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
Module Writers:
Noor Asma Jamaludin

Nor Asma Lode
Junaidah Hanim Ahmad
Azlan Zainol Abidin
Amin Ali
Norazita Marina Abd. Aziz
Universiti Utara Malaysia
Moderators:
Assoc Prof. Dr. Arfah Salleh

Assoc. Prof. Hashanah Ismail
Universiti Putra Malaysia
Azlina Abdul Aziz
Loo Sze Wei
Rosila Abu Zarin
Translated & Edited: Pearson (M) Sdn. Bhd.

Compiled by:
Lilian Kek Siew Yick

Desktop Publishing:
Centre for Instructional Design and Technology

Printed by:
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Lot 47-48, Jalan SR 1/9, Seksyen 9,
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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
Topic 2
ix-xi
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
1
2
2
2
3
4
6
6
10
13
16
17
17
22
24
25
25
26
27
33
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
X 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
79
80
82
85
87
88
89
90
94
94
95
98
104
Topic 4
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
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
TABLE OF CONTENTS W
4.6
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
Topic 5
Answers
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
128
129
130
132
132
134
136
141
142
144
145
145
146
148
149
151
152
154
156
157
158
158
166
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172
173
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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.
understand the fundamental concepts of accounting;
2.
describe the meaning of accounting information, its role as well as its

importance;
3.
elaborate the process of preparing accounting information from beginning

until the completion of the accounting cycle;
4.
discuss the functions and information contained in financial statements;
5.
analyse the financial performance of a company using financial ratio

analysis; and
6.
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.
Topic1X Accounting
Environment
LEARNING OUTCOMES
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
Types of
information
required
Internal Users
External Users
Information that can help them

make planning and exercise
control over the entity.
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
1.1.3
Using the status or position in

the company.
Limited to what is made available

by the company.
Example
Annual report published by the
company.
Branches of Accounting
Accounting is divided into several different branches or other specialised fields.

Among them are:
(i)
Financial Accounting;
(ii)
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
Management Accounting
Preparation of
report
Preparation of financial reports

of an entity for external and
internal users but focus is given
to the external users.
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.
Standard or
Format
Financial reports produced are

periodically and in accordance
to specified standard or format.
Report is produced at any time

based on requirement and is
not subject to any 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.
(b)
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:
(i)
(ii)
(iii)
(iv)
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.
(c)
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.
(d)
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.
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.
(i)
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
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.
10 X
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.
W 11
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
Transaction
(RM)
Business 1
Profit
6,000
Business 2
Loss
8,000
Business 3
Profit
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
12 X
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.
W 13
Figure 1.4 shows examples of accounting period.

Starting Date
Ending Date
1 January 2001
30 December 2001
1 July 2002
30 June 2003
1 March 2002
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.
14 X
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
(ii)
(c)
W 15
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.
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.
16 X
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.
(b)
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).
1.3
W 17
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.
18 X
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
Date
(Nov)
1
15
30
30
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.
30
Unused office supplies valued at RM1,100.
30
Reen withdrew money from the business amounting to

RM4,000 for her personal use.
No.
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.
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
W 19
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
OWNERS EQUITY
Capital, Reen
30,000
15,000
15,000
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
Balance
3
Balance
ASSET
Cash
25,000
+ 20,000
25,000
Land
20,000
=
+ Supplies
2,700
2,700
LIABILITY
NP
=
=
=
AP
15,000
15,000
+
2,700
2,700
OWNERS
EQUITY
Capital,
Reen
30,000
30,000
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.
20 X
Transaction
ASSET
Cash
Land
Supplies
Balance
4
25,000
+15,000
20,000
2,700
Balance
40,000
2,700
20,000
LIABILITY
NP
AP
=
=
15,000
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
ASSET
Cash
Balance
5
40,000
4,250
+ Land
+ Supplies
20,000
2,700
=
=
LIABILITY
NP
AP
15,000
2,700
1,600
-900
-900
paid utility
-550
paid sundry
-550
Balance
32,700
OWNERS
EQUITY
Capital,
Reen
45,000
-4,250 paid
salary
1,600 paid
rental
20,000
2,700
15,000
2,700
37,700
W 21
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
Balance
6
Balance
ASSET
Cash
+ Land
+ Supplies
32,700
1,900
30,800
+ 20,000
2,700
+ 20,000
2,700
LIABILITY
NP
= 15,000 +
=
= 15,000 +
AP
2,700 +
-1,900
800 +
OWNERS
EQUITY
Capital,
Reen
37,700
37,700
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
ASSET
Cash
Land
+ Supplies
LIABILITY
NP
AP
Balance
7
30,800 +
-1,600
20,000
2,700
-1,600
= 15,000
=
800 +
Balance
30,800 +
20,000
1,100
= 15,000
800 +
OWNERS
EQUITY
Capital,
Reen
37,700
-1,600
Supplies
expenses
36,100
Transaction 8: Reen took RM4,000 of the business cash for personal use.
Transaction
ASSET
Cash
Land
+ Supplies
LIABILITY
NP
Balance
8
30,800 +
4,000
20,000
1,100
= 15,000
=
Balance
26,800 +
20,000
1,100
= 15,000
AP
800
800
OWNERS
EQUITY
Capital,
Reen
36,100
-4,000 cash
drawings
32,100
22 X
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;
(b)
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
(c)
Owners equity will increase with investment from the owner and revenue,
while drawings by the owner and expenses will reduce owners equity.
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.
W 23
Table 1.4: Analysis of Transaction for R.C.S, November 2000

Transaction
ASSET
Cash
30,000
Balance
2
Balance
3
Balance
4
30,000
-5,000
25,000
25,000
15,000
Balance
5
40,000
4,250
Land
=
+
Supplies
LIABILITY
NP
AP
30,000
15,000
2,700
2,700
30,000
15,000
service
revenue
45,000
-4,250
paid
salary
-1,600
paid
rental
-900
paid
utility
-550
paid
sundry
37,700
20,000
20,000
=
=
=
=
=
=
15,000
15,000
+
+
20,000
2,700
2,700
20,000
2,700
=
=
15,000
2,700
=
=
=
=
15,000
15,000
2,700
-1,900
800
-1,600
-900
-550
Balance
6
Balance
7
32,700
1,900
30,800
20,000
2,700
20,000
2,700
1,600
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
+
+
OWNER
EQUITY
Capital,
Reen
30,000
investment
by Reen
30,000
OWNERS EQUITY
32,100
37,700
-1,600
bought
supplies
36,100
-4,000
cash
drawings
32,100
24 X
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)
Income Statement;
(b)
Statement of Changes in Owners Equity;
(c)
Balance Sheet; and
(d)
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
W 25
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
4,250
1,600
900
1,600
550
RM
15,000
(8,900)
Net profit
6,100
Figure 1.8: Income statement/Profit and loss statement
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.
26 X
Reen Cyber Service

Opening Capital 1 November
(+) Net profit
RM
30,000
6,100
(-)
36,100
(4,000)
Drawings
Closing Capital 30 November
32,100
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
RM
Current Assets:
Cash
LIABILITIES AND OWNERS EQUITY
RM
Liabilities:
26,800 Current Liabilities:
Supplies
1,100
Account payable
800
27,900 Long-term liabilities:

Fixed Assets:
Land
Notes payable
20,000 Total liabilities
15,000
15,800
Owner Equity:
Capital
32,100
TOTAL LIABILITIES AND

TOTAL ASSETS
47,900 OWNERS EQUITY

Figure 1.10: Balance Sheet in accounts format
47,900
W 27
In the statement format, the asset, liability and owners equity are listed
vertically.
Reen Cyber Service
Balance Sheet
as at 30 November 2000
RM
RM
Fixed Assets:
Land
20,000
Current Assets:
Cash
Supplies
26,800
1,100
27,900
() Current liabilities:
Account payable
(800)
27,100
Net current assets
47,100
Financed by:
Owners equity:
Capital, Reen
32,100
Long term liabilities:

Notes payable
15,000
47,100
Figure 1.11: Balance Sheet in statement format
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.
28 X
Reen Cyber Services

Cash Flow Statement
RM
RM
RM
Cash from operating activities:

Cash received from customers
() Expenditure paid
Payment to supplier
Net cash flow from operating activities
15,000
7,300
1,900
Cash from investing activities:

Payment for purchase of land
Net cash flow from investing activities
(9,200)
5,800
(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
(5,000)
26,000
26,800
Figure 1.12: Cash flow statement
Discuss the issues that might arise if a business entity did not disclose
the relevant information in its financial statement.
W 29
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)
www.masb.org.my
Financial Reporting Foundation (FRF)
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.
30 X
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
9.
10.
Determine the appropriate amount in the spaces marked ?

