financian accounting module

BBAW2103FINANCIALACCOUNTINGNoor Asma JamaludinNor Asma LodeJunaidah Hanim AhmadAzlan Zainol AbidinAmin AliNorazita Marina Abd Aziz

Project Directors: Prof Dr Mansor Fadzil Prof Dr Zakaria Ismail Open University Malaysia

Module Writers: Noor Asma Jamaludin Nor Asma Lode Junaidah Hanim Ahmad Azlan Zainol Abidin Amin Ali Norazita Marina Abd Aziz Universiti Utara Malaysia

Moderators: Assoc Prof Dr Arfah Salleh Assoc Prof Hashanah Ismail Universiti Putra Malaysia

Azlina Abdul Aziz Loo Sze Wei Rosila Abu Zarin Open University Malaysia

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

Developed by: Centre for Instructional Design and Technology Open University Malaysia

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First Printing, April 2008Second Printing, May 2009Third Printing, November 2009Fourth Printing, March 2010Fifth Printing, October 2010

Copyright © Open University Malaysia (OUM), October 2010, BBAW2103All 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

Course Guide ix – xiii

Topic 1 Accounting Environment 1 1.1 Introduction to Accounting 2 1.1.1 Defi nition of Accounting 2 1.1.2 Users of Accounting Information 2 1.1.3 Branches of Accounting 3 1.1.4 Professional Accounting Bodies in Malaysia 4 1.2 Fundamental Accounting Concepts 6 1.2.1 Qualitative Characteristics of Accounting

Information 6 1.2.2 Accounting Assumptions 10 1.2.3 Basic Principles of Accounting 13 1.2.4 Accounting Constraints 16 1.3 Accounting Equation 17 1.3.1 Analysis of Transaction 18 1.3.2 Summary of Analysis 23 1.4 Types and Objectives of Financial Statement 25 1.4.1 Income Statement 26 1.4.2 Statement of Changes in Owner’s Equity 26 1.4.3 Balance Sheet 27 1.4.4 Cash Flow Statement 28 Summary 34 Key terms 35

Topic 2 Recording Process 36 2.1 Chart of Accounts 37 2.2 Format of Account 39 2.3 Rules of Debit and Credit 41 2.3.1 Normal Balance 42 2.4 Steps in Recording Process 43 2.4.1 Journal 43 2.4.2 Journalising and Posting of Entry 45 2.4.3 Example of Analysis and Summary of Transaction 51 2.4.4 Trial Balance 77 Summary 83 Key Terms 83

Table of Contents

iv TABLE OF CONTENTS

Topic 3 Completing the Accounting Cycle 84 3.1 Adjusting Entries 85 3.1.1 Prepaid Expenses 86 3.1.2 Depreciation Expenses 88 3.1.3 Unearned Revenue (Unearned Income) 89 3.1.4 Accrued Expenses 91 3.1.5 Accrued Revenue 91 3.2 Preparation of Adjusted Trial Balance 93 3.3 Preparation of Financial Statements 100 3.3.1 Income Statement 100 3.3.2 Statement of Changes in Owner’s Equity 105 3.3.3 Balance Sheet 107 3.3.4 Cash Flow Statement 117 3.4 Preparation of Closing Entries 121 3.4.1 Steps In Preparation of Closing Entries 121 3.5 Preparation of Reversing Entries 124 Summary 128 Key Terms 128

Topic 4 Financial Reporting 129 4.1 Statutory Requirement 129 4.2 Financial Report 132 4.2.1 Non-fi nancial Information 133 4.3 Main Financial Statements 135 Summary 138 Key Terms 138

Topic 5 Trading Business Environment 129 5.1 Trading Business Environment 142 5.2 Important Transactions in Trading Firms 144 5.2.1 Purchases 144 5.2.2 Sales 144 5.2.3 Discounts 145 5.2.4 Returns and Allowances 148 5.2.5 Transportation Cost 150 5.3 Accounting for Inventory 152 5.4 Journal Entry for Periodic and Perpetual Inventory System 155 5.5 Examples of Recording Journal Entries 160 5.6 Format of Income Statement for Trading Firms 163 5.6.1 Single Level of Income Statement 163 5.6.2 Multiple Levels of Income Statement 164 5.7 Closing Entries 168 Summary 175 Key Terms 175

TABLE OF CONTENTS v

Topic 6 Financial Statement Analysis 176 6.1 Purpose of Financial Statement Analysis 177 6.2 Sources of Information 178 6.3 Basis of Comparison 179 6.4 Techniques of Analysis 180 6.5 Horizontal Analysis 181 6.5.1 Comparison of Horizontal Analysis for 2 Years 181 6.5.2 Comparison of Horizontal Analysis for A Sequential Period (Trend Analysis) 185 6.6 Vertical Analysis 186 6.6.1 Vertical Analysis for Balance Sheet 186 6.6.2 Vertical Analysis for Income Statement 188 6.7 Financial Ratio Analysis 190 6.8 Liquidity Ratio 191 6.9 Effi ciency Ratio 194 6.10 Profi tability Ratio 194 6.11 Debt Management Ratio 194 6.12 Sample of Ratio Calculations 200 Summary 214 Key Terms 214

Answers 215Reference 265

COURSE GUIDE

COURSE GUIDES ix

COURSE GUIDE DESCRIPTIONYou must read this Course Guide carefully from the beginning to the end. It tells you briefl y 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.

INTRODUCTIONBBAW2103 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 AUDIENCEThis 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 confi rm the course material, the course requirements and how the course is conducted.

STUDY SCHEDULEIt 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 OUTCOMESBy the end of this course, you should be able to:

Discuss the fundamental concepts of accounting and classify types of 1. fi nancial statements;

Describe the meaning of accounting information, its role and importance;2.

Compute journal entry and illustrate the process of preparing accounting 3. information and completion of the accounting cycle;

Apply management accounting techniques or analyses to assist the 4. management in decision-making; and

Propose and plan an accounting information.5.

COURSE SYNOPSISThis 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 defi nition 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 fi nancial statements in fi nancial 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 fi nancial 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 fi nancial report or annual report by registered business entities, statutory requirement on fi nancial reporting, main fi nancial 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 fi nancial statement analysis using the horizontal and vertical analysis and fi nancial ratio analysis. Financial ratio analysis that will be discussed includes the liquidity, effi ciency, profi tability and debt management ratios. These fi nancial analyses are important in decision-making.

TEXT ARRANGEMENT GUIDEBefore 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 refl ect 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 fi nd 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 defi ne.

Summary: You can fi nd 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 fi nd 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 fi nd 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

REFERENCESHorngren 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 Accounting Environment

INTRODUCTIONAccounting plays an important role in our daily lives without us realising it. Accounting is a fi nancial 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 fi nancial 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 decision- maker still requires the necessary fi nancial information.

LEARNING OUTCOMES

By the end of this topic, you should be able to:

1. Explain the meaning, role and importance of accounting;

2. Identify the users and branches of accounting;

3. Describe the main functions of professional accounting bodies in Malaysia;

4. Assess the qualitative characteristics of fi nancial information, assumptions, principles and constraints in accounting;

5. Apply the accounting equations; and

6. Analyse transactions based on the accounting equation.

2 TOPIC 1 ACCOUNTING ENVIRONMENT

In this topic, you will be introduced to the basics of accounting. Among them are the defi nition and branches of accounting, users of accounting information, professional accounting bodies in Malaysia as well as the fundamental concepts in accounting.

1.1 INTRODUCTION TO ACCOUNTING

1.1.1 Definition of Accounting

Accounting is an information system that prepares reports on the economic activities of an entity for users to help them make better decisions. More accurately:

Accounting is a process to identify, measure, record and present the economic information of an entity to the users in order to help them make evaluations or economic decisions.

Economic information are information related to economic activities; whereas an entity refers to a business unit.

1.1.2 Users of Accounting Information

Users of accounting information are parties that use the accounting information for specifi c 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 External Users

Types of information required

Information that can help them make planning and exercise control over the entity.

Information required are different depending on the type of decisions made.

Example:

Investor:

Require information on the profi tability 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.

ExampleAnnual report published by the company.

1.1.3 Branches of Accounting

Accounting is divided into several different branches or other specialised fi elds. 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 fi nancial accounting course will combine two of the most basic and important accounting branches; that are fi nancial 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.


Table 1.2: Differences between Financial Accounting and Management Accounting

Financial Accounting Management Accounting

Preparation of report Preparation of fi nancial reports of an entity for external and internal users but focus is given to the external users.

Preparation of fi nancial and non-fi nancial information that are required by parties in the company for planning, evaluating and controlling purposes of the operations of an entity.

Standard or Format Financial reports produced are periodically and in accordance to specifi ed standard or format.

Report is produced at any time based on requirement and is not subject to any standard or format.

1.1.4 Professional Accounting Bodies in Malaysia

We also need to familiarise ourselves with the organisations that are involved in the accounting profession in Malaysia. The organisations are:

(a) Malaysian Institute of Accountants (MIA) MIA was established under the Accountants Act 1967 as the main

accounting body in the country. Overall, it functions as the core body in regulating the accounting profession. Other major functions of MIA as discussed in the Accountants Act 1967 are:

(i) to set the required qualifi cation 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 Certifi ed Public Accountants (MICPA) MICPA, formally known as “The Malayan Association of Certifi ed Public

Accountants”, was established in 1958 under the Companies Ordinances. On 6 July 1964, the name was changed to “The Malaysian Association of Certifi ed Public Accountants” to refl ect the change of name from Malaya to Malaysia. Since February 2002, it is known as “The Malaysian Institute of Certifi ed Public Accountants”. Among the main objectives and functions of MICPA are:

(i) to advance the accounting theories and practices in all aspects;


(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 1.1EXERCISE 1.1

1. Provide examples of common decisions made by both internal and external users.

2. How does Financial Accounting and Management Accounting assist users in making decision?

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 Certifi ed Public Accountants (MICPA) www.micpa.com.my

• Malaysian Accounting Standards Board (MASB) www.masb.org.my

• Financial Reporting Foundation (FRF) www.masb.org.my

WEBSITE


1.2 FUNDAMENTAL ACCOUNTING CONCEPTS

1.2.1 Qualitative Characteristics of Accounting Information

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

Qualitative characteristics of accounting information refer to the characteristics that must be present in the accounting information to make it useful.

These characteristics are divided into two categories; primary and secondary qualities. The primary qualities of accounting information are relevant and reliability, while the secondary qualities are comparability and consistency. In summary, accounting information is only useful if it has relevant, reliability, comparability and consistency qualities.

Figure 1.1 shows the summary for qualitative characteristics of accounting information.

Figure 1.1: Qualitative characteristics of accounting information

(a) Relevant In everyday terms, we might describe relevant as important or being related.

In accounting, relevant is described as something that makes a difference in arriving at a decision. In other words, something is said to be relevant if it infl uences or affects the decision being made.


The extent to which information is considered relevant depends on its importance in decision making and may differ between one decision maker to another. Information that is relevant to you might not be relevant to another person and vice versa.

For example, suppose you are an investor and you intend to buy shares of a public listed company. What kind of information might be relevant to your needs? You might want to know the profi tability and performance of the said company for the past fi ve years, including new projects or products for the company that will be profi table in the future. This information is relevant as it will infl uence your decision. Suppose the information that you obtained showed that the company is experiencing continuous losses for the past fi ve years and it does not have any new projects. Will you still proceed with the proposal to invest in the company? Probably not.

Figure 1.2 shows an example of performance information of a company in order to assist investors in decision making.

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

After knowing the meaning of relevant, you must also know how certain information are said to be relevant. To become relevant, the information must have three characteristics, namely feedback value, forecast value and timeliness.(i) Feedback Value Relevant information must be able to assist users in substantiating or

correcting early expectations matters at hand.

(ii) Forecast Value Relevant information must be able to assist users in forecasting.


(iii) Timeliness Relevant information must be obtained before it becomes obsolete or

unusable.

(b) Reliability Reliability means that users can rely or depend on the said information to

make good decisions. This characteristic is important because users might not have the time or expertise to evaluate some information. Generally, users simply depend on the information presented by the related entity and assume it to be true. This information is then used in decision making.

Reliability does not mean that the said information must be precise. This is because in accounting there are a lot of information that involves estimation and approximation that might not be precise. What is important is that the estimation and approximation made must be reliable.

Reliable information must have the following characteristics:

(i) Verifi able This means that the accounting information could be verifi ed

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 fi nancial statements must be able to fulfi l 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 specifi ed 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 profi t 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 profi t of the business in the year 2008 or the net profi t of other businesses in the same industry as shown in Figure 1.3. Thus, fi nancial statements contained in the Annual Report also include information on the previous year in addition to the current year for comparison purposes.


(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 fi nancial statement to explain to the users why they are making the changes and the effect of the changes towards the fi nancial statements.

Figure 1.3: Profi tability comparison

EXERCISE 1.2

1. State the qualitative characteristics of accounting information.

2. Explain the meaning of comparability provide an example to show its role in making accounting information useful.

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?


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 fi nancial 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.


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 Transaction (RM)

Business 1 Profi t 6,000

Business 2 Loss 8,000

Business 3 Profi t 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 profi t of RM10,000 [RM6,000 + (-8,000) + RM12,000]. Based on this result, Mr. Ali might be satisfi ed 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 profi t of RM12,000.

(b) Assumption of Going Concern According to this assumption, an entity is assumed to continue to exist and

in operation in the future. This assumption is important because it enables the principle of historical cost to be applied. According to the historical cost principle, all assets and liabilities must be recorded at the purchase price (original cost). For most assets, this cost would be depreciated throughout the life span of the assets to depict its usage. However, asset of property would not be depreciated as its value would always appreciate.

As an example, a machine with a life span of 25 years will be depreciated for 25 years based on the assumption of going concern. With this assumption, the entity would continue to exist for a period of more than 25 years. If we assume that the entity would exist only for another 10 years in absence of this assumption, we obviously cannot use 25 years as the basis for calculating the depreciation.


The assumption also enables users to make decisions without any doubt or worries. Suppose you are interested to invest in a company that has consistently achieved high profi ts in the past few years. However, you were informed that the company would exist only for another fi ve 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 diffi culties 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.


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 fulfi l the requirement of users that might need a more up-to-date report.

Starting Date Ending Date

1 January 2008 31 December 2008

1 July 2008 30 June 2009

1 March 2008 28 February 2009

Figure 1.4 shows examples of accounting period.

Figure 1.4: Examples of accounting period

ACTIVITY 1.2

There is a company that has obtained high profi ts 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 fi nancial 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


of RM72,000 in your fi nancial 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 justifi ed by its high reliability. The value recorded in the fi nancial 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.


(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 (benefi t

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 specifi c 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 profi t or loss. If revenue is more than expense, the difference will be net profi t. However, if the revenue is less than expenses, the difference will be recognised as net loss. Figure 1.5 summarises the concept of profi t and loss.

Figure 1.5: The relationship between revenue and expense

Income – Expenses = Profit or Loss

Income > Expenses = Net ProfitIncome < Expenses = Net Loss

(d) Principle of Full Disclosure The principle stresses for the full disclosure of all relevant information and

material in the fi nancial 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 fi nancial statements will be explained in detail in Topic 4.


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-Benefi t Relationship Before deciding on obtaining specifi c information, a company would

normally analyse the cost involved and the benefi t that may be gained from the information. If the cost of obtaining the information is very high but the benefi t 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 fi gures 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).

ACTIVITY 1.3

1. Explain the weaknesses exist in the assumption of monetary unit.

2. Describe three conditions that must be fulfi lled before revenue can be recognised.


1.3 ACCOUNTING EQUATIONAccounting 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 benefi t, owned by the entity. For example, cash, building and fi ttings.

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 fi rst 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?


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 fi eld, 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. Date (Nov) Transactions

1 1 Reen invested cash of RM30,000 into Reen Cyber Service.

2 2 Purchased a piece of land valued at RM20,000. The business paid cash RM5,000 and the balance is fi nanced by bank loan.

3 4 Purchased offi ce supplies valued at RM2,700 on credit.

4 15 Received revenue from consultancy services provided to customer. The customer paid RM15,000 cash.

5 30 Paid staff salary expense RM4,250; rental expense RM1,600; utility expense RM900 and other expenses RM550.

6 30 Made payment for account payable of RM1,900.

7 30 Unused offi ce supplies valued at RM1,100.

8 30 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.


Transaction ASSET = LIABILITY + OWNER’S EQUITY

Cash 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 fi nanced 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 fi nal balance for each item after every transaction.

Transaction ASSET = LIABILITY + OWNER’S EQUITY

Cash + Land NP Capital, Reen

Balance 30,000 = 30,000

2 (-5,000) + 20,000 = 15,000

Balance 25,000 20,000 = 15,000 30,000

Transaction 3: Purchased offi ce 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 ASSET = LIABILITY +OWNER’S EQUITY

Cash + Land + Supplies NP + AP Capital, Reen

Balance 25,000 + 20,000 = 15,000 + 30,000

3 2,700 = 2,700

Balance 25,000 20,000 2,700 = 15,000 2,700 30,000


Normally, offi ce supplies bought are not only used in the current accounting period. The purchase of offi ce supplies are prepaid expenses. The usage of offi ce supplies for the specifi c 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.



Balance 25,000 + 20,000 + 2,700 = 15,000 + 2,700 + 30,000

4 15,000 = 15,000 service

revenue

Balance 40,000 20,000 2,700 = 15,000 2,700 45,000

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.

Transaction 5: Paid salary expense RM4,250; rental expense RM1,600; utility expense RM900 and other expenses RM550.

Revenue ↑ = Owner’s equity ↑Capital ↑ = Owner’s equity ↑Expenses ↑ = Owner’s equity ↓Drawings ↑ = Owner’s equity ↓

Figure 1.6: Analysis of transaction




Balance 40,000 + 40,000 + 2,700 = 15,000 + 2,700 + 45,000

5 (-4,250) = (-4,250) paid salary

(-1,600) (–1,600) paid rental

-900 (-900)paid utility

-550 (-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.



Balance 32,700 + 20,000 + 2,700 = 15,000 + 2,700 + 37,700

6 (-1,900) = -1,900

Balance 30,800 + 20,000 + 2,700 = 15,000 + 800 + 37,700


Transaction 7: At the end of the month, the unused offi ce supplies were valued at RM1,100. The offi ce supplies was originally bought for RM2,700. The value of offi ce supplies used up during the period is RM1,600 (RM2,700 – RM1,100)



Balance 30,800 + 20,000 + 2,700 = 15,000 + 800 + 37,700

7 -1,600 = -1,600 Supplies expenses

Balance 30,800 + 20,000 + 1,100 = 15,000 + 800 + 36,100

Transaction 8: Reen withdrew money from the business amounting to RM4,000 for her personal use.



Balance 30,800 + 20,000 + 1,100 = 15,000 + 800 + 36,100

8 (-1,600) = (-4,000) cash

drawings

Balance 26,800 + 20,000 + 1,100 = 15,000 + 800 + 32,100

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.


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 defi nitely involve more than one item in the fi nancial 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.


