of the main sources of funding. It provides tax advantage as interest is a tax deductible item. The costs of debt transactions are also lower as debts are easier to obtain compared to the issuance of shares. Usually, the more debt in relative to total assets, the higher the financial leverage of the company. Leverage ratios can be divided into two groups, that is: (a) ratios to evaluate the debt level used by the company such as debt ratio, debt-equity ratio and equity multiplier; and ratios to see the ability of the company in fulfilling its claims or obligations to the creditors such as interest coverage ratio.
(b)
Normally, analysers would focus their attention on the long-term loans as the company is bound by interest payments for a longer period and at the end of that period, the company must repay the principal amount of the loan. As creditors'claims must be settle first before any earnings can be distributed to the shareholders, potential shareholders will usually look at the debt level and the ability of the company to repay the company's debts. Creditors will also focus on the leverage ratios as the higher the debt level, the higher the probability of the company being unable to settle the debts of all its creditors. Therefore, the management of the company must prioritise on the
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leverage ratio as it attracts attention from several parties that are concerned with the debt level of the company.
4.4.1
Debt Ratio
Debt ratio measures the percentage of total asset that are financed by debts. Creditors prefer lower debt ratio as the lower the debt ratio, the higher the protection for their losses upon liquidation. Unlike the preference of creditors for a lower debt ratio, the management might choose a higher leverage to increase earnings. This is because they do not like to issue new equity as they fear the degree of control in the company will reduce. The higher the debt ratio, the higher the percentage of assets being funded by debts. The debt ratio of Company ABC is:
Debt ratio
Total liabilities Total assets

RM164, 300 RM359, 700
X 100
(2.12)
=
= Industry average =
X 100
45.7%
40.0%
The debt ratio of the company is 45.7% higher compared to the industry average of 40%. Potential creditors might be reluctant to provide additional loans to the company as they worry that the company would be incapable to settle the interest and principal payment, due to its rather high debt ratio.
4.4.2
Debt-Equity Ratio
Debt equity ratio measures the total long-term debts for each ringgit of equity. The lower this ratio, the better it is because it shows that the total equity owned by the company exceeds the long-term debts.
The debt-equity ratio of Company ABC is: Debt-equity ratio =
Long - term liabilities Shareholders equity RM102, 300 RM195, 400 X 100
(2.13)
52.4% 50%
The debt equity ratio of the company is higher compared to the industry average. This shows that the long-term debt of the company is 52.4% more compared to the shareholders' equity.
4.4.3
Equity Multiplier
Equity multiplier shows the asset ownership for each ringgit of equity. Debt ratio and equity multiplier provides the same information but in different approach. Debt ratio of 40% means that the company is being funded by 40% debts. Based on the balance sheet identity: Asset = Liability + Equity From this information, we know that the company is being funded by 60% equity. Equity multiplier is 100/60 = 1.67 times. Therefore, when the debt ratio of Company ABC is 45.7%, thus the equity multiplier is 100/54.3 = 1.84 times. In general, Equity multiplier = = 1 1 - Debt ratio Total asset Total equity RM359, 700 RM195, 400 1.84 times (2.14)
= = Industry average =
1.67 times
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The equity multiplier of the company is higher compared to the industry average. This shows that the funding of the company's assets via equity is higher compared to the other companies in the industry.
4.4.4
Interest Coverage Ratio
Creditors and other parties intend to know the company's ability to make interest payments periodically by using the current operation's income. Interest coverage ratio is used to decide the number of times the company can repay all its interest expenses with the current income. This ratio is obtained by dividing the operations profit with interest expenses. Interest coverage ratio of Company ABC is: =
Profit before interest and tax Interest expenses RM41, 800 RM 9, 300
(2.15)
4.49 times
4.3 times
Interest coverage ratio of 4.49 times is more satisfactory compared to the industry average performance of 4.3 times. This indicates the interest expenses margin with current income. Interest coverage ratio can also be calculated by using the following formula: Interest coverage ratio = Net profit + Interest expenses + Tax expenses Interest expenses = RM22,100 + RM9,300 + RM9,400 RM9,300 = 4.39 times (2.16)
EXERCISE 4.3
1. The summary balance sheet and income statement of Adiy Corporation are as below:
Adiy Corporation Balance Sheet Assets: Cash Account receivable Inventory Net fixed assets Income Statement Sales (all credit) Cost of goods sold Operating expenses Interest expenses Tax Net Profit Liabilities and Equities: Account payable Notes payable Long-term liabilities Equities 150,000 150,000 1,200,000 1,500,000 RM6,000,000 3,000,000 750,000 750,000 420,000 1,080,000
RM 150,000 450,000 600,000 1,800,000
(a) (b) (c) (d) (e) (f)
Calculate the financial ratios for Adiy Corporation based on the information given above. Assume that there are 365 days in a year. Debt ratio Interest coverage ratio Return on assets Average collection period Total asset turnover
4.5
PROFITABILITY RATIO
The profitability ratio measures the effectiveness of the company in generating returns from investments and sales. It is used as a sign to determine the business's efficiency and effectiveness in achieving its profit objective. Profitability ratios are shown in Figure 4.4.
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Figure 4.4: Profitability ratio
4.5.1
Gross Profit Margin
Gross profit margin measures the profit for each ringgit of sales that can be used to pay the sales and administration expenditures. The higher the gross profit margin, the better the status of the company as this shows lower expenditures or costs involved in implementing sales activities. Gross profit margins can be obtained by dividing the gross profit with sales. It shows the balance percentage for each ringgit of sales after the company had paid all the costs of goods.
Gross Profit Sales RM98, 600 RM307, 400 32.1% 30%
Gross Profit Margin
=
= =
X 100 X 100
(2.17)
Industry average
Gross profit margin of 32.1% is higher compared to the industry average of 30%. This shows that the purchasing management and cost of the company are better compared to the industry average. The company generates 32.1 cents profit after deducting all costs of goods for each ringgit of sale.
4.5.2
Net Profit Margin
Net profit margin measures the ability of the company to generate net profit from each ringgit of sale after deducting all expenditure including the cost of goods sold, sales expenditures, general and administrative expenditures, depreciation expenses, interest expenses and tax. The higher the net profit margin, the better the status of the company as this shows an efficient purchasing management with low purchasing costs. Net profit margin is calculated by dividing the profit after tax with sales. Net profit margin of Company ABC is as follows: Net profit margin = = = Industry average = Profit after tax Sales RM23, 100 RM307, 400 X 100 (2.18)
X 100
7.5%
6.4%
The net profit margin for the company of 7.5% is higher compared to the industrys performance of 6.4%. This shows that the management of purchasing and related purchasing costs are better compared to the industry average. The company had managed to generate 7.5 cents net profit for each ringgit of sale compared to the industry average that only managed to generate 6.4 cents for each ringgit of sale.
4.5.3
Operating Profit Margin
The operating profit margin measures the efficiency of operations in reducing costs and increasing returns before interest and tax. The higher the result of this ratio, the better as it indicates that the company is able to operate efficiently. The operating profit margin of Company ABC is: Operating Profit Margin = = = Industry average = Operating Profit Sales RM41, 800 RM307, 400 13.6% X 100 (2.19)
X 100
10%
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The operating profit margin of company ABC is better compared to the industry average. This shows that the company is more efficient in its operations and control its operating expenditures to generate high earnings before interest and tax.
4.5.4
Return on Asset
Return on asset or return on investment measures the effectiveness of the company in using its assets to generate profit. The higher this ratio, the better the status of the company as it indicates the management's efficiency in using its assets to generate profit. Return on Asset =
Profit after tax Total Assets