ASSET
LIABILITY
(a)
84,000
38,000
(b)
72,000
28,000
(c)
125,000
50,000
OWNERS EQUITY
State the effects of the following transactions on the asset, liability and
owners equity. An example is shown in transaction (a):
Transaction
11.
W 31
Effect
(a)
Paid debts to supplier.
(b)
Purchased office equipment

by cash.
(c)
Owner took cash from the

business for personal use.
(d)
Paid staff salary

current period.
(e)
Received cash from customer

to settle his account receivable.
(f)
Owner
contributed
office
equipment for business use.
for
Asset decreased, Liability

decreased.
the
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.
32 X
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.
W 33
In this topic, you have learned and discovered:

1.
The users of accounting information consist of internal users and external

users.
2.
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.
3.
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).
4.
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.
5.
The accounting equation is fundamental in accounting and it consists of

three components, namely asset, liability and owners equity.
6.
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.
Topic2 X 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.
X 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
2.1
35
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.
36 X
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.
37
Table 2.1: Chart of Accounts for Reen Cyber Service

Accounts in Balance Sheet
Accounts in Income Statement
ASSETS
11
Cash
12
Account receivable
14
Supplies
15
Insurance prepayment
17
Land
18
Office equipment
REVENUE
41
Service revenue
LIABILITIES
21
Account payable
22
Notes Payable
23
Deferred Rental
OWNERS EQUITY
31
Capital, Reen
32
Drawings, Reen
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)
2.2
The capital contribution of the owner into the business.
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.
38 X
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
Account Title
Date
Description
Reference
Amount
Date
Credit
Description
Reference
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?
39
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.
40 X
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?
2.4
41
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.
(b)
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:
42 X
(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.
43
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
Description
pg 1
Reference
Cash
Debit
Credit
30,000
Capital, Reen
30,000
(Cash invested by Reen)

Journal 1: General Journal for Transaction 1
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.
44 X
Journal entry:
General Journal
Date
Nov 1
Description
pg 1
Reference
Debit
Land
Credit
20,000
Cash
5,000
Notespayable
15,000
(Purchased land by cash and

bank loan)
Post to ledger:
Land
Nov 2
Cash
5,000
Notes Payable
15,000
Cash
Nov 1
Capital, Reen
30,000
Nov 2
Land
5,000
Land
15,000
Notes Payable
Nov 2
Transaction 3: On 4 November, the business bought office supplies valued at

RM2,700 on credit.
45
Journal entry:
General Journal
Date
Description
Nov 4
pg 1
Reference
Debit
Supplies
Credit
2,700
AccountsPayable
2,700
(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
Description
pg 1
Reference
Cash
Debit
Credit
15,000
Service revenue
(Cash received for services

provided)
15,000
46 X
Post to ledger:
Cash
Nov 1 Capital, Reen
15 Service revenue
30,000 Nov 2
15,000
Land
5,000
Service revenue
Nov 15
Cash
15,000
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
Reference
Salary expenses
pg 1
Debit
Credit
4,250
Rentalexpenses
1,600
Utilityexpenses
900
Sundryexpenses
550
Cash
7,300
(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
Salary expenses
Nov 30 Cash
Rental expenses
4,250
Nov 30 Cash
Utility expenses
Nov 30 Cash
47
1,600
Sundry expenses
900
Nov 30 Cash
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
Reference
Accounts Payable
pg 1
Debit
Credit
1,900
Cash
1,900
(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
48 X
Transaction 7: Unused office supplies on 30 November were valued at RM1,100.

Journal entry:
General Journal
Date
Nov 30
Description
Reference
pg 1
Debit
Supplies expenses
Credit
1,600
Supplies
1,600
(Recording usage of
supplies)
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
Nov 30 Drawings, Reen

Cash
pg 1
Debit
Credit
4,000
(Cash drawings by owner)

4,000
49
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)
Determine whether the transaction will affect the asset, liability, owners
equity, revenue or expense accounts.
(b)
For every account involved, determine whether the account will increase or
decrease.
(c)
Decide whether the increase or decrease should be recorded as debit or

credit.
50 X
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
Date
(Dec 2000)
1
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.
11
Paid RM800 for the transaction on 4 December.
13
16
Paid salary of temporary staff for RM1,900 for the first two weeks
of December.
Received RM6,200 cash from customer for services provided.
16
10
20
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.
11
21
Customer made payment for account receivable of RM1,300.
12
23
Purchased supplies by cash for RM2,900.
13
27
14
31
15
31
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.
16
31
Billed customer for the services provided of RM2,240.
17
31
Reen made cash drawings of RM4,000.
No.
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.
51
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
Prepaid insurance account (asset) increased by RM4,800.

Cash account (asset) reduced by RM4,800.
Analysis 3:
Rule of debit and credit
Prepaid insurance account (asset) increased: debit

Cash account (asset) reduced: credit
Journal entry:
General Journal
Date
Description
pg 1
Reference
Debit
L15
4,800
Dec 1 Prepaid insurance
L11
Cash
Credit
4,800
(Paid insurance premium for

24 months)
Post to ledger:
Prepaid Insurance Account
Date
Description
Dec 1 Cash
No: 15
Reference
Debit
J2
4,800
Credit
Cash Account
Date
Balance
No: 11
Description
Dec 1 Prepaid insurance
Reference
Debit
J2
Credit
4,800
Balance
52 X
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:
Rental expenses account (expense) increased by RM1,600.

Cash account (asset) reduced by RM1,600.
Analysis 3:
Rental expenses account (expense) increased: debit

Cash account (asset) reduced: credit
Journal entry:
General Journal
Date
Description
Dec 1 Rental expenses

Cash
pg 1
Reference
Debit
L52
1,600
L11
(Paid rental expenses for December month)

Credit
1,600
53
Post to ledger:
Rental expenses Account
Date
Dec 1
Description
Cash
No: 52
Reference
Debit
J2
1,600
Credit
Cash Account
Date
Dec 1
Balance
No: 11
Description
Rental expenses
Reference
Debit
J2
Credit
Balance
1,600
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.
54 X
Analysis 1 and 2:
Cash account (asset) increased by RM720.

Deferred rental account (liability) increased by RM720.
Analysis 3:
Cash account (asset) increased: debit

Deferred rental account (liability) increased: credit
Journal entry:
General Journal
Date
Description
pg 1
Reference
Debit
L11
720
L23
Dec 1 Cash
Deferred rental
Credit
720
(Cash received for three months rental)

Post to ledger:
Cash Account
Date
Dec 1
No: 11
Description
Deferred rental
Reference
Debit
J2
720
Credit
Deferred rental Account

Date
Dec 1
Balance
No: 23
Description
Rental expenses
Reference
Debit
J2
Credit
720
Balance
55
Transaction 4: Purchased office equipment on credit for RM3,600.

Analysis 1 and 2:
Office equipment account (asset) increased by RM3,600.

Accounts payable (liability) increased by RM3,600.
Analysis 3:
Office equipment account (asset) increased: debit

Accounts payable (liability) increased: credit
Journal entry:
General Journal
Date
Description
pg 1
Reference
Debit
L8
3,600
Dec 1 Office equipment
L21
Accounts payable
Credit
3,600
(Purchased office equipment on credit)

Post to ledger:
Office Equipment Account
Date
Description
Dec 4
Accounts payable
No: 18
Reference
Debit
J2
3,600
Credit
Account Payable
Balance
No: 15
Date
Description
Dec 1
Office equipment
Reference
Debit
J2
Credit
Balance
3,600
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.
56 X
Analysis 1 and 2:
Sundry expenses account (expense) increased by RM360.

