TYLER

GODWIN
ALDERMAN
3RD
ASIA-PACIFIC
EDITION

FINANCIAL

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ACCT3 Financial e> 219 cengage Leaming Australia Pty Umited
3rd Edition
jonathan Tyler Copyright Notice
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 BRIEF
CONTENTS

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Copyrlghl 2019 Cengago Lea ng. AU Rights R--...d. llay noc be coplecl. scanned .,.. d u p l - In whole.,.. In part WCN 02 200-202
iii
 CONTENTS

The stat ement of changes in equity 29

1 Information beyond the financial statements 30
Notes to the flllanc.a statements 30
Beginning assumptions 2 Auditor's report 31
Econom•c enuty assumpuon 2 D~rectors' report 31
Accounung penod assumption 2 Other .nformat1on 31
Monetary un.t assumpuon 2 Susta•nab•l•ty report•ng 32
Go1ng concern assumptiOn 2 Governance •nformat•on 33
Reporting profitability: the income statement 3 Exercises 34
Revenues 3
Expenses 4
Probl em s 37
The 1ncome statement 4 Cases 39
Reporting fi nancial positi o n : the balance sheet
Assets
uaboht•es
5
5
5
D Recording accounting transactions 40
Equity 6 The accounting information system 40
The balance sheet 6
Accounting transactions and
Reporting equity: the statement of changes in equity 7 the accounting equation 42
lJnk1ng the 1ncome Statement and the balance Sheet 7 Transaction analys•S 42
Reporting cash flows: the cash flow statement 8 The d u al-entry accounting system 46
F1nanc•ng aCtiVIties 8 The T-account 46
lnvesung actiVIties 8 Deb•t and cred1t rules 46
Operattng act•v•t•es 8 Summary of deb1t and cred•t rules 48
The cash flow statement 8
Recording transactions in t he accounting sy stem 48
Th e objectives of financial reporting 9 The journal 48
Relevance and matenality 9 The ledger 48
Fa1thful representation 10 The tnal balance 49
Comparab•hty 10
Comprehensive example: joumal entries to
Venfl8bil•ty 10 financial statements 50
T1mehness 10 Record•ng transacti()I\S n the 1ournal and posung
Understandabo •tv 10 to the ledger 50
The language of accounting 11 Prepanng a trial balance 54
Exercises Prepanng f•nancial statements 54
13
Problems Exerci ses 55
15
Cases Problems 58
17
Cases 59
Financial statements

Business forms
18

18
D Accrual accounting and
adjusting entries 60
Generally accepted account in g princip l es (GAAP) 19
The bal ance sheet 20
Accrual and cash bases of accounti ng 60
Report•ng accrual- and cash-based 1ncome 61
The income stat ement 22
Profns before 1ncome tax expense 25
Adjusting joumal entries 62
ScenariO 1 Deferred revenue 62
Other comprehenswe 1ncome 25
ScenariO 2. Accrued revenue 64
Horizontal and vertical analyses 25 Scenano 3. Deferred expense 65
Honzontal analys1s 25 Scenano 4 . Accrued expense 67
Ven•cal analys•s 26 Summary of ad1ust•ng JOurnal entnes 69

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iv
Comprehensive example: adjusting journal entries 69 Inventory costing meth ods 114
Journalising and posting adjusting entries 70 Specific identification 115
Preparing an adjusted trial balance 71 First-in, first-out (FIFO) 115
Preparing financial statements 71 Last-in, first-out (LIFO) 117
Closing process 72 Moving average 117
The accou nti ng cycle: a summary 74 Comparing inventory costi ng methods 118

Exercises 75 Esti mati ng ending inventory 119

Problems 77 Lower-of-cost-and-net realisable valu e 120
Evaluati ng a busi ness' management of inventory 121
Cases 79
Horizontal and vertical analyses 121
D Cash and internal controls 81
Inventory turnover ratio
Appendix: periodic inventory system
122
123
Recording inventory 123
Internal control 81 Inventory costing methods 123
Component s of internal control 82 Exercises 126
Control environment 82
Risk assessment 83 Problems 128
Control activities 83 Cases 129
Information and communication 84
Monitoring
Limitations of internal control
84
84 D Non-current assets and
intangible assets 130
Cash controls 84
Bank reconciliations 85
Bank reconciliation example Recording, expensing and reporting
86
non-current assets 130
Peny cash funds 87
Recording non-current assets 130
Reporting cash and cash equivalents 88 Expensing non<urrent assets 131
Analysing cash 89 Reporting non<urrent assets 132
Horizontal and vertical analyses 89 Calculating depreciation expense 132
Free cash flow 90 Straight-line method 133
Exercises 93 Reducing-balance method 134
Units-of-activity method 135
Problems 95 Comparing depreciation methods 135
Cases 96 Adjustments made during a non-current
asset's useful life 137
~~ Receivables 97 Changes in depreciation estimates 137
Expenditures after acquisition 138
Recording and reporting accounts receivable 97 Asset impairment 139
Recording accounts receivable 97 Asset revaluations 139
Reporting accounts receivable 98 Disposing of non-current assets 140
Uncollectible receivables 99 Loss example 140
Direct writ~ff method 99 Gain example 141
Allowance method 100 Evaluati ng a company's management of
Estimati ng bad debt expense 102 non-current assets 142
Percentage-of-sales approach 102 Horizontal and vertical analyses 142
Percentage-of-receivables approach 102 Non<urrent asset turnover ratio 143
Average life and age of non-current assets 144
Analysing accounts receivable 104
Horizontal and vertical analyses 104 Non-current assets and cash flows 144
Receivables turnover ratio 104 Intangible assets 145
Allowance ratio 105 Recording intangible assets 145
Notes receivable 106 Amortising and impairing intangible assets 146
Recording the note 106 Exercises 148
Recording interest 106
Problems 149
Collecting the note 107
Cases 151
Exercises 108
Problems 110
~~ Liabilities 152
Cases 111

D Inventory 112
Current liabilities
Taxes payable
Current liabilities with payroll
152
153
153
Recording, expensing and reporting inventory 112 Notes payable 154
Recording inventory 112 Current portion of non-current debt 154
Expensing inventory 114 Reporting current liabilities 155
Reporting inventory and cost of sales 114 Non-current liabilities 155

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Contents v
 ~n~ 1~ DMdend 1mputat1on 192
Bonds ISSued at face value 157 RegulatiOn 193
Bonds ISSued at a d1scount 158 Ordinary shares 193
Bonds ssued at a pcem1um 160 Shareholder roghts 193
Redeeming a bond before maturity 162 Record•ng ordmary shares 194
lssu1ng shares by 1nstalment 194
Additionalliabilities 163
Lease hab•ll!les Oversubscnpuon 195
163
Forfe1ture 196
Conungent hab1h11es 164
Evaluating a company's management of liabilities
Dividends 196
165
Cash d1v1dends 196
Honzontal and vert1cal analyses 165
Current rat•o 166
Share dividends 198
Debt to assets ratio
Dividend Reinvestment Plans 1n Australia 198
166
Share splits 199
Appendix: detemnining a bond's Issue price 167
Preference shares 200
Appendix: effective interes1 method of amortisation 168 Record1ng preference shares 200
D•scount example 169 Cash diVIdends on preference shares 200
Prem•um example 169
Share buybacks 201
Exerci ses 171 Record•ng share buybacks 201
Problems 173 Evaluating a company's management of equity 203
Cases 174 Honzontal and vert1ca analyses 204

m Partnerships 175
Earmngs per share
Return on eqUity
DIVIdend payout rat•o
Div1dend y1eld
204
205
205
206
Th e partnership fomn of bu siness 175 Shareholders' equ1ty and cash flows 207
Ease of formation 176
Partnersh•p agreement Exercises 208
176
Mutual agency and co-ownersh1p of property 176 Prob lems 210
Unlimited hab•hty of owners 176 211
Cases
Transferab•hty of ownership 177

~~
No partnership taxat1on 177
Cap.tal accounts for each partner 177 Statement of cash flows 212
Commencing a partnership 1n
Cap.ta account for each panner
The statement of cash flows 212
178
Cash flows from operaung actMt1es 213
Allocate profits and losses 179 Cash flows from •rrvest•ng actMIIeS 213
Shanng proftts based on a set percentage 179 Cash flows from hnanc1ng acllv111es 213
Shanng prof•ts based on capital balances and on serv.ce 179 Net 1ncrease (decreasel•n cash 214
Admission and withdrawal of a partner 180 Add1t10nal disclosures 215
Purchas1ng a current partner's interest 180 Preparing the statement of cash flows 216
Investing 1n the partnership 181 Direct and indlfect methods for operating cash flows 217
Investing 1n the partnership: bonus to new partner 181 Example data 217
Investing 1n the partnership: bonus to ex1st1ng partners 182
Reporting cash flows from operating activities:
Withdrawal of a partner 182 d irect method 218
Revaluat1on of assets before Withdrawal of a partner 183
Cash receiVed from customers 218
Withdrawal of a partner at carrymg amount 183
Cash pa1d for Inventory 218
W1thdrawal of a partner at more
Cash pa•d for operat•ng expenses 219
than the carrying amount 184
Cash paid for taxes 220
Wothdrawal of a partner at less
Other revenues and expenses 220
than the carry1ng amount 184
Net operat1ng cash flows 220
Uquidation 184
Reporting cash flows from operating activities:
Sale of assets 184 indirect method 221
Pay1ng the hab1h11es 185
Adjustments for non~ash 11ems 221
Partners receive rema1ning cash 185
Adjustments for ga1ns and losses from investing and
Partnership financial statements 186 financing act1v1t1eS 221
Exercises 187 Adjustments for current assets and current liabilities 222
Net operatong cash flows 223
Problems 188
Calculating cash flows from investing activities 223
Cases 189 Investments 223
EqUipment 223
Shareholders' equity 191 Accumulated deprecoatoon 224
Summary of 1nvest1ng cash flows 224
The corporate fomn of business 191 Calculati ng cash flows from financing activities 224
Separate 1egal enllty 191 Non<urrent ltab•htoes 224
Ab•l,ty to ra•se cap1tal 191 Contnbuted equity 224
limited liab•hty of owners 192 Reta~ned earnongs 225
Transferab•hty of ownership 192

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 Net financing cash flows 225 Liquidity analysis 245
Complete statement of cash flows: indirect method 225 Current ratio 245
Analysing a compa ny 's statement of cash flows 226 Quick ratio 246
Free cash flow 226 Receivables turnover ratio 246
Cash flow adequacy ratio 226 Inventory turnover ratio 246
Summary of liquidity analysis 247
Exercises 228
Solvency analysis 247
Problems 231 Debt to assets ratio 248
Cases 232 Debt to equity ratio 248

m Financial statement analysis 234

Times interest earned
Summary of solvency
DuPont analysis
248
249
249
Financial statement analysis 234 Exercises 251
Financial information 235 Problems 254
Standards of comparison 235
Analysis tools 236 Cases 256
Horizontal and vertical analyses 236
Horizontal analysis 236 Appendix A : Time value of money 257
Vertical analysis 238 Appendix B: CSL Limited, annual report 2017 266
Profitability analysis 242
Endnotes 289
Profit margin 242
Return on equity 242 Index 291
Return on assets 243 Tear-out review cards
Earnings per share 243
Price to earnings ratio 244
Summary of profitability 244

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Contents vii
 As you read this text you will find a number of features in every
chapter to enhance your study of financial accounting and help you
understand how the theory is applied in the real world.

Learning objectives at the start of each chapter identify key concepts

~ ''llri'II11M!d.W!G\14!!•irlfi
that will be covered. and Learning objective icons appear throughout
the chapter to identify where each objective is discussed.
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CSL Analysis boxes link to the CS L
annua l report extract provided in
Append ix 8 of the textbook, and
provides an opportunity to apply
financial accounting concepts to a
real-world business.
Making it Real boxes present real-life Important key terms are marked in
financial accounting scenarios to bold in the text and defined in the
demonstrate the chapter concepts in margin when they are used in the text
practice. for the first time.

S\.d'l as a
month. a ~ner. bul no 1onget 8Cl00Unting period
than a year. This is known as the ISSUmplion Ill!
accounting period assumption - the 8SS!IDPIO'II'A&debt
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asSUTiption made bv aocountants that
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• lnvesttng a<tivtttn w.eod $862 9 mrlhon
judgements and estimates not simptv mathematical
• F~nanang acttvitieos u'ed S 103 5 m1llion
calculations.

Apply this icons in the text link you to ACCT3 onl ine content. including interactive
quizzes. videos and more.

• ___ ____
At the end of each Chapt er t ear-out cards
chapter you will
find several tool s
·--- ..

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found at the back of the
book provide a portable
to help you to ==::;;"'::'..":.."'=~ :-_ ______ study tool.
review. practice =:r.::.::=:-.::."';:"'-.. : ==~.:=.==­ summarising each
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viii
Cengage is pl eased to provide you with a selection of resources that will help you prepare
your lectures and assessments. These teac hing tool s ar e accessible via cengage.com.au/
instructors for Australia or cengage.co.nz/instructors for New Zealand.

COURSEMATE EXPRESS FOR IN STRUCTO R'S MANUAL

ACCT3 FINANCIAL The Instr uctor 's Manual includes:
Course Mate Express is your one-stop shop for learning • Overview of the chapter content and learn ing
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lx
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In whole or In part. WCN 02·200-202

After studying the material in this chapter, you
should be able to:
Explain the four assumptions made when
communicating accounting information.
Describe the purpose and structure of an
income statement and the terms and
principles used to create it.
Describe the purpose and structure of a
balance sheet and the terms and principles
used to create it.
Describe the purpose of a statement of
changes in equity and how it links the
income statement and the balance sheet.
Describe the purpose and structure of a
statement of cash flow and the terms and
principles used to create it.
Appreciate the objectives of financial
reporting and qualitative characteristics that
make accounting information useful.
Review the language of accounting.
apply this -·······-
CourseMate Express
Copyright 2019 Cengage Learning A R ghta ftnervecl May not be
Imagine for a moment that you are on summer holidays
and decide to turn your hobby into a business which you
name Aerial Filming. With $1000 of your own money and
a S2000 microenterprise loan from the bank you purchase
a S2600 drone (with gimbal, camera and rechargeable
battery), $350 of spare propellers, disposable batteries,
SIM cards and other supplies. During December, January
and February, you had 28 aerial filming jobs at an average
of $400 each job, you buy $750 additiona l suppli es and
pay the bank $50 interest. At the end of February, you
still have the bank loan, you also have $1940 in cash,
S100 of supplies and $1200 owing to you from three
customers.
Given this information, can you tell what happened to
your business over summer? Did you make enough
money to make it worth continuing or would it have been
financially more rewarding working at the locaiiGA store?
How can you tell? Getting answers to such questions
requires accounting, because ultimately you are filming
to make money, no longerfor the simple pleasure of flying
and fi lming with a drone or to provide a community
service. Working for yourself has certain advantages, but
also hassles, which may not come with being an employee,
and these need t o be balanced aga i nst the financial
success of the business. All of us need money to eat, pay
for accommodation, the phone, travel, buy clothes,
entertainment, and hopefully, at some stage save.
Ac c ounting is the process of
accounting The
identifying, measuring and communicating ~of odentdyillg.
economic information to permit informed measunngand
judgements and decisions. Put more COITITl\lliCatlng econonw:
UlfonnatJon to penn1t
simply, account ing IS t he language of mtormed jUdgements and
business. When you want to know about dec1s1ons
the financial results of a business, you
must understand and speak accounting. The purpose
of this book is to help you learn, write and speak this
language so that you can make socially responsible and
financially sound business decisions.
With this overall purpose in mind, this chapter
introduces the basic terms, principles and rules that
comprise the 'spelling' and 'grammar' of the accounting
 language. It does so by creating t he summer fi nancial
statements of the aerial filming business, Aerial Filming,
described above. At the end of the chapter, you should be
familiar with the four main financial statements- income
statement, balance sheet. statement of cash flow,
statement of change in equity. Further, you should also
have a working accounting vocabulary that will be
expanded and refined In the following chapters.
The purpose of accounting IS to ident1fy, measure and
communicate economic information about a particular
entity to interested users. To do this, accountants make the
following four basic assumptions: economic entity,
4t'<~ ''" accounti ng period .
Checkoutlhevideosummary monetary unit and going
• for Chapter 1 concern.
ECONOMIC ENTITY ASSUMPTION
The economic entity assump tion
economic entity
assumption The states that the financial activities of a
assumption made by business can be separated from the
accountants that the
finaocial activities of a fmancial activities of the business' owner(s)
business can be sepa~ated and from other business activities. This
from the finaocial activ1t1es
of the business' O'Mler(sl assumption allows a user to examine a
company's (sole trader's or partnership's)
accounting information without concern that the information
includes the personal affa1rs of the owner(s) or other business
activities. For the Aerial Filming example in the introduction,
this means that the bus1ness IS the reporting entity and your
personal activities (such as the cost of your Saturday evening
out) should not be 1nclucled wtth bus1ness activities (such as
buying batteries for the drone).The defimtlon of the 'reporting
entity' can be complex and IS covered in detail in the
(Australian) Financial Reporting Handbook (the big book of
rules for accountants preparing financial statements)
Statement of Accounting Concept SAC 1.
ACCOUNTING PERIOD ASSUMPTION
Business owners and other interested parties usually do not
want to wait too long before they receive information about
how a business is doing. They want periodic measurements
of the business' financial success or failure. For many
activities, be it a diet or sports training, it is useful to measure
your performance at regular intervals to determine if you
should change your strategy. In business. performance is
measured primarily in financial terms. Accountants therefore
assume that economic information can be meaningfully
captured and commun1cated over short periods of time,
even if those account1ng periods are somewhat artificial,
__ ..;;
2
ACCT3 Fw>~flgllt 2018 Cengoge l.aml119- AU Rights R~ May no< be c opMd scanned. or dUI'lieaod,ln wholo or In pan. WCN 02·200-202
such as a month, a quarter, but no longer accounting period
than a year. This is known as the assumption The
asSIIII1lllon made by
accou nting period assumption - the accountants that econo011c
assumpt ion made by accountants that lnfOIITiabon can be
economic information can be meaningfully meanongfully captured and
CCIIIV'IU\Icated IM!I short
captured and communicated over short penods of time.
periods of time.Aithough the measurement
involves numbers, it usually reqUires
judgements and estimates not simply mathematical
calculations.
Publicly traded compames such as CSL Llm1ted are
required to file financial statements w1th the Australian
Securities Exchange (ASX) at least twice a year. For the
Aerial Filming business example, the time period is the
three months of summer.
MONETARY UNIT ASSUMPTION
monetary unit
The monetary uni t ass umption assumption AA
assumes that the dollar is th e most assumption made by
accoontants that the dollar
effective means to communicate economic is lhe most effective
activity- it is the 'attribute of interest'. The meansto communicate
economic activity.
drone has many attributes: manufacturer,
model. range, f lying time, colour; but the attribute of interest
in accounting is the cost in dollars. If an economic activity
cannot be expressed in dollars, then it is not recorded in the
account ing system. For Aerial Filming, placing a paid
advertisement in the local paper would be recorded as an
expense. while a favourable story would not be recorded in
accounting as no money was exchanged. Th1s IS one of the
limitations (and strengths) of accounting. It assumes further
that the dollar is a reasonably stable measure (the effect of
inflation and deflation can be 1gnored).
GOING CONCERN ASSUMPTION
going concem
The goi ng concern assumpt ion takes assumption The
assumpllon made by
as a given that a business will cont1nue to
accountants that a
operate in to the foreseeable future. company will continue to
Unless there is evidence to the contrary, operate 1nto the
foreseeable future.
most businesses are assumed to be going
concerns. This is important because it affects the dollar
amount recorded with respect to the value of certain
assets. Because Aerial Filming will continue beyond the
summer, it is a going concern and we value t he drone at
what it is worth to the bu siness, not what it can be sold for
at the end of summer.
CSl ANALYSIS p

Which assumf>tion does each description best relate to?
This reports a company's revenues and expenses and the
resulting profit or loss (net income or total comprehensive
income). When a company releases its annual report, the
news headline is almost always the profit or loss number; for
example. 'Commonwealth Bank Reports $9.9 Billion Profits'.

REVENUES
1i
~-------------------------------------------1 !
!!
~
}

A revenue is an increase in resources

revenue An increase in
resulting from the sale of goods (sales resources resulting from
revenue) or the provision of services (service the sale of goods or the
provision of services.
revenue). Receiving $400 for filming a
surfing competition is an example of revenue.You have $400
that you didn't have before you proVICled the service.
Revenues are recorded accord1ng to the revenue
recognition principle. The revenue
revenue recognition
recognition principle states that revenue principle The pnoople
should be recorded when a resource has that le\'l!flJI! should be
recorded when a resruce
been earned. regardless of when the cash has been earned iWld not
is received. That is, you may ask for just when the cash is
advance payment prior to film1ng the surf received

contest or decide not to b1ll the surfers

until after they have received their prize money. Regardless
~,u r~, of when cash is received, revenue is earned when you do
the filming. The provision of the service is substantially
• Review this content with the e-lecture
complete. and collection is reasonably assured. This is
known as accrual-based accounting and is distinguished
from cash-based accounting. The Australian Accounting
REPORTING PROFITABILITY: Standard: AASB 15 Revenue f rom Contracts with
THE INCOME STATEMENT Customers provides much more detail on calculating the
amount and timing of revenue recognition.
The first question usually asked of a business is whether it Given these definitions, total revenue for summer for
is making any money. In accounting we would ask: Is the Aerial Filming is as follows: you have only one source of
business profitable? Does it generate more resources than revenue- airborne filming. Assuming that your customers will
income statement it uses? Accounting provides answers to pay, your filming business earns revenue each time a filming
(profit and loss these questions with a financial statement job is undertaken. So, if you filmed 28 occasions at $400 each,
statement) The
called the i ncome stat ement revenues total $11200 for the summer. Of those revenues,
iocome statement reports
a company·s r!MlrueS and (sometimes called the p rofit and loss you have received cash for all except three ($1200). The $1200
expenses iWld the resuhulg st atement) or, to be technically correct, has been earned (you have carried out the service and expect
profit or loss.
I
the statement of comprehensive income.

R
to be paid), although it has not been received 1n cash.

R - - . May no< be copMd scanned. "'dUI>l oca. "' C~A'IJ&1t '( k"nancfa1 accounting __
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3
 EXPENSES
expense A decrease in An expense is a decrease in resources
resoun:es resulting from resulting from the operation of a
the operation of a
business.
bus1ness. The replacement propellers.
disposable batteries and other supplies
consumed (used up) whil e f1lmi ng are examples of
expenses. Other expenses common to businesses are
wages. taxes. advertising, rent, Interest and utilities (i.e.
electricity, water and gas).
Expenses are recorded in the periOd they are incurred.
mat ching principle The matching principle states that
The JnOCiple that expenses should be recorded in the
expenses should be
recooled 1n the penod
period resources are used to generate
resoun:es are used to revenues. For example. in summer the
genernte revenues. disposable batteries are used and should
the refore be included in summer's
expenses. The recording of revenues and expenses in the
period they are eamed and incurred should result in accurate
matching and the calculation of a 'true and fair' profit or loss.
Given these definitions. total summer expenses for the
filming business are as follows. While the business has
only one source of revenue, the filming business has three
sources of expenses. The first is supplies. From the given
information, the amount of supplies used during summer
can be calculated as follows:
THE INCOME STATEMENT
Once a company's revenues and expenses are calculated,
they are reported on the i ncome income
statement The
statement . This is the financial statement
that shows a business' revenues and fiMlcial statement that
reports a company's
expenses over a speetfic period of time. reveroes and expenses
0\'er a specdic penod of
Its purpose is to demonstrate the fmanctal
llme
success or failure of the b usiness over
that specific period. When revenues exceed expenses. a
company generates a profrt. When expenses exceed
revenues, a company incurs a loss. The basic structure of
the statement is as follows:
INCOMIITATIIIIIINT
Revenues- Expenses= Net Profit or Net Loss
(or Income, more formally, Total Comprehensive Income)
Given the revenues and expenses determined
previously, Aerial Filming's summer income statement
wou ld appear as shown in Exhib it 1.1 . It contains the
business name, the statement name (that is. ' Income
st atement') and the time period. which for this example is
the summer - the months of December, January and
February. It also shows that the filming business generated
$9650 of profits during summer. This part of the statement

- Amount-on hand at the beginmng of summer s 350 is often called the 'profit and loss' sect1on.
Plus amount purchased dunng summer 750
Aerial Filming
less amount on hand at the end of summer (100) Income statement
Amount used dunng summer $1000 for the three months endi ng 28 February
Revenues $11 200
Therefore. supplies expense 1n th1s period is $1000. Expenses:
The second expense relates to your borrOIIVing.You paid
Supplies $1 000
the bank $50 at the end of summer to compensate them ----~--------------
Interest 50
for loaning you $2000. Pay1ng for the use of someone else's
money is called Interest. Therefore, 1nterest expense is $50. Depreciation .. 650
The third expense relates to your equipment - the Total expenses
drone. Unlike supplies. which are used up and need to be Profit
refilled, equipment includes things like tools and furniture ~ Income statement for Aenal F1lm1ng
that is used on an ongoing basis (although it w ill eventually
deteriorate and be of no economic value to the business).
Because this equipment was used in summer to generate
revenues, the matching principle requires that some portion CSL
ANALYSIS
of the equipment's cost be expensed in summer. This is Look at CSL's income statement
(consolidated statement of comprehensive income) In
called depreciation expense. Chapter 8 will discuss the
Appendix B. The statement contains six revenues
various methods for calculating depreciation expense, but (including 'finance income' and 'gain on acquisition' _in the .
for now we will keep things simple. Assuming that the middle of the statement) and six expenses (including 'cost
equipment will be used for another three seasons and then c osts' and 'income tax expens47'). . -
of sales', 'finance _
thrown away, it is reasonable to expense onErquarter of the 1 ; Ca11 you identify the others?
equipment's cost each season. This equals $650 for the 2 What was the company's 'net profit for the
drone ($2600 cost d1vided by four seasons). Therefore. period'_(after tax) for 2017? · ~
depreciation expense for summer IS $650.

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 ASSETS
An asset is a resource of a business.
asset An economc:
More formally, 11 IS an economic resource resoute !hallS objOClively
that is ob1ecllvely measurable. that results measurable. results from a
poor transaction and will
from a prior transaction, and that will provide futllre econorr.c
provide future economic benefit. Cash is benefit.
a good example of an asset: it can be
counted, it is received through a transaction with someone
else and it can be used to buy things in the future . Other
common assets include inventories, receivables. property,
plant and equipment, and intangible assets (assets that
have no phys1cal form. such as trademarks and copyright).
Money owed to the business is often called a receivable.
it is an asset because you expect to exchange 1t for cash
when you are pa1d.
Assets are recorded and reported according to the
historical cost principle, which is often shortened to the
cost principle. The cost p rinciple states cost principle The
WHY DO WE HAVE that assets should be recorded and princ1ple that assets
FINANCIAL STATEMENTS? reported at the cost paid to acquire them. should be recorded and
repooed at the cost pa•d to
Dun & Bradstreet2 Given these definitions, Aerial Filming acquire them Somet•mes
has several assets at the end of February: referred to as the
'histoncal cost pnoople'.
• $1940 of cash
• $100 of remaining supplies
• $1200 of receiVables from customers.
You also have a used drone. but the value of this asset
is calculated a hnle d1fferently because it Wlll continue to
be used beyond this summer. The drone originally cost
$2600, but (as explained above) the matching principle
allows us to expense $650 of that cost in summer. This is
called depreciation expense. As a result, the drone's
remaining value to the business is $1950 ($2600 - $650).
Again, Chapter 8 will discuss in much more detail the
accounting for equipment and the related depreciation
expense calculations.

LIABILITIES
A liability IS an obligation of a business.
liability An obllgabon
More formally, 11 is a present obligation of of a busoness that results
REPORTING FINANCIAL a business that results from a past from a pasttransact•on
and will requ1re the
POSITION: THE transaction and will require the sacrifice of samfw:e of econom•c
resources at a future date.
BALANCE SHEET economic resources at a futu re date.
Examples of liabilities common to
Another important issue for any business is its current businesses include accounts payable to suppliers. salaries
financial position. What does the business own? What payable to employees and taxes payable to governments.
does it owe? Accounting provides answers to these The only liability of Aerial Filming at the end of summer is
questions with a financ1al statement the $2000 borrowed from the bank which is cons1dered a
balance sheet A called the balance sheet (sometimes creditor. A creditor IS a person or business who you owe
finanaaf statementlhat money to. As WJII be explained below. the business does not
reports a busoness' assets. called the statement of financial position).
habilrt•es and eQUity at a which reports a business' assets. have a liability for the $1000 of your own money that was
speofw: pouttlll bme contributed to the bus1ness.You are the owner, not a creditor.
liabilities and equity at a po1nt m time.

I
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C HAPTER 1 Flnanctal account1ng 5 ---
;..
 EQUITY time. Its purpose is to show a business' resources and the
claims against those resources. Because a balance sheet
equity The dofference Equity is the difference between a
is reported at a moment on trme, it is often referred to as a
between a business' business' assets and liabilities and
assets iM1d habohtJes.
still photograph or snapshot of a business. The basic
reJreSilfl(ong 1he share of
represents the share of assets that are
structure of the statement is as follows:
assets that os claomed by claimed by the business' owner(s). An
the busoness' owne~sl example of equity with which you may
• • ntiiBA1IOHIHIP IIIIWIBI.uaTI.
be familiar is home equity. A homeowner's equity refers to LIA81una AND EQUITY
the difference between the value of the home and the
amount owed to the bank. Equity in accounting is the same Assets = Liabil ities+ Equity
principle except t hat it usually refers to the difference
between the cost of the business' assets and its liabilities. Given the assets, liabilities and equity determined
A business (company) can generate eqUity in two ways. previously, Aerial Filmong's balance sheet would appear as
The forst is through contributed (or ossued) capital. shown in Exhibit 1.2. It contains the business name, the
Contributed capital os defoned as the statement name and the time reference. which for this
contributed capital
The resourti!S that resources that investors put into a example is 28 February.
mestOIS contribute to a business in exchange for an ownership
business on exchange for
interest. The $1000 that you. the owner, Aerial Filming
ownershoponterest
Balance sheet
put into Aerial Filming is contributed at 28 February
capital. Note here that contributed capital is not revenue. Cash $1940
The increase of $1000 did not result from the filming
Accounts receivable 1200
business providing a service or selling a product. It came (money customers owe)
-··- ··- ··-··-"_,_,_,_,.
by contributing an ownership interest. The most common Supplies 100
method that companies use to generate contributed capital
Drone 1950
is the issue (sale) of shares to investors. (Note that this is
different to the daily buying and selling of shares on the Total assets
securities exchange where existing owners sell to new loan from bank
owners.) Totalliabiliues
The second way a business generates equrty os through
Controbuted capo tal $1000
profitable operations. When a business generates profits,
Retained earnongs 2190
it can either distribute them t o owner(sl or retain them to
grow the business. Profit s that are distributed to a
-··- ·- ··- ··-··-··-··-..-·-·-·-"_"_,_,_··-··--··- ··- ··- ··- ··- ··- ··- ··- ··-·-··-···-··- ..
Total equity $3190
_,_,_
- ··- ··- ··- ··- ··-"_,_,_,_ .... . ..... ···-···-···-··-···-···- ··- ···-···- ··- ···- ·.....···-··-··-... ~···
company's owners (shareholders) are called dividends or Total liabilities and equity $5190
drawings for a non-company business
dividends Profits that ~ Balance sheet for Aeroa l Fol mong
are dostributed to OWilflfS (sole t rad er or partnership). Note here
(usually called drawongs of that dividends are not an expense of a
the busoness os not a
cornpanyl company: they are simply a distribution
Notice that total assets equal total liabilities plus total
retained earnings of company assets to owners. Profits
equity (or assets mrnus liabilities equals net assets, whiCh
Ptofits that are kept on the that are retained in the business are
business. is equity). This will always be the case for any business. An
called retained earnings. A oompany's
entity's assets are always claimed by someone. Either they
retarned eamrngs therefore represent the equrty generated
are owed to someone (in the filming business' case, the
from profitable operations that is kept in the company.
bank) or claimed by an owner (you). No asset of any
Since Aerial Filming at the end of summer has less assets
business is ever unclaimed. This relationship between
than the combined liabilities and contributed equity plus
assets, liabilities and equity is represented by the following
profits. there must have been some assets distributed to
equation, known as the account ing equation or balance
you. You obviously needed some 'spending money' over
sheet equation: Assets = Liabilities + Equity. During
summer.
summer you must have withdrawn $7310 ($9500- $7310 =
$2190). because even if you were not a good record keeper
THE BALANCE SHEET we could calculate the amount of retained earnings srmply
The balance sheet is the financial statement that shows a by inserting the retained earnings dollar amount to make
busrness' assets, liabilities and equity at a specrf1c potnt in the accounting equatron balance.

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 Aerial Filming
Statement of changes in retained earnings
L:ook at CSL:s oalance slieet in f rom 1 December to 28 February
Retained earnings, 1 December $ 0
....-···-···-··- ··-···-···-···-··- ··-···-···-···-···-··- ··-···-···-···-··- ··-···-···-···-·-··- ··-···-···-··- ··-···-···-··-···-···-··-
+ Net income (or Net profits) 9 500
....-···-··- ··- ··-···-···-···-··- ··-···-···-···-···-··- ··-···-···-···-··- ··- ··-···-···-·-···-··-···-···-··- ··-···-···-··-···-···-··-
- Drawings (Dividends) 7310
....-···-···-··- ··-···-···-···-··- ··-···-···-···-···-··- ··-···-···-···-··- ··- ··-···-···-·-··- ··-···-···-··- ··-···-···-··-···-···-··-
Retained earnings, 28 February
fWIIiil Statement of changes in retained earn1ngs for Aerial
~ Fil ming

Your business started w ith no reta ined earnings but

~,u ' <r generated profits of $9500 over summer. Since $7310 was
• Review this content with the a-lecture distributed in dividends (or drawings) the business retained
some of that money. Therefore. retained earnings increased
from $0 to $2190.
REPORTING EQUITY: THE
STATEMENT OF CHANGES LINKING THE INCOME STATEMENT AND THE
IN EQUITY BALANCE SHEET
In addition to showing the change in retained earnings, the
Business owners are usually interested in how their equity changes in retained earnings part of the statement of
is growing as a result of profitable operations. They are also changes in equity links the income statement and the
interested in how that equity is d istributed in the form of ba lance sheet. A business cannot calculate its reta ined
dividends. Such information is reported on earnings balance at the end of the period w ithout factoring
statement of
ch anges in equity A the st atement of ch anges in equit y. It in the profit earned during the period. The changes in
financial statement that shows the change in a business' equity; retained earnings provide this link by including net profit or
repo<ts the change in a
business' equity but most importantly, the changes in loss in the calculation of retained earnings, which is then
(contributed equity, retained earnings over a specific period of reported on t he balance sheet. This means that when
reserves and retained
earnings) over a specific time. The basic structure of the statement preparing financial statements for any business, the income
period of time. is as follows: statement must be prepared first, followed by t he
statement of changes in equity and then the balance sheet.
STATEMENT OF CHANGES IN EQUITY A depiction ofthese links is included in Exhibit 1.4.
(THE RETAINED EARNINGS PART)
[ Aerial Filming
Retained Earnings, Beginning Ba lance
Income statement
+1- Net Profit/Loss
- Dividends Revenue $1 1200
= Retained Earnings, Ending Balance

.···=~~.!?.=~~e..s..- . -..·-··-···-·-···-·-···-·-··-·-··-·-···-·-···-·-··-···-···-··-···-···-···-·-·~~~~-
.~.~~.~~=~~-=. ~~.~.P.!.~ -fi.~. .-..
Statement of ch anges in equity
·-···-···-···-···-···-···-···-···-···-···--···-···-···-···-···-··-···-·$ 950.0_
(retained earnings)
Retained earnings, 1 December S 0
····-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-·..-·-··- ···-···-···-···- ··- ···-···-···-···-···- ·-
+ Net income (from above) 9500

~. Drawi.n9.S..·-· ·-· ·-· ·-· ·-· ·-· ·-· ·-· ·-· ·-· ·-· ·-· ·-· ·-· ·-· ·-· ·--··-· ·-· ·-· ·-· ·-· -· ·-· ·-· ·~·~1·~·-
. ~=t~fl_e~:a~n.~n~S.:2~£e_~~u~~---------------1?. ~9.~ .
Balance sheet
Total assets $ 5190
····-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-·..-·-··- ···-···-···-···- ··- ··- ···-···-···-···- ·-
liabilities 2 000
Contributed capital 1000
Aerial Filming's statement of changes in equity (retained
earn ings) would appear as shown in Exhibit 1.3. It contains
the name of the business, the statement name and the
t ime period, wh ich for this example is the summer. Note
there are a number of acceptable ways to express the time
m
Total liabilities and equity
Relationship between the financial statements

or t iming in financial statements.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In whole or In ~}!rA~Df·~~?al accounting .:,_
7
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CS[ ANALYSIS
Look at CSL:s statement of
~ REPORTING CASH FLOWS:
~ THE CASH FLOW
STATEMENT
Another important issue for any business is the
management of cash. Where does a company get its cash?
Where does its cash go? Will there be enough cash to pay
the employees? Accounting provides answers to these
questions w ith a f inancial statement called a cash flow
statement. A cash flow statement reports a business' cash
inflows and outflows from its operating, investing and
financing activities.
FINANCING ACTIVITIES
Most businesses must ra ise funds to begin. Borrowing
money from creditors and receiving contributions from
investors are both ways to finance a business' operations.
Therefore, generating and repaying cash from creditors and
investors are considered financing activities. In the film ing
business, you contributed $1000 of your own money and
borrowed $2000. Both of these inflows are from financing
activit ies. Therefore, the cash inflow in summer from
financing activit ies is $3000. You withdrew $7310- th is is
a cash outflow from financing activities.
INVESTING ACTIVITIES
Once a company has raised sufficient capital from creditors
and investors, it usually acquires the revenueijenerating
assets that it needs for operations. The buying and
__
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8
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selling of such assets are considered investing activities.
In the f ilm ing business, you paid $2600 for the drone.
Therefore, the cash flows f rom investing activities were
negative $2600. In other words, Aerial Filming experienced
a cash outflow of $2600 in summer from investing
activities.
OPERATING ACTIVITIES
After the proper equipment is acquired, a business can
begin operations. Operating a business may include the
purchase of supplies, the payment of employees and the
sa le of produ cts. These t ransactions are considered
operating activities. For Aeria l Filming, cash flows from
operations over summer included $10000 received from
customers for filming, $1100 paid for supplies and $50 paid
to the bank in interest. As a result, the net cash inflow from
operating activit ies for the mon th was $8850 ($10000
minus $1100 minus $50). Note: this is not the same as
profits, because revenue included the $1200 you are owed;
expenses included depreciation but not the cost of unused
supplies.
THE CASH FLOW STATEMENT
The details of cash inflows and outflows for a business
are reported on a cash flow statement. cash flow
The cash flow statement is a f inancial statement Afinancial
statement that reports a
statement that shows a business' business' sources and
sources and uses of cash over a specific uses of cash over a
specific pe<iod of time.
period of time. Its purpose is to inform
users about how and why a business'
cash changed during the period. The basic structure of the
statement is as follows:
Cash Flows Provided (Used) by Operating Activities
+1- Cash Flows Provided (Used) by Investing Activities
+1- Cash Flows Provided (Used) by Financing Activities
= Net Increase (Decrease) in Cash
+Cash at the beginn ing
= Cash at the end
Given the cash inflows and outflows described
previously, Aerial Filming's summer cash f low statement
wou ld appear as shown in Exhibit 1.5. It con tains the
business name, the statement name and the time period
covered, which for this example is the three months to the
end of February. It also shows a net change in cash from
1 December to 28 February of $1940. Again, note the three
months is expressed differently but clea rly and
commun icates the time period covered.
 Aerial Filming
Cash flow statement THE OBJECTIVES OF
for the months of December, January and February
FINANCIAL REPORTING
01)11fa~ng ac~v,Ms
- - - -- - - The ob.recuve of general purpose financial reporting IS to
Cash rece1ved from customers $10000
prOVIde flnanciCIIJnformatJon about the reporting ent1ty
Cash pa1d for supplies (1100)
·- --·- --·-·- ·- ·- ·- ·- ·-·-· - -·--·- --·--··- ·--·-·-·-·-·· that1s useful to eXJs!lng and potential investors, lenders
Cash pa1d for interest ____j§Ql and other cred1tors in making decisions about provld1ng
resouroes to the enllty.Those decisions involve buy1ng,
Net cash provided by operating activities $8850 selling or hold~ng equity and debt instruments, and
Investing activities provid1ng or settling loans and other forms of credit. 3

Cash paid for drone $ (2600) Even though accounting is a very quantitative process and
Net cash used by investing activities (2600) the financial statements introduced so far are full of
numbers, accounting information must possess certain
Financ1ng ac~v1ties
- - - - -- - - qualitative characteristics to be considered useful.
Cash rece•ved from borrowing 2000 Information 1n the financial reports is often based on
Cash rece1ved from owner 1000 estimates. Judgements. and at t imes the choice of one
Oraw~ngs (d1vidend) (7310) accounting method rather than an alternative. Jt is also
important to note that financial reports cannot prov1de all
Net cash used by financing activities (4310)
the information that different users may want.
Net increase in cash $1940 If f inancial information is to be useful, it must be
Cash balance. 1 December 0 relevant and faithfully represent what it is reporting on .
........-... ..-..-..-··-··-···
~

Cash balance. 28 February $1940 Financial information is more useful if it is comparable,

verifiable, timely and understandable.
~ Cash flow statement for Aerial Fllm1ng

RELEVANCE AND MATERIALITY

Note that the ending cash balance on the statement Relevant f1nancial in formation can
relevance The capacrty
agrees wtth the cash balance shown on the balance sheet influence the dec1s1ons made by users of aa:ouliJng ~nformation
1n Exhib it 1.2. Since $2600 of the $3000 of cash generated because it has predictive value (allovvs the to make a dlff~'"
from f1nancing activities was invested into the drone, the decJSIOOS
user to better determine what the future
majority of the $1940 of cash on hand was generated may be), confrrmatory value (provides feedback on past
through operations. This. of course, is a good sign and predictions) or both.
indicates you are likely to be able to repay the bank and to Information that can help confirm may also help predict.
keep or spend some cash on yourself. For example, information about the revenue Aerial Filming
You might also consider the situation if all customers earned over summer can be compared with the revenue
waited three months to pay you. Your profit in summer predicted at the commencement of the business to determine
would have been the same, but your cash flow very how accurate those predictions were, and in tum may be
d1fferent. There would have been no spare cash to draw out used to help predict revenue in autumn with greater accuracy.
and you would have needed to borrow more money just to InformatiOn IS considered material if materiality The
buy most of the supplies and interest. it has the capac1ty to affect decisions tlveshold at whdl a
when om1tted or misstated. For a student financJal1tem beg.ns to
affect deciSion-making.
the difference between an exam mark of
49 and 50 is material since a 49 means the student fails
but one additional mark means he or she passes; however,
a larger difference. say bet ween 90 and 95, may not
influence decisions. An example of materiality in practice
is how CSL report results to the closest tenth of a million
of dollars (see Appendix B). The numbers being reported
are so large that giving more exact amounts is unlikely to
make a difference to decision-making.
Measurement uncertainty will also impact relevance. If
~\'JT~ estimates are d1ff1cult to make or the range is large the
Download the Enrichment Modules
• for further practice

I
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9
~--
 information will be less useful; for example, forecasts of
tomorrow's temperature are usually given 1n whole degrees
since they are estimates, while reportmg of yesterday's
temperature can be given to two decimal places s1nce the
exact temperature is known.