RM23, 100 RM359, 700
X 100
(2.20)
=
X 100
6.42%
4.8%
Return on assets of the company is better compared to the industry average that only contributes 4.8%. This shows that the company is better in managing its assets to generate profit compared to the other companies in the industry.
4.5.5
Return on Equity
Return on equity measures the efficiency of the company in generating profit for its ordinary shareholders. The higher the ratio, the better as the company is able to generate high profit for its owners. Return on Equity =
Profit after tax X 100 (2.20)
Shareholders' Equity
RM23, 100 RM195, 400 11.8% 8% X 100
Return on equity of the company is 11.8% more satisfactory compared to 8% for the industry average. This shows that the management of the company is more efficient compared to the industry average. The calculation of return on equity will be discussed further when we discuss the DuPont analysis.
4.5.6
Earnings Per Share
Earnings per share calculate the net profit that is generated from each ordinary share. This information is often given priority by the management and investors as it is regarded as an important indication of the company's success. Therefore, the bigger the value of this ratio, the better the status of the shareholders. Earnings per share is obtained by dividing the net profit with the number of shares issued Earnings per share = Profit available to ordinary shareholders Number of ordinary shares issued RM22,100 76,262 RM0.29 RM0.26 (2.22)
The company obtained RM0.29 for each unit of shares issued compared to the industry average of only RM0.26. The value of this difference is small and in practice, this value does represent the actual amount that will be distributed to the shareholders.
4.6
MARKET VALUE RATIO
Provide the differences between price earnings ratio and dividend yield ratio.
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Market value ratio measures the ability of the company to generate market values in excess of its investment costs. This aspect is very important as these market value ratios are directly related to the objective of the company, that is to maximise shareholders' wealth and value of the company. Therefore, it can be said that the value of market value ratio influences the market's reaction and investors' confidence towards the ability of the company's management in generating profit efficiently and effectively. Market value ratios are shown in Figure 4.5.
Figure 4.5: Market value ratio
4.6.1
Price Earnings Ratio
Price earnings ratio shows the total ringgit that the investor is willing to pay for each ringgit of profit reported by the company. The level of price earnings ratio shows the degree of confidence of the investors towards the future performance of the company. The higher the price earnings ratio, the higher the confidence of the investors towards the company's future. Price earnings ratio can be obtained when the market price per share is divided by the earnings per share. To calculate the price earnings of Company ABC, we assumed that the market price for the company's share is RM3.23. Price Earnings Ratio = Market price per share Earnings per share RM3.23 RM0.29 11.1 1.25 (2.23)
= =
Industry average
The ratio shows that the degree of confidence of the investors towards the company is significantly higher compared to the industry average as the investors are willing to pay 11.10 times more for each company's share compared to 1.25 for each share in the industry average. You can see this price earning ratio in share prices section in the newspaper. However, newspapers provides current price ratio instead of latest profits. Investors prioritise more on the price relative to future earnings.
4.6.2
Dividend Yield Ratio
There are investors who will buy ordinary shares to receive dividends. Others will be more interested in the growth of their share market value. Dividend yield ratio measures the rate of return in the form of dividends received from a share investment. Assume that Company ABC practices a stable dividend policy and pays dividends of RM0.15 per share. This means that the investors will receive return from dividends of 4.6%. A lot of companies try to maintain paying a stable dividend and, if possible, increases the dividends so that investors will receive more returns from their share holdings. There are companies that pay small dividends and there are those that do not pay any dividends to their shareholders. This is because they put in more effort to expand their businesses by retaining and reinvesting the profit obtained. Dividend Yield = Dividend per share Market price per share RM0.15 RM3.23 4.6% X 100 (2.24)
= =
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EXERCISE 4.4
1. 2. ___________ is the ability of the company to fulfil its current liabilities' obligations by using its current assets. Current ratio is similar to _________ divided with ___________. ______ is included in the calculation of current ratio but excluded from the calculation of the quick ratio. Inventory turnover is obtained by dividing ___________ with _______________. Ratio of total liabilities to ____________ is used to ascertain the level of debt in the capital structure. Return on equity is obtained when ______________ is divided with ____________. Price earnings ratio is equal to ______________ per share divided with _____________ per share. X-Cell and N-Hance are two companies operating in the same industry. The financial information for both companies as at 31 December 2000 are as follows
Total assets Total liabilities Total equities Net sales Interest expenses Tax expenses Net profit Earnings per share Market price per share of ordinary shares Dividends per share for ordinary shares X-Cell RM3,000,000 1,800,000 1,200,000 3,700,000 90,000 240,000 380,000 5.60 35.00 2.40 N-Hance RM1,600,000 960,000 640,000 1,880,000 38,000 100,000 180,000 2.10 26.50 0.50
3. 4. 5. 6.
For each of the company, calculate the following ratios: X-Cell N-Hance (a) Return on assets _______________ _______________ (b) Return on equity _______________ _______________ (c) Net profit margin _______________ _______________ (d) Total asset turnover _______________ _______________ (e) Debt ratio _______________ _______________ (f) Equity multiplier _______________ _______________ (g) Interest coverage ratio _______________ ____________ __ (h) Price earnings ratio _______________ _______________ (i) Dividend yield ratio _______________ _______________
4.7
CONDUCTING A COMPLETE RATIO ANALYSIS
As stated above, one ratio is not sufficient to evaluate all aspects of the company's financial status. Therefore, the manager must conduct a complete ratio analysis to cover all aspects of liquidity, asset management, leverage, profitability and market value ratio. The two approaches can be conducted are: (a) DuPont Analysis looks at the main sections that contribute to the companys financial performance. Summary of financial ratio analysis looks at all the financial aspects of the company to identify sections that required further investigations or improvements.
(b)
4.7.1
DuPont Analysis
DuPont analysis is used by finance managers to evaluate the financial status of a company. The DuPont analysis combines the income statement and the balance sheet to become two measurements of profitability. (a) (b) return on assets; and return on equity
The first step in DuPont analysis is to show the DuPont formula: Return on asset = = = = Net profit margin x Total asset turnover Profit after tax x Sales Sales Total assets 7.5% x 0.85 times 6.4%
In the DuPont formula, the net profit margin measures the profitability of sales while the total asset turnover shows the efficiency of management in using assets to generate sales. The value of return on asset is calculated by using the DuPont formula is the same as the value of return on assets calculated directly parting section 2.10.4. However, the DuPont formula allows the company to evaluate its return on asset by separating it into two different components that is the profit on sales and efficiency in asset management.
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The second step in DuPont analysis is to connect the return on asset with return on equity. This relationship can be shown below. Return on equity = = Return on assets x Equity multiplier Profit after tax Total asset 6.4% x 1.84 times 11.8%
Total assets Total equity
= =
When the values for return on asset and equity multiplier are replaced in the formula above, the result is 11.8%, same as calculated directly in topic 2.10.5. However, the DuPont analysis has the advantage of allowing the manager to evaluate the return on equity by looking at three separate components, which are: (a) (b) (c) profit on sales; efficiency of asset management; and effect of using debts in funding assets
If the DuPont analysis is extended, the return to the owner can be evaluated by looking at each important dimension as shown in Figure 4.6.
Figure 4.6: Extended DuPont analysis
From Figure 4.6, we found that the return on equity for Company ABC (11.8%) is higher compared to the industry average (8%). This higher return on equity is influenced by the companys higher return on asset compared to the industry and less influenced by the pattern of funding as illustrated by the equity multiplier. (Return on asset of the company is 6.41% while the return on asset of the industry is only 4.8%. The difference in equity multiplier between the company and the industry is quite marginal, 1.84 times for the company and 1.67 times for the industry). The difference in returns between the company and the industry is influenced by the difference in net profit margin compared to the difference in total assets turnover. The difference in profit margin between the company and industry is significant. (7.5% for the company and 6.4% for the industry) compared to the difference in total assets turnover (0.85 times for the company and 0.75 times for the industry). Net profit margin of the company is influenced by the higher operating profit margin compared to the gross profit margin. Therefore, the higher return on equity for the company is due to the management efficiently in managing its operations.
4.7.2
Summarising All Financial Ratios
The performance of Company ABC is valued based on five groups of ratio, which are: (a) (b) (c) (d) (e) liquidity; asset management; leverage; profitability; and market value
The companys financial ratios can be compared with the ratio of other equivalent companies, or with the industry average at one point of time. These comparisons provides explanations on the financial status and performance of the company relatively compared to the performance of its competitors. This analysis uses industry average as a benchmark or standard of comparison. When the industry average cannot be obtained, comparisons are usually made with other companies in the same industry. This benchmark is assumed as the suitable value for a company in the same industry. The assumption here is for the companies in the same industry to have an almost identical financial ratio. If the
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ratio of a company shows a significant difference with the standard ratio, then further investigation must to be done to find the source of that difference. For evaluation, a companys financial ratio is compared to the industrys ratios one by one, and then classified as satisfactory or unsatisfactory, depending upon the direction and how far it has diverted from standard. Figure 2.10 summarises the comparison between Company ABCs financial ratios with the industry average for the year 2001. From Figure 2.10, we can make a summary that: (a) Liquidity The companys achievement in current ratio and quick ratio are much different compared with the industry. Overall, the companys liquidity is rather satisfactory. Asset Management The companys inventory management is quite satisfactory. The company might face problems with its account receivables as the collection period for company is higher compared to the industry. Therefore, attention had to be given to the management of account receivables. Leverage The level of the companys debts is higher than the industry average. However, the ability of the company to pay interests is better compared to the industry. Profitability Profitability, relative to the investors (as seen in the return on asset and return on equity ratios) of the company is better compared to the industry. This is the same with the gross profit margin and net profit margin. Market Value The companys shares were sold at the lower price earnings ratio than the industry. This is the same for dividends yield ratio which is smaller compared with the industry.
(b)
(c)
(d)
(e)
Table 4.1: Summary of Ratio Analysis for Company ABC Compared with the Industry Average for Year 2001 Company ABC Liquidity Ratio Current ratio Quick ratio Asset Management Ratio Account receivable turnover Average collection period Inventory turnover Average inventory sales period Fixed asset turnover Total asset turnover Leverage Ratio Debt ratio Debt-equity ratio Interest coverage ratio Profitability Ratio Gross profit margin Net profit margin Return on assets Return on equity Earnings per share Market Value Ratio Price earnings ratio Dividend yield ratio 1.97 times 1.51 times Industry Average 2.05 times 1.43 times Notes* US US
6.11 times 58.92 days 7.22 times 49.86 days 1.29 times 0.85 times
8.24 times 44.3 days 6.6 times 55.30 days 1.35 times 0.75 times
US US S US US S
45.7% 52.4% 4.49 times
40.0% 50% 4.3 times
US S S
32.1% 7.5% 6.42% 11.80% RM0.29
30% 6.4% 4.8% 8.0% RM0.26
S S S S S
RM11.1 RM0.046
RM1.25 RM0.50
US US
* S = Satisfactory
US = Unsatisfactory
4.8
WEAKNESSES IN FINANCIAL RATIO
Financial ratio is an important tool in financial analysis but when the users apply the financial ratios, they must take into consideration the weaknesses related to these financial ratios. Among the weaknesses are: (a) The accuracy of the financial ratio depends on the accuracy of the data found in the financial statements.
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(b)
In using the financial ratio for industrial comparison purposes, the users must take into consideration that the industry ratio is only a rough estimate. This is due to the difficulty to obtain the entire firms in the same industry. Financial ratio is a relative measurement and does not show the actual size of the firm. Financial ratio is used to measure the status of the firm but it can not show the issues that had caused the situation.
(c) (d)
Please visit the following websites to obtain additional information regarding the topics discussed in this chapter. http://www.ppkm.net/ Description: Persatuan Pasaran Kewangan Malaysia was established with the objective to provide an organisation for individuals who are actively engaged in the foreign exchange and financial markets in Malaysia. http://www.finpipe.com/equity/finratan.htm Description: Introduction of Financial Ratio Analysis http://www.investopedia.com/university/ratios/ Description: Steps and explanations on the calculations of Financial Ratio Analysis http://www.credit-to-cash-advisor.com/Document.asp?lid=120 Description: Detail explanation on DuPont Analysis including a convenient web calculator.
EXERCISE 4.5
1. When ratio comparisons show an obvious change in the financial status of a company, the manager should investigate the matter further. (a) 2. True (b) False
In the DuPont Analysis, return on equity is the result of multiplying three other ratios: net profit margin, total asset turnover and return on asset. (a) True (b) False
3.
Net profit divided by total asset is ___________ ratio. A. B. C. D. Return on equity Current ratio Gross profit margin Return on asset
4.
Dividend yield ratio is: A. B. C. D. Total money distributed to shareholders. Dividends paid to shareholders divided by retained earnings. Dividends per share divided by price per share. Retained earnings divided by sales.
5.
Use the following information to calculate the net profit. Return on asset Total asset turnover Cost of goods sold Gross profit margin = = = = 2% 0.5 times RM105,000 30%
6.
Calculate the return on equity based on the information below: Sales Net profit Total assets Total liabilities = RM100,000 = RM3,000 = RM150,000 = RM75,000
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7.
Listed below are several transactions made by Fima Corporation along with the financial ratios. For each of the transactions, state whether there is an increase, decrease or unchanged to the ratio listed next to the related transaction.
(a) (b) (c) (d) (e) (f) Transaction Selling of inventory on credit Issuing ordinary shares to collect cash Issuing long term bonds for cash Declaring and paying cash dividends for ordinary shares Collecting account receivable Making cash loans by issuing long term notes payable Financial Ratio Current ratio Return on equity Debt ratio Dividend yield Account receivable turnover Return on assets
8.
The finance manager of Lily Corporation provided the following financial information to you to prepare the company's financial analysis.
Lily Corporation Balance Sheet as at 31 December 2000 RM 1,000 8,900 4,350 15,675 35,000 13,250 21,750 Total liabilities Ordinary shares Retained earnings Total equity Total liability and equity 19,800 1,000 15,200 16,200 36,000 RM 9,000 6,675 14,250 4,125
Cas Account receivable Inventory Total current liabilities Total fixed asset Accumulated Depreciation Net fixed asset
Account payable Accrual account Total current asset Long-term loans
Total asset
36,000 RM 100,000 87,000 13,000 11,000 2,000 500 1,500 420 1,080
Sales Cost of goods sold Gross profit Operating expenditure Operating profit Interest expenses Profit before tax Tax Net Profit
Based on the financial information above, calculate the following financial ratio: (a) Current ratio __________________ (b) Quick ratio __________________ (c) Average collection period __________________ (d) Inventory turnover __________________ (e) Fixed asset turnover __________________ (f) Total asset turnover __________________ (g) Debt ratio __________________ (h) Interest coverage ratio __________________ (i) Gross profit margin __________________ (j) Operating profit margin __________________ (k) Net profit margin __________________ (l) Return on asset __________________ (m) Return on equity __________________ 9. Complete the balance sheet for Company Amri based on the following information. Assume that there are 360 days in a year.
Gross profit margin Inventory turnover Average collection period Sales Current ratio Total asset turnover Debt ratio = = = = = = = 38.7% 6 times 31 days RM720,000 2.35 times 2.81 times 49.4%
Assets
Current asset
Cash Marketable securities Account receivable Inventory Total current assets Total fixed assets Accumulated depreciation Net fixed asset
Total assets
Company Amri Balance Sheet RM Liability and Owners Equity Current liabilities 8,005 Account payable Notes payable Accruals Total current liabilities 159,565 Long-term liabilities Total liabilities 50,000 Shareholders equity Preference shares Ordinary shares Paid up capital Retained earnings Total equity Total liabilities and equity
RM
28,800 18,800
2,451 30,000 6,400 90,800
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Financial analysis ratio is suitable to be used when the company wants to interpret the financial statements of the company. Liquidity ratios such as net working capital, current ratio and quick ratio enables the measurement of the companys ability to fulfil its short-term maturity claims. Asset management ratios measure the companys efficacy in using the assets. The examples of this ratio includes account receivable turnover, average collection period, inventory turnover, average inventory sales period, fixed asset turnover and total asset turnover. Leverage ratio measures the level a company being funded by debt or the ability of a company to fulfil its financial claims such as interest claims. Profitability ratio measures the effectiveness of the company in generating returns from investment and sales; for example gross profit margin, net profit margin, return on assets and return on equity. Market value ratio such as price earnings ratio and dividend yield ratio, measures the ability of a company to create values in the market exceeding its investment costs. This aspect is very important as these ratios are directly connected with the companys objective that is to maximise shareholders wealth and value of the company. The DuPont analysis is used by finance managers to evaluate the financial status of the company by measuring the two important ratios, which are return on assets ratio and return on equity ratio while the approach on summarising the financial ratio analysis is to show all aspects of the companys overall financial status to identify sectors that require further investigation.
TUTORIAL QUESTION
INTRODUCTION
This activity is for the purpose of enhancing your further understanding on the main financial statements that are used to make the future plans of the company.
PROBLEM
The following are the financial data for Company SAA. The items in the balance sheet are values as at year ended 2000 and 2001, while the items in the income statement are income or expenditure throughout the year ended 2000 or 2001 (all values are in thousand of ringgit).
Sales revenue Cost of goods sold Depreciation Inventory Administrative expenses Interest expenses Tax Account payable Account receivable Fixed asset, net Long term loan Notes payable Dividends payable Cash and marketable securities
2000 RM000 4,000 1,600 500 300 500 150 400 300 400 5,000 2,000 1,000 410 800
2001 RM000 4,100 1,700 520 350 550 150 420 350 450 5,800 2,400 600 410 300
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QUESTION
(a) Prepare the balance sheet for Company SAA as at year 2000 and 2001. How much is the shareholders equity? Net working capital = Current asset Current liability. What had happened to the net working capital throughout the year? Prepare the income statement for Company SAA for the year ended 2000 and 2001. How much is the retained earnings for year 2001? Compare the increase in shareholders equity between these two years. Assumed the numbers of shares issued are 500,000 units. What is the earnings per share? Look at the values of net fixed asset for year 2000 and depreciation for year 2001. How much is the total investment of fixed assets in the year 2001? Prepare the cash flow statement for Company SAA for year 2001.
(b)
(c)
(d)
(e)
(f)
Topic5 Time Value