Cash account (asset) decreased by RM360
Analysis 3:
Sundry expenses account (expense) increased: debit

Cash account (asset) decreased: credit
Journal entry:
General Journal
Date
Description
pg 2
Reference
Debit
L55
360
L11
Dec 6 Sundry expenses

Cash
Credit
360
(Payment for advertisement expenses)

Post to ledger:
Sundry Expenses Account
Date
Dec 6
Description
Cash
No: 55
Reference
Debit
J2
360
Credit
Cash Account
Balance
No: 11
Date
Description
Dec 6
Sundry expenses
Reference
Debit
J2
Credit
360
Balance
57
Transaction 6 : Paid supplier (for transaction on 4 December) amounting to RM800.

Analysis 1 and 2:
Accounts payable (liability) decreased by RM800.

Cash account (asset) decreased by RM800.
Analysis 3:
Accounts payable (liability) decreased: debit

Journal entry:
General Journal
Date
Description
pg 2
Reference
Debit
L21
800
L11
Dec 11 Accounts payable

Cash
Credit
800
(Payment for accounts payable)

Post to ledger:
Accounts payable
Date
Dec 11
Description
Cash
No: 21
Reference
Debit
J2
800
Credit
Cash Account
Date
Dec 11
Balance
No: 11
Description
Account payable
Reference
J2
Debit
Credit
Balance
800
Transaction 7: Paid salary of temporary staff for the first two weeks of December
totalling RM1,900.
58 X
Analysis 1 and 2:
Salary expenses account (expense) increased by RM1,900.

Cash account (asset) decreased by RM1,900.
Analysis 3:
Salary expenses account (expense) increased: debit

Journal entry:
General Journal
Date
Description
Dec 13 Salary expenses
pg 2
Reference
Debit
L51
1,900
L11
Cash
Credit
1,900
(Salary payment for temporary staff)

Post to ledger:
Salary expense Account
Date
Dec 13
No: 51
Description
Cash
Reference
Debit
J2
1,900
Credit
Cash Account
Date
Dec 13
Balance
No: 11
Description
Salary expenses
Reference
Debit
J2
Credit
1,900
Balance
59
Transaction 8: Received cash for services provided for RM6,200:

Analysis 1 and 2:
Cash account (asset) increased by RM6,200.

Service revenue account (revenue) increased by RM6,200.
Analysis 3:

Service revenue account (revenue) increased: credit
Journal entry:
General Journal
Date
Description
Dec 16 Cash
pg 2
Reference
Debit
L11
6,200
L41
Service revenue
Credit
6,200
(Received cash for services provided)

Post to ledger:
Cash Account
Date
Dec 16
No: 51
Description
Service revenue
Reference
Debit
J2
6,200
Credit
Service revenue Account

Date
Dec 16
Description
Cash
Balance
No: 41
Reference
Debit
J2
Credit
6,200
Balance
60 X
Transaction 9: Billed customer for RM3,500 for services provided.

Analysis 1 and 2:
Accounts receivable (asset) increased by RM3,500.

Analysis 3:
Accounts receivable (asset) increased: debit

Journal entry:
General Journal
Date
Description
pg 2
Reference
Debit
Dec 16 Accounts receivable
L12
3,500
Service revenue
L41
Credit
3,500
(Billed customer for services provided)

Post to ledger:
Accounts receivable
Date
Dec 16
No: 12
Description
Service revenue
Reference
Debit
J2
3,500
Credit

Date
Dec 16
Description
Accounts receivable
Balance
No: 41
Reference
Debit
J2
Credit
3,500
Balance
61
Transaction 10: Payment of RM1,800 to supplier (for transaction on 4 December).

Analysis 1 and 2:
Accounts payable (liability) decreased by RM1,800.

Analysis 3:
Accounts payable (liability) decreased: debit

Journal entry:
General Journal
Date
Dec 20
Description
Accounts payable
pg 3
Reference
Debit
L21
1,800
L11
Cash
Credit
1,800
(Payment to accounts payable)

Post to ledger:
Accounts payable
Date
Dec 20
No: 12
Description
Cash
Reference
Debit
J3
1,800
Credit
Cash Account
Date
Dec 20
Balance
No: 11
Description
Accounts payable
Reference
Debit
J3
Credit
1,800
Balance
62 X
Transaction 11: Customer paid cash RM1,300 as payment on its accounts

receivable.
Analysis 1 and 2:
Cash account (asset) increased by RM1,300

Accounts receivable (asset) decreased by RM1,300
Analysis 3:

Accounts receivable (asset) decreased: credit
Journal entry:
General Journal
Date
Dec 21
Description
Cash
pg 3
Reference
Debit
L11
1,300
L12
Accounts receivable
Credit
1,300
(Payment received for accounts

receivable)
Post to ledger:
Cash Account
Date
Dec 21
No: 11
Description
Accounts receivable
Reference
Debit
J3
1,300
Credit
Accounts Receivable
Date
Dec 21
No: 12
Description
Cash
Balance
Reference
Debit
J3
Credit
1,300
Balance
63
Transaction 12: Purchased supplies by cash for RM2,900.

Analysis 1 and 2:
Supplies account (asset) increased by RM2,900.

Analysis 3:
Supplies account (asset) increased: debit

Journal entry:
General Journal
Date
Dec 23
Account and Description

Supplies
Cash
(Purchased supplies by cash)
pg 3
Reference
L14
L11
Debit
2,900
Credit
2,900
Post to ledger:
Supplies Account
Date
Dec 23
No: 14
Description
Cash
Reference
J3
Debit
2,900
Credit
Cash Account
Date
Dec 23
Balance
No: 11
Description
Supplies
Reference
J3
Debit
Credit
2,900
Balance
Transaction 13: Paid salary of temporary staff for the last two weeks of December
totalling RM2,400.
Analysis 1 and 2:
Salary expenses account (expense) increased by RM2,400.

Analysis 3:
Salary expenses account (expense) increased: debit

Journal entry:
General Journal
Date
Dec 27
Description
Salary expenses
Cash
(Payment for salary of temporary
staff)
pg 3
Reference
L51
L11
Debit
2,400
Credit
2,400
64 X
Post to ledger:
Salary expenses Account
Date
Dec 27
Description
Cash
Reference
Debit
J3
2,400
Credit
Cash Account
Date
Dec 27
No: 51
Balance
No: 11
Description
Salary expenses
Reference
J3
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:
Utility expenses account (expense) increased by RM1,070.

Analysis 3:
Utility expenses account (expense) increased: debit

Journal entry:
General Journal
Date
Dec 31
Description
Utility expenses
Cash
(Payment for telephone and electricity bill
for December)
pg 3
Reference
L53
L11
Debit
1,070
Credit
1,070
Post to ledger:
Utility expenses Account
Date
Dec 31
Description
No: 53
Debit
1,070
Credit
Balance
Description
Reference
Debit
Utility expenses
J3
Credit
1,070
Balance
Cash
Reference
J3
Cash Account
Date
Dec 31
No: 11
65
Transaction 15: Received cash RM5,740 for services provided.

Analysis 1 and 2:
Cash account (asset) increased by RM5,740.

Analysis 3:

Journal entry:
General Journal
Date
Dec 31
Description
pg 3
Reference
L11
L41
Cash
Service revenue
(Received cash for services
provided)
Debit
5,740
Credit
5,740
Post to ledger:
Cash Account
Date
Description
Dec 31
Service revenue
Date
Description
Dec 31
Cash
Reference
J3
Reference
J3
Debit
5,740
Debit
Credit
Credit
5,740
No: 11
Balance
No: 41
Balance
Transaction 16: Billed customer for RM2,240 for services provided.

Analysis 1 and 2:
Accounts receivable (asset) increased by RM2,240

Service revenue account (revenue) increased by RM2,240
Analysis 3:
Accounts receivable (asset) increased: debit

Journal entry:
General Journal
Date
Dec 31
Description
Reference
Accounts receivable
L12
Service revenue
L41
pg 3
Debit
2,240
Credit
2,240
66 X
Post to ledger:
Account Receivable
Date
Description
Dec 31
Service revenue
Reference
J3
Debit
2,240
Credit
Reference
Debit
J3
Credit
2,240

Date
Description
Dec 31
Accounts receivable
No: 12
Balance
No: 41
Balance
Transaction 17: Owner made cash drawings of RM4,000.