FAITHFUL REPRESENTATION
Financial statements summarise economic events in
words and numbers.To be useful it must faithfully represent
the business activities by providing information about the
substance of the activity not just its legal form. Information
faithful faithfully represents the financial
representation position and performance if it is complete,
Financiallnlormal!On that neutral and free from error (wh1ch does
is JXI!SEnled 11 a ~ that
is ~te. neutral and not mean accurate 1n all respects as
free from error. VERIFIABILITY
estimates and judgements need to be
made). In an attempt to provide complete information, Verifiability allows users to accept that
verifiability When
companies provide additional notes (for example. see CSL:s t he financial statements faithfully information allows
'Notes to the financial statements' in Appendix B). represent the business activity they claim d1fferent1ndependent
observers to arrive at the
Neutrality is supported by the exercise of prtJdence. w hich to rep resent. Verifiability means that same or similar
is caution when making judgements under conditions of different knowledgeable and independent outcomes.
uncertainty. The exercise of prudence means that assets and observers would have prepared financial
income are not overstated and liabilities and expenses are not statements that are not materially d ifferent. Verif1able
understated. The term 'conservatism' is no longer used. information does not need to only have one possible
Information must be both relevant and faithfully outcome to be verifiable. For Aerial Filming the drone may
represented if 1t is to be useful. Comparab1hty, verifiability, only last eleven months. A range of possible amounts and
timeliness and understandability are qualitative the related probabiht•es can also be verified.
characteristics that enhance the usefulness of Information
that is relevant and faithfully represented. TIMELINESS
In addition to having feedback or predictive value.
COMPARABILITY accounting information must be t imely to t imeliness When
Comparability refers to the ability to use be useful. Information that helps you infO<mation 1s provided
comparability The
ability to use acoounting accounting information to be weighed forecast March revenues is relevant when quickly enough that the
user can take actoon.
information to be weighed it is received in February, not when it is
against or contrasted to the financial
against 0< contrasted to
the financ1al actov1ues of activities of different businesses. Being able received in April. Generally, the older the information the
different businesses to compare information across businesses less useful.
allows an entity to assess its market
poSitiOn wrthin an industry, to gauge its success against a UNDERSTANDABILITY
competitor and to set future goals based on U1dustry standards. Accounting information should first and foremost be
Comparability does not imply uniformity. Accounting understandable. Understandability understandability
rules allow for some discretion in the manner in which refers to the ability of accounting The ab1hty of accotJlllng
accounting is applied to economic phenomena. As a result, infO<mauon to be
information to be comprehensible to those comprehensible to those
two businesses with the same economic phenomena could who have a 'reasonable understanding of who have a 'reasonable
have different account ing information because they use business and economic activities an d understanding of business
different acceptable accounting methods (such as different and economic activities
accounting and a willingness to study the and accounting and a
ways to calculate the depreciation) or make d ifferent information w ith reasonable diligence·• willingness to study the
estimates (such as how long the drone Will last). Because infO<mauon v.1th
Notice that this definition puts much of the reasonable dologence'
such d1fferences in accounting methods are a challenge to responsibility on the user of accounting
comparability, accounting rules require that entities disclose information. Users must be willing to spend a reasonable
the accounting methods that they use so that Information amount of t ime studying the information. No speclf1cs are
can be more easily compared across entrties. Usually, such given on what is a 'reasonable amount of time', but 1t IS
methods are disclosed in the notes to the fmancial obvious that the more time you spend studying accounting

__
statements. which are discussed in Chapter 2. information, the more you will understand.

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10
 The following tables summarise the elements of this
THE LANGUAGE OF conceptual framework and also serve to review t his chapter.
ACCOUNTING They will provide a good reference for you as you proceed
through the remaining chapters. As you tackle more
This chapter introduced many of the terms, principles, complex accounting methods and procedures, keep in
assumptions, objectives and qualitative characteristics that are mind that they are simply extensions of the basic grammar
necessary to communicate the financial activities and position presented in the tables. So, with a good understanding of
of a business. While they were initially the conceptua l fram ework, you have the grammar
Conceptual
Framework for
described as the grammar of accounting, necessary to ~,\, ' <r
Financial Reporting they are more forma lly known as begin your study Test your understanding with the •
The objectives, online revision quizzes for this chapter
components of the Conceptual of accounting.
characteristics and
concepts that guide the Framework for Financial Reporting ,
manner in which the collection of concepts that guide the
accounting is practised.
manner in which accounting is practised.

Temn Definition Reported on the

Asset A resource of a business Balance sheet
Liability An obligation of a business Balance sheet
···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···~- ..·-···-···-···-···-···-···-···-···-···-···-···- ··- ··- ··- ··- ···-···-···-···-···-···-···-···-···-···-···-···-···-··-··-···-···- ··- ··- ···-···-···-···-···-···-···- ··- ···-···-···-···-···-···-···-···- ··- ··- ···-···--
The difference between assets and liabilities Balance sheet
Contributed equity {capital) Equity resulting from contributions from owners Balance sheet
(often from issuing shares)
Retained earnings Equity resulting from profitable operations Balance sheet and statement of changes in equity
.,,_ ,,_ ,,_ ,,_ ,,_ ,,_ ,,_ , _ ,,_ ,,_ ,,_ , _ ,,_ , _ ,,_ ,,_ ,,_ ,,_ , .. .......,_ , _ ,,_ ,,_ ,,_ ,,_ ,,_ ,,_ ,,_ ,,_ ,,_ ,,_ ,,_ ,,_ ,,_ , _ , _ , _ , _ ,,_ , _ ,,_ ,,_ ,,_ ,,_ ,,_ ,,_ ,,_ ,,_ , ...._(change
..,_ ,,_ ,,_ , _in,,_retained earnings)
, _ ,,_ ,,_ ,,_ ,,_ ..,_ ,,_ , _ , _ ,,_ ,,_ ,,_ ,,_ ,,_ ,,_ ,,_ , _ ,,_ ,,__

Revenue An increase in assets resulting from sell ing a good Income statement
or providing a service

Expense A decrease in assets resulting from selling a good Income statement

or a service
Dividend (Drawings) A distribution of profits to owners Statement of changes in equity
Terms used to 1dent1fy and describe f1nanc1al information

Principle Definition Ramification

Revenue recognition Revenues are recorded when they are earned The receipt of cash is not required to record a revenue. If you
sell to a customer who will definitely pay you next week.
the revenue is earned when the sale is made, not when you
receive the cash
Matching Expenses are recorded in the time period when For many assets, the cost of the asset must be spread over
...
_ , _ , ,_ , ,_ .._ , _ , ,_ , ,_ , _ , ,_ , ,_ , _ , _ , ,_ ..____...they
_..,_..,_are
..,_..,_incurred
..,_..,_..,_..,_...to_ ,generate revenues
,_ , ,_ , _ , _ , _ , _ , ,_,, _ ..,_..,_..,_..,_..,_..,_..,_..,_..,_..,_.. _
the
..._ periods
..,_..,_ when
..,_..,_..,_..,_ it..,_
..,_..,_..,_ is..,_
used
..,_..,_..-we
,_..,_..,_..call
,_..,_..this
,_..,_..depreciation
,_..,_..,_..,_..,_..,_..,_..,_..,_..,_.. ,
Cost Assets are recorded at their historical costs Except in a few cases, market values are not used for reporting
asset values
Principles used to measure f1nancial information

Assumption Definition Ramification

Economic entity The financial activities of a business can be accounted We do not have to worry that the financial information of the
from the business' owners owner is mixed with the financial information of the business
Monetary unit The dollar, unadjusted for inflation, is the best means All transactions need to have a specific dollar value to be
of communicating accounting information recorded
Accounting period Accounting information needs to be communicated Most businesses prepare half-yearly and annual financial
effectively over short periods of time statements
Going concern The company for which we are accounting will continue If an entity is not selling its assets. then assets {like the drone)
its operations indefinitely are recorded at the value to the business (cost less depreciation)
Assumptions made when communicating financial Information

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In whole or In ~}!rA~Df·~~?al accounting __
.;.;...
11
 Term Definition Ramification
Relevance Accounting information should have the capacity to Information should have predictive or feedback
affect decisions value and should be timely
Materiality The threshold over which an item could begin to affect When an amount is small enough, normal
decisions accounting procedures are not always followed.
Note CSL reports to the nearest $0.1 million
Faithful representation Faithfully represent the phenomena that it purports to Financial reports represent economic phenomena
represent in words and numbers
Prudence (Conservatism) When uncertainty exists. accounting information should An entity should choose accounting techniques
present the least optimistic alternative that guard against overstating revenues or assets
-···-···-··- ··-···-··- ··- ··- ··-···-···-··- ··-···-···-··- ··-·-···-··- ···-··- ··-···- ··-···-···-··- ···-··- ··-···-···-···-···-··- ···-··- ··- ··-···-···-···-···-··- ··- ··- ··-···-···-·-···- ··- ··- ··- ··- ···-···-···-···-···-···- ··- ··- ···-···-···-..·-···-···- ··- ··- ..·-···-···-···-
Comparability Accounting information should be comparable across different Entities must disclose the accounting methods
businesses. This is aided by consistency wflere use of the that they use so that comparisons across
same accounting method aids comparabi lity companies can be made
-···-··- ··-···-···-··- ··-···-···-···-··- ··-···-···-··- ··-···-·-···-··- ··- ··-···-···-..·-...-···-··- ··- ··-···-···-···-···-···-··- ··- ··-···-···-···-···-···-··- ··- ··- ··-···-···-···-··-···-···-···- ··- ··- ···-···-···-···-···-···-···- ··- ···-···-···-···-···-···-···-···- ··- ··- ···-···-
Verifiability Verifiabi lity helps assure users that information is Different knowledgeable and independent
faithfully represented observers could reach consensus
-···-··- ··- ··-···-··- ··- ··- ··-···-··- ··- ··-···-···-··- ..-·-···-···- ··-···- ··-···- ··- ··- ··- ··- ··- ··- ···-···-···-···-···-···-···-···-···-···-···-···- ··- ··- ··- ··- ··- ··- ··- ·-···-···-···-···-···-··- ···-··- ··- ··- ··- ··- ··-···- ··-···-···-···-···-···-···-··- ··- ··- ..- ·..
Timel iness Information available to decision·makers before they The older the information generally the less
make decisions useful it is
Understandability Accounting information should be comprehensible by Users must spend a reasonable amount of time
those willing to spend a reasonable amount of time studying accounting information for it to be
studying it understood
Qualitative charactenstics that make fmanc1al reports useful

Statement Purpose Structure Links to other statements

Income statement Shows a company's revenues and Revenue- E;qlenses = Net Profit/ Net profit goes to the statement of changes in
expenses over a specific period of time Loss equity to calculate retained earnings
-···-···-··- ··- ··-···-···-··- ··- ··-···-···-···- ··- ··- ··- ··- ··- ··- ··- ··- ··- ··- ··- ..- ··- ··- ··- ··- ··-···- ·······- ··- ··- ··- ··- ···-···-···-···-···-···-···-···-···-···-···-···-···-·-··- ···-···-···-···-···- ··- ···-···-···-···- ··- ··- ···-···-···-···- ··- ···-···-···-···-···- -
Balance sheet Shows a company's assets. liabilities Assets= Liabilities+ Equity The balance in retained earnings comes from
and equity at a specific point in time the statement of changes in equity
The balance in cash should agree with the
cash balance on the cash flow statement
Statement of changes Shows the changes in a company's Beginning Retained Earnings+ Ending retained earnings goes to the balance
in equity (retained retained earnings over a specific Profits (or- Losses)- Dividends = sheet
earnings section) period of time Ending Retained Earnings
-···-···-···-··- ··-···-···-··- ··- ··-···-···- ···- ··- ··- ··- ··- ··- ··- ··- ··- ··- ··- ··- ..- ··- ··- ··- ··- ··- ··- ·······- ··- ··- ··- ··- ···-···-···-···-···-···-···-···-···-···-···-···-···- -··- ···-···-···-···- ··- ··- ···-···-···-···- ··- ···-···-···-···-···- ··- ···-···-···-···-···- -
Cash flow statement Shows a company's inflows and Operating Cash Flows +/ -Investing The ending cash balance on the cash flow
outflows of cash over a specific Cash Flows +/- Financing Cash statement should agree with the balance in
period of time Flows= Net Change in Cash cash on the balance sheet
Financial statements used to communicate econom ic information

:-. to Co..Jr5el\ a•e ACCT3 financ al

•
Interactive quizzes
Enrichment modules
Animations
E·lectures
Glossary
Flashcards and more
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12
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1 Calculate profit or loss
Sarah's Science Service generated $14000 in revenue in the
month of January. Salaries were $3500 for the month and
supplies used were $2000. Additionally, Sarah incurred $500
for advertrs1ng during the month.
REQUIRED
Calculate Sarah's profit or loss for the month of January.
2 Calculate equity
A company reports assets of $100000 and lrabrl1t1es of
$60000.
REQU IRED
Calculate the company's equity.
3 Identify accounting principles
Each of the following statements IS an appltcauon of the
revenue recognition principle, the match1ng prrnc1ple or the
cost prrnc1ple.
A company records Equ1pment for the purchase pnce
of $10000 although the suggested retail pnce was
$13000.
ii A company receives $2000 for a serv1ce to be
performed but records only $1000 as Service
Revenue because it earned only half in the current
period.
Iii A company pays $6000 for rnsurance but uses only
$4000 during the period. Therefore, it records only
$4000 as Insurance Expense.
6 Identify accounting assumptions and ~
qualitative characteristics
Consider the folloWing Independent scenanos:
Peter's P1zza has been 1n business for 25 years. All of
1ts operatrons are profitable, and the accountants
behave that the company will continue to operate
1nto the foreseeable future.
ii A bank used the information presented in Fiona's
financial statements to determine if it should extend
a $300000 loan to Fiona . The information in the
financial statements made a difference rn the bank's
lend1ng decis1on.
iii The manager of Martha's Antiques does not lrke to
change accounting procedures because 11 h1nders her
ability to make year-to-year compansons.
iv Sarah, owner of Abbotsford An1mal Acoommodatron,
rnforms her accountant that she does not want to
rev1ew any account1ng 1ssue that 1S smaller than
1 per cent of prolrts.
v Matthew paid $10000 lor inventory which could now
sell for only $6000, he recognises th1s decrease
while not recognising the increase in land from
$200000 to $300000.
vi Sue has two businesses, she keeps separate records
for both businesses and does not combine them
w1th her personal financ1al matters.
REQU IRED
Identify the acoountrng assumption or qualrtat1ve
characteristiC that relates to each scenano.
7 Accounting terms
Consider the following Information:
Item Appears on Classified as
Salaries expense
Equipment

REQU IRED Cash

Identify which principle relates to each statement. Accounts payable
Accounts receivable
4 Calculate retained earnings
Buildings
At the beg1nn1ng of the year, a company has reta1ned
earn1ngs of $175000. During the year, the company earns Contributed cap1tal
$110000 of profrts and distributes $30000 1n d1v1dends. Retained eam1ngs
REQU IRED Interest revenue --------------------
Calculate the company's retained earn1ngs at year end.
Advertising expense

5 Calculate cash flows Sales

A company starts the year with $15000 in cash. During the Unearned revenue
year, the company generates $80000 from operations, uses
$56000 in mvesting activities and uses $38000 in financmg REQUIRED
act1v1ties. Classify each of the items above accordrng to:
REQU RED a whether 1t appears on the 1ncome statement (Y/S) or
balance sheet (8/S)
Calculate the company's cash at year end us1ng a bas1c cash
flow format. b whether 11 IS class1fred as a revenue, expense, asset,
lrabrl1ty or equ1ty.

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13
 REQUIRED
8 Classify cash flows
Fill in the blanks with the financial statement(s) (1.e. income
A company entered mto the following cash transactions: statement, balance sheet, statement of retained earn1ngs
Cash pa1d to suppliers and/or cash flow statement) the user would most likely use
ii Cash rece•ved from ISSuing new shares to find this Information.
iii Cash pa1d to purchase a new off1ce bu1ldmg
i v Cash pa1d 10 drv~dends to owners 11 Profit or loss and retained earnings
v Cash rece•ved from customers Hazelwood reports the followmg as of 30 June:
vi Repaymg a bank loan
vii Cash rece•ved from the sale of land Revenues $99000
viii Company mcome tax paid. Begiooing retained earn•ngs 22000
REQUI RED Expenses 88000
lnd1cate the sect•on of the cash flow statement 1n wh1ch Dividends 1000
each item would appear: operating actiVIties (0), 1nvest1ng
act1v1ties (I) or f1nancmg act1V1t1es (F). REQU IRE D
Calculate profit or loss and end1ng reta•ned earnings for the
9 Accounting terms l J financial year ending 30 June.
Consider the follow1ng information:
Revenues during the period 12 Balance sheet equation
ii Supplies on hand at the end of the year Consider the followmg independent situatiOns:
iii Cash received from borrowings during the year Kelly contnbutes $80000 to the business and the
iv Total liabilities at the end of the period business has total assets of $200000. How much
are liabilities?
v Dividends paid during the year
i i Tran starts the year with $50000 in assets and
vi Cash paid for a building
$40000 in liabilities. Prof1t for the year is $12 500 and
vii Cost of build1ngs owned at year end
no dividends are pa1d. How much is Tran's eqUtty at
viii Profrts for the period (on two statements) the end of the year?
ix Closmg balance of retained earn1ngs (on two iii Evan doubles the amount of her assets from the
statements). beginmng to the end of the year. At the end of the
REQU IRED year, liabilities are $50000 and eQUity IS $30000.
lnd1cate whether you would f1nd each of the above items on What 1S the amount of Evan's assets at the begmnmg
the 1ncome statement (Y/S). the balance sheet (8/S). the of the year?
statement of reta1ned earn1ngs (SRE) or the cash flow iv Dunng the year the liabli•t•es of Hudson Company
statement !CF$). tnple. At the beg1nn1ng of the year. assets were
$40000 and eQUity was $20000. What IS the amount
of hab1ht1es at the end of the year7
10 Financial statements
Listed below are questions posed by vanous users of a
REQUIRED
company's f1nanc1al statements: Use the accountmg equation to answer each of the
independent quest1ons above.
User Questions Financial
statement
13 Statement of retained earnings
Shareholder How d1d th•s year's sales
figures compare with last Chan Company's reta1ned earnings on 1 July 1s $245800.
year's sales figures? The following information is available for the f~rst two
months of the financ1al year:
Banker How much 1n borrow.ngs
does the company currently July August
owe?
Revenues $80000 $102000
Supplier How much does the company
owe us suppliers in total? Expenses 85000 80000
Shareholder Did lhe company pay any Dividends 0 7000
dividends during the year?
REQUIRED
Advertising How much advenis1ng did
Agent the company .ncur in order to Prepare the retained earnmgs section of the Statement of
generate sales? Changes in Equity for the month ending 30 August.

Banker What was the company's

total 1nterest cost last year?

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;....;.
14
ACCD Fon~lll2019 Cengajle L.umlng. AU Rlghta R--...d.!Uy not be copied. scanned, 0< ~iealed, ln wholo Ot ln pat!. WCN 02·201>-202
 The way in which accountants deal w1th uncertainty.
14 links between financial statements
g The ab11ity to determ1ne similarities and dofferences.
Below are mcomplete financ.al statements for Jasm1ne:

Balance sheet 16 Assumptions and principles

Assets The Harbour Group had the following situatJons during the
year:
Cash $ 8000
Inventory With a cost of $186400 is reported at its
Inventory 22000 market value of $235 600.
Total assets $70000 ii Harbour added four additional weeks torts f1scal year so
that it could make its income look stronger. Past
liabilities
financial years were 52 or 53 weeks (in a leap year). this
Accounts payable financoal 'year' IS 56 weeks and it is not even a leap year.
~------
Equity iii Harbour's CEO purchased a yacht for personal use
and charged ot to the company.
Contnbuted capital
iv Revenues of $25 000 earned in the pnor year were
Reta1ned earnmgs recorded 1n the current year.
Total habilit1es & equity v Harbour will be pa1d 1n the next financoal year for
Income statement work earned out 1n th1s financial year; the dec1s1on
was made to 1nclude the revenue on the next fonancoal
Service revenue $90000
- - - - -- -
Salaries expense (c)
__
year.
vi In an anempt to show exactly how much profots are
- - - -- -
Electricity expense earned Harbour reports $9876 543.21 of profits for
20000
Profit ------------------- LJill
the financial year.
REQUIRED
In each Situation, 1dentofy the assumption or principle that
Statement of retained earnings
has been v1olated and discuss how Harbour should have
Retamed earnings, beginning balance $20000 handled the sotuation.
Profit _____kl
----------
Dividends 10000
Retained earmngs, ending balance

REQUIRED
Calculate the m1ssing amounts (not necessarily 1n alphabetic
order).

15 Qualitative characteristics
The following qualitative characteristics of accounting were
d1scussed in the chapter: 17 Prepare financial statements
consistency The followong items are available from the financial records
ii relevance of Innovators Incorporated at the financial year end1ng
iii understandability 30 June. 2018:
iv comparab1hty
Accounts payable $27000
v prudence (conservatism)
vi mater.al1ty Accounts receovable 21000
v ii fa1thful representation. Advertising expense 6000
REQU IRED Buildings 76000
Match the descriptions with the appropriate characteristic. Contributed capital 30000
a The ability of accounting information to be Cash 6320
comprehensible to those who have a reasonable Notespayable 70000
knowledge of business and are w1lling to study the
1nformat10n w1th reasonable diligence. Salaries expense 9500
b The capac1ty to affect business dec1sions. Service revenue 16820
c The dependability of accounting informatiOn. Equipment 25000
d The ab11ity to compare and contrast the fmanC1al
actiVIties of the same company over a periOd of ume.
e The threshold over which an 1tem beg1ns to affect
dec1sion-mak1ng.

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15
 REQU IRED
20 Errors in accounting
Prepare Innovators Incorporated's mcome statement and
statement of reta1ned earnings for the year and 1ts balance The Nguyen Company was mcorporated on 1 July. At 30
sheet at the end of the year. June the followtng year Ms Ly Nguyen. the CEO and sole
owner, prepared the company's balance sheet as follows:
18 Identify and correct income statement
Nguyen Company Balance Sheet
errors 30 June
Sivabalan Group was started on 1 July. At the end of the
Assets
financial year the company used an accounting mtern to
prepare the following financial statement: Cash $25000
Accounts receivable 40 000
Sivabalan Group income sheet
at 30 June Inventory 35000
Income from services $170000 Building 20000
Accounts receivable 40ml Uabilities and Equity

Total revenue $210ml Accounts payable S40 ml

less· Expenses Building loan 15ml
Salanes $ 57000 Retained earnings 37000
Adven1sing 114000) Ly is not an accountant by trade and she believes there may
Dividends
--- 10000 be some mistakes. She has prov1ded you with the following
additional information:
Electricity 22000
The building is Ly's personal beach house. However,
Total expenses $ 75 000 she plans on using it for company retreats and for
Total 1ncome $135000 hosting some large clients. She decided to list the
asset and the corresponding liability for th1s reason.
REQU IRED ii The 10ventory was ong1nally purchased at $12 000.
List all of the def1c1enc1es that you can 1dent1fy 1n th1s but due to a recent 1ncrease m demand she behaves
income statement and prepare an 10come statement w 1th she could sell I! for at least $35000. She thought that
correct 1nformauon and proper format. $35000 would best portray the economiC reahty of
her Inventory.
19 Identify and correct balance sheet errors i ii Ly 1ncluded $5000 1n accounts receivable and
reta1ned earnings for a serv1ce that she WJII prov1de
Hildebrand House Haunting (HHH) commenced bus10ess on next year. Since she is honest and will provide the
1 July. It was a good year as Hildebrand believes she has serv1ce. she decided to record the amount 10 this
over $ 100000 of assets. At the end of the financial year the year's balance sheet.
following financial statement was quickly prepared by a
student intern: REQUIRED
Comment on what accounting assumptions or principles
HHH Balance Statement for the have been v1olated; briefly describe how each item should
year ending 30 June be accounted for and prepare a correct balance sheet.
Resources.
Cash $30 21 Preparing financial statements
On 1 July you beg1n a whale watch1ng business for the w1nter
Thmgs we sell 40
whale m1grat1on season by contnbu!lng $60000 of cap1tal
Land 53 and borrOWing $80000 from your parents. With the money
Retamed earmngs 17 you pay $48000 10 July to rent a boat with all the equ1pment
needed. You also purchase advertismg on the hotel TV channel
Grand total
for $25000 and during the month fuel for $155000. You also
Debts: pay your parents $800 for monthly interest.
Money we owe S 43 You decide to charge $90 per passenger. At the end of
-------------------- -------
Contllbuted capital 63
the month of July, you have taken 2400 guests aboard the
boat. Included 1n those 2400 guests were tour groups from
Grand total SlOG China who always pay seven days after whale watching. The
tour group at the end of July owes you $1080.
REQU IRED REQUIRED
List all of the dehaenC1es that you can ident1fy 10 th1s Prepare an mcome statement and a statement of reta1ned
f1nanc1al statement and prepare a proper balance sheet.
earn1ngs for the month end1ng 31 July and a balance sheet
at 31 July. How m1ght the f1nancial statements 1nfluence
your plans next year?

__
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16
ACCTJ Fin~Jilflght 2019 Cengag<o l earnlng. All Rights R...rvod. May not be coplod. scanned, or dupllcatoa, In whole or In part. WCN 02·200-202

22 Read, locate and compare financial
statements
Access the latest fonancoal statements for CSl (Google 'CSl
Annual Report').
REQUIRED
a For CSlllmtted's (ASX: CSl) last ftnanctal year. tdenttfy
the amounts reported for revenues. total comprehensive
income. total assets and cash flows from operattng
acttvittes. Also. tdentify the date on whtch the ftnancial
statemen ts are prepared.
b locate Cochlear limited's (ASX: COH) financial
statemen ts for the same year. ldenttfy the same
informatiOn as in the previous requirement.
c Compare both companies. Identify which company is:
(i) the largest. (note how you define largest) (iil the most
profitable (be careful how you define most profitable)
and (iii) the best able to generate cash from its
operattons.
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23 Ethics in accounting
As the chief accountant at an educatton college which is ltsted
on the Australian Securittes Exchange you doscover that proftts
in each of the prevtOus ftve years have been understated due
to an error in accountmg. After much thought. you decode to
approach the CEO. Her response 1s: 'What the publte doesn't
knov.t won't hun them. We'IIIUSt adJUSt thts year's proftts to
make up for the m1stakes. We are havmg a bad year and th1s
comes as a great relief, tt will cenanly get us out of a hole'.
REQUIRED
Identify the ethocal dllemma of thts sttuatton; outhne the
ways that you could respond and explatn the posstble
consequences of your responses.
24 Written communication skills
Your wonderful brother has just won lotto. He is trying to fond
companies in whtch to invest his winnongs; hCivV8ver, he os h<Mng
trouble readong the fonancial statements because he has no idea
what they are say1ng. KnOWing you are in an acoounung class.
your brother 1S willing to pay you $10 a word to wnte to him
about financial statements (maXtmum 400 words).
REQUIRED
Prepare a written response to your brother explaining what
information is contaoned in each financial statement and how
it is relevant to Investors.
 Chapter 1 introduced the terms, assumptions, principles
and statements that accounting uses to capture and
commun1cate a company's economic activities. This
chapter takes a more detailed look at the accounting
information provided by businesses, particularly public
corporations (companies) such as CSL Specifically, this
chapter introduces the (classified) balance sheet, the
(multi-step) income statement and the statement of
changes in equity. Each of these three financial statements
represents a more detailed version of the statements
covered in Chapter 1. This chapter also introduces two
analysis techniques. horizontal and vertical analyses,
which are simple but powerful tools for generating a more
in-depth understanding of a company's financial position
and performance. By the end of this chapter, you should
be comfortable reading through, using and being able to
explain the financial statements of most companies.

After studying the material in this chapter, you

should be able to:
Explore the three major forms of business.
Define Generally Accepted Accounting
Principles (GAAP) and their origins.
Describe the main classifications of assets,
liabilities and equity in a balance sheet.
Discuss the main subtotals of income on an
income statement.
Analyse the balance sheet and the income
statement using horizontal and vertical
analyses.
Describe the structure of a statement of
changes in equity.
Look at the types of information usually
disclosed along with financial statements.

a BUSINESS FORMS
One of the first decisions that any new business faces is
the form that it will take. Businesses have the following
three basic options:
e sole proprietorship
e partnership
e company.
apply this-·· · · ·-· A sole proprietorship is a business sole proprietorship
owned by one person and is the most (sole trader)
A bus111ess owned by
common type of bus1ness in Australia. In one person.
a sole proprietorship (sometimes known
as a sol e t rader), the owner maintains complete control
of the business, bears all the risk of failure and reaps all
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11
 the rewa rds of success. For accounting purposes, a There are two main types of companies in Australia,
sole proprietorship is accounted for separately from the proprietary (private) and public compan ies. The most
proprietor's (owner's) personal affairs (and possibly separate common type of company in Australia is t he proprietary
f rom other businesses they may own). This is an application company (often indica ted by the ' Pty' at the end of
of the economic entity assumption. For tax purposes, the company name). A public company public company
though, a sole proprietor's business is not separated f rom is one in wh ich ownersh ip is ava ilable to A separate legal entity
in which ownership is
the proprietor. The income from the business is reported the general public. The shares of a public available to the
on the owner's personal tax return, along w ith other income company may be bought and sold on an general public.
like wages. open market such as the Austra lian
partnership
A partnership is a business that is Securities Exchange (ASX). To have a company's shares
A business that is flxmed formed when two or more proprietors traded on the ASX, a company needs to be 'listed' on the
when two or more
join together to own a business. Exchange, a much more expensive process than just
proprietors join together
to own a business. Partnerships can be established by either registering a company. Such companies are sa id to be
a written or verbal agreement and can 'publicly listed'. Examples of publicly listed compan ies are
include many partners. Partnerships are formed for various BHP, Commonwealth Bank, Te lstra, Woolworths and, of
reasons, such as joining proprietors w ith different skills, course, CSL. From th is point forward, we will focus on the
combining resources and spreading the f inancial risk of the accounting for publicly listed companies. This will allow us
business among several people. Like sole proprietorships, to see accounting issues in companies with which you may
a partnership is cons idered a separate accounting be familiar and that usually have the ir financial reports
entity, separate from the individual partners (owners). publicly available on their website.
However, like sole proprietorships, a partner's sha re of
partnership income is reported on the partner's individual
tax return. Partnerships are covered in detail in Chapter 10.
A company or corporation is a
company (or
corporation) separate legal entity that is established
Aseparate legal entity that by reg istering the company with the
is established by registering
with ASIC. Austra l ian Securities and
Australian Securities Invest ments Commi ssion (ASIC).
and Investments Once a company is formed, it sells shares
Commission
(ASIC) The agency to individuals who want to own part of
charged with protecting the company. This is one of the main
investors and maintaining
the integrity of securities reasons that compan ies are formed- the
markets. ability to raise equity (capital) through the
sale of ownership interests (issue of ~,..., ,,(#

shares). It is also why company owners are ca lled

Review this content with thee-lecture •
shareholders (or stockholders). Like a sole proprietorship
and a partnership, a company is accounted for separately
from its owners; however, it is also taxed separately. GENERALLY ACCEPTED
Income generated by a company is taxed on a company ACCOUNTING PRINCIPLES
tax return, not on the shareholders' individual tax returns. (GAAP)
One of the advantages of a company in Australia is that
dividends are not 'double taxed' as in many other countries.
When accounting for their economic Generally Accepted
Companies are covered in more detail in Chapter 11. Accounting
activities, public companies must follow
Principles

CS[ ANALYSIS -p Generally Accepted Accounti ng

Princi ples (GAAP). These GAAP are the
accounting standards p lus the rules,
(GAAP) The accoonting
standards, rules. principles
and procedures that
comprise authoritative
principles and procedures that comprise practice for financial
authoritative practice for fi nancial accounting.
Australian
accounting. The formal part of these
Accounting
principles, the accounting standards, have Standards Board
been developed over t ime by the (AASB) The standard-
setting body whose mission
Austra l ian Accounti ng Standards is 'to develop and maintain
Board (AASB) and enforced by ASIC. high-quality lilancial
reporting standards'.
High-quality accounting standards should
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1 __
..;..;_
19
 lead to financial statements that are 'presented fairly' or
provide a 'true and fair view'. It is interesting to note the
objective is not to produce 'accurate' or 'correct' financial
statements. because, although accounting is based
on numbers. there are many judgements and some
choices that are needed, which means financial statements
do not have the m athe matical precision many think they
possess.
In the Australian Accounting Standard AASB 101 , the
achievement of 'fa1r presentatiOn' IS laid out in paragraph 17.
which states:
In wtua ly all Circumstances. an entoty achoeves a fair
presentatoOn by comploance woth Australian Accountong
Standards. A faor presentatoon also requores an entrty:
a to select and apply accounting polooes in
accordanoe wrth AASB 108 Accountmg Poilc1es, THE BALANCE SHEET
Changes m Accountmg Esumates and Errors. AASB
108 sets out a hoerarchy of authorotatove gurdance
Chapter 1 introduced the balance sheet. A balance sheet
that management consrders on the absence of an
Australian Accountrng Standard that specifrcally is a f inancial statement that summarises a company's
applies to an otem; assets. liabilities and equity at a given point in time. Your
b to present informatron, including accounting balance sheet shown in Chapter 1 reported every account
policies. in a manner that provides relevant, reliable.
of your Aerial Filming business. However. most public
comparable and understandable rnformation; and
c to provrde addotional dosclosures when compliance companies are much too large to report every account. For
wrth the specofrc requirements in Australian ease of presentation, accounts of similar nature are placed
Accountrng Standards os rnsuffrcrent to enable users under one heading: e .g. Property, Plant and Equipment
to understand the ompact of particular transactions.
includes all CSL land, buildings, laboratories. scientific
other events and condotoons on the entity's fonancial
posotoon and fonancral performance. ' equ ipment. etc. The consolidated consolidated
balance sheet groups together all the balance sheet Atype
The accounting standards are part of the Corporations of balance sheet that
companies controlled by CSL into one groups together lhe parent
Act 2001 (as amended).
economic (reporting) entity. The process company and rts
Australian accounting standards are
of 'consolidation' 11110uld not be necessary subsodianesasone
based on the International Financi a l reportrrr,J entrty.
International if all operations were earned out by a
Financial Reporting Reporting Standards (IFRS). and as
Standards single company, but this is often not feas1ble because of
(IFRS) Stinlards
such the rules we follow in Australia
lega l. historical, geographic o r other reasons. The
issuedbylhe are the sa me as much of the rest of
kltemational Aa:ombrr,j consolidation process is covered on later years of accounting
the world (except the US). The IFRS
Stnlards~. study and is not important at th1s stage to your understanding
International are developed by the Internat ional
of the financial statements; 1t IS suffic1ent to know that
Accounting Accounting Standards Board (IASB)
Standards Board consolidation treats the whole bus1ness as one accounting
whose m1ssion is to have a single set of
(lAS B) A board. somolar entity ignoring the legal boundaries of each Individual
to the AASB. whose h1gh -qual 1ty standards requ i ri ng
mission is to develop a company in the 'group'.
transparent and comparable information.
single set of high-quality The following sections discuss the various asset.
standards requinng Because adoption of IFRS is voluntary,
liability and equity classifications commonly used on a
transparent and the effectiveness of the IASB at
comparable information. balance sheet. The 30 June 2017 balance sheet of CSL in
accomplishing its mission has been
Ex hibit 2.1 will be used as an illustration. As you review
limited because the US (and some other
the statement. note that all numbers except per share data
countries) have reta ined their own GAAP However, the
are in millions of dollars (to one decimal place. meaning
IASB and the US Financial Accounting Standards Board
t hat the number after the decimal point is a hundred
have agreed to a commitment to the convergence of US
thousand dollars (e.g . 20.3 is $20300000). Note also that
and international standards. At some time in the future, the
two years of data are presented. w ith the most recent year
world may very well use one set of g lobal accounting
listed first. This is the normal format for most company's
standards set by a global board.
financial statements. CSL reports in United States dollars.
This is not relevant to most of ou r analysis and only

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_.......;;;,;;
becomes critical when comparisons are made to compan ies Assets
reporting in Australian dollars. At the time of the financial
An asset is a resource of a business. Assets are generally
report $1 US = $1.3Aust.
grouped into two main categones on a balance sheet:
e current assets
Not es 2017 2016 e norH:urrent assets (includ1ng Intangible assets).
USSm USSm
CURRENT ASSETS Current assets
A current asset is any asset that is current asset Arrt
Cash and cash equivalents 14 844.5 556.6
reasonably expected to be converted to asset thai isreasmably
Trade and other receivables 15 1170.4 1107.2 expected to be COIM!rtEd
Inventones
-----------------------
4 2575.8 2152.0
cash or consumed within one year of the
balance sheet date. Common examples
tocashorconsuned
W1th1n one year of the
Cooent tax assets 6.2 1.6 include cash. investments that Wlll mature balance sheet date.

