BBAW2103 FINANCIAL ACCOUNTING

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 Zakaria Ismail Open University Malaysia Noor Asma Jamaludin Nor Asma Lode Junaidah Hanim Ahmad Azlan Zainol Abidin Amin Ali Norazita Marina Abd Aziz Universiti Utara Malaysia Assoc Prof Dr Arfah Salleh Assoc Prof Hashanah Ismail Universiti Putra Malaysia Azlina Abdul Aziz Loo Sze Wei Rosila Abu Zarin Open University Malaysia

Module Writers:

Moderators:

Translated & Edited: Pearson (M) Sdn. Bhd. Developed by: Centre for Instructional Design and Technology Open University Malaysia Meteor Doc. Sdn. Bhd. Lot 47-48, Jalan SR 1/9, Seksyen 9, Jalan Serdang Raya, Taman Serdang Raya, 43300 Seri Kembangan, Selangor Darul Ehsan

Printed by:

First Printing, April 2008 Second Printing, May 2009 Third Printing, November 2009 Fourth Printing, March 2010 Fifth Printing, October 2010 Copyright © Open University Malaysia (OUM), October 2010, BBAW2103 All right 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 March 2010

Table of Contents
Course Guide Topic 1 Accounting Environment 1.1 Introduction to Accounting 1.1.1 Definition of Accounting 1.1.2 Users of Accounting Information 1.1.3 Branches of Accounting 1.1.4 Professional Accounting Bodies in Malaysia 1.2 Fundamental Accounting Concepts 1.2.1 Qualitative Characteristics of Accounting Information 1.2.2 Accounting Assumptions 1.2.3 Basic Principles of Accounting 1.2.4 Accounting Constraints 1.3 Accounting Equation 1.3.1 Analysis of Transaction 1.3.2 Summary of Analysis 1.4 Types and Objectives of Financial Statement 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 Key terms 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 of Transaction 2.4.4 Trial Balance Summary Key Terms ix – xiii 1 2 2 2 3 4 6 6 10 13 16 17 18 23 25 26 26 27 28 34 35 36 37 39 41 42 43 43 45 51 77 83 83

Topic 2

iv

TABLE OF CONTENTS

Topic 3

Completing the Accounting Cycle 3.1 Adjusting Entries 3.1.1 Prepaid Expenses 3.1.2 Depreciation Expenses 3.1.3 Unearned Revenue (Unearned Income) 3.1.4 Accrued Expenses 3.1.5 Accrued Revenue 3.2 Preparation of Adjusted Trial Balance 3.3 Preparation of Financial Statements 3.3.1 Income Statement 3.3.2 Statement of Changes in Owner’s Equity 3.3.3 Balance Sheet 3.3.4 Cash Flow Statement 3.4 Preparation of Closing Entries 3.4.1 Steps In Preparation of Closing Entries 3.5 Preparation of Reversing Entries Summary Key Terms Financial Reporting 4.1 Statutory Requirement 4.2 Financial Report 4.2.1 Non-financial Information 4.3 Main Financial Statements Summary Key Terms Trading Business Environment 5.1 Trading Business Environment 5.2 Important Transactions in Trading Firms 5.2.1 Purchases 5.2.2 Sales 5.2.3 Discounts 5.2.4 Returns and Allowances 5.2.5 Transportation Cost 5.3 Accounting for Inventory 5.4 Journal Entry for Periodic and Perpetual Inventory System 5.5 Examples of Recording Journal Entries 5.6 Format of Income Statement for Trading Firms 5.6.1 Single Level of Income Statement 5.6.2 Multiple Levels of Income Statement 5.7 Closing Entries Summary Key Terms

84 85 86 88 89 91 91 93 100 100 105 107 117 121 121 124 128 128 129 129 132 133 135 138 138 129 142 144 144 144 145 148 150 152 155 160 163 163 164 168 175 175

Topic 4

Topic 5

TABLE OF CONTENTS

v

Topic 6

Financial Statement Analysis 6.1 Purpose of Financial Statement Analysis 6.2 Sources of Information 6.3 Basis of Comparison 6.4 Techniques of Analysis 6.5 Horizontal Analysis 6.5.1 Comparison of Horizontal Analysis for 2 Years 6.5.2 Comparison of Horizontal Analysis for A Sequential Period (Trend Analysis) 6.6 Vertical Analysis 6.6.1 Vertical Analysis for Balance Sheet 6.6.2 Vertical Analysis for Income Statement 6.7 Financial Ratio Analysis 6.8 Liquidity Ratio 6.9 Efficiency Ratio 6.10 Profitability Ratio 6.11 Debt Management Ratio 6.12 Sample of Ratio Calculations Summary Key Terms

176 177 178 179 180 181 181 185 186 186 188 190 191 194 194 194 200 214 214 215 265

Answers Reference

COURSE GUIDE

COURSE GUIDES

ix

COURSE GUIDE DESCRIPTION
You must read this Course Guide carefully from the beginning to the end. It tells you briefly what the course is about and how you can work your way through the course material. It also suggests the amount of time you are likely to spend in order to complete the course successfully. Please keep on referring to Course Guide as you go through the course material as it will help you to clarify important study components or points that you might miss or overlook.

INTRODUCTION
BBAW2103 Financial Accounting is one of the courses offered by the Faculty of Business and Management at Open University Malaysia (OUM). This course is worth 3 credit hours and should be covered over 15 weeks.

COURSE AUDIENCE
This is a core course for students undergoing Bachelor of Management, Bachelor of Business Administration, Bachelor of Tourism Management and Bachelor of Hospitality Management. For students undergoing Bachelor of Human Resource Management, this is basic major course. As an open and distance learner, you should be able to learn independently and optimise the learning modes and environment available to you. Before you begin this course, please confirm the course material, the course requirements and how the course is conducted.

STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every credit hour. As such, for a three-credit hour course, you are expected to spend 120 study hours. Table 1 gives an estimation of how the 120 study hours could be accumulated.

x

COURSE GUIDES

Table 1: Estimation of Time Allocation of Study Hours

LEARNING OUTCOMES
By the end of this course, you should be able to: 1. 2. 3. 4. 5. Discuss the fundamental concepts of accounting and classify types of financial statements; Describe the meaning of accounting information, its role and importance; Compute journal entry and illustrate the process of preparing accounting information and completion of the accounting cycle; Apply management accounting techniques or analyses to assist the management in decision-making; and Propose and plan an accounting information.

COURSE SYNOPSIS
This course is divided into 6 topics. The synopsis for each topic is presented below: Topic 1 discusses the Accounting Environment. Topic 1 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 GUIDES

xi

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. The last section in this unit 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 the types of adjustments entry that affect the accounts in the income statement and balance sheet. An adjusted trial balance is prepared after the adjustment entries had been recorded and transferred. Following this, four types of financial statements will be discussed in detail. The closing entries and reversal entries will also be covered in this topic. Topic 4 will discuss the requirements to prepare financial report or annual report by registered business entities, statutory requirement on financial reporting, main financial statements and accounting concepts as well as notes to the accounts. Topic 5 covers accounting for trading, comprising preparation of journal entries as well as income statement. Emphasis will be given on accounting for inventory using the perpetual and periodic inventory systems. The preparation of income statement involving single and multiple levels will also be focused on. Topic 6 introduces us to financial statement analysis using the horizontal and vertical analysis and financial ratio analysis. Financial ratio analysis that will be discussed includes the liquidity, efficiency, profitability and debt management ratios. These financial analyses are important in decision-making.

TEXT ARRANGEMENT GUIDE
Before you go through this module, it is important that you note the text arrangement. Understanding the text arrangement should help you to organise your study of this course to be more objective and more effective. Generally, the text arrangement for each topic is as follows: Learning Outcomes: This section refers to what you should achieve after you have completely gone through a topic. As you go through each topic, you should frequently refer to these learning outcomes. By doing this, you can continuously gauge your progress of digesting the topic. Self-Check: This component of the module is inserted at strategic locations throughout the module. It is inserted after you have gone through one sub-section

xii

COURSE GUIDES

or sometimes a few sub-sections. It usually comes in the form of a question that may require you to stop your reading and start thinking. When you come across this component, try to reflect on what you have already gone through. When you attempt to answer the question prompted, you should be able to gauge whether you have understood what you have read (clearly, vaguely or worse you might find out that you had not comprehended or retained the sub-section(s) that you had just gone through). Most of the time, the answers to the questions can be found directly from the module itself. Activity: Like Self-Check, activities are also placed at various locations or junctures throughout the module. Compared to Self-Check, Activity can appear in various forms such as questions, short case studies or it may even ask you to conduct an observation or research. Activity may also ask your opinion and evaluation on a given scenario. When you come across an Activity, you should try to widen what you have gathered from the module and introduce it to real situations. You should engage yourself in higher order thinking where you might be required to analyse, synthesise and evaluate instead of just having to recall and define. Summary: You can find this component at the end of each topic. This component helps you to recap the whole topic. By going through the summary, you should be able to gauge your knowledge retention level. Should you find points inside the summary that you do not fully understand, it would be a good idea for you to revisit the details from the module. Key Terms: This component can be found at the end of each topic. You should go through this component to remind yourself of important terms or jargons used throughout the module. Should you find terms here that you are not able to explain, you should look for the terms from the module. References: References is where a list of relevant and useful textbooks, journals, articles, electronic contents or sources can be found. This list can appear in a few locations such as in the Course Guide (at References section), at the end of every topic or at the back of the module. You are encouraged to read and refer to the suggested sources to elicit the additional information needed as well as to enhance your overall understanding of the course.

ASSESSMENT METHOD
Please refer to myVLE

COURSE GUIDES

xiii

REFERENCES
Horngren C. T., Harrison W. T. Jr. & 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. Roger, H. H et al. (1997), Accounting: A business perspective, (7th ed.), Irwin US. Warren et. Al (2001), Accounting: Customized by school of accountancy UUM for business accounting students, Thompson Learning. Warren C. S., Reeve J. M., & Fess P. E. (2004), Accounting (21st ed.), International Thompson Publishing, Ohio, USA. Weygandt Jerry J., Keiso Donald E., & Kimmel Paul D., (2004) Accounting principles, (7th ed.), John Wiley & Sons, Inc.

Topic

1
1. 2. 3. 4. 5. 6.

Accounting Environment

LEARNING OUTCOMES
By the end of this topic, you should be able to: Explain the meaning, role and importance of accounting; Identify the users and branches of accounting; Describe the main functions of professional accounting bodies in Malaysia; Assess the qualitative characteristics of financial information, assumptions, principles and constraints in accounting; Apply the accounting equations; and Analyse transactions based on the accounting equation.

 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. This 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.

2

TOPIC 1 ACCOUNTING ENVIRONMENT

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
1.1.1

INTRODUCTION TO ACCOUNTING
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.

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.

TOPIC 1 ACCOUNTING ENVIRONMENT

3

The other differences between these two groups are summarised in Table 1.1.
Table 1.1: Differences between Internal Users and External Users Internal Users Types of information required Information that can help them make planning and exercise control over the entity. External Users Information required are different depending on the type of decisions made. Example: Investor: Require information on the profitability of the company before making decision to invest. Loan providers: Require information on the stability and liquidity of the company before making decision on giving out credit. How does the information been obtained Using the status or position in the company. Limited to what is made available by the company. Example Annual report published by the company.

1.1.3

Branches of Accounting

Accounting is divided into several different branches or other specialised fields. Among them are: (i) Financial Accounting; (ii) Management Accounting; (iii) Taxation; and (iv) Auditing. These branches are not static as they evolve 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. Let’s look at Figure 1.2.

4

TOPIC 1 ACCOUNTING ENVIRONMENT

Table 1.2: Differences between Financial Accounting and Management Accounting Financial Accounting Preparation of report Preparation of financial reports of an entity for external and internal users but focus is given to the external users. Management Accounting Preparation of financial and non-financial information that are required by parties in the company for planning, evaluating and controlling purposes of the operations of an entity. Report is produced at any time based on requirement and is not subject to any standard or format.

Standard or Format

Financial reports produced are periodically and in accordance to specified standard or format.

1.1.4

Professional Accounting Bodies in Malaysia

We also need to familiarise ourselves with the organisations that are involved in the accounting profession in Malaysia. The organisations are: (a) Malaysian Institute of Accountants (MIA) MIA was established under the Accountants Act 1967 as the main accounting body in the country. Overall, it functions as the core body in regulating the accounting profession. Other major functions of MIA as discussed in the Accountants Act 1967 are: (i) to set the required qualification in order to become a member; (ii) to provide training and education for practitioners or those who are interested in becoming accounting practitioners; (iii) to control the accounting practices in Malaysia; and (iv) to protect the accounting interest in Malaysia. (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) to advance the accounting theories and practices in all aspects;

TOPIC 1 ACCOUNTING ENVIRONMENT

5

(ii) to train and evaluate the competent members; (iii) to ensure the independence of professional accountants; and (iv) 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 EXERCISE 1.1
1. 2. Provide examples of common decisions made by both internal and external users. How does Financial Accounting and Management Accounting assist users in making decision?

WEBSITE
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 Accountants (MICPA) www.micpa.com.my Malaysian Accounting Standards Board (MASB) www.masb.org.my Financial Reporting Foundation (FRF) www.masb.org.my

6

TOPIC 1 ACCOUNTING ENVIRONMENT

1.2
1.2.1

FUNDAMENTAL ACCOUNTING CONCEPTS
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.

TOPIC 1 ACCOUNTING ENVIRONMENT

7

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.

8

TOPIC 1 ACCOUNTING ENVIRONMENT

(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. Let’s look at an example. Assume that you were told that the net profit of a business in the year 2009 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 2008 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.

TOPIC 1 ACCOUNTING ENVIRONMENT

9

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.

SELF-CHECK 1.1
What are the important qualitative characteristics of accounting information?

ACTIVITY 1.1
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. 2. State the qualitative characteristics of accounting information. Explain the meaning of comparability provide an example to show its role in making accounting information useful.

10

TOPIC 1 ACCOUNTING ENVIRONMENT

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 owner’s 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 2008, 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.

TOPIC 1 ACCOUNTING ENVIRONMENT

11

Let’s look at an example Assuming that Mr. Ali owns three different businesses, all three are considered to be separated 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. Ali’s businesses show the following result on 31 December 2008:
Table 1.3: Mr Ali’s Business Business Business 1 Business 2 Business 3 Transaction Profit Loss Profit (RM) 6,000 8,000 12,000

If the assumption of separate entity is not complied with and all the entities are assumed as one, Mr. Ali will have an overall business profit of RM10,000 [RM6,000 + (-8,000) + RM12,000]. Based on this result, Mr. Ali might be satisfied and might not take any measures for improvement. However, by preparing separate accounts, Mr. Ali will know that Business 2 is facing problems as it is suffering a loss of RM8,000, while Business 3 is performing very well with a profit of RM12,000. (b) Assumption of Going Concern According to this assumption, an entity is assumed to continue to exist and in operation in the future. This assumption is important because it enables the principle of historical cost to be applied. According to the historical cost principle, all assets and liabilities must be recorded at the purchase price (original cost). For most assets, this cost would be depreciated throughout the life span of the assets to depict its usage. However, asset of property would not be depreciated as its value would always appreciate. As an example, a machine with a life span of 25 years will be depreciated for 25 years based on the assumption of going concern. With this assumption, the entity would continue to exist for a period of more than 25 years. If we assume that the entity would exist only for another 10 years in absence of this assumption, we obviously cannot use 25 years as the basis for calculating the depreciation.

12

TOPIC 1 ACCOUNTING ENVIRONMENT

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 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 country’s 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.

TOPIC 1 ACCOUNTING ENVIRONMENT

13

Figure 1.4 shows examples of accounting period.
Starting Date 1 January 2008 1 July 2008 1 March 2008 Ending Date 31 December 2008 30 June 2009 28 February 2009 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.

ACTIVITY 1.2
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

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. 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

14

TOPIC 1 ACCOUNTING ENVIRONMENT

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 period principle and provides a true picture of the project development.

TOPIC 1 ACCOUNTING ENVIRONMENT

15

(ii) Cash Basis Method complies with the basis of cash accounting. According to this method, revenue is only recognised when cash is received. This method is applied in credit transactions when cash receipts are not assured. (c) Principle of Matching This principle matches the expense (effort) with the revenue (benefit obtained from the effort). The matching of the revenue with the expense will be done when the transaction has completed. To comply with this principle, two steps will be involved, which are: (i) First Step Recognition of the revenue for a specific period.

(ii) Second Step Recognition of all the expenses involved in ascertaining the revenue. For example, when we provide services to customers, we will recognise the revenue according to the principle of income recognition. Then, we will recognise all the expenses involved in generating the revenue and match them with the revenue. The difference between the revenue and the expense will be either profit or loss. If revenue is more than expense, the difference will be net profit. However, if the revenue is less than expenses, the difference will be recognised as net loss. Figure 1.5 summarises the concept of profit and loss.

Income – Expenses = Profit or Loss

Income > Expenses = Net Profit Income < Expenses = Net 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 Topic 4.

16

TOPIC 1 ACCOUNTING ENVIRONMENT

ACTIVITY 1.3
1. 2. Explain the weaknesses exist in the assumption of monetary unit. 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).

TOPIC 1 ACCOUNTING ENVIRONMENT

17

1.3

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 owner’s equity. What is 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 owner’s equity in the accounting equation as shown below:

ASSET = LIABILITY + OWNER’S EQUITY

SELF-CHECK 1.3
A business has assets of RM120,000. RM50,000 is the owner’s capital and the balance is bank loan. What is the accounting equation?

18

TOPIC 1 ACCOUNTING ENVIRONMENT

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. 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 2008. 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 2008:
Table 1.3: List of Transactions for Reen Cyber Service, November 2008 No. 1 2 3 4 5 6 7 8 Date (Nov) 1 2 4 15 30 30 30 30 Transactions Reen invested cash of RM30,000 into Reen Cyber Service. Purchased a piece of land valued at RM20,000. The business paid cash RM5,000 and the balance is financed by bank loan. Purchased office supplies valued at RM2,700 on credit. Received revenue from consultancy services provided to customer. The customer paid RM15,000 cash. Paid staff salary expense RM4,250; rental expense RM1,600; utility expense RM900 and other expenses RM550. Made payment for account payable of RM1,900. Unused office supplies valued at RM1,100. Reen withdrew money from the business amounting to RM4,000 for her personal use.

All the transactions above are pertaining to Reen Cyber Service. The personal transactions of the owner (Reen) will not be taken into account if it does not involve the business. Now we have to analyse each transaction to see their effects on the accounting equation. Transaction 1: Reen invested cash of RM30,000 into Reen Cyber Service. Again, it needs to be emphasised that we are only interested in transactions involving Reen Cyber Service, and not Reen’s 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, owner’s equity will increase by RM30,000.

TOPIC 1 ACCOUNTING ENVIRONMENT

19

Transaction

ASSET Cash

=

LIABILITY

+

OWNER’S EQUITY Capital, Reen

1

30,000

=

30,000

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 Cash Balance 2 Balance 30,000 (-5,000) 25,000 + 20,000 20,000 ASSET + Land = = = 15,000 15,000 30,000 = LIABILITY NP + OWNER’S EQUITY Capital, Reen 30,000

Transaction 3: Purchased office supplies valued at RM2,700 on credit. The asset will increase by RM2,700. The purchase by credit will create a new liability, which is Account Payable (AP).
Transaction Cash Balance 3 Balance 25,000 20,000 25,000 + + ASSET Land 20,000 2,700 2,700 + Supplies = = = 15,000 = LIABILITY NP 15,000 2,700 2,700 30,000 + AP + + OWNER’S EQUITY Capital, Reen 30,000

20

TOPIC 1 ACCOUNTING ENVIRONMENT

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.
Transaction Cash Balance 4 25,000 15,000 + ASSET Land + Supplies 2,700 = LIABILITY NP + AP + + OWNER’S EQUITY Capital, Reen 30,000 15,000 service revenue 2,700 45,000

+ 20,000 +

= 15,000 + 2,700 =

Balance

40,000

20,000

2,700

= 15,000

Service revenue is one of the components in owner’s equity. The other components are expenses and drawings. Revenue will increase the owner’s equity while expenses and drawings will reduce it. Figure 1.6 shows the effect of revenue, capital, expenses and drawings on owner’s equity.

Revenue ↑ Capital ↑ Expenses ↑ Drawings ↑

= = = =

Owner’s equity ↑ Owner’s equity ↑ Owner’s equity ↓ Owner’s 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.

TOPIC 1 ACCOUNTING ENVIRONMENT

21

Transaction Cash Balance 5 40,000 (-4,250) (-1,600) -900 -550 + +

ASSET Land 40,000 + + Supplies 2,700

=

LIABILITY NP + AP 2,700

+

OWNER’S EQUITY Capital, Reen

= 15,000 + =

+

45,000 (-4,250) paid salary (–1,600) paid rental (-900) paid utility (-550) paid sundry

Balance

32,700

+

20,000

+

2,700

= 15,000 +

2,700

+

37,700

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 owner’s equity. Transaction 6: Made payment for account payable of RM1,900. When the business paid RM1,900, cash will decrease by RM1,900 and liability will also decrease by RM1,900.
Transaction Cash Balance 6 Balance 32,700 (-1,900) 30,800 + 20,000 + 2,700 = ASSET + Land + Supplies = = LIABILITY NP + AP + + OWNER’S EQUITY Capital, Reen 37,700

+ 20,000 + 2,700

15,000 + 2,700 = -1,900

15,000 + 800

+

37,700

22

TOPIC 1 ACCOUNTING ENVIRONMENT

Transaction 7: At the end of the month, the unused office supplies were valued at RM1,100. The office supplies was originally bought for RM2,700. The value of office supplies used up during the period is RM1,600 (RM2,700 – RM1,100)
Transaction Cash Balance 7 + ASSET Land 20,000 + + Supplies 2,700 -1,600 = = = LIABILITY NP + AP 800 + + OWNER’S EQUITY Capital, Reen 37,700 -1,600 Supplies expenses 15,000 + 800 + 36,100

30,800 +

15,000 +

Balance

30,800 +

20,000

+

1,100

=

Transaction 8: Reen withdrew money from the business amounting to RM4,000 for her personal use.
OWNER’S EQUITY Capital, Reen + 36,100 (-4,000) cash drawings 800 + 32,100

Transaction Cash Balance 8 30,800 (-1,600) +

ASSET Land + Supplies 1,100

=

LIABILITY NP + AP 800

+

+ 20,000 +

=

15,000 + =

Balance

26,800

+ 20,000 +

1,100

=

15,000 +

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 owner’s personal use.

TOPIC 1 ACCOUNTING ENVIRONMENT

23

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) Owner’s equity will increase with investment from the owner and revenue, while drawings by the owner and expenses will reduce owner’s 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.

24

TOPIC 1 ACCOUNTING ENVIRONMENT

Table 1.4: Analysis of Transaction for Reen Cyber Service, November 2008
Transaction Cash 1 30,000 + ASSET Land + Supplies = = LIABILITY NP + AP + OWNER EQUITY Capital, Reen 30,000 investment by Reen 30,000 15,000 15,000 2,700 15,000 + 2,700 + 30,000 15,000 service revenue 15,000 + 2,700 + 45,000 (-4,250) paid salary (-1,600) paid rental (-900) paid utility (-550) paid sundry + + 20,000 20,000 + + 2,700 2,700 -1,600 = = = = 15,000 + 15,000 + 2,700 -1,900 800 + 37,700 (-1,600 ) expenses supplies 15,000 + 800 + 36,100 (-4,000) cash drawings 15,000 + 800 + 32,100 + 37,700 + 30,000

Balance 2 Balance 3 Balance 4

30,000 -5,000 25,000 + 25,000 15,000 + 20,000 + 20,000 20,000 2,700 2,700

= = = = = =

Balance 5

40,000 (-4,250) (-1,600) (-900) (-550)

+

20,000

+

2,700

= =

Balance 6 Balance 7

32,700 (-1,900) 30,800

Balance 8 Balance

30,800 (-4,000) 26,800

+

20,000

+

1,100

= =

+

20,000

+

1,100

=

ASSET = 47,900 = 47,900 =

LIABILITY 15,800 47,900

+ +

OWNER’S EQUITY 32,100

TOPIC 1 ACCOUNTING ENVIRONMENT

25

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) (c) Income Statement; Balance Sheet; and (b) Statement of Changes in Owner’s Equity; (d) Cash Flow Statement. These statements are interconnected with one another. The title for each statement must contain the reporting entity’s 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 Topic 3.

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.

26

TOPIC 1 ACCOUNTING ENVIRONMENT

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 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 2008. Reen Cyber Service Income Statement for the month ended 30 November 2008 RM Service revenue Expenses: Salary expenses Rental expenses Utility expenses Supplies expenses Sundry expenses Net profit RM 15,000 4,250 1,600 900 1,600 550

(8,900) 6,100

Figure 1.8: Income statement

1.4.2

Statement of Changes in Owner’s Equity

This statement shows the changes in owner’s equity for a specific accounting period. Owner’s equity will increase when the owner makes a capital investment or when the entity gains net profit. Owner’s equity will decrease when the owner makes drawings or when the entity incurs net loss. Figure 1.9 shows the statement of changes in owner’s equity for Reen Cyber Services.

TOPIC 1 ACCOUNTING ENVIRONMENT

27

Reen Cyber Service Statement of Changes in Owner’s Equity for the month ended 30 November 2008 Opening Capital – 1 November (+) Net profit (-) Drawings RM 30,000 6,100 36,100 (4,000) 32,100

Closing Capital – 30 November

Figure 1.9: Statement of changes in owner’s equity

1.4.3

Balance Sheet

This statement is also known as the financial position statement, listing all the assets, liabilities and owner’s 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 owner’s equity on the right side (refer to Figure 1.10 and Figure 1.11) Reen Cyber Service Balance Sheet as at 30 November 2008 ASSETS Current Assets: Cash Supplies Non-current Assets: Land 20,000 26,800 1,100 27,900 RM LIABILITIES AND OWNER’S EQUITY Liabilities: Current Liability: Account payable Non-current liability: Notes payable Total liabilities Owner Equity: Capital TOTAL LIABILITIES AND TOTAL ASSETS 47,900 OWNER’S EQUITY 47,900 32,100 15,000 15,800 800 RM

Figure 1.10: Balance Sheet in accounts format

28

TOPIC 1 ACCOUNTING ENVIRONMENT

In the statement format, the asset, liability and owner’s equity are listed vertically. Reen Cyber Service Balance Sheet as at 30 November 2008 RM Non-current Assets: Land Current Assets: Cash Supplies Less: Current liability: Account payable Net current assets Financed by: Owner’s equity: Capital, Reen Non-current liability: Notes payable RM 20,000 26,800 1,100 27,900 (800) 27,100 47,100

32,100

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.

TOPIC 1 ACCOUNTING ENVIRONMENT

29

Reen Cyber Services Cash Flow Statement for the month ended 30 November 2008 RM Cash from operating activities: Cash received from customers (–) Expenditure paid Payment to supplier Net cash flow from operating activities Cash from investing activities: Payment for purchase of land Net cash flow from investing activities Cash flow from financing activities: Investment by owner (–) Drawings by owner Net cash flow from financing activities Net cash flow for entity and cash account balance as at 30 November
Figure 1.12: Cash flow statement

RM 15,000

RM

7,300 1,900

(9,200) 5,800

(5,000) (5,000)

30,000 (4,000) 26,000 26,800

ACTIVITY 1.3
Discuss the issues that might arise if a business entity did not disclose the relevant information in its financial statement. Present in your tutorial.

30

TOPIC 1 ACCOUNTING ENVIRONMENT

EXERCISE 1.4
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) (f) The qualitative characteristic that enables users to depend or rely on the information presented is _____________. 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) (j) According to the assumption of _____________, the entity is assumed to continue to exist and in operation in the future. 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 owner’s equity of an entity in a specific period.

TOPIC 1 ACCOUNTING ENVIRONMENT

31

EXERCISE 1.5
1. 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 Which of these is NOT a qualitative characteristic of accounting information? A. Materiality B. Reliability C. Relevant D. Comparability One example of internal user is: A. Inland Revenue Board B. Investor C. Creditors D. Management If the total assets increased by RM15,000 and the total liabilities decreased by RM10,000; owner’s equity had: A. increased by RM5,000 B. decreased by RM5,000 C. increased by RM25,000 D. decreased by RM25,000 For the purpose of simplifying accounting, the business owner and business entity are assumed as the same. True 6. False

2.

3.

4.

5.

The accounting period for all businesses must start from 1 January and ends at 31 December each year. True False

7.

Income statement shows the net profit or loss of a business entity at a specific date. True False

32

TOPIC 1 ACCOUNTING ENVIRONMENT

EXERCISE 1.6
Answers the questions below. 1. Determine the appropriate amount in the spaces marked “?” ASSET 84,000 ? 125,000 = = = = LIABILITY ? 72,000 50,000 + + + + OWNER’S EQUITY 38,000 28,000 ?

(a) (b) (c) 2.

State the effects of the following transactions on the asset, liability and owner’s equity. An example is shown in transaction (a): Transaction (a) (b) (c) (d) (e) Paid debts to supplier. Purchased office equipment by cash. Owner took cash from the business for personal use. Paid staff salary for the current period. Received cash from customer to settle his account receivable. Owner contributed office equipment for business use. Effect Asset decreased, decreased. Liability

(f)

3.

Mr. Ashwin established a tour agency on 1 June 2007. 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.

TOPIC 1 ACCOUNTING ENVIRONMENT

33

(i) (j)

Supplies unused at the end of the period is valued at RM250. Mr. Ashwin took cash from the business totalling RM750 for his personal use.

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. 4. Below are the assets and liabilities accounts balances for Seri Consultation Services as at 31 December 2008 including the revenue and expense incurred throughout the year 2008. On 1 January 2008, 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 2008.

(b) Statement of Changes in Owner’s Equity for the year ended 31 December 2008. (c) Balance Sheet as at 31 December 2008.

34

TOPIC 1 ACCOUNTING ENVIRONMENT

SUMMARY
In this topic, you have learned and discovered: • • The users of accounting information consist of internal users and external users. The difference between financial accounting and management accounting are: – Financial accounting prepares the financial report for external users while management accounting prepares the monetary and non-financial information for internal users. The financial reports in financial accounting is produced periodically and subject to specified format while the report for management accounting is produced according to specific needs and not subject to specified standards.

The professional bodies involved in the accounting profession are Malaysian Institute of Accountants (MIA), The Malaysian Institute of Certified Public Accountants (MICPA), Malaysian Accounting Standards Board (MASB) and Financial Reporting Foundation (FRF). The assumptions and fundamental principles of accounting consist of: – – – – – – – – assumption of separate entity; assumption of going concern; assumption of monetary unit; assumption of accounting period; principle of historical cost; principle of income recognition; principle of matching; and principle of full disclosure.