Analysis 1 and 2:
Drawings account (contra owner equity) increased by RM4,000

Analysis 3:
Drawings account (contra owner equity) increased: debit

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.
Journal entry:
General Journal
Date
Dec 31
Description
Drawings, Reen
Cash
(Cash drawings by Reen).
pg 3
Reference
L32
L11
Debit
4,000
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
Credit
4,000
No: 32
Balance
No: 11
Balance
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.
67
The following are the general journal entries and postings throughout November
and December 2000.
GENERAL JOURNAL
Date
Nov 1
15
30
30
30
30

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
provided)
Salary expenses
Rental expenses
Utility expenses
Sundry expenses
Cash
(Payment of expenses by cash)
Account payable
Cash
Supplies expenses
Supplies
(Recording of supplies usage)
Drawings, Reen
Cash
pg 1
Reference
L11
L31
Debit
30,000
L17
L11
L22
20,000
L14
L21
2,700
L11
L41
15,000
L51
L52
L53
L55
L11
4,250
1,600
900
550
L21
1,900
Credit
30,000
5,000
15,000
2,700
15,000
7,300
L11
1,900
L54
L14
1,600
L32
L11
4,000
1,600
4,000
68 X
GENERAL JOURNAL
Date
Dec 1
11
13
16
16

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
Salary expenses
Cash
(Payment for salary of
temporary staff)
Cash
Service revenue
provided)
Accounts receivable
Service revenue
(Billed customer for services
provided)
pg 2
Reference
L15
L11
Debit
4,800
L52
L11
1,600
L11
L23
720
L18
L21
3,600
L55
L11
360
L21
L11
800
L54
L11
1,900
L11
L41
6,200
L11
L41
3,500
Credit
4,800
1,600
720
3,600
360
800
1,900
6,200
3,500
GENERAL JOURNAL
Date
Dec 20
21
23
27
31
31
31
31

Accounts payable
Cash
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
Drawings, Reen
Cash
69
pg 3
Reference
L12
L11
Debit
1,800
L11
L12
1,300
L14
L11
2,900
L54
L11
2,400
L53
L11
1,070
L11
L41
5,740
L12
L41
2,240
L32
L11
4,000
Credit
1,800
1,300
2,900
2,400
1,070
5,740
2,240
4,000
Journal 26: General Journal for Reen Cyber Service for the month of November and
December 2000.
70 X
GENERAL LEDGER
Cash Account
Date
Nov 1
2
15
30
30
30
Dec 1
6
11
13
16
20
21
23
27
31
31
31
*
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
No: 11
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
Credit
5,000
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
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
It was previously explained that the Balance column will show the updated
balance after each transaction. Can you relate to it now?
Accounts Receivable
Date
Dec 16
21
31
Description
Service revenue
Cash
Service revenue
No: 12
Reference
J2
J3
J3
Debit
3,500
Credit
1,300
2,240
Balance
3,500
1,100
4,440
Supplies Account
Date
Nov 4
30
Dec 23
Description
Accounts payable
Supplies expenses
Cash
Reference
J1
J1
J3
Debit
2,700
Credit
1,600
2,900
Description
Cash
Reference
J2
Debit
4,800
Credit
Description
Cash
Notes payable
Reference
J1
J1
Debit
5,000
15,000
Credit
Description
Accounts payable
Reference
J2
Debit
3,600
Credit
Description
Supplies
Cash
Supplies
Cash
Cash
Reference
J1
J1
J2
J2
J3
Debit
Credit
2,700
1,900
3,600
800
1,800
Description
Land
Description
Cash
Balance
2,700
800
4,400
3,600
1,800
No: 22
Reference
J1
Debit
Credit
15,000
Deferred Rental Account

Date
Dec 1
Balance
3,600
No: 22
Notes Payable Account

Date
Nov 2
Balance
5,000
20,000
No: 18
Accounts Payable
Date
Nov 4
30
Dec 4
11
20
Balance
4,800
No: 17

Date
Dec 4
Balance
2,700
1,100
4,000
No: 15
Land Account
Date
Nov 2
71
No: 14
Prepaid insurance Account

Date
Dec 1
Balance
15,000
No: 23
Reference
J2
Debit
Credit
720
Balance
720
72 X
Capital, Reen Account

Date
Nov 1
Description
Cash
No: 31
Reference
J1
Debit
Credit
30,000
Drawings, Reen Account

Date
Nov 30
Dec 31
Description
Cash
Cash
No: 32
Reference
J1
J3
Debit
4,000
4,000
Credit
Service Revenue Account

Date
Nov 15
Dec 16
31
Description
Cash
Cash
Accounts receivable
Cash
Accounts receivable
Description
Reference
J1
J2
J2
J3
J3
Debit
Credit
15,000
6,200
3,500
5,740
2,240
Description
Cash
Cash
Reference
J1
J2
J3
Debit
4,250
1,900
2,400
Credit
Description
Cash
Cash
Reference
J1
J2
Debit
1,600
1,600
Credit
Description
Supplies
Balance
1,600
3,200
No: 53
Reference
J1
J3
Debit
900
1,070
Credit
Supplies Expenses Account

Date
Nov 30
Balance
4,250
6,150
8,550
No: 52
Utility Expenses Account

Date
Nov 30
Dec 31
Balance
15,000
21,200
24,700
30,440
32,680
No: 51
Rental Expenses Account

Date
Nov 30
Dec 1
Balance
4,000
8,000
No: 41
Salary Expenses Account

Date
Nov 30 Cash
Dec 13 Cash
27 Cash
Balance
30,000
Balance
900
1,970
No: 54
Reference
J1
Debit
1,600
Credit
Balance
1,600

Date
Nov 30
Dec 6
2.4.4
Description
Cash
Cash
73
No: 55
Reference
J1
J2
Debit
550
360
Credit
Balance
550
910
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
74 X
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.
What is meant by account, ledger and chart of accounts?
2.
State TWO account format of that you have learned. Which is the
easier format? Which format will show the latest balance after each
transaction?
3.
Drawings and expense will reduce owners equity. Discuss the

difference between these two terms.
4.
Which of the following accounts have a normal debit balance?

A. Owners capital
B.
Deferred rental
C. Prepaid expense
D. Service revenue
5.
A credit balance in which account might indicate an error?

A. Rental revenue
B.
Accounts payable
C. Drawings
D. Capital
6.
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
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.
Cash
a.
+5,000
b.
c.
+3,250
d.
750
e.
f.
-125
g.
-577
h.
-1,250
AR
Supplies
+275
AP
Owners
Equity
Capital,
Cindy
+5,000
Capital,
Cindy
+275
-125
+1,875
Service
revenue
-390
Paid utility
expense
-187
Paid
sundry
expense
-162
-500
Liability
+3,250
Service
revenue
-750
Paid rental
expense
+1,875
i.
j.
-50
-1,250
Paid salary
expense
-162
Paid
supplies
expenses
-550
Drawings,
Cindy
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.
75
76 X
8.
The following are the chart of accounts and accounts balances

for Edlin Enterprise on 1 February 2001:
Account
No
Accounts
Balance as at 1/2/01
(RM)
101
Cash
15,238
102
Accounts receivable
104
Supplies
108
Office equipment
8,400
201
Accounts payable
1,730
301
Capital, Edlin
302
Drawings, Edlin
401
Service revenue
501
Rental expenses
502
Advertisement expenses
503
Utility expenses
509
Sundry expenses
4,575
427
26,910
Transactions involving Edlin Enterprise throughout the month of