of Money
LEARNING OUTCOMES
At the end of this topic, you will be able to: 1. 2. 3. 4. identify the basic concept for time value of money that is known as the concept of compounding to determine the future time value of an investment made today; identify the advance concept for time value of money that is known as the concept of discounting to calculate the present value for a sum of cash that will be accepted in the future; explain the concept for time value of money for single cash flow and series cash flow, annuity, perpetuity and derivation cash flow; and analyse the concepts of compounding and discounting that occur frequently, more than once a year and that occur continuously.
INTRODUCTION
The public generally, assume time as very precious and must be managed efficiently. They place the value of time on par with various valuable objects and one of the globally accepted proverb is 'time is money'. From the financial management perspective, this proverb is a phrase that can be measured and proven quantitatively by using the financial mathematics. In fact, this quantitative prove has developed as one of the basic principles in financial decisions making known as the concept for time value of money.
TOPIC 5 TIME VALUE OF MONEY
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5.1
CONCEPT OF COMPOUNDING AND FUTURE VALUE
If you were given two choices either an offer of RM1,000 in the beginning of the year or an offer of RM1,000 at the end of the year, which offer will you choose? Rationally, you will certainly choose the offer at the beginning of the year as the value of money makes this alternative more profitable. The concept of compounding is the core in the concept for time value of money. The concept of compounding, in brief, explains that RM1 today is more valuable than RM1 in the future. This is because RM1 today can be invested to generate interest and subsequently multiply to become more than RM1 at the end of the investment year. Among the reasons why the time value of money makes this alternative more valuable are: In general, individuals are more interested in the present usage than postponing the usage to the future. During the inflation periods caused by uncontrollable development in the economy, the real purchasing power of RM1 now is more that the real purchasing power of RM1 in the coming years. Capital that is obtained now can be invested productively to generate a higher return in the future.
5.1.1
Time Line
The drawing of time line in Figure 3.1 can ease the understanding of the concept of time value of money especially for complex problems. Time is divided into several periods of valuation that is shown along the horizontal line and the calculation of the period begins from left to right. Time 0 (t0) refers to the present time or the starting of the first period, time 1 (t1) refers to the end of the first period or the starting of the second period, time 2 (t2) refers to the end of the second period or the starting of the third period and so forth.
146 TOPIC 5 TIME VALUE OF MONEY
Figure 5.1: Time line
5.1.2
Compounding Interest
There are two types of interest that is the simple interest and compounding interest. Simple interest is the interest that will be paid or accepted based on the principal amount. Compounding interest refers to the interest that will be paid not only on the principal amount but also on any interest payable not withdrawn throughout its period (accumulated interest). In this topic, we will focus our discussion on compounding interest as in the calculation for time value of money, only compounding interest is considered. Example 5.1 If you had invested RM100 in the savings account in a bank with the interest rates of 10% per year, how much returns will you receive at the end of the first year? Roughly, you will obtain RM110. These returns can be calculated as follows: Returns (F) = = = = = = = Total principal (P) + Total interest (i) Total principal (P) + [Total principal (P) x Interest (i)] RM100 + 10 RM100 + RM10 (10%) RM110 P + P(i) P(1 + i)
F1
If the stated returns are not withdrawn from the savings account, and the banks interest rates for the second and third year remained unchanged, how much return will you receive at the end of the second and third year?
147
F2
= = = = = = = = = =
P (1+i)2 F1 (1+i) RM100 (1 + 0.1)2 121 RM121 + RM12.10 RM133.10 that is F2 +F2 (i) F2 (1+i) P2 (1+i)2 (1+i) P (1+i)3
F3
When the savings period is extended to tn, the total returns that will be obtained in the period (n) is:
Fn = P (1+i) n
(3.1)
The complete time line for savings of RM100 at interest rate of 10% per year is as follows:
P1 = RM 110 100 + 100(10%)
P2 = RM 121 100 + 100(10%)
P3 = RM 121 100 + 100(10%)
EXERCISE 5.1
1. Salmah keeps RM100 in the savings account at Affin Bank with interest rate of 5% per year for 5 years. How much return will she get at the end of the 5 year period? Assume that Ah Seng keeps RM5,000 in the savings account at Bumiputra Commerce Bank at the interest rate of 10% per year for 2 years. How much return will Ah Seng receive at the end of the second year?
2.
5.1.3
Calculation of Future Value Using Schedule
Calculation of future value using the formula of Fn = P (1+i) n with the value of n being more than one sometimes takes a rather long time. Therefore, the usage of a financial schedule that is the schedule of Future Value Interest Factor (FVIF i,n) helps to save time in calculations. The equation 3.2 shows that the future value (FVn) is equivalent to the principal at the point of time equal to 0 or the original principal amount (PV0) multiply with the future value factor stated in the schedule of Future Value Interest Factor (FVIF i,n). This schedule is enclosed in Attachment A. FVn = PV0 (FVIF i,n) (3.2)
As a basic guide on the usage of the financial schedule, please refer to the extract on the schedule of Future Value Interest Factor (FVIFi,n) in Table 3.1 to solve examples 5.2 and 5.3. Example 5.2 You deposited RM2,000 in the savings account in a bank at a yearly interest rate of 5% for the period of one year. Upon the completion of one year, how much return will you receive? FVn Example 5.3 = = = = PV0(FVIFi,n) RM2,000(FVIF5%,1) RM2,000(1.0500) RM2,100
Assume you deposited RM2,000 in the savings account in your bank at a yearly interest rate of 5% for the period of four years. Upon the completion of four years, how much return will you receive? FVn = = = = PV0(FVIFi,n) RM2,000(FVIF5%,4) RM2,000(1.216) RM2,432
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Table 5.1: Extract from the Future Value Interest Factor (FVIF i, n) Schedule
It must be remembered that sometimes different answer might exist by using manual calculation compared to the calculations using the schedule. This is due to the usage of different numbers of decimal points. However, the difference is not obvious and both answers are acceptable.
EXERCISE 5.2
Use the schedule of Future Value Interest Factor (FVIFi,n) in Attachment A to calculate the answers for the questions below. 1. Assume that you keep RM5,555 in the savings account at Affin Bank with an interest rate of 15% per year for 5 years. How much potential return will you obtain at the end of the 5 year period? If you keep RM4,321 in the savings account at Maybank with an interest rate of 7% per year for 2 years, how much potential return will you obtain at the end of the 2 years period?
2.
5.1.4
(a) (b) (c)
Graphical Illustration of Future Value
There are three basic elements which will influenced the future value, these are: principal (amount that was borrowed or invested); time period (the number of periods or frequency of interest payments); and interest rate payable (if the money was borrowed) or interest receivable (if the money was invested).
To show how the interest rate influences the future value of an investment, we must assume that the principal and the time period are constant. Therefore, any changes to the future value are caused only by the interest rates. For example, you intend to deposit RM100 at Bank A, B and C that offer different compounding interest rates of 8%, 10% and 12%. How much will the future value of your deposit be in 3 years from now? Based on the formula FVn = PV0 (FVIFi, n) The future value for Bank A that offers an interest rate of 8% is: FV8%,3 = = = RM100 (FVIF8%,3) RM100 (1.26) RM126.00
The future value for Bank B that offers an interest rate of 10% is: FV10%,3 = = = RM100 (FVIF10%,3) RM100 (1.331) RM133.10
The future value for Bank C that offers an interest rate of 12% is: FV12%,3 = = = RM100 (FVIF12%,3) RM100 (1.405) RM140.50
The examples above can also be applied on either the principal value or the time period by assuming that the other variables are constant. You will discover that the future value has a positive correlation with the time period (n) and the interest rate (i) as shown in Figure 5.2.
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Figure 5.2: Correlation between interest rate, time period and future value for RM100.
As a bank manager, what are your strategies in attracting more people to deposit and invest in your bank?
5.2
CONCEPT OF DISCOUNTING AND PRESENT VALUE
In your opinion, how is the concept of discounting and present value different from compounding and future value?
The second concept that is related with the time value of money is the concept of cash flow discounting. This concept is used to ascertain the present value (PV0) or principal value for a sum of money in the future (FV0) that is discounted at an interest rate known as rate of return (i) for the valuation period (t).
The process to determine the present value is the reverse process of determining the future value. The relationship between these two processes is illustrated in the time line in Figure 5.3.
Figure 5.3: Comparison between future value and present value
5.2.1
Calculation of Present Value
The process of discounting is the reverse process of compounding. The present value (principal) can be found with a small variation to the basic formula of calculating the future value (formula 5.1). Example 5.4 Assume you expect to receive returns of RM2,500 a year from now. How much is the present value for RM2,500 if the discount rate or rate of return is 8% per year?
FVn
PV0 (1+ i)n