• •

The accounting equation is fundamental in accounting and it consists of three components, namely asset, liability and owner’s equity. Financial statement is the final product of the accounting process and it consists of Income Statement, Statement of Changes in Owner’s Equity, Balance Sheet and Cash Flow Statement.

TOPIC 1 ACCOUNTING ENVIRONMENT

35

Accounting Auditing External Users Financial Accounting Internal Users

Management Accounting Monetary Unit Qualitative Characteristics Taxation

Topic

2
1. 2. 3. 4. 5. 6. Prepare journal entries;

Recording Process

LEARNING OUTCOMES
By the end of this topic, you should be able to: Describe the chart of accounts for recording and summarise the effect of transactions on financial statement; Explain the format of accounts used; Assess the rule of debit and credit for each type of accounts; Post journal entries to ledger; and Prepare trial balance.

 INTRODUCTION
After studying how to analyse transactions, we will now learn about recording. Recording is the most important step in accounting for a business entity. However, before recording, we must identify the event that had occurred. Only events that occur to the business entity will be recorded in the entity’s book. Not all events are transactions, for example, recruitment of staff. Although it will affect the entity economically, this event is not considered as a transaction.

TOPIC 2 RECORDING PROCESS

37

2.1

CHART OF ACCOUNTS

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 in Topic 1, 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 owner’s equity) are put in front, followed by income statement items (revenue and expense).

SELF-CHECK 2.1
Why must transactions be recorded in accounts and not some other format?

38

TOPIC 2 RECORDING PROCESS

Figure 2.1 summarises the concept of ledger and chart of accounts.

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. Table 2.1 shows the chart of accounts 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 owner’s 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.

TOPIC 2 RECORDING PROCESS

39

Table 2.1: Chart of Accounts for Reen Cyber Service Accounts in Balance Sheet 1 ASSETS 11 Cash 12 Account receivable 14 Supplies 15 Insurance prepayment 17 Land 18 Office equipment LIABILITIES 21 Account payable 22 Notes Payable 23 Deferred Rental OWNERÊS EQUITY 31 Capital, Reen 32 Drawings, Reen 4 Accounts in Income Statement REVENUE 41 Service revenue

2

5

3

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? Explain. (a) The death of a branch manager. (b) The capital contribution of the owner into the business.

2.2
(a)

FORMAT OF ACCOUNT

Each account has three sections: Title or name of the account, which is the name of the items recorded in that particular account. Credit section on the right side.

(b) Debit section on the left side. (c)

40

TOPIC 2 RECORDING PROCESS

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. Accounts are also known as T-accounts due to their shapes that look like the letter T. Account Title Debit (left) Credit (right)

Figure 2.2: T-Account (simple format )

Each section of the T-account should have four columns in the debit section and four columns in the credit section.
Debit Date Description Reference Account Title Amount Date Description Reference Credit Amount

Figure 2.3: T-Account (detailed format )

There is another format of account known as the three column account. Although in fact there are actually six columns in this account’s 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

TOPIC 2 RECORDING PROCESS

41

2.3

RULES OF DEBIT AND CREDIT

We have previously stated that asset, liability and owner’s 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 entity’s 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 owner’s equity accounts. To observe this more clearly, please refer back to the accounting equation we had learned: ASSET = LIABILITY + OWNER’S EQUITY

The asset item is on the left side while the liability and owner’s 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 owner’s equity.

42

TOPIC 2 RECORDING PROCESS

SELF-CHECK 2.2
Identify the characteristics that allow an event to be viewed as a transaction and therefore must be recorded?

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. 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

TOPIC 2 RECORDING PROCESS

43

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.

ACTIVITY 2.1
Identify the characteristics that allow an event to be viewed as a transaction and therefore must be recorded? Discuss.

2.4

STEPS IN RECORDING PROCESS

Once the entity’s 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.

44

TOPIC 2 RECORDING PROCESS

(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: (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

TOPIC 2 RECORDING PROCESS

45

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.

ACTIVITY 2.2
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. 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 owner’s equity by RM30,000. According to the rules of debit and credit, the increase in asset account (cash) will be debited and increase in owner’s equity account (capital) will be credited. When recording, note that the name of the account to be debited is listed first, followed by the name of account to be credited. The name of the credited account will be aligned slightly to the right to differentiate it from the account to be debited. Journal entry: General Journal Date Nov 1 Cash Capital, Reen (Cash invested by Reen)
Journal 1: General Journal for Transaction 1

pg 1 Debit (RM) 30,000 30,000 Credit (RM)

Description

Reference

46

TOPIC 2 RECORDING PROCESS

Post to ledger: Cash Nov 1 Capital, Reen RM 30,000 Capital, Reen Nov 1 Cash RM 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. Journal entry: General Journal Date Nov 1 Land Cash Notes payable (Purchased land by cash and bank loan)
Journal 2: General Journal for Transaction 2

pg 1 Debit (RM) Credit (RM) 20,000 5,000 15,000

Description

Reference

Post to ledger: Land Nov 2 Cash Notes Payable RM 5,000 15,000 Cash RM 30,000 Nov 2

Nov 1

Capital, Reen

Land

RM 5,000

TOPIC 2 RECORDING PROCESS

47

Notes Payable Nov 2

Land

RM 15,000

Ledger 2: Ledger for Transaction 2

Transaction 3: On 4 November, the business bought office supplies valued at RM2,700 on credit. Journal entry: General Journal Date Nov 4 Description Supplies Accounts Payable (Purchased office supplies by credit)
Journal 3: General Journal for Transaction 3

pg 1 Debit (RM) Credit (RM) 2,700 2,700

Reference

Post to ledger: Supplies RM 2,700

Nov 4

Account Payable

Accounts Payable Nov 4 Supplies RM 2,700

Ledger 3: Ledger for Transaction 3

Transaction 4: On 15 November, the business received revenue from consultancy services provided to a customer. The customer paid cash of RM15,000.

48

TOPIC 2 RECORDING PROCESS

Journal entry: General Journal Date Nov 15 Cash Service revenue (Cash received for services provided)
Journal 4: General Journal for Transaction 4

pg 1 Debit (RM) Credit (RM) 15,000 15,000

Description

Reference

Post to ledger: Cash RM 30,000 Nov 2 15,000 Service revenue Nov 15 Cash RM 15,000 RM 5,000

Nov 1 Capital, Reen 15 Service revenue

Land

Ledger 4: Ledger for Transaction 4

Transaction 5: On 30 November, the business paid salary expenses (RM4,250), rental expenses (RM1,600), utility expenses (RM900) and sundry expenses (RM550). Journal entry: General Journal Date Nov 30 Description Salary expenses Rental expenses Utility expenses Sundry expenses Cash (Cash payment for the said expenses)
Journal 5: General Journal for Transaction 5

pg 1 Debit (RM) Credit (RM) 4,250 1,600 900 550 7,300

Reference

TOPIC 2 RECORDING PROCESS

49

Post to ledger: Cash RM 30,000 Nov 2 Land 15,000 30 Salary expenses Rental expenses Utility expenses Sundry expenses RM 5,000 4,250 1,600 900 550

Nov 1 Capital, Reen 15 Service revenue

Nov 30 Cash

Salary expenses RM 4,250

Nov 30 Cash

Rental expenses RM 1,600

Nov 30 Cash

Utility expenses RM 900

Nov 30 Cash

Sundry expenses RM 550

Ledger 5: Ledger for Transaction 5

Transaction 6: On 30 November, the business paid its debt to the supplier of supplies purchased on 4 November for RM1,900. Journal entry: General Journal Date Nov 30 Description Accounts Payable Cash (Payment payable) to accounts Reference 1,900 1,900 pg 1 Debit (RM) Credit (RM)

Journal 6: General Journal for Transaction 6

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

Nov 1 Capital, Reen 15 Service revenue

50

TOPIC 2 RECORDING PROCESS

Nov 30 Cash

Accounts Payable RM 1,900 Nov 4 Supplies
Ledger 6: Ledger for Transaction 6

RM 2,700

Transaction 7: Unused office supplies on 30 November were valued at RM1,100. Journal entry: General Journal Date Nov 30 Description Supplies expenses Supplies (Recording usage of supplies)
Journal 7: General Journal for Transaction 7

pg 1 Debit (RM) Credit (RM) 1,600 1,600

Reference

Post to ledger: Supplies Nov 4 Accounts payable RM 2,700 Nov 30 Supplies RM 1,600

Supplies expenses Nov 30 Supplies RM 1,600
Ledger 7: Ledger for Transaction 7

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

pg 1 Debit (RM) Credit (RM) 4,000 4,000

Reference

TOPIC 2 RECORDING PROCESS

51

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

Nov 30

Cash

Drawings, Reen RM 4,000
Ledger 8: Ledger for Transaction 8

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, owner’s 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.

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.

52

TOPIC 2 RECORDING PROCESS

We will now continue with the example of Reen Cyber Service by extending the transactions to December. In December, we will see more transactions. We will analyse the transactions one by one with emphasis given on the types of transaction that have not been analysed before. The transactions throughout December are listed in Table 2.4.
Table 2.4: Transactions for the month of December No. 1 2 3 Date (Dec 2008) 1 1 1 Transactions Paid insurance premium of RM4,800 for coverage against losses due to fire and burglary for a period of 24 months. Paid office rental for the month of December of RM1,600. A company planned to rent the land owned by Reen Cyber Service. The business rented the land for three months for RM720. The tenant paid the amount in cash. Purchased office equipment on credit from Office Equipment Sdn. Bhd. totalling RM3,600. Paid RM360 to advertise the business in the newspaper. Paid RM800 for the transaction on 4 December. Paid salary of temporary staff for RM1,900 for the first two weeks of December. Received RM6,200 cash from customer for services provided. Provided services valued at RM3,500 to a customer. The customer promised to pay next month. Made another payment of RM1,800 for transaction on 4 December. Customer made payment for account receivable of RM1,300. Purchased supplies by cash for RM2,900. Paid salary of temporary staff for RM2,400 for the last two weeks of December. Paid telephone and electricity bill for the month December for RM620 and RM450 respectively. Received cash of RM5,740 from customer on the services provided. Billed customer for the services provided of RM2,240. Reen made cash drawings of RM4,000.

4 5 6 7 8 9 10 11 12 13 14 15 16 17

4 6 11 13 16 16 20 21 23 27 31 31 31 31

TOPIC 2 RECORDING PROCESS

53

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 2008.
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Prepaid insurance account (asset) increased by RM4,800. Cash account (asset) reduced by RM4,800. Prepaid insurance account (asset) increased: debit Cash account (asset) reduced: credit

Journal entry: General Journal Date Dec 1 Description Prepaid insurance Cash (Paid insurance premium for 24 months)
Journal 9: General Journal for Transaction 1

pg 2 Debit (RM) Credit (RM) 4,800 L11 4,800

Reference L15

Post to ledger: Prepaid Insurance Account Date Dec 1 Description Cash Reference Debit (RM) Credit (RM) J2 4,800 No: 11 Reference Debit (RM) Credit (RM) J2 4,800 Balance No: 15 Balance

Cash Account Date Dec 1 Description Prepaid insurance

Ledger 9: Ledger for Transaction 1

54

TOPIC 2 RECORDING PROCESS

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. The adjustments will be taught in detail in Topic 3.
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Rental expenses account (expense) increased by RM1,600. Cash account (asset) reduced by RM1,600. Rental expenses account (expense) increased: debit Cash account (asset) reduced: credit

Journal entry: General Journal Date Dec 1 Description Rental expenses Cash (Paid rental expenses for December month)
Journal 10: General Journal for Transaction 2

pg 2 Debit (RM) Credit (RM) 1,600 1,600

Reference L52 L11

TOPIC 2 RECORDING PROCESS

55

Post to ledger: Rental expenses Account Date Dec 1 Description Cash Reference Debit (RM) Credit (RM) J2 1,600 No: 11 Reference Debit (RM) Credit (RM) J2 1,600 Balance No: 52 Balance

Cash Account Date Dec 1 Description Rental expenses

Ledger 10: Ledger for Transaction 2

ACTIVITY 2.3
Do you still remember the accounting constraints on materiality that we had studied earlier? Can you relate it to the recording of transaction 2? Discuss with your classmates.

Transaction 3: Received RM720 from the land’s 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 months 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.

56

TOPIC 2 RECORDING PROCESS

Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit

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

Journal entry: General Journal Date Dec 1 Description Cash Deferred rental (Cash received for three months rental)
Journal 11: General Journal for Transaction 3

pg 2 Debit (RM) Credit (RM) 720 720

Reference L11 L23

Post to ledger: Cash Account Date Dec 1 Description Deferred rental No: 11 Reference Debit (RM) Credit (RM) Balance J2 720 No: 23 Reference Debit (RM) Credit (RM) J2
Ledger 11: Ledger for Transaction 3

Derferred rental Account Date Dec 1 Description Cash

Balance

720

TOPIC 2 RECORDING PROCESS

57

Transaction 4: Purchased office equipment on credit for RM3,600.
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Office equipment account (asset) increased by RM3,600. Accounts payable (liability) increased by RM3,600. Office equipment account (asset) increased: debit Accounts payable (liability) increased: credit

Journal entry: General Journal Date Dec 4 Description Office equipment Accounts payable (Purchased office equipment on credit) Post to ledger: Office Equipment Account Date Dec 4 Description Accounts payable No: 18 Reference Debit (RM) Credit (RM) Balance J2 3,600 No: 15 Reference Debit (RM) Credit (RM) Balance J2 3,600 Reference L18 3,600 L21 3,600 pg 2 Debit (RM) Credit (RM)

Account Payable Date Dec 4 Description Office equipment

Ledger 12: Ledger for Transaction 4

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.

58

TOPIC 2 RECORDING PROCESS

Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit

Sundry expenses account (expense) increased by RM360. Cash account (asset) decreased by RM360 Sundry expenses account (expense) increased: debit Cash account (asset) decreased: credit

Journal entry: General Journal Date Dec 6 Description Sundry expenses Cash (Payment for advertisement expenses)
Journal 13: General Journal for Transaction 5

pg 2 Debit (RM) Credit (RM) 360 360

Reference L55 L11

Post to ledger: Sundry Expenses Account Date Dec 6 Description Cash No: 55 Reference Debit (RM) Credit (RM) Balance J2 360 No: 11 Description Sundry expenses Reference Debit (RM) Credit (RM) Balance J2 360

Cash Account Date Dec 6

Ledger 13: Ledger for Transaction 5

TOPIC 2 RECORDING PROCESS

59

Transaction 6 : Paid supplier (for transaction on 4 December) amounting to RM800.
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Accounts payable (liability) decreased by RM800. Cash account (asset) decreased by RM800. Accounts payable (liability) decreased: debit Cash account (asset) decreased: credit

Journal entry: General Journal Date Dec 11 Description Accounts payable Cash (Payment for accounts expenses)
Journal 14: General Journal for Transaction 6

pg 2 Debit (RM) Credit (RM) 800 800

Reference L21 L11

Post to ledger: Accounts payable Date Dec 11 Description Cash No: 21 Reference Debit (RM) Credit (RM) Balance J2 800 No: 11 Description Accounts payable Reference Debit (RM) Credit (RM) Balance J2 800

Cash Account Date Dec 11

60

TOPIC 2 RECORDING PROCESS

Transaction 7: Paid salary of temporary staff for the first two weeks of December totalling RM1,900.
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Salary expenses account (expense) increased by RM1,900. Cash account (asset) decreased by RM1,900. Salary expenses account (expense) increased: debit Cash account (asset) decreased: credit

Journal entry: General Journal Date Dec 13 Description Salary expenses Cash (Salary payment for temporary staff)
Journal 15: General Journal for Transaction 7

pg 2 Debit (RM) Credit (RM) 1,900 1,900

Reference L51 L11

Post to ledger: Salary expense Account Date Dec 13 Description Cash No: 51 Reference Debit (RM) Credit (RM) Balance J2 1,900 No: 11 Description Salary expenses Reference Debit (RM) Credit (RM) Balance J2 1,900

Cash Account Date Dec 13

Ledger 15: Ledger for Transaction 7

TOPIC 2 RECORDING PROCESS

61

Transaction 8: Received RM6,200 cash for services provided:
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Cash account (asset) increased by RM6,200. Service revenue account (revenue) increased by RM6,200. Cash account (asset) increased: debit Service revenue account (revenue) increased: credit

Journal entry: General Journal Date Dec 16 Description Cash Service revenue (Received cash for services provided)
Journal 16: General Journal for Transaction 8

pg 2 Debit (RM) Credit (RM) 6,200 6,200

Reference L11 L41

Post to ledger: Cash Account No: 51 Date Dec 16 Description Service revenue Reference Debit (RM) Credit (RM) Balance J2 No: 41 Reference Debit (RM) Credit (RM) Balance J2
Ledger 16: Ledger for Transaction 8

6,200

Service revenue Account Date Dec 16 Description Cash

6,200

62

TOPIC 2 RECORDING PROCESS

Transaction 9: Billed customer for RM3,500 for services provided.
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Accounts receivable (asset) increased by RM3,500. Service revenue account (revenue) increased by RM3,500. Accounts receivable (asset) increased: debit Service revenue account (revenue) increased: credit

Journal entry: General Journal Date Dec 16 Description Accounts receivable Service revenue (Billed customer for services provided)
Journal 17: General Journal for Transaction 9

pg 2 Debit (RM) Credit (RM) 3,500 3,500

Reference L12 L41

Post to ledger: Accounts receivable Date Dec 16 Description Service revenue No: 12 Reference Debit (RM) Credit (RM) Balance J2 3,500 No: 41 Reference Debit (RM) Credit (RM) Balance J2 3,500

Service revenue Account Date Dec 16 Description Accounts receivable

Ledger 17: Ledger for Transaction 9

TOPIC 2 RECORDING PROCESS

63

Transaction 10: Payment of RM1,800 to supplier (for transaction on 4 December).
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Accounts payable (liability) decreased by RM1,800. Cash account (asset) decreased by RM1,800. Accounts payable (liability) decreased: debit Cash account (asset) decreased: credit

Journal entry: General Journal Date Dec 20 Description Accounts payable Cash (Payment to accounts payable)
Journal 18: General Journal for Transaction 10

pg 3 Debit (RM) Credit (RM) 1,800 1,800

Reference L21 L11

Post to ledger: Accounts payable Date Dec 20 Description Cash Reference Debit (RM) Credit (RM) J3 1,800 No: 11 Description Accounts payable Reference Debit (RM) Credit (RM) Balance J3 1,800 No: 12 Balance

Cash Account Date Dec 20

Ledger 18: Ledger for Transaction 10

64

TOPIC 2 RECORDING PROCESS

Transaction 11: Customer paid cash RM1,300 as payment on its accounts receivable.
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Cash account (asset) increased by RM1,300 Accounts receivable (asset) decreased by RM1,300 Cash account (asset) increased: debit Accounts receivable (asset) decreased: credit

Journal entry: General Journal Date Dec 21 Description Cash Accounts receivable (Payment received for accounts receivable)
Journal 19: General Journal for Transaction 11

pg 3 Debit (RM) Credit (RM) 1,300 1,300

Reference L11 L12

Post to ledger: Cash Account Date Dec 21 Description Accounts receivable No: 11 Reference Debit (RM) Credit (RM) Balance J3 1,300 No: 12 Reference Debit (RM) Credit (RM) Balance J3
Ledger 19: Ledger for Transaction 11

Accounts Receivable Date Dec 21 Description Cash

1,300

TOPIC 2 RECORDING PROCESS

65

Transaction 12: Purchased supplies by cash for RM2,900.
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Supplies account (asset) increased by RM2,900. Cash account (asset) decreased by RM2,900. Supplies account (asset) increased: debit Cash account (asset) decreased: credit

Journal entry: General Journal Date Dec 23 Description Supplies Cash (Purchase supplies by cash)
Journal 20: General Journal for Transaction 12

pg 3 Debit (RM) Credit (RM) 2,900 2,900

Reference L14 L11

Post to ledger: Supplies Account Date Dec 23 Description Cash Reference Debit (RM) Credit (RM) J3 2,900 No: 11 Reference Debit (RM) Credit (RM) J3
Ledger 20: Ledger for Transaction 12

No: 14 Balance

Cash Account Date Dec 23 Description Supplies

Balance

2,900

66

TOPIC 2 RECORDING PROCESS

Transaction 13: Paid salary of temporary staff for the last two weeks of December totalling RM2,400.
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Salary expenses account (expense) increased by RM2,400. Cash account (asset) decreased by RM2,400. Salary expenses account (expense) increased: debit Cash account (asset) decreased: credit

Journal entry: General Journal Date Dec 27 Description Salary expenses Cash (Payment for salary of temporary staff)
Journal 21: Ledger for Transaction 13

pg 3 Debit (RM) Credit (RM) 2,400 2,400

Reference L51 L11

Post to ledger: Salary expenses Account Date Dec 27 Description Cash Reference Debit (RM) Credit (RM) J3 2,400 No: 11 Reference Debit (RM) Credit (RM) J3 2,400 Balance No: 51 Balance

Cash Account Date Dec 27 Description Salary expenses

Ledger 21: Ledger for Transaction 13

TOPIC 2 RECORDING PROCESS

67

Transaction 14: Made payment for telephone and electricity bill for RM620 and RM450, respectively. The payment of bills like electricity, water and telephone are normally grouped into the utility expenses account. This is because the expenses incurred are normally immaterial in terms of amount and significance until the entity has to open a separate account for each type of bill. Therefore, the total utility expenses paid on this date is RM1,070.
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Utility expenses account (expense) increased by RM1,070. Cash account (asset) decreased by RM1,070. Utility expenses account (expense) increased: debit Cash account (asset) decreased: credit

Journal entry: General Journal Date Dec 31 Description Utility expenses Cash (Payment for telephone and electricity bill for December)
Journal 22: General Journal for Transaction 14

pg 3 Debit (RM) Credit (RM) 1,070 1,070

Reference L53 L11

Post to ledger: Utility expenses Account Date Dec 31 Description Cash No: 53 Reference Debit (RM) Credit (RM) Balance J3 1,070 No: 11 Reference Debit (RM) Credit (RM) Balance J3 1,070

Cash Account Date Dec 31 Description Utility expenses

Ledger 22: Ledger for Transaction 14

68

TOPIC 2 RECORDING PROCESS

Transaction 15: Received cash RM5,740 for services provided.
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Cash account (asset) increased by RM5,740. Service revenue account (revenue) increased by RM5,740. Cash account (asset) increased: debit Service revenue account (revenue) increased: credit

Journal entry: General Journal Date Dec 31 Description Cash Service revenue (Received cash for services provided)
Journal 23: General Journal for Transaction 15

pg 3 Debit (RM) 5,740 5,740 Credit (RM)

Reference L11 L41

Post to ledger: Cash Account Date Dec 31 Description Service revenue No: 11 Reference Debit (RM) Credit (RM) Balance J3 5,740 No: 41 Reference Debit (RM) Credit (RM) Balance J3
Ledger 23: Ledger for Transaction 15

Service revenue Account Date Dec 31 Description Cash

5,740

TOPIC 2 RECORDING PROCESS

69

Transaction 16: Billed customer for RM2,240 for services provided.
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Accounts receivable (asset) increased by RM2,240 Service revenue account (revenue) increased by RM2,240 Accounts receivable (asset) increased: debit Service revenue account (revenue) increased: credit

Journal entry: General Journal Date Dec 31 Description Accounts receivable Service revenue (Billed customer for services provided)
Journal 24: General Journal for Transaction 16

pg 3 Debit (RM) Credit (RM) 2,240 2,240

Reference L12 L41

Post to ledger: Account Receivable Date Dec 31 Description Service revenue No: 12 Reference Debit (RM) Credit (RM) Balance J3 2,240 No: 41 Reference Debit (RM) Credit (RM) Balance J3 2,240

Service revenue Account Date Dec 31 Description Accounts receivable

Ledger 24: Ledger for Transaction 16

70

TOPIC 2 RECORDING PROCESS

Transaction 17: Owner made cash drawings of RM4,000.
Analysis 1 and 2: Accounts involved and effects of transaction Analysis 3: Rule of debit and credit Drawings account (contra owner equity) increased by RM4,000 Cash account (asset) decreased by RM4,000. Drawings account (contra owner equity) increased: debit Cash account (asset) decreased: credit

Notes: Although the drawings account is a type of owner equity account, it has an opposite feature against the owner’s equity. Therefore, we will put the word ‘contra’ to show the difference. Journal entry: General Journal Date Dec 31 Description Drawing, Reen Cash (Cash drawing by Reen).
Journal 25: General Journal for Transaction 17

pg 3 Debit (RM) Credit (RM) 4,000 4,000

Reference L32 L11

Post to ledger: Drawings, Reen Account Date Dec 31 Description Cash No: 32 Reference Debit (RM) Credit (RM) Balance J3 4,000 No: 11 Reference Debit (RM) Credit (RM) J3 4,000 Balance

Cash Account Date Dec 31 Description Drawings, Reen

Ledger 25: Ledger for Transaction 17

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 2008. The following are the general journal entries and postings throughout November and December 2008.

TOPIC 2 RECORDING PROCESS

71

GENERAL JOURNAL Date Nov 1 Account and Description Cash Capital, Reen (Investment by Reen) 2 Land Cash Notes payable (Purchase of land by cash and bank loan) 4 Supplies Accounts payable (Purchase of supplies on credit) 15 Cash Service revenue (Received cash for services provided) 30 Salary expenses Rental expenses Utility expenses Sundry expenses Cash (Payment of expenses by cash) 30 Account payable Cash (Payment to accounts payable) 30 Supplies expenses Supplies 30 (Recording of supplies usage) Drawings, Reen Cash (Cash drawings by owner) L54 L14 L32 L11 4,000 1,600 L21 L11 1,900 L51 L52 L53 L55 L11 4,250 1,600 900 550 L11 L41 15,000 L14 L21 2,700 L17 L11 L22 20,000 L11 L31 30,000

pg 1 Reference Debit (RM) Credit (RM) 30,000

5,000 15,000

2,700

15,000

7,300

1,900

1,600

4,000

72

TOPIC 2 RECORDING PROCESS

GENERAL JOURNAL Date Dec 1 Account and Description Prepaid Insurance Cash (Paid insurance premium for 24 months) 1 Rental expenses Cash (Paid rental for December) 1 Cash Deferred rental (Cash received for three months rental) 4 Office equipment Accounts payable (Purchased office equipment by credit) 6 Sundry expenses Cash (Payment for advertisement expenses) 11 Accounts payable Cash (Payment to accounts payable) 13 Salary expenses Cash (Payment for salary of temporary staff) 16 Cash Service revenue (Received cash for services provided) 16 Accounts receivable Service revenue (Billed customer for services provided) L12 L41 3,500 L11 L41 6,200 L51 L11 1,900 L21 L11 800 800 L55 L11 360 360 L18 L21 3,600 L11 L23 720 720 L52 L11 1,600 L15 L11 4,800

pg 2 Reference Debit (RM) Credit (RM) 4,800

1,600

3,600

1,900

6,200

3,500

TOPIC 2 RECORDING PROCESS

73

GENERAL JOURNAL Date Dec 20 Account and Description Accounts payable Cash (Payment to accounts payable) 21 Cash Accounts receivable (Received payment for accounts receivable) 23 Supplies Cash (Purchased of supplies by cash) 27 Salary expenses Cash (Payment for salary of temporary staff) 31 Utility expenses Cash (Payment of telephone and electricity bill) 31 Cash Service revenue (Received cash for services provided) 31 Accounts receivable Service revenue (Billed customer for services provided) 31 Drawings, Reen Cash (Cash drawings by owner) L32 L11 4,000 L12 L41 2,240 L11 L41 5,740 L53 L11 1,070 L51 L11 2,400 L14 L11 2,900 L11 L12 1,300 L12 L11 1,800

pg 3 Reference Debit (RM) Credit (RM) 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 2008.

74

TOPIC 2 RECORDING PROCESS

GENERAL LEDGER Cash Account Date Description Reference J1 J1 J1 J1 J1 J1 J1 J1 J1 J2 J2 J2 J2 J2 J2 J2 J3 J3 J3 J3 J3 J3 J3 5,740 4,000 1,300 2,900 2,400 1,070 6,200 1,800 720 360 800 1,900 15,000 4,250 1,600 900 550 1,900 4,000 4,800 1,600 Debit (RM) 30,000 5,000 Credit (RM) No: 11 Balance (RM) 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

Nov 1 Capital, Reen 2 Land 15 Service revenue 30 Salary expenses Rental expenses Utility expenses Sundry expenses 30 Accounts payable 30 Drawings, Reen Dec 1 Prepaid insurance Rental expenses Deferred rental 6 Sundry expenses 11 Accounts payable 13 Salary expenses 16 Service revenue 20 Accounts payable 21 Accounts receivable 23 Supplies 27 Salary expenses 31 Utility expenses 31 Service revenue 31 Drawings, Reen

* It was previously explained that the ‘Balance’ column will show the updated balance after each transaction. Can you relate to it now?