Table 1.4: Analysis of Transaction for Reen Cyber Service, November 2008

Transaction ASSET = LIABILITY +OWNER EQUITY


1 30,000 = 30,000 investment

by Reen

Balance 30,000 = 30,000

2 -5,000 20,000 = 15,000

Balance 25,000 20,000 = 15,000 + 30,000

3 + 2,700 = 2,700

Balance 25,000 + 20,000 + 2,700 = 15,000 + 2,700 + 30,000

4 15,000 = 15,000 service

revenue

Balance 40,000 + 20,000 + 2,700 = 15,000 + 2,700 + 45,000

5 (-4,250) = (-4,250)paid salary

(-1,600) (-1,600)paid rental

(-900) (-900)paid utility

(-550) (-550)paid sundry

Balance 32,700 + 20,000 + 2,700 = 15,000 + 2,700 + 37,700

6 (-1,900) = -1,900

Balance 30,800 + 20,000 + 2,700 = 15,000 + 800 + 37,700

7 -1,600 = (-1,600 )expenses supplies

Balance 30,800 + 20,000 + 1,100 = 15,000 + 800 + 36,100

8 (-4,000) = (-4,000) cash drawings

Balance 26,800 + 20,000 + 1,100 = 15,000 + 800 + 32,100

ASSET = LIABILITY + OWNER’S EQUITY47,900 = 15,800 + 32,10047,900 = 47,900


1.4 TYPES AND OBJECTIVES OF FINANCIAL STATEMENT

After the transactions have been identifi ed, analysed and recorded, we need to prepare a report for the users. This report is the fi nal product of the accounting process and is known as fi nancial statement. There are four types of fi nancial statement that you need to know:

(a) Income Statement;

(b) Statement of Changes in Owner’s Equity;

(c) Balance Sheet; and

(d) Cash Flow Statement.

These statements are interconnected with one another. The title for each statement must contain the reporting 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.


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 fi nancial 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 Profi t and Loss statement which lists all the revenues and expenses incurred by the entity for a specifi c period. The difference between the revenue and expense will result in either net profi t or net loss. Excess of revenue over expense will give us net profi t, 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 ServiceIncome Statement

for the month ended 30 November 2008

RM RM

Service revenueExpenses: Salary expenses Rental expenses Utility expenses Supplies expenses Sundry expenses

4,2501,600

9001,600

550

15,000

(8,900)

Net profi t 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 specifi c accounting period. Owner’s equity will increase when the owner makes a capital investment or when the entity gains net profi t. 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.


Reen Cyber ServiceStatement of Changes in Owner’s Equityfor the month ended 30 November 2008

Opening Capital – 1 November(+) Net profi t

(-) Drawings

Closing Capital – 30 November

RM30,0006,100

36,100(4,000)

32,100

Figure 1.9: Statement of changes in owner’s equity

1.4.3 Balance Sheet

This statement is also known as the fi nancial position statement, listing all the assets, liabilities and owner’s equity of the entity on a specifi c date. The purpose of this statement is to show the fi nancial status of the entity on a specifi c 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 ServiceBalance Sheet as at 30 November 2008

ASSETS RM LIABILITIES AND OWNER’S EQUITY RM

Current Assets: Liabilities:

Cash 26,800 Current Liability:

Supplies 1,100 Account payable 800

27,900 Non-current liability:

Non-current Assets:

Notes payable 15,000

Land 20,000 Total liabilities 15,800

Owner Equity:

Capital 32,100

TOTAL LIABILITIES AND

TOTAL ASSETS 47,900 OWNER’S EQUITY 47,900

Figure 1.10: Balance Sheet in accounts format


In the statement format, the asset, liability and owner’s equity are listed vertically.

Reen Cyber ServiceBalance Sheet

as at 30 November 2008

RM RMNon-current Assets: Land 20,000Current Assets: Cash 26,800 Supplies 1,100

27,900Less: Current liability: Account payable (800)

27,100 Net current assets 47,100

Financed by: Owner’s equity: Capital, Reen

32,100

Non-current liability: Notes payable 15,000

47,100

Figure 1.11: Balance Sheet in statement format

1.4.4 Cash Flow Statement

This statement reports all the cash receipts and payments of the entity in a specifi c period. Through this statement, the users will know the sources of cash received and why cash is paid. The difference between cash infl ows and outfl ows will provide the fi nal cash account balance of the entity. This balance will be the same as the cash amount shown in the Balance Sheet. In the cash fl ow statement, cash transactions are divided according to the type of activities, which are operating, investing and fi nancing activities. Figure 1.12 shows the cash fl ow statement for Reen Cyber Services.


Reen Cyber ServicesCash Flow Statement

for the month ended 30 November 2008

RM RM RMCash from operating activities:Cash received from customers 15,000(–) Expenditure paid 7,300 Payment to supplier 1,900 (9,200)Net cash fl ow from operating activities 5,800

Cash from investing activities:Payment for purchase of land (5,000)Net cash fl ow from investing activities (5,000)

Cash fl ow from fi nancing activities:Investment by owner 30,000(–) Drawings by owner (4,000)Net cash fl ow from fi nancing activities 26,000Net cash fl ow for entity and cash account balance as at 30 November

26,800

Figure 1.12: Cash fl ow statement

ACTIVITY 1.3

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


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) The qualitative characteristic that enables users to depend or rely on the information presented is _____________.

(f) The principle that matches the revenue with the expenses in the specifi c 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 specifi ed standard or format is ______________.

(i) According to the assumption of _____________, the entity is assumed to continue to exist and in operation in the future.

(j) Revenue is normally recognised when ________________.

(k) The statement that shows the cash fl ow of an entity for a specifi c period is _______________.

(l) ____________________ lists all the assets, liabilities and owner’s equity of an entity in a specifi c period.


EXERCISE 1.5

1. If revenue = RM12,000; expense = RM8,400 and drawings by owner = RM2,000; how much is the net profi t or net loss for that period?A. Net profi t RM5,600B. Net loss RM3,600C. Net profi t RM1,600D. Net profi t RM3,600

2. Which of these is NOT a qualitative characteristic of accounting information?A. MaterialityB. ReliabilityC. RelevantD. Comparability

3. One example of internal user is:A. Inland Revenue BoardB. InvestorC. CreditorsD. Management

4. If the total assets increased by RM15,000 and the total liabilities decreased by RM10,000; owner’s equity had:A. increased by RM5,000B. decreased by RM5,000C. increased by RM25,000D. decreased by RM25,000

5. For the purpose of simplifying accounting, the business owner and business entity are assumed as the same.

True False

6. 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 profi t or loss of a business entity at a specifi c date.

True False


EXERCISE 1.6

Answers the questions below.

1. Determine the appropriate amount in the spaces marked “?”

ASSET = LIABILITY + OWNER’S EQUITY(a) 84,000 = ? + 38,000(b) ? = 72,000 + 28,000(c) 125,000 = 50,000 + ?

2. State the effects of the following transactions on the asset, liability and owner’s equity. An example is shown in transaction (a):

Transaction Effect

(a) Paid debts to supplier. Asset decreased, Liability decreased.

(b) Purchased offi ce equipment by cash.

(c) Owner took cash from the business for personal use.

(d) Paid staff salary for the current period.

(e) Received cash from customer to settle his account receivable.

(f) Owner contributed offi ce equipment for business use.

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 offi ce rental of RM1,200.(h) Charged customer RM2,500 for services provided.


(i) Supplies unused at the end of the period is valued at RM250.(j) Mr. Ashwin took cash from the business totalling RM750 for his

personal use.

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 Amount (RM)Accounts payable 1,200Accounts receivable 18,755Supplies 8,480Supplies expenses 6,300Tax expenses 4,200Salary expenses 18,000Sundry expenses 1,265Rental expenses 14,400Utility expenses 7,350Service income 78,750Cash 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.


SUMMARY

In this topic, you have learned and discovered:

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

• The difference between fi nancial accounting and management accounting are:

– Financial accounting prepares the fi nancial report for external users while management accounting prepares the monetary and non-fi nancial information for internal users.

– The fi nancial reports in fi nancial accounting is produced periodically and subject to specifi ed format while the report for management accounting is produced according to specifi c needs and not subject to specifi ed standards.

• The professional bodies involved in the accounting profession are Malaysian Institute of Accountants (MIA), The Malaysian Institute of Certifi ed 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 fi nal product of the accounting process and it consists of Income Statement, Statement of Changes in Owner’s Equity, Balance Sheet and Cash Flow Statement.


Accounting

Auditing

External Users

Financial Accounting

Internal Users

Management Accounting

Monetary Unit

Qualitative Characteristics

Taxation

Topic

2 Recording Process

LEARNING OUTCOMES


1. Describe the chart of accounts for recording and summarise the effect of transactions on fi nancial statement;

2. Explain the format of accounts used;

3. Assess the rule of debit and credit for each type of accounts;

4. Prepare journal entries;

5. Post journal entries to ledger; and

6. Prepare trial balance.

INTRODUCTIONAfter 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 diffi cult 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 fi rm 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 reshuffl e the whole original format to accommodate this change. This also applies if errors are detected. It would be diffi cult 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 fi nancial 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 fi nancial statements to refer to specifi c accounts. Each account is given a special number as reference. These accounts are normally listed systematically in the fi nancial 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 fi rst 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 fi rst digit might be used to show the branch location.


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.

Table 2.1: Chart of Accounts for Reen Cyber Service

Accounts in Balance Sheet Accounts in Income Statement

1 ASSETS 11 Cash 12 Account receivable 14 Supplies 15 Insurance prepayment 17 Land 18 Office equipment

4 REVENUE 41 Service revenue

2 LIABILITIES 21 Account payable 22 Notes Payable 23 Deferred Rental

5 EXPENSES 51 Salary expenses 52 Rental expenses 53 Utility expenses 54 Supplies expenses 55 Sundry expenses

3 OWNERÊS EQUITY 31 Capital, Reen 32 Drawings, Reen

2.2 FORMAT OF ACCOUNTEach account has three sections:

(a) Title or name of the account, which is the name of the items recorded in that particular account.

(b) Debit section on the left side.

(c) Credit section on the right side.


The debit and credit section are used to record either the increase or decrease in the specifi c 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 Account Title Credit

Date Description Reference Amount Date Description Reference Amount

Figure 2.3: T-Account (detailed format )

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


2.3 RULES OF DEBIT AND CREDITWe 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 Increase Decrease

Asset Debit Credit

Liability Credit Debit

Capital Credit Debit

Drawings Debit Credit

Revenue Credit Debit

Expense 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.


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 Increase Decrease Normal Balance

Asset Debit Credit Debit

Liability Credit Debit Credit

Capital Credit Debit Credit

Drawings Debit Credit Debit

Revenue Credit Debit Credit

Expense 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


2.4 STEPS IN RECORDING PROCESSOnce the entity’s transactions are identifi ed, they must be recorded according to the accounting procedure specifi ed. Recording begins with journal entry, then post to ledger and fi nally 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 fi rst book to be used in the recording process. Recording in journals (journalising) is the fi rst 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.

ACTIVITY 2.1

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

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.


(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


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 fi nancial statement. Errors made in the journal will result in errors in the fi nancial statement. The name of accounts used must be specifi ed 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 fi rst, 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 pg 1

Date Description Reference Debit (RM) Credit (RM)

Nov 1 Cash 30,000

Capital, Reen 30,000

(Cash invested by Reen)

Journal 1: General Journal for Transaction 1


Post to ledger:Cash

Nov 1 Capital, ReenRM

30,000

Capital, Reen

Nov 1 CashRM

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 fi nanced 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.



Nov 1 Land 20,000

Cash 5,000


(Purchased land by cash and bank loan)


Post to ledger:Land

Nov 2 CashRM

5,000Notes Payable 15,000

Cash

Nov 1 Capital, ReenRM

30,000 Nov 2 LandRM

5,000


Notes PayableNov 2 Land RM

15,000


Transaction 3:On 4 November, the business bought offi ce supplies valued at RM2,700 on credit.



Nov 4 Supplies 2,700

Accounts Payable 2,700

(Purchased office supplies by credit)


Post to ledger:Supplies

Nov 4 Account PayableRM

2,700

Accounts Payable

Nov 4 SuppliesRM

2,700


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




Nov 15 Cash 15,000

Service revenue 15,000

(Cash received for services provided)


Post to ledger:Cash

Nov 1

15

Capital, Reen

Service revenue

RM30,000

15,000

Nov 2 LandRM

5,000

Service revenue

Nov 15 CashRM

15,000

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).



Nov 30 Salary expenses 4,250

Rental expenses 1,600

Utility expenses 900

Sundry expenses 550

Cash 7,300

(Cash payment for the said expenses)



Post to ledger:Cash

Nov 115

Capital, ReenService revenue

RM30,00015,000

Nov 230

LandSalary expensesRental expensesUtility expensesSundry expenses

RM5,0004,2501,600

900550

Salary expenses Rental expenses

Nov 30 CashRM

4,250 Nov 30 Cash RM

1,600

Utility expenses Sundry expenses

Nov 30 CashRM900 Nov 30 Cash

RM550


Transaction 6:On 30 November, the business paid its debt to the supplier of supplies purchased on 4 November for RM1,900.



Nov 30 Accounts Payable 1,900

Cash 1,900

(Payment to accounts payable)


Post to ledger:Cash

Nov 115


RM30,00015,000

Nov 230

30

LandSalary expensesRental expensesUtility expensesSundry expensesAccounts payable

RM5,0004,2501,600

900550

1,900


Accounts Payable

Nov 30 CashRM

1,900 Nov 4 SuppliesRM

2,700


Transaction 7:Unused offi ce supplies on 30 November were valued at RM1,100.



Nov 30 Supplies expenses 1,600

Supplies 1,600

(Recording usage of supplies)


Post to ledger:Supplies

Nov 4 Accounts payableRM

2,700 Nov 30 SuppliesRM

1,600

Supplies expenses

Nov 30 SuppliesRM

1,600


Transaction 8:On 30 November, Reen took RM4,000 cash from the business for her personal use.



Nov 30 Drawings, Reen 4,000

Cash 4,000

(Cash drawings by owner)



Post to ledger:Cash

Nov 115


RM30,00015,000

Nov 230

3030

LandSalary expensesRental expensesUtility expensesSundry expensesAccounts payableDrawings, Reen

RM5,0004,2501,600

900550

1,9004,000

Drawings, Reen

Nov 30 CashRM

4,000


How are you doing so far? Can you understand the recording process at this stage? By using the same transactions, we have prepared the journal entries and transferred them to ledger. The journalising and posting process that we have done is a very simple example for you to better understand the basic process, emphasising only on the date, accounts and amounts involved. In the next example, we will perform postings in detail involving reference column.

2.4.3 Example of Analysis and Summary of Transaction

The double entry system is very useful for analysing the effects of transactions. According to the system, every transaction will affect at least two items in the fi nancial 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 diffi cult at this stage to make an analysis, or feel there are too many things to remember. However, with familiarisation and frequent practice, you will fi nd that these three things can be done simultaneously.


We will now continue with the example of Reen Cyber Service by extending the transactions to December. In December, we will see more transactions. We will analyse the transactions one by one with emphasis given on the types of transaction that have not been analysed before. The transactions throughout December are listed in Table 2.4.

Table 2.4: Transactions for the month of December

No.Date

(Dec 2008)Transactions

1 1 Paid insurance premium of RM4,800 for coverage against losses due to fire and burglary for a period of 24 months.

2 1 Paid office rental for the month of December of RM1,600.

3 1 A company planned to rent the land owned by Reen Cyber Service. The business rented the land for three months for RM720. The tenant paid the amount in cash.

4 4 Purchased office equipment on credit from Office Equipment Sdn. Bhd. totalling RM3,600.

5 6 Paid RM360 to advertise the business in the newspaper.

6 11 Paid RM800 for the transaction on 4 December.

7 13 Paid salary of temporary staff for RM1,900 for the first two weeks of December.

8 16 Received RM6,200 cash from customer for services provided.

9 16 Provided services valued at RM3,500 to a customer. The customer promised to pay next month.

10 20 Made another payment of RM1,800 for transaction on 4 December.

11 21 Customer made payment for account receivable of RM1,300.

12 23 Purchased supplies by cash for RM2,900.

13 27 Paid salary of temporary staff for RM2,400 for the last two weeks of December.

14 31 Paid telephone and electricity bill for the month December for RM620 and RM450 respectively.

15 31 Received cash of RM5,740 from customer on the services provided.

16 31 Billed customer for the services provided of RM2,240.

17 31 Reen made cash drawings of RM4,000.


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 andeffects of transaction

Prepaid insurance account (asset) increased by RM4,800.Cash account (asset) reduced by RM4,800.

Analysis 3:Rule of debit and credit

Prepaid insurance account (asset) increased: debitCash account (asset) reduced: credit



Dec 1 Prepaid insurance L15 4,800

Cash L11 4,800

(Paid insurance premium for 24 months)


Post to ledger:

Prepaid Insurance Account No: 15

Date Description Reference Debit (RM) Credit (RM) Balance

Dec 1 Cash J2 4,800

Cash Account No: 11


Dec 1 Prepaid insurance J2 4,800



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 fi nal 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

Rental expenses account (expense) increased by RM1,600.Cash account (asset) reduced by RM1,600.


Rental expenses account (expense) increased: debitCash account (asset) reduced: credit



Dec 1 Rental expenses L52 1,600

Cash L11 1,600

(Paid rental expenses for December month)



Post to ledger:

Rental expenses Account No: 52


Dec 1 Cash J2 1,600

Cash Account No: 11


Dec 1 Rental expenses J2 1,600


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 specifi c 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.



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


Cash account (asset) increased: debitDeferred rental account (liability) increased: credit



Dec 1 Cash L11 720

Deferred rental L23 720

(Cash received for three months rental)


Post to ledger: Cash Account No: 11


Dec 1 Deferred rental J2 720

Derferred rental Account No: 23


Dec 1 Cash J2 720



Transaction 4:Purchased offi ce equipment on credit for RM3,600.


Office equipment account (asset) increased by RM3,600.Accounts payable (liability) increased by RM3,600.


Office equipment account (asset) increased: debitAccounts payable (liability) increased: credit



Dec 4 Office equipment L18 3,600

Accounts payable L21 3,600

(Purchased office equipment on credit)

Post to ledger:

Offi ce Equipment Account No: 18


Dec 4 Accounts payable J2 3,600

Account Payable No: 15


Dec 4 Office equipment J2 3,600


Transaction 5:Paid RM360 for advertisement in newspaper.

For large businesses that always advertise their products or services. For advertisement that involves large sums, a specifi c 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.



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


Sundry expenses account (expense) increased: debitCash account (asset) decreased: credit



Dec 6 Sundry expenses L55 360

Cash L11 360

(Payment for advertisement expenses)


Post to ledger:

Sundry Expenses Account No: 55


Dec 6 Cash J2 360

Cash Account No: 11


Dec 6 Sundry expenses J2 360



Transaction 6 :Paid supplier (for transaction on 4 December) amounting to RM800.


Accounts payable (liability) decreased by RM800.Cash account (asset) decreased by RM800.


Accounts payable (liability) decreased: debitCash account (asset) decreased: credit



Dec 11 Accounts payable L21 800

Cash L11 800

(Payment for accounts expenses)


Post to ledger:

Accounts payable No: 21


Dec 11 Cash J2 800

Cash Account No: 11


Dec 11 Accounts payable J2 800


Transaction 7:Paid salary of temporary staff for the fi rst two weeks of December totalling RM1,900.


Salary expenses account (expense) increased by RM1,900.Cash account (asset) decreased by RM1,900.


Salary expenses account (expense) increased: debitCash account (asset) decreased: credit



Dec 13 Salary expenses L51 1,900

Cash L11 1,900

(Salary payment for temporary staff)


Post to ledger:

Salary expense Account No: 51


Dec 13 Cash J2 1,900

Cash Account No: 11


Dec 13 Salary expenses J2 1,900



Transaction 8:Received RM6,200 cash for services provided:


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



Dec 16 Cash L11 6,200

Service revenue L41 6,200

(Received cash for services provided)


Post to ledger:

Cash Account No: 51


Dec 16 Service revenue J2 6,200

Service revenue Account No: 41





Transaction 9:Billed customer for RM3,500 for services provided.