PV0 (1+ 0.08)1
RM2, 500 =
PV0
RM2, 500 1.08 RM2, 314.81
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RM2,314.81
RM2,500
What is the present value that you must invest if you expect a return of RM2,500 in the period (a) 2 years and (b) 3 years at a discount rate of 8% per year? FV2= PV0 (1+i)2
RM2,500= PV0 (1+0.08)2 PV0= RM2,500 (1+1.08)2
PV0= RM2,143.35 FV3= PV0 (1+i)3 RM2,500= PV0 (1+0.08)3 RM2,500 PV0 = (1+1.08)3 = RM1,984.58
The present value of RM2,500 at a rate of 8% in period 1,2 and 3 years are as follows:
If the discounting period is extended to tn, the principal amount that must be invested is FVn PV0 = (3.3) (1+i)n Or PV 0 = FVn [1/(1+i)n]
EXERCISE 5.3
1.
You want RM1,100 in your account a year from now. How much investment must you make now if the interest rate offered by the bank is 10%? Seri Sdn. Bhd. offers a low risk security that promises a payment of RM3,000 at the end of 2 years period with an offer of 15% interest rate per year. What is the present value for RM3,000?
2.
5.2.2
Calculation of Present Value (Principal) Using Schedule
Similar to the future value factor, the present value factor can also be obtained by using a schedule that is the Present Value Interest Factor (PVIFi,n) as attached in Attachment B. The usage of this schedule helps to simplify the calculation of present value especially in complex problems. The equation 5.4 shows the present value (PV0) is equal to the future value amount (FVn) multiply with the present value interest factor (PVIFi,n). (3.4) PV0 = FVn (PVIF i,n) As a basic guide on the usage of the financial schedule, please refer to the extract on the schedule of Present Value Interest Factor (PVIFi,n) in Table 3.2 to solve examples 5.5 and 5.6. Example 5.5 Assume you expect to receive RM3,999 in 3 years time from now. How much is the present value for RM3,999 if the discount rate or rate of return is 9% per year?
PV0 =FV(PVIFi,n) =RM3,999(PVIF9%,3) =RM3,999(0.772) =RM3,087.23
Example 5.6 You intend to accumulate savings money at the bank for RM5,713 in the period of 4 years from now. How much savings you must make now if the interest rate offered by the bank is 10 percent per year?
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PV0
=FV(PVIFi,n) =RM5,713(PVIF10%,4) =RM5,713(0.683) =RM3,901.98

Table 5.2: Extract of Present Value Interest Factor Schedule (PVIF i, n)
It must be remembered that sometimes different answer might exist by using manual calculation compared to the calculations using the schedule. This is due to the usage of different numbers of decimal points. However, the difference is not obvious and both answers are acceptable.
EXERCISE 5.4
Use the schedule of present value interest factor to help you solve the questions below: 1. Assume that you are given the opportunity to purchase a low risk security that promised a payment of RM127.63 at the end of the period of 5 years with an interest rate offer of 5% per year. How much is the present value for RM127.63? You plan to accumulate savings money in the bank for RM6,213 in a period of 5 years from now. How much savings must you make now if the interest rate offered by the bank is 12% per year?
2.
5.2.3
Graphical Illustration of Present Value
To show how the interest rate influences the present value (principal) of an investment, we must assume that the future value (returns) and the time period are constant. Therefore, any changes to the present value are caused only by the interest rates. Example 5.7 You intend to obtain returns of RM1,000 in a period of 3 years in Bank A, B and C that offer different compounding interest rates of 8%, 10% and 12%. What is the principal value that you should make?
TheprincipalvalueforBankAthatoffersaninterestrateof8%is: PV8%,3 = RM1,000(PVIF8%,3) = RM1,000(0.7938) = RM793.80 TheprincipalvalueforBankBthatoffersaninterestrateof10%is: PV10%,3 = RM1,000(PVIF10%,3) = RM1,000(0.7513) = RM751.30 TheprincipalvalueforBankCthatoffersaninterestrateof12%is: PV12%,3 = RM1,000(PVIF12%,3) = RM1,000(0.7118) = RM711.80
The examples above can also be applied either in the future value or time period by assuming that the other variables are constant. You will find that the future value has a negative relation with the time period (n) and interest rates (i) as shown in Figure 5.4. This graph explains that the principal value of RM1,000 that will be received in the future will decrease when the acceptance period is extended. The rate of decrease for present value is higher with the increase in discount rates or interest rates.
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Figure 5.4: Correlation between interest rate, time period and future value for RM100
5.3
SINGLE CASH FLOW MONEY VALUE
Single cash flow is a cash flow that only occurs once throughout the period of valuation. Both the concepts of compounding and discounting that were explained earlier have used the examples of single cash flow. The examples stated clearly shows that the future value of an amount of single cash flow invested presently will increase from time to time with the existence of specific interest rates. In reverse, a sum value of single cash flow that has been determined in the future will decrease when time approaches zero. Future value (compounding process)
Figure 5.5: Single Cash Flow: Future value and present value
5.4
SERIES CASH FLOW MONEY VALUE
The concept of future value and present value is not limited to the process of compounding and discounting single cash flow only. These concepts can be applied to a series of cash flow. A series cash flow means that there are a series of receiving or payments of cash that occur throughout the valuation period. There are several categories of series cash flow which are annuity, derivation cash flow and perpetuity.
5.4.1
Annuity
Annuity is a series of payment or receiving of the same amount at the same intervals throughout the period of valuation. Therefore, a cash flow of RM5 each month for one year is an annuity. While a cash flow of RM5 that is swap alternately with a cash flow of RM10 each month for a year is not an annuity. Annuity has a clearly stated starting point and an ending, in other words, annuity cash flow would not be indefinite. Normally, annuity occurs at the end of each period and this annuity is known as ordinary annuity. However, in some cases, annuity occurs at the beginning of the period and this type of annuity is known as annuity due. (a) Future Value of Ordinary Annuity Ordinary annuity is annuity that occurs at the end of each period as shown in Figure 5.6.
Figure 5.6: Time line of ordinary annuity
The finance manager often makes future planning for the company but they usually do not know how much investment or savings that must be saved continuously to accumulate the sum of money required in the future. The future value of annuity is the number of annuity payments at a specific amount (n) that will increase at a specific period based on a specific interest rate (i).
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Example 5.8 You had deposited RM100 at the end of each year for 3 years continuously in the account that pays a yearly interest of 10%. How much is the future value of that said annuity? The solution can be illustrated by the time line below:
First step Second step
: :
Calculate the future value for t1, t2 and t3. Total the three future values to get the future value annuity (FVA).
Firststep: F1 = = = F2 = = = F3 = Secondstep: FVA3 = = =
RM100(1+0.1)1 RM100(1.1) RM110 RM100(1+0.1)2 RM100(1.21) RM121 RM100(noincreaseinthefuturevalueasthedepositwasmadeat theendofthethirdyear).
F1+F2+F3 RM110+RM121+RM100 RM331
The steps shown in the example above takes time even though it is a simple example. In cases where the calculation for future value of annuities are for a period of 20 or 30 years, it will be slow with complicated calculations. Therefore, we can simplify the calculations by using the formula below:
FVA n = A[(1+i)n 1] i (3.5)
FVAn = A(FVIFAi,n )
(3.6)
Equation 3.5 used to solve the future value problems that involve the ordinary annuity is by manual calculation. While equation 3.6 is the solution formula for ordinary annuity using schedule. Annuity future value schedule can be obtained in Attachment C. Example 5.9 Danon Company deposited RM5,000 at the end of each year for a period of 3 years consecutively in an account that pays a yearly interest of 10 percent. What is the future value of that annuity? (i) Manual solution
FVA n = =
A [ (1 + i) n - 1] i RM5, 000 [(1 + 0.10)3 1]
0.10 = RM16, 550

(ii) Solution using schedule
FVA n
= A (FVIFA i, n ) = RM5, 000 = RM5, 000 (3.310) = RM16, 550
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The time line for future value of ordinary annuity of RM5,000 for 3 years at a rate of 10% per year is as below:
(b)
Future Value of Annuity Due Sometimes we face a situation where the payment of annuity is at the beginning of a period, for example, the beginning of each month or year. This type of annuity is known as annuity due where it is different from ordinary annuity as ordinary annuity is paid at the end of a period. Annuity due occurs more frequently in future value annuity problems than present value annuity (PVA). Figure 5.7 shows the timeline for annuity due.
Figure 5.7: Time line for annuity in advance.
The equation of annuity due can be formulated with a little alteration to the ordinary annuity equation that is by multiplying the equation of ordinary annuity with (1 + i). This alteration is made because the cash flow for annuity due occurs at the beginning of a period. (i)
(ii)
Manual equation FVA n = A [ (1 + i) n 1] (1 + i) i
(3.7)
Equation using schedule FVA n = A (FVIFA i,n) (1 + i)
(3.8)
Example 5.10 helps you to differentiate between ordinary annuity and annuity due. Example 5.10 Danon Company deposited RM5,000 at the beginning of each period for 3 years consecutively in the account that pays yearly interest of 10 percent. How much is the future value for that annuity? (i) Solving manually
(1 + i)n 1 n A =A (1 + i) i
= RM5, 000 = RM18, 205
[1 + 0.10)3 1] (1 + 0.10) 0.10
(ii)
Solving using schedule
FVA n = A (FVIFA i, n ) (1 + i) = RM5,000 (3.310) (1.10) = RM18,205
The time line for future value annuity due of RM5,000 for 3 years at an interest rate of 10% per year is as follows: t0 RM5,000 t1 RM5,000 t2 RM5,000 t3
RM18,205
From the solution above, we found that the future value for annuity due (RM18,205 in example 5.10) is higher compared to the future value for ordinary annuity (RM16,550 in example 5.9). This is because for annuity due, the deposit is
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deposited in the beginning of the period and therefore generates interest longer compared to the ordinary annuity where the deposit is deposited at the end of the period.
EXERCISE 5.5
Solve the questions below by using the manual formula or schedule (FVIFA i,n). 1. Assume you had deposited RM100 into the bank at the beginning of the year for 3 years in the savings account that gives 5% interest rate. How much can be obtained at the end of the third year? Mr. Yeoh deposited RM10,000 into the bank on 31st December each year for 5 years at an interest rate of 10%. How much can he obtain at the end of the fifth year?
2.
(c)
Present Value of Ordinary Annuity Payment of annuity promises a return rate (investment in bonds) and cash flow (cash flow resulting from investment in equipment and plant). Therefore, it is important for a finance manager to know the value of the investment at the present time. As an example, a finance manager finds that an annuity that promises four yearly payments of RM500 starting from the current year. How much must be paid by the finance manager to obtain that annuity? The principal amount that must be paid by the finance manager is the present value of ordinary annuity. The present value of ordinary annuity (PVAn) can be obtained by using the manual equation (equation 5.9) or by using the financial schedule in Attachment D (equation 5.10). Both the equations below refer to the present value annuity (PVA n) equivalent to the annuity cash flow multiply by the present value annuity factor. (i) Manual equation
[ 1 [1/(1 + i) n ] PVA n = A i
(5.9)
(ii)
Equation using schedule PVAn = A (PVIFAi,n) (5.10)
Example 5.11 Taming Company expects to receive RM3,000 at the end of each year for 3 consecutive years. How much is the present value for that annuity if it is discounted at the rate of 6% per year? (i) Solution via manual equation:
PVA n =A
[1[1/(1+i)n ] i [1 [1/(1+i)3 ] =RM3, 000 0.06