Other financial assets 5.2 0.6 or be sold within a year. accounts

Total current assets 4602.1 3818.0 receivable from customers, Inventories and other assets
such as prepaid insurance. Current assets are listed in order
NON-CURRENT ASSETS
of their liquidity, which refers to the speed with which a
Other rece1vables
-··-··-·-·-·_,_,_,_,_,_,_ 15
......- ,...,_,_,_,,_,,,.,,_,,_,_ 16.5
,_ ,,_ ,,_ ,_
15.6
_,_,_,_,_,_
~·"
resource can be converted to cash. Cash is listed first,
Other financial assets 3.9 2.9 f ollowed by short-term investments. receivables,
Property. plant and eqUipment 8 2942.7 2389.6 inventories and then finally other assets.
Deferred tax assets 3 496.5 389.0 CSL reports five current assets totalling over $4.6 billion
Intangible assets 7 1055.4 942.6 on its 30 June 2017 balance sheet. As you might expect
-··-···-···-···-···-·"_"_,_,,_,,_,,_,_,....._..,_,,_,,_,_,,_,_,,_,,_ ,,_,,_ ,,_ ,,,_ ,,,_ ,,_ ,,,_ ,, _,_,,,_,,,_,,,_,,,_ ,,,_
from a biotechnology company, the majority of those
Retirement benefit assets 18 5.6 5.0
assets (almost $2.6 billion) is in inventories. trade and other
Total non-current assets 4520.6 3744.7
receivables and cash and cash equiva lents making up the
TOTAL ASSETS 9122.7 7562.7 majority of the other current assets.
CURRENT UABILITIES
Non-current assets
Trade and other payables 15 1155.8 996.1 Non-current assets are the resources
-·--·--·-·-- - - - - - - · - - - - - -·-·-·---·-·-·------- non-current asset
Interest-bearing liab11iues 11 122.5 62.3 that are used in a company's operations Aresooo:e that is used 1n a
c~ny's operations for
CUrrent tax liabilitieS 202.5 207.3 for more than one year and are not more than ooe year and is
Provisions 16 134.1 99.6 intended for resale. Examples tnclude not ml!!nded for 11!Sale.
property, plant and equ1pment, intangible
Deferred government grants 9 3.2 3.1
assets and deferred tax assets.
Derivauve financial insuuments 6.0
CSL reports over $4.5 b1llion of non-current assets
TOTAL CURRENT UABIUTIES 1618.1 1374.4 on its 30 June 2017 balance sheet, with almost $3 billion
NON-CURRENT UABIUTIES of property, plant and eqUipment, making them the largest
Other non-current liabillues 15 25.8 18.8 asset.
lnterest-beanng liabilities 11 3852.7 3081.0
Deferred tax liab11it1es 3 138.2 119.2
-·-·-·--·-----------·--·-·-·---·----- ·- ·- ·-·-·-
Provisions 16 32.9 Current Assets
-··-·-·-·-··-··-·-·-.. .. . -. ·-·--·-·-·-·-····-·-·-·- ·- ·- ·-- ·- ·-40.5
- ·-·-·-
-·~e.~~~·~·~·~"~!.~t. g~n~~-·-··-··-·-··-··-·~··-····---3_?.~-----3.~:~- + Non-<:urrent Assets
Retirement benefit liab1hties 18 255.3 326.6 =Total Assets
Total non-current liabilities 4340.8 3621.1
TOTAL LIABILITIES 5958.9 4995.5 Intangible assets
NET ASSETS 3163.8 2567.2 An int angi ble asset is a type of non- intangible asset
EQUITY current asset that has no physical A resoorce that is used in
substance. Examples include trademarks. operatioo for more tllan
Contributed eq~~Y_._ -··- -·- -·- 12 (4534.3) (4213.01 one year. is not intended
patents. franchise rights. copyrights and for resale and has no
Reserves 12 294.2 187.9
··-·-·....-·-·-·-..-·-··-·-·-··- ·- ··- goodwill. Like other non-current assets. phys1cal substance.
Reta1ned earnings 19 7403.9 6592.3 intangi ble assets are subject to
TOTAL EQUITY 3163.8 2567.2 depreciation (although it is actually called amortisation
[iiiiiii] CSL L1m1ted's Consolidated Balance Sheet as at
~ 30 June 2017

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21
 instead of depreciation) and are reported net of amortisation
or impairment. Intangible assets, which Note 7 of CSL:s
annual report 2017 shows is predom inantly goodwill, is the
second largest non-current asset that CSL reports in its
balance sheet. At this stage a detailed knowledge of
goodwill is not important. For now, it can be understood
simply as the excess CSL paid when acquiring other
businesses for assets that are not separately identifiable:
th ings like brand recogn ition, distribution network, researdl
teams etc. (not intellectual property, which is recognised
separately).
Liabilities
A liability is an obligation of a business, wh ich is generally
amount of equity a company generates through the sale
(issue) of shares to investors (equity contributed by the
shareholders). Such equity is often referred to as share or
issued capital. Like most publicly traded companies, CSL
reports its equity accounts in one general section called
(Shareholders') Equity. There is just over $4.5 billion in
Contributed Equity and almost $7.5 billion in Reta ined
Earnings, indicating a lot of profits in previous years that have
not been distributed as dividends, but retained and used in
the business to buy assets. Reserves are like Retained
Earnings but a little
more complex and ~,\Y Tt/,
w ill be discussed in Check out lhe animated S1111mary on •
Financial Statements: Part 1
depth in Chapter 11.

a
classified into two main categories on a balance sheet:
• current liabilities
• non-current liabilities.
THE INCOME STATEMENT
Current liabilities
current liability A current liability is an obligation that Chapt er 1 also introduced the income statement. The
An obligation tllat is is reasonably expected to be satisfied income statement is a financial statement that summarises
reasonablyexpected to be with in one year. Examples include
satisfied within one year. a company's revenues and expenses over a period of time.
accounts payable to suppl iers, salaries Companies generally use one of two forms for their income
payable to employees and taxes payable statemen ts - a single-step stat ement or a multi-step
to the government. Even long-term debt, if maturing within statement.
one year, is classified as a current liability. A single-step income statement, as seen in Exhibit 2.2,
CSL reports six current liabilities tota lling over calcu lates total revenues and total expenses and then
$1.6 billion on its 30 June 2017 balance sheet. The largest determines net income in one step by subtracting all
is over $1.1 b illion in Trade and other payables, whidl is expenses f rom the revenues. The income statement
basically the amount owed to suppliers. The company also prepared in Chapter 1 was a single-step income statement.
reports over $200 million in current tax liabilities. The major advantage of a single-step statement is its
Non-current liabilities simplicity. For a service organ isation such as Chartered
non-current A non-current l iabi lity is an obligation Accountants Austra lia and New Zea land, a single-step
liability An obligation that is not expected to be satisfied within income statement presents its income clearly.
tllat is not expected to be A multi -step income statement
satisfied within one year. one year. Examples include interest- multi-step income
bearing liabilities, wh ich for CSL, make calculates income by grouping certain statement CalctJiates
up the majority of its non-current liabilities. In Note 11 , as revenues and expenses together and income by grouping certain
revenues and expenses
part of its risk management CSL discusses the interest- calculating several subtotals of income. together and calculating
bearing liabilities. CSL has over $4 billion of non-current These subtotals provide information on several subtotals of
income.
liabilities at 30 June 2017. the profitability of various aspects of the
company's operations. Wh ile most compan ies prepare
Equity multi-step statements, there is some slight variation in
Equity is the difference between a company's assets and how they are prepared. However, most include some or all
its liabilities. It is generated from the following two main of the following subtotals of income:
sources: • total revenue
• retained earnings (including reserves) • cost of sales
• contributed equity. • gross profit other
Retained earnings is the amount of • expenses comprehensive
contributed income Includes gains
equity The amount of equity a company generates by being • profits before income tax expense and losses not included in
equity a company profitable and retaining those profits in the • profits after income tax expense tiaditional revenue and
generates through the expense items.
sale of shares to investors business (earnings retained by the • ot her comprehensive income
{shareholders). business). Contributed equity is the • total comprehensive income.
The following sections discuss these subtotals that
are commonly used by companies. For illustration

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22
_......;;;.;;
 Notes 2017 2016
$'000 $'000

Revenue 127882 121624

Other income 2534 2900
Total revenue and other income 3{a) 130416 124524
Service expenses {31282) {29683)
Occupancy expenses {8828) {8914)
Administration expenses {71 000) {69765)
Information technology expenses {18159) {16326)
Other expenses {7917) {8014)
Total expenses {137186) {132702)
{Deficit) before tax {6770) {8 178)
Income tax expense 4
{Deficit) aher tax {6770) {8 178)
Other comprehensive income
Items that may be reclassified subsequently to surplus or deficit:
Exchange differences on translation of foreign operations {15) 120
Fair value increment of freehold property 7 4994 3370
Total other comprehensive income 4979 3490
Total comprehensive {deficit) for the year, net of tax {1791) {4688)
~ Consolodated statement of profit or loss and other comprehensove on come

Ths consolda:ted statement ol p-olit « loss an:l ocl& COI11lret.!nslw •n:xme :sh:luld be read witfl tfle acCQnl)af?(lrg llltes.
Source: Jl 0\arteredAo:oumcrusAustraha an:l New Zealand, AnnualReport 2017, p_ 9l.

Notes 2017 2016

USSM US$M
Continuing operations
Sales revenue 6615.8 5909.5
Pandemic Facility Reservation fees 94.0 68.7
Royalties and licence revenue 203.3 122.7
Other income 9.7 14.4
Total operati ng revenue 6922.8 6115.3
Cost of sales {3326.8) {3 0528)
Gross profit 3596.0 3062.5
Research and development expenses 6 {645.3) {6138)
Selling and marketing expenses {697.0) {6209)
General and administration expenses {484.8) {3903)
Operating profit 1768.9 1437.5
Finance costs 2 {90.0) (716)
Finance income 10.9 139
Gain on acquisition 1b 176.1
Profit before income tax expense 1689.8 1555.9
Income tax expense 3 {352.4) (3135)

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1 23
 Net profit for the period 1337.4 1242.4
Total of other comprehensive income/(expenses) 173.0 (1988)
Total comprehensive income for the period 1510.4 1043.6
Earnings per share (based on net profit for the period)
Basic earnings per share 10 2.937 2.689
~ CSts consolidated 1ncome statement

Sotl'ce: Pdapta:l from CSI.Limrted. Amua/REport2017. p. 82.

purposes, Exhibit 2.3 contains CSl:s income statement Operating (other) expenses
for the financial year ended 29 June 2014. Note that the
After gross profit is reported, operating expenses are listed.
company uses the t itle Consolidated statement of
Operating expenses are the expenses operating
comprehensive income because it includes the revenues
that a company incu rs during normal expenses Recurring
and expenses of the parent entity as well as all of t he expenses that a oompany
operations. Such expenses are recurring, incurs during normal
subsidiaries. Note also that, as with t he balance sheet,
meaning that they are incurred year after operations.
the numbers are in millions of (US) dollars (shown to one
year as the company runs its business.
decimal point) except earnings per share.
CSL reports these expenses in three categories:
Gross profit Research and developmen t, Selling and marketing, and
sales revenue The
General and administration. There is no requirement to
resources that a oompany In a mult i-step statement, revenue is
generates during a period report particular categories or details, bu t you may note
from selling its inventory.
liste d first. Sal es revenue, which
Research and development has 'Note 6' which provides
is revenue from sale of goods, is
information on how the expense is calculated but not what
the resources that a company generates during a period
it was spent on or what kind of expenses made up the total,
from selling its inventory. CSL reports three other revenues,
while the other two expenses simply have the total. A
which it lists as ' Pandemic Facility Reservation fees',
business might believe providing too mudl information to
'royalties and licence revenue', and 'other income', (note
competitors would harm f uture profits.
the use of other common terms used for revenue).
contributing to a tota l operating revenue of $6922.8.
(Finance income is reported in the middle of the statement
as this is seen to offset Finance cost reported just above.)
cost of sales The cost Liste d next is cost of sales.
of the inventory sold sometimes called cost of goods sold,
during a period.
wh ich represents the cost (to CSL) of
gross p rofrt (gross
margin) The profit that the inventory that was sold during a
a company generates period. Subtracting cost of sales from
when considering only the
sale price and the cost of
total operating revenue yields the f irst
the product sold. subtota l of income, gross profit. Gross
profit (some t imes called g r oss
margin) represents the profit that a company generates
when considering only the sales price and the cost of the
product sold. It therefore represents the gross dollar
'mark-up' that a company is able to achieve when selling
its inventory. Look at CSL:s income statement in
CS[ ANALYSIS
W ith cost of sales of over $3.3 billion, CSL generated ApP.endix B. What form of income
a gross profit of almost $3.6 b illion for the year. This statement does the comP.any use?
gives an average mark-up on inventory of a little over
100 per cent. Note th is is not 'bottom line profit' (total CS ~ uses a multi-step income statement. It snows se

comprehensive income); out of gross profit CSL pays for
research and development, rent, wages, advertising,
electricity, etc.
suototals of income, including gross profit, operating
profit, profit before income tax expense, net profits
for the P.eriod and total comP-rehensive income for
the P.eriod.

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 PROFITS BEFORE INCOME TAX EXPENSE
Gross profit less Operating expenses yields the second
subtotal. Operating profits. Net finance costs (Finance
costs m1nus Finance income) and Gam on acquisition are
profrts before income then deducted to give profits before
tax expense The profit incom e tax expense. sometimes also
that a oompany generates
when coosidenng both the called 'earnings before income taxes'
cost of the inventQr( and and other similar titles. This represents
the normal expenses h f' h
incurred to operate the t e pro 1t t at a company generates
busmess. when considering revenues and
expenses except for income tax.
After reporting its profit before tax.
income tax
expense The amount of CSL reports Income tax expense of
•noome tax expense for a over $350 million to y1eld a Net profit
QM!npenod
for the period (proftt after tax) of
$1337.4 million.

OTHER COMPREHENSIVE INCOME
Note in the top section on the Income statement the term
'profit' is used (gross. operating, before income tax, net
for the period). Compreh ensive income items include
movements in equity that are not part of the realised gains
or losses in profits. These can include movement in
translation of foreign operations (due to changes in
exchange rates between the Australian dollar currencies
of other countries in which CSL operates) and gains and
losses m 'cash flow hedges'. AASB 101 Presentation of
Fmanc1al Statements requires the d1sclosure of
comprehensive income items either after the profit and
loss section, as CSL does, or in a separate statement. In
summary, CSL:s income statement provides a picture of
how the company generated its profits for the year. This
translates to earnings per share of almost $3U S,
~,u '"' unsurprising given the
Clleclt out lheanimated Sll'llmaJy share price is around
• on financial Statements: Part2 $lOOUS.
~.'lY '""
Review lhis content wid11he e-lecture •
HORIZONTAL AND
VERTICAL ANALYSES
The previous sections demonstrate that financ1al
statements communicate economic information about a
company to Interested parties; for example, investors and
creditors learnt from CSL:s income statement that the
company earned JUSt under $2 billion (Australian) of total
comprehensive income for the 2017 financial year. This is
useful in formation because it demonstrates that the
company was profitable during the year. However. the
information can be even more useful if it is compared to
something else. For example. is $1.5104 billion (US) better
or worse than last year? Is it high enough given sales for
the period? How does it compare to competitors? Such
comparisons prov1de the necessary context for a richer
understanding of a company's financial activities. Such
context can be easily generated through two techniques
called horizontal and vertical analyses.

HORIZONTAL ANALYSIS
Horizontal analysi s is a method of horizontal
analysing a company's account balances analysis Amethod of
analySing a company's
over time. It is normally conducted on
account balances over
both the balance sheet and the income time by calculating
statement. The analysis calculates both absolute and percaltage
changes meadl account
the absolute and percentage change in
each account balance on a financial statement. As a result,
it is very useful1n Identifying promising or troublmg trends
in a company. The analysis is called 'horizontal ' because

Copyrlghl2019 Cengage learning. All R1gh11 R...rvod. May not be copied, scanned, or dupllcatod In whole or In p;>rt. WCN 02·200-20l
~HAPTER 2 Flnanc1al statements 25::,__ _
:;
 the calculation compares an account's balance across the
columns of yearly data - that is, horizonta lly across
the financial statement.
Horizontal analySIS IS calculated as follows. First, the
dollar dlange in an account is determined. This is defined
as the current year balance less the prior year balance. The
dollar dlange is then d1vided by the pnor year balance to
yield a percentage change . These two calculations are
shown below:
Dollar Change in Current Year Balance-
Account Balance Prior Year Balance
Percentage Change _ Dollar Change
in Account Ba lance - Prior Year Balance
To illustrate, consider the inventories balance from
CSL.:s balance sheet in Exhibit 2.1 ; th e com pany's
inventory increased $424 million over th e year, f rom
$2152 in 2016. Dividing that increase by the 2016 ba lance
yields a percentage change of almost 20 per cent. These
calculations are easily done on a spreadsheet where t he
financial information can be directly downloaded. Such an
analysis of the income statement in Exhi bit 2.3 would
show a 10.9 per cent increase (3596- 3062.5)/3062.5 in
gross profits and a 23.1 per cent increase (1768.9 -1437.5)
1437.5 in operating profrts. For a full horizontal analysis,
both dollar and percentage changes are calculated for
each account on both the balance sheet and the income
statement.
Further analysiS of the balance sheet shows significant
growth. Total assets m the most recent year were 21 per
cent higher than the prior year. Since total liabilities
increased 19 per cent, the company's asset growth was
not only generated by borrow1ng money. Rather, the
company grew by being profitable and not paying out all
profits in dividends (12 per cent increase in retained
earnings}. The negat1ve contributed equity is due to share
buybacks at prices higher than they were originally issued
(see CSL.:s Note 12 to the financial statements). Share
buybacks are discussed in Chapter 11 'Shareholders'
equity'. An examination of the income statement may
appear to be complicated by the presentation in $US. In
vertica l and horizontal analysis the perce ntages and
percentage changes are exactly the same as t hey would
have been had the financial statements been in $A,
because we are comparing within and between figures
in one currency. Only when comparing actual dollar
amounts or dollar dlanges between CSL and financial
statements in $A, would a currency conversion be
ACCT3 Fw>~flgllt 2018 Cengoge l.aml119- AU Rights R~ May no< be copMd, scanned. or dUI'lieaod,ln wholo or In pan. WCN 02·200-202
26
_.......;;;,;;
required. A minor complication may be the change in the
price of the products sold by CSL. While the Consumer
Price Index in Australia rose around 2 per cent in the 2017
financial year, if CSL.:s med1cines rose by a similar amount
(which is unlikely given the global nature of CSL.:s sales}
then selling the same quantity would account for
2 per cent rise in sales.
In summary, horizontal analysiS of the balance sheet
and the income statement shows that CSL had another
growth year. Horizontal analysiS (as seen in Exhibit 2.4}
has provided the context for a more thorough
understanding of the financ1al statements. The five-year
summary information for CSL is an extension of the
horizontal analysis undertaken above, showing total
operating revenue rose from A$5.1 to A$7.0 billion
between 2013 and 2017. or 37.3 per cent, while profits
aher tax rose from A$1.21 to A$1.43 bi llion, a more
modest 17.8 per cent.•
VERTICAL ANALYSIS
Ver tica l anal ysis is a method o f vertical analysis
comparing a company's account balances A method of comparing a
company'saccount
within one year. It also is normally
balances within one year
conducted on both the balance sheet and by drvidong each account
the income statement. The ana lysis is balance by a base amount
to yield a percentage.
calculated by dividing each account
balance by a base account, yieldmg a percentage. The
base account is total assets for balance sheet accounts
and sales or total revenues for income statement accounts.
These two calculations are shown below.
For the For the income
balance sheet statement
Account Balance Account Balance
Percentage Total Assets Net Sales or Revenue
The product of a vertical analysis IS
sometimes called a common - size common-size
financial statement
f inanci al statement, which is a A statement on which all
statement in whidl all accounts have been accoonts have been
standardised by the overall
standardised by the overall size of the size of the company.
company. Common-size sta tements are
very useful because they allow financial statement users
to determine the importance of each account to the overall
company and t o compa re that importance to other
companies. even those of vastly different sizes (and even
companies reporting in different currencies}.
 A B c D E

~
2
3
4
I
CURRENT ASSETS
Cash and cash equivalents
:t!tu.t.j .s;JCCtif.f.'tjnn
2017US$m

844.5
2016US$m

556.6
$Change

287.9
% Change

0.52
i
5 Trade and other receivables 1 170.4 1107.2 63.2 0.06
6 Inventories 2575.8 2152.0 423.8 0.20
7 Current tax assets 6.2 1.6 4.6 2.88
8 Other financial assets 5.2 0.6 4.6 7.67
9 Total current assets 4602.1 3818.0 784.1 0.21
10 NON-CURRENT ASSETS
11 Other receivables 16.5 15.6 0.9 0.06
12 Other financial assets 3.9 2.9 1.0 0.34
13 Property, plant and equipment 2942.7 2389.6 553.1 0.23
14 Deferred tax assets 496.5 389.0 107.5 0.28
15 Intangible assets 10554 942.6 112.8 0.12
16 Retirement benefit assets 5.6 5.0 0.6 0.12
17 Total non<urrent assets 4520.6 3 744.7 775.9 0.21
18 TOTAL ASSETS 9 122.7 7562.7 1560.0 0.21
19 CURRENT LIABILITIES
20 Trade and other payables 1155.8 996.1 159.7 0.16
21 Interest-bearing liabilities 122.5 62.3 60.2 0.97
22 Current tax liabilities 202.5 207.3 (48) -0.02
23 Provisions 134.1 99.6 34.5 0.35
24 Deferred government grants 3.2 3.1 0.1 O.Q3
25 Derivative financial instruments 6.0 (60) -1.00
26 Total current liabilities 1618.1 1374.4 243.7 0.18
27 NON-CURRENT LIAB ILITIES
28 Other non-current liabilities 25.8 18.8 7.0 0.37
29 Interest-bearing liabilities 3852.7 3081.0 771.7 0.25
30 Deferred tax liabilities 138.2 119.2 19.0 0.16
31 Provisions 32.9 40.5 (76) -0.19
32 Deferred government grants 35.9 35.0 0.9 O.Q3
33 Retirement benefit liabilities 255.3 326.6 (713) -0.22
34 Total non-current liabi lities 4340.8 3621.1 719.7 0.20
35 TOTAL LIABILITIES 5 958.9 4995.5 963.4 0.19
36 NET ASSETS 3163.8 2 567.2 596.6 0.23
37 EQUITY
38 Contributed equity (4 534.3) (4213.0) (3213) 0.08
39 Reserves 294.2 187.9 106.3 0.57
40 Retained earnings 7 403.9 6592.3 8116 0.12
41 TOTAL EQUITY 3163.8 2567.2 596.6 0.23
~ Horozontal anal ysos of CSt:s consolidat ed ba lance sheet

Sotl'ce:Pdapted tromCSlltd. Arrrval/lepott2017. p. 82.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In whole or In ~AA_~~-~~g~ statements
1 __
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27
 In vertical ana lysis we divide each inventory balance by For a full vertical analysis. percentages are calculated
total assets for that year. These calcu lations are shown in for every account on each financial statement. Exhibit 2.5
the following table. Also shown are similar calculations that contains a vertical analysis of CSt:s income statement.
would be made for a vertical analysis of total comprehensive Of course, sales revenue is 100 per cent (1.00) of itself.
income from the company's income statement in Cost of sales is 50.3 per cent of sales revenue in 2017
Exhibit 2.3. The only difference is that total comprehensive (51.7 per cent in 2016), whidl indicates, on average, CSL
income is divided by sales. not total assets. manufactures (or buys) medicines for about 51 c and sells
them for $1.00. At the bottom of the income statement in
2 017 2016 Exhib it 2.5 we can see CSL makes well over 20c f rom
Inventory balance S2 575.8 $2152.0 every $1 of sales in 2017 and well under 20c in 2016. The
Total assets S9122.7 $7 562.7 vertical analysis shows excellent improvement in f inancial
-···-···- ··- ··- ···-···-···-···-···-···-···- ··- ···-···-···-···-···-···-···-···- ··- ··- ·--...-···-···-···-···-···-···-··- ··- ··-···-·- performance in 2017.
= Percentage of total assets = 28.2% = 28.5%
A more advanced examination of the balance sheet
would show the single largest asset for CSL is property,
Total comprehensive income $1510.4 $1043.6
plant and equipment (PPE). PPE increased by 23 per cent
$6922.8 $6115.3 during the year (we know th is f rom the horizontal analysis).
=Percentage of net sales = 21.8% = 4.217.1% In 2016 it was 31.6 per cent oftotal assets (2389.6/7562.7)
-···-···- ··- ··- ···-···-···-···-···-···-···- ··- ··- ···-···-···-···-···-···- ··- ··- ··- ···-...-···-···-···-···-···-···-··- ··- ··-···-·-
•1n E>:fliblt 25 Sales feW!flue IS used rather thcrl Total opnbrg fewflue.. There may be reasms fer u;u·g one and 32.3 per cent of total assets (2942.7/9122.7) in 2017.
railer tfm tlvaotfler 111 analysing a particular CIJ01)ir'l'{. here ll•s 100re atoutease ot U"Kierstan:ling.
This is due to total assets increasing by 21 per cent (again

I A B c 0 E F I
.,
11 LI!'J'il.:r'• .... . .. .
Notes 2017 As % of 2016 As % of
2 US$M Total revenue US$M Total revenue
3 Continuing operations
4 Sales revenue 6615.8 1.000 5909.5 1.000
5 Pandemic Facility Reservation fees 94.0 0.014 68.7 0.012
6 Royalties and licence revenue 203.3 0.031 122.7 0.021
7 Other income 9.7 0.001 14.4 0.002
8 Total operating revenue 6922.8 1.046 6115.3 1.035
9 Cost of sales (33268) (0503) (3 0528) (0.517)
10 Gross profit 3596.0 0.544 3 062.5 0.518
11 Research and development expenses 6 (645.3) (0098) (6138) (0.104)
12 Selling and marking expenses (697.0) (0 105) (6209) (0.105)
13 General and administration expenses (484.8) (0073) (390.3) (0.066)
14 Operating profit 1768.9 0.267 1437.5 0.243
15 Finance costs 2 (90.0) (0014) (716) (0.012)
16 Finance income 10.9 0.002 139 0.002
17 1 Gain on acquisition 1b 176.1 0.030
18 Profit before income tax expense 1689.8 0.255 1555.9 0.263
19 Income tax expense 3 (352.4) (0053) (3135) (0.053)
20 Net profit for the period 1337.4 0.202 1242.4 0.210
21 Total of other comprehensive income/ (expenses) 173.0 0.026 (1988) (0.034)
22 Tota l comprehensive income for the period 1510.4 0.228 1043.6 0.177
1m Vertocal analysts of CSt:s consolidated oncome statement

Source:M!pted ftcm CSt limrted, Annual Report 2017, p. 81.

ACCTJ Fin~c!ll(lght 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In whole or In part. WCN 02·200-202
28
_......;;.;;,
from the horizontal analysis). Inventories increased 20 per
cent (again from the horizontal analysis) wh ile in 2016 it
was 28.5 per cent (2152.0/7562.7) of total assets and in
2017 it was 28.2 per cent (2575.8/9122.7). This may appear
to be incorrect, but simply shows inventories grew
substantially, but not quite as much as the average
other assets.
The analysis also reveals CSL:s capital structure. Capital
structure refers to t he degree to wh ich a company's assets
are generated f rom liabilities versus equity. In general, a
capital structure more heavily we ighted towards liabilities
is riskier. According to the vertical analysis, CSL financed
over 65 per cent of total assets from total liabilities (debt)
and t herefore less than 35 per cent from total
(shareholders') equity in the most recent year. Tota l
liabilities increased substantially over the year (1 9 per cent
from the horizontal analysis) and there was a small
reduction in debt as a percentage of total assets (2017:
65.3% [5958.9/9122.7): 2016: 66.1 o/o [4995.5/7562.7)).
~ THE STATEMENT OF
company's balance sheet changed from one year to the
next. It therefore focuses not only on retained earnings,
but also on other equity accounts relating to a company's
total equity.
For illustration purposes, Exhib it 2.6 contains CSL:s
Consolidated statement of changes in equity for the year
ended 30 June 2017. Like the other f inancial statements,
changes in equity reports two years of data. However,
unlike the income statement, each column reflects t he
activity in a specific equity account rather than a period of
time. The five columns of the statement refer to the five
equity accounts, four are shown in the balance sheet,
(Foreign currency translation reserve and Share·based
payment reserve are combined and shown as one line
'Reserves' in the balance sheet).
The f irst column 'Contributed equity', as discussed
previously, is negative. This is complex, and at the
introductory stage not important, but if you are interested
a simple example may be helpful. Assume a company sold
(issued) 100 shares for $1 each- it would have contributed
equity of $100. After a number of years t he company was
very financially successfu l and the shares were selling for

Viii/ CHANGES IN EQUITY $25 each. If the company wanted to buyback say 10 shares
it would need to pay $250 ($25 x 10), wh ich wou ld leave a
negative contributed equity of $150 (original $100 minus
Chapter 1 introduced t he statement of changes in equity.
$250 buyback). Reasons for buybacks are discussed in
The retained earnings section of t he statement of changes
Chapter 11.
in equity links a company's income statement and balance
The fourth column, Retained earnings, represents the
sheet by showing how profits or losses and dividends
equity that has been generated through profitable
change the company's retained earnings balance. A ll
operations and retained in the business. The Retained
companies show changes in retained earnings, but most
earnings column is csr.:s statement of changes in equity.
show it as a component of a more complete statement of
Profit for the period (and some of the comprehensive
changes in equity.
income) is added to the beginning reta ined earnings
A statement of changes in equity is a f inancial statement
balance, and dividends are subtracted. As we can calcu late,
that shows how and why each equity account in the

A B c 0

Contributed Foreign Share based Retained Total

equity cum!ncy payment eamings US$m
2 US$m translation reserve US$m
reserve US$m
US$m
3 At the beginning of the year (4213.0) 28.5 159.4 6 592.3 2567.2
4 Total comprehensive income for the full year 97.5 1412.9 1510.4
5 Share based payments 8.8 88
6 Dividends (6013) 6013
[7 Share buyback (334.0) 3340
8 Share issues • Employee share scheme 12.7 127
9 As at the end of the year (4534.3) 126.0 168.2 7403.9 3163.8
~ CSts consolidated statement of changes m equity

Sou:rc e: Pdapted from CSt limrted. ArttmlReport2017. p. 83.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In whole or In ~AA_~~-~~g~ statements
1 __
;;.;._
29
 CSL paid out around 43 per cent of its profits (and some
comprehensive income) in 2017 in dividends (601.3/1412.9).
The last row of the statement and bottom line of the
statement of dlanges in equity, 'As at the end of the year',
has (of course) the same numbers that appear in the

•
balance sheet $3163.8.

Download the Enrichment Modules

for further practice

~ INFORMATION BEYOND
Company A Company B ~ THE FINANCIAL
...........,...,._ ,,,..,._ , _ ,__, _______,__, ................... _,_.._.._,_
19.8% 35.1%
, _.._.._,,_....._.......,_ ,_
..,_...... .._.. , STATEMENTS
8.5%
A company's f inancial statements contain a significant
amount of information about the financial activities and
position of the company. However, they are not exhaustive,
and much information that is useful to users of annual
reports is not included directly in the financial statements.
As a result, compan ies like CSL prepare and report
additional information beyond the financial statements.
These items are normally included in a company's annual
report that is distributed to all shareholders. Four items of
interest are:
e notes to the financial statements
e auditor's report
e directors' report
e o ther information, whidl often includes: information
abou t the business operations, future prospects.
shareholder information and a sustainability report
e governance information.

NOTES TO THE FINANCIAL STATEMENTS

At the bottom of each of CSt:s f inancial statements is the
following quote: T he consolidated statement ... shou ld
be read in conjunction with the accompanying notes'.
In addition. next to many of the accounts in t he 'Note'
column is a number that refers to a specific note following
the f inancial statements. For CSL there are 24 not es in
2017. taking up 35 pages of the annual report.
A company's financial statements cannot communicate
or disclose to users all the informa tion necessary to
adequately understand the f inancial activities and condition
of an entity. Additional information, both quantitative and
qualitative, is necessary and can be found in the notes to
the financial statements.
Th e notes to the financ i al notes to the
statements are the t extual and financial
statements The
n umerica l in format ion immediately additiooal textual and
following the financial statements that: numerical infonnation
immediately following the
(1) disclose the accounting methods financial statements.
used to prepare the financial statements,

_ 30
__,;;.;;,
ACCTJ Fi n~c!ll(lght 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In whole or In part. WCN 02·200-202
(2) disclose additional detail and explanation of account Since most of us don't have access to the fi nancial and
balances and (3) provide information not recognised in the other records, nor the ability to determ ine whether the
financial statements. Financial statements should not be reported numbers are reliable. we trust a third party
examined without considering the notes to the financia l to provide assurance that the information is re liable. Th is
statements. is why all annual reports contain an independent
The content of the notes to the financial statements auditor's report.
varies by company, but there are some similarities across An independent auditor 's report
independent
companies. Initially, the f irst note of most compan ies is a report, prepared by a registered auditor's report
summarises the significant accounting policies used to company auditor for the sha reholders, A report, prepared by a
registered company auditor
prepare the financia l statements. For example, CSL stating an opi nion on whether the fof the shareholdBfS,
commences by stating the financial report is prepared in financia l statements give a true and fair stating an opinion on
whether the financial
accordance w ith Australian Accounting Standards. It goes v iew and comp ly w ith Austra l ian statements present fairly,
on to explain 'significant accounting policies that summarise Accounting Standards and the in confofmity with
Austialian Accounting
the measurement basis used and are relevant to an Corporations Regulations. Exhi bit 2.8 Standards, tile company's
understanding of the financial statements are provided contains an extract from CSL.:s 2017 financial conditioo and
results of operations and
throughout the notes to the financial statements'. 6 These auditor's report. cash flows.
explanations are especially useful in determining the As you can see in the report, EY. one
comparabi lity of f inancial statements across compan ies. of the 'big four' accounting f irms. performed the audit.
Second. most companies include a note for each of their The auditor's opinion is that the financial reports of CSL
significant accounts. These notes can vary depending on give a true and fa ir view and comply w ith Australian
the type of business, but most companies have notes for Accoun ting Standards and the Corporations Regulations
significant items such as property, plant and equipment, 2001. This type of op inion. wh ich is known as an
income taxes and employee benefit plans. among other unqualified opin ion. is what all companies hope to
things. Exhibit 2.7 is an extract from CSL:s balance sheet receive. W ith this assurance from EY. users can consider
w ith the corresponding note. the financial statements reliable.

No te DIRECTORS' REPORT
Current assets In addition to financial statements, notes and the auditor's
Cash and cash equivalents 14 repo rt, all annual re po rts contai n a section ca lled
...-···-···-··- ··- ··- ··- ··- ··-···-···-···-···-···-···-···-···-··- ···-··- ··- ··- ··-···-·..-···-··-···-··- ··- ··-···-···-···-···-···-·
Trade and other receivables 15 directors' report. The directors' report directors'
form s part of the fi nancial report and report Ftxms part of tile
Inventories 4 financial report and covers
covers matters which are the Board of
Current tax assets matters which are the
Directors' responsib ility, including: who Board of OirectOfs'
Non-current assets are the directors, how many meetings responsibility.
Other receivables 15 they attended. risk management - and
Other financial assets over the last ten years increasing in importance - how
Property, plant and equipment 8 much and why sen ior managers are paid (remunerated).
Intangible assets 7
···-···-···-··- ···-··- ··- ··- ··-···-···-···-···-···-···-···-···-···-···-··- ··- ··- ··-···-···-···-··-·..-··- ··- ··-···-···-···-···-···-· OTHER INFORMATION
Equity
···-··- ···-··- ··- ··- ··- ··- ··-···- ··-···-···-···-···-···-···-···-··- ··- ···-··- ··- ··-···-···-··-···-··- ··- ··- ··-···-·..-··- ···-·
Contributed equity 12 Sometimes referred to as management's discussion and
analysis, CSL commences the annual report by telling the
Reserves 12
reader about the business, including the major business
Retained earnings 19
sectors, reviewing the year and highlighting certain aspects.
[liUiTl Extract from CSL:s ba lance sheet w 1th the
Some of the information may be considered informative or
~ correspondmg note to the fmanc1al statements
some may cynically see it as public relations. Other
Satire e: kla!Xed from CSL L11n~ed. Annual Hepott 201J. p. 82.
information, such as major shareholders and corporate
governance, may be required by the Australian Securities
AUDITOR'S REPORT Exchange as part of a listed company's obligations. This
How do you know if a financial report can be trusted to other information normally precedes the financial report
fa irly present CSL:s financial position and performance ?

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In whole or In ~ AA_~ ~-~~g~ statements
1 __
;;;..;...
31
 INDIPINOlNT AUDITOR'S Ali'I'ORT
FOR THE YEAR ENDED 30 JUNE 2017

EY
=~

~Ai.dtclr'SAI!pMtod'IIIMfllUtS-c;:si.Limll4!f

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Atlport.Cir\tlle"'-'*alttlt,lnllilltiel....,

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_., .......,_..,._,.,,...,...,_.,_.,..._ .. _ ...., ... fNfo;ill...,.,
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~..,.,_ -..- ...,.,..
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......-..·-·
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INDIPINDINT AUDITOR'S RliPOAT

FOA: THE YEAR ENDED 30 JUNE 2017

EY
==-
II!Oepencii!I'C.~'S~tOtl'le~CIIIC$1.~

-"'-...-.. ._...,..,.._. . . . . _-....