Accounts receivable (asset) increased by RM3,500.Service revenue account (revenue) increased by RM3,500.


Accounts receivable (asset) increased: debitService revenue account (revenue) increased: credit



Dec 16 Accounts receivable L12 3,500


(Billed customer for services provided)


Post to ledger:

Accounts receivable No: 12





Dec 16 Accounts receivable J2 3,500



Transaction 10:Payment of RM1,800 to supplier (for transaction on 4 December).


Accounts payable (liability) decreased by RM1,800.Cash account (asset) decreased by RM1,800.


Accounts payable (liability) decreased: debitCash account (asset) decreased: credit



Dec 20 Accounts payable L21 1,800

Cash L11 1,800



Post to ledger:

Accounts payable No: 12



Cash Account No: 11


Dec 20 Accounts payable J3 1,800



Transaction 11:Customer paid cash RM1,300 as payment on its accounts receivable.


Cash account (asset) increased by RM1,300Accounts receivable (asset) decreased by RM1,300


Cash account (asset) increased: debitAccounts receivable (asset) decreased: credit



Dec 21 Cash L11 1,300

Accounts receivable L12 1,300

(Payment received for accounts receivable)


Post to ledger:

Cash Account No: 11



Accounts Receivable No: 12





Transaction 12:Purchased supplies by cash for RM2,900.


Supplies account (asset) increased by RM2,900.Cash account (asset) decreased by RM2,900.


Supplies account (asset) increased: debitCash account (asset) decreased: credit



Dec 23 Supplies L14 2,900

Cash L11 2,900

(Purchase supplies by cash)


Post to ledger:

Supplies Account No: 14



Cash Account No: 11


Dec 23 Supplies J3 2,900



Transaction 13:Paid salary of temporary staff for the last two weeks of December totalling RM2,400.


Salary expenses account (expense) increased by RM2,400.Cash account (asset) decreased by RM2,400.


Salary expenses account (expense) increased: debitCash account (asset) decreased: credit



Dec 27 Salary expenses L51 2,400

Cash L11 2,400

(Payment for salary of temporary staff)

Journal 21: Ledger for Transaction 13

Post to ledger:

Salary expenses Account No: 51



Cash Account No: 11


Dec 27 Salary expenses J3 2,400



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 signifi cance 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.


Utility expenses account (expense) increased by RM1,070.Cash account (asset) decreased by RM1,070.


Utility expenses account (expense) increased: debitCash account (asset) decreased: credit



Dec 31 Utility expenses L53 1,070

Cash L11 1,070

(Payment for telephone and electricity bill for December)


Post to ledger:

Utility expenses Account No: 53



Cash Account No: 11


Dec 31 Utility expenses J3 1,070



Transaction 15:Received cash RM5,740 for services provided.


Cash account (asset) increased by RM5,740.Service revenue account (revenue) increased by RM5,740.


Cash account (asset) increased: debitService revenue account (revenue) increased: credit



Dec 31 Cash L11 5,740




Post to ledger:

Cash Account No: 11








Transaction 16:Billed customer for RM2,240 for services provided.


Accounts receivable (asset) increased by RM2,240Service revenue account (revenue) increased by RM2,240


Accounts receivable (asset) increased: debitService revenue account (revenue) increased: credit



Dec 31 Accounts receivable L12 2,240




Post to ledger:

Account Receivable No: 12








Transaction 17:Owner made cash drawings of RM4,000.


Drawings account (contra owner equity) increased by RM4,000Cash account (asset) decreased by RM4,000.


Drawings account (contra owner equity) increased: debitCash 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.



Dec 31 Drawing, Reen L32 4,000

Cash L11 4,000

(Cash drawing by Reen).


Post to ledger:

Drawings, Reen Account No: 32



Cash Account No: 11


Dec 31 Drawings, Reen J3 4,000


After analysing all the transactions one by one, we will now combine all the journal entries and entries posting involved throughout the month of November and December 2008.

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


GENERAL JOURNAL pg 1

Date Account and Description Reference Debit (RM) Credit (RM)

Nov 1 Cash L11 30,000

Capital, Reen L31 30,000

(Investment by Reen)

2 Land L17 20,000

Cash L11 5,000

Notes payable L22 15,000

(Purchase of land by cash and bank loan)

4 Supplies L14 2,700


(Purchase of supplies on credit)

15 Cash L11 15,000



30 Salary expenses L51 4,250

Rental expenses L52 1,600

Utility expenses L53 900

Sundry expenses L55 550

Cash L11 7,300

(Payment of expenses by cash)

30 Account payable L21 1,900

Cash L11 1,900


30 Supplies expenses L54 1,600

Supplies L14 1,600

(Recording of supplies usage)

30 Drawings, Reen L32 4,000Cash L11 4,000





Dec 1 Prepaid Insurance L15 4,800

Cash L11 4,800

(Paid insurance premium for 24 months)

1 Rental expenses L52 1,600

Cash L11 1,600

(Paid rental for December)

1 Cash L11 720

Deferred rental L23 720

(Cash received for three months rental)

4 Office equipment L18 3,600


(Purchased office equipment by credit)

6 Sundry expenses L55 360

Cash L11 360

(Payment for advertisement expenses)

11 Accounts payable L21 800

Cash L11 800



Cash L11 1,900


16 Cash L11 6,200



16 Accounts receivable L12 3,500






Dec 20 Accounts payable L12 1,800

Cash L11 1,800


21 Cash L11 1,300

Accounts receivable L12 1,300

(Received payment for accounts receivable)

23 Supplies L14 2,900

Cash L11 2,900

(Purchased of supplies by cash)


Cash L11 2,400


31 Utility expenses L53 1,070

Cash L11 1,070

(Payment of telephone and electricity bill)

31 Cash L11 5,740



31 Accounts receivable L12 2,240



31 Drawings, Reen L32 4,000

Cash L11 4,000


Journal 26: General Journal for Reen Cyber Service for the month of November and December 2008.


GENERAL LEDGER

Cash Account No: 11

Date Description Reference Debit (RM)

Credit (RM)

Balance (RM)

Nov 1 Capital, Reen J1 30,000 30,000

2 Land J1 5,000 25,000

15 Service revenue J1 15,000 40,000

30 Salary expenses J1 4,250 35,750

Rental expenses J1 1,600 34,150

Utility expenses J1 900 33,250

Sundry expenses J1 550 32,700

30 Accounts payable J1 1,900 30,800

30 Drawings, Reen J1 4,000 26,800

Dec 1 Prepaid insurance J2 4,800 22,000

Rental expenses J2 1,600 20,400

Deferred rental J2 720 21,120

6 Sundry expenses J2 360 20,760

11 Accounts payable J2 800 19,960



20 Accounts payable J3 1,800 22,460

21 Accounts receivable J3 1,300 23,760

23 Supplies J3 2,900 20,860


31 Utility expenses J3 1,070 17,390


31 Drawings, Reen J3 4,000 19,130

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




Credit (RM)

Balance (RM)

Dec 16 Service revenue J2 3,500 3,500

21 Cash J3 1,300 1,100



Date Description Reference Debit(RM)

Credit(RM)

Balance(RM)

Nov 4 Accounts payable J1 2,700 2,700

30 Supplies expenses J1 1,600 1,100

Dec 23 Cash J3 2,900 4,000

Prepaid insurance Account No: 15


Credit(RM)

Balance(RM)

Dec 1 Cash J2 4,800 4,800

Land Account No: 17


Credit(RM)

Balance(RM)

Nov 2 Cash J1 5,000 5,000

Notes payable J1 15,000 20,000



Credit(RM)

Balance(RM)

Dec 4 Accounts payable J2 3,600 3,600

Accounts Payable No: 22


Credit(RM)

Balance(RM)

Dec 4 Supplies J1 2,700 2,700

30 Cash J1 1,900 800

Dec 4 Supplies J2 3,600 4,400

11 Cash J2 800 3,600

20 Cash J3 1,800 1,800


Notes Payable Account No: 22

Date Description ReferenceDebit(RM)

Credit(RM)

Balance(RM)

Nov 2 Land J1 15,000 15,000

Deferred Rental Account No: 23


Credit(RM)

Balance(RM)

Dec 1 Cash J2 720 720

Capital, Reen Account No: 31


Credit(RM)

Balance(RM)

Nov 1 Cash J1 30,000 30,000

Drawings, Reen Account No: 32


Credit(RM)

Balance(RM)

Nov 30 Cash J1 4,000 4,000

Dec 31 Cash J3 4,000 8,000

Service Revenue Account No: 41


Credit(RM)

Balance(RM)

Nov 15 Cash J1 15,000 15,000

Dec 16 Cash J2 6,200 21,200

Accounts receivable J2 3,500 24,700

31 Cash J3 5,470 30,440

Account receivable J3 2,240 32,680

Salary Expenses Account No: 51


Credit(RM)

Balance(RM)

Nov 30 Cash J1 4,250 4,250

Dec 13 Cash J2 1,900 6,150

27 Cash J3 2,400 8,550


Rental Expenses Account No: 52


Credit(RM)

Balance(RM)

Nov 30 Cash J1 1,600 1,600

Dec 1 Cash J2 1,600 3,200

Utility Expenses Account No: 53


Credit(RM)

Balance(RM)

Nov 30 Cash J1 900 900

Dec 31 Cash J3 1,070 1,970

Supplies Expenses Account No: 54


Credit (RM)

Balance (RM)

Nov 30 Supplies J1 1,600 1,600



Credit (RM)

Balance (RM)

Nov 30 Cash J1 550 550

Dec 6 Cash J2 360 910

2.4.4 Trial Balance

Trial balance is a list of all the accounts used including the corresponding balances at a specifi c date. Normally the trial balance would be prepared at the end of the specifi c accounting period and the debit and credit totals need to be equal.

The main purpose of preparing the trial balance is to ensure that the total debit and credit balances are the same. Unequal amount of total balances indicate that errors had happened in any one of the stages in the recording process, whether during the journal entry, posting to ledger or the preparation of the trial balance itself.

However, it must always be kept in mind that a balanced trial balance does not necessarily mean that there are no errors. Examples of errors that can occur even though the trial balance is balanced are:

(a) the transaction has not been recorded at all in the journal;

(b) the transaction entry has not been posted to the ledger;


(c) the transaction of entry posted to ledger had been done twice; and

(d) the usage of wrong account during journalising or posting.

In the fi rst 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 fi rst 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 fi nal case, the debit and credit amount is equal, only that they have been recorded on the wrong side of the accounts. The fi nal 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 diffi cult to detect as the fi nal 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?


Reen Cyber ServiceTrial Balance

as at 31 December 2008

Account Number

AccountsDebit(RM)

Credit(RM)

11 Cash 19,130

12 Accounts receivable 4,440

14 Supplies 4,000

15 Prepaid insurance 4,800

17 Land 20,000

18 Office equipment 3,600

21 Accounts payable 1,800

22 Notes payable 15,000

23 Deferred rental 720

31 Capital, Reen 30,000

32 Drawings, Reen 8,000

41 Service revenue 32,680

51 Salary expenses 8,550

52 Rental expenses 3,200

53 Utility expenses 1,970

54 Supplies expenses 1,600

55 Sundry expenses 910

TOTAL 80,200 80,200

Figure 2.7: Trial balance


EXERCISE 2.2

1. What is meant by account, ledger and chart of accounts?

2. State two account format of that you have learned. Which is the easier format? Which format will show the latest balance after each transaction?

3. Drawings and expense will reduce owner’s equity. Discuss the difference between these two terms.

4. Which of the following accounts have a normal debit balance?A. Owner’s capitalB. Deferred rentalC. Prepaid expenseD. Service revenue

5. A credit balance in which account might indicate an error?A. Rental revenueB. Accounts payableC. DrawingsD. Capital

6. Group the following accounts according to its type (asset, liability, owner’s equity, revenue or expense):

(a) Vehicle

(b) Insurance expenses

(c) Prepaid insurance

(d) Rental revenue

(e) Deferred rental

(f) Supplies

(g) Supplies expenses

(h) Accounts receivable


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 = Liability +Owner’s Equity

Trans. Cash + AR + Supplies = AP + Capital, Cindy

a. +5,000 +5,000 Capital,

Cindyb. +275 +275c. +3,250 +3,250

Service revenue

d. -750 -750Paid rental

expensee. -125 -125f. +1,875 +1,875

Service revenue

g. -577 -390Paid utility

expense-187

Paid sundry expense

h. -1,250 -1,250Paid salary

expensei. -162 -162

Paid supplies

expensesj. -500 -50 -550

Drawings, Cindy

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


EXERCISE 2.4

1. The following are the chart of accounts and accounts balances for Edlin Enterprise on 1 February 2007:

Account No

AccountsBalance as at 1/2/07

(RM)

101 Cash 15,238


104 Supplies 427

108 Office equipment 8,400


301 Capital, Edlin 26,910

302 Drawings, Edlin

401 Service revenue

501 Rental expenses

502 Advertisement expenses

503 Utility expenses

509 Sundry expenses

Transactions involving Edlin Enterprise throughout the month of February 2007 are:

Date Transaction Feb 1 Purchased office supplies by cash RM274. 2 Edlin withdrew cash from business totalling RM2,000 for personal

use. 5 Received RM2,740 cash from customer for payment on accounts

receivable. 9 Purchased office equipment valued at RM4,000 on credit. The seller

agreed to give a discount of RM150 from the amount. 15 Made payment to accounts payable for RM1,200. 18 Received cash for services provided for RM580. 25 Paid RM420 to advertise its business in the newspaper. 28 Paid telephone bills (RM75 for 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.

29 Paid RM1,200 for rental of business premises. 30 Paid RM220 to repair the office equipment.


SUMMARY

The important matters discussed in this topic were:

• The chart and format of accounts used to present the fi nancial 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.

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.

AssetsChart of AccountsCreditDebitExpenses

JournalLedgerLiabilitiesRevenueTrial Balance

Topic

3CompletingtheAccountingCycle

LEARNING OUTCOMES


1. Describe the types of adjusting entries;

2. Prepare the Adjusted Trial Balance;

3. Prepare the fi nancial statements consist of income statement, statement of changes in owner’s equity, balance sheet statement and cash fl ow statement;

4. Prepare the closing entries; and

5. Prepare the reversing entries.

INTRODUCTIONThis 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 fi nancial statements, comprising the income statement, statement of changes in owner’s equity, balance sheet and cash fl ow statement; are prepared based on the information from the adjusted trial balance. The preparation of cash fl ow 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 ENTRIESYou 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 fi nancial 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) prepaid expenses;

(b) depreciation expenses;

(c) unearned revenue;

(d) accrued expenses; and

(e) accrued revenue.

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 benefi t 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 fi rst 3 months. The landlord had set the rental at RM300 per month. The journal entries are as follows:

1 April 2006 Dr. Rental Prepaymewnt RM900 Cr. Cash RM900

When the entry is transferred to ledger, the accounts involved will be:

Rental Prepayment Account Cash AccountRM RM

April 1 2006 900 April 1 2006 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 fi nancial statement.

Therefore, an adjusting entry is needed to update and match the expenses accurately so that the correct total is reported in the fi nancial statements.

The adjusting entry is as follows:

30 April 2006 Dr. Rental expenses RM300* Cr. Rental prepayment RM300

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


*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 ExpensesRM RM

April 1 2006 900 April 30 2006 300

Balance 600

Rental Expenses AccountRM

April 30 2006 300

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.


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 offi ce 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 60,000 Cr. Cash 60,000


Vehicle Account Cash AccountRM RM

1 Jan 2007 60,000 1 Jan 2007 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.

3.1.2 Depreciation Expenses

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


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 AccountRM

31 Dec

2007 6,000

Accumulated Depreciation AccountRM

31 Dec 2007 6,000

The debit entry of RM6,000 in the depreciation expenses account refl ects 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:

RMVehicle’s cost as at 1 Jan 2007 60,000(-) Accumulated depreciation – vehicle (6,000)Vehicle’s book value as at 31 December 2007 54,000

3.1.3 Unearned Revenue (Unearned Income)

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.

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


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 800 Cr. Unearned revenue 800


Cash Account Unearned RevenueRM RM

1 Dec 2007 800 1 Dec 2007 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 800 Cr. Service revenue 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 AccountRM RM

1 Jan 2008 800 31 Dec 2007 800

Service Revenue AccountRM

1 Jan 2008 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.


3.1.4 Accrued Expenses

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 outfl ow 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 fi nancial 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 4,500 Cr. Salary Payable 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 Salary Payable AccountRM RM

31 Dec 2006 4,500 31 Dec 2006 4,500

This adjusting entry will recognise the salary expenses for the period even though cash outfl ow 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 expenses refer to all expenses incurred but have not yet been paid or recorded because there was no cash outfl ow from the business entity.

Accrued revenue refers to the revenue that had been obtained but there is no cash infl ow 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.


Accrued revenue is an asset as the benefi t 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 1,200 Cr. Rental revenue 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 AccountRM

31 Dec 2008 1,200

Rental Revenue AccountRM

31 Dec 2008 1,200

At the end of the accounting period, revenue that has been recorded or recognised totalled RM1,200 even though there is no cash infl ow while asset increased by RM1,200 when rental receivable was debited.

If there is no adjustment, the account balances presented in the fi nancial statements will not comply with the principle of revenue recognition and principle of matching. Therefore the fi nancial 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 fi nancial statements. The Adjusted Trial Balance will be discussed next. To ensure that you understand what you have learned, answer the following questions:


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 fi nancial 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) Unearned rental revenue at 31 December 2008 totalled RM480.

(d) Salary accrued but not yet paid at 31 December 2008 totalled RM500.

(e) Interest revenue accrued but not yet recorded for the month of December totalled RM1,000.

EXERCISE 3.1

Explain the meaning for each of the following:

(a) Accrued Revenue

(b) Accrued Expenses

(c) Prepaid Expenses

(d) Unearned Revenue


(f) Depreciation for offi ce 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


Credit (RM)

31 December Supplies expenses 2,480

Supplies 2,480

31 December Insurance expenses 200

Insurance prepayment 200

31 December Unearned rental revenue 240

Rental revenue 240

31 December Salary expenses 500

Salary accrued 500

31 December Accounts receivable 1,000

Interest revenue 1,000

31 December Depreciation expenses 100

Accumulated depreciation for offi ce equipment

100


Table 3.2: Unadjusted Trial Balance

Reen Cyber ServiceTrial Balance


Account Number

AccountsDebit (RM)

Credit (RM)

11 Cash 19,130


14 Supplies 4,000

15 Insurance prepayment 4,800

17 Land 20,000

18 Offi ce equipment 3,600


22 Notes payable 15,000

23 Unearned rental revenue 720

31 Capital, Reen 30,000

32 Drawings, Reen 8,000

41 Interest revenue 32,680

51 Salary expenses 8,550

52 Rental expenses 3,200

53 Utility expenses 1,970

54 Supplies expenses 1,600

55 Sundry expenses 910

TOTAL 80,200 80,200

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.


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 refl ected 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.