=RM8, 019.04
(ii)
Solution via equation using schedule PVAn = A (PVIFAi, n) = RM3,000 (PVIFA6%,3) = RM3,000 (2.673) = RM8,019
The time line for present value ordinary annuity of RM3,000 for 3 years at a discounted rate of 6% per year is as below: t0 i = 6% RM3,000
RM8,019.04 @ RM8,019.00
t1 RM3,000
t2 RM3,000
t3
(d)
Present Value of Annuity Due The concept of forming equation for present value of annuity due is as per the future value of annuity due where it is based on a small alteration to the ordinary annuity equation that is by multiplying equation 3.9 and 3.10 with (1 + i).
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PVA n = A
[ 1 [1/(1 + i) n ] (1 + i) i
(5.11)
Example 5.12 can help you to differentiate between the ordinary annuity with the annuity due for present value. Example 5.12 Taming Company expects to receive RM3,000 at the beginning of each year for consecutive 3 years. How much is the present value of that annuity if it is discounted at the rate of 6% per year? (i) Manual solution:
PVA n = A [ 1 [1/(1 + i)n ] (1 + i) i [ 1 - [1/(1 + 0.063)3 ] 0.06
= RM3,000
(1 + 0.06)
= RM8,500.18 (ii) Solution using schedule:
PVA n = A (PVIFA i,n ) (1 + i) = A (PVIFA

6%,3 )
(1 + 0.06)
= RM3,000 (2.673) (1.06) = RM8,500.14 The time line for present value annuity due of RM3,000 for 3 years at a discounted rate of 6% per year is as below: t0 i = 6% RM3,000
RM8,500.18 @ RM8,500.14
t1 RM3,000
t2 RM3,000
t3
As per the difference between ordinary annuity and annuity due for future value, the solution for present value of annuity due (RM8,500 in example 5.12) is also higher compared to the present value of ordinary annuity (RM8,019.00 in example 5.11). This is because in annuity due, the deposit is deposited in the beginning of the period and therefore generates interest longer compared to the ordinary annuity.
EXERCISE 5.6
1. You are offered an annuity payment of RM100 at the end of each year for 3 years and is deposited into the bank. The interest rate offered is 5% per year. How much is the present value of that annuity payment?
5.4.2
Derivation Cash Flow
Lots of decision in the financial field, for example the capital budgeting and dividend payments that involves a mixture of cash flow or cash flow that is irregular. The calculation of future value and present value of an irregular cash flow is a combination concept of determining money value for single cash flow and also annuity. (a) Future Value of Derivation Cash Flow The calculation for future value of derivation cash flow involves the determination of future value for each of the cash flows and subsequently totalling all that future values. Formula in equation 5.12 shows the future value (FVn) is obtained by adding each of the cash flow (Pt) that is adjusted with the exponent (n t) that is the number of periods in which the interest is obtained. Exponent is used in this formula because the last cash flow happens at the end of the last period. Therefore, interest is not obtained for it. The sigma symbol ( ) is the mathematical symbol for a total of a series of value. (i) Manual equation
FVn = Pt (1 + i)n1 t = 10
(5.12)
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If solution by using the schedule is chosen, you can use the formula in 5.2, 5.6 or 5.8 according to the suitability of the cash flow. This is because the calculation of future value of irregular cash flow is a combination concept of determining the value of money for single cash flow and also annuity. Example 5.13 Bikin Fulus Company made a decision to deposit RM2,000 at the end of the first and second year, withdrawing RM3,000 at the end of the third year and depositing RM4,000 again at the end of the fourth year. How much is this future value cash flow at the end of the fourth year if the annual interest rate is 10% per year? (i) Solution via manual formula FVn = Pt (1 + i)n-1
t=4 n
= (RM2,000)(1.10)4-1 + (RM2,000)(1.10)4-2 + (-RM3,000)(1.10) 4-3 + (RM4,000)(1.10) 4-4 = RM5,782 Example 3.13 can be illustrated by using the time line as shown below:
(ii)
Solution by using schedule Step 1: Find the future value of annuity for RM2,000 for 2 years (end of second year).
RM2,000 (FVIFA 10%, 2) = RM2,000 (2.10) = RM4,200

Step 2: Find the future value of RM4,2000 at the end of fourth year.
RM4,200 (FVIFA 10%, 2) = RM4,200 (1.21) = RM5,082

Step 3: Find the future value at the end of fourth year for the withdrawal of RM3,000 that occurred at the end of third year.
RM3,000 (FVIFA 10%, 1) = RM3,000 (1.10) = RM3,300