TOPIC 2 RECORDING PROCESS

75

Accounts Receivable Date Description Reference J2 J3 J3 2,240 Debit (RM) 3,500 1,300 Credit (RM)

No: 12 Balance (RM) 3,500 1,100 4,440 No: 14 Balance (RM) 2,700 1,600 2,900 1,100 4,000 No: 15 Reference J2 Debit (RM) 4,800 Credit (RM) Balance (RM) 4,800 No: 17

Dec 16 Service revenue 21 Cash 31 Service revenue Supplies Account Date Nov 4 Description Accounts payable

Reference J1 J1 J3

Debit (RM) 2,700

Credit (RM)

30 Supplies expenses Dec 23 Cash Prepaid insurance Account Date Dec 1 Cash Land Account Date Nov 2 Cash Notes payable Office Equipment Account Date Description Description Description

Reference J1 J1

Debit (RM) 5,000 15,000

Credit (RM)

Balance (RM) 5,000 20,000 No: 18

Reference J2

Debit (RM) 3,600

Credit (RM)

Balance (RM) 3,600 No: 22 Balance (RM) 2,700 800 4,400 3,600 1,800

Dec 4 Accounts payable Accounts Payable Date Description

Reference J1 J1 J2 J2 J3

Debit (RM)
1,900

Credit (RM)
2,700 3,600

Dec 4 Supplies 30 Cash Dec 4 Supplies 11 Cash 20 Cash

800 1,800

76

TOPIC 2 RECORDING PROCESS

Notes Payable Account Date Nov 2 Land Deferred Rental Account Date Dec 1 Cash Capital, Reen Account Date Nov 1 Cash Drawings, Reen Account Date Nov 30 Cash Dec 31 Cash Service Revenue Account Date Nov 15 Cash Dec 16 Cash Accounts receivable 31 Cash Account receivable Salary Expenses Account Date Nov 30 Cash Dec 13 Cash 27 Cash Description Reference J1 J2 J3 Debit (RM) 4,250 1,900 2,400 Credit (RM) Description Reference J1 J2 J2 J3 J3 Debit (RM) Credit (RM)
15,000 6,200 3,500 5,470 2,240

Description

Reference J1

Debit (RM)

Credit (RM)
15,000

No: 22 Balance (RM) 15,000 No: 23 Balance (RM) 720 No: 31 Balance (RM) 30,000 No: 32 Balance (RM) 4,000 8,000 No: 41 Balance (RM) 15,000 21,200 24,700 30,440 32,680 No: 51 Balance (RM) 4,250 6,150 8,550

Description

Reference J2

Debit (RM)

Credit (RM)
720

Description

Reference J1

Debit (RM)

Credit (RM)
30,000

Description

Reference J1 J3

Debit (RM) 4,000 4,000

Credit (RM)

TOPIC 2 RECORDING PROCESS

77

Rental Expenses Account Date Nov 30 Cash Dec 1 Cash Utility Expenses Account Date Nov 30 Cash Dec 31 Cash Supplies Expenses Account Date Description Reference J1 Debit (RM) 1,600 Credit (RM) Description Reference J1 J3 Debit (RM) 900 1,070 Credit (RM) Description Reference J1 J2 Debit (RM) 1,600 1,600 Credit (RM)

No: 52 Balance (RM) 1,600 3,200 No: 53 Balance (RM) 900 1,970 No: 54 Balance (RM) 1,600 No: 55 Balance (RM) 550 910

Nov 30 Supplies Sundry Expenses Account Date Nov 30 Cash Dec 6 Cash Description

Reference J1 J2

Debit (RM) 550 360

Credit (RM)

2.4.4

Trial Balance

Trial balance is a list of all the accounts used including the corresponding balances at a specific date. Normally the trial balance would be prepared at the end of the specific accounting period and the debit and credit totals need to be equal. The main purpose of preparing the trial balance is to ensure that the total debit and credit balances are the same. Unequal amount of total balances indicate that errors had happened in any one of the stages in the recording process, whether during the journal entry, posting to ledger or the preparation of the trial balance itself. However, it must always be kept in mind that a balanced trial balance does not necessarily mean that there are no errors. Examples of errors that can occur even though the trial balance is balanced are: (a) the transaction has not been recorded at all in the journal; (b) the transaction entry has not been posted to the ledger;

78

TOPIC 2 RECORDING PROCESS

(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 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. The following is the trial balance for Reen Cyber Service as at 31 December 2008. The balances of the accounts were derived from the previous general ledger.

ACTIVITY 2.4
Can you explain the consequences of each error that had occured in the trial balance by referring to examples on page 52?

TOPIC 2 RECORDING PROCESS

79

Reen Cyber Service Trial Balance as at 31 December 2008 Account Number 11 12 14 15 17 18 21 22 23 31 32 41 51 52 53 54 55 Cash Accounts receivable Supplies Prepaid insurance Land Office equipment Accounts payable Notes payable Deferred rental Capital, Reen Drawings, Reen Service revenue Salary expenses Rental expenses Utility expenses Supplies expenses Sundry expenses TOTAL Figure 2.7: Trial balance 8,550 3,200 1,970 1,600 910 80,200 80,200 8,000 32,680 Accounts Debit (RM) 19,130 4,440 4,000 4,800 20,000 3,600 1,800 15,000 720 30,000 Credit (RM)

80

TOPIC 2 RECORDING PROCESS

EXERCISE 2.2
1. 2. What is meant by account, ledger and chart of accounts? State two account format of that you have learned. Which is the easier format? Which format will show the latest balance after each transaction? Drawings and expense will reduce owner’s equity. Discuss the difference between these two terms. Which of the following accounts have a normal debit balance? A. Owner’s capital B. Deferred rental C. Prepaid expense D. Service revenue A credit balance in which account might indicate an error? A. Rental revenue B. Accounts payable C. Drawings D. Capital Group the following accounts according to its type (asset, liability, owner’s equity, revenue or expense): (a) (c) (e) (f) Vehicle Prepaid insurance Deferred rental Supplies (b) Insurance expenses (d) Rental revenue

3.

4.

5.

6.

(g) Supplies expenses (h) Accounts receivable

TOPIC 2 RECORDING PROCESS

81

EXERCISE 2.3
1. Cindy established Cindy Insurance Agency on 1 April 2008. The effects of all transactions throughout April 2008 are summarised in the following schedule:
Asset Trans. a. Cash +5,000 + AR + Supplies = = Liability AP + + Owner’s Equity Capital, Cindy +5,000 Capital, Cindy +3,250 Service revenue -750 Paid rental expense -125 +1,875 +1,875 Service revenue -390 Paid utility expense -187 Paid sundry expense -1,250 Paid salary expense -162 Paid supplies expenses -550 Drawings, Cindy

b. c.

+275 +3,250

+275

d.

-750

e. f.

-125

g.

-577

h.

-1,250

i.

-162

j.

-500

-50

Required: (a) Prepare the journal entries for all the above transactions. (b) Transfer the entries to ledger using the 3 column account format. (c) Prepare the trial balance as at 30 April 2008.

82

TOPIC 2 RECORDING PROCESS

EXERCISE 2.4
1. The following are the chart of accounts and accounts balances for Edlin Enterprise on 1 February 2007:
Account No 101 102 104 108 201 301 302 401 501 502 503 509 Cash Accounts receivable Supplies Office equipment Accounts payable Capital, Edlin Drawings, Edlin Service revenue Rental expenses Advertisement expenses Utility expenses Sundry expenses Accounts Balance as at 1/2/07 (RM) 15,238 4,575 427 8,400 1,730 26,910

Transactions involving Edlin Enterprise throughout the month of February 2007 are:
Date Feb 1 2 5 9 15 18 25 28 Transaction Purchased office supplies by cash RM274. Edlin withdrew cash from business totalling RM2,000 for personal use. Received RM2,740 cash from customer for payment on accounts receivable. Purchased office equipment valued at RM4,000 on credit. The seller agreed to give a discount of RM150 from the amount. Made payment to accounts payable for RM1,200. Received cash for services provided for RM580. Paid RM420 to advertise its business in the newspaper. Paid telephone bills (RM75 for EdlinÊs house and RM135 for business) and electricity bills (RM42 for EdlinÊs house and RM80 for business). All the payments had been made using money from his savings. Paid RM1,200 for rental of business premises. Paid RM220 to repair the office equipment.

29 30

TOPIC 2 RECORDING PROCESS

83

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 2007.

SUMMARY
The important matters discussed in this topic were: • • • • The chart and format of accounts used to present the financial report of an organisation. The rules of debit and credit are fundamental to the double entry system. The rules of normal balance for each type of account are used to assist in identifying errors in recording. Steps in recording beginning from journal entry, posting entries to ledger and preparation of the trial balance.

Assets Chart of Accounts Credit Debit Expenses

Journal Ledger Liabilities Revenue Trial Balance

Topic

3

Completing the Accounting Cycle

LEARNING OUTCOMES
By the end of this topic, you should be able to: 1. 2. 3. Describe the types of adjusting entries; Prepare the Adjusted Trial Balance; Prepare the financial statements consist of income statement, statement of changes in owner’s equity, balance sheet statement and cash flow statement; Prepare the closing entries; and Prepare the reversing entries.

4. 5.

 INTRODUCTION
This topic is the continuation of Topic 2, where you have come across the unadjusted trial balance. This topic will also discuss the preparation of adjusting entries for the purpose of preparing the adjusted trial balance. The adjusted trial balance is prepared after the adjusting entries have been recorded and transferred. The four main components of financial statements, comprising the income statement, statement of changes in owner’s equity, balance sheet and cash flow statement; are prepared based on the information from the adjusted trial balance. The preparation of cash flow statement also requires all information related to cash that can be found in the records.

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

85

At the end of Topic 3, you will be exposed to closing and reversal entries to complete the accounting cycle.

3.1

ADJUSTING ENTRIES

You might be wondering why adjusting entries need to be discussed before completing the accounting cycle. The answer becomes clearer once you know what adjusting entries are.

Adjusting entries are additional accounting information recorded at the end of the accounting period to accurately match revenues with expenses.

It is the main element in accrual-basis accounting. The accrual basis refers to revenues or expenses which are recognised in the current period irrespective of whether cash has been received. It is different from cash basis accounting, where revenues or expenses are only recognised when they involve cash receipts or payments. Adjusting entries will affect at least one income statement account (revenue or expense) and one balance sheet account (asset or liability). After the adjustments, the accounts in the trial balance will show the updated balances, which will then be used to prepare the financial statements. Prepaids and accruals are the basis for making adjusting entries. Prepaid refer to cash received or paid before revenues or expenses are recorded, while accruals are revenues or expenses which are recorded before cash is received or paid. Adjusting entries are divided into 5: (a) (c) (e) prepaid expenses; unearned revenue; accrued revenue. (b) depreciation expenses; (d) accrued expenses; and

86

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

3.1.1

Prepaid Expenses

Prepaid expenses refer to all expenses that have been paid in advance by cash but the benefit from the expenses has not been received or obtained.

It is an asset to the business and will be written off after it has been used or when it expires. Adjusting entries must be made at the end of the accounting period to recognise assets that have been written off as expenses. Examples of prepaid expenses are prepaid rental and prepaid insurance. Example 3.1 On 1 April 2006, Encik Zaini rented a house and paid a total of RM900 for the first 3 months. The landlord had set the rental at RM300 per month. The journal entries are as follows: 1 April 2006 Dr. Rental Prepaymewnt Cr. Cash RM900

RM900

When the entry is transferred to ledger, the accounts involved will be: Rental Prepayment Account RM April 1 2006 900 Cash Account April 1 2006 RM 900

The trial balance on 30 April 2006 before adjustment shows the rental prepayment account with a normal debit balance of RM900. This amount is incorrect if used for the purpose of preparing the financial statement. Therefore, an adjusting entry is needed to update and match the expenses accurately so that the correct total is reported in the financial statements. The adjusting entry is as follows: 30 April 2006 Dr. Rental expenses Cr. Rental prepayment RM300* RM300

Rental paid for 3 months is RM900, which is rental prepayment.

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

87

*One third of the total rental prepayment for a period of one month (April) is: 1/3 x 900 = 300 When the adjusting entry is transferred to ledger, it would involve one account from the income statement (rental expenses account) and one account from the balance sheet (rental prepayment account).

Figure 3.1: Process of transferring adjusting entries to ledger

The adjusting entries that had been transferred to ledger are as follows: Rental Prepayment Expenses RM 900 April 30 2006 600 Rental Expenses Account RM 300

April 1

2006

RM 300

Balance

April 30

2006

The adjusting entries had recognised the rental expenses for a period of one month in April, which is RM300. The rental prepayment account had been credited by RM300, causing the balance in the account to decrease by RM300. Therefore, the rental prepayment account has been updated from RM900 to RM600.

88

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

3.1.2

Depreciation Expenses

Depreciation expenses are provisions against the cost of fixed assets like plant, equipment and vehicle.

It is an expense throughout the lifespan of the asset. The concept used for asset and depreciation is the same as with prepaid expenses. Cash paid by the business to acquire the asset is viewed as a prepaid expense. In other words, the cash is paid in advance before the asset is used. Adjusting entries must be recorded as the asset expires or when the asset has been used by the business. The entry is made at the end of the accounting period and acknowledges the usage of the asset as expenses. Example 3.2 On 1 Jan 2007, Mazni Enterprise purchased a vehicle for office usage valued at RM60,000 by cash. This vehicle is estimated to have a lifespan of 10 years. The journal entries for this transaction are as follows: 1 Jan 2007 Dr.Vehicle Cr. Cash 60,000 60,000

When the entry is transferred to ledger, the accounts involved will be: Vehicle Account RM 1 Jan 2007 60,000 Cash Account 1 Jan 2007 RM 60,000

An adjusting entry is required at the end of the accounting period to record the expenses for the use of the vehicle, which will be as follows: 31 December 2007 Dr. Depreciation expenses 6,000* Cr. Accumulated Depreciation – Vehicle 6,000

*The straight line method was used to calculate the depreciation expenses.

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

89

Formula: (Cost of Assest - Scrap Value) –––––––––––––––––––––––––– Useful Life (RM60,000 – 0/10 year) = RM6,000 per year The adjusting entry is then transferred to ledger and will involve one account from income statement (depreciation expenses account) and one account from balance sheet (accumulated depreciation of vehicle account, which is a contra account for asset). Depreciation Expenses Account RM Dec 2007 6,000 Accumulated Depreciation Account 31 Dec 2007 RM 6,000

31

The debit entry of RM6,000 in the depreciation expenses account reflects the business’ use of the asset for the one year period, while the credit balance in the accumulated depreciation account for vehicle shows the total depreciation on the asset to date. The total accumulated depreciation will be deducted from the total asset to provide the book value or carrying value of the asset: RM 60,000 (6,000) 54,000

Vehicle’s cost as at 1 Jan 2007 (-) Accumulated depreciation – vehicle Vehicle’s book value as at 31 December 2007

3.1.3

Unearned Revenue (Unearned Income)

Unearned revenue refers to cash which is received in advance before goods or services has been provided.

This is an obligation or liability to the business entity. Cash received cannot be recognised as revenue for that period because the goods or services will only be provided at a future date.

90

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

Example 3.3 On 1 December 2007, Ayu Beauty Company received RM800 cash from a customer. This payment was for services that the Company will provide on 1 January 2008. The journal entry is as follows: 1 December 2007 Dr. Cash Cr. Unearned revenue 800 800

When the entry is transferred to ledger, the accounts involved will be: Cash Account RM 1 Dec 2007 800 Unearned Revenue 1 Dec 2007 RM 800

On 31 December 2007, a liability of RM800 was created for Ayu Beauty Company because cash was received while the services had not yet been provided. The liability will cease to exist and the revenue can be recognised once the company had provided the services on 1 January 2008. The adjusting entry to recognise the revenue is as follows: 1 January 2008 Dr. Unearned revenue Cr. Service revenue 800

800

The adjusting entry is then transferred to ledger and will involve one account from income statement (service revenue account) and one account from balance sheet (unearned revenue account). Unearned Revenue Account RM 800 31 Dec 2007 Service Revenue Account 1 Jan 2008 RM 800

1 Jan

2008

RM 800

When unearned revenue account is debited, the business entity ceases to have the liability and the revenue is recognised as the services which is now being provided.

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

91

3.1.4

Accrued Expenses

Accrued expenses refer to all expenses incurred but have not yet been paid or recorded because there was no cash outflow from the business entity. Accrued expenses are a liability as an obligation exists that must be settled by the business. At the end of the accounting period, the business entity must record/ recognise all expenditure even though no cash outflow occurred. Examples of accrued expenses are salary payable, rental payable, interest payable and tax payable. Example 3.4 Haruman Company has not paid its staff salary for the month of December 2006 totalling RM4,500 due to financial problems. However, the company promised to pay the salary in January 2007. On 31 December 2006 the adjusting entry will be as follows: 31 December 2006 Dr. Salary Expenses Cr. Salary Payable 4,500 4,500

The adjusting entry is then transferred to ledger and will involve one account from income statement (salary expenses account) and one account from balance sheet (salary payable/ salary accrued account). Salary Expenses Account RM 31 Dec 2006 4,500 Salary Payable Account 31 Dec 2006 RM 4,500

This adjusting entry will recognise the salary expenses for the period even though cash outflow from the business has not occurred while the salary payable/salary accrued is a liability to the business entity at that date.

3.1.5

Accrued Revenue

Accrued revenue refers to the revenue that had been obtained but there is no cash inflow into the business entity. This happens when the goods or services were provided to the customer but the customer has not paid for it yet.

92

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

Accrued revenue is an asset as the benefit in the form of cash will be obtained by the business entity in the future. Examples of accrued revenue are rental revenue receivable, service revenue receivable and interest receivable. Example 3.5 Geelang Company rented out a section of its building at the monthly rate of RM1,200 which must be paid at the end of the month. However, the tenant failed to pay the rental for the month of December 2008 but promised to settle the rental in the month of January 2009. The adjusting entry required for Geelang Company would be: 31 December 2008 Dr. Rental receivable Cr. Rental revenue 1,200 1,200

The adjusting entry is then transferred to ledger and will involve one account from income statement (rental revenue account) and one account from balance sheet (rental receivable or rental revenue accrued account). Rental Receivable Account RM 1,200 Rental Revenue Account 31 Dec 2008 RM 1,200

31 Dec

2008

At the end of the accounting period, revenue that has been recorded or recognised totalled RM1,200 even though there is no cash inflow while asset increased by RM1,200 when rental receivable was debited. If there is no adjustment, the account balances presented in the financial statements will not comply with the principle of revenue recognition and principle of matching. Therefore the financial statements published were presented without complying with the GAAP (Generally Accepted Accounting Principles). All the adjustments made to the account balances in the trial balance will produce the Adjusted Trial Balance. The Adjusted Trial Balance will be used as the basis in the preparation of the financial statements. The Adjusted Trial Balance will be discussed next. To ensure that you understand what you have learned, answer the following questions:

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

93

EXERCISE 3.1
Explain the meaning for each of the following: (a) (c) Accrued Revenue Prepaid Expenses (b) Accrued Expenses (d) Unearned Revenue

3.2

PREPARATION OF ADJUSTED TRIAL BALANCE

This section will expose you to the process of preparing the Adjusted Trial Balance. The Adjusted Trial Balance is a trial balance which is prepared after taking into account all the adjusting entries that have been journalised and transferred. The Adjusted Trial Balance will also show the balance of all the accounts irrespective of whether they were involved in the adjustment. The accounts involved in the adjustment will show the updated or adjusted balance. The purpose of preparing the Adjusted Trial Balance is to show the effect of all financial events that had occurred in the accounting period. The Adjusted Trial Balance is to verify that the total debit and total credit are equal for all the accounts in the ledger after the adjustments. You must refer to the information in the Unadjusted Trial Balance for Reen Cyber Service in Topic 2 (Figure 2.7: Trial Balance) for the preparation of this Adjusted Trial Balance. For students’ reading convenience, the unadjusted balance had been included in Table 3.2. Additional information relating to adjustments for Reen Cyber Service are as follows: (a) The supplies in hand at 31 December 2008 totalled RM1,520. (b) The insurance premium that had expired throughout the year totalled RM200. (c) (e) Unearned rental revenue at 31 December 2008 totalled RM480. Interest revenue accrued but not yet recorded for the month of December totalled RM1,000. (d) Salary accrued but not yet paid at 31 December 2008 totalled RM500.

94

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

(f)

Depreciation for office equipment for the month of December totalled RM100.

The adjustment entries that must be recorded by Reen Cyber Service as at 31 December 2008 are as per Table 3.1 below:
Table 3.1: Adjustment Entries Date 31 December Description Supplies expenses Supplies 31 December Insurance expenses Insurance prepayment 31 December Unearned rental revenue Rental revenue 31 December Salary expenses Salary accrued 31 December Accounts receivable Interest revenue 31 December Depreciation expenses Accumulated depreciation for office equipment 100 100 1,000 1,000 500 500 240 240 200 200 Reference Debit (RM) 2,480 2,480 Credit (RM)

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

95

Table 3.2: Unadjusted Trial Balance

Reen Cyber Service Trial Balance as at 31 December 2008
Account Number 11 12 14 15 17 18 21 22 23 31 32 41 51 52 53 54 55 Cash Accounts receivable Supplies Insurance prepayment Land Office equipment Accounts payable Notes payable Unearned rental revenue Capital, Reen Drawings, Reen Interest revenue Salary expenses Rental expenses Utility expenses Supplies expenses Sundry expenses TOTAL 8,550 3,200 1,970 1,600 910 80,200 80,200 8,000 32,680 Accounts Debit (RM) 19,130 4,440 4,000 4,800 20,000 3,600 1,800 15,000 720 30,000 Credit (RM)

The treatment for each additional item of information are as follows: (a) The supplies account shown in the Unadjusted Trial Balance is the opening balance at 1 January 2008 which is RM4,000. The additional information stated the current balance, which is the balance at 31 December 2008 totalling RM1,520. Therefore, the difference between both the balances is the supplies expenses that must be recognised/recorded, which is RM2,480.

96

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

Supplies Account (Opening Balance)

– –

Supplies Account (Current Balance)

= =

Supplies Expenses

RM4,000

RM1,520

RM2,480

This adjusting entry affects one account in Income Statement (supplies expenses) and one account in Balance Sheet (supplies account). The current balance for supplies account is RM1,520, which is RM4,000 (opening balance) – RM2,480 (credit entry from adjustment) which resulted in the same total as stated in the additional information. (b) Insurance prepaid account with debit balance totalling RM4,800 showed insurance prepaid for a period of 24 months starting 1 December 2008. Therefore, the insurance expenses at 31 December 2008 that must be recognised total RM4,800 ÷ 24 = RM200. This adjusting entry causes the insurance prepayment account in the Balance Sheet to have a current balance of RM4,600 (RM4,800 – RM200) while insurance expenses of RM200 will be recognised in the income statement for the period. (c) Unearned rental revenue account has a normal credit balance of RM720 which showed total cash for the rental received in advance for three months. Therefore, the rental revenue that need to be recognised for the month of December is 1/3 x RM720 = RM240. The effect of this adjusting entry is the unearned rental revenue account in the Balance Sheet which will be reduced by RM240 to RM480 while the rental revenue of RM240 will be reflected in the Income Statement . (d) Salary accrued or unpaid for the month of December totalled RM500. The salary accrued will increase the total expenditure and is a liability to the business entity. The adjusting entry will recognise this salary expense as an item in the Income Statement and the salary payable/accrued as a balance sheet item totalling RM500 for the period. (e) Interest revenue accrued for the business entity but yet to be recognised or recorded totalled RM1,000. This amount is an asset and will increase the total revenue of the business entity. The adjusting entry will recognise the interest revenue as an item in the Income Statement and accounts receivable account in Balance Sheet will show a total of RM1,000 for the period.

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

97

(f)

Depreciation of office equipment for the month of December totalling RM100 will increase the total expenditure for that business entity. The adjusting entry will recognise the depreciation as an expenses item in the income statement and will affect one account in balance sheet, the accumulated depreciation account which is a contra account for asset.

The worksheet as per Table 3.3 is used to prepare the Adjusted Trial Balance for Reen Cyber Service for two months ending at 31 December 2008.
Table 3.3: Worksheet Trial Balance Name of Account Cash Accounts receivable Supplies Insurance prepayment Land Office equipment Accounts payable Unearned rental revenue Notes payable Capital, Reen Drawings, Reen Interest revenue Salary expenses Rental expenses Utility expenses Supplies expenses Sundry expenses Insurance expenses Rental revenue Salary accrued Depreciation expenses Accumulated depreciation – equipment 80,200 80,200 4,520 (6) 100 (6) 100 4,520 81,800 8,550 3,200 1,970 1,600 910 (2) 200 (3) 240 (4) 500 100 100 81,800 (1) 2,480 8,000 32,680 (4) 500 (5) 1,000 9,050 3,200 1,970 4,080 910 200 240 500 Dr. (RM) 19,130 4,440 4,000 4,800 20,000 3,600 1,800 720 15,000 30,000 8,000 33,680 (3) 240 (5) 1,000 (1) 2,480 (2) 200 Cr. (RM) Adjustment Dr. (RM) Cr. (RM) Adjusted Trial Balance Dr. (RM) 19,130 5,440 1,520 4,600 20,000 3,600 1,800 480 15,000 30,000 Cr. (RM)

98

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

You can also prepare the Adjusted Trial Balance for Reen Cyber Service without using the sheet by: (a) (c) preparing the adjusting entries. entering the current balance that had been adjusted into the Adjusted Trial Balance as below:
Table 3.4: Adjusted Trial Balance

(b) updating all the account involved with the adjusting entries

Reen Cyber Service Adjusted Trial Balance as at 31 December 2008
RM 19,130 5,440 1,520 4,600 20,000 3,600 RM

Cash Accounts receivable * Supplies * Insurance prepayment * Land Office equipment Accounts payable Unearned revenue * Notes payable Capital, Reen Drawings, Reen Interest revenue * Salary expenses * Rental expenses Utility expenses Supplies expenses * Sundry expenses Insurance expenses ** Rental revenue ** Salary accrued ** Depreciation expenses ** Accumulated depreciation – equipment **

1,800 480 15,000 30,000 8,000 33,680 9,050 3,200 1,970 4,080 910 200 240 500 100 100 81,800 81,800

* Updated accounts ** New accounts created after the adjusting entries.

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

99

After the adjustments are made, you will find that the ledger accounts in the Adjusted Trial Balance show the same total debit and total credit. This Adjusted Trial Balance will be used in the preparation of the financial statements, which will be discussed next.

ACTIVITY 3.1
In your opinion, what are the uses of the Adjusted Trial Balance for small businesses? Discuss.

SELF-CHECK 3.1
When is the right time to prepare the Adjusted Trial Balance?

Before we proceed to the next topic, answer the following exercise to test your understanding.

EXERCISE 3.2
Information for adjustments is as follows: 1. 2. 3. 4. 5. 6. Supplies in hand at 31 December 2007 amounted to RM750. Supplies at 1 January 2007 totalled RM1,000. Depreciation of equipment for the year 2007 totalled RM400. Interest accrued on notes payable totalled RM300. Insurance expired throughout the year 2007 totalled RM1,500. Revenue accrued at 31 December 2007 totalled RM750. Unearned revenue received throughout the year 2007 totalled RM5,000.

Prepare the adjusting entries at 31 December 2007.

100

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

3.3

PREPARATION OF FINANCIAL STATEMENTS

After studying the preparation of Adjusted Trial Balance, you will now learn how to prepare Financial Statements. The financial statements are prepared after all transactions are recorded or journalized, transferred and summarised in the trial balance. The financial statements are also known as the accounting report that reports the financial status at the end of the accounting period. This topic will only discuss on the preparation of the financial statements for service-oriented businesses. As you know, the financial statements consist of 4 statements, which are: • • • • Income Statement; Statement of Changes in Owner’s Equity; Balance Sheet Statement; and Cash Flow Statement.

3.3.1

Income Statement

Income Statement refers to the financial statement which presents the operational results of the business entity for a specific period.

It is also known as the summary of revenue and expense for a specific period whether it is one month, three months, six months or a year. If the business entity’s total revenue is more than total expenditure, then net profit will be reported in its income statement. Total Revenue > Total Expense = Net Profit If the total expense exceeds total revenue, the business entity will report a net loss. Total Expense > Total Revenue = Net Loss

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

101

The matching process is used to determine the net profit or net loss. The contents in the Income Statement comprise of 5 main elements: (a) Name of business entity Example: Noora Jaya Company (b) Title of statement, which is Income Statement (c) Report period and date. Example: For the month/year ended 31 December 2008. (d) Revenue and expenditure items (e) Net profit/loss

Figure 3.2 shows the format for Income Statement:

Figure 3.2: Format of income statement for service firms

The revenue and expense items are the main components in the income statement. Revenue is the gross revenue obtained from business activities that were conducted for the purpose of generating revenue. Normally revenue is derived from sales of goods, provision of services, rental of land and loans.

102

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

Figure 3.3 shows examples sources of revenue.

Figure 3.3: Examples of sources of revenue

Revenue obtained will increase the total asset and owner equity for a business entity. For example, the main revenue for a car wash business is revenue from the car wash services provided. Other examples of revenue are fees, commission, interest, dividend, royalty and rental.

Expenses are costs to the assets or services used or provided in the process to generate the revenue.

Expense will reduce the total asset and owner equity. Examples of expense for a car wash business are water, cleaning materials and staff salary. The steps involved in preparing the Income Statement for Reen Cyber Service are as follows:

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

103

(a)

You must analyse the information reported in the following Adjusted Trial Balance: Reen Cyber Service Adjusted Trial Balance as at 31 December 2008
RM Cash Accounts receivable Supplies Insurance prepayment Land Office equipment Accounts payable Unearned interest revenue Notes payable Capital, Reen Drawings, Reen Interest revenue Salary expenses Rental expenses Utility expenses Supplies expenses Sundry expenses Insurance expenses Rental revenue Salary payable Depreciation expenses Accumulated depreciation 81,800 100 100 81,800 9,050 3,200 1,970 4,080 910 200 240 500 8,000 33,680 19,130 5,440 1,520 4,600 20,000 3,600 1,800 480 15,000 30,000 RM

104

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

(b) Extract all the revenue and expense items only because these are the main components in the preparation of Income Statement. The following are all the revenue and expense items found in the Adjusted Trial Balance for Reen Cyber Service.
Interest revenue Rental revenue Salary expenses Rental expenses Utility expenses Supplies expenses Sundry expenses Insurance expenses Depreciation expenses 9,050 3,200 1,970 4,080 910 200 100 19,510 33,920 33,680 240

(c)

Calculate the net profit or loss by adding all the revenue items and deducting all the expense items. If the total revenue exceeds total expenditure, then net profit is obtained. If total expense exceeds total revenue then net loss is obtained. Total revenue is RM33,920, which includes interest revenue of RM33,680 and rental revenue of RM240. Total expense, which is RM19,510 will be deducted from the total revenue of RM33,920 to generate the net profit of RM14,410. RM 33,920 (19,510) 14,410

Total revenue Total expense Net Profit

(d) Finally, you must enter all the items involved (revenues, expense and net profit) into the income statement format.

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

105

Reen Cyber Service Income Statement For two months ended 31 December 2008
RM Revenue: Interest revenue Rental revenue Less expenses: Salary expenses Rental expenses Utility expenses Supplies expenses Sundry expenses Insurance expenses Depreciation expenses Net Profit RM 33,680 (240) 33,920 9,050 3,200 1,970 4,080 910 200 100 (19,510) 14,410

This total will be reported in the statement of changes in owner’sequity

3.3.2

Statement of Changes in Owner’s Equity

Statement of changes in owner’s equity is a summary of changes in the owner equity that occurred in a specific period.

This statement is related to Income Statement and Balance Sheet (which will be discussed after this) and is prepared at the end of the accounting period.

Equity is the owner’s claim on the total asset. It equals to the total assets after deducting all the liabilities.

106

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

Equity is comprised of the following items: (a) (c) opening capital; drawings; and (b) the yearly retained profit or loss; (d) closing capital. Drawings refer to the total cash or goods taken by the business entity’s owner for personal use. Statement of Changes in Equity for Reen Cyber Service: Reen Cyber Service Statement of Changes in Owner’s Equity For two months ended 31 December 2008 RM 30,000* 14,410 (8,000)* 36,410

Capital Reen, 1 November 2008 Net profit Drawings Capital Reen, 31 December 2008

from income statement

will be reported in the balance sheet

*

Total opening capital and drawings were taken from the Adjusted Trial Balance.