AQponcnlNAilclll.ofV'ef~~

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.._......._.,,_,..
J -...........- f l

-"---
.,.... _ _ _ .., . . . fllloll~ . . . . . jlllllllioll-. . . . . . .,~201l --11.1-~~ ... .,.,.,.._

---__
::=:.,·:.:;::.-=:==-~~:=::., .. ~~===~-~..;:::::;-..--;:
no.ctlll..,...._.. ___
<IOII»f_ . .....,....,_.,..,. ... ~,..._..Mf(.,_,..,_.....,.,NUIIO r-lii[IIIICSfllo'~.....,_ ...c:o..t_
. . . . . . . . ._ . . . fl __
..,.........------- ·~-......- -..-._..._..,__
cw.
ll.-w_ ...................... _ . . . _ ...

_,__,_...,_....., .....__ .._

......,... ..,.............
::.-==:::::.-:~-~~.:.:==:-..::v:::.::==::;::~::..-- _
..
.....,_ _____
. . ,___
____ .._

Err:] Extract from CSL:s independent aud1tor 's report

Source: CSliJd. AmJaiRepar2017, p. 121 & 126. ¢l2017 CStlimrted.

and, for CSL:s 2017 annual report. takes up the first SUSTAINABILITY REPORTING
fifty pages. Many companies report information that is broader than the
I would encourage you to look at more detail of this f inancial and operating activit ies. Some reporting areas and
report in Appendix B and on the internet. An excerpt of this f rameworks have been developed over recent decades
is presented in Exhibit 2.8. which consider a more comprehensive set of stakeholders.

_ 32
__,;;.;;
ACCTJ Fi n~c!ll(lght 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In whole or In part. WCN 02·200-202

Dnven by our promise, CSL is a global biotechnology
company that develops and delivers Innovative
medicmes that save lives, protect public health and
help people with life-threatening med•cal conditions
live full lives. Our Values guide us in creating
sustainable value for our stakeholders.
Delivering on promises is what we do at CSL.
Starting a century ago in Melbourne, Australia, we
made a promise to save lives and protect the health of
people who were stricken with a broad range of serious
medical conditions. Today, that same promise has
never been stronger. As a leading global biOtechnology
company, CSL delivers medicines to patients in more
than 60 oountries and employs nearly 20000 people ...
CSL focuses its world -c lass research and
development (R&D). high-quality manufacturing, and
patient-centred management to develop and deliver
innovative biotherapies, influenza vaccines and
support programs ...
~ Excerpt from 'About CSt:
Source: CSLLad, Atnfii Repar 2017, p. 2. C12017 CSl Lm...S Alpoclt.ad 'NO pPIISSIXI.
Integrated reporting combines financial, corporate social
respons1b1lity and other non-financial Information into a
s•ngle report. Integrated reporting is encouraged 1n India and
China and required in South Africa, but voluntary m Australia.
CSL lists the following corporate responsibility priority
areas:
• mnovat10n by focussing on product research and
development and operational excellence
•
Interactive quizzes
Enrichment modules
Animations
E-lectures
Glossary
Flashcards and more
Copyrtght 2019 Cengage Learning. All R1ght1 R...rv.cj. May not be copied. scanned, or duplicated In whole or In p~~~~·~~g~lstatements
• ensurong our therap1es are safe and of the h1ghest
quality by ma nta1n1ng the highest standards
throughout all stages of the product life cycle
• opera~ng responsibly in the marketplace by
marl<e~ng our med Cines in an ethiCal manner.
work1ng With others to 1mprove equrty of access and
sharong our hnanc1al success
• prov1d1ng a pos1t1ve working environment for our people
by engendenng a culture of mutual trust and respect,
enabhng them to do their jobs safely and effectively,
and rewarding and recognising their contributions
• supporting our patient, biomedical and local
communitieS by improving access to our therapies
and enhanc1ng the quality of life for patients,
advanong SC1enttf1c knowledge and support1ng
future med cal researchers, and engag1ng our staff
1n the support of local oommunities. 7
While there ISno requirement to provide any informatiOn
on sustainab•hty, many businesses see providing such
information as useful for stakeholders.
GOVERNANCE INFORMATION
CSL devotes 12 pages in the annual report to Corporate
Governance. The Australian Securities Exd1ange (ASX) requires
listed companies to report on corporate governance principles
and recommends that companies 'lay solid foundations for
management and oversight' to 'make timely and balanced
disclosures' and 'remunerate fairly and responsibly'.•
The board of directors is the governing group of a
company; the board selects and appoints the sen1or
managers and makes the major strategic decis•on. The
recognition and management of risk is a major function of
boards today. CSL reports on the directors' knowledge, sk1lls
and experience, their length of service on the board and
important ly, if they •
are independent. Tes.t your ~n.dersta.nding wi~ the ~
online rev1s1on qu1zzes for lh1s chapter
__
;.;...
33
 4 Calculating profit after tax
Brancatisano Clothi ng Supercentre generated a gross profit
of $3 875 000 during the year. Also, during the year,
Brancatisano incurred advertising expense of $750000,
salaries expense of $1 050000 and incom e tax expense of
$1 000000.
REQUIRED
1 Miscellaneous terms Calculate th e com pany's profit or loss after tax for the year.
The following defi nitions were discussed in the chapter:
a A form of business in which two or m ore people 5 Horizontal and vertical analyses
combi ne their capital and talents. The following information (in millions) was taken from a
b Information following the financial statem ents that recent income statement of l ucy-Rose and Sarah Com pany:
provides additional information and disclosures.
c A form of business that is a separate legal entity, Current year Prior year
established by filing proper forms w ith ASIC. Net sales $32235 $26306
d A report that attests to the fai r presentation of a
Cost of sales 19726 17920
company's financial statements.
Gross profit $12 509 $8386
e The most common form of business.
Information on role of the board and how it provides REQUIRED
responsible leadership. Conduct horizontal and vertical analyses of gross profit.
REQUIRED Was the com pany m ore or less profitable in the current
Match each definition with one of the followi ng terms: sole year? Do both horizontal and vertical analyses ind icate that ?
proprietorship; governance information; notes to th e For your calculations, round percentages to one decimal
financial statements; partnership; auditor's report; company point (e.g . 10.1 %).
or corporation.
6 Horizontal analysis
2 Classified balance sheet The horizontal analysis of a company's sales shows a
The following is a list of accou nts taken from Jann's Jeans: $34.2 million increase, wh ich equated to a percentage
change of 22.8 per cent.
Accounts receivable $ 2400 REQUIRED
Sales 36000 Interpret the dollar change and percentage change and
Inventory identify w hich item(s) from the following list would
6300
poten tially explain the results o f the analysis:
Contributed equity 52000
a A sales promotion was highly successful.
Accounts payable 9240 b A m ajor suppl ier was unable to deliver goods on time.
Cash 14660 c The com pany opened several new stores.
Prepaid insurance 5600 d The com pany lost market share to Amazon.
Equipment 27000 e The com pany's contributed equity increased by
$1.5 m illion from the issue of shares.
Short-term investments 1600
f Additional optional question: what were sales in the
REQUIRED previous year?
Prepare the current asset section of Jann's balance sheet.
Attempt to list the accou nts in the proper sequence 7 Statement of changes in equit y
(liquidity).
A com pany provides the following account balances for the
curren t year:
3 Calculating gross profit
During the m onth, a retailer generates $45000 of sales, Contributed equity, beginning of year $ 20600
$9500 of operating expenses, and $34 500 in cost of sales. Retained earnings, beginning of year 62496
At the end of the month, the company had $3000 of
Additional contributed equity 100000
inventory (goods) on hand.
Dividends 9500
REQUIRED
Profits {comprehensive income) 22 133
Calculate the company's gross profit for the m onth.
REQUIRED
Prepare a statement of changes in equity at year-end in a
single colu mn to give the closing balance of total equity.

A CCTJ Fi n~c?.Xf'ght 2019 Cengage l earning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or In part. WCN 02·200-202
34
_.......;;..;.
8 Classified balance sheet 10 Balance sheet
The following is a list of accounts:
~-~~~~-- Balance sheet ;~~---~-
Mortgage payable, due in 15 years
Short-term investments Pauline's Barnaby's Sue's
Fish It Bar It Surf
Cash Chips Grill and Turf
Prepaid rent
ASSETS
Patents
Contributed equity Current assets $ 48500 $ 35000 $ 64500
Accounts payable Non-current assets 125 750 100000 150000
Buildings Intangible assets 32250 55250 15000
Notes payable, due in six months. Other assets (a) 35500 6500
REQUIRED Total assets 220000 225 750 (g)
Identify each account as a current asset, non-current asset, LIABI LITIES
intangible asset, current liabi lity, non-current liability,
Current liabilities $ 15500 $ 7000 (h)
contributed equity, or retained earnings.
Non-current liabilities 45000 (d) 65500
9 Classified balance sheet tenns Total liabilities (b) 75000 69000
The following is a list of balance sheet classifications and EQUITY
descriptions:
Contributed equity $ 55000 {e) s 67500
a Current asset
Retained earnings {c) 105000 {i)
b long-term investment
Total liabilities and equity 220000 (f) ij)
c Non-current asset
d Contributed equity REQUIRED
e Intangible asset Fill in the 10 missing numbers (a)-(j) for the independent
Current liability businesses.
g Non-current liability
h Retained earnings 11 Classified balance sheet
An obligation that is reasonably expected to be The following items were taken from the 30 June balance
satisfied w ithin the coming financial year. sheet of Samantha Solarium:
ii An investment in the shares or bonds of another
entity that the company does not intend to sell Bui ldings. net $120400
within one year. Accounts receivable 29040
iii An obligation that is not expected to be satisfied Prepaid insurance 9360
within one year.
Cash 41680
iv The portion of equity contributed by shareholders
through the purchase of shares. Equipment (net) 127360
v Resources that are reasonably expected to be land 123600
converted to cash or consumed during the
Mortgage payable 206080
coming financial year.
vi Tangible resources that are used in the company's Contributed equity 132000
operations for more than one year and are not Retained earnings 80000
intended for resale. Interest payable 7200
vii The profits that a company earns over time and is not
paid out in dividends. Accounts payable 24960
viii Resources to be used in the company's operations REQUIRED
for more than one year that have no physical Recreate the company's classified balance sheet, assuming
substance. that $27200 of the mortgage payable balance will be paid
REQUIRED within three months of the balance sheet date.
Match the classification to the description.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or In p~~~ ~-~~g~ statements
1 __
;;;.;;..
35
 12 Multi-step income statement 15 Horizontal and vertical analyses,
These items were taken from the financial records ofTran income
Nguyen Pty Ltd: Comparative statements of comprehensive income are
available for Fiona's Fine Fruit (all figures in millions):
Electricity expense s 17650
Interest expense 50 2020 2019
Selling expense 14600 Sales $850 S800
Administrative expense 15230 Cost of sales 325 275
Interest revenue 500 Gross profit 525 525
Cost of sales 75620 Other expenses 175 121
Net sales 154900 Profits before tax 350 404
Income tax expense 105 121
REQUIRED
Prepare a multi-step income statement assuming Tran Total comprehensive income $245 $283
Nguyen pays the 25 per cent company rate and has a
30 June financial year end (you can assume in this case
REQUIRED
accounting profit equals taxable income). a Perform horizontal and vertical analyses on each of the
items in the above comparative income statements.
Round percentages to one decimal point (e.g. 10.1%).
13 Multi-step income statement
b Briefly comment on the performance and suggest areas
The following income statement items are taken from where management need to devote attention if they
the records of Matthew Music Mania for the year ending wish to reverse the decline in profits.
30June:

Advertising expense $ 6210 16 Horizontal and vertical analyses,

balance sheet
Cost of sales 83910
The following comparative balance sheet data is available for
Income tax expense 2250 Elizabeth Enterprises:
Insurance expense 3960
Interest expense 4115 2020 2019

Interest revenue 6055 Total assets $850000 $700000

Rent expense 11410 Total liabi lities 240000 280000
Salaries expense 28525 Total equity 610000 420000
Sales 153100 REQUIRED
Electricity expense 5600 Perform horizontal and vertical analyses on each of the
items above. Round percentages to one decimal point
REQUIRED (e.g. 10.1% ). If generating assets through debt is considered
Prepare a multi-step income statement for the year ending riskier than generating assets through equity, is Elizabeth
30June. more or less risky in 2020?

14 Financial statement accounts 17 Horizontal and vertical analyses

The following is a list of accounts: A company provides the following information:

Accounts receivable Interest payable Current year Prior year

Interest revenue Contributed equity Net sales $121345 $119872
Inventory Pandemic reservation fees Accounts receivable 30192 12676
Buildings Cost of sales Total assets 246933 250361
Dividends Administrative expense
REQUIRED
Mortgage Sales Should the company be concerned about its performance?
Accounts payable Retained earnings Use horizontal and/or vertical analyses to 'prove' it should or
Supplies Cash should not be concerned. Rou nd percentages to one
decimal point (e.g. 10.1% ). What other information may be
Reserves Finance costs considered more relevant to a question about
'performance'? Why?
REQUIRED
Identify if each account would appear on the balance sheet,
income statement and/or statement of changes in equity.

ACCTJ Fi n~c?.Xf'ght 2019 Cengage l earning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or In part. WCN 02·200-202
36
_.......;;.;;.
 account balances, and information not recognised in the
18 Financial accounting terms financial statements.
The following are various terms and definitions from iii A statement in which all accounts have been
financial accounting: standardised by the overall size of the company.
a Common size financial statement iv A discussion and analysis of strategic and risk
b Notes to the financial statements management by the board of directors.
c Governance repor1 v A report, prepared by a specialist accountant for the
d Auditor's report stakeholders stating the company's financial
performance and position are fairly stated.
e Venical analysis
vi A technique that calculates the change in an account
Horizontal analysis.
balance from one period to the next and expresses that
A technique that compares account balances within one change in both dollar and percentage terms.
year by stating each account balance as a percentage of
a base amount. REQUIRED
ii Textual and numerical information immediately following a Match each term with the appropriate definition.
the financial statement's disclosing information such as b Rewrite two of the definitions in your own words
accounting methods used, detail and explanation of explaining to a group of 16-year-old students what the
two terms mean. You may use examples.

19 Prepare a classified balance sheet

Bay Company thinks there may be a problem with its balance sheet:

Assets Uabilltles and shareholders' equity

Current assets Current liabilities

Buildings $70000 Accounts payable $16000
Interest revenue 11000 Interest expense 39000
Equipment 41000 Total current liabilities $ 55000
Cash 8000 Shareholders' equity
Other current assets 4000 Retained earnings $50000
Total current assets $134000 Contributed equity 35000
Accounts receivable $12000 Bonds payable 40000
Land 20000 Total shareholders' equity 125000
Interest payable 14000
Total non·current assets 46000
Total assets $180000 Total liabilities and shareholders' equity $180000

REQUIRED
Prepare a correctly classified balance sheet.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or In p~~~ ~-~~g~ statements
1 __
;;;.;...
37
 REQUIRED
20 Prepare a multi-step income statement
a Prepare a comparative, classified balance sheet for
The auditor for Chan Corporauon not1ced that 1ts 1ncome Lim Limited.
statement was incorrect b Perform horizontal and vert1cal analyses and Interpret
the results. Round percentages to one dec1mal point
Chan Corpol'lltion Income statement 30 June (e.g. 10.1%).
Sales S130!XXJ c Assume the same mformat1on above except that m
Cost of sales OO!XXJ 2021 , Bonds payable IS $0 while Reta•ned earn1ngs 1s
$271 295. Does this new mf()(matiOn change any
Accounts receivable 19500
interpretatJons previously made?

Gross profit 30500 22 Multi-step income statement and

Interest expense $15!XXJ classified balance sheet
Selling and adm1n1strauon expense 13!XXJ The folloWing items were taken from the fmanc1al
statements of Wells Company for 2018:
Dividends 1000
Total other expenses (29000) Accounts payable-- - - - - - - - - $15780

Interest revenue 16500 Accounts receivable 8470

Advertising expense
---------- 4200
Accounts payable
Income before taxes
4000 8500
10000 Cash ----------------- 16080

Income tax expense 112 850) Contributed equity 15400

Loss $ 1850) Cost of sales 41250

Dividends 2310
REQUIRED
Equipment. net 45420
Prepare a corrected multi-step income statement.
Income tax expense 3260
21 Prepare and analyse the balance sheet Insurance expense 4680
The followmg comparatiVe balance sheet 1tems are available Non<urrent liabilities 9920
from L1m Limited as of 30 June 2021: Prepaid insurance 5970
2021 2020 Retained earnings, 1 Jan 28450

Accounts payable s 75500 $ 35035 Salaries expense 17420

Accounts reoe1vable 50 (XX) 85065 Salaries payable 5210

Bonds payable. due 30106/2028 125!XXJ 25!XXJ Sales 78400

Buildings, net 240!XXJ 300!XXJ Electricity expense 4100

Contributed eqUity 100!XXJ OO!XXJ REQUIRED

Cash 15000 25635 Prepare a multi-step 1ncome statement for the year endmg
31 December 2018, and a class1fied balance sheet at
Equipment, net 24000 24!XXJ
31 December 2018. H1nt: you must calculate end1ng reta1ned
Income taxes payable 12250 16465 earnings.
Interest payable 13755 7550
Inventory 25650 27270 23 Prepare and analyse an income
statement
Land 300000 200000
The following income statement 1tems are available from
Long·term investments 125000 100000
Bugeja Li mited for the years ending 3 1 December:
Notes payable, due 31/12/2021 100000 100000
2019 2018
Supplies 12500 13500
Additional equity 200000 190000 Advertising expense $ 7765 $ 9789
- -- 4879 6010
Patents 6000 6000 Commissions expense
Prepaid rent 10150 12275 Cost of sales 48596 58896
----
Retained earnings
---
146295 306135 Income tax expense 2217 2684
-- 4897
Salaries payable 35500 33560 Insurance expense 5236
- --- Interest expense 2584 2695

3S ACCD Ftn~l112019 Cengajle L.umlng. AU Rights R--...d.!Uy not be copied. scanned, 0< ~iealed,ln wtto1o Otln part. WCN 02·200-202
_......;;.;;.
 Interest revenue REQUIRED
4287 4189
a Identify the company's current-year and prior-year
Sales 95950 106569 balances 1n total current assets; properly, plant and
Suppl1es expense 1654 2106 equipment; total current liabilities; Jnterest-beanng
Salaries expense 19320 21012 liabilities; and total shareholders' equ1ty. Conduct ven1cal
analys1s on each account balance. What broad trend
Rent expense 7634 7856 (1f any) 1s md1cated by the calculations? Round
percentages to one dec1mal pomt (e.g. 10.1%).
REQUIRED
b Identify the company's current-year and pnor-year total
a Prepare a comparatiVe, multi-step mcome statement for
operatJng revenue, gross profit, operaung profits and
Buge)<l.
total comprehensrve mcome for the period. Conduct
b Perfomn honzontal and veniCal analyses and Interpret honzontal analys1s on each account balance. What broad
the results. Round percentages to one dec1mal pomt trend (If any) IS md1cated by the calculations? Round
(e.g. 10.1%). percentages to one dec1mal point.
c Assume the follow1ng changes: Cost of sales m 2019, c Look up CSt:s share pnce. How has 11 changed over the
$62470 and 1n 2018. $45670. Does thiS new Information penod covered by the 1ncome statement? Calculate the
change previously made 1nterpretat1ons? percentage change in the share price. Of the change m
the four accounts 1n (b) above, wh1ch IS it closest to?
24 Using horizontal and vertical analyses
The pres1dent of Wakef1eld Investments is disappointed that 26 Research and analysis
the company was less profitable th1s year than last. Access the latest annual report for Cochlear by searching the
Comparative income statements for Wakefield are: internet for 'Cochlear limited annual repon'.

Current year Prior year REQUIRED

Sales $500000 a Conduct horizontal analysis of Cochlear's sales. gross

$800000
profit and total comprehensive mcome, and vert1cal
Cost of sales 300000 200000 analysis for the same accounts for both the current and
Gross profit 500000 300000 prior year. Round percentages to one decimal point
(e.g. 10.1 %). What conclusions can you draw about the
Operaung expenses 167000 130000
company's ability to earn a profit from its sales?
Profits after tax 333000 170000 b Conduct horizontal analysis of the company's inventory,
Gain on hedge transaction 0 180 000 total liabilities and total equ1ty for the current year and
(net of tax) venical analys1s for the same accounts for both the
Profit 333000 350000 current and pr1or year. Round percentages to one
dec1mal po1nt (e.g. 10.1%) . What conclus1ons can you
REQU IRED draw about the comparry's chang,ng bus1ness model?
Why was Wakefield's profit lower 1n the current year? Use c Look up Cochlear's share priCe. How has 1t changed over
horizontal and ven1cal analyses to show the ways 1n which the period ccrvered by the 1ncome statement? Calculate
Wakefield was more profitable 1n the current year. Round the percentage change 1n the share priCe. Of the change
percentages to one dec1mal pomt (e.g. 10.1 %). in the three accounts m (a) above, wh1ch IS 11 closest to?

25 Reading and analysing financial

statements
Access the latest copy of CSt:s Annual Report by searching
the internet for 'CSL Annual Report' (the annual report is
released 1n September or October each year).

Copyright 2011 c.ng.g. Laamlng. AI Rights R--.llay not be coped, scannod, or dUI>IIcMocl, ln whole"' CAA~~ z f,.....,~ statements l~_ __
;:
9

After studying the material in this chapter, you
should be able to:
Describe the purpose of an accounting
information system.
Analyse the effect of accounting
transactions on the accounting equation.
Understand how T-accounts and debits and
credits are used in a dual-entry
accounting system.
Explain the purpose of the journal, ledger
and tria l balance.
Record and post accounting transactions,
prepare a trial balance, i ncome statement,
the changes in equity and balance sheet.
apply this-·· · ·-·
Copyrlght2019 Cengage Loa nlng A R ght Rnervecl May not
40
The first two chapters of th is book focused on how
economic information Is communicated to users through
financial statements, including:
balance sheets (statement of financial position )
income statements (statement of comprehensi ve
income)
statements of changes in equity
cash flow statements.
This chapter and Chapter 4 focus on how the activities
of a business are captured by the accounting system so
that these financial statements can be prepared. More
specifically, they describe the accounting cycle. Because
financial statements must be prepared periodically, the
process of captur ing and reporti ng information i s a
repetitive process, or cycle. This chapter explores the f1rst
three steps in the accounti ng cycle. The next chapter
explores the remaming steps.
LOl THE ACCOUNTING
INFORMATION SYSTEM
An organisation's a c count in g accounting
informatio n system IS the system that information
system The system
identifies, records, summarises and
tllat identifies. reoords.
communicates the vanous transactions smvnanses and
of a business entity. Accounting aliMUliCates the vanous
tra~SaetJOilS of a business
information systems vary widely.
rangi ng from manual, pencil-and-paper systems in
some micro businesses to highly complex electronic
systems in other organisa tions. However different
their forms. all accounting systems are built to capture
and report the effects of a business' accounting
transactions.
An accou n tin g tran saction is any accounting
economic event that affects a business' transaction Arrt
ecommiC event that
assets. liabilities or equ1ty at the time of affects a business· assets.
the event. Examples include the liabohbes 2M/Of equ•ty at
the bme of the event
purchase of eqUipment. the consumption
of supplies in operations and the issuance of debt or
shares. In each example. the event increases or decreases
a specific asset, liability and/or equity account of the
business. Accounting transactions between a business
and an external party (for example, an equipment purchase
or the issuance of shares) are external transactions. while
transactions w ithin a business (the consumption of
supplies) are mtemaltransactions.
To record accounting transactions
and summa r ise the resulting
account AA acmoot1ng
record tllat ac:cunulates
information. compan1es use accounts. the actMty of a specafic
Item and Yields the Item's
An ac co unt is an accounting record bal<n:e
copied. scanned, or dupllcotod, In whole or In part, WCN 02·200-202
 t hat acc umulates the activity of a speci fic item and
yields the item's balan ce. For example, a b usiness' cash
account is increased and decreased as cash is received
an d paid, and it shows the amount o f cash held at any
point in time. The various accounts that a business uses
to capture it s b usiness activities are o ften
chart of list ed in a c h a rt o f acc o u n ts.
accounts The list of
accounts that a business An e x amp l e, co m p l e t e wi t h
uses to capture its numerical references for ea ch accou nt, is
business activities.
found in Exhi bit 3.1.
Charts o f accounts will vary across
b usinesses. For examp le, a bank will have accou nts
relating to customer d eposi ts, while a biotech company
like CSL w ill have accoun ts relating to research and
develop ment. Of course. there cert ainly w ill be many
commonalities across chart s of accounts, f or example,
p racti cally every business w ill have an account f or
cash, b ut there will be differen ces depending on the
bu siness' activities. As a result, you can tell a lot about
• what a b usiness does if
~ Checkoutthevideosummary y ou h ave its ch art o f
for Chapter 3
accounts .

10Q-199 ASSETS
100 Cash
101 Accounts Receivable
110 Supplies
- ..- ···-··- ···-··- ···-··- ···-··- ···-··- ···-··- ··- ··- ···-···-···-···-···-···-···-···-···-··- ··- ··- ··- ··- ··-···-···-···-···
120 Equipment
- ...-···-···-···-··- ···-··- ···-··- ···-··- ···-··- ···-··- ··..-···-···-···-···-···-···-···-···-··- ··- ··- ··- ··- ··-···-···-···-···
20Q-299 LIABILITIES
210 Accounts Payable
211 Unearned Revenues
-··- ···-··- ···-··- ···-··- ···-···-···-···-···-··- ···-··- ·.. -··- ··-···-···-···-···-···-···-··- ..- ..- ··- ··- ··- ··- ··-···-···
_,,.............................2.~.0.................................. ~.....~O.':e..~.~a.~~?,l~. . . . . . . . -.. . . . . . . . . . . . .
30Q-399 EQUITY

350 Retained Earnings

40Q-499 REVENUES
400 Service Revenue
410 Sales Revenue
- ···-···-···-···-··- ···-··- ···-··- ··- ··- ··- ··- ··- ..- ···-···-···-···-···-···-···-···-···-··- ··- ··- ··- ··- ··- ··-···-···-···
50Q-599 EXPENSES
501 Administrative Expense
- ...-···-···-···-···-···-··- ···-··- ···-··- ···-··- ···-··- ···-···-···-···-···-···-···-···-···-··- ··- ··- ··- ··- ··-···-···-···-···
502 Advertising E.xpense
Account
Account description
60Q-699 DIVIDENDS number
906420 COHTLE Library Collection
···- ··- ··- ··- ··- ···-··- ···-··-···-···-···-···-··- ··- ··- ··- ··-···-···-···-···-···-..·-···-···-···-··- ···-··- ··- ··-···
~ An example of a chart of accounts 906500 COHTLE Library
906610 COHWPS Widening Participation Funding
··- ··- ··- ··- ··- ···-···-···-··-···-···-···-···-··- ··- ··- ··-···-···-···-···-···-···-···-···-···-···-··- ···-··- ··- ··-···
906620 COHWPS Partnership Funding
···- ··- ··- ··- ··- ···-···-···-··-···-···-···-···-··- ··- ··- ··-···-···-···-···-···-···-···-···-···-···-··- ···-··- ··-···- ··
906630 COHWPS Bridges to Higher Education
··- ··- ··- ··- ··- ···-··- ···-··-··- ···-··- ···-··- ··- ··- ··-···- ··-···-···-···-···-···-···-··- ···-··- ··- ··- ··- ··- ··
906640 COHWPS Additional Partnership Funding
···- ··- ··- ··- ··- ···-···-···-··-···-···-···-···-··- ··- ··- ··-···-···-···-···-···-···-···-···-···-···-··- ··- ··- ··- ··- ··
907010 COHRES- COH- CSU Managed

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..;...;...
41
 account; for the equation to stay in balance, the transaction

Look at CSL's balance sheet in

CS[ ANALYSIS must also e ither decrease another asset account, or
increase a liability or equity account. This means that every
Append1x B and determine how many accounts it uses to
report its assets, liabilities and equity. Also, consider the account ing transaction must affect at least two accounts.
scenario when one shareholder of CSL sells het shares to For every transaction there is a sou rce and dual nature of
another shareholder. Is this an economic event relating to a use. Money comes from somewhere accounting Every
CSL? Is it an accounting transaction? accoonting transaction
and it goes somewhere. This is known as must affect at least two
the dual nat ure of accounting. accoonts.

TRANSACTION ANALYSIS
To illustrate how accounting transactions affect the
accounting equation, consider the following 10 transactions
in t he f irst month of operations of Video Memories, a
business that documents graduations, weddings, birthdays
and other significant life events. Although the example is a
small hypot hetical business, the transactions wou ld be
treated in the same way by a large company. We start by
recording the transactions in a spreadsheet and later in the
chapter use the more ~·\111q
formal accounti ng Check outthe animated summary •
~ ACCOUNTI NG journal and ledger.
on Tmnsaction Analysis

'iliJ TRANSACTIONS AND THE

ACCOUNTI NG EQUATION
All accounting transactions must be recorded in the
accounting information system. To understand the nature
of recording transactions, it is best to start with the
fundamental accounting equation:
Assets= liabilities+ Equity

The equation states that a business entity's assets

must always equal the sum of its liabilities and equ ity. This
means that any change to one part of t he equation must
be accompanied by a second change to another part. For
example, suppose that a t ransaction increases an asset V1deoin2 a customer's weddin2

Assets = liabilities + Equity

Cash = + Contributed Equity
Prior bal. $ 0 s 0
#1 + $15000 + $15000
New bal. $15500 $15000
$15000 = $0 + $15500

~ TransactiOn summary forV1deo Memones (Contmued)

__
.;.;;
42
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 Transaction 12

+
Cash Suppl ies Equipment + Contributed Equity
Prior bal. $15000 $ 0 $ 0 $15000
#2 -$10000 + $1000 + $ 9000
New bal. $ 5000 $1000 $ 9000 $15000
$15000 s0 + $15000

Transaction 13
Video Memories receives a $1500 payment immeaiately after viaeoing a customer's weaaing. Since Video Memories is
receiving cash, assets increase. But unlike the previous transaction in which assets were exchanged, the increase in
assets in this transaction results from videoing the wedding. Recall from Chapter 1 that an inflow of assets from
providing a service is a revenue. Revenues increase profits and therefore retained earnings. As a result, Video
Memories' equity increases. At this stage we record the revenue as an increase in retained earnings, fo~ simJ>Iicity and
to emrhasise that revenues increase the value of the business to tlie owner.

Assets liabilities + Equ ity

Cash Supplies Equipment + Contributed Equity Retained Earnings
Prior bal. $5000 $1000 $9000 $15000 s 0
#3 + $1500 + $1500
New bal. $6500 $1000 $9000 $15000 $1500
$16500 $0 + $16500

Assets liabilities + Equity

Cash Supplies Equipment Unearned Revenue + Contributed Equity Retained Earnings
Prior bal. $6500 $1000 $9000 s 0 $15000 $1500
#4 + $2000 +$2000
New bal. $8500 $1000 $9000 $2000 $15000 $1500
$18500 $2000 + $16500

Transaction 15
Viaeo Memories paid $250 casn to nave tne ousiness appear on Google Maps for tne montn. Because Video Memories
paid cash, assets decrease. The decrease in assets results from advertising its business. Recall from Chapter 1 that a
decrease in resource (in this case an asset) from operating a business is an expense. ExP.enses decrease rrofits and
therefore retained earnings. As a result, Video Memories' equity decreases. At this stage we record ttie exrense as a
decrease in retained earnings, for simP.Iici):y and to emrhas1se that exP.enses decrease the value of the business to tlie

rn:J Transact1on summary for V1deo Memones I Contmued)

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43
 Assets = Liabilit ies + Equ ity
Unearned
Cash Supplies Equipment = + Contributed Equity Retained Earnings
Revenue
Prior bal. $8500 $1000 $9000 $2000 $15000 $1500
15 -S 250 -S 250
New bal. $8250 $1000 $9000 $2000 $15000 $1250
$18250 = $2000 + $16250

Transaction 16

+
Accounts Unearned Contributed Retained
Cash Supplies Equipment +
Receivable Revenue Equity Earnings
Prior bal. $8250 $ 0 $1000 $9000 $2000 $15000 $1250
#6 + $3500 +S3500
New bal. $8250 $3500 $1000 $9000 $2000 $15000 $4750
$21750 $2000 + $19750

Assets Liabilities + Equ ity

Accounts Unearned Notes Contributed Retained
Cash Supplies Equipment +
Receivable Revenue Payable Equity Earnings
Prior bal. $8250 $3500 $1000 $9000 $2000 so $15000 $4750
17 + $9000 ~
New bal. $8250 $3500 $1000 $18000 $2000 $9000 $15000 $4750
$30750 $11000 + $19750

Viaeo Memories receives $3500 from tl"ie customer in payment of tlie invoice from Transaction #6. In this trans
Video Memories exchanges one asset for another. It receives cash in satisfaction of the receivable that was ere
when the service was performed. As a result, cash increases while receivables decrease. irhere is no change in t
assets and this is not the earning of revenue (the revenue was earned in irransaction #6).

Assets = Liabilities + Equ ity

Accounts Unearned Notes Contributed Retained
Cash Supplies Equipment = +
Receivable Revenue Payable Equity Earnings
Prior bal. $8250 $3500 $1000 $18000 $2000 $9000 $15000 $4750
#8 + $3500 -$3500
New bal. $11750 $0 $1000 $18000 $2000 $9000 $15000 $4750
$30750 = $11000 + $19750

~ Transact1on summary forV1deo Memones (Contmued)

__
.;.;.
44
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 Transaction 19

+
Accounts Unearned Notes Contributed Retained
Cash Supplies Equipment +
Receivable Revenue Payable Equity Earnings
Prior bal. $11750 $0 $1000 $18000 $2000 $9000 $15000 $4750
#9 ;,llQQQ -$2000
New bal. $ 9750 $0 $1000 $18000 $2000 $9000 $15000 $2750
$28750 $11000 + $17750

Transaction 110

liabilities + Equity
Accounts Unearned Notes Contributed Retained
Cash Receivable Supplies Equipment +
Revenue Payable Equity Earnings
Prior bal. $9 750 $0 $1000 $18000 $2000 $9000 $15000 $2750
#1 0 ;;.1!,§QQ -$1500
New bal. $8 250 $0 $1000 $18000 $2000 $9000 $15000 $1250
------ ------ -$-27-2-50- -
$11000 + $16250

SUMMARY OF TRANSACTIONS
Tlie 10 transactions of Video Memories are summarisea
in . The business entity started the month witli
nothing out an idea ana enaea the month with $27 250 in
assets, $11 000 in liabilities and $16250 in equity. As you
review the exhibit, note that changes to the left side of
the equation equal the changes to the right side of ttie
equation for all transactions. As a result, the accounting
e~uation was always in balance. Note also that eve!)'

Assets = liabilities + Equity

Accounts Unearned Notes Contributed Retained
Cash Supplies Equipment = +
Receivable Revenue Payable Equity Earnings
#1 +S15000 = + +$15000
#2 -10000 +$1 000 +$9000 = +
#3 +1500 = + +$1500
#4 +2000 = +S2000 +
#5 -250 = + -250
#6 +3500 = + +3500
#7 +9000 = +9000 +
#8 +3500 -3500 = +
#9 -2000 = + -2000
#10 -1500 = + -1500
s 8250 $0 $1000 $18000 = $2000 $9000 + $15000 $1250
$27250 = $11000 + $16250

~ Transact1on summary forV1deo Memones

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45
 Asset: Cash
THE DUAL-ENTRY
15000
ACCOUNTING SYSTEM
10000
While the preceding analysis IS an excellent way to 1500
understand and v1suahse the effect of accounting 2000
transactions, accounting Information systems do not record 250
transactions us1ng pluses and m inuses in a spreadsheet 3500
format, because although it is accurate, it is very
2000
cumbersome . Instead a d ual-e ntry
dual-entry 1500
accounti n g syst em is used, which
accounting 8250
system Asystemof traces 1ts orig1ns bad< to a mathematical
iiCCWlting in v.fuch every treatise wntten in the 15th century by a
iiCCWlting transacbon The areas between the horizontal lines contain the
affects at least two Franciscan monk, Luca Pacioli. The dual-
activity in each account, w ith the account balance below.
iiCCWlts. entry system is based on the dual nature
The asset account has four debit entries totalling $22 DOD
of accounting demonstrated in the
and four credit entries totalling $13 750, leaving a debit
preceding transaction analyses. That is, every accounting
balance of $8250.
transaction affects at least two accounts, so accounting
It is no coincidence that in this example the asset
systems record those transactions with a 'dual' or 'double'
account has a debit balance. In a dual-entry system, asset
entry. The following sections explain the mechanics of t his
accounts should normally have debit balances while liability
dual-entry system, starting with the T-account.
and equity accounts should normally have credit balances.
Such 'normal' balances mirror the accounting equation,
THE T-ACCOUNT where assets are on the left side of the equal sign, and
All accounts can be characterised or represented in the liabilities and equity are on the right side.
following form known as aT-account due to its resemblance
Nonnal account balances
to an upper-{;ase letter T.
Asset Liability Equit y
Account name accou nts accounts accounts
Oeb1t s1de Cred1ts1de
Normal I Normal Normal

The name of the account IS listed at the top with two

columns appearing below. The left column is the debit side
while the right column is the credit side.
debit A use of fmds. The word debit comes from the Latin
racooled on the left-hand word debitum, meanmg 'what is due', and
side of a T-aa:ounl
credit comes from creditum, something
credit A source of
hnls. I13COided on the entrusted to another or a loan. Recall that
ri!#Jt-hand side of a a list of all the d1fferent asset, liability and
T-accounl
equ1ty accounts is called a chart of
accounts.
T-accounts work as follows. When a transaction affects
an account balance, the amount of the transaction is
entered on the account's debit side or credit side, depending
on the transaction. You will see how transactions are
recorded shortly. Once all entries are made. the balance in
an account is determined by separately adding up all debits
and all credits and subtracting the smaller total from the
larger, leaving the difference as the account balance on the
side that is larger. The fol lowing example illustrates this
process:
balance balance I balance
Accounting equation
Assets ; liab1l1ues + Equity
This arrangement of normal balances IS the key to how
a dual-entry system works.To keep the accounting equat1on
balanced. a dual-entry system must keep deb1t balances
equal to credit balances. This means that every accounting
transaction must be recorded with equal changes to debit
and credit balances. That, again, is why the system is 'dual-
entry'. How debits and credits are used to change account
balances is discussed next.
DEBIT AND CREDIT RULES
In a dual-entry system, changes in account balances are
recorded according to the following basic rules:
e To increase an account balance: record the transaction
on the same side as the normal balance.
e To decrease an account balance: record the transaction
on the opposite side of the normal balance.