Step 4: The present value cash flow is obtained by adding the result of step 2-3 with the final cash flow of RM4,000. As RM4,000 occurs that the last period, there is no interest earnings from it.
FV4
(b)
= =
RM5,082 + (-RM3,300) + RM4,000 RM5,782
Present Value of Derivation Cash Flow Similar to the concept in determining the future value of derivation cash flow, the present value of derivation cash flow is also a combination concept of present value of single cash flow and annuity.
Manual equation:
PV0 = Pt [1/(1 + i)n ]
t=10 n
(5.13)
If solution by using the schedule is chosen, you can use the formula in present value of single cash flow, present value of ordinary annuity or present value of annuity in advance according to the suitability of the type of cash flow stated in the problem.
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Example 5.14 Buat Pitih Company expects to receive RM1,000 at the end of the first and second year, RM2,000 at the end of the third year and RM4,000 at the end of the fourth year. How much is the present value cash flow if the yearly interest rate is 10% per year? (i) PV0 Solution via manual formula = Pt (1 + i)n-t
t=10 n
= [RM1,000][1/(1.10)1 ] + [RM1,000][1/(1.10)2 ] + [RM2,000][1/(1.10)3 ] + [RM4,000][1/(1.10) 4 ] = RM5,970.22 The time line for example 3.14; present value for derivation cash flow is as below: t0 i = 10% t1 RM1,000 t2 RM1,000 t3 RM2,000 t4 RM4,000
RM909.99 RM826.45 RM1,502.632 RM5,970.22 RM2,732.05
(ii)
Solution via schedule Step 1: Find the present value for annuity of RM1,000 for 2 years. RM1,000 (PVIFA 10%, 2) = RM1,000 (1.736) = RM1,736 Step 2: Find the present value for RM2,000 that occurs at the end of third year. RM2,000 (PVIF 10%, 3) = RM2,000 (0.751) = RM1,502
Step 3: Find the present value for RM4,000 that occurs at the end of forth year. RM4,000 (PVIF 10%, 4) = RM4,000 (0.683) = RM2,732
Step 4: The present value cash flow is obtained by adding all the previous results earlier (figure bolded). PV 0 = RM1,736 + RM1,502 + RM2,732 = RM5,970
5.4.3 Perpetuity
Perpetuity is a type of series cash flow that involves the same amount for each period continuously. In other words, perpetuity is an annuity that has an infinity period. An example of perpetuity is the payment of dividends for preference shares. The concept for future value of perpetuity is illogical and cannot be used in making financial decisions as the concept do not predict the period ending point while future value is something that can be expected. Instead, the concept for present value of perpetuity can be applied in making financial decisions. For example, the usage of this concept to determine the present value for preference shares and present value for pensions. From the formula of present value of annuity, we know that:
PVA n = A [ 1 [1/(1 + i)n ] i (5.14)
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Try to imagine what will happen if the value of n increases. The value of (1 + i)n will also increase. This will caused 1/(1 + i)n to become smaller. When (n) approaches infinity, the value of (1 + i)n will become extremely big while the value of 1/(1 + i)n will approach zero. The situation above can be summarised as follows: PV p = P / i (5.15)
Based on this equation, the present value of perpetuity is equivalent to the payment of annuity amount (P) divided by the interest rate (i). Solution by schedule and scientific calculator cannot resolve the present value of perpetuity. This is because schedule PVIFA does not contain the value for infinity and the same with scientific calculators that do not have an infinity button. It must be calculated manually by calculation in stages. Figure 3.19 shows the position of variables in equation 3.15. t0 i% PVp t1 P t2 P t60 P t=
Figure 5.19: Present value of perpetuity
Example 5.15 Sukehati Company issued securities that promised a payment of RM100 per year at the yearly interest rate of 8% to the holders of that security. How much is the present value for that cash flow? PVp =P/i = RM100 / 0.08 = RM1,250
The financial schedule does not provide the factor for present value of perpetuity because perpetuity involves an infinity period. Therefore, the solution for perpetuity cases can only depend on manual calculations.
EXERCISE 5.7
1. Consider the perpetuity that pays RM100 per year, with an interest rate of 10%. How much is the present value of this perpetuity?
5.5
COMPOUNDING AND DISCOUNTING MORE THAN ONCE A YEAR
The practice of compounding or discounting interest more than once a year is also known as intrayear compounding or discounting. For example, compounding or discounting twice a year, three times a year, four times a year or each month. The frequency of compounding or discounting several times in a year is a normal practice in making financial decisions. When the frequency of compounding or discounting for future value or present value is more than once a year (n x m), the interest rate must also be divided with the said frequency (i / m). The purpose is to adjust the changes in the period and interest rate to enable both the variables to change consistently. Therefore, a little alteration must be made to the formulas that had been learned previously. The formula for manual solution is: FV = PV (1 + i/m)nm FV PV i m n = = = = = Future value Present value Interest rate Frequency of compounding or discounting in a year Number of years (5.16)
While the solution by schedule is as follow: FV = PV x (FVIF i/m,nm) (5.17)
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Example 5.16 The future value of RM1 now after 6 years, using the interest rate of 10% per year with different compounding frequencies.
Presumed Compounding Once a year Twice a year Four times a year Every month nm 6x1=6 6 x 2 = 12 6 x 4 = 24 6 x 12 = 72 i/m 0.1/1=0.01 0.1/2=0.05 0.1/4=0.025 0.1/12=0.0083 FV nm RM1.772 RM1.796 RM1.809 RM1.817
Example 5.17 The present value of RM1 received in 6 years from now, discounted at the interest rate of 10% per year with different discounting frequencies.
Presumed Discounting Once a year Twice a year Four times a year Every month nm 6x1=6 6 x 2 = 12 6 x 4 = 24 6 x 12 = 72 i/m 0.1/1=0.01 0.1/2=0.05 0.1/4=0.025 0.1/12=0.0083 PV 0 RM0.564 RM0.557 RM0.553 RM0.550
The conclusion that can be made based on examples 5.16 and 5.17 is: the higher the frequency of compounding, the higher the future value of cash flow; and higher the frequency of discounting, the lower the present value of cash flow.
5.6
CONTINUOUS COMPOUNDING AND DISCOUNTING
Before this, you were only exposed to situations where the interest is compounded or discounted at specific discrete intervals whether yearly or twice a year, monthly and so forth. However, in some cases of time value of money, interest must be compounded or discounted continuously or at each microsecond. Referring to formula 3.16, FV = PV x (1 + i/m) nm, we cannot divide the value (i) with infinity and multiply (n) with infinity. Instead, we use the term (e) that is e ~ 2.71828. The value e is an antilog to 1 and same as pi ( ) with value of 3.142, which cannot be represented by one exact value but only as an estimated value.
The new formula for future value and present value that is compounded and discounted continuously is as follows. Future value: FVn = PV0 (e in) Present value: PV0 = FVn (e in) (5.18) (5.19)
The estimate number for the symbol e in equation 5.18 and 5.19 is 2.72 (or more accurately, 2.71828183). Example 5.18 What is the future value for RM100 that is invested now for 6 years with an interest rate of 8 percent per year and compounded continuously? Manual solution: FVn = PV 0 (e in) = RM100 (2.72 (0.08)(6)) = RM161.61
Example 5.19 What is the present value of RM161.61 that will be received in 6 years from now that is discounted continuously at an interest rate of 8 percent per year? PVn = FVn (e in) = = 161.61 (2.72 (0.08)(6) RM100
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EXERCISE 5.8
1. What is the future value for RM260 that is invested now for 3 years at the interest rate of 10 percent per year and compounded continuously? What is the present value for RM200 that will be received 5 years from now and discounted continuously at the interest rate of 6 percent per year? Mr. Sarbat plans to invest RM3,000 a year in the Pension Investment Scheme for a period of 15 years. Mr. Sarbat wants to know the result of the RM3,000 investment at the beginning of each year compared with the end of each year. Calculate the value differences between the two types of cash flow if the interest rate is 8 percent per year. Mas Joko Company is considering an investment on a new machine that involves a total purchase and assembly cost of RM30,000. The usage of this new machine is expected to generate a yearly cash flow for 5 consecutive years: end of first year RM4,000, end of second and third year RM5,000, end of fourth year RM6,000 and end of fifth year RM8,000. If the company requires a yearly 18% rate of return on its investment, is it reasonable for the company to continue with its investment? Complete the present value for a series of indefinite yearly payments of RM180, assuming that the interest rate is (a) (b) 6. 5 percent 10 percent
2.
3.
4.
5.
You have just won a puzzle contest where you were offered two choice of prizes that is whether to accept RM60,000 today or RM12,000 at the end of each year for 5 consecutive years. If the cash flow is discounted at a yearly rate of 12 percent and compounded twice a year, which choice would you choose? Mrs. Aimi plans to get a loan for a total of RM6,000 at the interest rate of 10% from a kind-hearted money lender. The money lender agrees to receive a sum of payment for the same amount at the end of each year for 4 years. What is the size of payment that Mrs. Aimi must give to the money lender each year? What is the present value for RM400 that will be received in 7 years from now and discounted continuously at the interest rate of 10 percent per year?
7.
8.
In this topic, you have learnt the importance of time value of money. The concepts of compounding and discounting are used respectively to compute future value and present value for single or series of cash flows. The knowledge in this area would help you to make better financial decisions that involves cash flows.
TUTORIAL QUESTION
INTRODUCTION
The purpose of these activities is to test your understanding on the basic concepts in financial management, which is the concept of time value of money, risk and return as well as leverage. These concepts are important in financial decisions making.
PROBLEM 1
Naim and Nadiah are planning in sharing to buy a house 10 years from now with the expected price of RM100,000. Naim will save RM5,000 every year in his account beginning a year from now. His last annual savings will be made at the end of the tenth year. Nadiah will deposit RM4,000 in the account now and another RM8,000 four years from now. They also plan to help Naims father (Mr. Roslee) who had just retired and Nadiahs sister (Nurul) who had just started her studies in university. Naim will deposit a sum of money into his fathers account to enable him to withdraw RM3,600 per year, starting a year from now until his fathers death. While, Nadiah will deposit RM6,000 into Nuruls account and will only allow Nurul to withdraw the same amount every year starting a year from now. As the period of her studies is four years, Nurul will make four withdrawals.
ASSIGNMENT
With the assumption that all the accounts will pay an interest of 9%, compounded yearly, answer the following questions: (a) (b) (c) How much should be added by Naim and Nadiah at the end of the tenth year to enable them to buy the said house? How much is the amount that Naim must deposit into his fathers account? How much is the amount that Nurul can withdraw every year?
ANSWERS
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Answers
TOPIC 1: ACCOUNTING ENVIRONMENT Exercise 1.1
1. Internal users are people who have direct access to the resources of an entity and are normally involved in the management of the company; an example being the companys management. These people are involved in planning and controlling the activities of the company to enable it to achieve specified objectives. Examples of common decision making are: (a) does the company require additional capital or not; if the company requires additional capital, would the company be applying for loan or issue shares. does the company require additional asset; if the company requires additional asset, would the company be buying or renting it. how much is the companys excess cash, if any, should be utilised. how the company is going to overcome insufficient cash flow problems it might be facing. the companys strategy to expand the market for its products
(b) (c) (d) (e)
External users are people who do not have direct access to the resources of the company and to not involved in the management of the company. Examples of external users are investors, loan providers, Inland Revenue Board, government agencies and the public. The types of decision made are different according to user groups. For example, investors make decisions on whether to invest in a company, loan providers make decisions on whether to approve loans while the Inland Revenue Board decide on the total tax to be imposed. 2. Financial accounting helps decision makers by preparing the entitys financial reports for external and internal users; but is focused more on external users. The financial report is released periodically and is subject to specific standards and formats. The users are able to make decisions on the performance and status of the company through this report. Management Accounting provides the financial and non-financial information required by the management of the company for planning,
178
ANSWERS
evaluating and controlling the operations of the entity. Reports may be issued at any time according to requirement and are not subject to any standards and formats. Through this report, the users are able to take the necessary measures required for improvement in order to ensure that the company achieves its objectives.
Exercise 1.2
1. The characteristics of accounting information can be divided into two categories, primary characteristics and secondary characteristics. The primary characteristics are comprised of relevant and reliability, while the secondary characteristics are comparability and consistency. Comparability means that the information can be compared; whether among companies, among industries or across different periods. Let us assume that you are interested in investing in a company. You were informed that the net income of the company in year 2000 was RM10 million. Is this information useful? Actually, it is only useful if you have other information that can be compared with that figure. For example, the net income in 1999 for the company was RM3 million. This information enables you to conclude that the company has gained a huge increase in net income. What if you were told that the net income of the company in 1999 was RM19 million? You might not want to proceed with the investment because the company has experienced a huge decline in net income. You would not be able to come to this conclusion by only referring to the RM10 million figure.
2.
Exercise 1.3
1. The weaknesses in the assumption of monetary unit: (a) Limiting the scope of accounting. This is because only transactions that can be measured in monetary unit will be taken into consideration in accounting, whereas there are many other factors that will also affect the business. For example, the death of the companys manager, termination of staff, recognition by specific bodies on the business achievements and other factors. All these cannot be recorded in the financial statements as it cannot be stated in monetary terms. Assuming the value of money is stable at all times; when we know that the currency value fluctuates. You have often heard the grumblings or even experienced the fluctuation in currency value. We used to be able to buy several items with RM10 but not so presently.
(b)
ANSWERS
179
In the early days, school children only took 20 cents to school, now they bring RM2. All these examples show that the currency value has changed. In other words, the RM1 you have today will not have the same value as the RM1 you will receive in a couple of months time. The fluctuation in the currency value should have been taken into account when recording transactions but was ignored. 2. Three conditions that must be fulfilled before revenue can be recognised are: (a) The seller had done the necessary action to obtain the revenue (for example, had supplied the goods for trade or rendered its services to customer). The revenue cannot be recognised if the goods or services are not supplied or rendered to the customer, even though the customer had paid cash. The amount of revenue can be measured objectively. If the seller had handed over the goods or provided the services, but have not determined the amount that must paid by the customer, then the revenue cannot be recognised. For credit transactions, the revenue can be collected. The seller had handed over the goods or provided the services and had stated the amount to be paid by the customer. If the seller is confident that cash is collectable from the customer, then the revenue will be recognised at the point of sale. However, if the seller is uncertain, then the revenue will only be recognised when cash is received.
(b)
(c)
Exercise 1.4
1. (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) accounting period historical cost relevant Malaysian Accounting Standards Board reliability principle of matching cost benefit relation, materiality management accounting going concern point of sale Cash Flow Statement Balance Sheet
180
ANSWERS
2. 3. 4. 5. 6. 7. 8. 9.
D A D C False False False (a) (b) (c) 46,000 100,000 75,000 Asset increased, Asset decreased or has no effect on the Asset Asset decreased, Owners Equity decreased Asset decreased, Owners Equity decreased Asset increased, Asset decreased or has no effect on the Asset Asset increased, Owners Equity increased
10.
(a) (b) (c) (d) (e)
ANSWERS
181
11.
ASSET Trans action a. Cash + +20,000 AR + Supplies = LIABILITY = AP + + O.EQUITY Capital, Ashwin +20,000 Investment by Ashwin 20,000 20,000 20,000 +4,200 Service revenue 24,200 -1,000 Salary expenses 23,200 -700 Transportation expenses -150 Sundry expense 22,350 -1,200 Rental expenses 21,150 +2,500 Service revenue 23,650 -550 Supplies expenses 23,100 -750 Drawings, Ashwin 22,350
Balance b. Balance c. Balance d. Balance e. Balance f.
20,00 20,000 -620 19,380 +4,200 23,580 -1,000 22,580 -700 +800 800 800
= = = +800 800 -620 180 180 800
800
180
-150 Balance g. Balance h. Balance i. Balance j. 21,730 -1,200 20,530 +2,500 20,530 2,500 800 -550 250 = 180 800 = 180
800
180
20,530 -750
2,500
180
Balance
19,780
2,500
250
180
182
ANSWERS
12.
(a)
Seri Consultation Services Income Statement For the year ended 31 December 2000 RM Service Revenue (-) Expenses: Supplies expenses Tax expenses Salary expenses Rental expenses Utility expenses Sundry expenses Net income RM 78,750
6,300 4,200 18,000 14,400 7,350 1,265
(51,515) 27,235
(b)
Seri Consultation Services Statement of Changes in Owners Equity For the year ended 31 December 2000 Capital, Seri Dewi 1 Jan (+) Net income (-) Drawings Capital, Seri Dewi 31 Dec RM 22,200 27,235 49,435 (6,000) 43,435
(c)
Seri Consultation Services Balance Sheet As at 31 December 2000 RM ASSETS Cash (23,300 6,000) Accounts receivable Supplies TOTAL ASSETS LIABILITIES Accounts Payable OWNERS EQUITY Capital, Seri Dewi TOTAL LIABILITIES AND O.EQUITY 17,300 18,855 8,480 44,635
1,200
43,435 44,635
ANSWERS
183
TOPIC 2: RECORDING PROCESS