Normally this statement is not prepared and is only shown in the notes to the accounts (which will be discussed at the end of this unit). Items in this statement will be shown either in the income statement or in the balance sheet. For example, the yearly retained profit/loss is shown in the income statement while the total closing capital is shown in the balance sheet. The statement of changes in equity contains the total net profit taken from the income statement that had been prepared previously. From the statement of changes in equity thus prepared, the closing capital is obtained. This total will be reported in the balance sheet statement. Therefore, the statement of changes in equity has linked the income statement with the balance sheet.

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

107

3.3.3

Balance Sheet

Balance sheet or statement of financial position is a statement which reports the financial status of the business at a point of time. The financial status of a business entity covers the control on its economic resources, financial structure and sustainability in the long-term. Balance sheet contains three main components, which are:

Self Check 3.4

(a)

Asset Asset is an economic resource owned by a business entity that can bring benefit to the business entity in the future. Asset exists in a business due to past occurrences and transactions. Asset is a valuable resource to the company as it can be used or exchanged to generate products or provide services. Asset is recorded in the balance sheet based on historical cost, which is the original cost of purchase. Three characteristics that enable a resource to be classified as an asset are: • • The resource can help the business entity to generate cash inflow in the future, whether directly or indirectly. The resource must benefit the business entity in the future and the entity has controlling power on the said resource. Controlling power means that the entity can prevent other people from using the said resources. Transaction or event that gives the rights to the business entity to control the said resource had occurred. If the transaction of purchasing the resource had not occurred then the resource cannot be considered as an asset to the entity.

Asset consists of current asset and long-term asset.

108

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

(i)

Current Asset Current asset is an asset that is expected to be exchanged for cash or sold or used in a period of one year or in the operating cycle period (whichever is longer).

Operating cycle refer to the time frame taken by the business entity to process as well as to sell the inventory, to collect accounts receivable (AR) as well as to transform the accounts receivable into cash as shown in Figure 3.4.

Figure 3.4: Operating cycle

Current assets include: • • • • • Cash; Trading securities/Short-term investment; Items receivable; Inventories; and Prepayment expenses.

Cash includes cash in hand and cash in saving/current accounts in the bank. Cash that cannot be used immediately is known as cash equivalents. It is also classified under cash items. Marketable securities or short-term investment comprise of investment in the equity securities (example: investment in stocks) and investment in debt security (example: investment in bonds). Investments in both of these securities are considered current assets because these investments are ready

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

109

to be sold or traded. These two types of investments can be exchanged for cash by the business entity in a period of a year or in the operating cycle period, whichever is longer. Items receivable is created when the business entity has provided services or sold goods but the cash is yet to be received. Items receivable are accounts receivable (AR), notes receivable, interest receivable and fees receivable. Prepaid expenses can also be classified as item receivable, for example rental prepayment, salary prepayment, insurance prepayment. Inventory for a business entity is different according to the type of business. A business entity which provides services do not have inventory. This is different from a business entity that produces/manufactures its goods. It will have raw material inventories, work in process inventories and finished goods inventory (all these types of inventories will be discussed in Topic 5). Similarly, businesses that buy and sell goods (trading firms) have inventory for retail stocks. (ii) Long-Term Asset/Non-curent Asset Long-term asset is an asset that can be used in the business or held for a longer period, usually more than a year. Long-term asset comprises noncurrent asset, other long-term asset and intangible asset. • Long-Term Asset Land, plant, building and equipment are examples of long-term assets. It has physical form and is used in the operation of the business entity. All these assets must be depreciated, except for land. Land need not be depreciated as its value is always appreciating while plant, equipment and building must be depreciated as the value of the assets will reduce as they get older. Long-term asset is also known as non-current asset or tangible asset. In the balance sheet, non-current assets are presented at their original or historical cost less the corresponding accumulated depreciation. • Other Long-Term Asset Other long-term assets include long-term investment, deferred expenditure and amounts that are involved in the long-term such as item receivable.

110

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

These investments consist of investment in securities such as investment in stocks and bonds that would not be exchangeable for cash in the short period. Other long-term investments include investment in property that is held for speculation purposes or for use in future operation and investment in special funds such as pension funds. Long-term investments are investment held by the business entity for a period of more than one year.

The amount involved in the long-term is amount which is expected to be received after a year. It includes accounts receivable, notes receivable, receivable from director, receivable from transaction between companies and other item receivables. Deferred expenses are prepaid expenses for a long-term period like deferred tax, companies’ restructuring expenses and business’ preliminary expenses.

Intangible/Non-physical Asset Goodwill, patent, copyright and trademark are intangible assets because they lack physical substance. The economic benefits that can be provided by the intangible assets to the business entity in the future are difficult to evaluate. Examples of other intangible assets are franchise, trade names and computer software’s cost. Generally intangible assets are amortised in a period of 5 to 40 years. The intangible asset will be reported in the balance sheet at book value, which is cost less accumulated amortisation expenses. Figure 3.5 shows the types of long-term assets.

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

111

Figure 3.5: Long-term assets

The following is a summary on assets. Asset Economic resources that can generate benefit to the entity in the future.
Current Assets 1. 2. Expected usage within 1 year or operating cycle period Comprises: (a) Cash (b) Trading securities/Short-term (c) Item receivables (d) Inventory (e) Prepayment expenses 1. 2. Long-Term Assets/Non-current Assets Can be used or held by the business for more than 1 year. Comprises: (a) Long-term asset/non-current asset (land, plant, building, equipment) (b) Other long-term assets (long-term investment, deferred expenditure). Intangible asset (patent, copyright, trademark)

Figure 3.6: Summary of assets

SELF-CHECK 3.2
Describe the difference between current assets and long-term assets. State the items contained in these two types of assets.

112

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

(b) Liability Liability is an obligation or responsibility of a business entity to external parties like creditors or other business entities that have claims on the said business. Liability is presented in the balance sheet to help users of financial statements to measure the extent of the claims of other entities toward the business entity’s resources. Liability is divided into two, which are current liability and long-term liability (non-current liability).

(i)

Current Liability Current liability is a responsibility or obligation that is expected to be paid using the current asset or by creating another current liability within the period of one year. Current liabilities include: • • • • Bank loan or overdraft; Item payable; Portion of current long-term liability; and Deferred revenue.

Bank loan exists when a business entity applies for loan from the bank, which must be settled within a year. Meanwhile, overdraft is a facility given to current account holders to make withdrawal in excess of the savings available. Item payable consists of accounts payable (AP) and notes payable. It exists when a business entity makes credit purchase from another business entity. AP exists without any written agreement between the two business entities but only via verbal agreement. It is different from notes payable which has written agreement between the two business entities. Other items payable are salary payable, rental payable, interest payable, which are expenses accrued or payable by the business entity. The service is already received by the business entity but the payment is still outstanding or there is no cash outflow from the business entity.

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

113

Portion of current long-term liability occurs when there is a portion from the long-term liability that must be settled in a year’s period. The total is classified as current liability and not long-term liability. The balance will be classified as long-term liability. The cash received will be the current liability to the business entity as long as the services have not been provided. Examples of deferred revenue are unearned fees, unearned revenue and deposit from customers.

Deferred revenue refers to the cash received from the customer but the services have not provided yet.

(ii) Long-term Liability/Non-current Liability Compared with current liability, long-term liability is a responsibility or obligation that would not be settled or paid within the period of one year. Long-term liabilities include: • • • • Bonds payable Notes payable Inter-company loan Secured loan

Bonds payable are long-term liabilities or obligation to a business entity. The entity must settle the total cash received from the bonds issued within a period which may exceed one year, that is upon maturity of the bonds. Notes payable are transactions involving credit with written agreement between the two business entities. The business entity which received the notes payable with maturity date exceeding one year means that it has a liability/responsibility that must be settle in that period. Inter-company loan involved obligation or responsibility between companies that must be settled within the specific period which exceeds one year. Secured loan is a liability to a business company towards another party, for example bank or financial institution. The institution will get the business entity’s asset (such as land and building) as security for the loan provided to the company. Figure 3.6 shows a summary of liabilities.

114

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

Table 3.5: Summary of Liabilities Liabilities Economic benefit that must be sacrificed by transferring the asset or providing services/goods to another business entity. Current Liability 1. 2. Expected to be paid within a period of one year Comprises: • Bank loan • Item payable • Portion of current long-term liability • Deferred revenue Long-Term Liability/Non-current Liability 1. 2. Expected to be settled within the period > one year. Comprises: • Bonds payable • Notes payable • Inter-company loans • Secured loan • Contingent liability

(b) Owner’s Equity Owner’s equity means rights or claims against the assets of the business by the owner. Owner’s equity is the excess of total asset against total liability of the business. Owner’ equity for each ownership business structure differ: • • • For company, owner’s equity consist of paid-up capital, premium shares, retained earnings and reserve. For partnership, owner’s equity consist of total capital account for all partners. For sole proprietorship, owner’s equity consist of capital account contributed by its sole owner.

You have know all the items that need to be reported in the balance sheet: namely asset, liability and owner’s equity.

ACTIVITY 3.1
How may a debt be considered as a bad debt? If you have your own business, what is your interpretation on the term of bad debt? Discuss.

Activity 3.2

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

115

The following balance sheet statement reports all items of asset, liability and owner’s equity found in the Adjusted Trial Balance and Statement of Changes in owner’s equity for Reen Cyber Service:
Reen Cyber Service Balance Sheet as at 31 December 2008 RM Non-current assets: Land Office equipment Accumulated depreciation RM 20,000 3,600 (100) 3,500 Current assets: Cash Accounts receivable Suppliers Insurance prepayment Less: Current Liabilities: Account payable Salary payable Unearned revenue Net current assets Finance by: Owner’s Equity Capital, Reen Non-curent liability: Notes payable 23,500 RM

19,130 5,440 1,520 4,600

30,690

1,800 500 480 (2,780) 27,910 51,410

36,410* 15,000 51,410

From the statement of changes in owner’s equity

If the statement of changes in equity has not been prepared, all the items in that statement would be shown in the balance sheet for the purpose of reporting the closing capital as at 31 December 2008.

Net assets refer to the difference between net current assets and net current liabilities. This item must be reported according to the regulation and standards approved by the Malaysian Accounting Standards Board (MASB) 1: Presentation of Financial Statements.

116

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

To ensure that you have understood what you have learned, complete the following exercise.

EXERCISE 3.3
Information in the adjusted trial balance for Khairunnisa’ Consulting Services at 30 June 2007 are as follows:
Khairunnisa’ Consulting Services Adjusted Trial Balance as at 30 June 2007 Cash Accounts receivable Office supplies Rental prepayment Insurance prepayment Office equipment Accumulated depreciation – office equipment Accounts payable Unearned Fees Notes payable – long-term Salary payable Capital, Khairunnisa’ Fees revenue Sundry expenses Rental expenses Utility expenses Salary expenses Supplies expenses Insurance expenses Depreciation expenses Total From the information above, 1. Prepare the income statement for the period ended 30 June 2007 for Khairunnisa’ Consulting Services. Debit 56,350 41,600 12,300 4,400 15,100 99,000 Credit

10,725 17,600 10,980 100,000 7,100 51,990 119,280 10,700 13,800 4,900 49,600 5,600 3,500 825 317,675 317,675

2. Prepare the balance sheet as at 30 June 2007.

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

117

3.3.4

Cash Flow Statement

You will next be exposed to the fourth financial statement, the cash flow statement which summarises the cash received and cash payment for the period. It presents the basic cash information for operating, investing and financing activities. The cash flow statement can help users of accounting information to: (i) evaluate the capability of the company to generate positive cash flow in the future; and

(ii) evaluate the capability of the company in settling its debts, paying dividends and providing loans to external parties. Cash flow statement can be classified under three activities, which are operating activities, investing activities and financing activities.

Figure 3.7: Cash flow statement

(a)

Operating Activities Operating activities involve cash transactions that affect the business’ net profit, which are any cash received, such as cash from sales, and any cash payments, such as payment for purchases. Only cash received and payment related to the operation of the company are taken into account. MASB 5 also specified interest and dividend received as part of items from operating activities. However, both these items can also be classified as investing or financing activities, which will be discussed later.

(b) Investing Activities The second activity is investing activities, and would normally involve long-term asset items, such as purchase and sale of non-current asset. Any profit or loss from the sale of non-current asset will not be included in the calculation of net cash flow from investing activities.

118

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

(c)

Financing Activities This activity normally involves long-term liability and equity items such as issuance of share and payment of all debts. If there is profit or loss during the payment of all debts, it will not be taken into account while generating the net cash flow from financing activities.

Examples of Cash Received and Payments for each of the activities are as follows: Operating Activities Cash Received From: Sale of goods Service revenue Fees revenue Rental revenue Cash Payment For: Purchase of goods Staff wages and salary Utility expenses Rental expenses Investing Activities Cash Received From: Sale of non-current asset Sale of investment Collection of loan provided to other entities Cash Payment For: Purchase of non-current asset Purchase of shares (invest) Provision of loan to other entities

Financing Activities Cash Received From: Cash Payment For:

Loan or debt of the company Repayment of loan/debt from external parties Issuance of shares Share buyback

Examples for each activity above are reported in the Cash Flow Statement shown as follows: Cash balance as at 1 January 2007 is zero as the business is newly established.

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

119

Air Molek Enterprise Cash Flow Statement for the Period Ended 31 December 2007 Operating Activities Received: Collection from customer Payment: Staff salary Net cash flow from operation Investing Activities Sale of land Sale of shares Net cash flow from investment Financing Activities Investment by owner Total increase in cash Cash balance as at 1 January 2007 Cash balance as at 31 December 2007 RM RM 6,500

(1,200)

(1,200) 5,300

22,000 18,000 40,000

50,000

50,000 95,300 0 95,300

For your information, the Cash Flow Statement must take into account all cash related transactions. This means that you must refer to Topic 2, which is the recording of information related to incoming or outgoing cash flow. Cash Flow Statement for Reen Cyber Service is as follows:

120

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

Notes to Solution: Reen Cyber Service Cash Flow Statement For the Period Ended 31 December 2008 Operating Activities Received: Cash from customers Payment: Cash to suppliers Expenditure Net cash flow from operation Investing Activities Financing Activities Drawings by owner Total increase/(decrease) in cash Cash balance 1 December 2008 Cash balance 31 December 2008 RM RM 13,960 (2,600) (15,030)

(17,630) (3,670)

(4,000) (7,670) 26,800 19,130

Cash total is the same as the total reported in balance sheet.

(i)

Cash from customer total RM13,960, which is the total cash received throughout the month of December. You can refer to the journal entry done in Topic 2 relating to accounts receivable. RM13,960 was total cash received for 1 December for RM720; 16 December for RM6,200; 21 December for RM1,300 and 31 December for RM5,740.

(ii) Payment to suppliers totalling RM2,600 was for transaction on 11 December 2008 for RM800 and 20 December for RM1,800. (iii) Cash for payment of expenditure was from all transactions related to expenses and outgoing cash flow. Examples of expenses involved are rental expenses, insurance expenses, sundry expenses and utility expenses. You can try by using the same way we had derived the total cash from customers. You will find that total for all expenses are RM15,030. Therefore, the net cash flow from the operating activities totalled (RM3,670), which is (RM13,960 – RM17,630).

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

121

(iv) What had happened to the overall cash flow? The cash flow had decreased by RM7,670 throughout the month of December. This is different from the one reported in the income statement for the period ended 31 December, that is the net profit of RM14,410. This is because the entity had used the accrual basis in recognising the revenue and expenditure, without taking into account the incoming or outgoing cash. (v) Total cash balance as at 1 December 2008 which is RM26,800 refer to the cash transaction throughout the month of November 2008.

SELF-CHECK 3.3
Briefly explain the four financial statements which are included in the preparation of financial reports.

3.4

PREPARATION OF CLOSING ENTRIES

In the next section, you will learn how to prepare the closing entry. Drawings account will be closed directly to the capital account. Closing entry refers to the temporary closing of accounts, where all the accounts in the income statement (revenue and expenses accounts) will be transferred to the revenue summary account.

The purpose of closing entry is to measure the profit accurately. It is also for the purpose of making the temporary accounts into zero balance for the next period.

3.4.1

Steps in Preparation of Closing Entries

Temporary accounts are accounts related only to the current accounting period which will be closed, for example expenses accounts and drawings account. The fixed accounts (such as asset, liability and owner equity), however, will not be closed. These accounts are related to one or more accounting periods in the future with its balance reported in the balance sheet. Closing entry is done at the end of the accounting period.

122

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

The steps for making closing entries are as follows: (a) All revenue accounts will be debited and revenue summary account will be credited.

(b) All expenses accounts will be credited and revenue summary account will be debited. (c) Transfer balance from revenue summary account into capital account. (d) Drawings account will be credited and capital account will be debited. Figure 3.8 shows the summary of preparing the closing entry.

Figure 3.8: Summary for preparation of the closing entry.

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

123

Closing entries for Reen Cyber Services as at 31 December 2008 are as follows: 31 December 2008 Dr. Interest revenue Rental revenue Cr. Revenue Summary (Closing of all revenue accounts) Dr. Revenue Summary Cr. Salary expenses Rental expenses Utility expenses Supplies expenses Sundry expenses Insurance prepayment Depreciation (Closing of all expenses accounts) Dr. Revenue Summary Cr. Capital, Reen (Closing of revenue summary account) Dr. Capital, Reen Cr. Drawings (Closing of drawings account) 8,000 8,000

33,680 240 33,920 19,510 9,050 3,200 1,970 4,080 910 200 100 14,410 14,410

Notes to Solutions: (i) All revenue accounts will be closed by debiting the specific accounts and creating an revenue summary account. With this all the revenue accounts will have a zero balance while the revenue summary account will have RM33,920 credit balance.

(ii) All expenses accounts will be closed by crediting the said accounts. With this all the expenses accounts for that period will have a zero balance. Meanwhile the current balance of revenue summary account will become RM14,410 after taking into account the expenses transferred over to this account. (iii) Balance in the revenue summary account of RM14,410 will be transferred to the capital account. If it is a credit balance, it would be net profit, while if it has a debit balance, it will be net loss. This balance will be the same net profit reported in the income statement prepared in the previous topic.

124

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

SELF CHECK 3.4
What are the steps required to prepare a closing entry?

3.5

PREPARATION OF REVERSING ENTRIES

Reversing entry is a reversal to the adjusting entry from the previous period but only related to accruals, which are accrued revenue and accrued expenses.

Reversing entry is usually prepared on the first day of the next accounting period. It is to simplify the accounting process because it separates the expenses or revenue for the two accounting periods. However, business entity has a choice on whether to prepare this reversal entry or not. Example 3.7 At the end of year 2005, Mas Merah Company has accrued salary expenses of RM800. The adjusting entry recorded was: 31 December 2005 Dr. Salary Expenses Cr. Salary Payable 800 800

At 31 December, closing entry must be made to close the salary expenses account as this account is temporary. The entry needed is: 31 December 2005 Dr. Revenue Summary Cr. Salary expenses 800 800

If Mas Merah Company prepares the reversal entry on the first day of the next accounting period, the reversal entry would be: 1 January 2006 Dr. Salary payable Cr. Salary expenses 800 800

At 15 January 2006, Mas Merah Company made an actual salary payment of RM2,000. The journal entry involved would be: 15 January 2006 Dr. Salary expenses 2,000

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

125

Cr. Cash

2,000

After all the journal entries had been transferred to the ledger, the accounts involved are: Salary Expenses Account RM 31 Dec 2005 15 Jan 2006 Adjustment Payment 800 2,000 31 Dec 2005 1 Jan 2006 Closing Reversal RM 800 800

Salary Payable Account RM 31 Dec 2005 1 Jan 2006 Balance c/f Reversal 800 800 31 Dec 2005 Adjustment 1 Jan 2006 Balance b/d RM 800 800

Revenue Summary Account RM 31 Dec 2005 Closing 800

Cash Account RM 1 Jan 2006 Payment 2,000

Salary expenses account as at 15 January 2006 has a debit balance of RM1,200 (RM2,000 – RM800). This means that this total will be recognised as salary expenses for the accounting period of 2001. Therefore, the role of reversal entry is to separate the expenses for the two accounting period, that is for the years 2006 and 2005. As at 15 January 2006, the balance for salary payable account will be 0 that is after the reversal entry had been transferred to salary payable ledger. The revenue summary account will be closed by debiting the capital account while cash account will be permanently reported in the balance sheet.

126

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

EXERCISE 3.4
1. The trial balance for Berkat Enterprise as at 30 June 2008 is as follows:
Debit Cash Accounts receivable Supplies 3,425 7,000 1,270 620 51,650 9,700 925 1,250 29,000 5,200 59,125 22,415 8,420 100,000 100,000 Credit

EXERCISE Insurance prepayment
Office equipment

3.4

Accumulated depreciation – Office equipment Salary payable Unearned revenue Capital Drawings Service revenue Salary expenses Sundry expenses Total

Adjustment information: (i) Supplies in hand as at 30 June 2008 totalled RM380. (ii) Insurance premium expired for the year totalled RM315. (iii) Yearly depreciation for office equipment totaled RM4,950. (iv) Salary accrued but yet to be paid as at 30 June is RM440. (v) Service revenue accrued but yet to be recorded totaled RM1,000. (vi) Unearned revenue as at 30 June totaled RM750. From the information provided, you are required to: (a) (c) Prepare the journal entries to record all the adjustments. Prepare the Income Statement and Balance Sheet at the end of the accounting period.

(d) Prepare the closing entries.

TOPIC 3 COMPLETING THE ACCOUNTING CYCLE

127

2.

Mekar Serumpun Company paid salary to its workers once in every six days (the salary for Saturday until Thursday will be paid on Thursday). Friday is a holiday for Mekar Serumpun Company. The company pays a daily rate of RM20 as salary to its workers. The company had decided that 31 December is the last day for its accounting period and 31 December 2008 falls on a Wednesday. Based on the above information, prepare the reversing entries and transfer the entries to the corresponding ledgers for the final week of year 2008.

3.

Information in the Adjusted Trial Balance of Moiz Real Estate Company as at 31 December 2008 are as follows: Moiz Real Estate Company Trial Balance 31 December 2008
Cash Accounts receivable Supplies Insurance prepayment Office equipment Accumulated depreciation – office equipment Accounts payable Unearned revenue Capital, Moiz Drawings, Moiz Service revenue Salary expenses Rental expenses Depreciation expenses Sundry expenses Total RM 6,850 14,000 2,540 1,240 103,300 RM

19,400 1,850 2,500 58,000 10,400 118,250 44,830 8,400 5,430 3,010 200,000

200,000

From the information above, you are required to: (a) Prepare the income statement, statement of changes in equity and balance sheet statement.

(b) Prepare the closing entries.

128

TOPIC 3 COMPLETNG THE ACCOUNTING CYCLE

SUMMARY
• In this topic, you have been introduced to the following items: – – – – – • Prepaid expenses Depreciation expenses Unearned revenue Accrued expenses Accrued revenue

The preparation of Adjusted Trial Balance is for the purpose of showing the effect of all financial events that had occurred in the specific accounting period. The preparation of Financial Statements is done after the transactions have been recorded, journalised, transferred and summarised in the Trial Balance. The Financial Statements prepared for an entity include: – – – – Income Statement Statement of Changes in Equity Balance Sheet Statement Cash Flow Statement

• •

The preparation of closing entries must be done for the purpose of measuring the profit accurately and to make the temporary accounts into zero balance for the next accounting period. The preparation of reversing entries must be done on the first day of the next accounting period. This is a reversal to the adjusting entries made in the previous period and is related only to accruals (accrued revenue and accrued expenses).

Accrued Expenses Adjusted Trial Balance Adjusting Entries Current Asset Current Liability

Depreciation Expenses Long-term Asset Long-term Liability Prepaid Expenses Unearned Revenue

Topic

4
1. 2. 3. 4.

Financial Reporting

LEARNING OUTCOMES
By the end of this topic, you should be able to: Explain the purpose of the financial report; Describe the statutory requirements for the preparation of financial report or annual report; Examine the contents in the annual report comprising financial information and non-financial information; and Prepare the financial statements that must be presented in the key financial statements according to MASB1.

 INTRODUCTION
This topic discusses the statutory requirements that necessitate business entities to prepare the financial report or annual report. The contents in the financial reports released by business entities comprise financial information and non-financial information, which will be discussed at the end of the topic.

4.1

STATUTORY REQUIREMENT

Before further discussion on financial reporting, it is better we analyse in advance the statutory requirements for the preparation of this report. Business entities are required to report their financial status at the end of each accounting period in a formal report known as the financial report or annual report. The purpose of the report is to present the financial status of the business entity for a specific accounting period.

130

TOPIC 4 FINANCIAL REPORTING

Financial reports are very useful and important for users of accounting information such as investors, creditors, government, economic analysts and other interested users as they help them to conclude on the performance and financial status of a business entity. In addition, these financial reports are also prepared to fulfil statutory requirements. The regulations that must be complied with in the preparation of financial report are Companies Act 1965, Securities Commission 1995, Financial Reporting Act 1997 and Income Tax Act 1967, whilst organisations such as Bursa Malaysia Berhad and Central Bank of Malaysia require business entities to submit financial reports. Figure 4.1 shows the summary of statutory bodies that require annual reports.

Figure 4.1: Statutory bodies that require annual report prepared by business entity

(a)

Companies Act 1965 You will now be introduced to the first regulation that requires the preparation of annual report, which is the Companies Act 1965. Business institutions formed as companies are bound by the Companies Act 1965 with regards to the aspect of preparation of financial and accounting report. It is stated clearly under Schedule VI: Account and Audit of the Companies Act 1965. Sections 169 (1), (2), (3), (4) and (5) of the Companies Act 1965 require a newly incorporated business entity registered with the Registrar of Companies to prepare the annual report not later than 18 months from the date of its incorporation. For the following years, the annual report must be prepared at the end of each accounting period. A business entity will be fined or its registration be annulled by the Registrar of Companies if it failed to prepare the annual report.

TOPIC 4 FINANCIAL REPORTING

131

To enhance your understanding on the companies’ rules and regulations stated above, you can refer to Section 169 of the Companies Act 1965. (b) Securities Commission 1995 Securities Commission 1995 is a statutory body established under the Securities Commission Act 1993. This commission emphasises the importance of standard financial reporting. It also has statutory power that requires business entities to comply with its regulation. Regulation 8 of the commission requires all companies that are listed on the Stock Exchange to prepare their accounts according to the approved accounting standards. Companies can be imposed with disciplinary actions or fine if they failed to comply with this regulation. (c) Financial Reporting Act 1997 The Financial Reporting Act 1997 had established an accounting standards setting body that is the Malaysian Accounting Standards Board (MASB) on 1 July 1997. Companies registered in this country must observe the stipulated regulations, by complying with the accounting standards approved by MASB. MASB 1 lists the minimum accounting information that must be reported by a company for the purpose of preparing a report. Please refer to the Financial Reporting Act 1997 for further information. (d) Income Tax Act 1967 Compliance with the Income Tax Act 1967 is legal requirement. This Act is important as it includes specific provisions relating to the retention of accounting records of business entities for the purpose of tax calculations (Sections 82, 108 and 110). (e) Bursa Malaysia Berhad Next is Bursa Malaysia Berhad. Bursa Malaysia Berhad requires all business entities listed on its exchange to comply with several conditions as follows: (i) Printed financial report must be distributed within six months from the last financial date to the shareholders and Bursa Malaysia Berhad;

(ii) Annual audited accounts must be in the form of Consolidated* Financial Statement; and (iii) Annual audited accounts must be prepared according to the standards approved by MASB and the Companies Act 1965

132

TOPIC 4 FINANCIAL REPORTING

*Consolidated accounts are the accounts of a parent company combined with the accounts of its subsidiaries.

(f)

Central Bank of Malaysia The Central Bank of Malaysia or Bank Negara Malaysia had prepared a guideline relating to financial reporting for financial institutions of this country under the Banking and Financial Institutions Act 1989. This guideline deals with general disclosure in the preparation of financial statement, and detailed disclosures are highly encouraged.

SELF-CHECK 4.1
Why is it important for business entities to comply with the regulations as set by the statutory bodies in this country?

EXERCISE 4.1
List the regulations and organisations that require financial reporting.

To test your understanding, answer the following question.

4.2

FINANCIAL REPORT

Let us take a look at the information contained in the financial report in detail. The Companies Act 1965 (Section 169) had stipulated the contents that must be reported in the financial report/annual report. Most of the business entities also include additional information such as corporate information and structure. The contents and presentation format of the annual reports prepared by business entities are normally different depending on the policy adopted by the management.

TOPIC 4 FINANCIAL REPORTING

133

Financial and non-financial information are the main components in financial report/annual report for a business entity.

4.2.1

Non-Financial Information

Non-financial information comprise the following: (a) Chairman’s Report Report on financial performance or financial status of the company. A chairman’s report also specifies future planning and prospects including dividend payout to shareholders based on available proof, such as the profit or loss status and the current economic situation.

(b) Notice of Annual General Meeting This notice is an invitation to the annual general meeting which is distributed to all members or shareholders. It usually states the date, time, meeting venue, meeting agenda and other related matters. The notice is normally prepared by the company secretary. (c) Corporate Information and Structure Corporate information relates to information on members of the board of directors, company secretary, audit committee, registered office, principal bankers, auditors and corporate lawyers. The company structure states information relating to subsidiaries and associated companies* including percentage of share ownership on subsidiaries and associated companies within the group’s structure.

*Associated company – when a business entity has a percentage share ownership of 20 - 50% in another business entity.

(d) Summary of Financial Information This report compares a summary of the company’s past financial results, usually for the past five to ten years. The information is normally presented in the form of graphs or charts to show comparison between the previous and the current results. (e) Auditors’ Report Auditors’ report is the opinions given by Auditors as an independent external party who are appointed by the company. The auditors provide opinion after checking and auditing all the accounts and financial report, according to the standards and procedure.

134

TOPIC 4 FINANCIAL REPORTING

Figure 4.2: Non-financial information

ACTIVITY 4.1
If you intend to invest by buying shares in a company, is it important for you to evaluate or read the company’s prospectus yourself?

SELF-CHECK 4.2
State the contents of non-financial information.

TOPIC 4 FINANCIAL REPORTING

135

This report is for the purpose of verifying that all the information prepared and reported in the annual financial statements had given a true and fair view. Non-financial information discussed earlier can be seen in Figure 4.2.