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46
--~
 These t\1110 rules seem simple enough, but the1r application Accounts Payable
can be confusing at first because different accounts have
850 2500
different normal balances. The follcNving sectiOilS demonstrate
I 150
how these rules are applied to asset, liability and equity
1800
accounts. Also demonstrated is how these rules are applied
to the three types of accounts that affect equ1ty: revenues, To illustrate an equity account. suppose that a company
expenses and dividends (drawings). Once you have mastered has $34 000 of contributed equity. The company then
the mechanics of these six types of accounts. you should be issues additional shares for $10000 and later buys back
able to record any accounting transaction correctly. $6000 of shares. The original $34000 balance appears on
the credit side of the Contributed Equity T-account.
Asset accounts
Since the Contributed Equity account has a normal credit
Asset accounts have normal debit balances. Therefore,
balance, the $10 000 increase is recorded on the cred1t side
increases to assets are recorded on the debit side while
while the $6000 decrease is recorded on the opposite or
decreases are recorded on the credit s1de.
debit side of the account. Netting the debit and cred1t sides
Asset acc:ounts gives a cred1t balance of $38000.
Record increases Record deaeases Contributed Equity
on debit side on cred1t s1de
6000 34000
Balance
10000
To illustrate, suppose that a business starts the day with
$5000 in cash. receives $300 from a customer and pays
I 38000

$250 to a supplier. The beginning balance of $5000 is Revenue accounts

recorded on the debit side of the cash T-account. The
increase of $300 is also recorded on the debit side. but the
$250 decrease in cash is recorded on the side opposite of
the normal balance- the credit side. Netting the debit and
credrt sides gives a debit balance of $5050. (Remember, if
vve were recording these transactions there would be a
corresponding $300 credit to revenue and a $250 debit to
accounts payable.)
Cash
5000 250
300
5050
Lability and equity accoun s additional $13000 1n revenue. Since the Service Revenue
Lrability and equity accounts have normal credrt balances.
Therefore. increases are recorded on the cred1t side, while
decreases are recorded on the debit s1de.
When a business earns revenue, it is increasing its equity.
As demonstrated previously, increasing an equity account
requires a cred1t entry. Therefore, revenue accounts are set
up so that they also are increased with a credit entry. That
is. revenue accounts have normal credit balances and are
increased w 1th cred1t entries and decreased w 1th deb1t
entries.
Revenue Accounts
Record decreases Record increases
on debit side on credit side
Balance
To illustrate, suppose that a business has $115000 in
existing service revenue. The business then earns an
account has a normal credit balance. both the existing
$115000 balance and the $13000 increase are shown on
the credit side, resulting in a balance of $128000.

Uability and Equity Accounts Service Revenue

Record decreases Record Increases
on debit side on credit side
Balance
To illustrate a liability account, suppose that a business
owes $2500 to a supplier. then buys an additional $150 of
inventory on account and then pays $850 of its obligation.
The beginning balance of $2500 is recorded on the credit
s1de of the accounts payable T-account. The additional
payable of $150 is also recorded on the credit side. In
contrast. the $850 payment. which is a reduction to the
payable. is recorded on the debit side. Netting the debit
and credit sides yields a credit balance of $1800.
115000
13000
128000
Expense and dividend accounts
When a bus1ness incurs expenses or pays d ividends. it is
decreasi ng 1ts equ ity. As demonstrated prev1ously,
decreasing equrty requires a debit entry. Therefore. for
expense and dMdend acoounts to effectively reduce equrty,
they have normal debit balances. Expense and drvidend
accounts are therefore increased with debit entrres and
decreased w1th credit entries. Although expenses and

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47
 dividends both reduce equity they are very different:
expenses reduce profrts while dividends are voluntary
distributions out of retained earnings.
Expense and dividend accounts
accounting transactions are first recorded in a journal. Once
recorded. the information is transferred or posted to a
ledger. Information in the ledger is then summarised in a
worksheet known as a trial balance. Financial statements
are then prepared from the information in the trial balance.

debit side fI
Record mcreases on Record decreases on
cred1t side
Balance
To illustrate an expense. suppose that a business has
$66000 in salaries expense when it incurs an additional
$6000 in salaries expense. Since the Salaries Expense
account has a normal debit balance. both the $66000 in
existing expense and the $6000 1ncrease should be recorded
on the debit side of the account. giving a balance of $72 000.
Salaries Expense
THE JOURNAL
A journa l is a chronological (in t1me order) joumal Achronolog.:al
record of transactions. Entnes recorded record of transactims.
in the journal are called journal entries. A
business can have various types of JOurnals in wh1ch 1t
records transactions. but since the mechaniCS of all Journals
are the same. we will focus on the most basic of journals.
t he general journal. The general journal and an example
journal entry take the form shown in Exhi bit 3.4.

66000
6000
Account and
72000 Date explanation Debit Credit
Date of transaction Account(s) debited Amount
SUMMARY OF DEBIT AND CREDIT RULES Account(s) credited Amount
You have now seen each major type of account and how the (Explanation of
debit and credit columns are used to increase or decrease transaction)
those accounts. For asset, expense and dividend accounts. ~ General journal form
increases are recorded in the debit column and decreases
are recorded in the cred1t column. For liability, equity and
revenue accounts. increases are recorded in the credit At the far left of the journal is a column for the transaction
column and decreases are recorded in the debit column. A date. To the right of the date IS a column to record the
summary of these rules IS presented in Exhibit 3 .3. names of the accounts affected by the transaction and an
explanation. The account{s) recerv1ng deb1t entnes are listed
Type of Normal Increase Decrease first. followed by the account{s) receiving cred1t entries.
account balance w ith a with a which are slightly indented. To the right of the account
Asset Deblt Debn Credit names are debit and credit columns to record the monetary
l iability Cred1t Credit Debit amounts of the transaction. As explained prev1ously, the
Equity Cred1t Credit Debit totals in the debit and credit columns should be the same
Revenue Cred1t Cred1t Debit for each transaction. When an accounting transaction is
Expense Deb1t recorded in the general journal, we often say that the
Deb1t Credit
transaction has been JOUrnaltsed.
Dividend Deb1t Debit Credit
The general journal is useful 1n that it contains in one
~ Summary of debit and cred1t rules place a record in time order of all the accounting transactions
of a business. However. the general journal is not very
~1\1 11q. useful if a business is t rying to determine the balance in a
• Review this content with thee-lecture particular account. To get an account balance. one would
have to find all journal entries affecting that account and
then calculate a balance. To avoid such a time-consuming

~ RECORDING
task. t he information recorded in the general journal is
transferred {posted) to a ledger.
'iii' TRANSACTIONS IN THE
ACCOUNTING SYSTEM THE LEDGER
A ledge r is a collection of accounts and ledger Acollection of
This section examines the actual process of recording their balances. While most businesses accounts and lhe1r
accounting transactions rn a dual-entry system. Accounting balances
have various types of ledgers conta1n1ng

__ .;.;;.
48
transactions are not recorded d11ectly in "J:.accounts. Instead,

ACCT3 Fll'lf::lilf'- • N -
R
different accounts. we w1ll focus on the

.JS R_.,..._ May no< be copMd scanned. or dUI>l~Cao • "' ,. 1)0.202

 most basic type of ledger. the general/edger. The general
ledger is nothing more than a collection of all the T-accounts
for a busmess. which means that the general ledger
contams both the activity and balances of all the business'
accounts.
Account balances in the general ledger are updated as
follows. When an accounting transaction is recorded in the
general journal, the amounts recorded in the debit and
credit columns are transferred to th e debit and credit
columns of the respective T-accounts in the ledger. This
process of copying or transferring the information from the
journal to the ledger is called posting and results in up-to-
date account balances.

THE TRIAL BALANCE

After accounting transactions are recorded 1n the journal
and posted to t he ledger, compan1es prepare a
tri al bal ance. which is a listing of all the
trial balance A hstmg
of accounts and the1r accounts and their balances at a specific
balances at a specific point in time. In a trial balance. all accounts
point in time.
in the ledger are listed in a column on the
left. Asset accounts are usually listed first. followed by
liability accounts, equity account s and then revenue,
A trial balance serves several f unctions. First. it proves
expense and dividend accounts. Each account's balance
that total debit balances equal total credit balances. If they
from the ledger is listed in the appropnate debit or credit
are unequal, then the accounting equation is out of balance
column. At the bottom of each column, a total 1s calculated.
and a correCtion is needed. Second. it summanses m one
The deb1t and credit totals should be the same. A trial
place all accounts of an entity and their respective balances.
balance IS shown in Exhibit 3.5.
Financial statements are then prepared from those
balances. Finally, a trial balance may be helpful in making
• . llffil any necessary adjustments to account balances at the end
of an accounting period. We wil l see this function in
Debit Credit Chapter 4.
Asset account(s) Amount
Ltabthty accoun~s) Amount
MAKING IT REAL
Equtty acoount(s) Amount
Revenue account(s) Amount ACCOUNnNG IN THE CLOUD
Expense acooun~s) Amount
Dividends Amount
---
Totals Total debits Total credits
~ Tnal balance form

CSL ANALYSIS

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~--
 STEP 3 Record the journal entry
Overall, such computerised systems are a great tool
for businesses because they help ensure that tho #1 Cash 15!XXJ
ccounting information is captured and
Conlnbuted Equ1ty 15!XXJ
ommunicated effectively and efficiently, and with the ---------- ~-------------------
{Owners 1nvest cash '" business)
loud available on any device anywhere.
Assets Liabilities EqUity
+15000
- - - - +- +15000
Download the Enrichment Modules for further practice
STEP 4 Post the information to the ledger

Cash Cont ributed Equity

15(XXJ

Transactton i2
The followmg section uses the Video Memories Video Memones buys a $9000 camera and $1000 of
transactions record ed earlier in the spreadsheet to supplies with $10000 cash.
demonstrate how to record transactions in the journal, STEP 1 What accounts are affected and how?
post information to the ledger, prepare a trial balance and Video Memories receives equipment and supplies, so both
prepare financial statements. We w ill now assume the the Equipment and the Supplies accounts increase. Cash
business entity is a company and will record the revenues. is paid, so cash decreases.
expenses and dividends rather tha n simply changes in STEP 2 What debit and credit entries are required?
reta1ned earnings. Equipment and supplies are assets. so the Equipment and
Supplies accounts are debited to increase them. Cash IS
RECORDING TRANSACTIONS IN THE JOURNAL also an asset. so the Cash account is credited to decrease it.
AND POSTING TO THE LEDGER STEP 3 Record the journal entry
Video Mem ories entered into 10 transactions. A four-step
process w ill be used to demonstrate how to properly #2 Equ1pment 9!XXJ
record each transaction and post it to the ledger. First, the Supplies 1000
accounts affect ed by the transaction w ill be identified. Cash 10000
Second, the relevan t debit/credit ru les for those accounts ----
{Purchase cameras and suppl ies)
w ill be identified. Third. the transaction w ill be recorded
Assets Liabilities + Equ1ty
in the journal. Fourth. the transaction will be posted to the
ledger. Th is four-step process can be followed when +9000
recording and posting any accounting transactiOn. t1 000
-10000
TransaClion #1
Video Memories issued shares for $15000.
STEP 4 Post the information to the ledger
STEP 1 What accounts are affected and how?
Video Memories receives ca sh, so the Cash account Cash Supplies Equipment
increases. Shares are issued, so the Contributed Equity 15 000 .!QQQQ 1000
9000 I
account also increases. 5000 10001 9000
STEP 2 What debit and credit entries are required?
Cash is an asset, so the Cash account needs to be debited Transaction #3
to increase it. Contributed equity is an equity account, so
Video Memories videos a wedding, for which it receives
the Contributed Equity account need to be credited to $1500 cash.
increase 1t.
STEP 1 What accounts are affected and how?
Cash has been received, so the Cash account increases.
The increase in cash has resulted from a service be1ng
provided, so the Serv1ce Revenue account increases.

_
___;;.;,
50
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STEP 2 What debit and credit entries are required? Transactio #5
Cash is an asset. so the Cash account needs to be debited Video Memories pays $250 cash for advertising.
to mcrease it. Revenues increase equity, so the Service
STEP 1 What accounts are affected and how?
Revenue account needs to be credtted to mcrease it.
Cash is paid. so the Cash account decreases. The decrease
STEP 3 Record the journal entry
in cash results from Video Memories advertising its serv1ce.
#3 Cash 15000 so Advertising Expense increases.
Service Revenue 15000 STEP 2 What debit and credit entries are requ ired?
(Provide service to customer) Cash is an asset, so the Cash account needs to be credited
Assets
+15000
LiabilitieS ____
+ Equity
___:_...:.

+15000
to decrease it. Expenses decrease equity, so debit the
Advertising Expense account to increase it.
STEP 3 Record the journal entry

STEP 4 Post the information to the ledger 115 Advert1s1ng Expense 250
Service Revenue Cash 250
Cash
10000 (Pa1d for advertising)
15000

---=~=t--
Liabilities EqUity
- - - -Assets
-250
+
-250
1500

STEP 4 Post the information to the ledger

Transaction 114
Video Memories receives $2000 to video a reception at a Cash Advertising Expense
future date. 15000 10000 250 1
STEP 1 What accounts are affected and how? 1500 250
We receive cash. so the Cash account 1ncreases. Because
Video Memories has not yet performed the required
2000
8250 250
I
serv1ce, there is a new liability to the customer called
Unearned revenue.
Transaction #6
STEP 2 What debit and credit entries are required?
Video Memories videos an event for $3500 and leaves an
Cash is an asset. so debit the Cash account to increase it.
invoice with the customer.
Unearned revenue is a liability, so credit the Unearned
Revenue account to increase it. STEP 1 What accounts are affected and how?
Video Memories performed a service for a customer, so
STEP 3 Record the journal entry
its Service Revenue account increases. Payment has not
#4 Cash 2000 been received from the customer. but they have promised
----------------~~--- to pay, so the Accounts Receivable account also increases.
Unearned Revenue 2000
(Cash received in advance of pr0V1d1ng STEP 2 What debit and credit entries are required?
service to customer) Accounts receivable IS an asset. so the Accounts Recetvable
Assets uabiht18S + E~1ty account needs to be debited to increase it. Revenues
+2000 +2000 increase equity, so the Service Revenue account needs to
be credited to increase it.
STEP 4 Post the information to the ledger STEP 3 Record the journal entry

Cash Unearned Revenue #6 Accounts Receivable 3500

15000 10000 2000 Service Revenue 3500
1500 (Provide servioe to customer

2000
8500
I 2000
on account)
Assets Liabilities + EQUity
+3500 +3500

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ecot •ng acc:ount•ng transacttOns 51;..__ _
;.
 STEP 4 Post the information to the ledger STEP 3 Record the journal entry

Accounts Receivable Service Revenu e #8 Cash 3500

1500 Accounts Receivable 3500
, .. I 3500 (Receive payment from customer)
3500 5000 Assets liabilities + Equity
-3500 +3500
Transaction #7
Video Memories buys another camera by signing a $9000 STEP 4 Post the information to the ledger
note payable.
Cash Accounts Receivable
STEP 1 What accounts are affected and how? 15000 10000 3500 3500
The camera has been received, so the Equipment account
1500 250
increases. A note has been signed for payment, so the
2000
Notes Payable account increases.
3500
STEP 2 What debit and credit entries are required?
11750 0
Equipment is an asset, so the Equipment account needs
to be debited to increase it. Notes payable is a liability,
so the Notes Payable account needs to be cred ited to Transaction #9
increase it. Video Memories pays $2000 in salaries to an employee.
STEP 3 Record the journal entry STEP 1 What accounts are affected and how?
Cash is paid, so the Cash account decreases. This reduction
#7 Equipment 9000
in cash results from salaries paid to employees. so the
Notes Payable 9000 Salaries Expense account increases.
(Purchase of a video camera
with a note payable) STEP 2 What debit and credit entries are required?
Cash is an asset, so the Cash account needs to be credited
Assets liabilities + Equity
to decrease it. Expenses decrease equity, so the Salaries
+9000 +9000
Expense account needs to be debited to increase it.
STEP 3 Record the journal entry
STEP 4 Post the information to the ledger
#9 Salaries E;qlense 2000
Equipment Notes Payable
Cash 2000
9000 9000
(Pay salaries to employees)
9000
Assets liabilities + Equity
18000 9000
- 2000 - 2000

Transaction #8
STEP 4 Post the information to the ledger
Video Memories rece ives $3500 from a customer in
payment of services provided in Transaction #6. (This is the Cash Salaries Expense
exchange of one asset for another. not the earning of 15000 10000
revenue: the revenue was earned in Transaction #6.) 1500 250
STEP 1 What accounts are affected and how? 2000 2000
Cash has been received, so the Cash account increases. A 3500
receivable has been collected from a customer. so the
9750 2000
Accounts Receivable account decreases.
STEP 2 What debit and credit entries are required?
Transaction #10
Cash is an asset. so the Cash account is debited to increase
Video Memories pays $1500 in d ividends to the owners.
it. Accounts receivable is also an asset account. so the
Accounts Receivable account is credited to decrease it. STEP 1 What accounts are affected and how?
Cash is paid, so the Cash account decreases. The cash
payment is a distribution of company assets to the owners,
so the Dividends account increases.

_ 52
__,;;.;;
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STEP 2 What debit and credit entries are requ ired? I 8 Cash 3500
Cash is an asset. so the Cash account needs to be credit ed Accounts Receivable 3500
to decrease it. Dividends decrease equity, so the Dividends I 9 Salanes Expense 2000
account needs to be debited to increase it (or simply, if you Cash 2000
debit Cash the other account must be credited). #10 D1vidends 1500
STEP 3 Record the journal entry Cash 1500
•10 Dividends 1500
-Cash- - --- 1500 Let's assume May was the first month o f operation.
(Pay dividends to owners)
Assets liabihlles + Equity General ledger

- 1500 -1500 Accounts

Cash Receivable Supplies
15000 10000

-i= ==F
STEP4 Post the information to the ledger
1500 250
Cash Dividends 2000 2000
15000 10000 1500 3500 1500

·~l
250 8250
2000 2000
3500 1500 Unearned
8250
- -- 1500 Equipment Revenue Notes Payable
9000
9000
18000

Contributed
Equity
+-Service
Revenue
2000

2000

Adverti sing
Expense
0

Hoi alllranucloons onvolve cash

Summary
---+-: Salaries
Expense
000

Dividends
1500
3500
5000
250

250 I
After recording and posting the 10transactions,VIdeo Memories'
complete journal and ledger would appear as follows: 2000
2000
I 1500
1500 1

~nucdon ~l
Gb.I§i.l\l.ii!;.f.D
Aooount Debit Video Memories
I 1 Cash 15000
Contributed Equity 15000
Debit Credit
I 2 Equ1pment 9000
Cash $8250
Supplies 1000
Supplies 1000
Cash 10000
Cash Equipment 18000
I 3 1500
Service Revenue 1500 Unearned Revenue $2000
I 4 Cash 2000 Notes Payable 9000
Unearned Revenue 2000 Contributed Equity 15000
I 5 Advertising Expense 250 Service Revenue 5000
Cash 250 Advertising Expense 250
I 6 Accounts Receivable 3500
Salaries Expense 2000
Serv1ce Revenue 3500
Dividends 1500
I 7 Equipment 9000
Notes Payable 9000 Total $31000 $31000

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c71Am:'li 3 Recor~~~ :!.:~~~ traMactions 53
 PREPARING A TRIAL BALANCE With net prof1t calculated, Video Memories' retained
earnings section of the statement of changes in eqUity
Once all transactions are recorded in the journal and posted
can be prepared. Reca ll from Chapter 1 that the
to the ledger. a trial balance can be prepared. Recall that a
statement takes the beginning balance in retai ned
trial balance IS a listing of all accounts and the1r balances at
earnings, adds profits and subtracts d ividends to yield
a spec1fic point in time. Therefore. it is a summary of the
the current balance in Retained Earnings. Its 31 May trial
balances in the ledger. You can confirm that the trial balance
balance shows no balance in beginning retained earnings
includes on ly the balances from the general ledger by
because the business had just started. It also shows a
reviewing again Video Memories' ledger. As expected, total
$150 0 balance in dividends. Co m b ining these two
debit balances of $31 000 equal total credit balances of
ba lances with profits yields t he following reta ined
$31 000 in the trial balance.
earnings section of the statement of changes in equity
for the month of May:
PREPARING FINANCIAL STATEMENTS
Video Memories
Once the trial balance is completed, the final product of the Statement of changes in equity
accounting system can be prepared - the fmancial (retained earnings section)
for the month ending 31 May
statements. As demonstrated in Chapter 1, the income
Retained eammgs. 1 M_
lf'(;.__ __ _ _ _ _ _ __s:-::::
0-
statement must be prepared first, followed by the
statement of changes in equity and then the balance sheet. + ~* 2~
------------------~
The income statement shows a company's revenues - Dividends 1500
and expenses. Video Memories' 3 1 May trial balance Retained earnings. 31 May $1 250
contains only one revenu e account and two expense
accounts. Therefore, its income statement for the month With retained earnings calculated, the company's
of May would appear as follows: balance sheet can be prepared. This shows a company's
assets. liabilities and equity at a point in time . Video
Video Memories
Memories' 31 May trial balance shows four asset accounts.
Income statement
two liability accounts and one equity account (Contnbuted
for the month ending 31 May
Equity). These seven accounts, along with the amount of
Service Revenue $5000
retained earn1ngs from the May statement of changes 1n
Adven1SIIlQ Elqlense $ 250 retained earnings, should be included on the balance sheet.
Salanes Expense 2000 Therefore, its 31 May balance sheet would appear as
Total Expenses 2250 follows:
Profit $2750 Video Memories
Balance sheet
at 31 May
~ ~~
Supplies 1000
Equipment 18 000
Total assets ~
Unearned Revenue S2 000
Notes Payable 9000
IIV!,__ _ _ _ _ _ _ _ _ _ _ _1~5~
Contributed Equ:.:. 000
Retained Earnings 1250
Total liabi lities and equity $27 250

~t1'11tq
Test your understanding wilh lhe •
online mision quizzes for lhis clapter V/fl

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_ _.....;;
5..;.
4 ACCTJ Finan o
 Account Ill Account#2 Account 113
1000 6000 8400 3250 4280 3600
4000 3000 2120 1 1660 1120
REQU IRED
Determ1ne the balance 1n each account and 1dent1fy whether
each account would most likely be an asset or a liab1hty
account.
1 Chart of account s
Compare Aerial Filming (drone business) in Chapter 1 to
6 Posting transact ions
V1deo Memories in this chapter. Which account/s would be
used for Aerial Film1ng that were not used for V1deo Greg's company records the following transactions durmg
Memories? November:

o.ta Acoount title Debit er.clt

2 Chart of accounts
1 Nov. Accounts Receivable 3200
Wh1ch of the followmg accounts are liabii11Jes?
SeNice Revenue 3200
Accounts Recetvable, Accounts Payable, Unearned - - -
Revenue. SeMce Revenue. Notes Payable. Notes 6 Nov. Cash 1!OJ
Reoe1vable, Loan, Retained Earnings, Wages Payable, Rent Accounts Receivable 1900
Expense.
15Nov. Telephone Expense 250
3 Accounting transactions Cash 250
The Howard company entered into the following economic 26 Nov. Inventory 2340
events: Accounts Payable 2340
i hired a new researcher
REQUIRED
ii b1lled customers for serv1ces performed
Post the transactions to appropnate T-accounts and prepare
iii announced the signing of a contract that should
a tnal balance.
produce $100000 of new revenue
iv paod for 1nsurance that wtll not be used until next year
7 Recording transactions
v owned land that was rezoned allow1ng h1gher dens1ty
accommodatiOn to be bu1lt on 11 Matthew rece1ved a payment from a customer and recorded
vi purchased and paid for supplies on the mternet that the follow1ng journal entry:
are never delivered. er.dlt ,
Acoount title Debit
REQUIRED 1 Mar. Cash 1000
Indicate whether eadh economic event would be considered
Accounts P
..;a:..:.y.:..
ab:...le
;___ _ __ _ 1000
an accounting transaction.
REQUIRED
4 Analyse transactions Is this entry correct or not? Explain your answer.
Sue's Serv1ces entered into the followmg transactiOns during
the month of August: 8 Trial balance
rece1ved $6350 for serv1ces performed dunng August H1ldebrand Consui!Jng prOVIdes the followmg mcomplete
ii purchased $1200 of supphes on account (on cred1tl tr•al balance:
iii pa1d employee salaries of $3280 for the ftrst week of
August
iv pa1d $900 towards the prev1ous purchase of supplies
v received $2460 for services performed 1n July. (a) $ 8640
REQUIRED Accounts Receivable (b)
a lnd1cate whether eadh transaction increases. decreases Supplies 1230
or has no effect on assets. liabilities and equity. If a Notes Payable $3000
transaction affects equity, ind1cate whether the
Contributed Equ1ty 10000
transaction affects revenues or expenses.
Retained Earnings (c)
b Prepare JOurnal entries for each transactiOn (omtnmg
explanations). Service Revenue 15000
Salaries Expense 10560
5 T-account s Electricoty Expense 2340
Brancatosano reports the followmg asset and hab1hty Totals S33333 $ (d)
T-acoounts:

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 REQUIRED v prov1ded serv•ces of $15325. receiving $12200 in
Determone the mossong values at (a). (b). (c) and (d). cash
vi pa1d $1000 for adven•song for January
9 Prepare financial statements v ii rece1ved payment of $3125 from customers on
transaction (v)
Revoew the Holdebrand Consulting onformatoon on the
viii paid $4000 on the account from transaction (1v)
preceding exercose.
ix paid d1v1dends of $1000 to shareholders
REQUIRED x paid employee salaries of $4000 for January
Using the given onformation and your answers for (a) to (d), xi boiled customers $3500 for services provided durong
prepare Hildebrand's income statement and statement of January
retained earnings for September and its balance sheet at 30 xii paid $100 interest on the notes payable.
September.
REQUIRED
10 Transaction analysis a Show the effects of each transaction on the accounting
equat1on by prepanng a spreadsheet using the follow1ng
The followong transactions occurred on summer:
column headongs: Cash, Accounts Receivable. Supphes.
ossued shares for cash Propeny and Equopment, Accounts Payable. Notes
ii purchased onventory on account Payable. Contributed Equ1ty, Retaoned Eamongs.
iii receoved cash payment from chent for servoces b Calculate Handywoman's profit for the month of January.
iv boiled customers for services
v paod rent on cash 13 Normal balances
vi receoved a bill for electricity used
The followong is a hst of possible accounts found in a trial
vii bought equipment for cash
balance:
viii received cash from customer previously billed in
Accounts Receivable
transaction (iv)
ii Contributed Equity
ix paod electricity bill received on transaction (vi)
iii Cash
x paod dovodends at the end of the year.
iv Reta1ned Earn1ngs
REQUIRED v Accounts Payable
a lndocate the accounts that would be affected by each vi Salanes Expense
transactoon. vii Long-term Investments
b lndocate whether each transactoon oncreases. decreases viii Serv~ce Revenue
or has no effect on assets. liabohtoes and shareholders' ix Div1dends
equity. Unearned Revenue.
X

11 Transaction analysis REQUIRED

Indicate each account's normal balance and the effect of a
The followong are a few possible ways in which the
debit and a credit to the account.
accounting equation can be affected by a transaction:

r i
AsMb
Increase
Uabllltles
Increase
Equity 14 T-account mechanics
The general ledger for MRT Company contaons the follow1ng
~Decrease Decrease accounts:
Ill Increase Increase
Cash Notes Payable
IV Increase/Decrease
v Decrease Decrease 2!XXJ 3!XXJ 10!XXJ 5500
VI Increase Decrease 8!XXJ (a) I 18100
4000 (b)
REQUIRED
Salaries Expense Accounts Payable
Describe at least two transactions that could result in each

~
13500 43500
of the six scenarios listed.
(c) ) 12775
12 Transaction analysis 15900 17300
Handywoman Services commenced bus1ness on 1 January Service Revenue Accounts Receivable
and entered 1nto the following transactions dunng January: (e) (f) 3500
issued shares (contributed equ1ty) for $300000 cash 33210 2500 I 9570
ii purchased an old warehouse for $250000 by 88690 7660 1
borrow1ng from the bank With a mortgage
i ii purchased a van for $35000 cash REQUIRED
iv purchased supplies for $5000 on account Determine the missong values at (a) to (f) .

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56
 c The system that idenUf1es economic events to be
15 Recording transactions recorded, measures and records those events, and then
The following Information perta1ns to Avon Challenge Raftmg processes the resulting mformation so that fmanc1al
Company 10 January: statements can be prepared.
2nd Issued shares to investors for $25000. d An accumulation of the actiVIty and balance for a spec1f1c
3rd P\Jrchased $3500 of supplies on account. 1tem.
4t h Pa1d rent for January $1200. e Any econom1c event that affects specific asset, habihty,
9th Invoiced a customer $7000 for serv1ces provided. or eqUity accounts at the time of the event.
16th Paid $1500 cash to supplier for the purchase on the 3rd. The right side of an account.
24t h Borrowed $10000 from local bank. g The left side of an account.
26th Received payment for billing made on the 9th. h A collect1on of accounts and their balances.
REQU IRED A hsting of all accounts and their balances at a spec1fic
pomt 1n ume.
a Prepare JOurnal entries for each transaction (om1ning
explanatiOns). A chronological record in wh1ch transactions are f1rst
recorded.
b f'bst the JOUrnal entries tO their appropnate ledger m
accounts and prepare a tnal balance at 31 January.
18 Errors in recording transactions
16 Recording transactions Sarah's Sc1enusts recently h1red a new accountant, who
made the follow1ng errors:
In the month of March. Peter Wells Consulting entered 1nto
the following transactions: recorded a $200 cash purchase of Inventory as a
debit to inventory and a credit to accounts payable
2nd Purchased a new bui lding for $935000.
ii failed to record the payment of $300 for advertismg
3rd Paid $860 for January's electricity bill which was
for the period
received in February.
iii deb1ted supplies for $150 and credited cash for
11th Issued shares to investors 1n return for $50000 cash.
invo1ce amount of $510
13th H1red a new administrative ass1stant for an annual
iv recorded $100 cash received for serv1ces but forgot
salary of $85000.
to record the serv1ce revenue.
19th Rece1ved payment in the amount of $750 for serviCe
billed 1n February. REQUIRED
23rd Sent an 1nvo1ce (bill) to a customer for the week's a Prepare each entry that should have been made.
work just completed $6800. b Wh1ch of the lour errors would result in the tnal balance
3 1st Pa1d d1v1dends of $1000. be1ng out of balance?
REQU IRED
Prepare all necessary journal entries for March (omitting
19 Posting information
explanations). The following is the general journal of Chan for the month of
November:
17 Accounting terms
The follow1ng is a list of various terms and definitions
o.t. Account Titles Debit er.dltJ
1 Cash $15000
associated w1th accounting information systems:
Nov.
Account1ng information system
Contnbuted Equ1ty $15000
ii Accounting transaction
iii Account 8 Equ1pment 5000
iv Dual-entry accounting Accounts Payable 3000
v Chart of accounts
Cash 2000
vi Deb1t
v ii Cred1t 11 Accounts Receivable 7500
v iii Journal Service Revenue 7500
ix Ledger 18 Accounts Payable 1700
X Trial balance.
Cash 1700
REQU IRED
21 Cash 5000
Match terms (i) to (x) with their matching defm1t1on in the list
that follows: Notes Payable 5000
a A hsung conta1nmg a name and a numerical reference for 24 D1111dends 1500
all the accounts that a busmess ent1ty uses to record Cash 1500
accounting mformation.
25 Cash 3500
b A record1ng system in wh1ch at least two accounts Wlll
be affected when record1ng every accounting Accounts Rece1vable 3500
transaction.

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 REQUIRED v boiled customers $14680 for services
a Post the JOurnal entries to the appropnate T-accounts, vi patd salanes of $8015
assumong Chan starts ots busoness m NOI/ember. vii recetved payment of $6023 from customers for bolls
b Prepare a tnal balance for the month endong 30 on transacuon (v)
N011ember. viii recetved $5000 cash for services to be performed on
March
ix patd $6000 to suppliers for purchase in transactoon (uo)
x received bill for January electricity, $975
xi paid dtvidends of $900 to shareholders
xi i borrowed $100000 from bank on a mortgage
xii i paid $400 interest on the bank loan.
REQUIRED
a Show the effects of each transaction on the accountong
equatoon by prepanng a spreadsheet using the followong
column headongs: Cash, Accounts receovabte. Supplies.
20 Recording transact.i ons Property and equopment, Accounts payable, Unearned
On 1 November, Geoff Howard started a small amusement revenue, Mortgage, Contrtbuted equity, and Retaoned
park. The park expenenced the followong transactions during earnongs.
the forst month of operations: b Record the transactions on the journal.
1st Shareholders contributed $350 000 on exchange for c Post to the ledger (T) accounts.
shares.
d Extract a tnal balance.
2nd Hired six employees to staff the park.
e Prepare an income statement for the month of January.
3rd Purchased go-carts for $87 500 on account (on
credot). Prepare the retained earnings section of a statement of
changes m equoty for the month of January.
3rd Borrowed $90000 from the bank.
3rd Purchased arcade games for $72 000. g Prepare a balance sheet at 31 January.
4th Patd $3000 to advertise the openong on vanous
websotes. 22 Recording transactions
7th Purchased 'bumper-boats' for $35250 on account. Madden Consulting was established on 1 March. and dunng
10th Billed le Ma $3300 for her son's btrthday party on March ot entered mto the folloWing transactiOns:
the 10th. 1st Issued $10000 shares on exchange for cash.
11th Receoved cash of $6600 for entry fees onto the park. 3rd Purchased $300 of supplies on account.
15th Paid $45000 towards the go-cart boll (purchase on 7th Prepatd $1500 total for Apnl. May and June rent.
3rd). 8th Paid $175 towards the 3 March purchase of supplies.
20th Received $10200 for entry fees into the park. 11t h Billed customers $5780 for services rendered .
25th Received full payment from l e Ma. 12th Paid $700 for March advertising.
28th Paid electricity, $7680. 25th Received $4500 from customers billed on 11 March.
30th Paid $900 mterest on loan. 28th Paid $200 on dtvtdends to shareholders.
REQUIRED 29th Paid $1200 for March salaries.
Prepare Journal entnes for each transactoon, mcludtng 29th Patd $760 for March water usage.
explanations. REQUIRED
a Prepare JOurnal entnes for each transacuon (omtntng
21 Transaction anal ysis, joumal, ledger, explanatoons).
trial balance, financial statements b Post the JOurnal to the appropriate ledger (T-accounts).
Megan and Sonclatr was established on 1 January and c Prepare a tnal balance at 31 March.
entered mto the following transactiOns durmg ots first month
d Prepare Madden's income statement for the month of
of busmess: March
issued shares of $50000 in exchange for cash
e Prepare the retained earnings section of the statement
ii purchased equipment for $24 000 cash of changes in equity for the month of March.
iii purchased supplies of $6000 on account Prepare Madden's balance sheet at the end of March.
iv receoved $235 bill for January advertisong

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58
 REQUIRED
23 Recording transactions a Identify the dollar change in the following subtotals in
The trial balance for Geoff Howard Limited at 31 January is the balance sheet: total current assets, total non-current
shown as follows: assets, total current liabilities, total non-current liabilities
and total shareholders' equity.

[ ~.l
b Identify whether the accounting system would debit or
credit each subtotal to achieve the change. Treat each
subtotal description as if it were an account (e.g. an
Debit increase of $XYZ in total current assets would be
Cash $ 5600 accomplished w ith a debit to that account).
Accounts Receivable 12890 c Prepare one journal entry that records the changes in all
subtotals. Again, use the subtotal descriptions as if they
Supplies 9235
were actual accounts.
Prepaid Rent 1500 d Does the answer to question c balance? Should it?
Property, Plant & Equipment 30500 Explain why or why not.
Accounts Payable $7625
Unearned Revenue 6400 25 Ethics in accounting
You are a junior accountant at a large construction company.
Notes Payable 15000
Your company is under tremendous pressure to meet
Contributed Equity 25000 earnings targets so that the company share price can
Sales Revenue 9650 continue to grow. For the current year. it appears that the
company will m iss its earnings targets simply because heavy
Salaries E;qlense 2300
rain prevented work being carried out towards the end of the
Electricity Expense 650 financial year. Your boss, who has been a mentor to you,
Dividends asks you to prepare a journal entry to record $280 m illion of
1000
revenue for work that will be done in the first two weeks of
Totals $63675 $63675 the next financial year. He provides a fabricated invoice as
documentation. He states that w ithout the rain the work
Du ring February the following transactions occurred: would have been completed before year end and it is extra
1st Billed customers for orders shipped, $2500. work the business w ill be doing in the next financial year
2nd Paid $150 interest on note from bank. anyway. He asks you to do this as a personal favour to him.
4th Received payment from customers billed in January, REQUIRED
$4500. a Identify the ethical issues associated w ith this scenario.
6th Bought office supplies on account, $560.
b What factors other than accounting are at play here?
7th Completed an order for which payment had
c What are your alternatives?
previously been received in January, $3500.
8th Paid creditors for purchase of supplies in January, $1895.
26 Written communication
24th Paid dividends to shareholders. $1000.
28th Paid salaries of $2100; paid electricity of $775. As the only accountant on the company board, explain to
your fellow directors why the balance sheet may not show
REQU IRED assets at current market value.
a Prepare opening T-accounts for the month of February.
b Prepare journal entries for transactions in the month of 27 Written communication
February.
Since you are enrolled in an introductory accounting class. a
c Post journal entries to appropriate T-accounts. friend asks you the following: 'I've never understood debits
d Prepare a trial balance at 28 February. and credits. All I know is that debit means bad and credit
means good'.
REQUIRED
Write a brief explanation of the terms debit and credit and
how they are used in an accounting information system.
Explain why debit and credit cannot mean good and/or bad.