February 2001 are:
Date
Transaction
Feb 1
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.
15
Made payment to accounts payable for RM1,200.
18
Received cash for services provided for RM580.
25
Paid RM420 to advertise its business in the newspaper.
28
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.
29
Paid RM1,200 for rental of business premises.
30
Paid RM220 to repair the office equipment.
77
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.
The chart and format of accounts used to present the financial report of an
organisation.
2.
The rules of debit and credit are fundamental to the double entry system.
3.
The rules of normal balance for each type of account are used to assist in
identifying errors in recording.
4.
Steps in recording beginning from journal entry, posting entries to ledger

and preparation of the trial balance.
78 X
TUTORIAL QUESTION
X 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.
X 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)
Mrs. Disdi made a cash investment of RM5,000 for market expansion.
(b)
Received RM2,920 in cash from customers for services provided.
(c)
Paid creditors RM1,350.
(d)
Paid RM2,000 office rental for the month of January.
(e)
Billed customers for RM4,245 for services provided.
(f)
Purchased supplies valued at RM280 on credit.
(g)
Sent staff to attend beautification course, the fees of RM500 was paid by
cash. Mrs. Disdi has a special allocation for staff training.
(h)
Received cash from customer for RM2,000 as payment on accounts

receivable.
(i)
The value of the balance of supplies at the end of the month was calculated
at RM750.
(j)
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.
79
X QUESTION
1.
Determine the amount of asset, liability and owners equity for the business
of Anggun Rias as at 1 January 2001.
2.
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.
3.
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.
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.
2.
know the structure of the accounting equation and the effect of transactions
on the components in the equation.
3.
be familiar with the formats of the four main financial statements in

financial reporting.
Topic
3X 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.
X 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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3.1
FINANCIAL STATEMENTS
ANNUAL REPORT AND USERS OF

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.
(b)
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).
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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85
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
31-12-2001
RM
RM
40,000
60,000
40,000
60,000
200,000
30,000
20,000
50,000
90,000
190,000
120,000
85,000
30,000
10,000
5,000
250,000
130,000
120,000
320,000
105,000
80,000
22,000
8,000
5,000
220,000
120,000
100,000
290,000
70,000
60,000
10,000
140,000
60,000
200,000
50,000
70,000
20,000
140,000
40,000
180,000
10,000
10,000
Total equities
12,000
38,000
60,000
120,000
12,000
38,000
50,000
110,000
TOTAL LIABILITIES AND EQUITIES
320,000
290,000
Assets
Current assets
Cash
Marketable securities
Account receivables
Inventory
Total current assets

Long-term assets
Land and building
Machines and equipment
Fixtures and fittings
Vehicles
Others (including lease)
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
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3.3.1
87
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
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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89
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)
preference shares;
(b)
ordinary shares;
(c)
paid up capital above par; and
(d)
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
2.
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
3.
Fixed assets are items would not be converted into cash within a
period of one year.
(a) True
(b) False
4.
Investments in financial securities are considered as current

assets
(a) True
(b) False
5.
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
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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).
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
Depreciation
Accumulated depreciation
Land
Cash
(1) Statement
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
_______________
(2) Type of Account

___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
_________________
TOPIC 3
7.
Use the relevant items listed below to prepare the income

statement for Company PC for period ending 31 December 2001.
Items
Account receivable
Cost of goods sold
General and administrative expenses
Interest expenses
Preference shares dividends
Sales revenue
Sales expenses
Shareholders equity
Tax Rate = 30%
8.
Value as at 31 December 2001

(RM 000)
3,500
2,050
2,850
550
600
250
100
5,250
350
2,650
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
Sales revenue
Long-term loans
Inventory
Equipments
Cost of goods sold
Machines
Note payable
Retained earnings
Ordinary shares (at par)
Preference shares
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
Retained earnings, 1 January 2002
+ Net profit (throughout year 2002)
Dividends paid (throughout year 2002)
Preference shares
Ordinary shares
Retained earnings, 31 December 2002
3.5
RM50,000
18,000
RM1,000
7,000
8,000
RM60,000
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.
(a)
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.
(b)
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.
(c)
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.
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.
Step 3
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
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

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

Cash Flow from Financing Activities
Changes in notes payable
Changes in long-term loans
Changes in shareholders equity
(other than retained earnings)
xx
BS
BS
BS
xx
Increase (or decrease) in cash and marketable securities
___
XX
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
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)
Cash flow from operating services

Increase in total fixed assets
78,000
(30,000)

Decrease in short term notes payable
Increase in long term loan
Changes in shareholders' equity
Dividends paid

Net increase in cash and marketable securities
RM
(30,000)
(10,000)
20,000
(8,000)
2,000
50,000
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(a)

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)

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.
(c)

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.
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
Cash Usage
Decrease in asset
Increase in asset
Increase in liability
Decrease in liability
Net profit
Net loss
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Depreciation
Payment of dividends
Sale of shares
Shares Buyback
(a)
99
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.
(d)
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.
100 X 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
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
(130,000)
10,000
10,000
70,000
60,000
10,000
60,000
+20,000
10,000
10,000
+20,000
20,000
10,000
12,000
38,000
60,000
0
0
0
+10,000
RM
10,000
40,000
10,000
30,000
30,000
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
101
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
2.
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
3.
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
4.
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
5.
Information included in the cash flow statement are obtained

from _______________.
A.
B.
C.
6.
income statement
balance sheet
income statement and balance sheet
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
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)
(b)
(c)
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?
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?
9.
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
________________
________________
________________
________________
________________
________________
________________
________________
________________
________________
________________
________________
103
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 X Financial
Statement
Analysis
LEARNING OUTCOMES
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.
X 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 X 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.
(b)

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.
(c)
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.
(d)
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.
TOPIC 4 FINANCIAL STATEMENT ANALYSIS
(e)
W 107
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
Sales
Gross profit
Less: Operating expenses
Sales expenses
Lease 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
2001
RM
307,400
208,800
98,600
2000
RM
256,700
171,000
85,600
10,000
19,400
3,500
23,900
56,800
41,800
9,300
32,500
9,400
23,100
1,000
22,100
10,800
18,700
3,500
22,300
55,300
30,300
9,100
21,200
6,100
15,100
1,000
14,100
0.29
0.18
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.
Table 4.2: Balance Sheet

Company ABC
Balance Sheet
as at 31 December 2001 and 31 December 2000
Assets
Current Assets
Cash
Account receivable
Inventory
2001
2000
RM
RM
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
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
Paid-up capital above par

Retained earnings
42,800
113,500
41,800
101,200
Total equities
195,400
359,700
182,000
327,000

Net Fixed Assets
Total Assets
Current liabilities
Account payable
Notes payable
Accruals

Long-term loans
Total liabilities
Equities
Preference shares
Ordinary shares, RM2.50 par value,
100,000 shares issued 2001: 76,262;
2000: 76,244
Total liabilities and shareholders' equities
W 109
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.
W 111
Net working capital of Company ABC for the year 2001 is calculated as follows:
Net working capital
Industry average
=
=
=
Current assets Current liabilities

RM122,300 RM62,000
RM60,300
RM42,700
(2.1)
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
Industry average
Current Assets
Current Liabilities
RM122,300
RM 62,000
1.97
2.05
(2.2)
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
Industry average
Current Assets-(Inventory+ Prepayments)

Current liability
RM122,300 RM28,900
RM62,000
1.51 times
1.43 times
(2.3)
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.
W 113
EXERCISE 4.1
1.
The following data is taken from the financial statements of

Company Fazrul
Sales
Cost of sold goods
Cash
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)
4.3
Net working capital

Current ratio
Quick ratio
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
Industry average
Credit sales
Account receivable
RM307,400
RM50,300
6.11 times
(2.4)
8.24 times
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.
4.3.2
W 115
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
Industry average
Cost of goods sold

Inventory
RM208,800
RM28,900
7.22 times
6.6 times
(2.7)
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)
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.
(b)
The usage of sales as the numeric figure a number is not appropriate as it

will increase the value of inventory turnover.
(c)
Must remember that for comparison, the company must ensure that the
method of inventory recording must be similar between the company and
the industry.
(d)
W 117
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
360
Inventory turnover
360
7.22
= 49.86 days
= 55.30 days
(2.8)
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
Industry average
Sales
Net Fixed assets
RM307,400
RM237,400
1.29 times
1.35 times
(2.10)
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)
W 119
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
Account receivables
Inventory
Prepayment items
Net fixed assets
Current liabilities
(a)
(b)
(c)
(d)
(e)
(f)
1999
RM640,000
380,000
30,000
40,000
70,000
150,000
10,000
300,000
120,000
Account receivables turnover