4.3

MAIN FINANCIAL STATEMENTS

In sub-topic 4.2.1, you were exposed to the non-financial information. In this topic, the discussion will revolve on financial information which forms the most important part in the annual report which will be presented in the form of Key Financial Statements. MASB 1 lists the financial statements that must be presented in the Key Financial Statements as follows: (a) Income Statement The first financial statement discussed here is the income statement. The income statement reports the financial performance by showing loss or profit during the accounting period. All related accounting information must be disclosed in the income statement. The following are the minimum accounting information required by MASB 1 for reporting purposes: (i) Turnover (ii) Profit from operating (iii) Profit/Loss in associate companies (iv) Tax (v) Operating Profit/Loss (vi) Extraordinary items (vii) Minority interest (viii) Net profit/loss MASB 1 also requires business entities to report the dividend per share either in the income statement or in the notes to the accounts. (b) Balance Sheet Statement Balance sheet is the statement that shows the financial status of a business entity at any one time. This statement reports the status of assets, liabilities and owner’s equity. MASB 1 requires business entities to report the following items, which are the minimum disclosure in the balance sheet: (i) Land, plant and equipment

136

TOPIC 4 FINANCIAL REPORTING

(ii) Intangible asset (iii) Investment (iv) Item receivable (v) Cash (vi) Item payable (vii) Tax liability (viii) Minority interest (ix) Share issued and reserves However, several of the above items will only be studied in the more advanced accounting curriculum. (c) Statement of Changes in Owner’s Equity Statement of changes in Owner’s equity is the statement that reports the changes in the equity for the accounting period. The disclosures required by MASB 1 in this statement are as follows: (i) Net profit/loss for the current period. (ii) Revenue and expenditure items. (iii) Effect of changes in accounting policy and correction of any significant errors. Apart from the above, MASB 1 also requires additional information that are to be reported in either the statement of changes in equity or in the notes to the accounts. This information include: (i) Transactions involving owners and distribution to owners. (ii) Opening and closing balance of accumulated profit/loss for the period and changes that occurred during that period. (iii) Reconciliation between the carrying value of each equity items, share premiums, and reserves as at the opening and closing period. (d) Cash Flow Statement As the name implies, cash flow statement involves cash transactions. The cash flow statement shows the changes in cash that occurred for the business entity during a specific period. Information from this statement is very important to users of financial information as it reports the ability of the business entity to generate cash in the future. MASB 5 requires business entities to report the net cash flow from the following activities:

TOPIC 4 FINANCIAL REPORTING

137

(i)

Operating activities

(ii) Investing activities (iii) Financing activities All the statements discussed above must be reported in the annual report by comparing two accounting periods which is the current period and the previous period. (e) Notes to the Accounts and Accounting Policies (i) Notes to the Accounts Notes to the accounts refer to the detailed descriptions relating to the accounts reported in the balance sheet and income statement. MASB 1 defines notes to the accounts as part of the financial report. Among the notes to the accounts reported in the financial report are in relation to: • • • • • • Accounting policy Debtors Account/Account Receivable Inventory Account Investment Share capital Reserves

The function of notes to the accounts is to provide an explanation to the users of accounting information on how the total of the accounts reported in the financial statements are derived. (ii) Accounting Policies Accounting policies for a business entity refer to the accounting policies practised by the entity in preparing and presenting the financial statement. These accounting policies are subject to the standards released by MASB and the accounting bodies. Examples of accounting policy that must be disclosed by a business entity are: • • • • • Basis of accounting used, either historical cost or revaluation. Basis of consolidation for consolidated accounts. Meaning of consolidated companies. Meaning of associated companies Basis of accounting for fixed asset and the methods used for calculation of depreciation.

138

TOPIC 4 FINANCIAL REPORTING

EXERCISE 4.2
1. What are the differences between financial and non-financial information? Financial Information Non Financial Information

2.

Why are notes to the accounts being prepared?

SUMMARY
Several important points that were discussed in this topic are: • Financial report prepared by business entities shows the financial status of the business which is useful to the investors, creditors, government, economic analysts and other interested users. Financial and non-financial information are the main components in the financial/annual report of a business entity. MASB 1 lists the financial statements that must be presented in the key financial statements: – – – – – Income Statement Balance Sheet Statement Statement of Changes in Equity Cash Flow Statement Notes to the Accounts and Accounting Policies

• •

Financial Information Financial Report Financial Statements

Non-financial Information Statutory Requirement

Topic

5
1. 2.

Trading Business Environment

LEARNING OUTCOMES
By the end of this topic, you should be able to: Explain the difference between services business activities and trading business activities; Prepare the journal entries for trading transactions relating to: (a) purchases; (b) sales; (c) transportation costs; and (d) transactions that involves buyer and seller. Differentiate between periodic and perpetual inventory systems; and Prepare the income statement for trading business.

3. 4.

 INTRODUCTION
Topic 1 - 4 had discussed the accounting environment and recording process, as well as the way to complete the accounting cycle, including the types of adjusting entries that will affect the accounts in the income statement. Topic 5 - 6 will discuss on the different types of firms, with more emphasis placed on trading firms. There are two types of firms: trading firms and service firms. However, this topic will only focus on trading firms. Trading firms are businesses that buy goods which will be resold to its buyers. Trading firms usually have inventories of goods to be resold. Service firms do not have these inventories.

140

TOPIC 5 TRADING BUSINESS ENVIRONMENT

The difference between trading firms and service firms can be narrowed down to the revenue and expense items which appear in the Income Statement (refer to Figure 5.1)
Service Firms Fees earned Operating expense RM XXX (XX) XXX Trading Firms Sales Cost of goods sold Gross profit Operating expense Net operating income RM XXX (XX) XXX (XX) XXX

Figure 5.1: Difference in income statement for service firms and trading firms

Service firms derive their revenue from services which they provide to customers. For example, the revenue of accounting firms relate to fees from conducting audits in organisations. For income statement of service firms, revenue from these services is reported as fees earned (or service revenue). Net operating revenue for service firms is the difference between the fees earned and the operating expense involved in offering the services. This can be clearly seen in Figure 5.1. However, the situation is different for trading firms. For trading firms, revenue is generated from buying and selling goods. Trading firms buy goods and then sell it to customers. When goods are sold, the revenue received is reported as sales revenue. What about the cost of buying the goods? The trading firms would, of course, purchase their goods from suppliers and the cost of buying the merchandise will be recorded as an expense item known as cost of goods sold. The difference between sales revenue and cost of goods sold is known as gross profit. Gross profit is the profit before deducting the operating expense involved in buying and selling these goods. You must be thinking that not all goods bought can be sold. What will happen? Goods which are unsold by the end of the accounting period will be kept as inventory. This inventory will be reported in the current asset section of the company’s balance sheet. As a note, you have now started to identify the transactions involved in the income statement (sales, cost of goods sold and gross profit) and balance sheet (trading goods inventory). Trading transactions will be recorded in the accounts using the rules of debit and credit as explained in Topic 1 until Topic 4.

TOPIC 5 TRADING BUSINESS ENVIRONMENT

141

5.1

TRADING BUSINESS ENVIRONMENT

Income statements for trading and service firms are different as both involve different activities. Trading firms buy goods from supplier and then resell the goods to generate profit. There are two types of trading firms; retailers and wholesalers. Example of retailers are supermarkets (large scale retailers) and retail shops such as electrical and furniture (small scale retailer). Retailers are trading firms that buy goods from wholesalers and resell it directly to consumers.

Wholesalers do not sell the goods directly to consumers but instead sell it to retailers. Wholesalers are trading firms that buy goods directly from manufacturers in large quantities.

The characteristics of trading firms are: (a) buy goods for resale. (b) goods sold will be reported as sales revenue and cost of goods sold is the cost of inventory sold; (c) Cost of goods sold will be deducted from sales revenue to obtain gross profit; Gross Profit = Sales revenue – Cost of goods sold

(d) Operating expense will be deducted from gross profit to obtain Net Operating Revenue; and Net Operating Income = Gross profit – Operating expense

142

TOPIC 5 TRADING BUSINESS ENVIRONMENT

(e)

Goods or inventory that is not sold by the end of the accounting period will become the closing inventory and will be reported as current asset in balance sheet.

As trading firms deal in goods, a trading entity must have an inventory system which is efficient and effective to value the opening inventory and closing inventory of the trading firm. There are two types of inventory management system, periodic inventory system and perpetual inventory system.

ACTIVITY 5.1
Kamdar and Mydin are two companies that are successful and famous in Malaysia as they can afford to offer various goods at low prices. What are their success factors?

Test your understanding by answering the exercise below.

EXERCISE 5.1
Tick () at the correct column. 1. Gross profit is: (a) (b) (c) (d) 2. operating expense deducted from net operating revenue. sales revenue is more than operating expenses. sales revenue is more than cost of goods sold. operating expenses more than cost of goods sold. True False

Berjaya Sdn. Bhd. recorded sales revenue of RM110,000, cost of goods sold totalled RM70,000 and operating expense is RM20,000 Calculate: (a) gross profit; (b) net operating revenue

TOPIC 5 TRADING BUSINESS ENVIRONMENT

143

5.2

IMPORTANT TRANSACTIONS IN TRADING FIRMS

For trading firms that sell on credit, the business’ operating cycle include the following transactions: (a) (c) purchase of goods; collection of accounts receivable. (b) sale of goods; and

For cash sales, however, the operating cycle is related only to buying and selling goods involving cash. This operating cycle will be repeated throughout the lifetime of the business. There are 5 important types of transactions in a trading firm, these are: (a) (c) (e) Purchases Discounts Transportation Cost (b) Sales (d) Returns and Allowances

5.2.1

Purchases

Purchase transactions involve purchasing goods to be resold. Any item bought for use in the business, such as purchase of asset, is not regarded as purchases. Purchases can be made by cash or credit. Credit purchases will be supported by purchase invoices. Copies of sales invoices from the seller are regarded as purchase invoices. The buyer can only recognise the purchase or inventory in its business when the ownership of the goods purchased has been transferred from the seller to the buyer.

5.2.2

Sales

Sales involve goods or inventories. Based on the principle of income recognition as stated in the Malaysian Accounting Standard Board 9, sales revenue will be recorded when the goods had changed hands from the seller to the buyer. For credit sales, the duration taken to transfer the goods from the seller to the buyer depends on the delivery terms stated. Sales can be made by cash or credit. Credit sales may include cash discount, depending on the credit payment period.

144

TOPIC 5 TRADING BUSINESS ENVIRONMENT

5.2.3

Discounts

Discounts are price reductions given by the seller to the buyer.

There are two types of discount: • • Quantity discount; and Cash discount. Quantity discounts are discounts given for purchases made in bulk.

The purpose of giving quantity discounts is to encourage the buyer to buy at higher quantities. No journal entry is needed to record the quantity discount as the quantity discount amount will be deducted directly from the invoice. Example of quantity discount: If quantity purchased is between: (i) 3000 – 4000 units, then a 10% discount will be given. (ii) 4001 – 5000 units, then a 20% discount will be given. This shows that as more units are purchased, the higher the discount obtained. Cash discounts are offered for credit purchases. Cash discounts are price reductions given if payment is made within the discount period.

If quantity discount is given together with cash discount, the cash discount will be calculated after deducting the quantity discount amount. Cash discount is given to encourage early payment. Credit terms are the terms given by the seller to the buyer on the period for payment.

TOPIC 5 TRADING BUSINESS ENVIRONMENT

145

Several credit terms are commonly used: (i) 2/10, n/30 This credit term means that a discount of 2% will be given if payment is made within 10 days from the date of invoice, while the payment period (without discount) is for a period of 30 days. If purchases were made on 5 January, the expiry period for cash discount is on 15 January (5 January + 10 days = 15 January). This means that a 2% discount will be obtained if payment is made on or before 15 January.

(ii) n/30 No discount was offered but the total purchase amount must be settled within 30 days. (iii) 4/15, n/eom 4% discount will be given if payment is made within 15 days and the payment period is at the end of the current month. EOM as stated above means end of month. Cash discount can be categorised into two: purchase discount and sales discount. (a) Purchase Discount Cash discount is known as purchase discount by the buyer if the buyer pays within the discount period for the purchase transaction made.

Purchase discounts or discounts received are price reductions given by the seller to the buyer if the buyer pays his debt within the discount period.

If the buyer pays within the discount period, the price paid will be less than the price stated in the purchase invoice. In the periodic system, the purchase discounts account with credit balance will be set-off (contra) against the purchases account. (b) Sales Discount Cash discount is known as sales discount to the seller if the buyer pays within the discount period for the purchase transaction made. Sales discounts or discounts given are price reductions given to credit sales if the customer pays up within the discount period.

146

TOPIC 5 TRADING BUSINESS ENVIRONMENT

Cash payable by the customer or debtor will be less compared to the price stated in the invoice. Sales discounts are offered to encourage customer to make early payment. Example of purchases and sales involving sales discount and purchase discount are shown in Figure 5.2:

Figure 5.2: Example of purchases and sales involving sales discount and purchase discount

ACTIVITY 5.2
Why would business entities provide discounts to its buyers? Discuss.

EXERCISE 5.2
1. 2. 3. Explain the meaning of the credit term 2/10, n/30. Explain the meaning of sales discount. Explain the meaning of purchase discount.

TOPIC 5 TRADING BUSINESS ENVIRONMENT

147

5.2.4

Returns and Allowances

Returns and allowances are known as Purchase Returns and Purchase Allowances by buyers, and as Sales Return and Sales Allowances by sellers. As an example: Besta Sdn. Bhd. sold goods to Ali Company. Therefore, Besta Sdn. Bhd. is the seller and Ali Company is the buyer. Besta Sdn. Bhd. (seller) Ali Company (buyer)

Assuming Ali Company had returned goods to Besta Sdn. Bhd. as the goods were not as per specifications. For Ali Company (buyer), goods returned is known as purchase return as they relate to purchases that had occurred earlier. However, the returned goods received by Besta Sdn. Bhd. (seller) will be viewed as sales return as they relate to their earlier sales. Further details on sales returns and allowances and purchase returns and allowances are explained below. (a) Purchase Returns and Allowances When businesses purchase goods, and then they are not satisfied with the goods, they are allowed to return the goods to the supplier. They can also choose to keep the goods. When a buyer returns the goods, it is known as purchase return from the buyer’s perspective. For credit purchases, the return made will reduce the amount in the accounts receivable balance. For cash purchases, cash will be refunded to the buyer. Purchase allowances exist when the buyer does not return the goods that did not fulfil the specification and the seller agreed to reduce the purchase price. In this case, the buyer will send a debit memo to the seller to remind the seller to reduce the buyer’s account balance. Example of debit memo is as shown in Figure 5.3. Purchase returns and allowances account is the contra account for purchases account and the normal balance is on the credit side.

148

TOPIC 5 TRADING BUSINESS ENVIRONMENT

Figure 5.3: Example of debit memo

(b) Sales Returns and Allowance From the seller’s perspective, sales returns occur when a buyer or customer returns goods which are damaged or for other reasons. Sales allowances exist when a buyer chooses to keep the damaged goods. The seller must adjust the invoice price to enable the outstanding balance to be reduced. The seller will send a credit memo to the buyer when this happens. Example of a credit memo is shown in Figure 5.4.

Figure 5.4: Example of credit memo

TOPIC 5 TRADING BUSINESS ENVIRONMENT

149

SELF-CHECK 5.1
Why do companies provide sales return allowances to their customers?

ACTIVITY 5.3
Discuss the importance of having return allowances to the buyer and seller.

EXERCISE 5.3
1. Choose the most accurate answer. The account which is related to sales and has a normal debit balance is: (a) (c) 2. 3. sales discounts; both (a) and (b). (b) sales returns and allowances; and Explain the meaning of purchase returns and allowances. Describe sales returns and sales allowances.

5.2.5

Transportation Cost

In general, transportation terms are specified in trade. The transportation term will decide who will pay for the transportation cost (either the buyer or the seller) and the time frame for the goods to be transferred from the seller to the buyer.

Transportation costs can be classified into two: (a) Free on Board (FOB) shipping point; and (b) Free on Board (FOB) destination.

150

TOPIC 5 TRADING BUSINESS ENVIRONMENT

(a)

FOB Shipping Point In the FOB shipping point term, the goods will be transferred from the seller to the buyer when the goods are sent by the seller to the transport company: lorry, ship and others. The goods will belong to the buyer and can be recorded as buyer’s inventory at the time of purchase. The transportation cost would be borne by the buyer. The transportation cost paid by the buyer will be recorded as carriage inwards. Carriage inwards account would normally have a debit balance and will be added to the purchase cost to obtain the cost of goods sold in the income statement.

Figure 5.5: FOB shipping point

(b) FOB Destination The ownership of the goods will be transferred from the seller to the buyer when the goods reach the buyer’s destination, which is the buyer’s warehouse. The goods purchased will be owned by the buyer and can be recorded as buyer’s inventory when the buyer received the goods. The buyer cannot record the goods in its inventory during purchase. Entry will only be made when the goods are received. The seller will bear the transportation cost and record it as carriage outwards after the transportation cost had been paid. This carriage outwards will be included in the income statement as a part of the operating expenditure.

TOPIC 5 TRADING BUSINESS ENVIRONMENT

151

Figure 5.6: FOB destination

ACTIVITY 5.4
Which FOB term is suitable for business selling computers?

EXERCISE 5.4
Describe the difference between FOB shipping point with FOB destination.

5.3

ACCOUNTING FOR INVENTORY

As you know, trading firms buy goods for the purpose of resale. The goods purchased will become inventory for the business entity. There are two methods of recording inventory: (a) Periodic Inventory System Under the Periodic Inventory System, the amount of the inventory will only be known by calculating the inventory physically. The stock count is made at the end of the accounting period, when the total closing inventory is needed to calculate the cost of goods sold. Companies do not have updated

152

TOPIC 5 TRADING BUSINESS ENVIRONMENT

information on the total inventory in the store. The characteristics of Periodic Inventory System are: (i) Goods purchased would be recorded in the Purchases Account. (ii) Transportation cost would be recorded in the Carriage Inwards Account. (iii) Purchase returns and allowances will be recorded in the Purchase Returns and Allowances Account. (iv) Purchase Discounts obtained will be recorded in the Purchase Discounts Account. (v) Inventories (in record) would not be reduced when goods were sold. (vi) The calculation of inventories physically is done once a year. (vii) This system is used by businesses selling low-priced items which may not derive any significant benefit from the preparation of inventory records. In Periodic Inventory System, companies must calculate the cost of goods sold at the end of the accounting period. The calculations for cost of goods purchased and the cost of goods sold are done in the income statement. The calculation for cost of goods purchased is shown:

TOPIC 5 TRADING BUSINESS ENVIRONMENT

153

The opening inventory amount for the current year will be the closing inventory for the previous year. This closing inventory amount will be determined by physical calculation. (b) Perpetual Inventory System Under the Perpetual Inventory System, an inventory account will be created and the inventory records will always be updated. The usage of this method enables the company to know the inventory account balance at any time by checking the balance of the said account. Every transaction affecting the inventory will be recorded into the inventory account. The characteristics of Perpetual Inventory System are: (i) Inventory purchased will be recorded in the Inventory Account. Therefore the inventory account will increase when purchases are made.

(ii) Transportation cost will be recorded in the Inventory Account. The transportation cost will increase the balance in the Inventory Account. (iii) Purchase returns and allowances including purchase discounts will be recorded in the Inventory Account. (iv) Sales of inventory will be recorded at two prices, sales price and cost price. The sales recorded at selling price will show the total sales revenue, while the recording at cost price will show the total cost of goods sold. In the Perpetual Inventory System, there is no need to calculate the cost of goods purchased and the cost of goods sold. Companies can know the value of cost of goods sold directly by checking the balance in the cost of goods sold account. This is because each time goods or inventories are sold, it will be recorded in the Cost of Goods Sold Account at cost value.

SELF-CHECK 5.2
What are the usages of inventory recording for business entities?

154

TOPIC 5 TRADING BUSINESS ENVIRONMENT

5.4

JOURNAL ENTRY FOR PERIODIC AND PERPETUAL INVENTORY SYSTEM

As a continuation from Section 5.3, the differences in the journal entries for Periodic Inventory System and Perpetual Inventory System are shown in this section. (a) Cash and Credit Sales If cash or credit sales were made, journal entries are needed to record the sales at sales price. In Periodic Inventory System, the journal entry is only recorded for sales at the sales price without any entry for cost price. In Perpetual Inventory System, journal entries must be made to record the sales at both the sales and cost price. Cash or credit sales at cost are made by debiting the cost of goods sold account.

(b) Sales Returns and Allowances (Cash and Credit) In the Periodic Inventory System, the journal entries for sales returns and allowances are recorded at sales price only. However, for Perpetual Inventory System, the sales returns and allowances made on cash sales or credit sales must be recorded at sales and cost price. The journal entry to record the returns at cost price can be done by crediting the cost of goods sold account. Table 5.1 shows the different journal entries between the two inventory systems while Table 5.2 shows the journal entries for the related transactions, from the view of the buyer and seller.

Table 5.1: Differences in Journal Entries for Periodic Inventory System and Perpetual Inventory System

TOPIC 5 TRADING BUSINESS ENVIRONMENT 

155

156

Table 5.1: Differences in Journal Entries for Periodic Inventory System and Perpetual Inventory System (continuation)

TOPIC 5 TRADING BUSINESS ENVIRONMENT

Table 5.2: Illustration of Journal Entries for Buyer and Seller

TOPIC 5 TRADING BUSINESS ENVIRONMENT 

157

158

Table 5.2: Illustration of Journal Entries for Buyer and Seller (continuation)

TOPIC 5 TRADING BUSINESS ENVIRONMENT

TOPIC 5 TRADING BUSINESS ENVIRONMENT

159

Before proceeding with our discussion, test your understanding by completing the following exercise.

EXERCISE 5.5
1. Inventory was purchased at cost of RM2,000 on 15 July, with credit term 2/10, n/30. On 18 July, a credit memo had been received from supplier due to damage to goods for RM100. Prepare the journal entries for payment made on 24 July, using the perpetual inventory system. A credit sale had been made on 10 July totalling RM800 with credit term of 2/10, n/30. On 12 July, RM100 goods had been returned. Prepare the journal entry on 19 July to record the cash received from customer.

2.

5.5

EXAMPLES OF RECORDING JOURNAL ENTRIES

The following are the transactions for Selasih Sdn. Bhd. throughout the month of December 2009. The company adopts the Perpetual Inventory System.
December 3 December 5 December 6 December 8 December 10 December 13 December 14 December 15 December 16 December 19 December 22 December 24 December 25 December 31 Purchased goods from Firdaus Sdn. Bhd. for RM4,000, FOB shipping point term, 2/10, n/30 with prepayment of carriage for RM120. Purchased goods from Kenari Sdn. Bhd. for RM8,500, with FOB destination term 1/10, n/30. Sold goods bought on 3 December to Hijrah Sdn. Bhd. at the price of RM5,800. Purchased office supplies by cash for RM150. Returned RM1,300 of goods purchased on 5 December from Kenari Sdn. Bhd. Paid Firdaus Sdn. Bhd. for purchases made on 3 December, after discount. Purchased goods by cash of RM10,500. Paid Kenari Sdn. Bhd. for the purchases made on 5 December, after deducting returns on 10 December and discount. Received cash for sales made to Hijrah Sdn. Bhd. on December 6, after deducting discount. Sold goods, payment made via American Express credit card for RM2,450. Cost of goods sold is RM980. Sold goods to Cerating Sdn. Bhd. total RM3,480, credit term 2/10, n/30. Cost of goods sold is RM1,400. Purchased goods by cash for RM4,350. Cost of goods sold is RM1,750. Received returns from Cerating Sdn. Bhd. for sales made on 22 December, RM1,480. Cost of goods returned is RM600. Received cash from American Express for sales made on 19 December and the service charges is RM140.

160

TOPIC 5 TRADING BUSINESS ENVIRONMENT

Required: Prepare the journal entries for the transactions above. Solution:
Date Dec 3 Dec 5 Dec 6 Descriptions Inventory Accounts payable – Firdaus SB Inventory Accounts payable – Kenari SB Accounts receivable – Hijrah SB Sales [4,000 - (30% x 4,000)] Cost of goods sold Inventory Office supplies Cash Accounts payable – Kenari SB Inventory Accounts payable – Firdaus SB Inventory Cash [4,000 – (2% x 4,000) + 120] Inventory Cash Accounts payable – Kenari SB Inventory [(8,500 – 1,300) x 1 %] Cash [8,500 – 1,300 – 72] Cash Sales discount Accounts receivable – Hijrah SB Accounts receivable – American Express Sales Cost of goods sold Inventory Accounts receivable – Cerating SB Sales Cost of goods sold Inventory Cash Sales Cost of goods sold Inventory Sales returns and allowances Accounts receivable – Cerating SB Inventory Cost of goods sold Cash Credit card expenses Accounts receivable – American Express Debit (RM) 4,120 8,500 8,500 5,800 5,800 4,000 4,000 150 150 1,300 1,300 4,120 80 4,040 10,500 10,500 7,200 72 7,128 5,684 116 5,800 2,450 2,450 980 980 3,480 3,480 1,400 1,400 4,350 4,350 1,750 1,750 1,480 1,480 600 600 2,310 140 2,450 Credit (RM) 4,120

Dec 8 Dec 10 Dec 13

Dec 14 Dec 15

Dec 16

Dec 19

Dec 22

Dec 24

Dec 25

Dec 31

TOPIC 5 TRADING BUSINESS ENVIRONMENT

161

EXERCISE 5.6
Cempaka Sdn. Bhd. conducts trading activities for the month of May. At the start of the month of May, Cempaka Sdn. Bhd. has a cash total RM5,000 and the capital contributed by Abu Bakar totalled RM5,000. May 1 May 2 May 5 May 9 May 10 May 11 May 12 May 15 Purchased trading goods for RM6,000 from Depot Wholesaler, with terms 2/10, n/30. Sold goods worth RM4,500 to Rahmat, credit terms 2/10, n/30. Cost of goods is RM3,000. Returned goods worth RM200 to Depot wholesaler. Received full payment, after deducting discount, from Rahmat for the sales of RM4,500 made on 2 May. Paid Depot Wholesaler. Purchased supplies from supplier by cash for RM900. Purchased goods by cash for RM2,400. Received refund of RM230 for goods purchased on 12 May from supplier due to the goods being of unsatisfactory quality. Purchased goods from Harrods Sdn. Bhd. for RM1,900, FOB shipping point, with terms 2/10, n/30. Paid carriage of RM250 for purchases made on 17 May. Sold goods by cash for RM6,200. Cost of goods sold is RM4,340. Purchased goods from Horizon Sdn. Bhd. for RM1,000, FOB destination, terms 2/10, n/30. Goods were only received on 28 May. Paid Harrods Sdn. Bhd. for the purchases made on 17 May. Refunded RM100 for damaged goods. The cost of goods returned is RM70. Sold goods of RM1,600 to Rahmat, with term n/30. The cost of goods sold is RM1,120.

May 17 May 19 May 24 May 25

May 27 May 29 May 31 Required: (a) (b) (c)

Prepare the journal entries for the above transactions by using the Perpetual Inventory System. Prepare the ledgers for each of the entries. Prepare the Income Statement for the month ended 31 May 2009.

162

TOPIC 5 TRADING BUSINESS ENVIRONMENT

5.6

FORMAT OF INCOME STATEMENT FOR TRADING FIRMS

Income statements for trading firms contain three items which are not found on income statements of service firms: (a) (c) sales revenue from trading goods; gross profit. (b) cost of goods sold;

Two types of statement normally used are: (a) single level of income statement; and (b) multiple level of income statement.

5.6.1

Single Level of Income Statement

In the Single Level Income Statement, all the expenditures are deducted in only one step as shown in the next page, inclusive of cost of goods sold. In the income section, companies would not report the gross sales, sales returns and allowances and sales discounts individually but will only report overall net sales. Single Level Income Statement emphasises more on the total revenue and total expenditure to determine the net profit. The Single Level Income Statement also does not show directly the information on gross profit and revenue from operations for analysis purposes.

TOPIC 5 TRADING BUSINESS ENVIRONMENT

163

5.6.2

Multiple Levels of Income Statement

Generally, Multiple Level Income Statement comprises several sections and sub-totals of those sections. Multiple Level Income Statement can be prepared according to the Periodic Inventory System and Perpetual Inventory System, as explained in Section 5.3. In the Perpetual Inventory System, the closing balance of cost of goods sold can be obtained directly from the account. This is because sales or sales returns and allowances are recorded at sales and cost price. In comparison, information on cost of goods sold for the Periodic Inventory System can only be obtained through calculation which must be done physically. This had been explained in Section 5.3 (a). Figure 5.7 shows the format for Multiple Level Income Statement using the Periodic Inventory System, while Figure 5.8 illustrates the format for Multiple Level Income Statement using the Perpetual Inventory System.

164

TOPIC 5 TRADING BUSINESS ENVIRONMENT

Angsana Berhad Income Statement for the year 30 June 2007 RM Revenue: Sales (–) Sales returns and allowances Sales discount Net sales Less: Cost of goods sold Opening inventory RM RM XX XX XX (XX) XX XX XX XX XX (XX) XX XX XX XX (XX) XX XX RM

Purchases

*

Purchases returns and allowances Purchases discount Net purchases (+) Carriage inwards Cost of goods purchased Cost of goods ready for sale (–) Closing inventory Cost of goods sold Gross profit Add: Other income Interest revenue Rental revenue Less: Operating expenditures Sales expenses Sales salary expenses Advertisement expenses Sales maintenance expenses Store depreciation expenses Total sale expenses Administrative expenses Administrative salary expenses Equipment depreciation expenses Insurance expenses Rental expenses Total administrative expenses Total sale and administrative expenses Revenue from operating Total administrative expenses Total sales and administrative expenses Revenue from operating Add: Other revenue Interest revenue Rental revenue Less: Other expenditures Interest expenses Net profit

(–)

XX XX XX

XX XX XX XX XX XX XX XX XX (XX) XX XX XX

XX (XX) XX XX

* Cost of goods sold must be calculated according to the calculation explained in Section 5.3.1

Figure 5.7: Multiple level income statement – periodic inventory system
Angsana Berhad

TOPIC 5 TRADING BUSINESS ENVIRONMENT

165

Income Statement for the Year 30 June 2007 RM Revenue: Sales (-) Sales returns and allowances Sales discount Net sales (-) Cost of goods sold Gross profit Add: Other income Interest revenue Rental revenue Less: Operating expenditures Sales expenses Sales salary expenses Advertisement expenses Sales maintenance expenses Store depreciation expenses Total sale expenses Administrative expenses Administrative salary expenses Equipment depreciation expenses Insurance expenses Rental expenses Total administrative expenses Total sale and administrative expenses Revenue from operating Total administrative expenses Total sales and administrative expenses Revenue from operating Add: Other revenue Interest revenue Rental revenue Less: Other expenditures Interest expenses Net profit

RM XX

RM

XX XX

(XX) XX XX XX

XX XX XX XX XX XX XX XX XX XX XX XX (XX) XX XX XX XX (XX) XX XX

* Cost of goods sold can be determined by looking at the closing balance of the cost of goods sold account. Please see Section 7.3 (b) for further information.

Figure 5.8: Multiple level income statement – perpetual inventory system

The major difference between these two formats is the total cost of goods sold (COGS). In the Perpetual Inventory System, the cost of goods sold account was created to record the credit sales or cash sales at cost. It is the same for returns. For credit sales or cash sales, the returns will be recorded at sales price and cost price. Therefore, the closing balance for the cost of goods sold can be determined from the cost of goods sold account balance. As the accounting method for Perpetual Inventory System records the credit sales and cash sales at the sales price and cost price, cost of goods sold closing balance can be determined from the balance of the cost of goods sold account. The accounting method for Periodic Inventory System only records the credit sales and cash sales at sales price, therefore numerical calculation must be done to obtain the cost of goods sold.