24 Read and interpret financial statements

Access Woolworth's (or another company as instructed)
latest annual report (e.g. conduct an internet search of

__
'Woolworth annual report')

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59

After studying the material in t his chapt er, you
should be able to:
Explain how profit is measured and
reported under the accrual and cash bases
of accounting.
Identify the four major circumstances in
which adjusting journal entries are
necessary.
Record and post adjusting journal entries as
well as p repare an adjusted trial balance
and financial statem ents.
U nder stand t he purpose of the closing
process and prepare closing entries.
Describe the st eps of the accounting cycle.
apply this -· · · ·-·
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60
Chapter 3 introduced the first three steps in the accounting
cycle: recording transactions, posting information to the
ledger and preparing a trial balance from which financial
statements are prepared. This chapter explores the
remaining steps in the cycle.
This includes the adjusting process that leads to accrual·
based financial statements and the closing process that
prepares the accounting system for the next period. Both
the adjusting and closing processes occur at the end of
each accounting period.
One of the matn functions of the accounting information
system is to record the revenues and expenses that a
business generates. In accounting, there are two poss1ble
bases for recording revenues and •
expenses: the cash basis and the Check out the video ~
summary lOt Chapter 4
accrual basis. The main difference
betw een the two is the timing of when revenues and
expenses are recorded.
The cash basi s of acco unting records cash basis of
revenues when cash is received and records account ing Aeolrds
rMrueS when cash is
expenses when cash i s paid. The best received and records
example of a cash bas1s accounting system I!Xjlef\SeS when cash is
is your personal bank account. Revenues paod
such as wages are recorded only when you are pa1d.
Expenses such as paying your credit card are recorded
only w hen you transfer the money.
In contrast, the accrual basis of accounting accrual basis of
records revenues when they are earned and accounting Records
revenues when they are
records expenses when they are incurred.This is earned and records
an application of the revenue recognition and expenses when they are
lllCUITed
matching principles diSCUssed in Chapter 1.1n an
accrual accounting system. revenues such as Yfllwage5 woukl
be recorded when 'r()U earn them. regardless of when payment
is received. likewise, expenses such as event tickets are
recorded when you attend the event. regardless of when
payment is made. A summary of each basis is as follows:
Cash basis Accrual basis
Record revenues Cash is received Revenue isearned
when:
Record expenses Cash is paid Expense is incurred
when:
To illustrate the difference between the cash and
accrual bases, suppose that a neighbour leaves town for
the months of December and January and asks you to
collect her ma1l and newspapers. Before she leaves, she
pays you $100. Suppose further that you agree to pay a
friend $40 to do the work, but you pay him at the end of
January after the work is completed. Income for December
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and January under each basis would be calculated as
outlined 1n the following.
Under the cash basis. December revenues are $100
because you received $100 during the month. Likewise,
December expenses are $0 because you paid nothing
during the month. As a result. December profit is $100. For
January, you received no money but paid your friend $40,
so revenues are $0, and expenses are $40 . Therefore,
January's loss is $40.
Under the accrual basis. revenue for December is $50
because you earned half of the $100 during December.
And, even though you don't pay your fnend until January,
he provided half of the agreed labour 1n December, so
December expenses are $20. As a result, December profit
is $30. Because the exact same circumstances occur in
January, profit for January is also $30.
December January Total December January Total
The comparative income statements (or statements of
comprehensive income) show that although each basis
results 1n the same $60 of cumulative profit. monthly profit
or loss varies considerably. The cash-based statement
reports that you generated a $100 profit one month and a
$40 loss the next, while the accrual-based statement
reports that you generated $30 in profits each month. Given
that your activities were exactly the same each month,
accrual-based income of $30 each month makes more
sense than a $100 profit and a $40 loss. Even though both
bases result in the same total $60 profit over the two
months. the accrual basis provides a better representation
of 1ncome for each month. As a result, the accrual basis is
reqwed by Generally Accepted Accounting Principles
(GAAP) and specifically by the Accounting Standard AASB
15 Revenue from Contracts with Customers.
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REPORTING ACCRUAL- AND
CASH-BASED INCOME
Because GAAP require the accrual basis, income
statements report accrual-based profits or losses. However.
cash basis informat1on IS also useful in understanding the
financial cond1tion of a company. A company that generates
accrual income but never generates cash is a company that
will soon fail. As a result, cash-based income is reported
on the cash from operations section of a cash flow
statement. Recall from Chapter 1 that the operating
activities section calculates and reports the cash generated
from operating the business. Cash generated from
operations IS the same as cash-based income.
CSl ANALYSIS
To illustrate, consider the reconciliation of profits after
tax to cash flow from operations for CSL. It uses the direct
method of reporting operating cash flows in the cash flow
statement (see the CSL 2017 Annual Report in Appendix
B) while in the reconciliation the difference between net
cash from operating activities (cash profits of $ 1246.6
million) and profits after income tax (accrual profits of
$1337.4 m1llion) is almost $91 million. In the preVIOUS year
the figure was almost $64 million. Cash basis mcome is
less than accrual baSIS mcome due primarily to 1ncreases
in inventory of $389 million and increases in net tax assets
(unimportant at th1s stage) of $111 million.The reconciliation
of Profits AfterTax to Cash Flow from Operations in CSL:s
2017 Annual Report (see Appendix B or download full
report online) also shows depreciation of $279 million and
increase s trade and other payables of $154 million.
offsetting the increases in inventory and tax assets. There
are a number of other smaller items that contribute to
cash from operat1ons being less than profit after tax .
61
::...:....--
 you fly. When a company receives cash before it provides
ADJUSTING JO URNAL the service, it has a deferred revenue (sometimes known
ENTRIES as revenue received in advance or unearned revenue). The
term deferred is used because at the time of cash receipt,
To ensure that revenues and expenses are properly the company has not yet provided the promised service
recorded under an accrual baSIS, accounting information and therefore cannot record a revenue in its accounting
adjusting joumal systems use adjusting journal entries. system. Instead, it must record a liability. Recording the
entries Entnes made on These are entries made in the general revenue must be deferred until the revenue is earned.
the geneoal JOOOli!l to roumal to record revenues that have been
record reverues that have
been earned but not earned but not recorded, and expenses
Subscription revenue
recorded and expenses that have been 1ncurred but not recorded To illustrate a deferred revenue adrustment, suppose that
that have been lllCUiled
but not rerorded. (and the corresponding updating of a company sells 12-month subscnptlons to rts monthly
assets and liabilitieS). The process of magazine. On 1 October. the company rece1ves a total of
recording and post1ng adjusting entries is the fourth step $120 for 12 subscriptions. To record th1s transaction, the
in the accounting cycle and occurs at the end of each company would record the following entry in its general
accounting period after the tnal balance is prepared. After journal:
adjusting entries are journalised and posted. an 'adjusted' Cash
1 Oct. 120
trial balance is then prepared. from which financial
Unearned Subscription Revenue 120
statements are generated.
While adjusting entries can vary significantly across (To record cash received for future magazines)
companies. t hey all arise because the exchange of cash Assets Liabilities + Equity
does not always coincide with the earning of a revenue or +120 +120
incurrence of an expense. For example. sometimes cash
is received before a revenue is earned while at other times This entry first increases the Cash account by the
cash is received after a revenue is earned. Likewise. amount received. And, because the company now has an
sometimes cash is paid before an expense is incurred obligation to its customers to deliver the magazines. the
while at other times cash IS paid after an expense is entry also increases a liability account called Unearned
incurred. These four basic scenarios are the reasons that Subscription Revenue. As a result, both assets and liabilities
adjusting journal entries are necessary. Each scenario is are increasing. The entry would then be posted to the
listed in the following table and is discussed further in the relevant T-accounts as follows:
following sectiOns.
Uneamed
Subscription Subscription
Classification of scenario Adjusting entry Cash Revenue Revenue
Cash 1S receoved before Deferred revenue ISearned 120 0
revenue. (An msuranoe 120 0
company receoves the cash at
the beg1nning of the policy)
Suppose further, that the company prepares financial
2 Cash 1S received after Accrued revenue is earned statements at the end of each month. As of 31 October,
revenue. (The phone company
the company has provided one month of magazines and
receives cash after the
customer has made calls and has therefore earned one month of revenue. or $10
accessed the Internet) ($120/12 months). Because the accounting system does
3 Cash is paid before expense. Deferred expense is incurred not yet reflect this earned revenue. the following adjusting
(The tenant pays rent to the journal entry should be made on 31 October:
property owner for the coming
month's rent) 31 Oct. Unearned Subscription 10
Revenue
4 Cash is paid after expense. Accrued expense is incurred
(Electricity may be used for cr:.:!:.
_ _ _ ___:S~ub:.:s~ iption Revenue 10
three months before the bill is record revenue earned dunng October)
(To _
_ _____:._
received and then paid)
Assets Liab1htoes + Equ1ty
------~ ----------~------
- 10 +10
SCENARIO 1: DEFERRED REVENUE
Companies somet1mes rece1ve cash before they earn the
revenue; for example. a1rlines receive your money before

ACCD Fon~l2019 CensJa9e L.umlng. AU RlghU R--..cl. l&ay not be copied. scanned. 0< ~iealed I n - 0< In part. WCN 02·200-202
62
_.......;;.;;.
 This entry increases the Subscription Revenue account desirable way to record the transaction, however it is
by the amount earned during the month and decreases the important to your understanding of adjusting entries).
liability account Unearned Subscription Revenue by the To record this transaction (the other way). the company
same amount. As a result, liabilities are decreasing and would record the following entry in its general journal:
equity is increasing. The entry wou ld be posted to the
1 Oct . Cash 120
relevant T-aocounts as follows:
Subscription Revenue 120
Unearned (To record cash received for future magazines)

----,-
Su bscrip t ion Subscription
Cash Revenue Revenue Assets liabilities + Equity

0 ~ +120 +1 20

~ 0
~ This entry first increases the Cash account by the
amount received (as before). Because the company
After posting, the Subscription Revenue T-account recorded it as a revenue (it may have believed the revenue
reflects the $10 earned in the current period while the would be soon earned), the entry has also increased the
Unearned Subscription Revenue T-account reflects the revenue account called Subscription Revenue. As a result,
remaining $110 to be earned over the next 11 months. both Assets and Revenue (Equity) are increasing. The
These two accounts have been adjusted so that they entry would then be posted to the re levant T-accounts as
properly reflect revenues earned during October and follows:
liabilities owed on 31 October. The Cash account is not
Unearned
affected by the adjusting journal entry. Cash was exchanged Subscription Su bscription
and recorded on 1 October. Cash Revenue Revenue
120
General rule
120
When a company receives cash before it provides a service,
the company should always increase a liability account The company prepares financial statements at the end
for the amount received. As the company provides the of each month. As of 31 October, the company has
service, the liability account is adjusted down (decreased) provided only one magazine and has therefore earned
and the related revenue account is adjusted up (increased). on ly 1/12 of the revenue, or $10 ($120/12 months). as
So, the adjusting journal entry for this scenario shou ld before. Because the accounting system reflects all the
always be a reduction to a liability account and an increase revenue being earned in the month of October, the
to a revenue account, as shown in Exhib it 4. 1. revenue needs to be decreased and the liability increased,
and the following adjusting journal entry shou ld be made
Exception to the general rule on 31 October:
What if the money received was, for some reason, credited
to Revenue rather than the liability Unearned Revenue? The 31 Oct. Subscription Revenue 110
necessary adjustment at the end of the period would need Unearned Subscription Revenue 110
to be totally different, but the balances after adjustment in (To record revenue earned during October)
both the revenue account and the liability account would
Assets liabilities + Equity
be exactly the same as above.
+1 10 -110
To illustrate the same situation, accept that the credit
was made to the revenue account (this may not be the

Receipt Endof f""'~

of cash period~
Provid e service

Cash $$ liabili ty $$
Liability $$ Revenue $$

rn:l Entroes 1n a d eferred revenue scenano

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;;;.;;...
63
 This entry decreases the Subscription Revenue account
by the amount not yet earned ($110) and increases the
liability account Unearned Subscription Revenue by the
same amount. As a resu lt, liabi lities are increasing and
revenue is decreasing. The entry would be posted to the
relevant T-accounts as follows:
The entry increases the Accounts Receivable account
for the amount that the client owes the firm and increases
the Service Revenue account for the amount that the firm
has earned. As a resu lt, both assets and equity are
increasing. The preceding entry wou ld be posted to the
relevant T-accounts as follows:

Unearned Accounts Service

Subscription Subscript ion Cash Receivable Revenue
Cash Revenue Revenue

~I
+.
1000
----,-~ 0
1000

~~ 0 After posting, the Service Revenue T-account reflects

the $1000 earned in the current period while the Accounts
After posting, the Subscription Revenue T-account Receivable T-account reflects the $1000 of expected cash
reflects the $10 earned in the current period wh ile the receipts from the client. These two accounts have been
Unearned Subscription Revenue T-account reflects the adjusted so that t hey properly reflect revenues earned
remaining $110 to be earned in the future (or to be returned during September and receivables held on 30 September.
to the customer if the magazines are not provided). These
two accounts have been adjusted so that they properly
reflect revenues earned during October and liabilities owed
on 31 October. Again, the Cash account is not affected by
the adjusting journal entry. Note that we end up with the
same balances in the accounts regard less of how the
transaction was originally recorded, the adjusting entries
'fix them up'.

SCENARIO 2: ACCRUED REVENUE

Companies often provide a service and then collect the
cash. When a company earns a revenue before it receives
cash. it has an accrued revenue. The term 'accrue' means
to accumulate or increase. An accrued revenue is another
name for a receivable.

Service revenue
To illustrate an accrued revenue adjustment, suppose that
an accounting firm agrees to provide a service to a cl ient Revenue from the sale of gift cards IS recognised
for a $1000 fee. The firm completes its work on 23 when the card is redeemed and the customers
September, bills the client on 10 October and receives
payment on 21 October.
Suppose further that the accounting firm prepares its
own financial statements at the end of eadl month, whidl
in this case is 30 September.
Because the accrual basis requires that revenues be
recorded in the period in which they are earned, the
accounting firm must record the $1000 of revenue on 30
September w ith the following adjusting journal entry:

30 Sept. Accounts Receivable 1000

Service Revenue 1000
(To record revenue earned during September)
Assets Liabilities + Equity
+1 000 +1 000

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 When the customer pays cash on 21 October, the example is rent. You pay rent for a period (possibly a
following entry is made: month or only a week) in advance and are then able to
occupy the accommodation.
21 Sept . Cash 1(00
------------------------~
When a company pays for a resource before rt uses or
Accounts Receivable 1tnl consumes it, the company has a defe"ed expense. We use
(To record receipt of cash) the term defe"ed because at the time of cash payment for
Assets Liabilitres + Equity the resource, the company has yet to use or consume the
+1000 resource it is acquiring and therefore cannot record an
expense in the accounting system. Instead, it records an
-1000
asset. Recording of the expense must be deferred until the
This entry increases the Cash account and decreases expense is incurred.You should note that a deferred expense
is nothing more than an asset- a resource to be used.
the Accounts Receivable account for the amount collected.
As a result. although specific asset accounts are changing, Insurance expense
total assets remain unchanged. No revenue is recorded
To illustrate a deferred expense adjustment, suppose that
because it was recorded in the prior period when it was
on 1 March, a company purchases a 12-month rnsurance
earned. The entry would be posted to the relevant
policy for $3600. To record this transaction. the company
T-accounts as follows:
would record the following entry in its general journal:
Cash Accounts Receivable
- - - -Prepaid Insurance
1 M ar. 3600
-
100~] 100001 1000 -----
------
Cash
(To record purchase of insurance)
3600

1000 Assets liabilities + Equity

---------------------
+3600
---------
General rule -3600
When a company earns a revenue before rt receives cash,
the company should increase a receivable account (asset) This entry rncreases the asset account Prepaid Insurance
and a revenue account for the amount earned. In other to reflect the amount of insurance bought and decreases
words. the receivable account should be adjusted up the Cash account for the same. Since both of these
(increased) and the revenue account should also be accounts are assets, this entry does not change total
adjusted up (increased). When the company collects the assets. The entry would then be posted to the relevant
receivable, th e receivable account is decreased and T-accounts as follows. For illustration purposes, assume that
the cash account is increased. So, the adjusting journal the Cash account has a $10000 balance prior to the entry:
entry for this scenario will be an increase to an asset
account and an increase to a revenue account, as shown Prepaid Insurance
Cash Insurance Ex pense
rn Exhibit 4.2.

~
10(0) ol

~
3600
SCENARIO 3: DEFERRED EXPENSE
Companies often pay cash before they incur an
600 o I
expense. You need look no further than your own Suppose further that the company prepares frnancral
personal expenses to find numerous examples of statements at the end of April. As of 30 April, the company
payments made before you use the service. One has been covered for two months and has therefore

Endof~ Rece1pt
period ~
f Provide ServiCe r
ofcash - -....:.:..

•
Recervable SS Cash $S
Revenue $$ Receivable SS

~ Entroes 1n an accrued revenue scenaroo

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~--
 consumed two months of insurance, or $600 (1$3600 .;. 121 1 July Equ1prnent 40000
x 2 months). Because the accounting system does not yet
Cash 40000
reflect th1s expense. the following adjusting jOurnal entry
(To record purchase of film studio equipment)
should be made on 30 April:
Assets Liabilities + Equ1ty
~-'--'-
30 Apr. Insurance Expense 600 -40000
Prepaid Insurance 600 - --- +40000
(To record expense incurred during March)
Assets Liabilities + Equity This entry increases the asset account Equipment to
-600 -600 reflect the cost of the equipment and decreases the Cash
account for the same. Since both of these accounts are
This entry increases the Insurance Expense account by asset s, this entry does not change total assets. The entry
the amount consumed during the two months and would then be posted to the relevant T-accounts as follows.
decreases the asset account Prepaid Insurance by the We will assume that the Cash account has a $70000
same amount. As a result. both assets and eqUity are balance prior to the entry:
decreas1ng. The entry would be posted to the relevant
Depreciation
T-accounts as follows: Cash Equipment Expense

Cash
10000

6400
3600

~ l=
Prepaid
Insurance

000
Insurance
Expense

00

After posting, the Insurance Expense "J:account reflects

70 000

the $600 of 1nsurance that was consumed in the current
period while the Prepaid Insurance "]:account reflects the
rema1mng $3000 of insurance to be consumed over the
next 10 months. These two accounts have been adjusted
so that they properly ref lect expenses 1ncurred during
March and April and unexpired assets on 30 April. The Cash
account is not affected by the adjusting journal entry. Cash
was exchanged and recorded on 1 March.
If the purchase of insurance was originally (incorrectly)
recorded as an expense. then the adjusting entry would be
needed to increase the asset Prepaid Insurance by $3000
and reduce the expense Insu rance Expense by $3000.
Such an adjustment would result in the same outcome.
with Insurance Expense for the months of March and April
of $600 and an asset Prepaid Insurance at the end of April
of $3000. Aga1n, no cash is involved in the adjustment.
Depreoation expense
Another example of an expense where cash is paid before
the expense is incurred. is depreciation. Depreciation is the
process of spreading over their useful lives the cost of non·
current assets such as equipment and buildings. For
example, suppose t hat on 1 July, a company purchases film
studio eqUipment for $40000. This transaction would be
recorded 1nto the accounting system as follows:
30000
40000 40000 t - - -
40000
+
Suppose further that the company prepares f inancial
statements at the end of the f inancial year, 30 June the
following year. As of 30 June. the company has used the
equipment for one year and should therefore record some
amount of expense associated with the use of the studio
equipment. If we assume for simplicity that the amount of
expense to be recogmsed 1n the financial year is $10000, the
following adjustmg JOurnal entry should be made on 30June:
30 June DepreciatiOn Expense 10000
Accumulated Depreciation 10000
{To record expense incurred the financial year)
Assets Liabilities + Equ1ty
- 10000 -10000
This entry increases the Depreciation Expense account
by the amount of expense allocated to the current year.
However, instead of decreasing the Equipment account
directly, the entry 1ncreases Accumulated Depreciation. We
discuss accumulated depreciation in detail in Chapter 8.
but for now you should know that the account is a contra-
asset account t hat accumulates depreciation expense to
date and is subtracted from the Equipment account to yield
the net balance of the asset. As a result of the entry, both
assets and equity are decreasing. Equity is decreasing
because the company recorded an expense. Assets are
decreasing because the net balance of Equipment and
Accumulated Depreciation at the end of June is now
$30000 ($40000- $10000).The entry would be posted to
the relevantT-accounts as follows:

_
___;:;,;;
66
ACCTJ Finf.1'J1lflght 2019 Cengage learning. All R1gh11 R...rvod. May not be coplod, scanned, or dupllcatod, ln whole or In part. WCN 02·200-202
 Accumulated Depreciation 30 Nov. Salaries E-xpense 5000
Equipment Depreci ation Expense
Salaries Payable 5000
40000 0 0 0
(To record salaries incurred during Apri l)
10000 10000
Assets Liabilities + Equity
40000 10000 10000
+5000 -5000
The Depreciation Expense and Accumulated
The preceding entry increases the Salaries Expense
Depreciation accounts have been adjusted so that they
account for the $5000 of salaries incurred for the week and
properly reflect the $10000 of expenses incurred during
the financial year and the $30 000 of net unexpired balance increases the Salaries Payable account for the same since
it owes the employees those salaries. As a result, liabilities
of Equipment on 30 June.
are increasing and equ ity is decreasing. The preceding
General rule entry would be posted to the relevant T-accounts as follows:
When a company pays cash before it incurs an expense,
Cash Salary Payable Salaries Expense

-----r--=- ----=r-
the company shou ld always increase an asset account for
the amount paid. As the company consumes the asset, the 8000 1
asset account is adjusted down {decreased) and the related
expense account is adjusted up (increased). Depending on
the type of asset, either the actual asset account w ill be
sooot- ~ ~
After posting, the Salaries Expense T-account reflects
decreased or a re lated contra-asset account will be
increased {which is a decrease in total assets). So, the the $5000 incurred in the current period while the Salaries
adjusting journal entry for this scenario will always be a Payable T-account reflects the $5000 owed to employees
reduction to an asset account and an increase to an on 30 November. These two accounts have been adjusted
expense account, as shown in Exhibit 4. 3. so that they properly reflect expenses incurred during
November and the payable owed on 30 November.
The Cash account is not affected by the adjusting
SCENARIO 4: ACCRUED EXPENSE
journal entry. Cash, wh ich has an $8000 balance for
Compan ies often incur expenses and pay for them later. A
illustrative purposes, will be paid on Saturday 1 December.
good example is employee salaries. Most companies pay When the company pays its employees, the following entry
their employees after the employees have provided labour would be made:
for the company. When this occurs, the company has an
accrued expense. An accrued expense is another name for 1 Dec. Salaries Payable 5000
a liability. Cash 5000
(To record payment of cash)
Salaries expense
Assets Liabilities + Equity
To illustrate an accrued expense adjustment, suppose that
a company's daily payroll is $1000. The company pays its -5000 -5000
employees via direct deposit every Saturday for the work
The entry decreases the Cash account for the $5000
the employees have provided to the end of Friday. Suppose
pa id to employees and decreases the Sa laries Payable
further that the company prepares its financial statements
account by the same $5000. No expense is recorded
on 30 November, wh ich is a Friday.
because it was recorded in the prior period when the
Because the accrual basis requires that expenses be
expense was incurred. As a resu lt, both assets and liabilities
recorded in the period in which they are incurred, the
are decreasing. The entry would be posted to the relevant
company must record the $5000 of expense on 30
T-accounts as follows:
November with the following adjusting journal entry:

Payment Endof j~
of cash period L . M l
Use resource

Asset $$ Expense $$
Cash $$ Asset $$

~ Entroes for a deferred expense scenaroo

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Accru
.!l'account•ng
lrt. we~ 02·~2 3~
an a JUSting entries ;:;
6 .:.,
7 _ __
 Salaries Payable
After posting, the Interest Expense T-account reflects
Cash
the $500 incurred in the current period and t he Interest
8000 5000
Payable T-account ref lects the $500 owed to the bank on
5000 30 November. These two accounts have been adjusted so
3000 0 that they p roperly reflect expenses incurred during
November and the payables owed on 30 November.
Interest expense The Cash account is not affected by the adjusting
journal entry. Cash, which has a $1100 balance for illustrative
Interest is another example of incurring an expense befo re
pu rposes, w ill be paid on 1 Decem ber. On that date, the
cash is paid. For example, suppose t hat a company borrows
following entry wou ld be made:
$100000 on 1 November. The annual interest rate on the
loan is 6 per cent and interest is payable on the f irst day of 1 Dec. Interest Payable 500
each month. Suppose further that the company prepares Cash 500
its financial statements on 30 November.
(To record payment of cash)
As of 30 Novemb er, the company has used the
borrowed money fo r one month, so it has incu rred one Assets Liabilities + Equity
mont h's worth of inte rest. To ca lculate the amount of - 500 -500
interest, we simply multiply the principal amount ($100 000)
by t he annual interest rate (6 per cent) and by the relevant The preceding entry decreases t he Cash accou nt fo r
number of periods (1 month out of 12, or 1/12). So, interest t he $500 paid t o t he bank an d decreases the Interest
for the m onth of November is: Payable account by the same $500. As a resu lt , both assets
and liabilities are decreasi ng. The entry would be posted to
Principal x annual rate x time= $100000 x 0.06 x 1/12 = $500
the relevant T-accou nts as follows:
Therefore, the following adjusting journal entry should
Cash Interest Payable
be made on 30 November:
500
30 Nov. Interest Expense 500 '1 001 500
Interest Payable 500 .. I
600 0
{To record interest incurred during November)
Assets Liabilities + Equity
General rule
+500 -500
When a company incurs an expense before it pays cash,
t he company should always increase a payable account
The preceding entry increases t he Interest Expense
an d an expense account for the amount incurred. In other
account for the $500 o f interest for November and
words, t he payab le account shou ld be adjusted up
increases the Interest Payable account for the same. As a
{increased) and t he expense account shou ld also be
result , liabilities are increasing and equ ity is decreasing.The
adjusted up {increased). W hen t he company pays the
preceding entry would be posted to t he relevant T-accounts
liability, t he liability account is reduced an d t he cash
as follows:
account is decreased. So, the adjusting journal entry for
this scenario w ill always be an increase t o a liability

~ ~ ----=r-
Interest Expense
accou nt and an increase ~'\1 Tfy
to an expense account, Check out the animated •

----,oof- ~ ~
summary on Adjusting Entries
as shown in Exhibit 4.4.

End of ~ Payment
period lJ=miD of cash
Use resource

Expense $$ liability $$
Liability $$ Cash $$

~ Entries on an accrued expense scenaroo

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68
_.......;;.;:;
 Entry before end of Adjusting entry at end Entry after end of
Scenario Classification
period of period period
Cash is received before Deferred revenue Cash $S Liability S$
revenue is earned
__
. ,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,
Liabil ity S$ Revenue $$
,,_,,_,,_,,_,_,,_,,_,,_,,_,_,,_,,_,,_,,_,,. ,,_,_,,_,,_,,_,,_,,_,,_,,_,_,_,,_,,_,,_,.....,,_,,_,,_,_,_,,_,,_,,_,,_,_,_,,_,,_,,_,,__,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,

Cash is received after Accrued revenue Receivable S$ Cash S$

revenue is earned Revenue $$ Receivable $$
Cash is paid before Deferred expense Prepaid Asset $S Expense S$
expense is incurred Cash S$ $$
Cash is paid after expense Accrued expense Expense S$ Payable S$
is incurred Payable $$ Cash $$
~ Summary of adjusting JOurna l entry scenanos

SUMMARY OF ADJUSTING JOURNAL ENTRIES

Exhibit 4.5 summarises t he four scenarios that give rise
to adjusting journa l entries and the dlaracteristics of t he Credit
relevant entries. As you review th is exhibit, consider the Cash
following generalisations of all adjusting entries: Supplies 1000
e The pu rpose of adjusting entries is to record revenues Equipment 18000
that have been earned but not recorded and expenses
Unearned Revenue $ 2000
that have been incu rred but not recorded.
Notes Payable 9000
e Eve ry adjusting journal ent ry w ill affect at least o ne
revenue o r one expense account. In addit ion, every Ordinary Shares 15000
adjusting journal entry will affect at least one asset or Service Revenue 5000
liability accou nt. This m eans t hat every adjusting entry Advertising Expense 250
w ill affect at least one acc ount f rom t he income Salaries Expense 2000
statement and one accou nt from the balance sheet. Dividends 1500
e Adjusting journal ent ries arise because t he tim ing of
Totals S31000 $31000
revenue and expense recognition diffe rs f rom the
exchange of cash . Therefo re. cash will never be In ad ditio n t o t hese acco unts an d ba lan ces, the
increased or decreased in an adjusting entry. following information w as available o n 31 May:
1 On 31 May, Video M em ories filmed t he ret irem ent
reception for t he customer who paid $2000 on 10 May
Review this content with thee-lecture
(see Transaction #4 in Chapter 3).
2 O n 3 1 May, Video M emories f ilmed t he f irst night of a
two-night local play. The second night will be f ilmed o n
1 June. at w hich time Video M em o ries w ill bi ll t he
custom er.
3 The loca l play custo m e r has agreed to pay Video
M em ories $ 1500 for eadl night.
4 After a physical count, Video M emories determined t hat
To illustrate the process of making adjusting journal entries it had $650 of supplies remaining.
f rom a trial balance and then preparing an adjusted trial 5 The interest rate for the note payable is 6 per cent (per
balance. t he Video M emories example f rom Chapter 3 will annum).
be continued. As a result of the t ransactions entered into 6 Video Mem ories estimat es t hat depreciation for May
by Video M emories during its f irst m onth of operations, on its two cameras totals $600.
the follow ing unadjusted t rial balance w as prepared at Given this inform ation, t he adjusting entries that follow
3 1 May (this is taken f rom Chapt er 3). Notice that it is an can be prepared.
unadjusted t rial balance because adjusting entries have not
yet been made.

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69
 JOURNALISING AND POSTING The entry would be posted to the relevant T-accounts
ADJUSTING ENTRIES as follows:

Ad .ment 1: Deferred reven Accounts Receivable Service Revenue

Video Memones has now filmed the ret1rement reception, 0 5000
so it no longer has a liability to the customer; it has a 2000
revenue instead. However, the trial balance still shows the
$2000 liability. Thus. the adjusting entry required to adjust
the liability down and t he revenue up is as follows:

31 May Unearned Revenue 2000

1500
1500

Adjustment 3· Deferred expense

-----+-- 1500
8500

Service Revenue 2000 Video Memories has $650 in supplies on hand. However,
(To record revenue earned) the trial balance shows $1000 in the Supplies account,
Assets liabilotoes + Equny which is the amount that Video Memories originally
000
--------~~----------_-2- 000~
~-- ---.~2~
purchased. Therefore, Video Memories must have used
$350 of supplies ($1000- $650). To adjust the Supplies
The entry would be posted to the relevant T-accounts account down from $1000 to $650 and to record the $350
as follows: in expense, the following adjusting journal entry is required.

Uneamed Revenue Service Revenue 31 May Supplies Expense 350

2000 5000 Supplies 350
2000 {To record expense incurred)
0 7000 Assets Liabilities + Equ1ty
-350 -350
Ad u .ment 2: Accrued reven
The entry would be posted to the relevant T-accounts
Video Memories filmed one night of a local play.Therefore, as follows:
it has earned revenue for one night, $1500. The trial balance
does not reflect this because Video Memories has not Supplies Supplies Expense

-----1000--1~--3_50_
issued a b1ll, so the adjusting journal entry to adjust 0
receivables and revenues up is as follows: 350
31 May Accounts Receivable 1500 650
------
Service Revenue 1500
(To record revenue earned) Adjustment 4: Accrued expense
Assets liabilitoes + EqUity Video Memories must pay interest on the notes payable at
+1500 +1500 a 6 per cent annual rate (we have assumed the loan was
obtained at the beg1nnmg of May). Therefore, after one
month, Video Memones has incurred $45 of interest
expense ($9000 x 6% x 1/12). This expense and the related
obligation are not reflected in the trial balance because they
have not yet been recorded. To record them, the following
adjusting entry is required:

31 May Interest Expense 45

Interest Payable 45
-------~----------
{To record expense incurred)
Assets Liabilities + Equ1ty
+45 -45

_
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 The entry would be posted to the relevant T-accounts
as follows:
9!XXl
Interest Payable Interest Expense 15!XXl

=~---
0 8500

~
~ [merest Expense

~ciallon Expen=s= - - - - -- - - = -
Adjustment 5: Deferred expense Advertising Expense 250
Video Memories determines that depreciation on its Salaries Expense ----------- - 2 000
------~------
cameras should be $600 for the month of May. To record Dividends 1 500
thts depreciation. the following adjusting entry is required. Totals ~

31 May Depreciation Expense

Accumulated Depreciation PREPARING FINANCIAL STATEMENTS
(To record expense incurred)
Once all revenues and expenses are recorded and an
Assets Liab•li!les + Equity adjusted trial balance is prepared. financial statements can
-aJO -600 be generated. Recall from Chapter 1 that the income
statement should be prepared first. Using the adjusted
The entry would be posted to the relevant T-accounts revenue and expense account balances from the adjusted
as follows: trial balance. Video Memories' income statement for the
month of May would appear as follows:
Depreciation Accumulated
Equipment Expen se Depreciation
Video Memories

~
18!XXl 0 Income statement
for the month ending 31 May
600
Revenues $8500
18!XXll 600
Expenses
Suppltes Expense $ 350
PREPARING AN ADJUSTED TRIAL BALANCE Interest Expense 45
Once all of the preceding adjusting entries are journalised Depreciatton Expense 600
and posted to the ledger, an adjusted trial balance can be Advertising Expense 250
prepared. Like the previous trial balance. the adjusted trial Salaries Expense 2000
balance simply lists all balances from the ledger. Since the Total Expenses 3245
ledger now reflects several adjustments, so does the
Profit $5255
adjusted trial balance.
The following is the adjusted trial balance for Video Note the proftt figure is $2505 higher than shown in
Memones on 31 May. The accounts that were either Chapter 3. Thts ts due entirely to the adjusting entries
created or adjusted by the adjusting entries are htghlighted. updating the revenue and expense figures.
The other accounts. sudl as cash, have not changed from With profrts calculated. Video Memories' retatned
the unadjusted trial balance presented earlier. earnings part of the statement of <flanges in equity (or the
statement of changes in retained earnings) can be prepared.
Video Memories
Adjusted trial balance Recall that the statement of retained earnings takes the
31 May beginning balance in Retained Earnings, adds profits and
Debit Credit subtracts dividends to yield the current balance in Retained
Cash $ 8250 Earnings. Video Memories' 31 May adjusted trial balance
-=-::------
Accounts Receivable
1500 shows no balance in beginning Retained Earnings and a
=~---- -
Supplies 650 $1500 balance tn Dtvidends. Therefore, Video Memories'
18!XXl statement of retatned earnings for the month of May would
appear as follows:
$ 600
~-

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---
71
 Retained Earnings, 1 May $ 0
Add: Profits 5255
Less: Dividends (1500)
Retained Earnings, 31 May $ 3755

W ith retained earnings calculated, Video Memories'

balance sheet can be prepared. Video Memories' 31 May
adjusted t rial balance shows seve ral balance s heet
accounts, st arting with Cas h an d continuing t hrough
Ordinary Shares. These accounts. along with the amount
of retained earnings f rom the M ay statement of retained
earnings, should be include d on the balance sheet.
Therefore, Video Memories' 31 May ba lance sheet would
appear as follows:

Cash s 8250
Accounts Receivable 1500
Supplies 650
Equipment $18 000 ~lU Tf/_,
Download the Enrichment •
Less: Accumulated Depreciation 600 17400 Modules for further practice
Total Assets $27 800
----------------------------~
Interest Payable $ 45
CLOSING PROCESS
Notes Payable 9000
Afte r f inanc ial st atemen ts are prepare d, companies
Total Liabi lities s 9045
conduct t he closing process. The c l osing
Contributed Equity $15000 closing process The
process is w hen all revenue, expense process of tiansferring all
Retained Earnings 3755 revenue. expense and
and d ivid e nd accou nt ba lances are
Total Shareholders' Equity 18755 dividend account balances
transferred t o the Retained Earn ings to the Retained Earnings
Total Liabil ities and account . This transfe r is necessary for account.
Shareholders' Equity
three reasons.
First, revenue. expense and d ividend accounts are
temporary accounts, meaning t hat they temporary
accumu late balances on ly for the current accounts Accounts that
acculllJiate balances only
account ing period. After the period ends
fo< the current period.
and financial statements are prepared, all
temporary accou nts must be reset to zero for the start of
the next period.
Second, the transfer updates t he Reta ined Earnings
account to its correct end-of-period balance. In t he preceding
example, t he balance in Retained Earnings is generated f rom
the statem ent of retained earnings, not the adjusted trial
balance.The closing process is the mechanism that updates
the actual Retained Earnings account balance in the ledger.
Third, t he closing entries leave t he revenue, expense and
dividend accounts w ith zero balances to com mence the next
accounting period and any amount now entered in these
temporary accounts relates to the new accounting period.

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closing entries Entries The closing process is accomplished total expenses. In the second entry, the dividends account
made in the journal and w ith several entries. Closing entries, is eliminated an d the Retained Earnings account is
posted to the ledger that
eliminate the balances in all wh idh are made in the journal and posted decreased by the same amount.
tempaary aa:ounts and to the ledger, eliminate the balances in all All three closing entries would be poste d to t he
transfer those balances to temporary accounts and transfer those appropriate T-accounts as follows:
the Retained Eamings
aa:ount. balances to the Retained Earnings
account. Usually, one entry is made for Retained Supplies Interest
Earnings Expense Expense
revenues, one for all the expenses and a fina l entry for
dividends. To illustrate, the temporary accounts from Video 8500
Memories' adjusted trial balance are shown in the following 3245
partial adjusted trial balance: 1500

Video Memories 3755

Partial adjusted trial balance
31 May
Depreciation Advertising Salaries
Debit Credit Expense Expense Expense

~~
Service Revenue $8500 2000
Supplies Expense $ 350 0 0 2000
Interest Expense 45 0 0 0
Depreciation f;(pense 600
Advenising Expense 250 Service
Revenue Dividends
Salaries f;(pense 2000
8500 1500
Dividends 1500
8500 1500
Video Memories has one revenue account with an 0 0
$8500 credit balance. To eliminate that balance and t ransfer
Notice t hat after the closing entries are posted, all
it to the Retained Earnings account, the following closing
revenue, expense and dividend accounts have zero
entry is required:
balances as desired. They are now ready to begin the next
31 May Service Revenue 8500 reporting period. Also, Retained Earnings has a $3755
Retained Earnings 8500 cred it balance. This is the balance reported on Video
(To close revenue account) Memories' statement of retained earnings and balance
sheet. In other words, t he Retained Earnings account now
In this entry, t he revenue balance is eliminated wh ile has the correct ba lance at the end of the period.
the Retained Earnings account is increased. As a final dheck that all accounts have been properly
Expense and dividend accounts are closed in a similar closed, a new t rial balance is prepared. Appropriately called
fashion. To eliminate those balances and transfer them to a post-closing trial balance, it contains all account balances
Retained Earn ings, t he following clos ing entries for t he beginning of the next accounting period. Video
are required: Memories' post-closing t rial balance is as follows:

31 May Retained Earnings 3245 Video Memories

Post-closing trial balance
Supplies Expense 350 31 May
Interest Expense 45 Cash $ 8250
Depreciation Expense 600 Accounts Receivable 1500
Advenising Expense 250 Supplies 650
Salaries Expense 2000 Equipment 18000
(To close the expense Accumulated Depreciation $ 600
accounts) Interest Payable 45
31 May Retained Earnings 1500 Notes Payable 9000
Dividends 1500 Ordinary Shares 15000
(To close the dividends account) Retained Earnings 3755
Totals $28400 $28400
In t he f irst entry, all expense accounts are eliminated
and the Reta ined Earnings account is decreased by the

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.;.;;...
73
 prepare a trial balance. This chapt er demonstrated the two
major pro cesses that occur at the en d of t he period:
adjusting and closing. The adjusting process includes the
recording and posting o f adjusting entries, and t he
preparation of an adjusted t rial balance, f rom which f inancial
statements are prepared. The closing process includes the
recording and posting of closing entries, and the preparation
of a post-closing trial balance. Once closing is completed,
the accounting information system is prepared to begin the
next period. Exhibit 4.6 summarises these steps.