Exercise 2.1
1. (a) It is not a transaction and must not be recorded. This is because it will not affect the entitys financial position (will not affect the asset, liability or owner equity) and cannot be measured in currency unit. It is a transaction and must be recorded. This will affect the entitys financial position (increase asset and owners equity) and can be measured in currency unit.
(b)
Exercise 2.2
1. Account is a specific and separate accounting record for each item in the financial statement. All transactions that affect the items will be recorded in the accounts. Ledger is a group of accounts for a business entity. Chart of accounts is the list of accounts in the ledger. T-Account and three column account. T-account is easier but the three column account enables us to know the last balance after each transaction. Drawings are made by the owner for personal use while expenses are incurred by the entity for the purpose of generating income. Drawings are not considered in the calculation of net profit or loss, but are deducted directly from owners equity. Expenses will be matched against income. The difference between income and expenses will be either net profit or net loss. This difference will be added or deducted from owners equity. C C (a) (b) (c) (d) (e) (f) (g) (h) Asset Expense Asset Income Liability Asset Expense Asset
2.
3.
4. 5. 6.
184
ANSWERS
7.
(a)
Date Apr 2001 a. Account and Description Cash Capital, Cindy (Cash investment by Cindy) Supplies Accounts payable (Purchase of supplies on credit) Cash Service revenue (Cash received for services provided) Rental expenses Cash (Payment of rental by cash) Accounts payable Cash (Payment to accounts payable) Accounts receivable Service revenue ( Customer has not paid for services provided) Utility expenses Sundry expenses Cash (Payment for expenses by cash) Salary expenses Cash (Payment for salary by cash) Supplies expenses Supplies (Usage of supplies) Drawings Cash Supplies (Cash and supplies drawings by owner) Reference Debit 5,000 5,000 275 275 3,250 3,250 Credit
b.
c.
d.
750 750 125 125 1,875 1875
e.
f.
g.
390 187 577 1,250 1,250 162 162 550 500 50
h.
i.
j.
ANSWERS
185
(b)
Post to ledger Cash Account Date Apr 2001 Description Capital, Cindy Service revenue Rental expenses Accounts payable Utility expenses Sundry expenses Salary expenses Drawings, Cindy Reference Debit 5,000 3,250 Credit Balance 5,000 8,250 7,500 7,375 6,985 6,798 5,548 5,048
750 125 390 187 1,250 500
Account Receivable Date Apr 2001 Description Service revenue Reference Debit 1,875 Credit Balance 1,875
Supplies Account Date Apr 2001 Description Accounts payable Supplies expenses Drawings, Cindy Reference Debit 275 Credit 162 50 Balance 275 113 63
Accounts Payable Date Apr 2001 Description Supplies Cash Reference Debit 125 Credit 275 Balance 275 150
Capital Account, Cindy Date Apr 2001 Description Cash Reference Debit Credit 5,000 Balance 5,000
Drawings Account, Cindy Date Apr 2001 Description Cash Supplies Reference Debit 500 50 Credit Balance 500 550
186
ANSWERS
Service Revenue Account Date Apr 2001 Description Cash Accounts receivable Reference Debit Credit 3,250 1,875 Balance 3,250 5,125
Rental Expenses Account Date Apr 2001 Description Cash Reference Debit 750 Credit Balance 750
Utility Expenses Account Date Apr 2001 Description Cash Reference Debit Credit 350 Balance 350
Sundry Expenses Account Date Apr 2001 Description Cash Reference Debit 187 Credit Balance 187
Salary Expenses Account Date Apr 2001 Description Cash Reference Debit 1,250 Credit Balance 1,250
Supplies Expenses Account Date Apr 2001 Description Cash Reference Debit 162 Credit Balance 162
ANSWERS
187
(c)
Trial Balance Cindy Insurance Agency Trial Balance as at 30 April 2001 Accounts Cash Accounts receivable Supplies Accounts payable Capital, Cindy Drawings, Cindy Service revenue Salary expenses Rental expenses Utility expenses Supplies expenses Sundry expenses TOTAL Debit (RM) 5,048 1,875 63 150 5,000 550 5,125 750 390 187 1,250 162 10,275 Credit (RM)
10,275
8.
(a)
GENERAL JOURNAL Date Account and Description Reference Feb 1 Supplies L104 Cash L101 (Purchased supplies by cash) 2 Drawings, Edlin L302 Cash L101 (Cash drawings by owner) 5 Cash L101 Accounts receivable L102 (Received cash from customer for payment of accounts receivable) 9 Office equipment L108 Accounts payable L201 (Purchased office equipment on credit) 15 Accounts payable L201 Cash L101 (Payment to accounts payable) Debit 274 Credit 274 2,000 2,000 2,740 2,740
3,850 3,850
1,200 1,200
188
ANSWERS
(b)
Cash Service revenue (Received for services provided) 25 Advertisement expenses Cash (Payment for advertisement) 28 Utility expenses Cash (Payment for businesss telephone and electricity bill) 28 Drawings, Edlin Cash (Payment for telephone and electricity bill of owners house by cash from the business) 28 Rental expenses Cash (Payment for rental of business premises) 28 Sundry expenses Cash (Repair of office equipment by cash) Post of entries to ledger Cash Account Date Feb 1 1 2 5 15 18 25 28 28 28 28 Description Cash Supplies Drawings, Edlin Accounts receivable Accounts payable Service revenue Advertisement expenses Utility expenses Drawings, Edlin Rental expenses Sundry expenses Reference J1 J1 J1 J1 J1 J1 J1 J1 J1 J1
18
L101 L401
580 580
L502 L101 L503 L101
420 420 215 215
L302 L101
117 117
L501 L101
1,200 1,200
L509 L101
220 220
No: 101 Debit Credit Balance 15,238 274 14,964 2,000 12,964 15,704 1,200 580 420 215 117 1,200 220 14,504 15,084 14,664 14,449 14,332 13,132 12,912
2,740
ANSWERS
189
Accounts Receivable Date Feb 1 5 Description Balance Cash Reference J1 Debit Credit 2,740
No: 102 Balance 4,575 1,835 No: 104 Reference J1 Debit 274 Credit Balance 427 701 No: 108 Reference J1 Debit 3,850 Credit Balance 8,400 12,250 No: 201 Reference J1 J1 Debit Credit 3,850 1,200 Balance 1,730 5,580 4,380 No: 301 Reference Debit Credit Balance 26,910 No: 302 Reference J1 J1 Debit 2,000 117 Credit Balance 2,000 2,117 No: 401 Reference J1 Debit Credit 580 Balance 580 No: 501 Reference J1 Debit 1,200 Credit Balance 1,200
Supplies Account Date Feb 1 1 Description Balance Cash
Office Equipment Account Date Feb 1 9 Description Balance Account payable
Accounts Payable Date Feb 1 9 15 Description Balance Office equipment Cash
Capital Account, Edlin Date Feb 1 Description Balance
Drawings Account, Edlin Date Feb 2 28 Description Cash Cash
Service Revenue Account Date Feb 18 Description Cash
Rental Expenses Account Date Feb 28 Description Cash
190
ANSWERS
Advertisement Expenses Account Date Feb 25 Description Cash Reference J1 Debit 420 Credit
No: 502 Balance 420 No: 503
Utility Expenses Account Date Feb 28 Description Cash Reference J1 Debit 215 Credit
Balance 215 No: 509
Sundry Expenses Account Date Feb 28 (c) Description Cash Reference J1 Debit 220 Credit
Balance 220
Trial Balance Edlin Enterprise Trial Balance as at 28 February 2001 Account Number 101 102 104 108 201 301 302 401 501 502 503 509 Accounts Cash Accounts receivable Utilities Office equipment Accounts payable Capital, Edlin Drawings, Edlin Service revenue Rental expenses Advertisement expenses Utility expenses Sundry expenses TOTAL Debit (RM) 12,912 1,835 701 12,250 4,380 26,910 2,117 580 1,200 420 215 220 31,870 Credit (RM)
31,870
ANSWERS
191
TOPIC 3: FINANCIAL STATEMENTS

Exercise 3.1
1. 2. 3. 4. 5. 6. (b) False (b) False (a) True (b) False C
Account Account payable Account receivable Accruals Building General expenses Interest expenses Sales expenses Operating expenses Administrative expenses Tax Preference shares' dividends Sales revenue Long term loans Inventory Cost of goods sold Paid up capital above par Notes payable Retained earnings Equipment Ordinary shares Preference shares Marketable securities Depreciation Accumulated depreciation Land Cash (1) Statement BS BS BS BS IS IS IS IS IS IS IS IS BS BS IS BS BS BS BS BS BS BS IS BS BS BS (2) Type of Account CL CA CL FA E E E E E E E R LTL CA E EQ CL or LTL EQ FA EQ EQ CA E FA (contra account) FA CA
192
ANSWERS
7. Company PC Income Statement for the Year Ended 31 December 2001

Sales Less: Cost of goods sold Gross profit Less Operating expenditure Sales expenses Administrative and general expenses Depreciation expenses Total operating costs Profit before interest and tax Interest expenses Profit before tax Tax (30%) Profit after tax Less: Preference shares dividend Net profit (or profit available for ordinary shareholders) Earnings per share RM5,250,000 2,850,000 RM2,400,000 RM350,000 600,000 550,000 RM1,500,000 RM 900,000 250,000 RM 650,000 195,000 RM 455,000 100,000 RM 355,000 RM 0.17
8.
Company ODC Balance Sheet as at 31 December 2001

Assets Current assets Cash Marketable securities Account receivable Inventory

Fixed assets Land Building Machines Equipments
RM2,150,000 750,000 4,500,000 3,750,000 RM11,150,000 RM2,000,000 RM2,250,000 4,200,000 2,350,000 RM10,800,000 2,650,000 8,150,000 RM19,300,000
Total fixed assets

Less: Accumulated depreciation Fixed assets, net Total Assets
ANSWERS
193
Liabilities and Equities
Current liabilities
Account payable Notes payable Accruals

Long-term loans Total liabilities Equities Preference shares Ordinary shares Paid up capital Retained earnings
RM2,200,000 4,750,000 550,000 RM7,500,000 4,200,000 RM11,700,000
Total equities
Total liabilities and equities
RM1,000,000 900,000 3,600,000 2,100,000 RM7,600,000 RM19,300,000
Exercise 3.2
1. 2. 3. 4. 5. 6. 7. (b) False (b) False (a) True (b) False C D (a)
Hugo Enterprise Statement of Retained Earnings for the year ended 31 December 2000 Retained Earnings, 1 January 2000 + Net Profit (throughout year 2000) - Dividends paid (throughout year 2000) Preference shares RM 4,700 Ordinary shares 21,000 Retained Earnings, 31 December 2000
RM 92,800 37,000
25,700 RM104,800
194
ANSWERS
(b)
Earnings per share
RM37,700 RM4,700 14,000
= RM2.36
(c) 8.
Dividends per share =
RM21,000 14,000
= RM2.36
Dividends paid = =
RM736,000 + RM186,000 RM812,000 RM110,000
9.
Items Cash Account payable Notes payable Long-term loans Inventory Fixed assets Account receivable Net profit Depreciation Share buyback Cash dividend Sales of Share Changes (RM) + 1,000 -10,000 + 5,000 -20,000 +20,000 + 4,000 - 7,000 + 6,000 + 1,000 + 6,000 + 8,000 + 10,000 Cash Flow U U R U U U R R R U U R
ANSWERS
195
10.
Suresh Corporation Changes in balance sheet items between 31 December 2001 and 31 December 2002 2001 Assets Cash Marketable securities Account receivable Inventory Total fixed assets Less: Accumulated depreciation 2002 Changes Resource Usage
15,000 18,000 20,000 29,000 295,000 147,000
10,000 12,000 18,000 28,000 281,000 131,000
+5,000 +6,000 +2,000 +1,000 +14,000 (16,000)
5,000 6,000 2,000 1,000 14,000 16,000
Liabilities Account payable Notes payable Wages accrual Long term loans Equities Preference shares Retained earnings TOTAL
16,000 28,000 2,000 50,000
15,000 22,000 3,000 50,000
+1,000 +6,000 - 1,000 0
1,000 6,000 1,000
100,000 14,000
100,000 28,000
0 +6,000
6,000 RM29,000
RM29,000
196
ANSWERS
Suresh Corporation Cash Flow Statement For the Year Ended 31 December 2002 Cash Flow from Operating Activities Net Profit Depreciation Increase in account receivable Increase in inventory Increase in account payable Decrease in accrual
RM14,000 16,000 (2,000) (1,000) 1,000 (1,000) RM27,000 (14,000) (14,000) RM6,000 (8,000) (2,000) RM11,000
Cash flow from operating activities