166

TOPIC 5 TRADING BUSINESS ENVIRONMENT

EXERCISE 5.7
The Trial Balance for Melati Sdn. Bhd. involved the following accounts for the year ended as at 31 December 2008. Melati Sdn. Bhd. Trial Balance 31 December 2008
Cash Accounts receivable Trading goods inventory Land Building Accumulated depreciation – building Equipment Accumulated depreciation – equipment Notes payable Accounts payable Capital – Aminah Drawings – Aminah Sales Sales discount Cost of goods sold Salary expenses Utility expenses Repair expenses Maintenance expenses Insurance expenses Debit (RM) 23,400 37,600 90,000 92,000 197,000 83,500 42,400 50,000 37,500 267,800 10,000 902,100 4,600 709,900 69,800 19,400 5,900 7,200 3,500 1,353,800 Credit (RM)

54,000

1,353,800

Additional information: 1. Depreciation for building is RM10,000 and equipment RM9,000 (both are administrative expenses). 2. Interest payable RM7,000 and notes payable still outstanding as at 31 December 2008. 3. Salary expenses are 80% for sales and 10% for administration. 4. Utility expenses, repair expenses and insurance expenses are 100% for administration. 5. RM15,000 from the notes payable will mature this year. 6. Maintenance expenses are for sales expenses. Required: (a) Prepare the journal for adjusting entries. (b) Prepare the Income Statement for the year ended 31 December 2008. (c) Prepare the balance sheet as at 31 December 2008. (d) Prepare the closing entries.

TOPIC 5 TRADING BUSINESS ENVIRONMENT

167

5.7

CLOSING ENTRIES

Closing Entries are made at the end of the accounting period of a company. It is the last process in preparation of accounts for the period. For trading firms, the closing entries are made to close all the temporary accounts. The accounts involved are revenue accounts, expenses accounts and drawings account. This is in accordance to the principle of matching and principle of revenue and expenses recognition. By this action, the accounts involved will not be added to the revenue and expenses of other periods. All accounts involved in calculating net profit will be closed to the revenue summary account. Drawings account will be closed and included in the capital account. Accounts for assets and liabilities will be maintained and will not be closed. Assets and liabilities account balances will be carried forward to the next accounting period. The format of closing entries for Periodic Inventory System is shown in Figure 5.9, while the format of closing entries for Perpetual Inventory System is shown in Figure 5.10.
1. Dr Dr 2. Dr Closing accounts with credit balances. Sales Interest revenue Cr Revenue summary Closing accounts with debit balances Revenue summary Cr Sales returns and allowances Cr Sales discount Cr Cost of goods sold Cr Carriage outwards Cr Insurance expenses Cr Salary expenses Cr Other expenses RM XX RM XX XX XX XX XX XX XX RM XX RM XX RM XX RM XX RM XX XX RM XX

3. Dr 4. Dr

Closing revenue summary account – net profit or loss Revenue Summary Cr Capital Closing drawings account to capital account Capital Cr Drawings

Figure 5.9: Closing entries for trading firms using periodic inventory system

168

TOPIC 5 TRADING BUSINESS ENVIRONMENT

1. Dr Dr Dr Dr 2. Dr

Closing accounts with credit balances. Inventory (closing) Sales Interest revenue Purchase returns and allowances Cr Revenue summary Closing accounts with debit balances Revenue summary Cr Inventory (closing) Cr Sales returns and allowances Cr Purchases Cr Sales discount Cr Carriage inwards Cr Carriage outwards Cr Insurance expenses Cr Salary expenses Cr Other expenses Closing revenue summary account Revenue Summary Cr Capital Closing drawings account to capital account Capital Cr Drawings RM XX RM XX RM XX RM XX RM XX RM XX XX XX XX XX XX XX XX XX RM XX XX XX XX RM

XX

3. Dr 4. Dr

Figure 5.10: Closing entries for trading firms using perpetual inventory system

Example: Sejahtera Company has just started its retail business on 1 September 2009. The following are the transactions made by Sejahtera Company Sdn Bhd throughout the month of September 2009: Sept 1 Sept 1 Sept 2 Owner of Sejahtera Company, Farid invested cash of RM50,00 into the business. Purchased and received inventory of RM10,000 bought on credit from Azlan Company with the terms 2/10, n/30, FOB destination. Sold inventory for RM8,000 on credit to Indah Company with terms 2/10, n/30, FOB shipping point. Cost of inventory sold total RM3,200.

TOPIC 5 TRADING BUSINESS ENVIRONMENT

169

Sept 5 Sept 9 Sept 10 Sept 11 Sept 15 Sept 17 Sept 22 Sept 25 Sept 28 Sept 30

Returned RM500 of inventory purchased on 1 September from Azlan Company as the inventory was found to be damaged. Received cash from Indah Company for the sales made on 2 September. Settled all debts to Azlan Company for purchase made on 1 September after deducting returns on 5 September. Purchased inventory totalling RM4,800 by cash. Purchased inventory totalling RM4,000 on credit from Huda Company with terms 1/10, n/30, FOB shipping point. Paid carriage expenses of RM300 for purchases on 15 September. Sold inventory totalling RM12,500 by cash to Cahaya Company. Cost of goods sold totalled RM6,250. Received inventory returned of RM200 from Cahaya Company for sales on 22 September. The cost of the inventory is RM100. Sold inventory for RM3,500 on credit to Umi Company with term n/30. Cost of inventory sold is RM1,500. Paid building rental for the month of September total RM2,000 and salary for the month of September for RM6,000.

Required: (a) Prepare the journal entries for the above transactions, assuming Sejahtera Company adopts the Perpetual Inventory System.

(b) Prepare the Single Level of Income Statement for the month ended 30 September 2009. (c) Prepare the closing entries for Sejahtera Company.

170

TOPIC 5 TRADING BUSINESS ENVIRONMENT

Answer (a)
Date Sept 1 Sept 1 Description Cash Capital, Farid Inventory Accounts payable – Azlan Company Accounts receivable – Indah Company Sales Cost of goods sold Inventory Accounts payable – Azlan Company Inventory Cash Accounts receivable – Indah Company Accounts payable – Azlan Company Cash Inventory (2% x 9,500) Inventory Cash Inventory Accounts payable – Huda Company Inventory Cash Cash Sales Cost of goods sold Inventory Sales returns and allowances Cash Inventory Cost of goods sold Accounts receivable – Umi Company Sales Cost of goods sold Inventory Salary expenses Cash Rental expenses Cash Reference Debit 50,000 10,000 10,000 8,000 8,000 3,200 3,200 500 500 7,840 7,840 9,500 9,310 190 4,800 4,800 4,000 4,000 300 300 12,500 12,500 6,250 6,250 200 200 100 100 3,500 3,500 1,500 1,500 6,000 6,000 2,000 2,000 Credit 50,000

Sept 2

Sept 5 Sept 9

Sept 10

Sept 11 Sept 15

Sept 17 Sept 22

Sept 25

Sept 28

Sept 30 Sept 30

TOPIC 5 TRADING BUSINESS ENVIRONMENT

171

Answer (b)
Sejahtera Company Income Statement for the Month Ended 30 September 2009 RM Revenue: Net sales (8,000-160+12,500-200+3,500) Less: Expenditure Cost of goods sold (3,200+6,250-100+1,500) Salary expenses Rental expenses Total expenditure 10,850 2,000 6,000 (18,850) 4,790 23,640 RM

Net profit

Answer (c)
Date Sep 30 Description Sales (8,000+12,500+3,500) Revenue summary Revenue summary Sales return and allowance Sales discount Cost of goods sold Salary expenses Rental expenses Revenue summary Capital, Farid Reference Debit 24,000 19,210 200 160 10,850 6,000 2,000 4,790 4,790 Credit 24,000

WEBSITE
Visit the following websites to obtain additional information on the topics discussed. http://www.ameritrade.com/educationv2/fhtml/learning/uincomestates.fhtml Description: Information on Income Statement. http://management.about.com/cs/adminaccounting/ht/readincomestmt.htm Description: Guide to understanding Income Statement. http://www.ibm.com/investor/financialguide/ Description: Introduction to identifying Financial Statement.

172

TOPIC 5 TRADING BUSINESS ENVIRONMENT

EXERCISE 5.8
1. Prepare journal entries to record the following transactions for Kelana Sdn. Bhd. by using the Perpetual Accounting System. (a) On 2 March, Kelana Sdn. Bhd. sold RM800,000 goods to Kenari Sdn. Bhd., with credit terms 2/10, n/30. Cost of goods sold is RM600,000.

(b) On 6 March, Kenari Sdn. Bhd. returned RM120,000 of goods sold on 2 March due to damage. Cost of goods returned is RM90,000. (c) On 12 March, Kelana Sdn. Bhd. received payment from Kenari Sdn. Bhd.

2.

Merlimau Sdn. Bhd. has trading account balances as follows: Sales Discount Cost of goods sold Goods inventory RM 180,000 RM 2,000 RM 100,000 RM 40,000

Prepare the closing journal entries by recording the above items in the revenue summary. 3. Information reported by Olen Sdn. Bhd. are as follows: (a) On 5 April, Olen purchased trading goods from Danau Sdn. Bhd. totalling RM16,000, credit terms 2/10, n/30, FOB shipping point.

(b) On 6 April, Olen paid transportation cost of RM900 for goods sold to Danau Sdn. Bhd. (c) (e) On 7 April, Olen purchased equipment for RM26,000. On 15 April, Olen settled the outstanding amount to Danau Sdn. Bhd. (i) Prepare the journal entries to record the transactions for Olen Sdn. Bhd. using the perpetual inventory system. (d) Olen returned damaged goods of RM3,000 to Danau Sdn. Bhd.

(ii) Assume payment was made on 4 May instead of 15 April. Prepare the journal entries to record this payment.

TOPIC 5 TRADING BUSINESS ENVIRONMENT

173

4.

On 1 September, Pertama Sdn. Bhd. had 30 calculators costing RM20 each. The company adopts the perpetual inventory system. The following transactions occurred throughout the month of September. September 6 September 9 September 10 September 12 Purchased 80 calculators at the price of RM19 each from Digital Sdn. Bhd. by cash. Paid transportation RM80. Returned 2 calculators, valued at RM40, as they did not meet specifications. Sold 26 calculators at the price of RM20 per unit, or RM30 per unit if transportation cost is included. A calculator priced at RM30 was returned to the company as the customer had ordered in excess. Sold 30 calculators at a selling price of RM30 each. These calculators cost RM20 each.

September 14 September 20 Required: 5.

Prepare the journal entries for the transactions throughout the month of September.

The following are the transactions for Selasih Sdn. Bhd. December 3 Selasih Sdn. Bhd. sold goods totalling RM480,000 to Desaru Sdn. Bhd., with terms 2/10, n/30, FOB shipping point. Cost of goods sold amounted to RM320,000. Desaru Sdn. Bhd. received allowances worth RM20,000 for the goods purchased on December 3. Selasih Sdn. Bhd. received payment from Desaru Sdn. Bhd.

December 8

December 13 Required: (a) (b)

Prepare the journal entries to record the transactions for Selasih Sdn. Bhd., using the perpetual inventory system. Assume that Selasih Sdn. Bhd. had received the payment from Desaru Sdn. Bhd. on 2 January instead of 13 December. Prepare the journal entries for the payment received on 2 January the following year.

174

TOPIC 5 TRADING BUSINESS ENVIRONMENT

SUMMARY
This topic emphasised on the following: • Income statement for trading and service firms are different due to the different activities involved. There are two types of trading business which are: – – • – – – – – • Retailers Wholesalers Purchased goods for resale. Goods sold are treated as sales revenue, while cost of goods sold relate to the cost of inventories which have been sold. Gross profit can be calculated by deducting cost of goods sold from sales revenue. Net operating revenue can be calculated by deducting operating expenditure from gross profit. Goods unsold by the end of the accounting period will become closing inventory, which will be reported as current asset. Purchases Sales Discounts Returns and allowances Transportation cost Periodic Inventory System Perpetual Inventory System Single level income statement Multiple level income statement

Main characteristics of trading firms are:

Important transactions for trading firms are: – – – – –

Two important methods to record inventory are: – –

There are two types of income statement for trading firms: – –

The closing entries must be made at the end of the accounting period to close all the temporary accounts for trading firms.

TOPIC 5 TRADING BUSINESS ENVIRONMENT

175

Cash discounts Cash sales Credit sales Credit terms Discount

Purchases Quantity discounts Sales Sales Returns and Allowance

Topic

6
1. 2. 3. 4. 5. 6.

Financial Statement Analysis

LEARNING OUTCOMES
By the end of this topic, you should be able to: Explain three techniques that can be used to analyse the financial statement; Discuss the basis of item comparison in financial statement; Differentiate between Horizontal Analysis and Vertical Analysis in evaluating financial statement; Explain the importance of financial ratio in analysing and interpreting the accounting infomation; Calculate and interpret the financial ratio that can be used to measure profitability, liquidity, efficiency and debt management; and Explain the purposes as well as the effectiveness of financial ratios to evaluate the liquidity, profitability and debt management.

 INTRODUCTION
Topic 6 will explain financial statement analysis in more detail. Financial statement analysis provides useful information to internal users for decisionmaking. This topic will discuss financial statement information that will be used to evaluate the performance and financial status of a company. The main reasons for comparison and analysis techniques used are emphasised in this topic. There are three types of analysis techniques: (a) (c) horizontal analysis; ratio analysis. (b) vertical analysis; and

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

177

6.1

PURPOSE OF FINANCIAL STATEMENT ANALYSIS

The main function of financial statement analysis is to help users make better decisions, whether for internal or external users of the company concerned. Internal users of accounting information are individuals involved in the management and operations of the organisations.

They include the management, internal auditors, other employees, consultants and parties involved in decision-making in an organisation. Figure 6.1 shows an illustration of internal users.

Figure 6.1: Internal users of accounting information

Internal users are responsible for planning strategies and executing the company’s operations. The purpose of financial analysis is to provide them with information in order to improve the efficiency and effectiveness in producing output or services of the organisation.

External users of accounting information are not directly involved in the operation of the organisation.

They comprise shareholders, creditors, non-executive directors, customers, suppliers, legislators, lawyers, brokers, media and others. Figure 6.2 illustrates a summary of external users.

178

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

Figure 6.2: External users of accounting information

External users utilise accounting information to determine the financial status of the company for their own purposes. Shareholders and creditors will evaluate the investment and financing prospects of the company. Members of the board of directors will analyse the financial statement for the purpose of monitoring the effectiveness of decisions which have been made. Suppliers will use the financial information to evaluate the credit standing of the organisations. Generally, financial statement analysis is done to: (a) make the information more meaningful to enable users to make decisions; and

(b) assist users to measure the performance level and financial status of the business.

SELF-CHECK 6.1
Do internal users need to obtain prior approval from external users before implementing specific financial decisions? Why?

6.2

SOURCES OF INFORMATION

Financial statement analysis requires information for analysis. Financial statement analysis can be done using the annual report of organisations. The annual report contains information in the form of: (a) (c) (e) Income Statement; Cash Flow Statement; Notes to the financial statement; (b) Balance Sheet; (d) Statement of Changes in Equity;

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

179

(f)

Summary of accounting methods used;

(g) Management’s discussion and analysis of operating revenue; (h) Auditors’ report; and (i) Financial data comparison for several years.

6.3
• • • (a)

BASIS OF COMPARISON

Financial information can be compared using three bases: within the company (intra-company); between companies (inter-company); and industry average. Within the Company Using this basis, the company will compare the items in its financial statements relating to two different years, or more. The comparison of current year’s financial statement with previous years will show the trend of the company that can be used for future prediction. For example, the comparison of cash item for the current year with previous years will show its increase or decrease within the company.

(b) Between Companies Using this basis of comparison, the items in the financial statement of one particular company are compared with those of other companies, all of which are operating the same type of business. The comparisons are made based on the financial statement published by the companies. Comparisons between companies provide useful information on the specific company’s status as compared to its competitors. (c) Industry Average This basis of comparison compares items in the financial statement of the specific company with other companies in the related industry in general. Comparison made between the company and industry average will provide information on the company’s performance within the industry.

ACTIVITY 6.1
How can the basis between comparison for financial information be useful for a printing company that has operated for the past 40 years? Discuss.

180

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

EXERCISE 6.1
State the differences between the following basis of comparison: (a) (c) Within company; Industry average. (b) Between companies; and

6.4

TECHNIQUES OF ANALYSIS

Three techniques may be used in evaluating financial statement data: Horizontal Analysis, Vertical Analysis and Ratio Analysis. Horizontal analysis is especially used for comparison within the company. Vertical analysis can be used either for comparison within the company or between companies, while ratio analysis can be used for all the three bases of comparison, which are within company, between companies and industry average. Figure 6.3 summarises the analysis techniques mentioned.

Figure 6.3: Techniques of Analysis

SELF-CHECK 6.2
Explain the three techniques of analysis in evaluating financial statement data.

ACTIVITY 6.2
Which analysis technique is suitable for a business selling sports cars?

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

181

6.5

HORIZONTAL ANALYSIS

Horizontal analysis is a technique used to assess the trend of the items in the financial statement (increasing or decreasing) in terms of amount or percentage of fluctuation.

There are two characteristics of horizontal analysis. First, the comparison is made on every item in the financial statement for at least two accounting period or years. The basis of comparison for these two years (the current year and the previous year) will be set by using the financial statement of the previous year as the base to determine an increase or decrease. Second, the comparison for sequential financial data is normally for 5 to 10 years or more. This comparison is also known as trend analysis. Horizontal analysis is classified into: (a) (b) Period of at least 2 years; and Period of more than 2 years – also known as trend analysis.

6.5.1

Comparison of Horizontal Analysis for 2 Years

The calculation for percentage of increase or decrease in horizontal analysis for a period of 2 years is made using the following steps: (a) First, calculate the amount of change for the base year (previous year) and the following year (current year), for every item in the financial statement.

(b) Second, divide the amount of change, as calculated above, with the amount in the base year for every item in the financial statement, to obtain the percentage of change.
Change in Ringgit Percentage of change = = Current year amount - Base year amount Current year amount - Base year amount ––––––––––––––––––––––––––––––––––––  100 Base year amount

182

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

Percentage of change for the Cash item in the Balance Sheet (Refer Table 6.2)
Current year amount - Base year amount  100 ––––––––––––––––––––––––––––––––––––––––– Base year amount RM90,500 - RM64,700 –––––––––––––––––––––  100 RM64,700 39.9%

Percentage of change

=

Percentage of change

= =

The calculation above must be repeated for each item in the balance sheet, income statement and retained earnings statement. The next examples are on marketable securities and non-current liability as shown in Table 6.1:
Table 6.1: Percentage change for Marketable Securities and non-current Liability Item 2009 Marketable Securities 75,000 Year 2008 60,000 Increase (Decrease) Amount (RM) 75,000 – 60,000 = 15,000 Percentage (%) 15,000 –––––––  100 60,000 = 25 (100,000) ––––––––  100 200,000 = (50)

Non-current Liability

100,000

200,000

100,000 – 200,000 = (100,000)

First step calculation Second step calculation

Table 6.2 shows the horizontal analysis for the entire Balance Sheet based on the format set by the Malaysian Accounting Standards Board in MASB 1, which is ‘Presentation of Financial Statements’ and in MASB 3 titled ‘Net Profit or Loss for the Period, Fundamental Errors and Changes in Accounting Policies’.

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

183

Table 6.2: Anggerik Sdn. Bhd.: Comparison Balance Sheet Anggerik Sdn. Bhd. Comparison Balance Sheet as at 31 December 2006 and 2007 Increase (Decrease) 2007 (RM) Non-current Assets: Long-term investment Building and Equipment (net) Intangible assets Total non-current assets Current Assets: Cash Marketable securities Accounts receivable Inventory Expenses pre-payment Total current assets Current liability: Accounts payable Total net current assets Financed by owner and long-term liability: Owner’s equity: 6% Preference shares, RM100 Ordinary shares, RM10 Retained earnings Non-current liability Total owner’s equity and long-term liability 150,000 500,000 179,500 100,000 929,500 150,000 500,000 137,500 200,000 987,500 – – 42,000 (100,000) (58,000) – – 30.5 (50.0) 5.9 210,000 340,000 929,500 243,000 290,000 987,500 (33,000) 50,000 (58,000) 5.9 (13.6) 17.2 90,500 75,000 115,000 264,000 5,500 550,000 64,700 60,000 120,000 283,000 5,300 533,000 25,800 15,000 (5,000) (19,000) 200 17,000 39.9 25.0 (4.2) (6.7) 3.8 3.2 95,000 444,500 50,000 589,500 177,500 470,000 50,000 697,500 (82,500) (25,500) – (108,000) (46.5) (5.4) – (15.5) 2006 (RM) Amount (RM) Percentage (%)

184

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

Table 6.3 shows the horizontal analysis for Income Statement.
Table 6.3: Anggerik Sdn. Bhd.: Comparison Income Statement Anggerik Sdn. Bhd. Comparative Income Statement for the Year Ended 31 December, 2007 and 2006 Increase (Decrease) 2007 2006 Amount Percentage (RM) (RM) (RM) (%) Sales 1,530,500 1,530,500 296,500 24 (–) Sales return and allowance 32,500 34,000 (1,500) (4.4) Net sales 1,498,000 1,200,000 298,000 24.8 (–) Cost of goods sold 1,043,000 820,000 223,000 27.2 Gross profit 455,000 380,000 75,000 19.7 (–) Sales expenses 191,000 147,000 44,000 29.9 (–) Adminis-trative expenses 104,000 97,400 6,600 6.8 Net operating revenue 160,000 135,600 24,400 18.0 (+) Other revenue or profit 8,500 11,000 (2,500) (22.7) (–) Other expenses and loss 6,000 12,000 (6,000) (50.0) Profit before tax 162,500 134,600 27,900 20.7 Taxation 71,500 58,100 13,400 23.1 Profit after tax 91,000 76,500 14,500 19.0

Horizontal analysis for Retained Earnings Statement is shown in Table 6.4.
Table 6.4: Anggerik Sdn. Bhd.: Comparative Retained Earnings Statement Anggerik Sdn. Bhd. Comparative Retained Earnings Statement as at 31 December, 2007 and 2006 Increase (Decrease) 2007 2006 Amount Percentage (RM) (RM) (RM) (%) Retained earnings, 1 Jan 137,500 100,000 37,500 37.5 Current year profit 91,000 76,500 14,500 19.0 228,500 176,500 52,000 29.5 (–) Dividend Preference shares 9,000 9,000 – – Ordinary shares 40,000 30,000 10,000 33.3 49,000 39,000 10,000 25.6 Retained earnings, 31 December 179,500 137,500 42,000 30.5

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

185

6.5.2

Comparison of Horizontal Analysis for a Sequential Period (Trend Analysis)

Horizontal Analysis for a sequential period or Trend Analysis is a technique to evaluate the financial data for specific periods.

Trend analysis is a horizontal analysis involving the income statement and balance sheet for three years or more. In trend analysis, the item from the first statement or initial period will be used as the base for comparison. Example: Information obtained from Balance Sheet of Angsana Sdn. Bhd., the Net Sales item for 2003-2007, is shown in Table 6.5.
Table 6.5: Angsana Sdn. Bhd. – Net Sales Data for a Period of 5 Years Angsana Sdn. Bhd. Net sales 2007 (RM) 41,296 2006 (RM) 38,064 2005 (RM) 34,835 2004 (RM) 33,110 2003 (RM) 30,518

By using 2003 as the base year for comparison, calculation of increase or decrease of the financial data for the following years can be done.
Amount for a specific year – Base year amount Change from base year = ––––––––––––––––––––––––––––––––––––––––––  100 Base year amount

Example: Increase in net sales for year 2004: RM33,110 – RM30,518 = ––––––––––––––––––––  100 RM30,518 = 8.5%

186

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

Therefore, net sales have increased by 8.5% in 2004 from the base year of 2003. By using the sales figure for 2003 – 2007, a sequential period analysis can be obtained (refer Table 6.6).
Table 6.6: Angsana Sdn. Bhd. – Net Sales Data for a Period of 5 Years Angsana Sdn Bhd 2007 2006 2005 (RM) (RM) (RM) 41,296 38,064 34,835 135% 125% 114% 2004 (RM) 33,110 108% 2003 (RM) 30,518 100%

Net sales

6.6

VERTICAL ANALYSIS

Vertical Analysis is a technique to evaluate items in the financial statement by stating each of the items in the form of percentage as compared to the base amount.

Vertical analysis shows the relationship of every item in the financial statement with one item which is being used as the base. The base item for balance sheet is Total Asset, and base item for Income Statement is Net Sales.

6.6.1

Vertical Analysis for Balance Sheet

To perform the vertical analysis, items found in the financial statement as stated in MASB 1 must be presented according to the format shown in Table 1. This is to facilitate the calculation of the percentages in the vertical analysis. The vertical analysis can be performed more easily if (Total Asset) and (Total Liability and Owner Equity) is shown in the analysis. The basis of comparison in vertical analysis is based on (Total Asset) or (Total Liability and Owner Equity). This can be illustrated based on the accounting equation: Asset = Liability + Owner’s equity

Table 6.7 shows examples of the calculation for Cash and Accounts payable items for 2007 and 2006.

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

187

Table 6.7: Percentage Calculation Examples of Vertical Analysis for Balance Sheet 2007 Cash Percentage:
Cash ––––––––––––  100 Total assets RM90,500 = ––––––––––––  100 RM1,139,500 = 7.9% RM64,700 = ––––––––––––  100 RM1,230,500 = 5.3%

2006

AP Percentage:
Total Liability –––––––––––––––––––––––––––––  100 Total Liability and Owner Equity RM210,000 = ––––––––––––  100 RM1,139,500 = 18.4% RM243,000 = ––––––––––––  100 RM1,230,500 = 19.7%

The vertical analysis for the entire Balance Sheet of Anggerik Sdn. Bhd. as at 31 December 2007 and 2006 is shown in Table 6.8.
Table 6.8: Anggerik Sdn. Bhd.: Comparative Balance Sheet
Anggerik Sdn. Bhd. Comparative Balance Sheet as at 31 December 2007 and 2006 2007 Total Percentage (RM) (%) Current Assets: Cash Marketable Securities Accounts receivable Inventory Expenses Prepayment Total Current Assets Non-current Assets: Long-term Investment Building and Equipment (Net) Intangible Asset Total Non-current Assets Total Assets Current Liability: Accounts payable Non-current Liability Total Liabilities Owner’s Equity: 6% Preference Shares, RM100 Ordinary Shares, RM10 Retained Earnings Total Owner’s Equity Total Liabilities and Owner’s Equity 90,500 75,000 115,000 264,000 5,500 550,000 95,000 444,500 50,000 589,500 1,139,500 210,000 100,000 310,000 150,000 500,000 179,500 829,500 1,139,500 7.9 6.6 10.1 23.2 0.48 48.3 8.3 39.0 4.4 51.7 100 18.4 8.8 27.2 13.2 43.9 15.8 72.8 100

Total (RM) 64,700 60,000 120,000 283,000 5,300 533,000 177,500 470,000 50,000 697,500 1,230,500 243,000 200,000 443,000 150,000 500,000 137,500 787,500 1,230,500

2006 Percentage (%) 5.3 4.9 9.8 23.0 0.4 43.3 14.4 38.2 4.1 56.7 100 19.7 16.3 36.0 12.2 40.6 11.2 64.0 100

188

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

The analysis can also be done by comparing the percentage of an item for one year with its percentage for another year. For example, in 2006, total liabilities form 36% of the total liabilities and owner’s equity. The corresponding figure for 2007 is only 27.2%, implying that the usage of debts in year 2007 had decreased as compared to 2006. The same approach can be used to analyse the other items.

6.6.2

Vertical Analysis for Income Statement

In vertical analysis for income statement, the item used as the base for comparison is Net Sales.
Table 6.9: Percentage Calculation Example of Vertical Analysis for Income Statement 2007 Sales percentage:
Sales ––––––––––  100 Net assets RM1,530,500 = ––––––––––––  100 RM1,498,000 = 102.2% RM1,234,000 = ––––––––––––  100 RM1,200,000 = 102.8%

2006

Administrative expenses percentage:
Administrative expenses –––––––––––––––––––––––  100 Net sales

RM104,000 = ––––––––––––  100 RM1,498,000 = 6.9%

RM97,400 = ––––––––––––  100 RM1,200,000 = 8.1%

The calculation results of vertical analysis for the entire Income Statement are shown in Table 6.10.

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

189

Table 6.10: Anggerik Sdn. Bhd.: Comparative Income Statement

Anggerik Sdn. Bhd. Comparative Income Statement for 31 December 2007 and 2006
2007 Total Percentage (RM) (%) 1,530,500 102.2 32,500 2.2 1,498,000 100.0 1,043,000 69.6 455,000 30.4 191,000 12.8 104,000 6.9 160,000 10.7 8,500 0.6 6,000 0.4 162,500 10.9 71,500 4.8 91,000 6.1 2006 Total Percentage (RM) (%) 1,234,000 102.8 34,000 2.8 1,200,000 100.0 820,000 68.3 380,000 31.7 147,000 12.3 97,400 8.1 135,600 11.3 11,000 0.9 12,000 1.0 134,600 11.2 58,100 4.8 76,500 6.4

Sales (–) Sales return and allowance Net sales (–) Cost of goods sold Gross profit (–) Sales expenses (–) Administrative expenses Total operating revenue (+) Other revenue or profit (–) Other expenses or loss Profit before tax Taxation Profit after tax

As explained in section 6.6.1 regarding the Balance Sheet, analysis can be done by comparing the percentage of an item for one year with its percentage for another year. For example, in 2006, profit after tax (as percentage of net sales) is 6.4%. The corresponding figure in 2007 is only 6.1%. It is possible to identify the reason for the decrease by making the same comparison for the other items. For example, in 2006, cost of goods sold (as percentage of net sales) is 68.3%. The corresponding figure in year 2007 had increased to 69.6%. This increase might be the reason for the decrease in the percentage of profit after tax. After studying the methods for analysing financial statement, complete the following exercise to test your understanding.

190

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

EXERCISE 6.2
1. The two methods of analysing financial statement are Horizontal Analysis and Vertical Analysis. Describe the differences between these two methods. Horizontal Analysis Vertical Analysis

2.

The data shown below are extracted from the Comparative Balance Sheet of Bidara Sdn. Bhd. for the year ended 31 December 2006 and 2007. 31 December 2006
Accounts receivable Inventory Total current assets 500,000 840,000 3,220,000

31 December 2007
400,000 600,000 2,800,000

Prepare the horizontal and vertical analysis by using the above data.