1 Joumal ise and post accounting transactions

2 Prepare a trial balance
3 Joumal ise and post adjusting entries
4 Prepare an adjusted trial balance
5 Prepare financial statements
6 Journal ise and post closing entries
7 Prepare a post<losing trial balance
This and t he previous chapter covered the accounting cycle.
The accounting cyc le is the sequence
accounting ~ The accountong cycle
cycle The sequence ol o f step s in wh ich an accou nting
steps in which an
information system captures, processes
accounting information
system captures,
processes and reports a
and repo rts a company's accoun t ing
~·\'1 ""
t ransactions during a period. Chapt er 3 Test your understanding willl the •
company's accounting online revision quizzes for this chapter
transactions during a demonstrated t he f irst three steps: how
period. to record journal entries in the journal,
post t he information to t he ledger and

•
Interactive quizzes
Enrichment modules
Animations
E·lectures
Glossary
Flashcards and more

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 5 Adjust i n g journal entry- revenue
Leopard Legal agrees to prepare and represent Ah m court
for a speedmg fme. The firm charges a flat fee of $250 per
hour and always connpletes the service before billing the
client. The ftrm completes the service on 16 Apnl and bills
Ali on 1 March, w1th the b1ll amounting to 20 hours. Leopard
Legal prepares fmanc1al statements at the end of each
month.
1 Cash and accrua l basis
During 2017. Supreme M edia Company earned $77 500 in
REQU IRED
revenue. At year-end, only $58500 of that revenue had been a Prepare any adjusting journal entry necessary for
collected. Not only this. Supreme Med1a incurred $39600 of Leopard Legal on 30 April.
expenses of wh1ch only $35000 had been paid . b Expla1n if th1s s1tuat1on is a deferred or accrued revenue.
REQUIRED c Show the T-accounts w1th the adjusting JOurnal entry
posted to them .
Determ1ne prof1t or loss (total comprehensive 1ncome) for
the year under (a) the cash bas1s of accounting and (b) the
accrual bas1s of accounting. 6 A d justing journal entry - expense
On 1 March, Mustafa borrows $62 000 from Northern Lights
2 Adjusting journal entries Bank on a short-term loan. Interest is paid after three
months and annual1nterest rates are 6 per cent.
Cons1der the following incomplete adJUSting journal entries:
REQU IRED
{a) 5600
a Record the adjusting journal entry necessary on 1 May.
Accumulated Depreciation 5600 b Post the 1 May journal entry to the relevant ledger
2 Interest Expense 8500 T-accounts.
{b) 8500
7 Adjust i n g journal entry errors
3 Accounts Receivable 17000
Natali!!, a ftrst-year 1ntern at an mvestment bank, believes
{c) 17000 that she may have made errors 1n her adJuSting entries. She
4 (d) 6750 has asked you for adv1ce and reveals the follow1ng
account1ng records:
Subscnption Revenue 6750
a Deprec1at1on expense on a car vvas not recorded .
REQU IRED b Revenue was recorded for the current year when the JOb
Identify the likely account(s) that would complete each will be completed next year.
adjusting journal entry (a) to (d). c Comm1ssion from customer service operators has been
overlooked .
3 Adjusting journal entries REQU IRED
Consider the four entries in the preced1ng exercise. Determ1ne the likely accounts that are affected by each error
and whether those accounts are understated or overstated
REQUIRED
as a result of the error.
Identify each entry as an accrued expense. an accrued
revenue, a deferred expense or a deferred revenue.
8 Calcul at e expenses and revenues

4 A d justing journal ent ry - expense The current and pnor-year balance sheet of NCA show the
follow1ng account balances:
Muscle Man Ltd pays its one-year msurance pol1cy of
$29 000 on 1 October. The insurance policy covers all claims Current year Prior ye•r
in the next 12 months. The company is preparing its fmancial Supplies $4000 $6500
statements on 31 December.
Unearned Revenue 8400 8000
REQU IRED
During the current year, NCA purchased $13300 of supplies
a Determine whether the expense IS deferred or accrued
expense and explain why. and rece1ved $8700 of cash for services to be performed later.

b Prepare the journal entries that Muscle Man would make REQU IRED
dunng October (receipt of cash) and on 31 December. Usmg ledger accounts, determme Net\s supplies expense
and serviCe revenue for the current year.

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 9 Adjusting journal entries 12 Adjusting and c.losing process
Christina Industries provides the following selected Consider the following accounts: Cash, Accounts
information from its trial balance and adjusted trial balance Receivable, Accounts Payable, Retained Earnings, Service
at 31 October: Revenue, and Supplies Expense.
REQUIRED
Determine which accounts fall into the following categories:
a Accounts that can be adjusted and closed.
Unadjusted Adjusted b Accounts that can be adjusted but not closed.
Debit Credit Debit Credit c Accounts that are not normally adjusted or closed.
Accounts $6910 $9240
Receivable 13 Adjusting journal entries
Supplies 3400 2200 In its first year of operations, Savina Sweeties entered into
Service Revenue $17480 $19810 the following transactions, among others:
1 January: Bought equipment, $90 000.
Supplies Expense 5320 6520
ii 31 February: Prepaid one year's rent, $30000.
REQUIRED iii 1 June: Took out a one-year loan from the bank at an
Prepare the adjusting journal entries that Christina Industries annual interest rate of 5 per cent, $25000.
must have made at 3 1 October. iv 1 August: Received payment for goods not yet
rendered, $15000.
10 Prepare financial statements from ij v 1 September: Paid for salaries expense, $3000.
trial balance On 31 December, Savina has earned $5000 of the
The adjusted trial balance for Mark Boxing Bros is as $15000 in transaction (iv) and has incurred but not recorded
follows: $800 of electricity and $500 of salaries expense. Savina
prepares adjusting entries on an annual basis.

I ~J
REQUIRED
Prepare journal entries for transactions (i) to (v) and any
adjusting journal entries needed at 31 December. Assume
Debit that the equipment depreciates $10000 annually.
Cash $3500
Accounts Receivable 400 14 Adjusting journal entries
Supplies 1500 Marshall Company's annual accounting period ends on 30
$ 650 June 2019. Marshall makes adjusting journal entries semi-
Accounts Payable
annually, and the following information applies to all
Salaries Payable 1900 necessary adjusting journal entries at 30 June 2019:
Retained Earnings 1600 a Marshall carries the following two insurance policies:
Service Revenue 5450
Policy Purchase Policy Cost at purchase
Salaries Expense 3700 date length date
Supplies Expense 500 1 July 2017 5 years $50000

Total $9600 $9600 ii 1 July 2018 2 years $20000

b At 1 January 2019, office supplies totalled $ 1800. In the
REQUIRED
past six months, additional supplies of $2700 were
Prepare Mark's income statement and statement of retained purchased, and a count revealed $2150 available supplies
earn ings for the month of June and his balance sheet at 30 at 30 June 2019.
June.
c Marshall owns one building:

11 Closing entries Cost Useful life Annual depreciation

Patrick Lawn and Order generates and records $45000 of $150000 25 $6000
revenues and $36000 of expenses during the month. It also d Marshall decides to rent out a portion of its building. On
pays and records $1500 in dividends for the month. 1 June 2019, Marshall received a prepayment of $5700
REQUIRED for rent for the months of June. July and August.
Prepare Patrick's closing entries for the month and
determine the net change in retained earnings because of
those entries.

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e The Marshall staff consists of seven employees. Each
employee earns a total of $1200 a week and 1s pa•d each
Monday for the prev•ous week's work. 30 June 2019,
falls on Thursday.
REQUIRED
Prepare all necessary ad)UStmg entnes at30 June 2019.
15 Adjusting journal entries
Tammy, a f~rst-year accountant at V1ohnda. has asked you to
rfNiew the follOWing •tems for potential errors. Viohnda has a
31 December year~nd.
D1d not adJUSt the Prepaid Insurance account for the
$7700 of msurance that exp~red dunng the year.
ii Recorded a full year of accrued Interest on a $20 000.
10 per cent note payable that was entered into on 1
July (6 months ago). Interest is payable each 1 July.
iii Did not record $10000 of deprec1at10n on an office
build1ng.
iv Recorded revenues of $16 500 when payment was
received for a job that will be completed next year.
v Recorded $900 of electricity expense for December
even though Violinda will not pay the bill until January
of next year.
vi Fees due from customers amounting to $4050 are
not included in the accounts.
REQU IRED
Determ1ne ifTammy made any errors in the six items. For
those 1n wh1ch an error was made, prepare the entry that
Tammy should have made. What was the net effect of
Tammy's errors on the mcome of Viohnda?
17 Match terms and definitions
The following is a list of various accounung terms and
definitiOns:
Accrued expense
ii Accrued revenue
iii Deferred revenue
iv AdJuSting JOUrnal entries
v Cash bas1s of account•ng
vi Deferred expense
vii Accrual bas1s of accounung
viii Clos1ng process
ix The final step 10 the accounung cycle whereby all
revenue, expense and d•v•dend account balances are
transferred to the Reta•ned Earnmgs account.
REQUIRED
Match accounting terms (i) to (1x) with the appropnate
definition below:
a Cash is received before revenue is earned.
b Cash is paid before expense is incurred.
c Expense is incurred before cash •s paid.
d Revenues are recorded only when cash is received. and
expenses are recorded only when cash is paid.
e Entries made into the general journal at the end of an
accounting period that record prev1ously unrecorded
revenues or expenses.
Revenues are recorded only when they are earned. and
expenses are recorded only when they are incurred.
g Revenue 1S earned before cash IS rece1ved.

16 Closing process
A part1al adJUSted tnal balance for Sebastian Empanadas 1S
shown as follows:

Sebastian Empanadas
Partial adjusted trial balance
30 June

Retained Earnings $1 7150

18 Cash and accrual income
Sales Revenue 30500
Golden Glona Time Ltd keeps records under the cash bas1s
Advenising Expense s 1200 of accounting rather than the accrual bas1s. Glona's 2020
Depreciation Expense 10750 income statement and additional data from 2019 and 2020
are as follows:
Interest Expense 560
Salaries Expense 5000 Golden Gloria Time Ltd Cash-Basis
Supplies Expense 2500 Income statement
for the year ending 31 December 2020
Utilities Expense 2080
$54000
Dividends 1000 - - - Revenues
Expenses 35000
REQU IRED Profit $19000
a Prepare Sebast•an Empanadas' 1ncome statement and
statement of retained earmngs for the month of June.
b Prepare the appropriate clos1ng entries at 30 June.
c What •s the purpose of •closmg the books' at the end of
an account1ng penod?
 Addtttonaltnformation: REQUIRED
Prepare all necessary adJUSting entnes for the month of
31 December 31 December
September and prepare an adJuSted trial balance as of 30
2019 2020
August.
Accrued Revenues 6!m B!m
Deferred Revenues 131m 4500 20 Adjusting entries and closing entries
Accrued Expenses 5000 4000 The unadJusted and adJUSted trial balances of lee
Deferred Expenses 10000 Enterprises are as follows:
9500

All accrued revenues and expenses as of 31 December

2019 were collected and paid, in 2020. All deferred revenues
and expenses as of 31 December 2019 were earned and
used, tn 2020.
REQUIRED
Conven revenues and expenses from the cash basts to the
Cash 3500 s 3500
accrual baStS and recalculate income. Bnefly expla1n why Accounts 8250 10750
each adJUStment tS made. Receivable
Prepaid Insurance 4600 3400
19 Adjusting entries and trial balance Supplies 600 200
The unadjusted trial balance of AmyTran Spa is shown as Buildings 165000 165000
follows:
Land 75000 75000
AmyTran Spa Accumulated $15000 $ 31500
Unadjusted trial balance Depreciation
30 August
Accounts Payable 9950
--- 11000
Salaries Payable 0 1800
Cash $ 4300
Unearned 12050 10050
Supplies 2250 Revenue
Equipment 181m Notes Payable 501m 501m
Accumulated Depreciation 2400 IOO!m
Contributed lOO!m
Unearned Revenue $ 1500 Capital
Notes Payable 10000 Retained 34600 34600
10000 Earnings
Contributed Capital
Service Revenue
--- 48550 53050
Service Revenue 4000
Advertising Expense 650 Advertising 5600 5600
Expense
Deprectatton Expense 1200
Depreciation 16500
Interest Expense 400 Expense
Salanes Expense 600 Insurance 1200
500 Expense
DIVidends
$27!m $27!m Salaries Expense 7600 9400
Totals
Supplies Expense 400
Additional tnformaiiOn: Electricity 1050
on 30 August, Amy completed a servtce for whtch tt Expense
had received payment in August, $1500
Totals ~270 150 $270150 $292000 $292000
ii on 30 August, Amy determined that she had earned
but not yet billed (invoiced) revenues of $500 REQUIRED
i ii monthly depreciation on Amy's eqUipment is $150
a Compare the two trial balances and recreate all adJUSting
iv the tnterest rate on the prom tssory note is 6 per cent journal entries that were made at 30 June.
v a count of the supplies revealed $500 of supplies b What tS the net effect of the adjusting journal entnes on
remammg on 30 August totaltncome (profrt or loss)?
vi recetved an advenising bill to be pa1d next month of
$400
vii assume the tnal balance was last adJUSted on 31 July.

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78
21 Adjusting entries and financial 22 The accounting cycle
statements Johnvo Photography was founded on 1 April and entered
The 30 June unadjusted trial balance of ly & Thai Tutoring into the following transactions:
appears as follows: 1st Issued shares to shareholders in exchange for
$100000 cash.

[ ~.l
1st Purchased a camera (equipment) for $65000.
1st Purchased supplies for $2000.
Debit 1st Purchased a one-year insurance pol icy to be
consumed evenly over the next period, to be paid
Cash s 6900 next month - $3700
Accounts Receivable 4500 1st Took out a loan from First Bank for $100 000.
Prepaid Rent 6300 6th Hired two new employees on salary of $4000 a
Supplies 2250 month each.
Equipment 18000 6th Received prepayment for a contracted job to be
$ 900 performed in May - $22 500.
Accumulated Depreciation
8th Billed customers for services provided - $42 000.
Unearned Revenue 1500
12th Paid to have an ad placed on website during
Notes Payable 10000 April - $7000.
Contributed Capital 8000 18th Billed customers for services provided- $34000.
Retained Earnings, 1 April 12200 24th Paid dividends to shareholders - $5000.
Service Revenue 11200 30th Prepaid the next six months of rent starting with
May-$18000.
Advertising Expense 650
Additional information:
Depreciation Expense 900
April depreciation for the delivery van is $1085
Interest Expense 150 ii Interest on the loan from the bank is paid annually at
Rent Expense 2100 a rate of 6 per cent
1700 iii Prepaid insurance has expired
Salaries Expense
iv Employees' salaries earned during April but to be
Dividends ___j§Q paid in May.
Totals $43800 ~ REQUIRED
Additional Information: a Journalise the transactions for the m onth of April.
rent expires (is used up) at a rate of $800 per m onth b Post the journal entries to the general ledger usi ng
T-accounts.
ii monthly depreciation on equipment is $600
iii interest on the 6 per cent promissor y note is paid c Prepare a trial balance as of 30 April.
biannually on 1 July and 1 January d Prepare all necessary adjusting journal entries and post
iv performed services for which payment was received the entries to the appropriate T-accounts.
in April of $800 e Prepare an adjusted trial balance as of 30 April.
v received electricity bill for $600 to be paid next m onth Prepare an income statement and a statement of
vi services to customers earned $2000 during June but retained earnings for the month of April. Also prepare a
was unrecorded at 30 June classified balance sheet as of 30 April.
vii supplies on hand totalled $1000 at 30 June g Prepare all closing entries for the temporary accounts
viii owed employees for salaries totalling $900 for the and post the entries to the appropriate T-accounts.
last week of June to be paid in July h Prepare a post-closing trial balance as of 30 April.
ix l y & Thai Tutoring prepares adjusting entries each
quarter. Adjustments were last made on 3 1 March.
REQUIRED
a Prepare all adjusting journal entries for the quarter
ending 30 June.
b Post journal entries toT-accounts using totals on the
unadjusted trial balance as the opening balances.
c Prepare an adjusted trial balance as of 30 June.
d Prepare an income statement and a statement of
retained earnings for the three months end ing 30 June.
23 Locate and understand accounting information
e Prepare a classified balance sheet as at 30 June.
Access the latest annual report for Oantas (perform an
internet search for 'Qantas Annual Report')

Copyright 2019 Cengage l earning. All Rights Reserved. May not be copied, scanned, or dupllci:~~Et{'~l'h~c~~Jr.~C:~~gn~2;,~;Jfusting &ntr i&s __
.;..;..
79
 REQUIRED
Rev1ew the first note to the f1nanc1al statements and answer
the followmg questions:
a When does Oantas recogmse expenses from frequent
flyer po1nts? Where does it report 'redemption revenue'?
Is th1s an example of a deferred or accrued revenue?
b When does Oantas recogmse passenger and fretght
revenues?
c When does Oantas recogn1se revenues from members'
fees?
d How does Oantas recogn1se employee benefrts7
24 Communication activity
You are the ch1ef flnanc1al off1cer of a top-tier firm and the
date IS 30 June. You recently asked the new accountant to
prepare the 1nillal draft of the fmanc1al statements for your
review. However, when you rece1ved the draft. you qu1ckly
noticed that no adJUSting journal entnes were made.
REQUI RED
Write a short memo explaining the importance of adjusting
entries and the potential misstatements that can result from
their exclusion.
25 Communication activity
You are studying for your mid-term accounting exam with
your friend, Andrew. He IS struggling and says, 'I can never
understand why adjuSting entries are so important; you just
debit/credit cash, right?'
REQUIRED
Explain the Importance of adjusung entnes usmg accounting
concepts and address why the cash account IS never
Involved 1n any adjUSting journal entnes.
26 Ethics and adjusting entries
Mohammad's Kebabs IS a leadmg server of halal food.
Dunng the current year, 11 was on target to have record
mcreased revenues and profrts. However, towards the end
of the current year, 11 was found that a quaniJty of the food
was not halal cert1f1ed, wh1ch resulted 1n some lawsu1ts and
80 ACCD Fon~lll 2019 Cengajle L.umlng. AU Rlghta R--...ci.!Uy not be copied. scanned, 0< ~iealed,ln wholo Otln pat!. WCN 02·201>-202
_......;;;.;;.
a product recall of Mohammad Kebab's Kebab line. R1chard
Yalda the CEO recently approached Sadek Ahmed the ch1ef
accountant, about the Inevitable losses next year and asked
Sadek to defer all possible revenue until next year and to
accrue all possible expenses to the current year. 'We have
so much revenue to spare th1s year; R1chard sa1d, 'but next
year. we Wlll need all the help we can get'.
REQUIRED
a What eth1Cal1ssues are 1nvolved 1n th1s scenariO?
b If Richard gets hiS way, what accounting pr1nc1ples
would be v1olated?
c Some may say that R1chard IS s1mply manag1ng h1s
earmngs like he manages all other aspects of the
bus1ness. What IS your op1n1on of 'earn1ngs
management' of th1s kmd?
27 Ethics and adjusting entries
You are the serv1ce manager w1th a maJOr company. When
you sell a service, the customer pays cash and you provide
the service. At the end of each year. you are required to
estimate how much of each outstanding service contract
has been earned. At year-end, you have $1 million of
outstanding contracts. You estimate that you have earned
somewhere between 45 per cent and 55 per cent of those
contracts.
REQUIR ED
Under the following independent conditions. identify the
amount of outstanding contracts that you would report
earned. Explain why you would report those amounts.
a Your compensation IS based on performance and you are
$550000 short of your quota before your est1mate.
b Your compensation IS based on performance and you are
$450000 short of your quota before your esumate.
c Your compensatiOn IS based on your group's
performance, and while you have met your quota before
your est1mate, the group needs $600000 to meet the
group quota.

After studying the material i n th is chapte r, you
shou ld be able to:
Identify the role of internal control
in a business.
Describe five components of
internal control.
Understand two methods of internal control
over cash- bank reconciliations and petty
cash funds.
Appreciate the repo rting of cash and cash
equivalents.
Ana lyse cash t h rough t he calculation and
interpretation of h orizontal, vertica l and
ratio analyses and free cash flow.
apply this -·······-
Copyrlght2019 Cengage Loa nlng A R ght Rnervecl May not be c
This chapter examines the concepts of internal control and
how those concepts affect the accounting for cash . Internal
control is a company-wide process that seeks to improve
a company's operations and financial reporting and to
protect its assets.There are few assets that are more prone
to theft than cash, so internal control is extremely relevant
and important to the accounting for cash .
This chapter begins with the role and overall concepts
of internal control and then examines two control activities
relating to cash: bank reconciliations and petty cash funds.
The chapter concludes with how cash is reported and how
a company's cash position can be analysed.
III INTERNALCONTROL
A report prepared by forensic accounting firm Warfield &
Associates, Employee fraud in Australian financial
institutions. found Australian bank workers have taken from
the employer over $200 million in the past decade. with
gambling addiction being given as t he primary reason. 1
Other cases. like the nearly $20 million taken over a two-year
period by an accountant at (former) retailer Clive Peters.
illustrate the importance of good controls over the asset
cash.The accountant was sentenced to eight years 1n pnson.
In recent years. there have been numerous w idely
publicised accounting frauds. Major corporations such as
HIH Insurance 1n Australia and Enron in the US fa1led as a
result of fraudulent activity. Many began to question the
reliability and integrity of financial reporting of publicly listed
companies.
Faced with this crisis, the Australian Government
passed the Corporate Law Economic Reform Program
(Audit Reform and Corporate Disclosure) Act (CLERP 9) in
July 2004. The act sought to restore public confidence in
financial reporting by strengthening auditor independence
and enhancmg f1nancial reporting. At the heart of aud1t1ng
and financial report1ng is internal control.
In its broadest sense, i nternal intemal control The
c ontrol is the process that a company's sys~em ol policies ood
f)OCI!dures used on a
management uses to help the company company to p-crnote
meet its operational and financial effioont ard effective
reporting objectives. More specifically, qJerabons. rehable filmcial
reportu~ and 00111>harce
internal control is the system of policies with laws and regulations.
and procedures that a business
puts in place to provide ~,\1 11/,
reasonable assurances Cheek out the video sunvnary •
for Chapter 5
that
e the company's operations are effective and eff1c1ent
e the company's financial reporting is reliable
e the company IS complying with applicable laws and
regulations.
All companies have systems of internal control. The only
question is how strong or weak those systems are.
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81

Recognising that internal control affects a company's
success or failure. the Sarbanes-Oxley Act of 2002 in the
Umted States contained several new requirements for
publicly traded companies regarding internal control. One
of the most important requirements was that corporations
include in their annual reports to shareholders an internal
control report. To illustrate management's responsibility for
internal control, Exh ibit 5.1 contains an excerpt from the
Institute of Chartered Accountants in Australia Limited
(now known as Chartered Accountants Australia and New
Zealand) non-financial information assurance report. A
similar statement is also contained 1n the Independent
auditor's report on the financial informatiOn. You can see
from the aud1t report that the Institute's management is
respons1ble for its internal control.
The Responsibility of M anagement
for t he Report
The management of the Institute is responsible for the
preparauon and presentation of the non-financialmfonmation
1n accordance woth the subject maner and cmeria set out1n
the basis of preparation on page 43 of the amual repon. Th1s
responsibility Includes establishing and maonta111ing internal
conuols relevant to the preparation and presentatiOil of the
non-financialmformation in the amual report that IS free from
mate11al misstatement. whether due to fraud or error. selectmg
and apply1ng spec1fic principles. methodologoes. polic1es and
data sources used to prepare and present the Information; and
reponing targets that are reasonable, when appropriate.
Ernst & Young
Meredith Scon
Partner
Sydney 30 August 201 1
~ Lomoted assurance repon ICAA
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Chnnd _·-~on.-
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... ...... -~---
_ 82
___;;.;;
ACCTJ Finf.1'J1lftght 2019 Cengage learning. All Roghta R...rvod. May not be coptod, scanned, or dupllcatod In whole or In part. WCN 02·200-202
In 1992 the Committee of Sponsoring Organizations
(COSO) of the Treadway Commission released a report
called Internal control - rntegrated framework. The report
was the culminatiOn of the committee's exhausuve
researdh and deliberatiOn on the elements of sound internal
control. The comm1ttee's objective was to provide a
common understanding of internal cont rol- a framework
fo r implementing good internal control practices. Its
success is clear. The framework has become the standard
for understanding what good internal control looks like
in an organisation. and it is the
basis for the discussion in this
~·\'J '#"
Review this content •
dhapter. with the e-lec111ro
• COMPONENTS OF
INTERNAL CONTROL
The broad purpose of internal control is to help management
achieve effective and efficient operations, reliable financial
reporti ng and compliance with law s and regu lations.
Internal control - integrated framework states that good
internal control consists of the following five interrelated
components:
e control enwonment
e risk assessment
• control activitieS
e information and communication
e monitoring.
CONTROL ENVIRONMENT
The contr o l environment is t he control environment
foundation for al l other component s of The atmosphere in whoch
int ernal control. It is the atmosphere in the members of an
organosation conduct their
which the members of an organisation actovoties and cany out theor
conduct their activities and carry out their responsobihtJes
responsibilities. The control environment
is often called the 'tone at the top' because it reflects the
overall control consciOusness of an organisation.
Many factors affect an organisation's control
environment. One of the most important is the overall
integrity and ethical values of personnel. These attributes
translate into standards of behaviour t hat can permeate
t hroughout an organ isation's operations. Other factors
include management's philosophy and operat ing style. the
assignment of authority and responsibility. and the general
structure of an organisation. Each of these factors
contributes to the overall corporate culture w ithin whidh
internal control operates. W ithout a sound control
environment the remammg elements of internal control
suffer.

RISK ASSESSMENT
All organisations face a variety of risks that threaten the
ach ievement of the objectives. Risk
risk assessment
The identificatioo and assessment refers to the identification
analysis of the risks that and analysis of these risks, w ith the goal
threaten the achieY9111ent
of ()(ganisational obtectrves. of effectively managing them. Because
business conditions change over time,
risk assessment is an ongoing activity for any organisation.
Risks in any organisation can arise from both external
and internal sources. External sources mrght rnclude new
compeutors, changing customer expectations or even
natural catastrophes. Internal sources mrght include
rnadequate workforce training, errors in frnancral reporting
of activities or theft of assets by employees.
Once an organisation identifies its risks they can be
analysed with the following general process:
1 Estimate the sign ificance of a risk.
2 Assess the likelihood of the risk occurring.
3 Consider what actions should be taken to manage
the risk.
In CSL:s 2017 Annual Report ten risks are listed (e.g.
healthcare industry risk. manufacturrng and supply risk.
market practice risk. to name a few) along wrth Key risk
management for each.3
Minor risks are those with a lower likelihood of
occurrence that generally do not warrant serious concern.
For example, the risk of a meteorite destroying a company's
warehouse can likely be ignored. In contrast, significant
risks with higher likelihood demand considerable attention.
For example, the risk of an employee stealing cash requires
more attention. That attention comes in the form of control
activities.
Copyright 2019 Cengage learning. All R1ght1 R...rvod. May not be copied, scanned, or dupllcatod,ln whole ar In Dart WCN 02-200-202
CONTROL ACTIVITIES
Control activities are the policies and control activities The
procedures that management establishes policoes and procerues
to address the rrsks that might prevent established to adQ-ess the
nslts that t!Yeaten the
the organrsatron from achieving its achoevement of
objectives. A lthough specific control oryanosallonal objectNes.
activities vary widely across organisations,
they generally fall into one of several categories:
e establishing responsibility
• maintaining adequate documentation
• segregation of duties
• physical secunty
• independent venfication.
Estabhsnin responsibility
A critical factor in good internal control is establishing
responsibility for the performance of a given task. When
responsibility is clear, two benefits arise. First, the employee
knows that they w ill be held accountable for completion of
the task. Second, management knows who to consult if
the task is not completed satisfactorily.
A good example is a retailer's cashiers. Each cashier is
assigned sole responsibility over a specific cash drawer.
No other cashier has access to or responsibility for that
drawer. If a drawer is returned to the office short of cash,
management knows exactly which cashier to speak to. As
a result, cashrers are motivated to perform therr tasks well,
and the risk of theft or error is reduced.
Maintaming adequate documentation
Accounting information is useful only when it is reliable,
which means that it must be free from error. Control
activit ies are necessary in all organisations to promote
error-free accounting records. Consider the sale of a
company's inventory as an example. Good control practices
would requ ire that the sale be documented on a sales
invoice, preferably sequentially numbered so that the sale
will neither be lost nor recorded twice. The invoice m rght
also require the employee's password (or card swrpe) to
establish responsrbrhty for the sale. and it will have multrple
copies to be sent electronically throughout the organisation
for proper fulfilment and recording of the sale.
Segregation of duties
Segregation of duties is a technique that limits one person's
control over a particular task or area of a company. Often
called separation of duties, it is accomplished by spreading
responsibility among multiple employees so that one
employee's work can serve as a check against another's
work. For example, consider the process of ordering,
receiving and payrng for inventory. If one employee handles
all three tasks, there rs greater risk of error and possibly
theft of assets. However, if these three tasks are handled
CHAPTER 5 "Cash and 1nternal controls
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83
 by different employees, errors by one employee can be
caught by another employee. Moreover, unless the
employees work unethically together (collude), company
assets are more protected against theft.
Physical secum
Good internal control mcludes an effort to safeguard
company assets and records. Most of these safeguarding
controls are meant to prevent the loss of assets. Examples
include secured facilitieS, f1re and alarm systems, computer
passwords and encrypuon, v1deo monitors and door
sensors that signal when product IS inappropriately taken
from a store. This is particularly Important for a biotechnical
company where the product often has restrictions on
availability to the general public. Other controls are meant
to detect the loss of assets. An example is the periodic
counting of inventory for comparison to accounting records.
Significant discrepancies can then be investigated.
Independent verification
Independent verification is the process of reviewing and
reconciling information w ithin an organisation. Thi s is
particularly useful when reconciling an asset balance with
t he accounting records for that asset. An example would
be a bank reconciliation, where the bank's cash balance
and the company's cash balance are reconciled. Often, the
most effective verifications are conducted on a surprise
basis and are conducted by 1nd1viduals who have no
connection to the process or the employee being verified.
Internal aud1t divisions of organisations commonly perform
such venfications.
INFORMATION AND COMMUNICATION
Information and commumcauon IS another element of
sound internal control. Information and communication
refers to the need for the open flow of
infonnation and relevant information throughout an
communication
Requirad for the open organisatiOn. Information must be
How of relevant captured and communicated in a form
information throoghout an
and a timeframe that enables employees
organisation.
to complete their responsibi lities. This
requ ires information systems that produce relevant and
reliable reports. It also requires both upward and downward
lines of communication. M anagement must communicate
w ith employees, and employees with management.
MONITORING
monitoring Monit oring refers to the assessment of
The assessment of the the quality of an organisation's internal
quality of an
organisation's internal control. Monitoring can be accomplished
control. 1n two ways. The f irst is through ongoing
activities. For example, in their recurring
S4 ACCD Fon~l2019 CensJa9e L.umlng. AU RfghU R--..cl.l&ay not be copied. scanned.
_......;;.;.
daily responsibilities, supervisors can check for evidence
that a control activity is functioning properly. They can also
ask employees if they understand the controls in place and
if those controls are being completed. The second is
through a separate evaluation. In both ways, the purpose
of monitoring is to continuously improve mtemal control.
LIMITATIONS OF INTERNAL CONTROL
Regardless of how well mternal control is des1gned within
an organisation. it can provide only reasonable assurances
that a company is meeting rts ob1ect1ves. Internal control
systems are limited in their effectiveness because of the
human element and cost-benefit analysis.
The human element refers to the fact that internal
controls are often based on human judgement and action.
Despite our best efforts. we all make mistakes at times
and internal control cannot eliminate them all. Furthermore.
empl oyees can deliberately circumvent controls for
personal gain. Sometimes this w ill be a manager who
overrides the control activities in place. Other times this
w ill be multiple employees working together to circumvent
(get around) existing controls. Such collusion among
employees can be very effective at defeating a company's
internal controls.
Cost-benefit analysis refers to the cost of implementing
a control activity versus the benefit that the control
provides. For example, a company could install retina-
scanning security systems for its warehouses to decrease
the risk of theft. However. the cost of the installation may
far outweigh the marg1nal advantage that ret1na-scanning
security provides aver normal lock-and-key security. Further.
retina-scanning may be seen as too personally Intrusive.
and a non-biotechnical phys1cal access system such as a
staff card may be the comprom1se. A record of each card
tapped is recorded but without the added security of
knowing a lost or borrowed card is being used.
CASH CONTROLS
The best asset to use in demonstrating interna l control is
cash. Cash is a highly desired asset. It is easily concealed.
taken and converted into other assets with only a small
chance of det ection. As a result. companies normally
institute m any controls to safeguard their cash and to
report it properly. Electronic transfer of cash , either
physically by cards or online have their own controls:
passwords. PIN. SMS authorisation code, security
questions, etc.Two of these controls are bank reconciliations
and petty cash funds. Each is discussed in the following
sections.
0< ~iealed I n - 0< In part. WCN 02·201).202
 BANK RECONCILIATIONS The first reason relates to deposits and payments made
by the bustness that are not reflected on the bank
Most bustnesses keep the majority of thetr cash in a bank.
statement. For example. a deposit in deposit in transit
Thts tn ttself is a good control procedure because tt limits
transit ts a deposit that has been made Adepos~ttllathasbeen
opportuntties for theft - it is clearly more dtfftcult to steal made by the business but
by the company but does not appear on has not deared the bank
cash when it is locked up in the bank. The use of a bank
the bank statement because it had not asot the statement date.
also provides two sources of opposing record keeping; the
cleared the bank as of the statement
liability the bank has to the customer and the asset the
date. Because the cash is now in the bank. deposits in
customer has at the bank. That is. both the business and
transit should be added to the bank's cash balance. An
the bank keep a record of all cash transactions between
outstandi ng cheque is one that has outstanding cheque
them. As a result, a business (company} can compa re
been distributed by the business but does A d1eque that has been
these records to verify its cash balance. This comparison distributed by the bus1ness
not appear on the bank statement but has not cleared the
is called a bank reconciliation. because it had not cleared the bank as of bank as ot lhe statement
A bank reconciliation is the process
bank reconciliation the statement date. often because it has date.
The process of of recognising and nottng the dtfferences
not been depostted by the recipient.
reconcililg the drffE!fllllCeS between the cash balance on a bank
betv.oon the cash balance Because the cash tS no longer in the bank. outstanding
on a ~k statement ood statement and the cash balance in a
cheques should be subtracted from the bank cash balance.
the cash balance tn a business' records (at its simplest the
busmess' reoo rds As we move to a 'cashless' society these are becoming
'cash'ledgerT-account}. The purpose of a
less common.
bank reconciliation is twofold. First. it
confirms the accuracy of both the bank's and the business'
cash records and updates the business' records. Second,
~=:~ lj. /
it determines the actual cash balance to be reported on the
MUIIIII'1,_.
....... s
business' balance sheet. A bank reconciliation is prepared
as follows:
1 Reconcile the bank balance to the actual cash balance.
' '
2 Reconcile the business' bock balance to the actual cash
balance.
3 Adjust the business' bock balance to the actual cash
The second reason relates to errors made by the bank.
balance. Although bank errors are rare. they do occur and must
Reconciling the bank balance also be reconciled. An error can result in the need to add
to or subtract from the bank balance. For example,
The first step in a bank reconciliation is to adjust the cash
suppose that the bank erroneously records a $1450
balance reported on the bank statement to the business'
deposit as $1540; the bank balance is overstated by $90
actual cash balance. The bank balance w ill differ from the
and should therefore be reduced by $90. In contrast.
actual cash balance and will therefore need adjustment for
suppose that the bank records a $100 cheque as $10; in
two main reasons.
that case. the bank balance is understated by $90 and
should be increased $90.
Once all adtustments to the bank balance are made. the
adjusted bank balance should equal the actual cash balance
to be reported on the statement of financial positiOn.

Reconciling the business book

(ledger account) balance
The second step in a bank reconciliation is to adjust the
cash balance reported on the business' books to the actual
cash balance. The business book balance is likely to differ
from the actual cash balance and therefore needs
adjustment. There are two main reasons for this. The ftrst
reason relates to bank activities that change a bustness'
cash balance but have not been recorded by the bustness.
The bank may nottfy the business of an addition to the cash
balance on the bank statement. Conveniently called credit

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 memoranda, they arise when the bank collects cash on 3 The 31 Mardl bank statement shows the collection of
behalf of the business - often through the collection of a a $550 receivable from one of Chapman's customers
business receivable or interest on a note. (Most deposits and a $50 monthly service fee. Chapman had not
in the business' bank accounts have an Electronic Funds recorded either of these two items.
Transfer [EFSJ Code and these deposits are regularly Resolution: The collection is a credit memorandum.
supplied to the business by the bank and automatically Add it to Chapman's cash balance. The fee is a debit
update the business' accounting records for both the memorandum. Subtract it from Chapman's cash
amount and the entity paying. It is on ly deposits not balance.
covered by the standard EFS that are included in the bank 4 The 31 March bank statement shows that a $220
reconciliation.) These shou ld be added to the business' customer cheque was returned to the bank for
book balance. A debit memorandum is notification of a non-sufficient funds (NSF). This is commonly known as
subtraction from the cash balance on the bank statement. a 'bounced' cheque . Chapman had not recorded
Common examples are fees charged for banking services th is item.
and customer cheques returned for insufficient funds. Both Resol ut ion: The NSF cheque is a debit memorandum
of these examples reflect cash that the business no longer because no cash was received from the customer's
has, so they should be subtracted from the business' book dleque that Chapman deposited earlier. Subtract it from
balance. With on line banking, bank account balances are Chapman's cash balance.
available at any time. The second reason relates to errors 5 A cheque clearing the bank for $400 was erroneously
made in the business' cash records. For example, suppose recorded in Chapman's records at $450. The cheque
that during the reconciliation a business discovers that it was written to pay off an open account payable.
erroneously recorded a dleque it had written for $1000 as Resol ut ion: Chapman recorded $50 too mudl for the
only $100. The business' balance is overstated by $900 and cheque. Therefore, Chapman's cash is understated by
shou ld be reduced by $900. $50. Add the $50 to Chapman's cash ba lance.
Chapman's resu lting bank reconciliation is shown as
Adjusting the cash balance follows. The top half shows the reconciliation of the bank
Once the bank balance and the business' book balance are balance while the bottom half shows the reconciliation of
reconciled, the business' cash balance must be adjusted the business' book balance:
to the actual cash balance determined by the reconciliations.
Therefore, the third step in a bank reconciliation is to record Chapman
Bank reconciliation
the journal entries necessary to adjust the business' book 31 March
balance to the actual cash balance. The journal entries Balance per bank statement $49880
are based on the credit and debit memoranda, and
Add deposits in transit:
~,\1 ,,,, errors identified during
30 March $6450
Check out the animated summary the reconciliation of the
• on Bank Reconciliation 31 March 7686
business' balance.
Deduct outstanding cheques:
BANK RECONCILIATION EXAMPLE No. 1987 $ 589
No. 1991 2669
To illustrate a bank reconciliation, suppose that Chapman
Enterprises maintains an account with Murray River Bank. Actual cash balance
At the end of March, Chapman shows a cash balance of Balance per business records $54567
$54 567 wh ile Murray River shows a balance of $49880. Add:
The differences result from the following: Collection of receivable $550
1 Deposits of $6450 on 30 Mardl and $1236 on 31 Mardl Error by Chapman 600
do not appear on the 31 March bank statement since Deduct:
they had not cleared the bank as of 31 March.
Monthly service charge $50
Resolution: These are deposits in transit. Add them to
NSF check
the bank balance.
Actual cash balance $54897
2 Cheques written in late March for $589 (Cheque #1987)
and $2080 (#1 991) do not appear on the 31 Mardl bank Both reconciliations correctly show an actual cash
statement since they had not cleared the bank as of 31 balance of $54 897. To adjust the business' cash balance to
March (probably yet to be deposited by the recipient). that actual balance, the following entries must be made.
Resolution: These are outstanding dleques. Subtract Note that each of the four entries comes from the four
them from the bank balance. adjustments made in the reconciliation of the book balance
to the actua l balance.

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Entry #1: Collection of the receivable After these four entries are recorded, the business'
cash balance is updated to the actual cash balance.
Chapman updates its cash balance to reflect the bank's
collection of the receivable.
PETTY CASH FUNDS
31 Mar. Cash 550 Most companies require that all disbursements of cash be
Accounts Receovable 550
____ (To record
;....._ the collection of a receivable by the bank)
made with an authorised electronoc transfer or double-
signed cheque. This is a baste control actovoty that allows a
Assets Loabiliues + E~ity business to better monitor ots cash outflows. However,
t550 there are many onstances when only a monor amount of
cash is needed and the process of wrottng a cheque is
-550 burdensome or a cheque os not aocepted. Examples would
include postage for small maoltngs and the purchase of
Entry #2: Corr~1on of error miscellaneous office supplies. To handle such cases. a
Chapman corrects the error made when the $400 cheque business may establish a petty cash fund.
was recorded for $450.This requires Chapman to add back A petty cash fund is an amount of petty cash fund
cash kept on hand to pay for minor An amount of cash kept
to both cash and accounts payable. on hand to pay fO< minor
expenditures. While the size and scope of
expendotures.
3 1 Mar. Cash 50 a petty cash fund wi ll vary ac ross
Accounts Payable 50 businesses, its operation will involve the
----------- -------------------
(To correct error) following three activities:
--------~-- -------------------- e establishing the fund
Assets Liabilities + Equity
e making payments from the fund
+50 +50 e replenishing the fund.