Inventory turnover
Total asset turnover
1998
RM560,000
360,000
26,000
52,000
62,000
140,000
10,000
260,000
140,000
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
(b)
ratios to see the ability of the company in fulfilling its claims or obligations
to the creditors such as interest coverage ratio.
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
W 121
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
Industry average
Total liabilities
Total assets
RM164, 300
RM359, 700
45.7%
40.0%
X 100
(2.12)
X 100
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
Industry average
Long - term liabilities

Shareholders equity
RM102, 300
RM195, 400
52.4%
50%
(2.13)
X 100
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
=
=
Industry average
1
1 - Debt ratio
Total asset
Total equity
RM359, 700
RM195, 400
1.84 times
1.67 times
(2.14)
W 123
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:
=
Industry average

Interest expenses
(2.15)
RM41, 800
RM 9, 300
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
RM 150,000
450,000
600,000
1,800,000
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
(a)
(b)
(c)
(d)
(e)
(f)
4.5
RM6,000,000
3,000,000
750,000
750,000
420,000
1,080,000
150,000
150,000
1,200,000
1,500,000
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
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.
W 125
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 Margin
=
=
Industry average
Gross Profit
Sales
RM98, 600
RM307, 400
32.1%
30%
X 100
(2.17)
X 100
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
7.5%
6.4%
X 100
(2.18)
X 100
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%
10%
X 100
X 100
(2.19)
W 127
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
Industry average
Profit after tax

Total Assets
RM23, 100
RM359, 700
6.42%
4.8%
X 100
(2.20)
X 100
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
Industry average
Profit after tax
Shareholders' Equity
RM23, 100
RM195, 400
11.8%
8%
X 100
X 100
(2.20)
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
Industry average
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.
W 129
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 =
Industry average
Market price per share

Earnings per share
RM3.23
RM0.29
11.1
1.25
(2.23)
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)
W 131
EXERCISE 4.4
1.
___________ is the ability of the company to fulfil its current

liabilities' obligations by using its current assets.
2.
Current ratio is similar to _________ divided with ___________.

______ is included in the calculation of current ratio but excluded
from the calculation of the quick ratio.
3.
Inventory turnover is obtained by dividing ___________ with

_______________.
4.
Ratio of total liabilities to ____________ is used to ascertain the

level of debt in the capital structure.
5.
Return on equity is obtained when ______________ is divided with

____________.
6.
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
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.
(b)
Summary of financial ratio analysis looks at all the financial aspects of the
company to identify sections that required further investigations or
improvements.
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)
return on assets; and
(b)
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.
W 133
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)
liquidity;
(b)
asset management;
(c)
leverage;
(d)
profitability; and
(e)
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
W 135
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.
(b)
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.
(c)
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.
(d)
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.
(e)
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.
Table 4.1: Summary of Ratio Analysis for Company ABC Compared with the
Industry Average for Year 2001
Company ABC
Industry Average
Liquidity Ratio
Current ratio
Quick ratio
1.97 times
1.51 times
2.05 times
1.43 times
US
US

Inventory turnover
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
Leverage Ratio
Debt ratio
Debt-equity ratio
Interest coverage ratio
45.7%
52.4%
4.49 times
40.0%
50%
4.3 times
US
S
S
Profitability Ratio
Gross profit margin
Net profit margin
Return on assets
Return on equity
Earnings per share
32.1%
7.5%
6.42%
11.80%
RM0.29
30%
6.4%
4.8%
8.0%
RM0.26
S
S
S
S
S
Market Value Ratio

Price earnings ratio
Dividend yield ratio
RM11.1
RM0.046
RM1.25
RM0.50
US
US
* S = Satisfactory
4.8
Notes*
US = Unsatisfactory
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.
W 137
(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.
(c)
Financial ratio is a relative measurement and does not show the actual size
of the firm.
(d)
Financial ratio is used to measure the status of the firm but it can not show
the issues that had caused the situation.
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)
C.
D.
Return on equity
Current ratio
Gross profit margin
Return on asset
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.
Use the following information to calculate the net profit.

Return on asset
Cost of goods sold
Gross profit margin
6.
False
Dividend yield ratio is:

A.
B.
5.
False
Net profit divided by total asset is ___________ ratio.

A.
B.
C.
D.
4.
(b)
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)
3.
True
=
=
=
=
2%
0.5 times
RM105,000
30%
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
7.
W 139
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)
Transaction
Selling of inventory on credit
Financial Ratio
Current ratio
(b)
Issuing ordinary shares to collect cash
Return on equity
(c)
Issuing long term bonds for cash
Debt ratio
(d)
Declaring and paying cash dividends

for ordinary shares
Collecting account receivable
Dividend yield
(e)
(f)
8.
Making cash loans by issuing long term notes payable

Return on assets
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
Cas
Account receivable
Inventory
Total fixed asset
Accumulated
Depreciation
Net fixed asset
RM
1,000
8,900
4,350
15,675
35,000
Account payable
Accrual account
Total current asset
Long-term loans
RM
9,000
6,675
14,250
4,125
13,250
21,750
Total asset
36,000
Sales
Cost of goods sold
Gross profit
Operating expenditure
Operating profit
Interest expenses
Profit before tax
Tax
Net Profit
RM
100,000
87,000
13,000
11,000
2,000
500
1,500
420
1,080
Total liabilities
Ordinary shares
Retained earnings
Total equity
Total liability and equity
19,800
1,000
15,200
16,200
36,000
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
Sales
Current ratio
Debt ratio
Assets
Current asset
Cash
Account receivable
Inventory
Total fixed assets
Net fixed asset
Total assets
=
=
=
=
=
=
=
38.7%
6 times
31 days
RM720,000
2.35 times
2.81 times
49.4%
Company Amri
Balance Sheet
RM
Liability and Owners Equity
Current liabilities
8,005 Account payable
Notes payable
Accruals
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
W 141
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
X 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.
X 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
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
W 143
X QUESTION
(a)
Prepare the balance sheet for Company SAA as at year 2000 and 2001. How
much is the shareholders equity?
(b)
Net working capital = Current asset Current liability. What had happened
to the net working capital throughout the year?
(c)
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.
(d)
Assumed the numbers of shares issued are 500,000 units. What is the
earnings per share?
(e)
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?
(f)
Prepare the cash flow statement for Company SAA for year 2001.
Topic5 X 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.
X 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
5.1
W 145
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 X 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)
F1
=
=
=
=
=
=
=
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)
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?
F2
=
=
=
=
P (1+i)2
F1 (1+i)
RM100 (1 + 0.1)2
121
F3
=
=
=
=
=
=
RM121 + RM12.10
RM133.10 that is
F2 +F2 (i)
F2 (1+i)
P2 (1+i)2 (1+i)
P (1+i)3
W 147
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?
2.
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?
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
W 149
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?
2.
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?
5.1.4
Graphical Illustration of Future Value
There are three basic elements which will influenced the future value, these are:
(a)
principal (amount that was borrowed or invested);
(b)
time period (the number of periods or frequency of interest payments); and
(c)
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.
W 151
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
RM2, 500 =
PV0
PV0 (1+ i)n

PV0 (1+ 0.08)1
RM2, 500
1.08
RM2, 314.81
RM2,314.81
W 153
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%?
2.
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?
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?
PV0
W 155
=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?
2.
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?
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.
W 157
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).
W 159
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
Firststep:
F1
=
F2
=
F3
=
Secondstep:
FVA3 =
:
:
Calculate the future value for t1, t2 and t3.