6.7

FINANCIAL RATIO ANALYSIS

We will now go on to discuss financial ratio analysis. The classifications of financial ratios are shown in Figure 6.4 below:

Figure 6.4: Classifications of financial ratios

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

191

(a)

Liquidity Liquidity ratio measures the business’s short term capability to discharge its obligations or debts upon maturity and to fulfil unforeseen cash requirements. This ratio is often used by short-term creditors.

(b) Efficiency Efficiency ratio is for the purpose of measuring the level of efficiency and capability of the management to operate its business, especially in the usage of assets to generate sales. (c) Profitability Profitability ratio measures the ability of the business to generate profit within a specific period. It is used as an indicator to analyse the efficiency and effectiveness level of the business in achieving its profit objective.

(d) Debt Management This ratio measures the ability of the business to continue its operation. The ratios that can be classified under debt management ratios are interest coverage ratio, debt ratio, equity ratio and debt to equity ratio.

ACTIVITY 6.4
How are financial ratios important to service firms? Give an example of service firm.

6.8

LIQUIDITY RATIO

Liquidity ratio measures the business’s capability to discharge its short-term financial obligation. However, long-term creditors also place importance on the evaluation of the company’s liquidity. This liquidity can be used by the company to determine its debt repayment capability in the short-term. Ratios that can be classified as liquidity ratios are: (a) (c) Working capital; Quick ratio. (b) Current ratio; and

Table 6.11 explains each of the liquidity ratios.

192

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

EXERCISE 6.3
1. 2. Explain the meaning of current ratio and quick ratio, including the formulae for both. The following is part of the data extracted from the Balance Sheet of Kenari Sdn. Bhd. Kenari Sdn. Bhd. Balance Sheet extract as at 31 December 2006 CURRENT ASSETS Cash Marketable securities Accounts receivable Inventory Expenses prepayment TOTAL CURRENT ASSETS CURRENT LIABILITY: Total current liability RM 8,241,000 1,947,000 12,545,000 14,814,000 5,371,000 42,918,000 45,844,000

Calculate the: (a) (c) Working Capital Quick Ratio (b) Current Ratio

Table 6.11: Classification of Liquidity Ratio

TOPIC 6 FINANCIAL STATEMENT ANALYSIS 

193

194

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

6.9

EFFICIENCY RATIO

Efficiency ratio measures the level of efficiency and capability of the management to operate its business, especially in the usage of assets to generate sales. Ratios that can be classified as efficiency ratios are shown in Table 6.12.

6.10

PROFITABILITY RATIO

Profitability ratio measures the ability of the business to generate profit within a specified period. It is used as an indicator to analyse the efficiency and effectiveness level of the business in achieving its profit objective. This ratio is a favourite among creditors, investors and owners. The ratios that can be classified as profitability ratio as well as their purposes and descriptions are explained in Table 6.13.

6.11

DEBT MANAGEMENT RATIO

Finally, the debt management ratio measures the ability of the business to continue its operation. The ratios that can be classified as debt management ratio are: (a) (c) interest coverage ratio; equity ratio; and (b) debt ratio; (d) debt to equity ratio. The purposes and summary to calculate the debt management ratio are shown in Table 6.14.

ACTIVITY 6.5
Suppose you run a business selling computers. How can the debt management ratios be able to help you in developing your business?

Table 6.12: Classification of Efficiency Ratio

TOPIC 6 FINANCIAL STATEMENT ANALYSIS 

195

196

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

Table 6.12: Classification of Profitability Ratio (Continuation)

Table 6.13: Classification of Profitability Ratio

TOPIC 6 FINANCIAL STATEMENT ANALYSIS 

197

198

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

Table 6.13: Classification of Profitability Ratio (Continuation)

Table 6.14: Classification of Debt Management Ratio

TOPIC 6 FINANCIAL STATEMENT ANALYSIS 

199

200

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

Before proceeding, answer the following exercise to test your understanding of financial ratios.

EXERCISE 6.4
The following Keris Sdn. Bhd. are data extracted from Income Statement of

Net sales Opening inventory Purchases Closing inventory

2006 (RM) 6,420,000 980,000 4,440,000 1,020,000

2005 (RM) 6,420,000 860,000 4,661,000 980,000

By using the information above, calculate the: (a) Inventory turnover ratio for year 2006. (b) Asset turnover for year 2006.

6.12

SAMPLE OF RATIO CALCULATIONS

The following is the Financial Statement for Kenanga Sdn. Bhd. This company operates a plastics-related business. The information on industry averages is also enclosed.
Kenanga Sdn. Bhd. Comparative Income Statement with Industry Average for the Year Ended 31 December 2007 Kenanga Sdn. Bhd. (RM) 600,000 384,000 216,000 194,000 22,000 (4,000) 28,000 (5,000) 13,000 Industry Average (%) 100 74.2 25.8 22.5 3.3 0.2 3.1 0.7 2.3

Net sales * (Cash sales RM330,000) Cost of goods sold Gross profit Sales and administrative expenses Operating profit Other expenses (Interest expenses RM3,000) Profit before tax Income tax expenses Net profit

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

201

Kenanga Sdn. Bhd. Comparative Balance Sheet as at 31 December 2006 and 2007 2007 (RM) Current assets: Cash Marketable securities Accounts receivable (net) Inventory Expenses pre-payment Total current asset Non-current asset Total asset Liabilities and owner equity: Current liability Non-current liability Owner’s equity Total liabilities and owner’s equity 15,000 10,000 35,000 55,000 5,000 120,000 80,000 200,000 60,000 15,000 125,000 200,000 2006 (RM) 10,000 15,000 25,000 40,000 5,000 95,000 45,000 140,000 50,000 10,000 80,000 140,000

The average ratios for the plastics industry are as follows:
Ratio Current ratio Quick ratio Accounts receivable turnover Average collection period Inventory turnover Asset turnover Gross profit margin Net profit margin Return on asset Return on owner equity’s ordinary shares Interest coverage ratio Debt ratio Debt to equity ratio Industry Average 1.8 : 1.0 1.1 : 1.0 9.5 times 38 days 4.8 times 2.3 times 25.8% 3.1% 4.0% 11.4% 2.8 times 44.1% 120.2

Required: (a) Prepare the vertical analysis for Kenanga Sdn. Bhd’s Income Statement. Compare it with the industry average and explain briefly the result of the analysis.

202

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

(b) Calculate the following financial ratios and compare it with industry average for 2007 for Kenanga Sdn. Bhd. Explain your analysis results. (i) Current ratio (ii) Quick ratio (iii) Accounts receivable turnover (iv) Average collection period (v) Inventory turnover (vi) Asset turnover (vii) Gross profit margin (viii) Net profit margin (ix) Return on asset (x) Return on owner equity’s ordinary shares (xi) Interest coverage ratio (xii) Debt ratio (xiii) Debt equity ratio Solution: (a) Vertical Analysis
Kenanga Sdn. Bhd. Comparative Income Statement with Industry Average for the Year Ended 31 December 2007 Kenanga Sdn. Bhd. (RM) Net sales * (Cash sales RM330,000) Cost of goods sold Gross profit Sales and administrative expenses Profit from operating Other expenses (Interest expenses RM3,000) Profit before tax Income tax expenses Net profit 600,000 384,000 216,000 194,000 22,000 (4,000) 18,000 (5,000) 13,000 Kenanga Sdn. Bhd. RM’000 600/600 384/600 216/600 194/600 22/600 4/600 18/600 5/600 13/600 % 100 64 36 32.3 3.7 0.7 3.0 0.8 2.2 Industry Average (%) 100 74.2 25.8 22.5 3.3 0.2 3.1 0.7 2.3

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

203

(b) Ratio Analysis
No (i) Ratio Current ratio Kenanga Sdn. Bhd. Industry Average 1.8 : 1.0

Current asset –––––––––––––– Current liability 120,000 = ––––––– 60,000 = 2.0 : 1.0 Quick asset –––––––––––––– Current liability 15,000 + 10,000 + 35,000 = ––––––––––––––––––––– 60,000 = 1.0 : 1.0
Analysis result: Quick ratio of the company is just enough to pay the short-term debts quickly. This quick ratio is less by 0.1 from the industry average

(ii)

Quick ratio

1.1 : 1.0

(iii)

Accounts receivable turnover

Net credit sales ––––––––––––––– Average Net AR 600,000 – 330,000 = ––––––––––––––––––––– (25,000 + 35,000)/2 = 9.0 times
Analysis result: The AR turnover for year 2001 is 9 times. This shows that the business is able to collect its debts quickly. The industry average is 0.5 times more than the company.

9.5 times

(iv)

Average collection period

365 days –––––––––––––– *AR turnover 365 = ––––––– 9 = 41 days
Analysis result: The company is able to collect debts within 41 days. The efficiency of the company in debt collection is late by 3 days compared to industry average of 38 days.

38 days

* AR = Account Receivable

204

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

No (v)

Ratio Inventory turnover

Kenanga Sdn. Bhd.

Cost of goods sold ––––––––––––––––––––– Average inventory 384,000 = ––––––––––––––––– (40,000 + 55,000)/2 = 8.1 times
Analysis result: The higher the inventory turnover the better. This shows the business is good in selling its inventory and reduces the chances of obsolete inventory. The company’s inventory turnover of 8.1 times is twice as fast as the industry average of 4.8 times.

Industry Average 4.8 times

(vi)

Asset turnover

Net sales ––––––––––––––––– Average total asset RM600,000 = ––––––––––––––––––––––––– (RM140,000 + RM200,000)/2 = 3.5 times
Analysis result: The higher the ratio, the better. Asset turnover for the company is better compared to industry average of 2.3 times.

2.3 times

(vii)

Gross profit margin

Gross profit –––––––––––– Net sales RM216,000 = –––––––––– RM600,000 = 36%
Analysis result: The higher the gross profit margin the better. This indicates good purchasing management and lower purchasing cost. The gross profit margin of this company is better compared to industry average. This shows the purchasing management and cost of the company is 10.2% better than industry average.

25.8%

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

205

No (viii)

Ratio Net profit margin

Kenanga Sdn. Bhd.

Industry Average

Net profit –––––––––––– Net sales RM13,000 = –––––––––– RM600,000 = 2.2%
Analysis result: The lower the sales price, the higher the sales revenue generated is being used for other activities. The higher the ratio, the better as it shows lower expenditure or cost needed to generate sales. The percentage of net profit margin for the company is less than the industry average.

3.1%

(ix)

Return on asset

Net profit ––––––––––––––––– Average total asset RM13,000 = ––––––––––––––––––––––––– (RM140,000 + RM200,000)/2 = 7.6%
Analysis result: This shows that profit return is 7.6% as relates to management efficiency in using the asset regardless of resources to finance the asset. Return on the company’s asset is much better compared to the industry average that only contributes 4.0%.

4.0%

(x)

Return on owner equity’s ordinary shares

Net profit – Dividend for preference shares –––––––––––––––––––––––––––––––––––––– Average owner’s equity RM13,000 – 0 = ––––––––––––––––––––––––– (RM80,000 + RM125,000)/2 = 12.68%
Analysis result: The higher the ratio the better as it shows the business is capable of generating higher profit for the shareholders. The company is able to give 12.68% profit to the ordinary shareholders. The return for the company’s ordinary shareholders is 1.28% higher than industry average, only a slight difference as compared to the industry average.

11.4%

206

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

No (xi)

Ratio Interest coverage ratio

Kenanga Sdn. Bhd.

Industry Average 2.8 times

Net profit – Taxation + Interest expenses –––––––––––––––––––––––––––––––––––––– Interest expenses RM13,000 + RM5,000 + RM3,000 = ––––––––––––––––––––––––––––– RM3,000 = 7 times
Analysis result: The higher the ratio, the better as it shows the business is capable to pay the interest expenses. This shows the company is able to obtain adequate funds to pay interest upon the maturity date. The company is able to use net profit after tax to pay the interest expenses 7 times. The interest coverage ratio is much better compared to industry average that is only able to use 2.8 times from the profit after tax to pay interest.

(xii)

Debt ratio

Total liability –––––––––––– Total asset RM75,000 = –––––––––– RM200,000 = 37.5%
Analysis result: To measure the percentage of total assets financed by creditors. This shows that 37.5% from the company’s asset are financed by creditors. The total percentage debt ratio of company is lower compared to industry average. This shows the company’s asset management is better at 37.5% compared to 44.1% for industry average.

44.1%

(xiii)

Debt to equity ratio

Total liability ––––––––––––––––––– Total owner’s equity RM75,000 = –––––––––– RM125,000 = 60.0%
Analysis result: To measure the percentage of liability covered by owner equity. The lower the ratio, the better as it shows the company is able to increase liability whenever needed. The company’s debt equity ratio is much better compared to the industry average.

120.2%

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

207

Test your understanding by answering the following questions.

EXERCISE 6.5
The following shows the Comparative Balance Sheet for Delima Sdn. Bhd. Delima Sdn. Bhd. Comparison Balance Sheet as at 31 December, 2008 and 2007
2008 (RM) Cash Accounts receivable Inventory Equipment (net) Accounts payable Mortgage (15%) Ordinary shares @ RM10 Retained earnings 20,000 65,000 60,000 200,000 345,000 50,000 100,000 140,000 55,000 345,000 2007 (RM) 30,000 60,000 50,000 180,000 320,000 60,000 100,000 120,000 40,000 320,000

Additional information for the year 2008: 1. 2. 3. The sales account total is RM420,000. Sales return and allowance totalled RM20,000. Cost of goods sold is RM198,000. Net income from operating activities totalled RM44,000.

Required: Calculate the ratios listed below for 2008. (a) (c) (e) current ratio; accounts receivable turnover; return on sales. (b) quick ratio; (d) inventory turnover; and

208

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

Table 6.15: Summary of Financial Ratios

Table 6.15: Summary of Financial Ratios (Continuation)

TOPIC 6 FINANCIAL STATEMENT ANALYSIS 

209

210

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

Table 6.15: Summary of Financial Ratios (Continuation)

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

211

EXERCISE 6.6
1. The financial information for Desa Sdn. Bhd. is shown below:
31 December 2005 125,000 400,000 91,000 144,000 155,000 135,000 31 December 2004 100,000 330,000 70,000 95,000 115,000 150,000

Current asset Equipment (net) Current liability Long-term liability Ordinary shares @ RM1 Retained earnings

Required: Prepare the Horizontal Analysis for year 2005 by using year 2004 as the base year. 2. The following is the comparative financial information for Sentosa Sdn. Bhd. The Balance Sheets are dated 31 December 2007 and 2006.
2007 (RM) 800,000 480,000 7,000 64,000 120,000 85,000 600,000 450,000 2006 (RM) 720,000 40,000 5,000 42,000 100,000 75,000 500,000 310,000

Net Sales Cost of sales Interest expenses Net revenue Account receivables Inventory Total asset Total owner equity

Required: Calculate the following ratios for year 2007. (a) (b) (c) (d) profit margin; asset turnover; return on asset; and return on owner equity.

212

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

3.

The information given relate to the Comparative Income Statement and Balance Sheet for Teguh Sdn. Bhd.
Teguh Sdn. Bhd. Comparative Balance Sheet as at 31 December 2001, 2000 and 1999 2001 (RM) 2000 (RM) 1999 (RM) 25,000 20,000 18,000 50,000 45,000 48,000 90,000 85,000 64,000 75,000 70,000 45,000 400,000 370,000 358,000 640,000 590,000 533,000 Current liability 75,000 80,000 70,000 Long-term liability 80,000 85,000 50,000 Ordinary share @ RM10 340,000 300,000 300,000 Retained earnings 145,000 125,000 113,000 640,000 590,000 533,000 Teguh Sdn. Bhd. Comparative Income Statement for the year ended 31 December 2001 2001 (RM) 2000 (RM) Sales 740,000 700,000 Less: Sales return allowance 40,000 50,000 Net sales 700,000 650,000 Cost of goods sold 420,000 400,000 Gross profit 280,000 250,000 Operating expenses 230,000 215,000 Net Revenue 50,000 35,000 Cash Accounts receivable (net) Expenses prepayment Investment Equipment (net)

Additional Information:

1. 2. 3.

The market values of ordinary shares for Teguh Sdn. Bhd. are RM4 for year 1999, RM5 for year 2000 and RM7.95 for year 2001. All dividends were paid by cash. At 1 July 2001, 4,000 units of new ordinary shares were issued.

Required:

Calculate the following ratios for 2001 and 2000. (a) profit margin; (b) asset turnover; (c) earnings per share; (d) price earnings ratio; (e) dividend payout ratio; and (f) debt ratio.

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

213

4.

The following are Comparative Income Statement and Balance Sheet of Teratai Sdn. Bhd.
Teratai Sdn. Bhd. Income Statement for the Year Ended 31 December 2006 Sales Less: Cost of goods sold Gross profit Sales and administrative expenses Interest expenses Taxation Les: Total expenses Net Revenue 2006 (RM) 650,000 415,000 235,000 150,000 7,200 18,000 175,200 59,800 2005 (RM) 520,000 354,000 166,000 114,800 6,000 14,000 134,800 31,200

Teratai Sdn. Bhd. Comparative Balance Sheet as at 31 December 2006 2006 (RM) ASSET Current asset: Cash Marketable securities Accounts receivable (net) Inventory Total current asset Equipment (Net) Total asset LIABILITIES AND OWNERS EQUITY Current liabilities: Accounts payable Tax payable Total current liabilities Long-term liability: Bond payable Total liabilities Owner’s equity: Ordinary share@RM5 Retained earnings Total owner’s equity Total liabilities and owners equity 2005 (RM)

41,000 18,000 92,000 84,000 235,000 403,000 638,000 112,000 23,000 135,000 130,000 265,000 150,000 223,000 373,000 638,000

18,000 15,000 74,000 70,000 177,000 383,000 560,000 110,000 20,000 130,000 80,000 210,000 150,000 200,000 350,000 560,000

214

TOPIC 6 FINANCIAL STATEMENT ANALYSIS

Additional information: 1. Ordinary shares are sold at RM19.50 per share. Required: Calculate the following ratios for the year 2006: (a) (c) (e) (f) current ratio; accounts receivable turnover; gross profit margin; asset turnover; (h) return on owner’s equity; (i) (j) (l) earnings per share; price earnings ratio; debt to equity ratio; and (b) quick ratio; (d) inventory turnover;

(k) dividend payout ratio; (m) interest coverage ratio.

(g) return on asset;

SUMMARY
This topic covered several important areas: • • Financial statement analysis is prepared for the purpose of helping internal and external users make better decisions. Financial information can be compared by using three basis of comparison. – Within the company (intra-company) – Between companies – Industry average Three analysis techniques normally used to evaluate financial statement data are: – Horizontal analysis – Vertical analysis – Financial ratio analysi

Debt Management Ratio Efficiency Ratio External Users Financial Statement Financial Statement Analysis Horizontal Analysis

Internal Users Liquidity Ratio Profitability Ratio Ratio Analysis Trend Analysis Vertical Analysis

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 company’s 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 company’s 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 company’s 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 entity’s 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, evaluating and controlling the operations of the entity. Reports may be

216

ANSWERS

issued at any time according to requirement and are not subject to any standards and formats. Through this report, the users are able to take the necessary measures required for improvement in order to ensure that the company achieves its objectives.

Exercise 1.2
1. The characteristics of accounting information can be divided into two categories, primary characteristics and secondary characteristics. The primary characteristics are comprised of relevant and reliability, while the secondary characteristics are comparability and consistency. Comparability means that the information can be compared; whether among companies, among industries or across different periods. Let us assume that you are interested in investing in a company. You were informed that the net income of the company in year 2000 was RM10 million. Is this information useful? Actually, it is only useful if you have other information that can be compared with that figure. For example, the net income in 1999 for the company was RM3 million. This information enables you to conclude that the company has gained a huge increase in net income. What if you were told that the net income of the company in 1999 was RM19 million? You might not want to proceed with the investment because the company has experienced a huge decline in net income. You would not be able to come to this conclusion by only referring to the RM10 million figure.

2.

Exercise 1.3
1. The weaknesses in the assumption of monetary unit: (a) Limiting the scope of accounting. This is because only transactions that can be measured in monetary unit will be taken into consideration in accounting, whereas there are many other factors that will also affect the business. For example, the death of the company’s 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. In the early days, school children only took 20 cents to school, now they bring RM2. All

ANSWERS

217

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) (c) (e) (f) accounting period relevant reliability principle of matching (b) historical cost (d) Malaysian Accounting Standards Board

(g) cost benefit relation, materiality (h) management accounting (i) (j) (l) going concern point of sale Balance Sheet

(k) Cash Flow Statement

218

ANSWERS

Exercise 1.5
1. 2. 3. 4. 5. 6. 7. D A D C False False False

Exercise 1.6
1. (a) (c) 2. (a) (c) (e) 46,000 75,000 Asset increased, Asset decreased or has no effect on the Asset Asset decreased, Owner’s Equity decreased Asset increased, Owner’s Equity increased (b) 100,000

(b) Asset decreased, Owner’s Equity decreased (d) Asset increased, Asset decreased or has no effect on the Asset

ANSWERS

219

3.
ASSET Trans action a. Cash + +20,000 AR + Supplies = LIABILITY = AP + + O.EQUITY Capital, Ashwin +20,000 Investment by Ashwin 20,000 20,000 20,000 +4,200 Service revenue 24,200 -1,000 Salary expenses 23,200 -700 Transportation expenses -150 Sundry expense 22,350 -1,200 Rental expenses 21,150 +2,500 Service revenue 23,650 -550 Supplies expenses 23,100 -750 Drawings, Ashwin 22,350

Balance b. Balance c. Balance d. Balance e. Balance f.

20,000 20,000 -620 19,380 +4,200 23,580 -1,000 22,580 -700 +800 800 800

= = = +800 800 -620 180

800

180

800

=

180

-150 Balance g. Balance h. Balance i. Balance j. 21,730 -1,200 20,530 +2,500 20,530 2,500 800 -550 250 = 180 800 = 180

800

=

180

20,530 -750

2,500

=

180

Balance

19,780

2,500

250

180

220

ANSWERS

4.

(a) Seri Consultation Services Income Statement For the year ended 31 December 2008 RM Service Revenue (-) Expenses: Supplies expenses Tax expenses Salary expenses Rental expenses Utility expenses Sundry expenses Net income RM 78,750

6,300 4,200 18,000 14,400 7,350 1,265

(51,515) 27,235

(b) Seri Consultation Services Statement of Changes in Owner’s Equity For the year ended 31 December 2008 RM Capital, Seri Dewi – 1 Jan 22,200 (+) Net income 27,235 49,435 (-) Drawings (6,000) Capital, Seri Dewi – 31 Dec 43,435

(c) Seri Consultation Services Balance Sheet As at 31 December 2008 RM ASSETS Cash (23,300 – 6,000) Accounts receivable Supplies TOTAL ASSETS LIABILITIES Accounts Payable OWNER’S EQUITY Capital, Seri Dewi TOTAL LIABILITIES AND O.EQUITY 17,300 18,855 8,480 44,635 1,200 43,435 44,635

ANSWERS

221

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 entity’s 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 entity’s financial position (increase asset and owner’s 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. T-Account and three column account. T-account is easier but the three column account enables us to know the last balance after each transaction. Drawings are made by the owner for personal use while expenses are incurred by the entity for the purpose of generating income. Drawings are not considered in the calculation of net profit or loss, but are deducted directly from owner’s 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 owner’s equity. C C (a) (b) (c) (d) (e) (f) (g) (h) Asset Expense Asset Income Liability Asset Expense Asset

2.

3.

4. 5. 6.

222

ANSWERS

Exercise 2.3
1. (a)
Account and Description Cash Capital, Cindy (Cash investment by Cindy) b. Supplies Accounts payable (Purchase of supplies on credit) c. Cash Service revenue (Cash received for services provided) d. Rental expenses Cash (Payment of rental by cash) e. Accounts payable Cash (Payment to accounts payable) f. Accounts receivable Service revenue ( Customer has not paid for services provided) g. Utility expenses Sundry expenses Cash (Payment for expenses by cash) h. Salary expenses Cash (Payment for salary by cash) i. Supplies expenses Supplies (Usage of supplies) j. Drawings Cash Supplies (Cash and supplies drawings by owner) 550 500 50 162 162 1,250 1,250 390 187 577 1,875 1875 125 125 750 750 3,250 3,250 275 275 Reference Debit (RM) Credit (RM) 5,000 5,000 Date Apr 2008 a.

ANSWERS

223

1

(b) Post to ledger

Cash Account
Date Apr 2008 Description Capital, Cindy Service revenue Rental expenses Accounts payable Utility expenses Sundry expenses Salary expenses Drawings, Cindy Reference Debit (RM) 5,000 3,250 750 125 390 187 1,250 500 Credit (RM) Balance (RM) 5,000 8,250 7,500 7,375 6,985 6,798 5,548 5,048

Account Receivable
Date Apr 2008 Description Service revenue Reference Debit (RM) 1,875 Credit (RM) Balance (RM) 1,875

Supplies Account
Date Apr 2008 Description Accounts payable Supplies expenses Drawings, Cindy Reference Debit (RM) 275 Credit (RM) 162 50 Balance (RM) 275 113 63

Accounts Payable
Date Apr 2008 Description Supplies Cash Reference Debit (RM) 125 Credit (RM) 275 Balance (RM) 275 150

Capital Account, Cindy
Date Apr 2008 Description Cash Reference Debit (RM) Credit (RM) 5,000 Balance (RM) 5,000

Drawings Account, Cindy
Date Apr 2008 Description Cash Supplies Reference Debit (RM) 500 50 Credit (RM) Balance (RM) 500 550

224

ANSWERS

Service Revenue Account Date
Apr 2008

Description
Cash Accounts receivable

Reference

Debit (RM)

Credit (RM)
3,250 1,875

Balance (RM)
3,250 5,125

Rental Expenses Account
Date Apr 2008 Description Cash Reference Debit (RM) 750 Credit (RM) Balance (RM) 750

Utility Expenses Account
Date Apr 2008 Description Cash Reference Debit (RM) 350 Credit (RM) Balance (RM) 350

Sundry Expenses Account
Date Apr 2008 Description Cash Reference Debit (RM) 187 Credit (RM) Balance (RM) 187

Salary Expenses Account
Date Apr 2008 Description Cash Reference Debit (RM) 1,250 Credit (RM) Balance (RM) 1,250

Supplies Expenses Account
Date Apr 2008 Description Cash Reference Debit (RM) 162 Credit (RM) Balance (RM) 162

1

(c)

Trial Balance

ANSWERS

225

Cindy Insurance Agency Trial Balance as at 30 April 2008 Accounts Cash Accounts receivable Supplies Accounts payable Capital, Cindy Drawings, Cindy Service revenue Salary expenses Rental expenses Utility expenses Supplies expenses Sundry expenses TOTAL Debit (RM) 5,048 1,875 63 Credit (RM)

150 5,000 550 5,125 750 390 187 1,250 162 10,275

10,275

226

ANSWERS

Exercise 2.4
1. (a) GENERAL JOURNAL Account and Description Reference L104 Debit (RM) 274 Credit (RM) 274 L302 2,000 2,000 L101 L102 2,740 2,740

Date

Feb 1 Supplies Cash L101 (Purchased supplies by cash) 2 Drawings, Edlin Cash L101 (Cash drawings by owner) 5 Cash Accounts receivable (Received cash from customer for payment of accounts receivable) 9 Office equipment Accounts payable (Purchased office equipment on credit) 15 Accounts payable Cash (Payment to accounts payable) 18 Cash Service revenue (Received for services provided) 25 Advertisement expenses Cash (Payment for advertisement)

L108 L201

3,850 3,850

L201 L101

1,200 1,200

L101 L401

580 580

L502 L101

420 420

ANSWERS

227

28

Utility expenses Cash (Payment for business’s telephone and electricity bill) Drawings, Edlin Cash (Payment for telephone and electricity bill of owner’s house by cash from the business) Rental expenses Cash (Payment for rental of business premises) Sundry expenses Cash (Repair of office equipment by cash)

L503 L101

215 215

28

L302 L101

117 117

28

L501 L101

1,200 1,200

28

L509 L101

220 220

1

(b) Post of entries to ledger Cash Account Date Description Reference Debit (RM) Credit (RM) No: 101 Balance (RM) 15,238 14,964 12,964

Feb Cash 1 2 Supplies Drawings, Edlin J1 J1 274 2,000

228

ANSWERS

5 15 18 25 28 28 28 28

Accounts receivable Accounts payable Service revenue Advertisement expenses Utility expenses Drawings, Edlin Rental expenses Sundry expenses

J1 J1 J1 J1 J1 J1 J1 J1

2,740 1,200 580 420 215 117 1,200 220

15,704 14,504 15,084 14,664 14,449 14,332 13,132 12,912 No: 102 Balance (RM) 4,575 1,835 No: 104 Balance (RM) 427 701 No: 108 Balance (RM) 8,400 12,250 No: 201 Balance (RM) 1,730 5,580 4,380 No: 301 Balance (RM) 26,910

Accounts Receivable Date Feb 1 5 Description Balance Cash Reference J1 Debit (RM) Credit (RM) 2,740

Supplies Account Date Feb 1 1 Description Balance Cash Reference J1 Debit (RM) 274 Credit (RM)

Office Equipment Account Date Feb 1 9 Description Balance Account payable Reference J1 Debit (RM) 3,850 Credit (RM)

Accounts Payable Date Feb 1 9 15 Description Balance Office equipment Cash Reference J1 J1 Debit (RM) Credit (RM) 3,850 1,200

Capital Account, Edlin Date Feb 1 Description Balance Reference Debit (RM) Credit (RM)

ANSWERS

229

Drawings Account, Edlin Date Feb 2 28 Description Cash Cash Reference J1 J1 Debit (RM) 2,000 117 Credit (RM)

No: 302 Balance (RM) 2,000 2,117 No: 401 Balance (RM) 580 No: 501 Balance (RM) 1,200 No: 502 Balance (RM) 420 No: 503 Balance (RM) 215 No: 509 Balance (RM) 220

Service Revenue Account Date Feb 18 Description Cash Reference J1 Debit (RM) Credit (RM) 580

Rental Expenses Account Date Feb 28 Description Cash Reference J1 Debit Credit (RM) (RM) 1,200

Advertisement Expenses Account Date Feb 25 Description Cash Reference J1 Debit (RM) 420 Credit (RM)

Utility Expenses Account Date Feb 28 Description Cash Reference J1 Debit (RM) 215 Credit (RM)

Sundry Expenses Account Date Feb 28 1. (c) Description Cash Reference J1 Debit (RM) 220 Credit (RM)

Trial Balance

230

ANSWERS

Account Number 101 102 104 108 201 301 302 401 501 502 503 509

Edlin Enterprise Trial Balance as at 28 February 2007 Debit Accounts (RM) Cash 12,912 Accounts receivable 1,835 Utilities 701 Office equipment 12,250 Accounts payable Capital, Edlin Drawings, Edlin 2,117 Service revenue Rental expenses 1,200 Advertisement expenses 420 Utility expenses 215 Sundry expenses 220 TOTAL 31,870

Credit (RM)

4,380 26,910 580

31,870

ANSWERS

231

TOPIC 3: COMPLETING THE ACCOUNTING CYCLE
Exercise 3.1
(a) Accrued Revenue Accrued revenue refers to the revenue that has been obtained but there is no incoming cash flow into the business entity. This happens when the goods or services have been supplied to the customer but the customer has not paid for it yet. Accrued revenue is an asset as the benefit in the form of cash will be obtained by the business entity in the future. Examples of accrued revenue are rental revenue receivable, service revenue receivable and interest receivable.