(f) Depreciation of offi ce 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 AdjustmentAdjusted Trial

Balance

Name of Account Dr. (RM)

Cr. (RM)

Dr. (RM)

Cr. (RM)

Dr. (RM)

Cr. (RM)

Cash 19,130 19,130

Accounts receivable 4,440 (5) 1,000 5,440

Supplies 4,000 (1) 2,480 1,520

Insurance prepayment 4,800 (2) 200 4,600

Land 20,000 20,000

Offi ce equipment 3,600 3,600

Accounts payable 1,800 1,800

Unearned rental revenue 720 (3) 240 480

Notes payable 15,000 15,000

Capital, Reen 30,000 30,000

Drawings, Reen 8,000 8,000

Interest revenue 32,680 (5) 1,000 33,680

Salary expenses 8,550 (4) 500 9,050

Rental expenses 3,200 3,200

Utility expenses 1,970 1,970

Supplies expenses 1,600 (1) 2,480 4,080

Sundry expenses 910 910

Insurance expenses (2) 200 200

Rental revenue (3) 240 240

Salary accrued (4) 500 500

Depreciation expenses (6) 100 100

Accumulated depreciation – equipment

(6) 100 100

80,200 80,200 4,520 4,520 81,800 81,800


You can also prepare the Adjusted Trial Balance for Reen Cyber Service without using the sheet by:

(a) preparing the adjusting entries.

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

(c) entering the current balance that had been adjusted into the Adjusted Trial Balance as below:

Table 3.4: Adjusted Trial Balance

Reen Cyber ServiceAdjusted Trial Balanceas at 31 December 2008

RM RM

Cash 19,130Accounts receivable * 5,440Supplies * 1,520Insurance prepayment * 4,600Land 20,000Offi ce equipment 3,600Accounts payable 1,800Unearned revenue * 480Notes payable 15,000Capital, Reen 30,000Drawings, Reen 8,000Interest revenue * 33,680Salary expenses * 9,050Rental expenses 3,200Utility expenses 1,970Supplies expenses * 4,080Sundry expenses 910Insurance expenses ** 200Rental revenue ** 240Salary accrued ** 500Depreciation expenses ** 100Accumulated depreciation – equipment **

100

81,800 81,800

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


After the adjustments are made, you will fi nd 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 fi nancial 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?

EXERCISE 3.2

Information for adjustments is as follows:

1. Supplies in hand at 31 December 2007 amounted to RM750. Supplies at 1 January 2007 totalled RM1,000.

2. Depreciation of equipment for the year 2007 totalled RM400.

3. Interest accrued on notes payable totalled RM300.

4. Insurance expired throughout the year 2007 totalled RM1,500.

5. Revenue accrued at 31 December 2007 totalled RM750.

6. Unearned revenue received throughout the year 2007 totalled RM5,000.

Prepare the adjusting entries at 31 December 2007.

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


3.3 PREPARATION OF FINANCIAL STATEMENTS

After studying the preparation of Adjusted Trial Balance, you will now learn how to prepare Financial Statements. The fi nancial statements are prepared after all transactions are recorded or journalized, transferred and summarised in the trial balance. The fi nancial statements are also known as the accounting report that reports the fi nancial status at the end of the accounting period.

This topic will only discuss on the preparation of the fi nancial statements for service-oriented businesses. As you know, the fi nancial 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

It is also known as the summary of revenue and expense for a specifi c 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 profi t will be reported in its income statement.

Total Revenue > Total Expense = Net Profi t

If the total expense exceeds total revenue, the business entity will report a net loss.

Total Expense > Total Revenue = Net Loss

Income Statement refers to the fi nancial statement which presents the operational results of the business entity for a specifi c period.


The matching process is used to determine the net profi t 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 profi t/loss

Figure 3.2 shows the format for Income Statement:

Figure 3.2: Format of income statement for service fi rms

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.


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.

Figure 3.3 shows examples sources of revenue.

Figure 3.3: Examples of sources of revenue

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:


(a) You must analyse the information reported in the following Adjusted Trial Balance:

Reen Cyber ServiceAdjusted Trial Balanceas at 31 December 2008

RM RM

Cash 19,130

Accounts receivable 5,440

Supplies 1,520

Insurance prepayment 4,600

Land 20,000

Offi ce equipment 3,600

Accounts payable 1,800

Unearned interest revenue 480


Capital, Reen 30,000

Drawings, Reen 8,000


Salary expenses 9,050


Utility expenses 1,970

Supplies expenses 4,080

Sundry expenses 910

Insurance expenses 200

Rental revenue 240

Salary payable 500

Depreciation expenses 100

Accumulated depreciation 100

81,800 81,800


(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.


Rental revenue



Utility expenses 1,970

Supplies expenses 4,080

Sundry expenses 910

Insurance expenses 200

Depreciation expenses 100

19,510 33,920

(c) Calculate the net profi t or loss by adding all the revenue items and deducting all the expense items. If the total revenue exceeds total expenditure, then net profi t 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 profi t of RM14,410.

RM

Total revenue 33,920Total expense (19,510)Net Profi t 14,410

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


Reen Cyber ServiceIncome Statement

For two months ended 31 December 2008

RM RMRevenue:Interest revenue 33,680Rental revenue (240)

33,920Less expenses:Salary expenses 9,050Rental expenses 3,200Utility expenses 1,970Supplies expenses 4,080Sundry expenses 910Insurance expenses 200Depreciation expenses 100

(19,510)Net Profi t 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 specifi c 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.


Equity is comprised of the following items:

(a) opening capital;

(b) the yearly retained profi t or loss;

(c) drawings; and

(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 ServiceStatement of Changes in Owner’s EquityFor two months ended 31 December 2008

RMCapital Reen, 1 November 2008 30,000* from income statementNet profi t 14,410Drawings (8,000)*

Capital Reen, 31 December 2008 36,410 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 profi t/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 profi t 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.


3.3.3 Balance Sheet

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

(a) Asset Asset is an economic resource owned by a business entity that can bring

benefi t 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 classifi ed as an asset are:

• The resource can help the business entity to generate cash infl ow in the future, whether directly or indirectly.

• The resource must benefi t 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.

Self Check 3.4


(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 classifi ed 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


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 classifi ed 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 fi nished goods inventory (all these types of inventories will be discussed in Topic 5). Similarly, businesses that buy and sell goods (trading fi rms) 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 non-current 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.


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.

Long-term investments are investment held by the business entity for a period of more than one year.

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.

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 benefi ts that can be provided by the intangible assets to the business entity in the future are diffi cult 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.


Figure 3.5: Long-term assets

The following is a summary on assets.

Asset

Economic resources that can generate benefi t to the entity in the future.

Current Assets Long-Term Assets/Non-current Assets

1. Expected usage within 1 year or operating cycle period

1. Can be used or held by the business for more than 1 year.

2. Comprises:(a) Cash(b) Trading securities/Short-term(c) Item receivables(d) Inventory(e) Prepayment expenses

2. 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.


(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 fi nancial 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 outfl ow from the business entity.


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 classifi ed as current liability and not long-term liability. The balance will be classifi ed 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 specifi c period which exceeds one year.

Secured loan is a liability to a business company towards another party, for example bank or fi nancial 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.


Table 3.5: Summary of Liabilities

Liabilities

Economic benefi t that must be sacrifi ced by transferring the asset or providing services/goods to another business entity.

Current Liability Long-Term Liability/Non-current Liability

1. Expected to be paid within a period of one year

1. Expected to be settled within the period > one year.

2. Comprises:• Bank loan• Item payable• Portion of current long-term

liability• Deferred revenue

2. 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 3.2

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.


Reen Cyber ServiceBalance Sheet


RM RM RM

Non-current assets: Land 20,000 Offi ce equipment 3,600 Accumulated depreciation (100) 3,500 23,500

Current assets: Cash 19,130 Accounts receivable 5,440 Suppliers 1,520 Insurance prepayment 4,600 30,690

Less: Current Liabilities: Account payable 1,800 Salary payable 500 Unearned revenue 480 (2,780) Net current assets 27,910 51,410

Finance by: Owner’s Equity Capital, Reen 36,410*Non-curent liability: Notes payable 15,000 51,410

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:

• 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.

From the statement of changes in owner’s equity


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 ServicesAdjusted Trial Balance

as at 30 June 2007

Debit CreditCash 56,350Accounts receivable 41,600Offi ce supplies 12,300Rental prepayment 4,400Insurance prepayment 15,100Offi ce equipment 99,000Accumulated depreciation – offi ce equipment 10,725

Accounts payable 17,600Unearned Fees 10,980Notes payable – long-term 100,000Salary payable 7,100Capital, Khairunnisa’ 51,990Fees revenue 119,280Sundry expenses 10,700Rental expenses 13,800Utility expenses 4,900Salary expenses 49,600Supplies expenses 5,600Insurance expenses 3,500Depreciation expenses 825

Total 317,675 317,675

From the information above,

1. Prepare the income statement for the period ended 30 June 2007 for Khairunnisa’ Consulting Services.

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


3.3.4 Cash Flow Statement

You will next be exposed to the fourth fi nancial statement, the cash fl ow statement which summarises the cash received and cash payment for the period. It presents the basic cash information for operating, investing and fi nancing activities. The cash fl ow statement can help users of accounting information to:

(i) evaluate the capability of the company to generate positive cash fl ow in the future; and

(ii) evaluate the capability of the company in settling its debts, paying dividends and providing loans to external parties.

Cash fl ow statement can be classifi ed under three activities, which are operating activities, investing activities and fi nancing activities.

Figure 3.7: Cash fl ow statement

(a) Operating Activities Operating activities involve cash transactions that affect the business’ net

profi t, 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 specifi ed interest and dividend received as part of items from operating activities. However, both these items can also be classifi ed as investing or fi nancing 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 profi t or loss from the sale of non-current asset will not be included in the calculation of net cash fl ow from investing activities.


(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 profi t or loss during the payment of all debts, it will not be taken into account while generating the net cash fl ow from fi nancing activities.

Examples of Cash Received and Payments for each of the activities are as follows:

Operating Activities

Cash Received From: Cash Payment For:

Sale of goods Purchase of goods

Service revenue Staff wages and salary

Fees revenue Utility expenses

Rental revenue Rental expenses

Investing Activities


Sale of non-current asset Purchase of non-current asset

Sale of investment Purchase of shares (invest)

Collection of loan provided to other entities

Provision of loan to other entities

Financing Activities


Loan or debt of the company from external parties

Repayment of loan/debt

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.


Air Molek EnterpriseCash Flow Statement

for the Period Ended 31 December 2007

Operating Activities RM RMReceived: Collection from customer 6,500

Payment: Staff salary (1,200) (1,200)Net cash fl ow from operation 5,300

Investing Activities Sale of land 22,000 Sale of shares 18,000Net cash fl ow from investment 40,000

Financing Activities Investment by owner 50,000 50,000

Total increase in cash 95,300

Cash balance as at 1 January 2007 0Cash balance as at 31 December 2007 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 fl ow.

Cash Flow Statement for Reen Cyber Service is as follows:


Notes to Solution:

Reen Cyber ServiceCash Flow Statement

For the Period Ended 31 December 2008

Operating Activities RM RMReceived:

Cash from customers 13,960Payment: Cash to suppliers (2,600) Expenditure (15,030) (17,630)Net cash fl ow from operation (3,670)

Investing Activities

Financing Activities Drawings by owner (4,000)Total increase/(decrease) in cash (7,670)Cash balance 1 December 2008 26,800Cash balance 31 December 2008 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 fl ow. 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 fi nd that total for all expenses are RM15,030. Therefore, the net cash fl ow from the operating activities totalled (RM3,670), which is (RM13,960 – RM17,630).


(iv) What had happened to the overall cash fl ow? The cash fl ow 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 profi t 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.

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 profi t 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 fi xed 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.

Briefl y explain the four fi nancial statements which are included in the preparation of fi nancial reports.

SELF-CHECK 3.3


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.


Closing entries for Reen Cyber Services as at 31 December 2008 are as follows:

31 December 2008Dr. Interest revenue 33,680

Rental revenue 240 Cr. Revenue Summary 33,920(Closing of all revenue accounts)

Dr. Revenue Summary 19,510 Cr. Salary expenses 9,050 Rental expenses 3,200 Utility expenses 1,970 Supplies expenses 4,080 Sundry expenses 910 Insurance prepayment 200 Depreciation 100(Closing of all expenses accounts)

Dr. Revenue Summary 14,410 Cr. Capital, Reen 14,410

(Closing of revenue summary account)

Dr. Capital, Reen 8,000 Cr. Drawings 8,000(Closing of drawings account)

Notes to Solutions:

(i) All revenue accounts will be closed by debiting the specifi c 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 profi t, while if it has a debit balance, it will be net loss. This balance will be the same net profi t reported in the income statement prepared in the previous topic.


3.5 PREPARATION OF REVERSING ENTRIES

SELF CHECK 3.4

What are the steps required to prepare a closing entry?

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 fi rst 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 800 Cr. Salary Payable 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 800 Cr. Salary expenses 800

If Mas Merah Company prepares the reversal entry on the fi rst day of the next accounting period, the reversal entry would be:

1 January 2006 Dr. Salary payable 800 Cr. Salary expenses 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


Cr. Cash 2,000

After all the journal entries had been transferred to the ledger, the accounts involved are:

Salary Expenses Account

RM RM

31 Dec 2005 Adjustment 800 31 Dec 2005 Closing 800

15 Jan 2006 Payment 2,000 1 Jan 2006 Reversal 800

Salary Payable Account

RM RM

31 Dec 2005 Balance c/f 800 31 Dec 2005 Adjustment 800

1 Jan 2006 Reversal 800 1 Jan 2006 Balance b/d 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.


EXERCISE 3.4

EXERCISE 3.4

1. The trial balance for Berkat Enterprise as at 30 June 2008 is as follows:

Debit Credit

Cash 3,425

Accounts receivable 7,000

Supplies 1,270

Insurance prepayment 620

Offi ce equipment 51,650

Accumulated depreciation – Offi ce equipment

9,700

Salary payable 925

Unearned revenue 1,250

Capital 29,000

Drawings 5,200



Sundry expenses 8,420

Total 100,000 100,000

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 offi ce 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) Prepare the journal entries to record all the adjustments.

(c) Prepare the Income Statement and Balance Sheet at the end of the accounting period.

(d) Prepare the closing entries.


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 fi nal 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 CompanyTrial Balance

31 December 2008RM RM

Cash 6,850Accounts receivable 14,000Supplies 2,540Insurance prepayment 1,240Offi ce equipment 103,300Accumulated depreciation – offi ce equipment 19,400Accounts payable 1,850Unearned revenue 2,500Capital, Moiz 58,000Drawings, Moiz 10,400Service revenue 118,250Salary expenses 44,830Rental expenses 8,400Depreciation expenses 5,430Sundry expenses 3,010Total 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.


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 fi nancial events that had occurred in the specifi c 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 profi t 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 fi rst 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 Financial Reporting

LEARNING OUTCOMES


1. Explain the purpose of the fi nancial report;

2. Describe the statutory requirements for the preparation of fi nancial report or annual report;

3. Examine the contents in the annual report comprising fi nancial information and non-fi nancial information; and

4. Prepare the fi nancial statements that must be presented in the key fi nancial statements according to MASB1.

INTRODUCTIONThis topic discusses the statutory requirements that necessitate business entities to prepare the fi nancial report or annual report.

The contents in the fi nancial reports released by business entities comprise fi nancial information and non-fi nancial information, which will be discussed at the end of the topic.

4.1 STATUTORY REQUIREMENTBefore further discussion on fi nancial reporting, it is better we analyse in advance the statutory requirements for the preparation of this report.

Business entities are required to report their fi nancial status at the end of each accounting period in a formal report known as the fi nancial report or annual report. The purpose of the report is to present the fi nancial status of the business entity for a specifi c 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 fi nancial status of a business entity. In addition, these fi nancial reports are also prepared to fulfi l statutory requirements.

The regulations that must be complied with in the preparation of fi nancial 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 fi nancial 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 fi rst 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 fi nancial 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 fi ned 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 fi nancial 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 fi ne 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 specifi c 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 fi nancial report must be distributed within six months from the last fi nancial 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


(f) Central Bank of Malaysia The Central Bank of Malaysia or Bank Negara Malaysia had prepared a

guideline relating to fi nancial reporting for fi nancial institutions of this country under the Banking and Financial Institutions Act 1989.

This guideline deals with general disclosure in the preparation of fi nancial statement, and detailed disclosures are highly encouraged.

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

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 fi nancial reporting.

To test your understanding, answer the following question.

4.2 FINANCIAL REPORTLet us take a look at the information contained in the fi nancial report in detail.

The Companies Act 1965 (Section 169) had stipulated the contents that must be reported in the fi nancial 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.


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

4.2.1 Non-Financial Information

Non-fi nancial information comprise the following:

(a) Chairman’s Report Report on fi nancial performance or fi nancial status of the company. A

chairman’s report also specifi es future planning and prospects including dividend payout to shareholders based on available proof, such as the profi t 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 offi ce, 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 fi nancial results,

usually for the past fi ve 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 fi nancial report, according to the standards and procedure.


Figure 4.2: Non-fi nancial 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-fi nancial information.


This report is for the purpose of verifying that all the information prepared and reported in the annual fi nancial statements had given a true and fair view.

Non-fi nancial information discussed earlier can be seen in Figure 4.2.

4.3 MAIN FINANCIAL STATEMENTSIn sub-topic 4.2.1, you were exposed to the non-fi nancial information. In this topic, the discussion will revolve on fi nancial 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 fi nancial statements that must be presented in the Key Financial Statements as follows:

(a) Income Statement The fi rst fi nancial statement discussed here is the income statement. The

income statement reports the fi nancial performance by showing loss or profi t 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) Profi t from operating

(iii) Profi t/Loss in associate companies

(iv) Tax

(v) Operating Profi t/Loss

(vi) Extraordinary items

(vii) Minority interest

(viii) Net profi t/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 fi nancial 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


(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 profi t/loss for the current period.

(ii) Revenue and expenditure items.

(iii) Effect of changes in accounting policy and correction of any signifi cant 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 profi t/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 fl ow statement involves cash transactions. The

cash fl ow statement shows the changes in cash that occurred for the business entity during a specifi c period. Information from this statement is very important to users of fi nancial 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 fl ow from the following activities:


(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 defi nes notes to the accounts as part of the fi nancial report. Among the notes to the accounts reported in the fi nancial 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 fi nancial 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 fi nancial 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 fi xed asset and the methods used for calculation of depreciation.


SUMMARY

Several important points that were discussed in this topic are:

• Financial report prepared by business entities shows the fi nancial status of the business which is useful to the investors, creditors, government, economic analysts and other interested users.

• Financial and non-fi nancial information are the main components in the fi nancial/annual report of a business entity.

• MASB 1 lists the fi nancial statements that must be presented in the key fi nancial statements:

– Income Statement

– Balance Sheet Statement

– Statement of Changes in Equity

– Cash Flow Statement

– Notes to the Accounts and Accounting Policies

EXERCISE 4.2

1. What are the differences between fi nancial and non-fi nancial information?

Financial Information Non Financial Information

2. Why are notes to the accounts being prepared?

Financial Information

Financial Report

Financial Statements

Non-fi nancial Information

Statutory Requirement

Topic

5 Trading Business Environment

LEARNING OUTCOMES


1. Explain the difference between services business activities and trading business activities;

2. Prepare the journal entries for trading transactions relating to: (a) purchases;(b) sales;(c) transportation costs; and(d) transactions that involves buyer and seller.

3. Differentiate between periodic and perpetual inventory systems; and

4. Prepare the income statement for trading business.

INTRODUCTIONTopic 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 fi rms, with more emphasis placed on trading fi rms.