Total the three future values to get the future value annuity
(FVA).
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]
(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
W 161
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)
Manual equation
A [ (1 + i) n 1] (1 + i)
FVA n =
(ii)
Equation using schedule

FVA n = A (FVIFA i,n) (1 + i)
(3.7)
(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
[1 + 0.10)3 1] (1 + 0.10)
0.10
= RM5, 000
= RM18, 205
(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
t1
t2
RM5,000
RM5,000
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
W 163
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).
(c)
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?
2.
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?
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
(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:
[1[1/(1+i)n ]
[1 [1/(1+i)3 ]
=RM3, 000
0.06
PVA n =A
=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%
t1
t2
RM3,000
RM3,000
RM3,000
t3
RM8,019.04
@
RM8,019.00
(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).
PVA n = A
[ 1 [1/(1 + i) n ]
(1 + i)
i
W 165
(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 ]
= RM3,000
(1 + i)
i
[ 1 - [1/(1 + 0.063)3 ]
0.06
(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%
t1
t2
RM3,000
RM3,000
RM3,000
RM8,500.18
@
RM8,500.14
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
n
FVn = Pt (1 + i)n1
t = 10
(5.12)
W 167
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

n
FVn = Pt (1 + i)n-1
t=4
= (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:
n
PV0 = Pt [1/(1 + i)n ]
(5.13)
t=10
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.
W 169
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)
Solution via manual formula
PV0
= Pt (1 + i)n-t
t=10
= [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
t3
t4
RM1,000
RM2,000
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)
W 171
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%
t1
t2
t60
PVp
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?
COMPOUNDING AND DISCOUNTING

MORE THAN ONCE A YEAR
5.5
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
=
=
=
=
=
(5.16)
Future value
Present value
Interest rate
Frequency of compounding or discounting in a year
Number of years
While the solution by schedule is as follow:

FV = PV x (FVIF i/m,nm)
(5.17)
W 173
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
nm
i/m
FV nm
Once a year
6x1=6
0.1/1=0.01
RM1.772
Twice a year
6 x 2 = 12
0.1/2=0.05
RM1.796
Four times a year
6 x 4 = 24
0.1/4=0.025
RM1.809
Every month
6 x 12 = 72
0.1/12=0.0083
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
nm
i/m
PV 0
Once a year
6x1=6
0.1/1=0.01
RM0.564
Twice a year
6 x 2 = 12
0.1/2=0.05
RM0.557
Four times a year
6 x 4 = 24
0.1/4=0.025
RM0.553
Every month
6 x 12 = 72
0.1/12=0.0083
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)
(5.18)
Present value: PV0 = FVn (e in)
(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
W 175
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?
2.
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?
3.
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.
4.
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?
5.
Complete the present value for a series of indefinite yearly

payments of RM180, assuming that the interest rate is
(a)
5 percent
(b)
10 percent
6.
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?
7.
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?
8.
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?
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
X 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.
X 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.
X ASSIGNMENT
With the assumption that all the accounts will pay an interest of 9%,
compounded yearly, answer the following questions:
(a)
How much should be added by Naim and Nadiah at the end of the tenth
year to enable them to buy the said house?
(b)
How much is the amount that Naim must deposit into his fathers account?
(c)
How much is the amount that Nurul can withdraw every year?
ANSWERS
W 177
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.
(b)
does the company require additional asset; if the company requires

additional asset, would the company be buying or renting it.
(c)
how much is the companys excess cash, if any, should be utilised.
(d)
how the company is going to overcome insufficient cash flow

problems it might be facing.
(e)
the companys strategy to expand the market for its products
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 X
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.
2.
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.
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.
(b)
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.
ANSWERS
W 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.
(b)
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.
(c)
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.
Exercise 1.4
1.
(a)
accounting period
(b)
historical cost
(c)
relevant
(d)
Malaysian Accounting Standards Board
(e)
reliability
(f)
principle of matching
(g)
cost benefit relation, materiality
(h)
management accounting
(i)
going concern
(j)
point of sale
(k)
Cash Flow Statement
(l)
Balance Sheet
180 X
ANSWERS
2.
3.
4.
5.
6.
False
7.
False
8.
False
9.
(a)
46,000
(b)
100,000
(c)
75,000
(a)
Asset increased, Asset decreased or has no effect on the Asset
(b)
Asset decreased, Owners Equity decreased
(c)
Asset decreased, Owners Equity decreased
(d)
Asset increased, Asset decreased or has no effect on the Asset
(e)
Asset increased, Owners Equity increased
10.
ANSWERS
W 181
11.
ASSET
Trans
action
a.
Cash +
AR
= LIABILITY
+
Supplies
AP
+20,000
Balance
b.
Balance
c.
Balance
d.
20,00
20,000
-620
19,380
+4,200
Balance
e.
23,580
-1,000
800
Balance
f.
22,580
-700
800
180
+800
800
800
+800
800
-620
180
180
-150
Balance
g.
21,730
-1,200
800
180
Balance
h.
20,530
800
180
Balance
i.
20,530
2,500
800
-550
180
Balance
20,530
2,500
250
180
j.
Balance
+2,500
-750
19,780
2,500
250
180
+ 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
182 X
12.
(a)
ANSWERS
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
(b)
6,300
4,200
18,000
14,400
7,350
1,265
(-) Drawings
Capital, Seri Dewi 31 Dec
(c)
(51,515)
27,235

For the year ended 31 December 2000
Capital, Seri Dewi 1 Jan
(+) Net income
RM
78,750
RM
22,200
27,235
49,435
(6,000)
43,435

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
W 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.
(b)
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.
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.
2.
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.
3.
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.
4.
5.
6.
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
Asset
Expense
Asset
Income
Liability
Asset
Expense
Asset
184 X
7.
ANSWERS
(a)
Date
Apr 2001
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.

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
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
Credit
5,000
5,000
275
275
3,250
3,250
750
750
125
125
1,875
1875
390
187
577
1,250
1,250
162
162
550
500
50
ANSWERS
(b)
W 185
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
750
125
390
187
1,250
500
Balance
5,000
8,250
7,500
7,375
6,985
6,798
5,548
5,048
Account Receivable
Date
Apr 2001
Description
Service revenue
Reference
Debit
1,875
Credit
Balance
1,875
Reference
Debit
275
Credit
Balance
275
113
63
Supplies Account
Date
Apr 2001
Description
Accounts payable
Supplies expenses
Drawings, Cindy
162
50
Accounts Payable
Date
Apr 2001
Description
Supplies
Cash
Reference
Debit
Credit
275
Balance
275
150
125
Capital Account, Cindy

Date
Apr 2001
Description
Cash
Reference
Debit
Credit
5,000
Balance
5,000
Reference
Debit
500
50
Credit
Balance
500
550
Drawings Account, Cindy

Date
Apr 2001
Description
Cash
Supplies
186 X
ANSWERS

Date
Apr 2001
Description
Cash
Accounts
receivable
Reference
Debit
Credit
3,250
1,875
Balance
3,250
5,125
Reference
Debit
750
Credit
Balance
750
Reference
Debit Credit
350
Balance
350
Reference
Debit
187
Credit
Balance
187
Reference
Debit
1,250
Credit
Balance
1,250
Reference
Debit
162
Credit
Balance
162

Date
Apr 2001
Description
Cash

Date
Apr 2001
Description
Cash

Date
Apr 2001
Description
Cash
Salary Expenses Account

Date
Apr 2001
Description
Cash
Supplies Expenses Account

Date
Apr 2001
Description
Cash
ANSWERS
(c)
W 187
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
8.
(a)
Debit (RM)
Credit
(RM)
5,048
1,875
63
150
5,000
550
5,125
750
390
187
1,250
162
10,275
10,275
GENERAL JOURNAL
Date
Reference
Feb 1 Supplies
L104
Cash L101
(Purchased supplies by cash)
2 Drawings, Edlin
L302
Cash L101
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 X
ANSWERS
18
(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
L101
L401
580
L502
L101
420
L503
L101
215
L302
L101
117
L501
L101
1,200
L509
220
580
420
215
117
1,200
L101
220
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
No: 101
Reference
Debit
J1
J1
J1
2,740
J1
J1
J1
J1
J1
J1
J1
Credit
Balance
15,238
274 14,964
2,000 12,964
15,704
1,200
420
14,504
15,084
14,664
215
117
1,200
220
14,449
14,332
13,132
12,912
580
ANSWERS
Accounts Receivable
Date
Feb 1
5
Description
Balance
Cash
No: 102
Reference
Debit
J1
Credit
2,740
Supplies Account
Date
Feb 1
1
Description
Balance
Cash
Description
Balance
Account payable
Reference
J1
Debit
Credit
274
Description
Balance
Office equipment
Cash
Reference
Debit
J1
3,850
Credit
Description
Balance
Reference
Debit
J1
J1
1,200
Credit
3,850
Description
Cash
Cash
Reference
Debit
Credit
Description
Cash
Reference
J1
J1
Debit
2,000
117
Credit
Description
Cash
Balance
2,000
2,117
No: 401
Reference
J1
Debit
Credit
580