(b) Accrued Expenses Accrued expenses refer to all the expenditure that has incurred but has not been paid or recorded because there is no outgoing cash flow. Accrued expense is a liability as an obligation exists that must be settled by the business. At the end of the accounting period, the business entity must record/recognise all the expenditure even though no cash flow has occurred. Examples of accrued expenses are salary payable, rental payable, interest payable and tax payable. (c) Prepaid Expenses Prepaid expenses refer to all expenses that have been paid in advance by cash but the benefit from the expenses has not been received or obtained. It is an asset to the business and will be written off after it has been used or when it has expired. Therefore, at the end of the accounting period, adjusting entries must be made to recognise the asset that had been written off as expense.

(d) Unearned Revenue Unearned revenue refers to the cash received in advance but the goods or services have not been supplied. This is an obligation or liability to the business entity. Cash received cannot be recognised as an revenue for that period because the goods or services will only be provided in the future.

Exercise 3.2
1. 2. 3. Supplies Expenses Supplies Depreciation Expenses Accumulated Depreciation Interest Expenses Interest payable RM250 RM250 RM400 RM400 RM300 RM300

232

ANSWERS

4. 5. 6.

Insurance Expenses Insurance Prepayment Accrued Revenue/Revenue Receivable Service Revenue Cash Unearned revenue

RM1,500 RM1,500 RM750 RM750 RM5,000 RM5,000

Exercise 3.3
Khairunnisa’ Consulting Services Income Statement For the Period Ended 30 June 2007 RM Fees Revenue Less Expenditure: Sundry expenses Rental expenses Utility expenses Salary expenses Supplies expenses Insurance expenses Depreciation expenses Total expenditure Net revenue RM 119,280

10,700 13,800 4,900 49,600 5,600 3,500 825 (88,925) 30,355

ANSWERS

233

Khairunnisa’ Consulting Services Balance Sheet as at 30 June 2007 RM Current Assets Cash Accounts Receivable Office supplies Rental prepayment Insurance prepayment 56,350 41,600 12,300 4,400 15,100 129,750 Current Liabilities Accounts Payable Salary Payable Unearned fees RM 17,600 7,100 10,980 35,680

Non-current Liabilities Notes Payable Total liabilities Owner’s Equity Opening capital, Khairunnisa’ Net revenue Closing capital, Khairunnisa’ Total Liabilities & Equity

100,000 135,680

Non-current Assets Office equipment Less: Accumulated Depreciation Net book value

99,000 10,725 88,275

51,990 30,355 82,345 218,025

Total Assets

218,025

The balance sheet is presented according to the account format. You can also use the report format as suggested by MASB1. If the report format is used, the net assets reported are RM94,070. Therefore, the total assets will be RM182,345. Total non-current liabilities and equity are the same at RM182,345.

234

ANSWERS

Exercise 3.4
1. (a) Adjusting Entries Supplies expenses Supplies Insurance expenses Insurance prepayment Depreciation expenses Accumulated depreciation Salary Expenses Salary payable Accounts Receivable Service revenue Unearned revenue Service revenue (b) Financial Statement RM 890 315 315 4,950 4,950 440 440 1,000 1,000 500 500 RM 890

Berkat Enterprise Income Statement For the Period Ended 30 June 2006 RM Service revenue Salary expenses 22,855 Sundry expenses 8,420 Supplies expenses 890 Insurance expenses 315 Depreciation expenses 4,950 Net profit

RM 60,625

(37,430) (23,195)

ANSWERS

235

Berkat Enterprise Balance Sheet 30 June 2006 RM Non-current Asset: Office equipment Accumulated Reprediation Curent assets: Cash Account receivable Supplies Insurance prepayment Current liablities: Salary payable Unearned revenue Total current assets Financed by: Owner’s Equity Capital Add: Net profit Less: Drawings RM 51,650 (14, 650) RM

37,000

3,425 8,000 380 305

12,110

1,365 750

2,115 9,995 46,995 29,000 23,195 (5,200) 46,995

236

ANSWERS

(c)

Closing entries Service Revenue Revenue Summary Revenue Summary Salary expenses Sundry expenses Supplies expenses Insurance expenses Depreciation expenses Revenue Summary Capital Capital Drawings RM 60,625 RM 60,625 37,430 22,855 8,420 890 315 4,950 23,195 23,195 5,200 5,200

2.

Adjusting entries Salary expenses Accrued/Payable Salary Closing entry Revenue summary Salary expenses Reversing entry Accrued salary Salary expenses Entry for salary payment Salary expenses Cash RM 100 RM 100

100 100

100 100

120 120

ANSWERS

237

Salary expenses 31/12/00 01/01/01 Adjusting Payment RM 100 100 120 31/12/00 01/01/01 Closing Reversing RM 100 100 100 RM 100 100 100

31/12/00 01/01/01

Balance Reversing

Accrued Salary RM 100 31/12/00 Adjusting 100 100 01/01/01 Balance Revenue Summary

31/12/00

Closing

RM100 Cash 01/01/01

Payment

RM120

3.

(a)

Moiz Real Estate Income Statement for the Period Ended 31 December 2004 Revenue: Service revenue Less Expenditure: Salary expenses Depreciation expenses Rental expenses Sundry expenses Total expenditure Net revenue RM RM 118,250 44,830 5,430 8,400 3,010 61,670 56,580

238

ANSWERS

Moiz Real Estate Statement of Changes in Equity for the Period Ended 31 December 2004 RM Capital, Moiz, 1 January 2004 85,000 Add: Net revenue 56,580 114,580 Less: Drawings (10,400) Capital, Moiz, 31 December 2004 104,180 Moiz Real Estate Balance Sheet As at 31 December 2004 RM Current Assets Cash Accounts Receivable Supplies Insurance prepayment Total current assets Non-current Assets Equipment Acc Dep Net book value Total Assets RM Current Liabilities 6,850 Accounts Payable 14,000 Unearned revenue 2,540 Total current liabilities 1,240 24,630 Owner’s Equity Capital, Moiz 103,300 (19,400) 83,900 108,530 Total Liabilities & Equity 108,530 RM 1,850 2,500 4,350

104,180

ANSWERS

239

The above Balance Sheet was reported using the account format. If the statement format is used, the total net assets would be RM20,280 and the total assets would be RM104,180. The total equity would also be RM104,180. 3.(b) Closing Entries Service revenue Revenue Summary Revenue Summary Salary expenses Depreciation expenses Rental expenses Sundry expenses Revenue Summary Capital Capital Drawings RM 118,250 RM 118,250 61,670 44,830 5,430 8,400 3,010 56,580 56,580 10,400 10,400

240

ANSWERS

TOPIC 4: FINANCIAL REPORTING
Exercise 4.1
1. Regulations that are linked with financial reporting (i) The Companies Act 1965 (ii) The Securities Commission 1995 (iii) The Financial Reporting Act 1997 (iv) The Income Tax Act 1967 2. Organisations that are linked with financial reporting (i) Bursa Malaysia Berhad (ii) Central Bank of Malaysia

Exercise 4.2
1. Non-financial information is additional information comprising chairman’s report, notice of annual general meeting, corporate information and structure and others. All the information is related to the organisation itself, while financial information comprises financial statements related to the organisation’s financial status. Financial information is the main and most important information in a financial report. Notes to the accounts are prepared for the users of accounting information to clarify the total of the accounts as reported in the financial statement.

2.

ANSWERS

241

TOPIC 5: TRADING BUSINESS ENVIRONMENT
Exercise 5.1
1. (a) (b) (c) (d) (a) False False True False Gross profit = Sales revenue – Cost of goods sold = RM 110,000 – RM 70,000 = RM 40,000.

2.

(b) Net operating revenue = Gross profit – operating expenses = RM40,000 – RM20,000 = RM20,000.

Exercise 5.2
1. 2/10, n/30 2% discount will be given if payment is made within 10 days from the invoice date and the last payment period (without discount) is within 30 days. Sales Discount Price reduction will be given on credit sales if customer pays within discount period. Purchase Discount Price reduction will be given by seller to buyer if buyer pays within discount period.

2.

3.

Exercise 5.3
1. 2. C Purchase Allowance Exists when buyer does not return the goods that do not meet specification and seller agreed to reduce the purchase price.] Purchase Return Exists when buyer return the goods that do not meet specification.

242

ANSWERS

3.

Sales Allowance Exists when buyer chooses to keep the damaged goods. Sales Return Exists when buyer returns the damaged goods.

Exercise 5.4
The differences between FOB shipping point with FOB destination are as below: FOB means Free On Board FOB shipping point defined that the ownership of the goods will be transferred from the seller to the buyer when the goods are sent by the seller to the transport company (lorry, ship and others). The goods will belong to the buyer and can be recorded as the buyer’s inventory at the time of purchase. The transportation cost would be borne by the buyer. The transportation cost paid by the buyer will be recorded as carriage inwards. Carriage inwards account would normally have a debit balance and will be added to the purchase cost to obtain the cost of goods sold in the income statement. FOB destination defined that the ownership of the goods will be transferred from the seller to the buyer when the goods reached the buyer’s destination, which is the buyer’s warehouse. The goods purchased will be owned by the buyer or can be recorded as the buyer’s inventory only when the buyer has received the goods. The buyer cannot record the goods in its inventory during purchase but only upon receiving the goods. The seller will bear the transportation cost and record it as carriage outwards after it had been paid. Carriage outwards will be included in the income statement as a part of the operating expenditure.

Exercise 5.5
1. Credit terms of 2/10, n/30 means that the company will receive 2% cash discount if payment is made within 10 days from the date of invoice. However, the last payment period is 30 days from date of invoice with the amount to be paid as stated in the invoice. Journal entry for the payment is as below: RM 1,900 RM

July 24

Dr: Accounts receivable (RM2,000 – RM100) Cr: Inventory (RM1,900 x 2%) Cr: Cash (RM1,900 – RM38)

38 1,862

ANSWERS

243

2.

One credit sales was on 10 July totalling RM800 with credit terms 2/10, n/30. On 12 July, RM100 worth of goods had been returned. Prepare journal entries on 19 July to record the cash received by customer. The journal entry for cash receipt is as below: RM 686 14 RM

July 19

Dr: Cash (RM700 – RM14) Dr: Sales discount (RM700 x 2%) Cr: Accounts receivable (RM800 – RM100)

700

Exercise 5.6
(a) Journal Date May 1 Description Inventory Accounts payable (Depot Wholesaler) Accounts receivable (Rahmat) Sales Cost of goods sold Inventory Accounts payable (Depot Wholesaler) Inventory Cash (RM4,500-RM90) Sales discount (4,500 x 2%) Accounts receivable (Rahmat) Accounts payable (6,000 – 200) Inventory (5,800 x 2%) Cash Supplies Cash Inventory Cash Cash Inventory Debit 6,000 Credit 6,000

May 2

4,500 3,000 200

4,500 3,000 200

May 5

May 9

4,410 90 4,500 5,800 116 5,684 900 900 2,400 2,400 230 230

May 10

May 11 May 12 May 15

244

ANSWERS

May 17 May 19 May 24

Inventory Accounts payable (Harrods) Inventory Cash Cash Sales Cost of goods sold Inventory

1,900 1,900 250 250 6,200 6,200 4,340 4,340 1,000 1,000 1,900 38 1,862 100 100 70 70 1,600 1,600 1,120 1,120

May 26 May 27

Inventory Accounts payable (Horizon) Accounts payable (Harrods) Inventory (1,900 x 2%) Cash Sales return and allowance Cash Inventory Cost of goods sold

May 29

May 31

Accounts receivable (Rahmat) Sales Cost of goods sold inventory

(b) Ledger Cash Date May 1 9 10 11 12 15 19 24 27 29 Description Balance Accounts receivable Accounts payable Supplies Inventory Inventory Inventory Sales Accounts payable Sales return and allowances Debit 4,410 Credit Balance 5,000 9,410 5,684 3,726 900 2,826 2,400 426 656 250 406 6,606 1,862 4,744 100 4,644

230 6,200

ANSWERS

245

Accounts receivable Date May 2 9 9 31 Inventory Date May 1 2 5 10 12 15 17 19 24 25 27 29 31 Supplies Date Cash Description Debit 900 Credit Balance 900 Description Accounts payable Cost of goods sold Accounts payable Accounts payable Cash Cash Accounts payable Cash Cost of goods sold Accounts payable Accounts payable Cost of goods sold Cost of goods sold Debit 6,000 3,000 200 116 2,400 230 1,900 250 4,340 1,000 38 70 1,120 Credit Balance 6,000 3,000 2,800 2,684 5,084 4,854 6,754 7,004 2,664 3,664 3,626 3,696 2,576 Description Sales Cash Sales discount Sales Debit 4,500 Credit 4,410 90 1,600 Balance 4,500 90 0 1,600

246

ANSWERS

Accounts payable Date May 1 5 10 10 17 26 27 27 Description Inventory Inventory Inventory Cash Inventory Inventory Inventory Cash Debit 200 116 5,684 1,900 1,000 38 1,862 Credit 6,000 Balance 6,000 5,800 5,684 0 1,900 2,900 2,862 1,000

Capital – Abu Bakar Date Description May 1 Balance Sales Date Description May 2 Accounts receivable 24 Cash 31 Accounts receivable Sales Return and Allowance Date Description May 29 Cash Sales Discount Date Description May 9 Accounts receivable Cost of Goods Sold Date Description May 2 Inventory 24 Inventory 29 Inventory 31 Inventory

Debit

Credit

Balance 5,000

Debit

Credit 4,500 6,200 1,600

Balance 4,500 10,700 12,300

Debit 100

Credit

Balance 100

Debit 90

Credit

Balance 90

Debit 3,000 4,340 1,120

Credit

70

Balance 3,000 7,340 7,270 8,390

ANSWERS

247

(c)

Cempaka Sdn Bhd Income Statement Extract For the Month Ended 31 May 2007 RM Sales revenue: Sales Less: Sales return and allowances Sales discount Net sales Cost of goods sold Gross profit RM 12,300 100 90 190 12,110 (8,390) 3,720

Exercise 5.7
(a) Adjusting Entries Entries (i) Depreciation expenses – building Accumulated depreciation – building (ii) Depreciation expenses – equipment Accumulated depreciation – equipment (iii) Interest expenses Interest payable Debit 10,000 9,000 9,000 7,000 7,000 Credit 10,000

248

ANSWERS

(b)

Melati Sdn Bhd Income Statement For the Year Ended 31 December 2008 RM RM 902,100 (4,600) 897,500 (709,900) 187,600 RM

Sales revenue: Sales Less: Sales Discount Net Sales Cost of goods sold Gross profit Less: Operating expenses Sales expenses: Salary expenses (69,800 x 80%) Maintenance expenses Administrative expenses Salary expenses (69,800 x 20%) Depreciation expenses – building Utility expenses Depreciation expenses – equipment Repair expenses Insurance expenses Total operating cost Operating revenue Other expenses – interest expenses Net revenue

55,840 7,200 13,960 10,000 19,400 9,000 5,900 3,500

63,040

61,760 (124,800) 62,800 (7,000) 55,800

ANSWERS

249

(c)

Melati Sdn Bhd Balance Sheet As at 31 December 2008 RM RM 92,000 197,000 (64,000) 83,500 (51,400) 133,000 32,100 257,100 RM RM

Non-current assets: Land Building Less: Accumulated depreciation Equipment Less: Accumulated depreciation Current Assets: Cash Accounts receivable Inventory Current Liabilities: Notes payable (mature in year 2008) Accounts payable Interest payable Net current asset/Working capital

23,400 37,600 90,000

151,000

15,000 37,500 7,000

59,500 91,500 348,600

Financed by: Capital (267,800+55,800-10,000) Non-current liability

313,600 35,000 348,600

250

ANSWERS

(d) Recording Closing Entries Date Dec 31 Dec 31 Description Sales Revenue summary Revenue summary Sales discount Cost of goods sold Salary expenses Utility expenses Repair expenses Maintenance expenses Insurance expenses Depreciation expenses – building Depreciation expenses – equipment Interest expenses Revenue summary Capital – Abu Bakar Capital – Abu Bakar Drawings Debit 902,100 846,300 4,600 709,000 69,800 19,400 5,900 7,200 3,500 10,000 9,000 7,000 55,800 55,800 10,000 10,000 Credit 902,100

Dec 31 Dec 31

Exercise 5.8
1.
Date Mar 2 Description Accounts receivable Sales Cost of goods sold Inventory Sales return and allowance Accounts receivable Inventory Cost of goods sold Cash (680,000 – 13,600) Sales discount (680,000 x 2%) Accounts receivable Debit 800,000 800,000 600,000 600,000 120,000 120,000 90,000 90,000 666,400 13,600 680,000 Credit

Mar 6

Mar 12

2.

ANSWERS

251

Description Sales Revenue summary Revenue summary Cost of goods sold Sales discount Goods inventory Revenue summary

Debit 180,000

Credit 180,000

102,000 100,000 2,000 40,000 40,000

3.

(i)
Date April 5 April 6 April 7 April 8 April 15 Description Inventory Accounts payable Inventory Cash Equipment Accounts payable Accounts payable Inventory Accounts payable (16,000-3,000) Inventory [(16,000-3,000) x 2%] Cash (13,000-260) Debit 16,000 16,000 900 900 26,000 26,000 3,000 3,000 13,000 260 12,740 Credit

(ii)
Date May 4 Description Accounts payable Cash Debit 13,000 13,000 Credit

252

ANSWERS

4.
Date Sept 6 Sept 9 Sept 10 Sept 12 Description Inventory (80 x RM19) Cash Inventory Cash Accounts receivable (2 x RM20) Inventory Accounts receivable (26 x RM30) Inventory Cost of goods sold (26 x RM20) Inventory Sales return and allowance Accounts receivable Inventory Cost of goods sold Accounts receivable (30 x RM30) Sales Cost of goods sold (30 x RM20) Inventory Debit 1,520 1,520 80 80 40 40 780 780 520 520 30 30 20 20 900 900 600 600 Credit

Sept 14

Sep 20

5.

(a)
Date Dec 3 Description Accounts receivable Sales Cost of goods sold Inventory Sales return and allowance Accounts receivable Cash (460,000 – 9,200) Sales discount [(480,000 – 20,000) x 2%] Accounts receivable (480,000 – 20,000) Debit 480,000 480,000 320,000 320,000 20,000 20,000 450,800 9,200 460,000 Credit

Dec 8 Dec 13

(b)
Date Jan 2 Sales Accounts receivable (RM480,000 – RM20,000) Description Debit 460,000 460,000 Credit

ANSWERS

253

TOPIC 6: FINANCIAL STATEMENT ANALYSIS
Exercise 6.1
The bases of comparison for intra-company, inter-company and industry average can be compared by looking at the financial information aspect. (a) Intra-company (Within the company) The basis for intra-company is that it compares the items in the financial statement for two different years (or more) for the same company. The comparison of current year’s financial statement with previous years will show the trend of the company which can be used for future predictions. For example, the comparison of cash item for Selatan Sdn. Bhd. of the current year with previous years will show the increase or decrease.

(b) Inter-company (Between companies) The basis for inter-company is that it compares the items in the financial statement of one company with one or more companies operating the same type of business. The comparison made is based on the financial statement published by the company. Inter-company comparison provides useful information on the company’s status as compared to its competitors. (c) Industry Average This basis compares items in the financial statement of the company with other companies in the related industry in general. Comparison made between the company and industry average can provide information on the company’s performance as compared to the industry.

Exercise 6.2
1. The difference between horizontal analysis with vertical analysis is that horizontal analysis is used especially for comparison within the company (intra-company) while vertical analysis can also be used for intra-company or inter-company comparison. Ratio analysis is used in all three bases of comparison, which are intra-company, inter-company and industry average. Horizontal analysis is a technique to evaluate the trend of items in the financial statement (increase or decrease) in terms of amount or percentage of change. The basis of comparison for these two years (the current year and the previous year) will be set by using the financial statement of the previous year as the base to determine an increase or decrease.

254

ANSWERS

Vertical Analysis is a technique to evaluate the items in the financial statement by stating each of the items in the form of percentage as compared with the base amount. It shows the relationship of each item in the financial statement with another item that is used as the base. In balance sheet, the amount normally used as the base for calculation is Total Asset for asset items, while Total Liability and Owner’s Equity will be used as the base for liability and equity items. For Income Statement, the Net Sales will be used as the base amount for each of the items in the income statement. 2. Horizontal Analysis
31 Dec 2006 Accounts receivable Inventory Total current assets 500,000 840,000 3,220,000 31 Dec 2007 400,000 600,000 2,800,000 Change in Amount (RM) 100,000 240,000 420,000 Calculation 100k/400k 240k/600k 420k/2,800k Percentage (%) 25%* 40%** 15%***

Vertical Analysis
Accounts receivable 31 Dec 2006 500,000 31 Dec 2007 400,000

Inventory Total asset

840,000 3,220,000

100%

600,000 2,800,000

100%

Exercise 6.3
1. The meaning of current ratio and quick ratio, including their formula, are shown below:
Explanation Current ratio To measure the adequacy of current asset to pay current liability To measure the business’s capability to pay short-term debt immediately. Formula Current asset Current liability Quick asset* Current liability *Quick asset comprise marketable securities accounts receivable. cash, and

Quick ratio

ANSWERS

255

2.

(a)

Working Capital = Current Asset – Current liability = RM42,918,000 – RM45,844,000 = (RM2,926,000) = = Current asset Current liability 42,918,000 45,844,000

(b) Current ratio

= 0.94 : 1 (c) Quick ratio = Cash + Marketable security + AR Current Liability 8,241,000 + 1,947,000 + 12,545,000 45,844,000

=

= 0.50: 1

Exercise 6.4
Inventory turnover = Cost of goods sold Average inventory Cost of Goods Sold (2006) 980,000 4,440,000 5,420,000 1,020,000 4,400,000 Cost of goods sold Average inventory 4,440,000 980,000 + 1,020,000 2 = 4.4 times Cost of Goods Sold (2005) 860,000 4,661,000 5,521,000 980,000 4,541,000

Opening inventory Add: Purchases Cost of goods ready for sale Less: Closing inventory Cost of goods sold (a) Inventory turnover 2006 =

=

256

ANSWERS

(b) Inventory turnover 2006

=

Cost of goods sold Average inventory 4,541,000 860,000 + 980,000 2 4.9 times

=

=

Exercise 6.5
(a) Current ratio = Current Asset Current Liability 20,000 + 65,000 + 60,000 50,000 2.9 : 1 Quick asset Current Liability 65,000 + 20,000 50,000 1.7 : 1 Credit sales (net) Average AR (net) 400,000 62,500* 6.4 times

= =

(b) Quick ratio

=

= =

(c)

AR turnover

=

= =

*[AR last year + AR current year] 2 60,000 + 65,000 2 = 62,500 =

ANSWERS

257

(d) Inventory turnover

=

= =

Cost of goods sold Average inventory 198,000 55,000** 3.6 times

**[Inventory last year + Inventory current year] 2 = 50,000 + 60,000 2

= 55,000 Net profit Sales (net) 44,000 420,000 - 20,000 11%

(e)

Return on sales (Profit margin)

= = =

258

ANSWERS

Exercise 6.6
1. Desa Sdn. Bhd. Balance Sheet as at 31 December 2004 and 2005
2005 (RM) Assets: Equipment (net) Current asset Total Assets Liabilities: Non-current liability Current liability Total Liabilities Owner’s Equity: Ordinary shares @ RM1 Retained earnings Total owner’s equity Total liabilities and owner’s equity 2004 (RM) Basis Year 330,000 100,000 430,000 Increase (Decrease) Amount (RM) 70,000 25,000 95,000 Percentage (%) 21.2 25.0 22.1

400,000 125,000 525,000

144,000 91,000 235,000

95,000 70,000 165,000

49,000 21,000 70,000

51.6 30.0 42.4

155,000 135,000 290,000 525,000

115,000 150,000 265,000 430,000

40,000 (15,000) 25,000 95,000

34.8 (10.0) 9.4 22.1

2.

(a)

Profit margin

Net profit Sales (net) 64,000 = 800,000 = = 8% Net sales Average total asset* 800,000 = 550,000 = = 1.5 times

(b) Asset turnover

ANSWERS

259

*[Total asset last year + Total asset current year] 2 500,000 + 600,000 = 2 = (c) 550,000 Net profit Average total asset* 64,000 = 550,000 = 11.6%

Return on asset =

*[Total asset last year + Total asset current year] 2 500,000 + 600,000 = 2 = 550,000 Net profit after tax Average ownerÊs equity ordinary shares 64,000 800,000 16.8%

(d) Return on owner’s equity =

= = 3. Ratio analysis for year 2000:

Formula (a) Profit margin Net profit Sales (net) (b) Asset turnover

2000

=

35,000 650,000 650,000 561,500*

= 5.4% Net sales Average total asset* * [Total asset last year + Total asset current year] 2

=

= 1.2 times *(533k+590k)/2 *561,500

260

ANSWERS

Formula (c) Earnings per share Not profit Dividend for Preference Shares Average ordinary shares issued (unit)

2000

=

35,000 30,000* unit

= RM1.17

*(300,000+300,000/2 RM10
*30,000

(d)

Price earnings ratio

Market value of ordinary shares per unit Earnings per share

=

RM5.00 RM1.17 23,000** 35,000

= 4.3 times

(e)

Dividend payout ratio

Cash dividend Net profit

=

= 65.7% **revenue year 1999 + 2000 current profit – 2000 retained revenue **113,000 + 35,000 – 125,000 =** 23,000 (f) Debt ratio Total liability Total asset

=

165,000 590,000

= 28.0%

Ratio analysis for year 2001: Formula (a) Profit margin
Net profit Sales (net)

2001 = 50,000 700,000 700,000 615,000*

= 7.1%

(b)

Asset turnover

Net sales Average total asset* * [Total asset last year + Total asset current year] 2

=

= 1.1times

*(590k+640k)/2 *615,000

ANSWERS

261

Formula (c) Earnings per share
Net profit - Dividend for Preference Shares Average ordinary shares issued (unit)

2001 = 50,000 32,000* unit

= RM1.56

*(300,000+300,000/2 RM10
*32,000

(d) Price earnings ratio

Market value of ordinary shares per unit Earnings per share

=

RM7.95 RM1.56 30,000** 50,000

= 5.1 times

(e)

Dividend payout ratio

Cash dividend Net profit

=

= 60.0% **revenue year 2000 + 2001 current profit – 2001 retained revenue **125,000 + 50,000-145000 = **30,000

(f)

Debt ratio

Total liability Total asset

=

155,000 640,000

= 24.2%

4.

(a)

Current ratio =

Current Asset Current Liability

235,000 135,000 = 1.7 : 1 = (b) Quick ratio = Quick asset Current Liability 41,000 + 18,000 + 92,00 135,000

=

= 1.1 : 1

262

ANSWERS

(c)

Accounts receivable turnover

= = 650,000 83,000

= 7.8 times *[AR last year + AR current year] 2 *74,000 + 92,000 2 * 83,000 (d) Inventory turnover = Cost of goods sold Average inventory* 415,000 77,000

=

= 5.4 times *[Inventory last year + Inventory current year] 2 70,000 + 84,000 2 77,000 Gross profit Sales (net) 235,000 650,000

(e)

Gross profit margin

=

=

= 36.2% Net sales Average total asset* 650,000 599,000

(f)

Asset turnover

=

=

= 1.1 times

ANSWERS

263

*[Total asset last year + Total asset current year] 2 560,000 + 638,000 2 599,000 Net profit Average total asset* 59,800 599,000

(g) Return on asset

=

=

= 10% *[Total asset last year + Total asset current year] 2 560,000 + 638,000 2 599,000 Net profit Average owners equityÊs ordinary share* 59,000 361,500

(h) Return on owner’s equity

=

=

= 16.3% *[Total owner equity last year + Total owner equity current year] 2 350,000 + 373,000 2 361,500 (i) Earnings per share = Net profit - Dividend on preference shares Average ordinary shares issued (unit)* 59,800 30,000

=

= RM1.99

264

ANSWERS

*RM150,000 / RM5 per share *30,000 units share (j) Price earnings ratio = Market value of ordinary shares per unit Earnings per share RM19.50 RM1.99

=

= 9.8 times Cash dividend* Net profit 36,000 59,800

(k) Dividend payout ratio =

=

= 61.5% *Opening retained earnings + Current net profit - Closing retained earnings *200,000 + 59,800 – 223,000 = 36,800 Total liability Total ownerÊs equity 265,000 373,000

(l)

Debt to equity ratio

=

=

= 71.0% Net profit + Taxation + Interest expenses* Interest expenses 85,000 7,200

(m) Interest coverage ratio =

=

= 11.8 times *Net profit + Taxation+ Interest expenses = 59,800 + 18,000 + 7,200 = 85,000

Reference
Akilah Abdullah et al. (1999), Business Accounting, Module PJJ, Centre for Professional and Continuing Education (PACE), UUM, Sintok. Che Zuriana et al, (2001) Business Accounting Education Book Series, (3rd ed.), Publisher UUM. Che Zuriana Muhammad Jamil, Akilah Abdullah, Noriah Che Adam, Noor Aziz Ismail & Mohd Azlan Yahya (2001), Education Book Series, (3rd ed.), University Utara Malaysia. Larson, K.D., Wild, J.J., and Chiappetta, B., (1999) Fundamentals Accounting Principles, (5th ed.), McGraw Hill. Malaysian Accounting Standards Board (Standard 1), Presentation of Financial Statements. Malaysian Accounting Standards Board, MASB 2: Inventories. Malaysian Accounting Standards Board, MASB 3: Net Profit or Loss for the Period, Fundamental Errors and Changes in Accounting Policies. Shamsul Nahar Abdullah (2000), Management Accounting, Publisher UUM, Sintok. Warren, C.S., Reeve, J.M., and Fess, P.E., (2001). Accounting, Customised by School of Accountancy UUM for Business Accounting Students, (1st ed.), International Thompson Publishing. Weygandt, J.J., Keiso, D.E., and Kimmel, P.D., (1999). Accounting Principles, (5th ed.), John Wiley & Sons, Inc.

Sign up to vote on this title
UsefulNot useful