There are two types of fi rms: trading fi rms and service fi rms. However, this topic will only focus on trading fi rms. Trading fi rms are businesses that buy goods which will be resold to its buyers. Trading fi rms usually have inventories of goods to be resold. Service fi rms do not have these inventories.

140 TOPIC 5 TRADING BUSINESS ENVIRONMENT

The difference between trading fi rms and service fi rms can be narrowed down to the revenue and expense items which appear in the Income Statement (refer to Figure 5.1)

Service Firms Trading FirmsRM RM

Fees earned XXX Sales XXXOperating expense (XX) Cost of goods sold (XX)

XXX Gross profi t XXXOperating expense (XX)Net operating income XXX

Figure 5.1: Difference in income statement for service fi rms and trading fi rms

Service fi rms derive their revenue from services which they provide to customers. For example, the revenue of accounting fi rms relate to fees from conducting audits in organisations. For income statement of service fi rms, revenue from these services is reported as fees earned (or service revenue). Net operating revenue for service fi rms 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 fi rms. For trading fi rms, revenue is generated from buying and selling goods. Trading fi rms 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 fi rms 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 profi t. Gross profi t is the profi t 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 profi t) 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 ENVIRONMENTIncome statements for trading and service fi rms are different as both involve different activities. Trading fi rms buy goods from supplier and then resell the goods to generate profi t. There are two types of trading fi rms; retailers and wholesalers.

Example of retailers are supermarkets (large scale retailers) and retail shops such as electrical and furniture (small scale retailer).

The characteristics of trading fi rms 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 profi t;

Retailers are trading fi rms that buy goods from wholesalers and resell it directly to consumers.

Wholesalers are trading fi rms that buy goods directly from manufacturers in large quantities.

Wholesalers do not sell the goods directly to consumers but instead sell it to retailers.

Gross Profi t = Sales revenue – Cost of goods sold

(d) Operating expense will be deducted from gross profi t to obtain Net Operating Revenue; and

Net Operating Income = Gross profi t – Operating expense


Tick () at the correct column.1. Gross profi t is:

(a) operating expense deducted from net operating revenue.

(b) sales revenue is more than operating expenses.

(c) sales revenue is more than cost of goods sold.

(d) operating expenses more than cost of goods sold.

2. 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 profi t;

(b) net operating revenue

(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 fi rms deal in goods, a trading entity must have an inventory system which is effi cient and effective to value the opening inventory and closing inventory of the trading fi rm. 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

True False


5.2 IMPORTANT TRANSACTIONS IN TRADING FIRMS

For trading fi rms that sell on credit, the business’ operating cycle include the following transactions:

(a) purchase of goods;

(b) sale of goods; and

(c) collection of accounts receivable.

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 fi rm, these are:

(a) Purchases

(b) Sales

(c) Discounts

(d) Returns and Allowances

(e) Transportation Cost

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.


There are two types of discount:

• Quantity discount; and

• Cash discount.

5.2.3 Discounts

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

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.


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.


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. Explain the meaning of the credit term 2/10, n/30.

2. Explain the meaning of sales discount.

3. Explain the meaning of purchase discount.


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 specifi cations.

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 satisfi ed 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 fulfi l the specifi cation 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.


(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 5.3: Example of debit memo

Figure 5.4: Example of credit memo


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) sales discounts;

(b) sales returns and allowances; and

(c) both (a) and (b).

2. Explain the meaning of purchase returns and allowances.

3. Describe sales returns and sales allowances.

5.2.5 Transportation Cost

In general, transportation terms are specifi ed 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 classifi ed into two:

(a) Free on Board (FOB) shipping point; and

(b) Free on Board (FOB) destination.

SELF-CHECK 5.1

Why do companies provide sales return allowances to their customers?


(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.

Figure 5.5: FOB shipping point

(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 5.6: 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 INVENTORYAs you know, trading fi rms 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


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 signifi cant benefi t 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:


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?


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.


Tab

le 5

.1: D

iffe

renc

es in

Jour

nal E

ntri

es fo

r Pe

riod

ic In

vent

ory

Syst

em a

nd P

erpe

tual

Inve

ntor

y Sy

stem


Tab

le 5

.1: D

iffe

renc

es in

Jour

nal E

ntri

es fo

r Pe

riod

ic In

vent

ory

Syst

em a

nd P

erpe

tual

Inve

ntor

y Sy

stem

(con

tinu

atio

n)


Tab

le 5

.2: I

llust

rati

on o

f Jou

rnal

Ent

ries

for

Buy

er a

nd S

elle

r


Tab

le 5

.2: I

llust

rati

on o

f Jou

rnal

Ent

ries

for

Buy

er a

nd S

elle

r (c

onti

nuat

ion)


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.

2. 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.

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 Purchased goods from Firdaus Sdn. Bhd. for RM4,000, FOB shipping point term, 2/10, n/30 with prepayment of carriage for RM120.

December 5 Purchased goods from Kenari Sdn. Bhd. for RM8,500, with FOB destination term 1/10, n/30.

December 6 Sold goods bought on 3 December to Hijrah Sdn. Bhd. at the price of RM5,800.December 8 Purchased offi ce supplies by cash for RM150.December 10 Returned RM1,300 of goods purchased on 5 December from Kenari Sdn. Bhd.December 13 Paid Firdaus Sdn. Bhd. for purchases made on 3 December, after discount.December 14 Purchased goods by cash of RM10,500.December 15 Paid Kenari Sdn. Bhd. for the purchases made on 5 December, after deducting

returns on 10 December and discount.December 16 Received cash for sales made to Hijrah Sdn. Bhd. on December 6, after

deducting discount.December 19 Sold goods, payment made via American Express credit card for RM2,450. Cost

of goods sold is RM980.December 22 Sold goods to Cerating Sdn. Bhd. total RM3,480, credit term 2/10, n/30. Cost of

goods sold is RM1,400.December 24 Purchased goods by cash for RM4,350. Cost of goods sold is RM1,750.December 25 Received returns from Cerating Sdn. Bhd. for sales made on 22 December,

RM1,480. Cost of goods returned is RM600.December 31 Received cash from American Express for sales made on 19 December and the

service charges is RM140.


Required:Prepare the journal entries for the transactions above.

Solution:

Date DescriptionsDebit (RM)

Credit (RM)

Dec 3 Inventory 4,120 Accounts payable – Firdaus SB 4,120

Dec 5 Inventory 8,500 Accounts payable – Kenari SB 8,500

Dec 6 Accounts receivable – Hijrah SB 5,800 Sales [4,000 - (30% x 4,000)] 5,800Cost of goods sold 4,000 Inventory 4,000

Dec 8 Offi ce supplies 150 Cash 150

Dec 10 Accounts payable – Kenari SB 1,300 Inventory 1,300

Dec 13 Accounts payable – Firdaus SB 4,120 Inventory 80 Cash [4,000 – (2% x 4,000) + 120] 4,040

Dec 14 Inventory 10,500 Cash 10,500

Dec 15 Accounts payable – Kenari SB 7,200 Inventory [(8,500 – 1,300) x 1 %] 72 Cash [8,500 – 1,300 – 72] 7,128

Dec 16 Cash 5,684Sales discount 116 Accounts receivable – Hijrah SB 5,800

Dec 19 Accounts receivable – American Express 2,450 Sales 2,450Cost of goods sold 980 Inventory 980

Dec 22 Accounts receivable – Cerating SB 3,480 Sales 3,480Cost of goods sold 1,400 Inventory 1,400

Dec 24 Cash 4,350 Sales 4,350Cost of goods sold 1,750 Inventory 1,750

Dec 25 Sales returns and allowances 1,480 Accounts receivable – Cerating SB 1,480Inventory 600 Cost of goods sold 600

Dec 31 Cash 2,310Credit card expenses 140 Accounts receivable – American Express 2,450


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 Purchased trading goods for RM6,000 from Depot Wholesaler, with terms 2/10, n/30.

May 2 Sold goods worth RM4,500 to Rahmat, credit terms 2/10, n/30. Cost of goods is RM3,000.

May 5 Returned goods worth RM200 to Depot wholesaler.May 9 Received full payment, after deducting discount, from

Rahmat for the sales of RM4,500 made on 2 May.May 10 Paid Depot Wholesaler.May 11 Purchased supplies from supplier by cash for RM900.May 12 Purchased goods by cash for RM2,400.May 15 Received refund of RM230 for goods purchased

on 12 May from supplier due to the goods being of unsatisfactory quality.

May 17 Purchased goods from Harrods Sdn. Bhd. for RM1,900, FOB shipping point, with terms 2/10, n/30.

May 19 Paid carriage of RM250 for purchases made on 17 May.May 24 Sold goods by cash for RM6,200. Cost of goods sold is

RM4,340.May 25 Purchased goods from Horizon Sdn. Bhd. for RM1,000,

FOB destination, terms 2/10, n/30. Goods were only received on 28 May.

May 27 Paid Harrods Sdn. Bhd. for the purchases made on 17 May.

May 29 Refunded RM100 for damaged goods. The cost of goods returned is RM70.

May 31 Sold goods of RM1,600 to Rahmat, with term n/30. The cost of goods sold is RM1,120.

Required:(a) Prepare the journal entries for the above transactions by using the

Perpetual Inventory System.

(b) Prepare the ledgers for each of the entries.

(c) Prepare the Income Statement for the month ended 31 May 2009.


5.6 FORMAT OF INCOME STATEMENT FOR TRADING FIRMS

Income statements for trading fi rms contain three items which are not found on income statements of service fi rms:

(a) sales revenue from trading goods;

(b) cost of goods sold;

(c) gross profi t.

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 profi t. The Single Level Income Statement also does not show directly the information on gross profi t and revenue from operations for analysis purposes.


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.


*

Angsana BerhadIncome Statement for the year 30 June 2007

RM RM RM RMRevenue:Sales XX(–) Sales returns and allowances XX Sales discount XX (XX)Net sales XXLess: Cost of goods soldOpening inventory XXPurchases XX(–) Purchases returns and allowances XX Purchases discount XX (XX)Net purchases XX(+) Carriage inwards XXCost of goods purchased XXCost of goods ready for sale XX(–) Closing inventory (XX)Cost of goods sold XXGross profi t XXAdd: Other incomeInterest revenueRental revenue XXLess: Operating expenditures XXSales expenses XXSales salary expensesAdvertisement expensesSales maintenance expenses XXStore depreciation expensesTotal sale expenses XXAdministrative expenses XXAdministrative salary expenses XXEquipment depreciation expensesInsurance expenses XXRental expensesTotal administrative expenses XXTotal sale and administrative expenses XXRevenue from operating XXTotal administrative expenses XXTotal sales and administrative expenses (XX)Revenue from operating XXAdd: Other revenueInterest revenue XXRental revenue XX XXLess: Other expendituresInterest expenses (XX) XXNet profi t 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 systemAngsana Berhad


Income Statement for the Year 30 June 2007RM RM RM

Revenue:Sales XX(-) Sales returns and allowances XX Sales discount XX (XX)Net sales XX(-) Cost of goods sold XXGross profi t XXAdd: Other incomeInterest revenueRental revenue XXLess: Operating expenditures XXSales expenses XXSales salary expensesAdvertisement expensesSales maintenance expenses XXStore depreciation expensesTotal sale expenses XXAdministrative expenses XXAdministrative salary expenses XXEquipment depreciation expensesInsurance expenses XXRental expensesTotal administrative expenses XXTotal sale and administrative expenses XXRevenue from operating XXTotal administrative expenses XXTotal sales and administrative expenses (XX)Revenue from operating XXAdd: Other revenueInterest revenue XXRental revenue XX XXLess: Other expendituresInterest expenses (XX) XXNet profi t 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.


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

Debit (RM) Credit (RM)Cash 23,400Accounts receivable 37,600Trading goods inventory 90,000Land 92,000Building 197,000Accumulated depreciation – building 54,000Equipment 83,500Accumulated depreciation – equipment 42,400Notes payable 50,000Accounts payable 37,500Capital – Aminah 267,800Drawings – Aminah 10,000Sales 902,100Sales discount 4,600Cost of goods sold 709,900Salary expenses 69,800Utility expenses 19,400Repair expenses 5,900Maintenance expenses 7,200Insurance expenses 3,500

1,353,800 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.


5.7 CLOSING ENTRIESClosing 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 fi rms, 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 profi t 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. Closing accounts with credit balances.

RM RMDr Sales XXDr Interest revenue XX

Cr Revenue summary XX

2. Closing accounts with debit balances

RM RMDr Revenue summary XX

Cr Sales returns and allowances XXCr Sales discount XXCr Cost of goods sold XXCr Carriage outwards XXCr Insurance expenses XXCr Salary expenses XXCr Other expenses XX

3. Closing revenue summary account – net profi t or loss

RM RMDr Revenue Summary XX

Cr Capital XX

4. Closing drawings account to capital account

RM RMDr Capital XX

Cr Drawings XX

Figure 5.9: Closing entries for trading fi rms using periodic 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 Owner of Sejahtera Company, Farid invested cash of RM50,00 into the business.

Sept 1 Purchased and received inventory of RM10,000 bought on credit from Azlan Company with the terms 2/10, n/30, FOB destination.

Sept 2 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.

1. Closing accounts with credit balances.

RM RMDr Inventory (closing) XXDr Sales XXDr Interest revenue XXDr Purchase returns and allowances XX

Cr Revenue summary XX

2. Closing accounts with debit balances

RM RMDr Revenue summary XX

Cr Inventory (closing) XXCr Sales returns and allowances XXCr Purchases XXCr Sales discount XXCr Carriage inwards XXCr Carriage outwards XXCr Insurance expenses XXCr Salary expenses XXCr Other expenses XX

3. Closing revenue summary account

RM RMDr Revenue Summary XX

Cr Capital XX

4. Closing drawings account to capital account

RM RMDr Capital XX

Cr Drawings XX

Figure 5.10: Closing entries for trading fi rms using perpetual inventory system


Sept 5 Returned RM500 of inventory purchased on 1 September from Azlan Company as the inventory was found to be damaged.

Sept 9 Received cash from Indah Company for the sales made on 2 September.

Sept 10 Settled all debts to Azlan Company for purchase made on 1 September after deducting returns on 5 September.

Sept 11 Purchased inventory totalling RM4,800 by cash.

Sept 15 Purchased inventory totalling RM4,000 on credit from Huda Company with terms 1/10, n/30, FOB shipping point.

Sept 17 Paid carriage expenses of RM300 for purchases on 15 September.

Sept 22 Sold inventory totalling RM12,500 by cash to Cahaya Company. Cost of goods sold totalled RM6,250.

Sept 25 Received inventory returned of RM200 from Cahaya Company for sales on 22 September. The cost of the inventory is RM100.

Sept 28 Sold inventory for RM3,500 on credit to Umi Company with term n/30. Cost of inventory sold is RM1,500.

Sept 30 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.


Answer (a)

Date Description Reference Debit CreditSept 1 Cash 50,000

Capital, Farid 50,000Sept 1 Inventory 10,000

Accounts payable – Azlan Company

10,000

Sept 2 Accounts receivable – Indah Company

8,000

Sales 8,000Cost of goods sold 3,200 Inventory 3,200

Sept 5 Accounts payable – Azlan Company 500 Inventory 500

Sept 9 Cash 7,840 Accounts receivable – Indah Company

7,840

Sept 10 Accounts payable – Azlan Company 9,500 Cash 9,310

Inventory (2% x 9,500) 190Sept 11 Inventory 4,800

Cash 4,800Sept 15 Inventory 4,000

Accounts payable – Huda Company

4,000

Sept 17 Inventory 300 Cash 300

Sept 22 Cash 12,500 Sales 12,500Cost of goods sold 6,250 Inventory 6,250

Sept 25 Sales returns and allowances 200 Cash 200Inventory 100 Cost of goods sold 100

Sept 28 Accounts receivable – Umi Company 3,500 Sales 3,500Cost of goods sold 1,500 Inventory 1,500

Sept 30 Salary expenses 6,000 Cash 6,000

Sept 30 Rental expenses 2,000 Cash 2,000


Answer (b) Sejahtera CompanyIncome Statement

for the Month Ended 30 September 2009

RM RMRevenue:

Net sales (8,000-160+12,500-200+3,500) 23,640

Less: Expenditure Cost of goods sold (3,200+6,250-100+1,500) 10,850 Salary expenses 2,000 Rental expenses 6,000 Total expenditure (18,850)

Net profi t 4,790

Answer (c)

Date Description Reference Debit CreditSep 30 Sales (8,000+12,500+3,500) 24,000

Revenue summary 24,000Revenue summary 19,210 Sales return and allowance 200 Sales discount 160Cost of goods sold 10,850 Salary expenses 6,000 Rental expenses 2,000Revenue summary Capital, Farid 4,790

4,790

Visit the following websites to obtain additional information on the topics discussed.

http://www.ameritrade.com/educationv2/fhtml/learning/uincomestates.fhtmlDescription: Information on Income Statement.

http://management.about.com/cs/adminaccounting/ht/readincomestmt.htmDescription: Guide to understanding Income Statement.

http://www.ibm.com/investor/fi nancialguide/Description: Introduction to identifying Financial Statement.

WEBSITE


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 RM 180,000 Discount RM 2,000 Cost of goods sold RM 100,000 Goods inventory 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) On 7 April, Olen purchased equipment for RM26,000.

(d) Olen returned damaged goods of RM3,000 to Danau Sdn. Bhd.

(e) 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.

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


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 Purchased 80 calculators at the price of RM19 each from Digital Sdn. Bhd. by cash.

September 9 Paid transportation RM80.

September 10 Returned 2 calculators, valued at RM40, as they did not meet specifi cations.

September 12 Sold 26 calculators at the price of RM20 per unit, or RM30 per unit if transportation cost is included.

September 14 A calculator priced at RM30 was returned to the company as the customer had ordered in excess.

September 20 Sold 30 calculators at a selling price of RM30 each. These calculators cost RM20 each.

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

5. 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.

December 8 Desaru Sdn. Bhd. received allowances worth RM20,000 for the goods purchased on December 3.

December 13 Selasih Sdn. Bhd. received payment from Desaru Sdn. Bhd.

Required:

(a) Prepare the journal entries to record the transactions for Selasih Sdn. Bhd., using the perpetual inventory system.

(b) 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.


SUMMARY

This topic emphasised on the following:

• Income statement for trading and service fi rms are different due to the different activities involved. There are two types of trading business which are:

– Retailers

– Wholesalers

• Main characteristics of trading fi rms are:

– 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 profi t can be calculated by deducting cost of goods sold from sales revenue.

– Net operating revenue can be calculated by deducting operating expenditure from gross profi t.

– Goods unsold by the end of the accounting period will become closing inventory, which will be reported as current asset.

• Important transactions for trading fi rms are:

– Purchases

– Sales

– Discounts

– Returns and allowances

– Transportation cost

• Two important methods to record inventory are:

– Periodic Inventory System

– Perpetual Inventory System

• There are two types of income statement for trading fi rms:

– Single level income statement

– Multiple level income statement

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


Cash discounts

Cash sales

Credit sales

Credit terms

Discount

Purchases

Quantity discounts

Sales

Sales Returns and Allowance

Topic

6 Financial Statement Analysis

LEARNING OUTCOMES


1. Explain three techniques that can be used to analyse the fi nancial statement;

2. Discuss the basis of item comparison in fi nancial statement;

3. Differentiate between Horizontal Analysis and Vertical Analysis in evaluating fi nancial statement;

4. Explain the importance of fi nancial ratio in analysing and interpreting the accounting infomation;

5. Calculate and interpret the fi nancial ratio that can be used to measure profi tability, liquidity, effi ciency and debt management; and

6. Explain the purposes as well as the effectiveness of fi nancial ratios to evaluate the liquidity, profi tability and debt management.