Cash Flow from Investing Activities Increase in total fixed assets

Cash Flow from Financing Activities Decrease in short term notes payable Dividends paid

Net increase securities in cash and marketable
Exercise 3.3
1. Fazrul Company
1999 RM180,000 2.5 times 1.17 times 1998 RM150,000 2.07 times 1 time
(a) Net working capital (b) Current ratio (c) Quick ratio
ANSWERS
197
Exercise 3.4
1. Fazrul Company
(a) Account receivable turnover (b) Average collection period (c) Inventory turnover (d) Average inventory sales period (e) Fixed asset turnover (f) Total asset turnover 1999 9.14 times 39.9 days 2.54 times 14.4 days 142.3 times 1.07 times 1998 9.03 times 40.4 days 39.87 times 14.2 days 140.01 times 1.02 times
Exercise 3.5
1. Adiy Corporation (a) (b) (c) (d) (e) Debt ratio = 50% Interest coverage ratio = 3 times Return on asset = 36% Average collection period = 27 days Total asset turnover = 2 times
Exercise 3.6
1. 2. 3. 4. 5. 6. 7. 8. liquidity current asset; current liability inventory cost of goods sold; inventory total asset net profit; owners equity share price; earnings
X-Cell 12.67% 31.67% 10.27% 1.23 times 60% 2.5 times 7.89 times 6.25 6.86% N-Hance 11.25% 28.13% 9.57% 1.18 times 60% 2.5 times 8.37 times 12.62 1.89%
(a) Return on asset (b) Return on equity (c) Net profit margin (d) Total asset turnover (e) Debt ratio (f) Equity multiplier (g) Interest coverage ratio (h) Price/earnings ratio (i) Dividend yield ratio
198
ANSWERS
Exercise 3.7
1. 2. 3. 4. 5. 6. 7. (a) True (b) False D C Net profit = RM6,000 Return on equity = 4.0% Fima Corporation (a) Current ratio increased. (b) Return on equity decreased. (c) Debt ratio increased. (d) Dividend yield increased. (e) Account receivables turnover decreased. (f) Return on asset decreased. Lily Company (a) Current ratio = 0.91 times (b) Quick ratio = 0.63 times (c) Average collection period = 32.5 days (d) Inventory turnover = 20 times (e) Fixed asset turnover = 4.60 times (f) Total asset turnover = 2.8 times (g) Debt ratio = 55% (h) Interest coverage ratio = 4.0 times (i) Gross profit margin = 13% Operating profit margin = 2% (j) (k) Net profit margin = 1.08% (l) Return on asset = 3% (m) Return on equity = 6.7% Amri Company Marketable securities Account receivable Inventory Total fixed asset Net fixed asset Total asset Notes payable Total current liability Long-term liability Total liability Total equity Total liability and equity
8.
9.
= = = = = = = = = = = =
RM16,000 RM62,000 RM73,560 RM146,663 RM96,663 RM256,228 RM20,300 RM67,900 RM58,677 RM126,577 RM129,651 RM256,228
ANSWERS
199
TOPIC 4: FINANCIAL STATEMENT ANALYSIS Exercise 4.1

1. Fazrul Company
1999 RM180,000 2.5 times 1.17 times 1998 RM150,000 2.07 times 1 time
(a) Net working capital (b) Current ratio (c) Quick ratio
Exercise 4.2
1. Fazrul Company
(a) Account receivable turnover (b) Average collection period (c) Inventory turnover (d) Average inventory sales period (e) Fixed asset turnover (f) Total asset turnover 1999 9.14 times 39.9 days 2.54 times 14.4 days 142.3 times 1.07 times 1998 9.03 times 40.4 days 39.87 times 14.2 days 140.01 times 1.02 times
Exercise 4.3
1. Adiy Corporation (a) Debt ratio = 50% (b) Interest coverage ratio = 3 times (c) Return on asset = 36% (d) Average collection period = 27 days (e) Total asset turnover = 2 times
200
ANSWERS
Exercise 4.4
1. 2. 3. 4. 5. 6. 7. 8. liquidity current asset; current liability inventory cost of goods sold; inventory total asset net profit; owners equity share price; earnings
X-Cell 12.67% 31.67% 10.27% 1.23 times 60% 2.5 times 7.89 times 6.25 6.86% N-Hance 11.25% 28.13% 9.57% 1.18 times 60% 2.5 times 8.37 times 12.62 1.89%
(a) Return on asset (b) Return on equity (c) Net profit margin (d) Total asset turnover (e) Debt ratio (f) Equity multiplier (g) Interest coverage ratio (h) Price/earnings ratio (i) Dividend yield ratio
Exercise 4.5
1. 2. 3. 4. 5. 6. 7.
True False D C Net profit = RM6,000 Return on equity = 4.0% Fima Corporation (a) Current ratio increased. (b) Return on equity decreased. (c) Debt ratio increased. (d) Dividend yield increased. (e) Account receivables turnover decreased. (f) Return on asset decreased. Lily Company (a) Current ratio = 0.91 times (b) Quick ratio = 0.63 times (c) Average collection period = 32.5 days (d) Inventory turnover = 20 times
8.
ANSWERS
201
(e) (f) (g) (h) (i) (j) (k) (l) (m) 9.
Fixed asset turnover = 4.60 times Total asset turnover = 2.8 times Debt ratio = 55% Interest coverage ratio = 4.0 times Gross profit margin = 13% Operating profit margin = 2% Net profit margin = 1.08% Return on asset = 3% Return on equity = 6.7%
Amri Company Marketable securities Account receivable Inventory Total fixed asset Net fixed asset Total asset Notes payable Total current liability Long-term liability Total liability Total equity Total liability and equity = = = = = = = = = = = = RM16,000 RM62,000 RM73,560 RM146,663 RM96,663 RM256,228 RM20,300 RM67,900 RM58,677 RM126,577 RM129,651 RM256,228
202
ANSWERS
TOPIC 5: TIME VALUE OF MONEY

Exercise 5.1
1. 2. RM127.63 RM6,050
Exercise 5.2
1. 2. RM11,171.10 RM4,974.55
Exercise 5.3
1. 2. RM1,000 RM2,268.43
Exercise 5.4
1. 2. RM100.06 RM3,522.77
Exercise 5.5
1. 2. RM330.96 RM61,050
Exercise 5.6
1. RM272.30
Exercise 5.7
1. RM1,000
ANSWERS
203
Exercise 5.8
1. 2. 3. RM346.06 RM149.4 FVOA FVAD
4.
= = = = = =
RM3,000(FVIFA8%,15) RM3,000(27.1521) RM81,456.30 RM3,000(FVIFA8%,15)(1.08) RM3,000(29.32) RM87,972.80
Thedifference:RM6,516.50 PV1=RM4,000(PVIF18%,1)=RM3,390.00 PV2=RM5,000(PVIF18%,2)=RM3,591.00 PV3=RM5,000(PVIF18%,3)=RM3,043.00 PV4=RM6,000(PVIF18%,4)=RM3,094.80 PV5=RM8,000(PVIF18%,5)=RM3,496.80 TotalPV =RM16,615.60 RM16,615.60RM30,000 =RM13,384.40 Therefore,MasJokoCompanyshouldnotcontinuewithitsinvestment.
5. 6.
(a) RM180/5% (b) RM180/10%
=RM3,600 =RM1,800
PVOA=RM12,000(PVIFA6%,10) =RM12,000(7.3601) =RM88,321.20 The second choice should be chosen (RM88,321.20) as the present value is morecomparedtothefirstchoice(RM60,000).
7. 8.
PMTA =PVA/(PVIFA10%,4) =RM6,000/3.170 =RM1,892.74 PV =RM400(2.72)(0.10)(7) =RM198.55

BQOEIII Fundamentals of Accounting &amp; Finance

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BQOE III FUNDAMENTALS OF ACCOUNTING AND FINANCE

128 129 130 132 132 134 136 141 142

TOPIC 1 ACCOUNTING ENVIRONMENT

Users of Accounting Information

TOPIC 1 ACCOUNTING ENVIRONMENT

TOPIC 1 ACCOUNTING ENVIRONMENT

Professional Accounting Bodies in Malaysia

TOPIC 1 ACCOUNTING ENVIRONMENT

(i) (ii) (iii) (iv) (c)

TOPIC 1 ACCOUNTING ENVIRONMENT

FUNDAMENTAL ACCOUNTING CONCEPTS

What are the important qualitative characteristics of accounting information?

Qualitative Characteristics of Accounting Information

Figure 1.1: Qualitative characteristics of accounting information

TOPIC 1 ACCOUNTING ENVIRONMENT

Figure 1.2: Performance information of a company to assist investor in decision making.

TOPIC 1 ACCOUNTING ENVIRONMENT

TOPIC 1 ACCOUNTING ENVIRONMENT

Figure 1.3: Profitability comparison

TOPIC 1 ACCOUNTING ENVIRONMENT

TOPIC 1 ACCOUNTING ENVIRONMENT

TOPIC 1 ACCOUNTING ENVIRONMENT

TOPIC 1 ACCOUNTING ENVIRONMENT

Figure 1.4 shows examples of accounting period.

Figure 1.4: Examples of accounting period

Basic Principles of Accounting

TOPIC 1 ACCOUNTING ENVIRONMENT

TOPIC 1 ACCOUNTING ENVIRONMENT

Figure 1.5: The relationship between revenue and expense

TOPIC 1 ACCOUNTING ENVIRONMENT

TOPIC 1 ACCOUNTING ENVIRONMENT

TOPIC 1 ACCOUNTING ENVIRONMENT

TOPIC 1 ACCOUNTING ENVIRONMENT

TOPIC 1 ACCOUNTING ENVIRONMENT

Transaction Cash Balance 4 25,000 +15,000 + +

ASSET Land 20,000 + + Supplies 2,700

OWNERS EQUITY Capital, Reen 30,000 15,000 service revenue 45,000

Figure 1.6: Analysis of transaction

TOPIC 1 ACCOUNTING ENVIRONMENT

30,800 + 4,000 26,800 +

TOPIC 1 ACCOUNTING ENVIRONMENT

TOPIC 1 ACCOUNTING ENVIRONMENT

Table 1.4: Analysis of Transaction for R.C.S, November 2000

Balance 2 Balance 3 Balance 4

30,000 -5,000 25,000 25,000 15,000 + +

20,000 20,000 20,000 + 2,700 2,700

15,000 15,000 15,000 + 2,700 2,700

32,700 1,900 30,800

2,700 2,700 1,600

2,700 -1,900 800

ASSET 47,900 47,900

LIABILITY 15,800 47,900

OWNERS EQUITY 32,100

TOPIC 1 ACCOUNTING ENVIRONMENT

TYPES AND OBJECTIVES OF FINANCIAL STATEMENT

Figure 1.7: Types of business

TOPIC 1 ACCOUNTING ENVIRONMENT

4,250 1,600 900 1,600 550

Statement of Changes in Owners Equity

TOPIC 1 ACCOUNTING ENVIRONMENT

Closing Capital 30 November

Figure 1.9: Statement of changes in owners equity

800 15,000 15,800 32,100 47,900

27,900 Long-term liabilities:

BQOEIII Fundamentals of Accounting & Finance

BQOEIII Fundamentals of Accounting & Finance