Date
Feb 28
Balance
26,910
No: 302

Date
Feb 18
Balance
1,730
5,580
4,380
No: 301
Drawings Account, Edlin

Date
Feb 2
28
Balance
8,400
12,250
No: 201
Capital Account, Edlin

Date
Feb 1
Balance
427
701
No: 108
Accounts Payable
Date
Feb 1
9
15
Balance
4,575
1,835
No: 104

Date
Feb 1
9
W 189
Balance
580
No: 501
Reference
J1
Debit
1,200
Credit
Balance
1,200
190 X
ANSWERS
Advertisement Expenses Account

Date
Feb 25
Description
Cash
Reference
J1
No: 502
Debit
420
Credit

Date
Feb 28
No: 503
Description
Cash
Reference
J1
Debit
215
Credit

Date
Feb 28
(c)
Description
Cash
Balance
420
Balance
215
No: 509
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)
Credit
(RM)
12,912
1,835
701
12,250
4,380
26,910
2,117
580
1,200
420
215
220
31,870
31,870
ANSWERS
W 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
Tax
Preference shares' dividends
Sales revenue
Long term loans
Inventory
Cost of goods sold
Notes payable
Retained earnings
Equipment
Ordinary shares
Preference shares
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 X
ANSWERS
7.
Company PC
Income Statement
Sales
Gross profit
Less Operating expenditure
Sales expenses
Total operating costs
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
8.
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
Company ODC
Balance Sheet
as at 31 December 2001
Assets
Current assets
Cash
Account receivable
Inventory

Fixed assets
Land
Building
Machines
Equipments
Total fixed assets

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

Long-term loans
Total liabilities
Equities
Preference shares
Ordinary shares
Paid up capital
Retained earnings
Total equities
Total liabilities and equities
RM2,200,000
4,750,000
550,000
RM7,500,000
4,200,000
RM11,700,000
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
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
RM 92,800
37,000
Retained Earnings, 31 December 2000
RM104,800
25,700
194 X
(b)
ANSWERS
Earnings per share
(c)
8.
RM37,700 RM4,700
14,000
Dividends per share =
Dividends paid =
=
= RM2.36
RM21,000
14,000
= RM2.36
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
W 195
10.
Suresh Corporation
Changes in balance sheet items
between 31 December 2001 and 31 December 2002
Assets
Cash
Account receivable
Inventory
Total fixed assets
Less:
Accumulated
depreciation
Liabilities
Account payable
Notes payable
Wages accrual
Long term loans
Equities
Preference shares
Retained earnings
TOTAL
Changes
2001
2002
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)
16,000
28,000
2,000
50,000
15,000
22,000
3,000
50,000
+1,000
+6,000
- 1,000
0
100,000
14,000
100,000
28,000
0
+6,000
Resource
Usage
5,000
6,000
2,000
1,000
14,000
16,000
1,000
6,000
1,000
6,000
RM29,000
RM29,000
196 X
ANSWERS
Suresh Corporation
Cash Flow Statement
For the Year Ended 31 December 2002
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)

Increase in total fixed assets
RM27,000
(14,000)

Decrease in short term notes payable
Dividends paid
(14,000)
RM6,000
(8,000)

Net increase
securities
in
cash
and
(2,000)
RM11,000
marketable
Exercise 3.3
1.
Fazrul Company
(a) Net working capital

(b) Current ratio
(c) Quick ratio
1999
RM180,000
2.5 times
1.17 times
1998
RM150,000
2.07 times
1 time
ANSWERS
W 197
Exercise 3.4
1.
Fazrul Company
1999
9.14 times
39.9 days
2.54 times
14.4 days
142.3 times
1.07 times
(a) Account receivable turnover

(b) Average collection period
(c) Inventory turnover
(d) Average inventory sales period
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
(a) Return on asset

(e) Debt ratio
(g) Interest coverage ratio
(h) Price/earnings ratio
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%
198 X
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.
8.
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%
9.
Amri Company
Account receivable
Inventory
Total fixed asset
Net fixed asset
Total asset
Notes payable
Total current liability
Long-term liability
Total liability
Total 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
ANSWERS
W 199
TOPIC 4: FINANCIAL STATEMENT ANALYSIS

Exercise 4.1
1.
Fazrul Company
(a) Net working capital

(b) Current ratio
(c) Quick ratio
1999
RM180,000
2.5 times
1.17 times
1998
RM150,000
2.07 times
1 time
Exercise 4.2
1.
Fazrul Company
(a) Account receivable turnover
(b) Average collection period
(c) Inventory turnover
(d) Average inventory sales period
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
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
200 X
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
(a) Return on asset

(e) Debt ratio
(g) Interest coverage ratio
(h) Price/earnings ratio
X-Cell
12.67%
31.67%
10.27%
1.23 times
60%
2.5 times
7.89 times
6.25
6.86%
Exercise 4.5
1.
2.
3.
4.
5.
6.
7.
True
False
D
C
Net profit = RM6,000
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.
8.
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
N-Hance
11.25%
28.13%
9.57%
1.18 times
60%
2.5 times
8.37 times
12.62
1.89%
ANSWERS
(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%
Amri Company
Account receivable
Inventory
Total fixed asset
Net fixed asset
Total asset
Notes payable
Total current liability
Long-term liability
Total liability
Total 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
W 201
202 X
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
W 203
Exercise 5.8
1.
2.
3.
4.
RM346.06
RM149.4
FVOA
FVAD
=
=
=
=
=
=
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

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BQOEIII Fundamentals of Accounting &amp; Finance

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BQOE III

Prof. Dr. Mansor Fadzil

Noor Asma Jamaludin

Assoc Prof. Dr. Arfah Salleh

Translated & Edited: Pearson (M) Sdn. Bhd.

Lilian Kek Siew Yick

Centre for Instructional Design and Technology

Meteor Doc. Sdn. Bhd.

First Printing, January 2009

Financial Statement Analysis

Market Value Ratio

Time Value of Money

understand the fundamental concepts of accounting;

describe the meaning of accounting information, its role as well as its

elaborate the process of preparing accounting information from beginning

discuss the functions and information contained in financial statements;

analyse the financial performance of a company using financial ratio

TOPIC 1 ACCOUNTING ENVIRONMENT

Accounting is an information system that prepares reports on the economic

Users of Accounting Information

TOPIC 1 ACCOUNTING ENVIRONMENT

Information that can help them

Information required are different

How does the

Using the status or position in

Limited to what is made available

Accounting is divided into several different branches or other specialised fields.

(iii) Taxation; and

TOPIC 1 ACCOUNTING ENVIRONMENT

Preparation of financial reports

Preparation of financial and

Financial reports produced are

Report is produced at any time

Professional Accounting Bodies in Malaysia

Malaysian Institute of Accountants (MIA)

The Malaysian Institute of Certified Public Accountants (MICPA)

TOPIC 1 ACCOUNTING ENVIRONMENT

to advance the accounting theories and practices in all aspects;

Malaysian Accounting Standards Board (MASB)

Financial Reporting Foundation (FRF)

TOPIC 1 ACCOUNTING ENVIRONMENT

FUNDAMENTAL ACCOUNTING CONCEPTS

What are the important qualitative characteristics of accounting

Qualitative Characteristics of Accounting

In this section, you will be exposed to the qualitative characteristics of accounting

Figure 1.1: Qualitative characteristics of accounting information

TOPIC 1 ACCOUNTING ENVIRONMENT

difference in arriving at a decision. In other words, something is said to be

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

In your opinion, what will happen to a business entity if it only presents

TOPIC 1 ACCOUNTING ENVIRONMENT

Assumption of Separate Entity

TOPIC 1 ACCOUNTING ENVIRONMENT

Assumption of Going Concern

TOPIC 1 ACCOUNTING ENVIRONMENT

Assumption of Monetary Unit

Assumption of Accounting Period

TOPIC 1 ACCOUNTING ENVIRONMENT

Figure 1.4 shows examples of accounting period.

Figure 1.4: Examples of accounting period

Basic Principles of Accounting

BQOEIII Fundamentals of Accounting & Finance

BQOEIII Fundamentals of Accounting & Finance