INTRODUCTIONTopic 6 will explain fi nancial statement analysis in more detail. Financial statement analysis provides useful information to internal users for decision-making. This topic will discuss fi nancial statement information that will be used to evaluate the performance and fi nancial 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) horizontal analysis;

(b) vertical analysis; and

(c) ratio analysis.

TOPIC 6 FINANCIAL STATEMENT ANALYSIS 177

6.1 PURPOSE OF FINANCIAL STATEMENT ANALYSIS

The main function of fi nancial statement analysis is to help users make better decisions, whether for internal or external users of the company concerned.

Figure 6.1: Internal users of accounting information

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.

Internal users are responsible for planning strategies and executing the company’s operations. The purpose of fi nancial analysis is to provide them with information in order to improve the effi ciency 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

External users utilise accounting information to determine the fi nancial status of the company for their own purposes. Shareholders and creditors will evaluate the investment and fi nancing prospects of the company. Members of the board of directors will analyse the fi nancial statement for the purpose of monitoring the effectiveness of decisions which have been made. Suppliers will use the fi nancial information to evaluate the credit standing of the organisations.

Generally, fi nancial 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 fi nancial status of the business.

Figure 6.2: External users of accounting information

SELF-CHECK 6.1

Do internal users need to obtain prior approval from external users before implementing specifi c fi nancial 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) Income Statement;

(b) Balance Sheet;

(c) Cash Flow Statement;

(d) Statement of Changes in Equity;

(e) Notes to the fi nancial statement;


(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 BASIS OF COMPARISONFinancial information can be compared using three bases:

• within the company (intra-company);

• between companies (inter-company); and

• industry average.

(a) Within the Company Using this basis, the company will compare the items in its fi nancial

statements relating to two different years, or more. The comparison of current year’s fi nancial 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 fi nancial 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 fi nancial statement published by the companies. Comparisons between companies provide useful information on the specifi c company’s status as compared to its competitors.

(c) Industry Average This basis of comparison compares items in the fi nancial statement of the

specifi c 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 fi nancial information be useful for a printing company that has operated for the past 40 years? Discuss.


6.4 TECHNIQUES OF ANALYSIS

Three techniques may be used in evaluating fi nancial 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.

EXERCISE 6.1

State the differences between the following basis of comparison:

(a) Within company;

(b) Between companies; and

(c) Industry average.

Figure 6.3: Techniques of Analysis

SELF-CHECK 6.2

Explain the three techniques of analysis in evaluating fi nancial statement data.

ACTIVITY 6.2

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


6.5 HORIZONTAL ANALYSIS

Horizontal analysis is a technique used to assess the trend of the items in the fi nancial statement (increasing or decreasing) in terms of amount or percentage of fl uctuation.

There are two characteristics of horizontal analysis. First, the comparison is made on every item in the fi nancial 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 fi nancial statement of the previous year as the base to determine an increase or decrease. Second, the comparison for sequential fi nancial data is normally for 5 to 10 years or more. This comparison is also known as trend analysis.

Horizontal analysis is classifi ed into:

(a) Period of at least 2 years; and

(b) 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 fi nancial statement.

(b) Second, divide the amount of change, as calculated above, with the amount in the base year for every item in the fi nancial statement, to obtain the percentage of change.

Change in Ringgit = Current year amount - Base year amount

Current year amount - Base year amountPercentage of change = –––––––––––––––––––––––––––––––––––– 100 Base year amount


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 Year Increase (Decrease)

2009 2008 Amount (RM) Percentage (%)

Marketable Securities

75,000 60,000 75,000 – 60,000= 15,000

Non-current Liability 100,000 200,000 100,000 – 200,000= (100,000)

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 Profi t or Loss for the Period, Fundamental Errors and Changes in Accounting Policies’.

First step calculation

Second step calculation

Percentage of change for the Cash item in the Balance Sheet (Refer Table 6.2)

Current year amount - Base year amount 100Percentage of change = ––––––––––––––––––––––––––––––––––––––––– Base year amount

RM90,500 - RM64,700Percentage of change = ––––––––––––––––––––– 100 RM64,700

= 39.9%

(100,000) –––––––– 100 200,000= (50)

15,000 ––––––– 100 60,000= 25


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)

2006 (RM)

Amount (RM)

Percentage (%)

Non-current Assets:

Long-term investment 95,000 177,500 (82,500) (46.5)

Building and Equipment (net) 444,500 470,000 (25,500) (5.4)

Intangible assets 50,000 50,000 – –

Total non-current assets 589,500 697,500 (108,000) (15.5)

Current Assets:

Cash 90,500 64,700 25,800 39.9

Marketable securities 75,000 60,000 15,000 25.0

Accounts receivable 115,000 120,000 (5,000) (4.2)

Inventory 264,000 283,000 (19,000) (6.7)

Expenses pre-payment 5,500 5,300 200 3.8

Total current assets 550,000 533,000 17,000 3.2

Current liability:

Accounts payable 210,000 243,000 (33,000) (13.6)

Total net current assets 340,000 290,000 50,000 17.2

929,500 987,500 (58,000) 5.9

Financed by owner and long-term liability:

Owner’s equity:

6% Preference shares, RM100 150,000 150,000 – –

Ordinary shares, RM10 500,000 500,000 – –

Retained earnings 179,500 137,500 42,000 30.5

Non-current liability 100,000 200,000 (100,000) (50.0)

Total owner’s equity and long-term liability

929,500 987,500 (58,000) 5.9


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 2006Increase (Decrease)

2007 (RM)

2006 (RM)

Amount (RM)

Percentage (%)

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 27.2Gross profi t 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 6.8Net operating revenue 160,000 135,600 24,400 18.0(+) Other revenue or profi t 8,500 11,000 (2,500) (22.7)(–) Other expenses and loss 6,000 12,000 (6,000) (50.0)Profi t before tax 162,500 134,600 27,900 20.7Taxation 71,500 58,100 13,400 23.1Profi t 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 2006Increase (Decrease)

2007 (RM)

2006 (RM)

Amount (RM)

Percentage (%)

Retained earnings, 1 Jan 137,500 100,000 37,500 37.5Current year profi t 91,000 76,500 14,500 19.0

228,500 176,500 52,000 29.5(–) DividendPreference shares 9,000 9,000 – –Ordinary shares 40,000 30,000 10,000 33.3

49,000 39,000 10,000 25.6Retained earnings, 31 December 179,500 137,500 42,000 30.5


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 fi nancial data for specifi c 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 fi rst 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)

2006 (RM)

2005 (RM)

2004 (RM)

2003 (RM)

41,296 38,064 34,835 33,110 30,518

By using 2003 as the base year for comparison, calculation of increase or decrease of the fi nancial data for the following years can be done.

Amount for a specifi c year – Base year amountChange from base year = –––––––––––––––––––––––––––––––––––––––––– 100 Base year amount

Example:

Increase in net sales for year 2004:

RM33,110 – RM30,518= –––––––––––––––––––– 100 RM30,518= 8.5%


Therefore, net sales have increased by 8.5% in 2004 from the base year of 2003.

By using the sales fi gure 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

Net sales

2007 (RM)

2006 (RM)

2005 (RM)

2004 (RM)

2003 (RM)

41,296 38,064 34,835 33,110 30,518135% 125% 114% 108% 100%

6.6 VERTICAL ANALYSIS

Vertical Analysis is a technique to evaluate items in the fi nancial 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 fi nancial 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 fi nancial 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.


Table 6.7: Percentage Calculation Examples of Vertical Analysis for Balance Sheet

2007 2006

Cash Percentage:

AP Percentage:

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 20062007 2006

Total (RM)

Percentage (%)

Total(RM)

Percentage (%)

Current Assets:Cash 90,500 7.9 64,700 5.3Marketable Securities 75,000 6.6 60,000 4.9Accounts receivable 115,000 10.1 120,000 9.8Inventory 264,000 23.2 283,000 23.0Expenses Prepayment 5,500 0.48 5,300 0.4Total Current Assets 550,000 48.3 533,000 43.3Non-current Assets:Long-term Investment 95,000 8.3 177,500 14.4Building and Equipment (Net) 444,500 39.0 470,000 38.2Intangible Asset 50,000 4.4 50,000 4.1Total Non-current Assets 589,500 51.7 697,500 56.7Total Assets 1,139,500 100 1,230,500 100Current Liability:Accounts payable 210,000 18.4 243,000 19.7Non-current Liability 100,000 8.8 200,000 16.3Total Liabilities 310,000 27.2 443,000 36.0Owner’s Equity:6% Preference Shares, RM100 150,000 13.2 150,000 12.2Ordinary Shares, RM10 500,000 43.9 500,000 40.6Retained Earnings 179,500 15.8 137,500 11.2Total Owner’s Equity 829,500 72.8 787,500 64.0Total Liabilities and Owner’s Equity 1,139,500 100 1,230,500 100

RM90,500= –––––––––––– 100 RM1,139,500

= 7.9%

Cash –––––––––––– 100 Total assets

Total Liability ––––––––––––––––––––––––––––– 100 Total Liability and Owner Equity

RM210,000= –––––––––––– 100 RM1,139,500

= 18.4%

RM64,700= –––––––––––– 100 RM1,230,500

= 5.3%

RM243,000= –––––––––––– 100 RM1,230,500

= 19.7%


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 fi gure 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 2006

Sales percentage:

Administrative expenses percentage:

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

RM1,530,500= –––––––––––– 100 RM1,498,000

= 102.2%

Sales –––––––––– 100 Net assets

Administrative expenses ––––––––––––––––––––––– 100 Net sales

RM104,000= –––––––––––– 100 RM1,498,000

= 6.9%

RM1,234,000= –––––––––––– 100 RM1,200,000

= 102.8%

RM97,400= –––––––––––– 100 RM1,200,000

= 8.1%


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

Anggerik Sdn. Bhd.Comparative Income Statementfor 31 December 2007 and 2006

2007 2006Total (RM)

Percentage (%)

Total (RM)

Percentage (%)

Sales 1,530,500 102.2 1,234,000 102.8(–) Sales return and allowance 32,500 2.2 34,000 2.8Net sales 1,498,000 100.0 1,200,000 100.0(–) Cost of goods sold 1,043,000 69.6 820,000 68.3Gross profi t 455,000 30.4 380,000 31.7(–) Sales expenses 191,000 12.8 147,000 12.3(–) Administrative expenses 104,000 6.9 97,400 8.1Total operating revenue 160,000 10.7 135,600 11.3(+) Other revenue or profi t 8,500 0.6 11,000 0.9(–) Other expenses or loss 6,000 0.4 12,000 1.0Profi t before tax 162,500 10.9 134,600 11.2Taxation 71,500 4.8 58,100 4.8Profi t after tax 91,000 6.1 76,500 6.4

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, profi t after tax (as percentage of net sales) is 6.4%. The corresponding fi gure 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 fi gure in year 2007 had increased to 69.6%. This increase might be the reason for the decrease in the percentage of profi t after tax.

After studying the methods for analysing fi nancial statement, complete the following exercise to test your understanding.


EXERCISE 6.2

1. The two methods of analysing fi nancial 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 31 December 2007Accounts receivable 500,000 400,000Inventory 840,000 600,000Total current assets 3,220,000 2,800,000

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

6.7 FINANCIAL RATIO ANALYSISWe will now go on to discuss fi nancial ratio analysis. The classifi cations of fi nancial ratios are shown in Figure 6.4 below:

Figure 6.4: Classifi cations of fi nancial ratios


(a) Liquidity Liquidity ratio measures the business’s short term capability to discharge

its obligations or debts upon maturity and to fulfi l unforeseen cash requirements. This ratio is often used by short-term creditors.

(b) Effi ciency Effi ciency ratio is for the purpose of measuring the level of effi ciency and

capability of the management to operate its business, especially in the usage of assets to generate sales.

(c) Profi tability Profi tability ratio measures the ability of the business to generate profi t

within a specifi c period. It is used as an indicator to analyse the effi ciency and effectiveness level of the business in achieving its profi t objective.

(d) Debt Management This ratio measures the ability of the business to continue its operation.

The ratios that can be classifi ed under debt management ratios are interest coverage ratio, debt ratio, equity ratio and debt to equity ratio.

ACTIVITY 6.4

How are fi nancial ratios important to service fi rms? Give an example of service fi rm.

6.8 LIQUIDITY RATIOLiquidity ratio measures the business’s capability to discharge its short-term fi nancial 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 classifi ed as liquidity ratios are:

(a) Working capital;

(b) Current ratio; and

(c) Quick ratio.

Table 6.11 explains each of the liquidity ratios.


EXERCISE 6.3

1. Explain the meaning of current ratio and quick ratio, including the formulae for both.

2. The following is part of the data extracted from the Balance Sheet of Kenari Sdn. Bhd.

Kenari Sdn. Bhd.Balance Sheet extract


CURRENT ASSETS RMCash 8,241,000Marketable securities 1,947,000Accounts receivable 12,545,000Inventory 14,814,000Expenses prepayment 5,371,000TOTAL CURRENT ASSETS 42,918,000CURRENT LIABILITY:Total current liability 45,844,000

Calculate the:

(a) Working Capital

(b) Current Ratio

(c) Quick Ratio


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6.9 EFFICIENCY RATIOEffi ciency ratio measures the level of effi ciency and capability of the management to operate its business, especially in the usage of assets to generate sales. Ratios that can be classifi ed as effi ciency ratios are shown in Table 6.12.

6.10 PROFITABILITY RATIOProfi tability ratio measures the ability of the business to generate profi t within a specifi ed period. It is used as an indicator to analyse the effi ciency and effectiveness level of the business in achieving its profi t objective. This ratio is a favourite among creditors, investors and owners. The ratios that can be classifi ed as profi tability ratio as well as their purposes and descriptions are explained in Table 6.13.

6.11 DEBT MANAGEMENT RATIOFinally, the debt management ratio measures the ability of the business to continue its operation. The ratios that can be classifi ed as debt management ratio are:

(a) interest coverage ratio;

(b) debt ratio;

(c) equity ratio; and

(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?


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EXERCISE 6.4

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

2006 (RM) 2005 (RM)Net sales 6,420,000 6,420,000Opening inventory 980,000 860,000Purchases 4,440,000 4,661,000Closing inventory 1,020,000 980,000

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

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

6.12 SAMPLE OF RATIO CALCULATIONSThe 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)

Industry Average (%)

Net sales *(Cash sales RM330,000)

600,000 100

Cost of goods sold 384,000 74.2Gross profi t 216,000 25.8Sales and administrative expenses 194,000 22.5Operating profi t 22,000 3.3Other expenses(Interest expenses RM3,000)

(4,000) 0.2

Profi t before tax 28,000 3.1Income tax expenses (5,000) 0.7Net profi t 13,000 2.3


Kenanga Sdn. Bhd.Comparative Balance Sheet

as at 31 December 2006 and 2007

2007 (RM) 2006 (RM)

Current assets:Cash 15,000 10,000Marketable securities 10,000 15,000Accounts receivable (net) 35,000 25,000Inventory 55,000 40,000Expenses pre-payment 5,000 5,000 Total current asset 120,000 95,000Non-current asset 80,000 45,000 Total asset 200,000 140,000

Liabilities and owner equity:Current liability 60,000 50,000Non-current liability 15,000 10,000Owner’s equity 125,000 80,000Total liabilities and owner’s equity 200,000 140,000

The average ratios for the plastics industry are as follows:

Ratio Industry AverageCurrent ratio 1.8 : 1.0Quick ratio 1.1 : 1.0Accounts receivable turnover 9.5 timesAverage collection period 38 daysInventory turnover 4.8 timesAsset turnover 2.3 timesGross profi t margin 25.8%Net profi t margin 3.1%Return on asset 4.0%Return on owner equity’s ordinary shares 11.4%Interest coverage ratio 2.8 timesDebt ratio 44.1%Debt to equity ratio 120.2

Required:

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


(b) Calculate the following fi nancial 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 profi t margin(viii) Net profi t 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


Kenanga Sdn. Bhd.

(RM)

Kenanga Sdn. Bhd. Industry Average

(%)RM’000 %

Net sales *(Cash sales RM330,000) 600,000 600/600 100 100Cost of goods sold 384,000 384/600 64 74.2Gross profi t 216,000 216/600 36 25.8Sales and administrative expenses

194,000 194/600 32.3 22.5

Profi t from operating 22,000 22/600 3.7 3.3Other expenses(Interest expenses RM3,000) (4,000) 4/600 0.7 0.2Profi t before tax 18,000 18/600 3.0 3.1Income tax expenses (5,000) 5/600 0.8 0.7Net profi t 13,000 13/600 2.2 2.3


(b) Ratio Analysis

No Ratio Kenanga Sdn. Bhd.Industry Average

(i) Current ratio 1.8 : 1.0

(ii) Quick ratio

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

1.1 : 1.0

(iii) Accounts receivable turnover

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

Analysis result:The company is able to collect debts within 41 days. The effi ciency of the company in debt collection is late by 3 days compared to industry average of 38 days.

38 days

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

Net credit sales ––––––––––––––– Average Net AR 600,000 – 330,000= ––––––––––––––––––––– (25,000 + 35,000)/2= 9.0 times

365 days –––––––––––––– *AR turnover 365= ––––––– 9= 41 days

* AR = Account Receivable



(v) Inventory turnover

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.

4.8 times

(vi) Asset turnover

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 profi t margin

Analysis result:The higher the gross profi t margin the better. This indicates good purchasing management and lower purchasing cost. The gross profi t 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%

Cost of goods sold ––––––––––––––––––––– Average inventory 384,000= ––––––––––––––––– (40,000 + 55,000)/2= 8.1 times

Net sales ––––––––––––––––– Average total asset RM600,000= ––––––––––––––––––––––––– (RM140,000 + RM200,000)/2= 3.5 times

Gross profi t –––––––––––– Net sales RM216,000= –––––––––– RM600,000= 36%



(viii) Net profi t margin

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 profi t margin for the company is less than the industry average.

3.1%

(ix) Return on asset

Analysis result:This shows that profi t return is 7.6% as relates to management effi ciency in using the asset regardless of resources to fi nance 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

Analysis result:The higher the ratio the better as it shows the business is capable of generating higher profi t for the shareholders. The company is able to give 12.68% profi t 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%

Net profi t –––––––––––– Net sales RM13,000= –––––––––– RM600,000= 2.2%

Net profi t ––––––––––––––––– Average total asset RM13,000= ––––––––––––––––––––––––– (RM140,000 + RM200,000)/2= 7.6%

Net profi t – Dividend for preference shares –––––––––––––––––––––––––––––––––––––– Average owner’s equity RM13,000 – 0= ––––––––––––––––––––––––– (RM80,000 + RM125,000)/2= 12.68%



(xi) Interest coverage ratio

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 profi t 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 profi t after tax to pay interest.

2.8 times

(xii) Debt ratio

Analysis result:To measure the percentage of total assets fi nanced by creditors. This shows that 37.5% from the company’s asset are fi nanced 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

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%

Net profi t – Taxation + Interest expenses –––––––––––––––––––––––––––––––––––––– Interest expenses RM13,000 + RM5,000 + RM3,000= ––––––––––––––––––––––––––––– RM3,000= 7 times

Total liability –––––––––––– Total asset RM75,000= –––––––––– RM200,000= 37.5%

Total liability ––––––––––––––––––– Total owner’s equity RM75,000= –––––––––– RM125,000= 60.0%


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) 2007 (RM)

Cash 20,000 30,000

Accounts receivable 65,000 60,000

Inventory 60,000 50,000

Equipment (net) 200,000 180,000

345,000 320,000

Accounts payable 50,000 60,000

Mortgage (15%) 100,000 100,000

Ordinary shares @ RM10 140,000 120,000

Retained earnings 55,000 40,000

345,000 320,000

Additional information for the year 2008:

1. The sales account total is RM420,000. Sales return and allowance totalled RM20,000.

2. Cost of goods sold is RM198,000.

3. Net income from operating activities totalled RM44,000.

Required:Calculate the ratios listed below for 2008.

(a) current ratio;

(b) quick ratio;

(c) accounts receivable turnover;

(d) inventory turnover; and

(e) return on sales.


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EXERCISE 6.6

1. The fi nancial information for Desa Sdn. Bhd. is shown below:

31 December 2005

31 December 2004

Current asset 125,000 100,000Equipment (net) 400,000 330,000Current liability 91,000 70,000Long-term liability 144,000 95,000Ordinary shares @ RM1 155,000 115,000Retained earnings 135,000 150,000

Required:Prepare the Horizontal Analysis for year 2005 by using year 2004 as the base year.

2. The following is the comparative fi nancial information for Sentosa Sdn. Bhd. The Balance Sheets are dated 31 December 2007 and 2006.

2007(RM)

2006(RM)

Net Sales 800,000 720,000Cost of sales 480,000 40,000Interest expenses 7,000 5,000Net revenue 64,000 42,000Account receivables 120,000 100,000Inventory 85,000 75,000Total asset 600,000 500,000Total owner equity 450,000 310,000

Required:

Calculate the following ratios for year 2007.

(a) profi t margin;

(b) asset turnover;

(c) return on asset; and

(d) return on owner equity.


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)Cash 25,000 20,000 18,000Accounts receivable (net) 50,000 45,000 48,000Expenses prepayment 90,000 85,000 64,000Investment 75,000 70,000 45,000Equipment (net) 400,000 370,000 358,000

640,000 590,000 533,000Current liability 75,000 80,000 70,000Long-term liability 80,000 85,000 50,000Ordinary share @ RM10 340,000 300,000 300,000Retained earnings 145,000 125,000 113,000

640,000 590,000 533,000Teguh Sdn. Bhd.

Comparative Income Statementfor the year ended 31 December 2001

2001 (RM) 2000 (RM)Sales 740,000 700,000Less: Sales return allowance 40,000 50,000Net sales 700,000 650,000Cost of goods sold 420,000 400,000Gross profi t 280,000 250,000Operating expenses 230,000 215,000Net Revenue 50,000 35,000

Additional Information:

1. 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.

2. All dividends were paid by cash.3. At 1 July 2001, 4,000 units of new ordinary shares were issued.

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


4. The following are Comparative Income Statement and Balance Sheet of Teratai Sdn. Bhd.

Teratai Sdn. Bhd.Income Statement


2006 (RM) 2005 (RM)Sales 650,000 520,000Less: Cost of goods sold 415,000 354,000Gross profi t 235,000 166,000Sales and administrative expenses

150,000 114,800

Interest expenses 7,200 6,000Taxation 18,000 14,000Les: Total expenses 175,200 134,800Net Revenue 59,800 31,200

Teratai Sdn. Bhd.Comparative Balance Sheet


2006 (RM) 2005 (RM)ASSETCurrent asset:Cash 41,000 18,000Marketable securities 18,000 15,000Accounts receivable (net) 92,000 74,000Inventory 84,000 70,000Total current asset 235,000 177,000Equipment (Net) 403,000 383,000Total asset 638,000 560,000LIABILITIES AND OWNERS EQUITYCurrent liabilities:Accounts payable 112,000 110,000Tax payable 23,000 20,000Total current liabilities 135,000 130,000Long-term liability:Bond payable 130,000 80,000Total liabilities 265,000 210,000Owner’s equity:Ordinary share@RM5 150,000 150,000Retained earnings 223,000 200,000Total owner’s equity 373,000 350,000Total liabilities and owners equity 638,000 560,000


Additional information:1. Ordinary shares are sold at RM19.50 per share.

Required:Calculate the following ratios for the year 2006:

(a) current ratio; (h) return on owner’s equity;

(b) quick ratio; (i) earnings per share;

(c) accounts receivable turnover; (j) price earnings ratio;

(d) inventory turnover; (k) dividend payout ratio;

(e) gross profi t margin; (l) debt to equity ratio; and

(f) asset turnover; (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 fi nancial statement data are:– Horizontal analysis– Vertical analysis– Financial ratio analysi

Debt Management Ratio

Effi ciency Ratio

External Users

Financial Statement

Financial Statement Analysis

Horizontal Analysis

Internal Users

Liquidity Ratio

Profi tability 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 specifi ed 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 insuffi cient cash fl ow 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 fi nancial reports for external and internal users; but is focused more on external users. The fi nancial report is released periodically and is subject to specifi c 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 fi nancial and non-fi nancial 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.

2. Comparability means that the information can be compared; whether among companies, among industries or across different periods. Let us assume that you are interested in investing in a company. You were informed that the net income of the company in year 2000 was RM10 million. Is this information useful?

Actually, it is only useful if you have other information that can be compared with that fi gure. 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 fi gure.

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 specifi c bodies on the business achievements and other factors. All these cannot be recorded in the fi nancial 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 fl uctuates. You have often heard the grumblings or even experienced the fl uctuation 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 fl uctuation in the currency value should have been taken into account when recording transactions but was ignored.

2. Three conditions that must be fulfi lled 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 confi dent that cash is collectable from the customer, then the revenue will be recognised at the point of sale. However, if the seller is uncertain, then the revenue will only be recognised when cash is received.

Exercise 1.4

1. (a) accounting period

(b) historical cost

(c) relevant

(d) Malaysian Accounting Standards Board

(e) reliability

(f) principle of matching

(g) cost benefi t relation, materiality

(h) management accounting

(i) going concern

(j) point of sale

(k) Cash Flow Statement

(l) Balance Sheet

218 ANSWERS

Exercise 1.5

1. D

2. A

3. D

4. C

5. False

6. False

7. False

Exercise 1.6

1. (a) 46,000

(b) 100,000

(c) 75,000

2. (a) Asset increased, Asset decreased or has no effect on the Asset

(b) Asset decreased, Owner’s Equity decreased

(c) Asset decreased, Owner’s Equity decreased

(d) Asset increased, Asset decreased or has no effect on the Asset

(e) Asset increased, Owner’s Equity increased

ANSWERS 219

3.

ASSET = LIABILITY + O.EQUITY

Transaction Cash + AR + Supplies = AP + Capital,

Ashwina.

Balance

+20,000

20,000 =

+20,000Investment by

Ashwin20,000

b.Balance 20,000

+800 800

+800= 800 20,000

c.Balance

-62019,380 800

-620= 180 20,000

d.

Balance

+4,200

23,580 800 180

+4,200Service revenue

24,200e.

Balance

-1,000

22,580 800 = 180

-1,000Salary expenses

23,200f.

Balance

-700

-150

21,730 800 = 180

-700Transportation

expenses-150

Sundry expense22,350

g.

Balance

-1,200

20,530 800 = 180

-1,200Rental expenses

21,150h.

Balance 20,530

+2,500

2,500 800 = 180

+2,500Service revenue

23,650i.

Balance 20,530 2,500

-550

250 = 180

-550Supplies expenses

23,100j. -750 -750

Drawings, Ashwin

Balance 19,780 2,500 250 180 22,350

220 ANSWERS

4. (a) Seri Consultation Services Income Statement For the year ended 31 December 2008

RM RM Service Revenue 78,750 (-) Expenses: Supplies expenses 6,300 Tax expenses 4,200 Salary expenses 18,000 Rental expenses 14,400 Utility expenses 7,350 Sundry expenses 1,265 (51,515) Net income 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) 17,300 Accounts receivable 18,855 Supplies 8,480 TOTAL ASSETS 44,635

LIABILITIES Accounts Payable 1,200

OWNER’S EQUITY Capital, Seri Dewi 43,435 TOTAL LIABILITIES AND O.EQUITY 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 fi nancial 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 fi nancial position (increase asset and owner’s equity) and can be measured in currency unit.

Exercise 2.2

1. Account is a specifi c and separate accounting record for each item in the fi nancial statement. All transactions that affect the items will be recorded in the accounts. Ledger is a group of accounts for a business entity. Chart of accounts is the list of accounts in the ledger.

2. T-Account and three column account. T-account is easier but the three column account enables us to know the last balance after each transaction.

3. Drawings are made by the owner for personal use while expenses are incurred by the entity for the purpose of generating income. Drawings are not considered in the calculation of net profi t 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 profi t or net loss. This difference will be added or deducted from owner’s equity.

4. C

5. C

6. (a) Asset (b) Expense (c) Asset (d) Income (e) Liability (f) Asset (g) Expense (h) Asset

222 ANSWERS

Exercise 2.3

1. (a) Date Account and Description Reference Debit (RM) Credit (RM)

Apr 2008

a. Cash 5,000

Capital, Cindy 5,000

(Cash investment by Cindy)

b. Supplies 275

Accounts payable 275

(Purchase of supplies on credit)

c. Cash 3,250


(Cash received for services provided)

d. Rental expenses 750

Cash 750

(Payment of rental by cash)

e. Accounts payable 125

Cash 125


f. Accounts receivable 1,875

Service revenue 1875

( Customer has not paid for services provided)

g. Utility expenses 390

Sundry expenses 187

Cash 577

(Payment for expenses by cash)

h. Salary expenses 1,250

Cash 1,250

(Payment for salary by cash)

i. Supplies expenses 162

Supplies 162

(Usage of supplies)

j. Drawings 550

Cash 500

Supplies 50

(Cash and supplies drawings by owner)

ANSWERS 223

1 (b) Post to ledger

Cash AccountDate Description Reference Debit

(RM)Credit (RM)

Balance (RM)

Apr 2008 Capital, Cindy 5,000 5,000Service revenue 3,250 8,250Rental expenses 750 7,500Accounts payable 125 7,375Utility expenses 390 6,985Sundry expenses 187 6,798Salary expenses 1,250 5,548Drawings, Cindy 500 5,048

Account Receivable


Credit (RM)

Balance (RM)

Apr 2008 Service revenue 1,875 1,875

Supplies Account


Credit (RM)

Balance (RM)

Apr 2008 Accounts payable 275 275

Supplies expenses 162 113

Drawings, Cindy 50 63

Accounts Payable


Credit (RM)

Balance (RM)

Apr 2008 Supplies 275 275Cash 125 150

Capital Account, Cindy


Credit (RM)

Balance (RM)

Apr 2008 Cash 5,000 5,000 Drawings Account, Cindy


Credit (RM)

Balance (RM)

Apr 2008 Cash 500 500

Supplies 50 550

224 ANSWERS

Service Revenue Account


Credit (RM)

Balance (RM)

Apr 2008 Cash 3,250 3,250

Accounts receivable 1,875 5,125

Rental Expenses Account


Credit (RM)

Balance (RM)

Apr 2008 Cash 750 750

Utility Expenses Account


Credit (RM)

Balance (RM)

Apr 2008 Cash 350 350

Sundry Expenses Account


Credit (RM)

Balance (RM)

Apr 2008 Cash 187 187

Salary Expenses Account


Credit (RM)

Balance (RM)

Apr 2008 Cash 1,250 1,250

Supplies Expenses Account


Credit (RM)

Balance (RM)

Apr 2008 Cash 162 162

1 (c) Trial Balance

ANSWERS 225

Cindy Insurance AgencyTrial Balance

as at 30 April 2008

Accounts Debit (RM) Credit (RM)Cash 5,048Accounts receivable 1,875Supplies 63Accounts payable 150Capital, Cindy 5,000Drawings, Cindy 550Service revenue 5,125Salary expenses 750Rental expenses 390Utility expenses 187Supplies expenses 1,250Sundry expenses 162TOTAL 10,275 10,275

226 ANSWERS

Exercise 2.4

1. (a) GENERAL JOURNAL

Date Account and Description Reference Debit (RM)

Credit (RM)

Feb 1 Supplies L104 274 Cash L101 274(Purchased supplies by cash)

2 Drawings, Edlin L302 2,000 Cash L101 2,000(Cash drawings by owner)

5 Cash L101 2,740Accounts receivable L102 2,740(Received cash from customer for payment of accounts receivable)

9 Offi ce equipment L108 3,850Accounts payable L201 3,850(Purchased offi ce equipment on credit)

15 Accounts payable L201 1,200Cash L101 1,200(Payment to accounts payable)

18 Cash L101 580Service revenue L401 580(Received for services provided)

25 Advertisement expenses L502 420Cash L101 420(Payment for advertisement)

ANSWERS 227

28 Utility expenses L503 215Cash L101 215(Payment for business’s telephone and electricity bill)

28 Drawings, Edlin L302 117Cash L101 117(Payment for telephone and electricity bill of owner’s house by cash from the business)

28 Rental expenses L501 1,200Cash L101 1,200(Payment for rental of business premises)

28 Sundry expenses L509 220Cash(Repair of offi ce equipment by cash)

L101 220

1 (b) Post of entries to ledger

Cash Account No: 101


Credit (RM)

Balance (RM)

Feb Cash 15,238

1 Supplies J1 274 14,9642 Drawings, Edlin J1 2,000 12,964

228 ANSWERS

5 Accounts receivable J1 2,740 15,70415 Accounts payable J1 1,200 14,50418 Service revenue J1 580 15,084

25 Advertisement expenses

J1 420 14,664

28 Utility expenses J1 215 14,44928 Drawings, Edlin J1 117 14,33228 Rental expenses J1 1,200 13,13228 Sundry expenses J1 220 12,912



Credit (RM)

Balance (RM)

Feb 1 Balance 4,5755 Cash J1 2,740 1,835



Credit (RM)

Balance (RM)

Feb 1 Balance 4271 Cash J1 274 701



Credit (RM)

Balance (RM)

Feb 1 Balance 8,4009 Account payable J1 3,850 12,250

Accounts Payable No: 201


Credit (RM)

Balance (RM)

Feb 1 Balance 1,7309 Offi ce equipment J1 3,850 5,580

15 Cash J1 1,200 4,380

Capital Account, Edlin No: 301


Credit (RM)

Balance (RM)

Feb 1 Balance 26,910

ANSWERS 229

Drawings Account, Edlin No: 302


Credit (RM)

Balance (RM)

Feb 2 Cash J1 2,000 2,00028 Cash J1 117 2,117

Service Revenue Account No: 401


Credit (RM)

Balance (RM)

Feb 18 Cash J1 580 580

Rental Expenses Account No: 501


Credit (RM)

Balance (RM)

Feb 28 Cash J1 1,200 1,200

Advertisement Expenses Account No: 502


Credit (RM)

Balance (RM)

Feb 25 Cash J1 420 420

Utility Expenses Account No: 503


Credit (RM)

Balance (RM)

Feb 28 Cash J1 215 215



Credit (RM)

Balance (RM)

Feb 28 Cash J1 220 220

1. (c) Trial Balance

230 ANSWERS

Edlin EnterpriseTrial Balance

as at 28 February 2007Account Number Accounts Debit

(RM)Credit (RM)

101 Cash 12,912102 Accounts receivable 1,835104 Utilities 701108 Offi ce equipment 12,250201 Accounts payable 4,380301 Capital, Edlin 26,910302 Drawings, Edlin 2,117401 Service revenue 580501 Rental expenses 1,200502 Advertisement expenses 420503 Utility expenses 215509 Sundry expenses 220

TOTAL 31,870 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 fl ow 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 benefi t 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 fl ow. 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 fl ow 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 benefi t 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. Supplies Expenses RM250 Supplies RM2502. Depreciation Expenses RM400 Accumulated Depreciation RM4003. Interest Expenses RM300 Interest payable RM300

232 ANSWERS

4. Insurance Expenses RM1,500 Insurance Prepayment RM1,5005. Accrued Revenue/Revenue Receivable RM750 Service Revenue RM7506. Cash RM5,000 Unearned revenue RM5,000

Exercise 3.3

Khairunnisa’ Consulting ServicesIncome Statement

For the Period Ended 30 June 2007

RM RMFees Revenue 119,280Less Expenditure: Sundry expenses 10,700 Rental expenses 13,800 Utility expenses 4,900 Salary expenses 49,600 Supplies expenses 5,600 Insurance expenses 3,500 Depreciation expenses 825Total expenditure (88,925)Net revenue 30,355

ANSWERS 233

Khairunnisa’ Consulting ServicesBalance Sheet

as at 30 June 2007

RM RMCurrent Assets Current LiabilitiesCash 56,350 Accounts Payable 17,600Accounts Receivable 41,600 Salary Payable 7,100Offi ce supplies 12,300 Unearned fees 10,980Rental prepayment 4,400 35,680Insurance prepayment 15,100

129,750 Non-current LiabilitiesNotes Payable 100,000Total liabilities 135,680

Non-current AssetsOffi ce equipment 99,000 Owner’s EquityLess: Accumulated Depreciation

10,725 Opening capital, Khairunnisa’

51,990

Net book value 88,275 Net revenue 30,355Closing capital, Khairunnisa’ 82,345

Total Assets 218,025 Total Liabilities & Equity 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 RM RM Supplies expenses 890 Supplies 890 Insurance expenses 315 Insurance prepayment 315 Depreciation expenses 4,950 Accumulated depreciation 4,950 Salary Expenses 440 Salary payable 440 Accounts Receivable 1,000 Service revenue 1,000 Unearned revenue 500 Service revenue 500 (b) Financial Statement

Berkat EnterpriseIncome Statement

For the Period Ended 30 June 2006RM RM

Service revenue 60,625Salary expenses 22,855Sundry expenses 8,420Supplies expenses 890Insurance expenses 315Depreciation expenses 4,950 (37,430)Net profi t (23,195)

ANSWERS 235

Berkat EnterpriseBalance Sheet30 June 2006

RM RM RM

Non-current Asset: Offi ce equipment 51,650 Accumulated Reprediation (14, 650) 37,000

Curent assets: Cash 3,425 Account receivable 8,000 Supplies 380 Insurance prepayment 305 12,110

Current liablities: Salary payable 1,365 Unearned revenue 750 2,115 Total current assets 9,995 46,995Financed by:Owner’s Equity 29,000Capital 23,195Add: Net profi t (5,200)Less: Drawings 46,995

236 ANSWERS

(c) Closing entriesRM RM

Service Revenue 60,625 Revenue Summary 60,625

Revenue Summary 37,430 Salary expenses 22,855 Sundry expenses 8,420 Supplies expenses 890 Insurance expenses 315 Depreciation expenses 4,950

Revenue Summary 23,195 Capital 23,195

Capital 5,200 Drawings 5,200

2. Adjusting entriesRM RM

Salary expenses 100 Accrued/Payable Salary 100

Closing entry Revenue summary 100 Salary expenses 100

Reversing entry Accrued salary 100 Salary expenses 100

Entry for salary payment Salary expenses 120 Cash 120

ANSWERS 237

Salary expenses

RM RM31/12/00 Adjusting 100 31/12/00 Closing 100

100 10001/01/01 Payment 120 01/01/01 Reversing 100

Accrued SalaryRM RM

31/12/00 Balance 100 31/12/00 Adjusting 100100 100

01/01/01 Reversing 100 01/01/01 Balance 100

Revenue Summary

31/12/00 Closing RM100

Cash01/01/01 Payment RM120

3. (a) Moiz Real Estate Income Statement for the Period Ended 31 December 2004

RM RMRevenue: Service revenue 118,250Less Expenditure: Salary expenses 44,830 Depreciation expenses 5,430 Rental expenses 8,400 Sundry expenses 3,010Total expenditure 61,670Net revenue 56,580

238 ANSWERS

Moiz Real EstateStatement of Changes in Equity

for the Period Ended 31 December 2004RM

Capital, Moiz, 1 January 2004 85,000Add: Net revenue 56,580

114,580Less: Drawings (10,400)Capital, Moiz, 31 December 2004 104,180

Moiz Real EstateBalance Sheet

As at 31 December 2004

RM RM RMCurrent Assets Current LiabilitiesCash 6,850 Accounts Payable 1,850Accounts Receivable 14,000 Unearned revenue 2,500Supplies 2,540 Total current

liabilities4,350

Insurance prepayment 1,240Total current assets 24,630 Owner’s Equity

Capital, Moiz 104,180Non-current AssetsEquipment 103,300Acc Dep (19,400)Net book value 83,900Total Assets 108,530 Total Liabilities &

Equity108,530

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 RM RMService revenue 118,250 Revenue Summary 118,250

Revenue Summary 61,670 Salary expenses 44,830 Depreciation expenses 5,430 Rental expenses 8,400 Sundry expenses 3,010

Revenue Summary 56,580 Capital 56,580

Capital 10,400 Drawings 10,400

240 ANSWERS

TOPIC 4: FINANCIAL REPORTING

Exercise 4.1

1. Regulations that are linked with fi nancial 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 fi nancial reporting

(i) Bursa Malaysia Berhad

(ii) Central Bank of Malaysia

Exercise 4.2

1. Non-fi nancial 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 fi nancial information comprises fi nancial statements related to the organisation’s fi nancial status. Financial information is the main and most important information in a fi nancial report.

2. Notes to the accounts are prepared for the users of accounting information to clarify the total of the accounts as reported in the fi nancial statement.

ANSWERS 241

TOPIC 5: TRADING BUSINESS ENVIRONMENT

Exercise 5.1

1. (a) False (b) False (c) True (d) False

2. (a) Gross profi t = Sales revenue – Cost of goods sold = RM 110,000 – RM 70,000 = RM 40,000.

(b) Net operating revenue = Gross profi t – 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.

2. Sales Discount Price reduction will be given on credit sales if customer pays within discount

period.

3. Purchase Discount Price reduction will be given by seller to buyer if buyer pays within discount

period.

Exercise 5.3

1. C

2. Purchase Allowance Exists when buyer does not return the goods that do not meet specifi cation

and seller agreed to reduce the purchase price.]

Purchase Return Exists when buyer return the goods that do not meet specifi cation.

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 BoardFOB shipping point defi ned 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 defi ned 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 RMJuly 24 Dr: Accounts receivable 1,900

(RM2,000 – RM100) Cr: Inventory (RM1,900 x 2%) 38 Cr: Cash (RM1,900 – RM38) 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 RMJuly 19 Dr: Cash (RM700 – RM14) 686

Dr: Sales discount (RM700 x 2%) 14 Cr: Accounts receivable (RM800 – RM100) 700

Exercise 5.6

(a) Journal

Date Description Debit CreditMay 1 Inventory

Accounts payable (Depot Wholesaler)

6,000 6,000

May 2 Accounts receivable (Rahmat) Sales

4,500 4,500

Cost of goods sold Inventory

3,000 3,000

May 5 Accounts payable(Depot Wholesaler) Inventory

200 200

May 9 Cash (RM4,500-RM90)Sales discount (4,500 x 2%) Accounts receivable (Rahmat)

4,41090

4,500May 10 Accounts payable (6,000 – 200)

Inventory (5,800 x 2%) Cash

5,800116

5,684May 11 Supplies

Cash900

900May 12 Inventory

Cash2,400

2,400May 15 Cash

Inventory230

230

244 ANSWERS

(b) Ledger

Cash

May 17 Inventory Accounts payable (Harrods)

1,9001,900

May 19 Inventory Cash

250250

May 24 Cash Sales

6,2006,200


4,3404,340

May 26 Inventory Accounts payable (Horizon)

1,0001,000

May 27 Accounts payable (Harrods) Inventory (1,900 x 2%) Cash

1,90038

1,862May 29 Sales return and allowance

Cash100

100Inventory Cost of goods sold

7070

May 31 Accounts receivable (Rahmat) Sales

1,6001,600

Cost of goods sold inventory

1,1201,120

Date Description Debit Credit BalanceMay 1 Balance 5,000

9 Accounts receivable 4,410 9,41010 Accounts payable 5,684 3,72611 Supplies 900 2,82612 Inventory 2,400 42615 Inventory 230 65619 Inventory 250 40624 Sales 6,200 6,60627 Accounts payable 1,862 4,74429 Sales return and allowances 100 4,644

ANSWERS 245

Accounts receivable

Date Description Debit Credit BalanceMay 2 Sales 4,500 4,500

9 Cash 4,410 909 Sales discount 90 0

31 Sales 1,600 1,600

Inventory

Date Description Debit Credit Balance

May 1 Accounts payable 6,000 6,0002 Cost of goods sold 3,000 3,0005 Accounts payable 200 2,800

10 Accounts payable 116 2,68412 Cash 2,400 5,08415 Cash 230 4,85417 Accounts payable 1,900 6,75419 Cash 250 7,00424 Cost of goods sold 4,340 2,66425 Accounts payable 1,000 3,66427 Accounts payable 38 3,62629 Cost of goods sold 70 3,69631 Cost of goods sold 1,120 2,576

Supplies

Date Description Debit Credit Balance

Cash 900 900

246 ANSWERS

Accounts payable

Date Description Debit Credit BalanceMay 1 Inventory 6,000 6,000

5 Inventory 200 5,80010 Inventory 116 5,68410 Cash 5,684 017 Inventory 1,900 1,90026 Inventory 1,000 2,90027 Inventory 38 2,86227 Cash 1,862 1,000

Capital – Abu BakarDate Description Debit Credit BalanceMay 1 Balance 5,000

SalesDate Description Debit Credit BalanceMay 2 Accounts receivable 4,500 4,500

24 Cash 6,200 10,70031 Accounts receivable 1,600 12,300

Sales Return and AllowanceDate Description Debit Credit Balance

May 29 Cash 100 100

Sales DiscountDate Description Debit Credit BalanceMay 9 Accounts receivable 90 90

Cost of Goods SoldDate Description Debit Credit BalanceMay 2 Inventory 3,000 3,000

24 Inventory 4,340 7,34029 Inventory 70 7,27031 Inventory 1,120 8,390

ANSWERS 247

(c) Cempaka Sdn BhdIncome Statement Extract

For the Month Ended 31 May 2007

RM RMSales revenue:SalesLess: Sales return and allowances Sales discount

100 90

12,300

190Net sales 12,110Cost of goods sold (8,390)Gross profi t 3,720

Exercise 5.7

(a) Adjusting Entries

Entries Debit Credit(i) Depreciation expenses – building Accumulated depreciation – building

10,00010,000

(ii) Depreciation expenses – equipment Accumulated depreciation – equipment

9,0009,000

(iii) Interest expenses Interest payable

7,0007,000

248 ANSWERS

(b) Melati Sdn Bhd Income Statement For the Year Ended 31 December 2008

RM RM RMSales revenue: Sales 902,100 Less: Sales Discount (4,600) Net Sales 897,500Cost of goods sold (709,900)Gross profi t 187,600Less: Operating expensesSales expenses: Salary expenses (69,800 x 80%) 55,840 Maintenance expenses 7,200 63,040Administrative expenses Salary expenses (69,800 x 20%) 13,960 Depreciation expenses – building 10,000 Utility expenses 19,400 Depreciation expenses – equipment 9,000 Repair expenses 5,900 Insurance expenses 3,500 61,760

Total operating cost (124,800)Operating revenue 62,800Other expenses – interest expenses (7,000)Net revenue 55,800

ANSWERS 249

(c) Melati Sdn BhdBalance Sheet

As at 31 December 2008

RM RM RM RMNon-current assets:Land 92,000Building 197,000Less: Accumulated depreciation (64,000) 133,000Equipment 83,500Less: Accumulated depreciation (51,400) 32,100 257,100

Current Assets:Cash 23,400Accounts receivable 37,600Inventory 90,000 151,000

Current Liabilities:Notes payable (mature in year 2008) 15,000Accounts payable 37,500Interest payable 7,000 59,500

Net current asset/Working capital 91,500348,600

Financed by:Capital (267,800+55,800-10,000) 313,600Non-current liability 35,000

348,600

250 ANSWERS

(d) Recording Closing Entries

Date Description Debit CreditDec 31 Sales

Revenue summary 902,100

902,100Dec 31 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

846,300 4,600

709,00069,80019,4005,9007,2003,50010,0009,0007,000

Dec 31 Revenue summary Capital – Abu Bakar

55,80055,800

Dec 31 Capital – Abu Bakar Drawings

10,00010,000

Exercise 5.8

1.

Date Description Debit Credit

Mar 2 Accounts receivable Sales

800,000800,000


600,000600,000

Mar 6 Sales return and allowance Accounts receivable

120,000120,000

Inventory Cost of goods sold

90,00090,000

Mar 12 Cash (680,000 – 13,600)Sales discount (680,000 x 2%) Accounts receivable

666,40013,600

680,000

2.

ANSWERS 251

Description Debit Credit

Sales Revenue summary

180,000180,000

Revenue summary Cost of goods sold Sales discount

102,000100,000

2,000Goods inventory Revenue summary

40,00040,000

3. (i)


April 5 Inventory Accounts payable

16,00016,000

April 6 Inventory Cash

900900

April 7 Equipment Accounts payable

26,00026,000

April 8 Accounts payable Inventory

3,0003,000

April 15 Accounts payable (16,000-3,000) Inventory [(16,000-3,000) x 2%] Cash (13,000-260)

13,000260

12,740

(ii)


May 4 Accounts payable Cash

13,00013,000

252 ANSWERS

4.


Sept 6 Inventory (80 x RM19) Cash

1,5201,520

Sept 9 Inventory Cash

8080

Sept 10 Accounts receivable (2 x RM20) Inventory

4040

Sept 12 Accounts receivable (26 x RM30) Inventory

780780

Cost of goods sold (26 x RM20) Inventory

520520

Sept 14 Sales return and allowance Accounts receivable

3030

Inventory Cost of goods sold

2020

Sep 20 Accounts receivable (30 x RM30) Sales

900900

Cost of goods sold (30 x RM20) Inventory 600600

5. (a)


Dec 3 Accounts receivable Sales

480,000480,000


320,000320,000

Dec 8 Sales return and allowance Accounts receivable

20,00020,000

Dec 13 Cash (460,000 – 9,200) Sales discount [(480,000 – 20,000) x 2%]Accounts receivable (480,000 – 20,000)

450,8009,200

460,000

(b)


Jan 2 Sales Accounts receivable (RM480,000 – RM20,000)

460,000460,000

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 fi nancial information aspect.

(a) Intra-company (Within the company) The basis for intra-company is that it compares the items in the fi nancial

statement for two different years (or more) for the same company. The comparison of current year’s fi nancial 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 fi nancial

statement of one company with one or more companies operating the same type of business. The comparison made is based on the fi nancial 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 fi nancial 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 fi nancial 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 fi nancial 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 fi nancial 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 fi nancial 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

31 Dec 2007

Change in Amount

(RM)Calculation

Percentage (%)

Accounts receivable

500,000 400,000 100,000 100k/400k 25%*

Inventory 840,000 600,000 240,000 240k/600k 40%**Total current assets

3,220,000 2,800,000 420,000 420k/2,800k 15%***

Vertical Analysis

31 Dec 2006 31 Dec 2007

Accounts receivable

500,000 400,000

Inventory 840,000 600,000Total asset 3,220,000 100% 2,800,000 100%

Exercise 6.3

1. The meaning of current ratio and quick ratio, including their formula, are shown below:

Explanation Formula

Current ratio To measure the adequacy of current asset to pay current liability

Quick ratio To measure the business’s capability to pay short-term debt immediately.

*Quick asset comprise cash, marketable securities and accounts receivable.

Current asset

Current liability

Quick asset*

Current liability

ANSWERS 255

2. (a) Working Capital = Current Asset – Current liability = RM42,918,000 – RM45,844,000 = (RM2,926,000)

(b) Current ratio =

= = 0.94 : 1

(c) Quick ratio =

= = 0.50: 1

Exercise 6.4

Inventory turnover =

Cost of Goods Sold(2006)

Cost of Goods Sold(2005)

Opening inventory 980,000 860,000Add: Purchases 4,440,000 4,661,000Cost of goods ready for sale 5,420,000 5,521,000Less: Closing inventory 1,020,000 980,000Cost of goods sold 4,400,000 4,541,000

(a) Inventory turnover = 2006 =

2 = 4.4 times

Current assetCurrent liability

42,918,00045,844,000

Cash + Marketable security + ARCurrent Liability

8,241,000 + 1,947,000 + 12,545,00045,844,000

Cost of goods soldAverage inventory


4,440,000980,000 + 1,020,000

256 ANSWERS

(b) Inventory turnover = 2006 =

2 = 4.9 times

Exercise 6.5

(a) Current ratio = = = 2.9 : 1

(b) Quick ratio =

= = 1.7 : 1

(c) AR turnover =

= = 6.4 times

=

= 62,500


Current AssetCurrent Liability

4,541,000860,000 + 980,000

20,000 + 65,000 + 60,00050,000

Quick assetCurrent Liability

65,000 + 20,00050,000

Credit sales (net)Average AR (net)

400,00062,500*

*[AR last year + AR current year]2

60,000 + 65,0002

ANSWERS 257

(d) Inventory turnover =

= = 3.6 times

=

= 55,000

(e) Return on sales = (Profi t margin)

=

= 11%

Cost of goods soldAverage inventory198,00055,000**

**[Inventory last year + Inventory current year]2

50,000 + 60,0002

Net profitSales (net)

44,000420,000 - 20,000

258 ANSWERS

Exercise 6.6

1. Desa Sdn. Bhd. Balance Sheet as at 31 December 2004 and 2005

2005(RM)

2004(RM)Basis Year

Increase (Decrease)

Amount(RM)

Percentage(%)

Assets:Equipment (net) 400,000 330,000 70,000 21.2Current asset 125,000 100,000 25,000 25.0

Total Assets 525,000 430,000 95,000 22.1

Liabilities:Non-current liability 144,000 95,000 49,000 51.6Current liability 91,000 70,000 21,000 30.0Total Liabilities 235,000 165,000 70,000 42.4

Owner’s Equity:Ordinary shares @ RM1 155,000 115,000 40,000 34.8Retained earnings 135,000 150,000 (15,000) (10.0)Total owner’s equity 290,000 265,000 25,000 9.4Total liabilities and owner’s equity

525,000 430,000 95,000 22.1

2. (a) Profi t margin =

=

= 8%

(b) Asset turnover =

=

= 1.5 times

Net profitSales (net)

64,000800,000

Net salesAverage total asset*

800,000 550,000

ANSWERS 259

= = 550,000

(c) Return on asset =

=

= 11.6%

= = 550,000

(d) Return on owner’s equity =

= = 16.8%

3. Ratio analysis for year 2000:

Formula 2000

(a) Profi t margin

(b) Asset turnover

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

*[Total asset last year + Total asset current year]2

500,000 + 600,0002

Net profitAverage total asset*

64,000 550,000


500,000 + 600,0002

Net profit after taxAverage ownerÊs equity ordinary shares

64,000800,000

Net profit

Sales (net)

Net sales

Average total asset*

* [Total asset last year +

Total asset current year]

2

35,000 =

650,000 = 5.4%

650,000 = 561,500*

= 1.2 times

260 ANSWERS

Formula 2000

(c) Earnings per share

(d) Price earnings ratio

(e) Dividend payout ratio

**revenue year 1999 + 2000 current profi t – 2000 retained revenue**113,000 + 35,000 – 125,000 =** 23,000

(f) Debt ratio

Ratio analysis for year 2001:

Formula 2001

(a) Profi t margin

(b) Asset turnover

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

Not profit Dividendfor Preference Shares

Average ordinary sharesissued (unit)

Market value of ordinaryshares per unit

Earnings per share

Cash dividend

Net profit

Total liability

Total asset

35,000= 30,000* unit= RM1.17

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

RM5.00= RM1.17= 4.3 times

23,000**= 35,000= 65.7%

165,000= 590,000= 28.0%

Net profit

Sales (net)

50,000= 700,000= 7.1%

Net sales

Average total asset*

700,000= 615,000*= 1.1times

* [Total asset last year +

Total asset current year]

2

ANSWERS 261

Formula 2001

(c) Earnings per share

(d) Price earnings ratio

(e) Dividend payout ratio

**revenue year 2000 + 2001 current profi t – 2001 retained revenue

**125,000 +

50,000-145000

= **30,000

(f) Debt ratio

4. (a) Current ratio = = = 1.7 : 1

(b) Quick ratio =

= = 1.1 : 1

Net profit - Dividendfor Preference Shares

Average ordinary sharesissued (unit)

50,000= 32,000* unit= RM1.56

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

Market value of ordinaryshares per unit

Earnings per share

RM7.95= RM1.56= 5.1 times

Cash dividend

Net profit

30,000**= 50,000= 60.0%

Total liability

Total asset 155,000= 640,000= 24.2%

Current AssetCurrent Liability

235,000 135,000

Quick assetCurrent Liability

41,000 + 18,000 + 92,00135,000

262 ANSWERS

(c) Accounts receivable turnover = = = 7.8 times

* 83,000 (d) Inventory turnover = = = 5.4 times

77,000

(e) Gross profi t margin =

= = 36.2%

(f) Asset turnover =

= = 1.1 times

650,000 83,000

*[AR last year + AR current year]2

*74,000 + 92,000 2

Cost of goods soldAverage inventory*

415,000 77,000

*[Inventory last year + Inventory current year]2

70,000 + 84,000 2

Gross profit Sales (net)

235,000 650,000

Net salesAverage total asset*

650,000 599,000

ANSWERS 263

599,000

(g) Return on asset =

= = 10%

599,000

(h) Return on owner’s equity =

= = 16.3%

361,500

(i) Earnings per share = = = RM1.99

Net profitAverage total asset*

350,000 + 373,000 2


560,000 + 638,000 2

Net profitAverage owners equityÊs ordinary share*

59,800 599,000


560,000 + 638,000 2

59,000 361,500

*[Total owner equity last year + Total owner equity current year]2

Net profit - Dividend on preference sharesAverage ordinary shares issued (unit)*

59,800 30,000

264 ANSWERS

*RM150,000 / RM5 per share *30,000 units share

(j) Price earnings ratio =

= = 9.8 times

(k) Dividend payout ratio =

= = 61.5% *Opening retained earnings + Current net profi t - Closing retained earnings *200,000 + 59,800 – 223,000 = 36,800

(l) Debt to equity ratio =

= = 71.0%

(m) Interest coverage ratio =

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

Market value of ordinary shares per unitEarnings per share

RM19.50 RM1.99

Cash dividend*Net profit

36,000 59,800

Total liabilityTotal ownerÊs equity

265,000 373,000

Net profit + Taxation + Interest expenses*Interest expenses

85,000 7,200

ReferenceAkilah 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 Profi t 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.

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