Entry #3: Monthly service charge Establishing the fund

Chapman records the monthly service charge as an A petty cash fund is established by writing a cheque for the
expense. As a result, both assets and equity decrease. amount of the fund, cashing the cheque and placing the
cash under the care of an employee designated as
31 Mar. SeMce Charge Expense 50 custodian. A journal entry is then made to record the
Cash
------------------
50 establishment of the fund.
(To record monthly expense for bank account) To illustrate, suppose that on I May, The Valley School
(Valley) cashes a $100 cheque to establish a petty cash fund
Assets Loabilnies + E~ity
and gives the cash to the custochan Thu Tran. On this date.
-50 ~
Valley would record the following entry.

Entry #4: Non-. c•ent funds cheque I May Petty Cash 100

Chapman records the effect of a cheque returned for NSF Cash 100
by reinstating the receivable (the customer still owes the (To establish $100 petty cash fund)
money) and reducing its cash balance. Since the cheque Assets Liabolitoes + Eqwty
was not valid, the receivable has not yet been collected. +100
Chapman must now try to collect again.
- 100
31 Mar. Accounts Receivable 220
Cash 220 The entry increases Petty Cash and decreases Cash.
Notice that t here is no change in total assets. Valley has
(To reinstate customer receivable)
Assets Liabolities ____
+ Equity
...:..._.:....
simply designated $ 100 to be used in a petty cash fund.
Valley still has its cash. It has not yet disbursed any cash
+220 outside of the business.
-220
Making payments from the fund
After the fund is established. the cash is used to pay for
qualifying expenditures. Payments are usually made in one
of two ways: cash can be taken from the fund to make
payment or employees can seek reimbursement from the
 fund for payments they have personally made. In either
case, the custodian should collect rece1pts and
authorisations for the use of any cash. As payments are
made from petty cash, no journal entries are made. Journal
entnes are recorded only when the fund is replenished.
I Assets
Replenishing the fund
As the cash in the fund decreases, the fund must be
replemshed. To do so, the remaining cash in the fund is
counted and the business cashes a cheque for the amount
that bnngs the total cash in the fund back to the original
balance. The receipts in the fund are then used as
documentatiOn for recording expenses.
To illustrate. suppose that on 31 May, Tran examines
the petty cash fund and prepares the following report.
The Valley School
Petty cash fund replenishment report
Petty cash fund $100
less. cash rema1ning in the fund
Cash requested to replenish fund s 85
Rece1pts m the fund
Postage $ 25
Office supplies
Miscellaneous
Total rece1pts ~
The report shows that the fund needs $85 to be fully
replenished. It also shows that there are receipts totalling
$85. As a result, Tran would cash a cheque for $85 to
replenish the fund and record expenses as follows :
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88
_......;;.;.
31 May Postage Expense 25
Supplies Expense 47
Miscellaneous Expense 13
Cash 85
(To replemsh petty cash fund and record
various expenses)
__; ____ _ _
- 85
liabilities + Equity
- 25
- 47
- 13
The entry increases the three expense accounts related
to the expenditures and decreases the Cash account for
the amount of the cheque. Because Valley is record1ng the
expenses resulting from fund use, the entry reduces both
assets and equ1ty. This same type of entry would be
repeated each time the fund is replenished.
Cash over and short
When a petty cash fund is replenished, the amount of cash
needed for replenishment should equal the total amount of
receipts. However, this will not always be the case.
Sometimes, the custodian will not obtain all receipts or will
give incorrect change, resulting in a discrepancy between the
cash needed for replenrshment and the amount of reoetpts.
In such cases, the discrepancy is charged to an account called
Cash Over and Short. Cash Over and Short is a temporary
account that can have either a debit or credit balanoe,
depending on the situation. A debit balance increases
expenses while a credit balance decreases expenses.
Many businesses have done away w ith petty cash and
require employees to spend their own money and seek
electronic reimbursement. In some cases employees are
issued with a business credit card and are required to
15 ju stify and receive authorisation for any purchases after
they are made. Bus1ness credit cards cannot prevent
unauthorised expenditure, but
it can easily be detected and the Review Ibis content
with the e-leewre
employee held to account.
47
13
REPORTING CASH AND
CASH EQUIVALENTS
At its most basic level. cash is a medium eash A med,um of
of exchange. A general rule is that exchange.
something is cash 1f you can deposit it into
a bank and readily use n to pay someone. A credit card IS
not cash although you can use it to buy goods and sei'Vlces;
it is access to a pre-arranged loan. A debit card is a means
of accessing cash and along with EFT has almost
completely replaced oheques.
 In addition to these forms of cash. companies often
hold investments that are so much like cash that they are
deemed to be equivalent to cash. A cash equivalent is
any investment that is readily convertible
cash equivalent
Any investment that is into a known amount of cash and may be
readily convertible into limited to investments that have a
cash.
maturity of a few months. Cash
equivalents are so much like cash that they are combined
w ith cash for reporting purposes. In its annual report CSL
states:
Cash and cash equivalents are held for the purpose of
meeting short term cash commitments rather than for
investment or other purposes. They are made up of:
• Cash on hand.
• At call deposits w ith banks or financial institutions.
• Investments in money market instruments with
original maturities of six months or less that are
readily convertible to known amounts of cash and
subject to insignificant risk of changes in value.•
Cash and cash equivalents are reported on the balance
sheet usually as the f irst current asset.
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A company's management of cash is critical to its success.
If a company does not have enough cash. it can quickly run
into major problems. The following sections examine the
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cash position of CSL. The examination will require the cash
ba lance f rom the company's ba lance sheet and various
items from its cash f low statement.
HORIZONTAL AND VERTICAL ANALYSES
A good place to start the analysis of any asset account is
horizontal and vertical analyses. Recall from Chapter 2 that
horizontal analysis ca lcu lates the dollar change in an
account balance, defined as the current-year balance less
the prior-year balance. and divides that change by the prior-
year balance to yie ld the percentage change. Vertica l
analysis divides each account balance by a base account.
yielding a percentage. The base account for an analysis of
cash is total assets. These calculations are summarised as
follows:
• HORIZONTAl ANALYSIS
DollarChange in Current Year Balance -
Account Balance Prior Year Balance
Percentage Change Dollar Change
in Account Balance Prior Year Balance
Cash
Percentage = Total Assets
Given CSt:s information in Appendix B. horizontal and
vertical analyses of cash result in the following:
Horizontal analysis
Cash and Cash Equivalents increase $328m or 59% increase
2016 to 2017
Vertical analysis
2017 2016
..-..-..-........................,..._ ,,,_,,_ ..,_...........
Cash and Cash Equivalents 9.7% 7.4%
The horizontal analysis shows that CSt:s cash increased
significantly, by over $328 million in 2016-17, wh ich equals
a 59 per cent increase over the prior year. The vertical
analysis shows t hat cash made up less than 10 per cent of
total assets in 2017. This was a smaller increase than the
pe rcentage increase from t he prior year. because total
assets increased over 20 per cent for the year.
Whi le the preceding analysis shows that CSL:s cash
increased during 2017, it does not indicate how cash
increased. To find th is out, investors and creditors can look
at the information on the company's cash flow statement.
Recall from Chapter 1 that the cash flow statement
classifies a company's cash inflows and outflows into three
main categories: operating activities. investing activities
__
and financing activities.
;;.;._
89
 Operating activities include those transact ions property, p lant and equ ipment (CSL would include
necessary to run the business. This wou ld include selling intangible assets as the business is based as much on
a product, paying employees and advertising. According to intellectual property as buildings and equipment) during t he
Exhibit 5.2, CSL generated almost $1250 million in cash year, or for a large diverse business such as CSL the net
from operations during 2017. wh ich is over f ive per cent cash flow from investing activity. Dividends are payments
more than in 2016. to shareholders during the year. For CSL this also includes
Investing activities include the buying and selling of payments for share buy-backs (these are d iscussed in
revenue-generating assets. CSL reports a net cash outflow Chapter 11). Each of these items is found on the cash flow
of over $860 billion from investing activit ies in 2017. The statement.
majority of that outflow was to pay for property, plant and
equipment.
Financing activities include the raising and repayment
of capital through debt and equity. During 2017. CSL both
repa id loans ($581 m) and borrowed ($1381 m) for an
$800 m illion increase in borrowings. The majority of t he net
outflow from f inancing activities was to pay dividends (over
$600m). From the bottom of t he cash f low statement you
can see cash over the period increased by $280 million.
CSL does not tell us why it increased its cash holdings, it
even states that ' liquidity and refinancing risks are not
significant'5 , this may be due to the large cash holdings.

FREE CASH FLOW

A company needs to generate enough cash to pay its bills.
It also needs to generate enough to maintain its operating
assets and to reward its sha reholders w ith dividends. If a
company can generate more cash than it needs for these
commitments, it is generating free cash f low.
Free ca sh flow is the excess cash a From the information in Exhibit 5.2, CSL:s f ree cash
free cash flow The
excess cash a company company generates beyond what it flow for 2017 and 2016 is calcu lated as follows (rounded to
generates beyond what it needs t o invest in productive capacity the closest $ million):
needs to invest in
productive capacity and and pay dividends to shareholders. That
pay dividends to is, free cash flow is a measure of a
l@i§JiMtJIW
shareholders. 2017 2016
company's ability to generate cash for
expansion, for other forms of improved Cash Flows from Operating Activities $ 1247 $1 179
operations or for increased returns to shareholders. While Less: Capital Expenditure (863) (810)
free cash flow can be defined in many ways, the most (investing activities)
straightforward definition is as follows:

.. FREE CASH ROW

Less: Dividends and share buy-backs

Equals: Free Cash Flow ~)

(916)

~)
(1227)

Cash Flows f rom Operating Activities
-Capital Expenditures
- Dividends
= Free Cash Flow
The analysis starts with cash flows f rom operating
activit ies, which is a measure of a company's abi lity to
generate cash from its current operations. Cap ita l
expenditures refers to the amount a company spends on
As a growing business CSL may be expected to
increase its cash. The balance sheet shows an increase of
almost $287.7 million during the year ($555.3m to $843.0m).
yet there is negative free cash flow. From the cash f low
statement (financing activities) it can be seen proceeds
f rom borrowings (debt) was greater than repayment of
borrowings by about $800m ($1381m - $581m).
$847 m illion in 2017. The cash f low statement shows the
shortfall in free cash f lows and the increase in cash came
from borrowings.

__ ;.;.
90
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Cash and cash equiva lents at the end of the financial year
~ CSL:s 2017 consolidated statement of cash flows

The CG'Isolidatecl statemoot oi casta Rows !iflould be read •n CCJrliU'CbCII \\1th tlva ao:unpanyrlg notes.
CSl. AnrllalFle{at2017,p_ 84. t02017 CSliJmited. Reproduced wrthpennssion.

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.;...;...
91
 ~,\1 ,,/,
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 4 Bank reconciliation items
The follewtng 1tems may or may not be relevant to a
company's bank reconc11ia110n:
The company recorded a depostt as $400, but 1t
correctly cleared the bank for $350.
ii A cheque recorded for $800 is shown on the
bank statement as an $800 reduction to the cash
1 lntemal control balance.
iii The bank statement shows a $20 monthly service
Consider the following independent scenarios:
fee.
A company installs electronic sensors and camera
iv A $2750 depostt made by the company is not
surveillance to mitigate the risk of theft.
reflected on the bank statement.
ii A company creates customer tnvotces to be used for
verification. v Payment recetved from a customer is reflected on
the bank statement but not on the company's books.
REQU IRED
REQU IRED
Whtch element of tnternal control does each of the above
scenanos best relate to? Identify whether each 1tem IS (a) an addition to or
subtraction from the book balance. (b) an add1t10n to or
subtraction from the bank balance or (c) not 1ncluded on a
2 Match terms and definitions bank reconctliatton.
The following is a list of the components of mternal controls:
i Control environment 5 Petty cash
ii Risk assessment
On 1 June, JEA Rosario Branch established a petty cash
iii Control activities fund for $300. On 30 June, the fund's custodian prepares a
iv Information and communication repon showtng $96.20 in cash remaining and recetpts of
v Monitonng. $46.55 for postage, $86.50 for office supplies and $70.75 for
miscellaneous items. The custodian presents the report to
REQUIRED
the head off1ce accountant. who replenishes the fund .
Match each Internal control at (i) to (v) with the appropriate
def1mt1on below: REQUIRED
a The poliCies and procedures estabttshed to address the Prepare all necessary JOurnal entnes for the month of June.
nsks that threaten the achtevement of orgamsattonal
ObJeCtives. 6 Calculate free cash flow
b The assessment of the quality of an organtsatton's During the year, a company had cash flow from operattons
internal control. of $240000. During the year the company also bought a
c The atmosphere in which the members of an new piece of equipment for $70000. and $30000 of
organisation conduct their activities and carry out their dividends were paid.
responsibility.
REQUIRED
d The Identification and analysis of the nsks that threaten What is the company's free cash flow for the year?
the ach1evement of organisatiOnal objectives.
e A reqwement for the open flow of relevant mforma110n
7 Evaluate cash
throughout an organisation.
Estay Engtneenng stnves to keep a 'conSIStent' amount of
cash on hand. Its latest balance sheet prov1des the follOWing
3 lntemal control activities
tnformatton:
Garc1a Company has the followmg internal control
procedures: Cash and cash equivalents. current year
- - ' - - -- - -
An tnternal auditor reconciles the bank statement Cash and cash equtvalents. prior year
each month. ---'---- - -
Total assets, current year
ii The manager is required to authorise purchases
before they are made by employees. Total assets, prior year
iii A pre-numbered shipping document IS used for each
REQUIRED
shtpment to customers.
Ustng horizontal and venical analyses. determtne whether
iv The employee who wntes cheques cannot make
Estay IS matntatning a 'conststent' amount of cash. Round
entries m the general ledger.
percentages to one dectmal potnt (i.e. 9.4%).
v The company stores tnventory 1n a room that is
momtored by cameras.
REQU IRED
For each ttem, tdentlfy the internal control pnnctple that is
betng followed.

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93
 REQUI RED
8 Reporting cash and cash equivalents
Identify whether each 1tem IS (a) an addition to the book
The follow1ng IS a hst of items that may or may not be balance, (b) a deductiOn from the book balance, (c) an
mcluded m the cash and cash equ1valents total on the add1t1on to the bank balance or (d) a deduction from the
balance sheet: bank balance.
undepos1ted cheque from a customer
ii petty cash on hand 11 Bank reconciliation items
i ii ordmary shares of BHP Consider the followmg two mdependent situations:
iv interest collected from savings at Westpac Bank A company's 30 April bank reconciliation shows
v one-month Commonwealth Government Bonds deposits in transit of $4000. The company's books
vi certificate of deposit maturing in 45 days indicate deposits of $24 200 for the month of May,
vii cert1f1cate of deposit that matures m 120 days but the bank statement indicates deposits of
viii cash 1n cheque account $22 250 for May.
ix a customer's cheque returned by the bank and ii A company's 30 April bank reconciliation md1cates
marked non-suffic1ent funds. outstand,ng cheques of $4500. The company's
books Indicate disbursements of $18450 for the
REQUIRED month of M;ry, but the bank statement shows
FOf each of the stated rtems. indiCate whether the 1tem $20400 of diSbursements for M;ry.
should be 1ncluded or excluded from the cash and cash
equ1valents total. REQU IRED
a For s1tuat1on (1), determine deposits in trans1t at 28 May
9 Internal control activities b For situation (ii), determme outstanding cheques at
28 May.
Maria's Boutique uses the following control procedures:
The employee who works the register reconc1les
12 Prepare bank reconciliation
cash to receipts at the end of the day.
II Employees know that the Internal aud1tor will Juan Company's 30 June bank statement shows a balance
perform a bank reconciliatiOn at the end of each of $19 250. Juan's books show a 30 June cash balance of
month. $18100. Juan also has the follow1ng information:
iii Cheques are not pre-numbered because the depositS in transit as of 30 June. $2500
purchas1ng manager must approve payments II outstanding cheques as of 30 June. $3900
before cheques are signed. iii $150 serv1ce charge reported on the bank statement
iv A cash1er lets another employee work h1s ass19ned iv non-suff1c1ent funds cheque returned with bank
reg1ster while he helps a customer. statement. $2500
v Petty cash IS kept in a back room but is not v interest on note rece1vable collected by the bank,
momtored during the day. $1800.
vi The company's accountant records the receipt of REQUIRED
cash and cheques and makes deposits at the bank.
Prepare Juan's bank reconciliation as of 30 June and prepare
REQUIRED any necessary JOurnal entries resulting from the
ldent1fy the problem with each internal control procedure. reconciliation. What is the actual cash balance that should be
reported on the 30 June balance sheet?
10 Bank reconciliation items
Ar;rya's Wraps IS prepanng a bank reconciliation for the
13 Prepare bank reconciliation
month of March and needs help w1th the follow1ng 1tems: Noem1 Company's 30 September bank statement shows a
I A customer's $95 cheque was depOSited on 31 balance of $53810. Noem1's 30 September cash balance IS
March but does not appear on the bank statement. $45800. Noemi also has the following information:
II A cheque cleanng for $60 was recorded by Araya's deposits made but not appearing on the September
Wraps for $84. bank statement, $5500
iii The bank statement shows a $50 non-sufficient i i cheque written but not appearing on the September
funds cheque. bank statement, $12 200
iv A service charge of $45 was reported on the bank ii i one cheque wntten for the purchase of supplies was
statement. erroneously recorded for $890 but appears on the
bank statement as $980
v The bank statement shows that the bank collected
$105 of interest on Araya's Wraps' behalf. iv monthly serv1ce charges hsted on the bank
statement are $230. Noem1 had already recorded the
vi A charge of $25 for internet bank1ng was reported on
the bank statement. effect of $130 of those charges
v a customer payment fOf a $1500 rece1vable was
vii A $75 cheque written on 31 March does not appear
on the bank statement. collected by the bank but not yet recorded by
Noemi.

_ 94
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REQU IRED REQU IRED
Prepare Noemi's bank reconci liation as of 30 September and a Prepare horizon tal and vertical analyses of Nicole's
also prepare any necessary journal entries resulting from the Nursery's cash balance. Round percentages to one
reconciliation. decimal poi nt (e.g . 8.2% ).
b Calculate free cash flow.
14 Bank reconciliation items c Interpret th e results of you r calculations.
A company m akes the followi ng journal entries after
preparing a bank reconciliation:

Cash 920
Accounts Payable 920
Cash 900
Accounts Receivable 900
iii Service Charge Expense 20
Cash 20
18 Prepare bank reconciliation
REQU IRED
Rolo Hardware Company's bank statement for the month of
Explain the likely circumstance behind each of the entries. April and its general ledger cash account at the end of April
are as follows:
15 Petty cash
On 1 Septem ber. Saul's Consultants establishes a petty
cash fund for $350. On 30 September. the fund's
custod ian prepares a report showing $180 in cash
1 Apri l $8250
remaini ng and receipts of $54.75 for miscellaneous items.
$56.25 for postage and $61 for supplies. The custodian 3 1300 $1220 7030
presents the report to the company accountant. who 4 $2 100 9130
replenishes the fund.
6 1303 365 8765
REQU IRED 840
9 1304 7925
Prepare all necessary journal entries for the m onth of
September.
15 1302 900 7025
16 1307 1400 5625
16 Petty cash 18 1305 2000 3625
On 1 January, Melissa Co. establishes a petty cash fund in 18 3500 7125
the amou nt of $750. On 31 January, the fund is replenished .
19 1308 1620 5505
Before replenish ment. there was $278.25 remai ning in the
petty cash drawer and the followi ng receip ts: 22 1309 150 5355
parking fees - $125.25 25 2220 7575
ii postage - $71
26 1311 355 7220
iii office supplies - $222
27 1312 3650 3570
iv miscellaneous expenses - $52.
28 5100 8670
REQU IRED
30 $100 8770
Prepare all journal entries necessary to record the
establishment and replenishment of the fund. 30 130 8640

17 Evaluate cash
In a recent ann ual report. Nicole's Nursery reported the
following account balances (in mill ions):

Cash and cash equivalents. current year $ 1753

Cash and cash equivalents. prior year 957
Total assets. current year 71253
Cash flows from operating activities 8653
Capital expenditures 1834
Dividends 1588

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole ~~~ R 'g~~-~~n~~rnal controls
95
~--
 Cash
1 Apnl 9130 5 April l 301 700
17 April 3500 6April l 302 900
24Apnl 2220 6April l 303 365
27 April 5100 BApnl l 304 840
30 April 1750 11 April# 305 2000
15 April # 306 1180
16 April#307 1400 20 Research and analysis
1BApril#308 1260 Access the latest copy of CSL.:s annual report by doing an
20 April #309 150 internet search for 'CSL Annual Report' (annual reports are
made pubhc around the beg1nnrng of October each year) .
22 Apnl# 310 560
23 April # 311 355
REQUIRED
a Conduct ho nzontal and vertrcal analyses of CSL Lrmrted's
26April # 312 3650
IASX: CSU cash balance. Round percentages to one
dectmal pornt (e.g . 8.2%).
Other 1nforma110n: Rolo had one deposrt rn transrt of
$2100 and one outstandrng cheque (#300) of $1220 at 31 b Examrne the company's statement of cash flows and
March. All cancelled cheque amounts agree wrth the bank determine the major ways 1n which the company has
been using rts cash 1n the past two years.
statement.
c Based on your answers above, write a paragraph
REQUIRED explaining your opinion of CSL Limited's (ASX: CSL) cash
a Identify all deposits in transit and outstanding cheques at position . Use your answers as supporting facts.
30April.
b Prepare a bank reconciliation for the month of April. 21 Written communication
c Prepare all JOurnal entries required by Rolo at 30 April. You partner w ith a frrend of yours, Vladimir. start up a
Assume any debit memorandum rs a serv1ce charge, any cosplay1ng cloth1ng retailer busrness. You plan on
credrt memorandum is a collection of an account implementing the rnternal controls that you have learnt from
recervable, and any error relates to an account payable.
universrty, but your frrend IS worrred about rts effectrveness.
Vlad1m rr wonders what rnternal controls there are and what
19 Evaluate cash happens rf they do not work.
In therr recent annual reports. Jasm1ne and Danrela reported REQUIRED
the followrng account balances:
Explain the types of Internal control that can be used and
Jasmine Daniela address the issue of the limitatron of internal control.
Cash and cash equivalents, 30/06/1 7 $1880 1427
22 Written communication
Cash and cash equivalents, 30/ 06/1 6 2087 1086
You are the owner of S1mple V1ntage, an indie retail business
Total assets 26275 62169
close to the univerSity. You have a store manager who
Cash flows from operating activities 3744 4779 superv1ses employees. Most employees are part-time
Caprtal expend1tures 1014 2005 universrty students and your manager is havrng a drff1cult
time gettrng the employees to follow internal control
Orvidends 541 479 procedures. Most of the employees think that the
REQU IRED procedures are a waste of 11me and that they don' t relate to
the main purpose of the bus1ness, which is to 'sell stuff'.
For both compan1es, calculate and interpret (a) honzontal
and vertrcal analyses of cash balance and (b) free cash flow. REQUIRED
How do the cash positions compare? Round percentages to Prepare a memo that can be given to incoming employees
one decimal point (e.g . 8.2%). explaining to them the importance of the control
environment in general and control activities specifically.

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96
 This chapter examines the accounting for recei vables.
Specifically, the chapter focuses on how companres
account for the recording, the collection and the non-
collection of accounts receivable. After a discussion of
how to analyse a company's receivable position, the
chapter concludes w ith the accounting for a second type
of receivable - a note receivable.

RECORDING AND
REPO RTING ACCOUNTS
RECEIVABLE
A receivab le represents a company's cla im on the
assets of another entity. The most common type of
receivable rs an account receivable. An
account receivable is an amount account receivable
owed by a customer who has purchased All amount owed by a
customer who has
the company's product or service. purchased the company's
After studying the material in th is chapter, you Sometimes these rece ivables are product or service.
should be able to: referred to as debtors or
Describe the recording and trade rece i vab l es
because they arise from Clledt out the video s..,.,..ry
reporting of receivables. for Cllapter 6
the trade of the company.
Compare the methods used to account for
uncollectible receivables.
RECORDING ACCOUNTS RECEIVABLE
Contrast the methods for estimating bad
debt expense. Receivables are recorded at the time of the sale. To
illustrate, suppose that on 4 June, Howard Limited sells
Evaluate accounts receivable through the $1000 of product to a customer on account Howard would
ca lculation and interpretation of horizontal,
record the revenue and receivable arising from the sale
vertical and ratio analyses.
with the following entry Note that this example ignores
Understand the accounting the effects on Howard's inventory and cost of goods sold.
for notes receivable. These w ill be covered in Chapter 7.

4 Jun.
Accounts Receivable 1000
Sales 1000
~------------------~~
(To record sale on account)
Assets liabilities + Equrty
--------~~ --~~~--~--~~
+1000 +1000

Both assets and equity (revenue) increase because of

this sale. When Howard collects the receivable, it will
increase its cash and eliminate the receivable.
In some cases, a customer will return a product instead
of paying for it, and this affects the Accounts Receivable
balance. To illustrate. suppose that on 6 June the customer
apply this - ·······- returns a $150 product because it is faulty. Howard would
record the return Wlth the following entry.

6 Jun. Sales Returns and AllaNall:es 150

Accounts Recervable 150
_ _ _ _ _(To record sal~es:..r..:e:..
ru...
m.:,I---------:---
Assets liabilities + Equrty
--------~,;;;,_-
~50 ~50
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97

Again, the example focuses only on the effect on
receivables and ignores the effects on inventory and cost
of goods sold.
The entry decreases Accounts Receivable for the sa les
price of the product. However, instead of decreasing the
Sales account directly, the entry increases Sales Returns
and Allowances. Sales Returns and Allowances is a contra·
revenue account, meaning that its balance is subtracted
from Sales when calculating a company's net sa les.
Companies use this account to maintain a record of returns
each period. Like the Sales account. Sales Returns and
Allowances is a temporary account. the balance is closed
(zeroed out) at the end of each period (see 'L04 Closing
process', Chapter 4 .)
In addition to returns, companies sometimes provide
discounts to customers 1f they pay within a certain time
period. For example, sales are commonly made with terms
2/70. n/30, meamng that customers can receive a 2 per
cent discount 1f they pay within 7 days of the invoice. To
illustrate, suppose that Howard grants terms of 217. n/30.
On 10 June the customer pays the remaining $850 bill. By
qualifying for a 2 per cent discount, the customer saves
$17 ($850 x 2%) and pays only $833. Howard would record
the receipt of payment as follows:
10 Jun. Cash 833
Sales Discounts 17
Accounts Receivable
(To record payment)
Assets liabilities + Equity
+833
-850
The entry increases Cash for the $833 payment and
decreases Accounts Receivable for the full $850 balance.
The difference, wh1ch equals the d1scount of $17 for timely
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_ _...;9~
8 ACCT3 Fw>~.
payment. goes into the Sales Discounts account. Like
Sales Returns and Allowances. the Sales Discounts account
is a contra-revenue account that is subtracted from sales
when calculating net sales. Companies use this account to
maintain a record of discounts each penod. It IS a temporary
account whose balance is closed at the end of each period.
Some may treat sales discount as a 'f.nancial expense' as
it might be seen as a way of receiVIng cash earlier than
would happen if there was no IncentiVe for customers to
pay quickly.
REPORTING ACCOUNTS RECEIVABLE
Because accounts receivables are expected to be collected
wit hin a month (or two), they are classified and reported as
current assets. However, companies do not normally
collect all their receivables because customers do not
always pay their bills. Among other reasons. customers
have financial hardships, relocate without paying or simply
refuse to pay. As a result, companies must follow the
principle of prudence and report their accounts receivable
at net rea lisable value.
N et realisable value is t he amount of net realisable
cash that a company expects to collect from value Theamoont of
its total or gross accounts receivable balance. cash that a company
expects to collect from
It is calculated by subtracting from gross its total acootJnts
receivables the amount that a company does receM!ble.
not expect to collect. For example, a company
that has $2000 of gross receivables but does not expect to
collect $50 of them has receivables with a net realisable value
of $1950. The amount that a company does not expect to
collect goes by many names: prOVISIOn for 1mpa1rment loss,
allowance for bad debts. allowance for doubtful debts. and
provision for bad and doubtful debts. Here we use an
:oJiowance' account as 'Provisions' may be confused with
'Equity' accounts. How compan1es estimate and record the
allowance will be examined later in the chapter.
CSL ANALYSIS
850
-17
 MAKING IT REAL

To illustrate the reporting of receivables, consider the

following receivables balances from CPA Australia's Annual
Report 2016: 2

2016 2015
S'OOOs S'OOOs
Current
Trade and other receivables 2425 7804
Less allowance for doubtful debts {24) {1021 profit and loss statement. Thus, you will rarely find a
2401 7702 company's bad debt expense listed separately. If you do, it
floe CO'IIOhcS.wl ant1ty has ra:::ogrned a~ aiiOW"Ciml for doutrful dellts tJ I lXI pew CII"C l!Qa•na:t all reoetYables is likely bad news because the amount was large enough
o..- ~ tiiVIIliCXI~ lor those debeors,lmsnbels \\ho at bal;me dale ha\<1 comrnttlldto Pl'f Hismcal 8qlllnerce to warrant individual reporting.
has been that teC8M!ibles !hat are J~al dut btyotd 90 days n d1flaft to recowr.
There are two methods to account for bad debt expense:
In contrast, Chartered Accountants Australia and New
the direct write-off method and the allowance method. Each
Zealand, in its Financial Report 2017, Trade and other
method is discussed in the following sections.
receivables', lists: 3
2017 2016
S'OOOs
DIRECT WRITE-OFF METHOD
S'OOOs
Current Under the direct write-off method, bad direct write-off
debt expense IS recorded when a method
Trade receivables {a) 12363 14253 Method 1n whiCh bad debt
company determ1nes that a receivable is expense IS recorded when
Allowance for impairment loss (6221 {658) acompany determines
uncollectible and removes it from its
11 741 13595 that a receivable is
records. The receivable is eliminated or uncollectibleand removes
hdl 1Ct1'4bllit W'I ra:o11usa:J aid carried at the on9naii'I\Oa .-nou'lllm ll'lllk:Mwu lor rnpQ~rrrmt. We 'written off' the company's accounting it fromits records.
IIO'Jirtv ""'...., tJw c:dla::tallllcty of trade recewable:s. and apPy an ln1lillnfllllC PIO't'410n ~ !here 15 eon:1erce
tlwl• ~'AO!l'tbt illleto cdle::t. WlenwedenerlyRJMdlill deW: Nl •tun:ollltbbll. WV'Mltatl'an oil. records, and bad debt expense is recorded
t• ltJCtt ...,.,.., 0111'1 h'XK!IEiesl bearrg ard are gEnitally on Xkllv llrmt A pt~Mson tor urpaumwrt al for the amount of the receivable.
S6220XI (2016 S668CDJJ has teen rased 10 C0/8 expec:ted ulmllc11blt dlbeors Tht G1011p 0:111 1111 td:l q
eolllwll cr.,_ baln:es. To illustrate. suppose that Chan makes a $4000 credit
~1lt Tft# sale during October 2019 to Baron. In April 2020, Chan
Check out the animated summart determines that It Will be unable to collect from Baron.
• on Accounts Receivable
Chan would make the following entries to reflect th1s
activity:

Oct. 2019 Accounts Receivable 4000

UNCOLLECTIBLE
Sales 4000
RECEIVABLES
{To record sale on account)

As stated in the previous section, most companies are Assets Liabilities + Equity
unable to collect all their accounts receivable. Losses from +4000 -4 000
the inability to collect accounts receivable Apr. 2020 Bad Oebt Expense 4000
bad debt expense are recorded in the accounting system as
The expense resulhng from Accounts Receivable 4000
bad debt expense.
the 1nallihty to collect all
acaJUliS recenr.Jble Because uncollectible accounts are a (To record bad debt expense and
normal part of any busmess, bad debt wnte off receiVable)
expense IS considered a normal operating expense. It is Assets liabilities + Equ1ty
1ncluded in the calculation of net profits or losses but is +4000 -4000
usually combined with other operating expenses on the

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---
99
 The first entry records the account receivable created That is. instead of writ ing off specific receivables at year-end,
from the sa le. Both assets and equity increase as a a company increases a contra-asset account called Allowance
result. The second entry increases Bad Debt Expense to for Doubtful (Bad) Debts or Allowance for
reflect the loss incurred from the inability to collect from Impairment Loss. Th e allowance for allowance for
doubtful debts
Baron. It also decreases Accounts Receivable to remove doubtful debts represents the dollar amount
The dollar amount
the rece ivable from Chan's records. As a result of this of receivables that a company believes will of receivables that
write-off, both assets and equity decrease. All write-offs ultimately be uncollectible. As described a company believes
will ultimately be
under the direct method w ill result in the same basic earlier, its balance is subtracted from gross uncollectible.
entry. The on ly difference will be the dollar amount. receivables to yield the rece ivables' net
The major advantage of the direct write-off method is realisable value.
its simplicity. When an account is deemed uncollectible, it To illustrate, suppose that Duncan Sports makes credit
is written off and an expense is recorded. The major sales of $800000 during 2019. Based on experience.
disadvantage is that it can violate the matching principle. Duncan estimates that $16000 of these sales w ill not be
The matching principle requires that expenses be matched collected. Duncan would therefore make t he following
as closely as possible to the period in which the related entries to record th is activity:
revenues are recognised. In the preceding example, the
During Accounts Receivable 800000
revenue is recorded in 2019. but the expense is recorded 2019
in 2020. Assuming that Chan prepares financial statements
Sales 800000
at the end of December, the expense is not recorded in the
{To record sales on account)
same year as the revenue.
Because the direct method violates the matching Assets Liabilities + Equity
principle. generally accepted accounting principles prohibit +800000 +800000
its use. The on ly exception to this prohibition is when bad
debt expense is immaterial to the company. For most
End of Bad Debt Expense 16000
companies. though, bad debt expense is material. so they 2019
must use the allowance method.
Allowance for Doubtful Debts 16000
Using the direct method wou ld have also overvalued
{To record bad debt expense)
Chan's asset. Accounts receivable at 31 December 2019 is
in breach of the prudence concept; another reason for Assets liabilities + Equity
using the allowance method. -16000 -16000

ALLOWANCE METHOD The first entry increases Accounts Receivable and Sales
for the credit sales during the year. This increases both
Wh ile the di rect wr ite-off method accou nts f or
assets and equity. The second entry increases both Bad
uncollectible receivables w ith one entry, the allowance
Debt Expense and A llowance for Doubtful Debts by
allowance method method splits the accoun ting into two $16000. This effectively matches the expense of futu re
Methodinwhich entries- one to record an estimate of
uncollectible receivables to 2019 sales. It also reduces
companies use two b dd b d h ·
entries to account for a e t expense an anot er to w nte Duncan's net realisable value of receivables by $16000
bad debtexpense - one off receivables when they become because it is now allowing for $16000 of those receivables
toestimatetheexpense uncol l ect ib le. Both entri es are
and a second towrite off to be uncollectible. As a result. both assets and equity
receivables. described in the fo llowing sections.
decrease.
The same basic entry w ill be recorded each time bad
debt expense is estimated under the allowance method.
Recording bad debt expense
The only difference w ill be the amount of the estimate.
The purpose of the allowance method is to match the
which will depend on circumstances and the estimation
expense from uncollectib le receivables to the period in
method a company uses. Methods of estimating bad debt
which those receivables were created. To achieve this
expense are covered later in the chapter.
purpose. a company must record bad debt expense at the
end of each accounting period. However, at the end of the Recording a write-off
period, the company does not yet know wh ich receivables Regardless of the method used to account for uncollectible
will be uncollectible. receivables, a company must write off a receivable when
Because of this inability to know which specific it is deemed to be uncollectible. Under the direct write-off
receivables w ill turn out to be uncollectible. the allowance method. the company records bad debt expense at the
method requires a company to set up an 'allowance' for t ime of the write-off. However. under the allowance
uncollectible receivables when recording bad debt expense. method, bad debt expense has already been estimated and

_ 1 00
_..;.;;.;;.
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recorded and an allowance balance created for uncollectible
receivables. Therefore, instead of increasing bad debt
expense at the time of the write-off, the company reduces
the balance in the allowance account.
COLLECnNG DEBTS
To illustrate, suppose that Duncan Sports determines
in 2020 that a $5000 receivable f rom W illiam Johnson is
uncollectible and decides to write it off the books. Duncan
wou ld make the following entry:

2020 Allowance for Doubtful Debts 5000

Accounts Receivable 5000
(To record write·off)
Assets liabilities + Equity
-5000
+5000

The entry decreases Accounts Rece ivable an d

decreases an equal amount of Allowance for Doubtfu l
Debts. Note that t he entry has no effect on total assets or
profit or loss. More specifically, the entry has no effect on
Duncan's net realisable value of receivables.This is because
both the asset account and the contra-asset account are
decreasing by the same am ou nt, thereby offsetting one
another. Duncan now knows that Johnson will not pay, but
Duncan had already allowed for that possibility. Therefore,
Duncan's expected cash receipts are unchanged. This w ill
be the case for all write-offs under t he allowance method.

Recording the recovery of a write-off

Occasionally, a company will collect a receivable that it had
previously written off. For example, suppose that Johnson
pays his bill in full later during 2020. When t his payment
occurs, the following two entries are made:

2020 Accounts Receivable 5000

Allowance for Doubtful Debts 5000
(To reverse the original write-off)
Cash 5000
Accounts Receivable 5000 Prison
(To collect the receivable) Debtors' Tower
Assets liabilities + Equity (1790)
+5000 Tbh Towtr was buill to lmprl.n dtblon who
Otted IIIOMJ'· A,.,. trt.-aular 'liMe ~aii"('Ut
-5000 ._... to ,_. ~ dh·kkd into relb. MMDC!

..........,. ......
- ............ l'rlooamo.......ua.d ..
...--lllrypeld lllrir dd>ls.
The f irst entry simply reverses t he original entry writing ......,_,.
off the receivable. The second entry records the collection
of cash and t he reduction of the receivable. Notice that
once again there is no effect on total assets by either of

• __
these two entries.

Review d1is content with me e-lecture ""...

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101

il')i ESTIMATING BAD
'Ill' DEBT EXPENSE
The previOus section demonstrated how to record bad debt
expense under the allowance method. This section
demonstrates how to estimate the amount of bad debt
expense to be recorded .
When estimating bad debt expense. companies may
use one of two different approaches:
percentage-of-sales approach
percentage-of-receivables approach.
Both approaches use information such as past
experience, industry norms or trends and current customer
credit ratings to make the estimate as accurate as possible.
Each approach is discussed in the followong sectiOns.
PERCENTAGE-OF-SALES APPROACH
percentage-of-sales Under t he percentage- of -sales
approach
approach. bad debt expense is a
Method that estimates
bad debt expense as a f unction of a company's sa les. It is
percentage of sales calculated by multiplying sales for the
period by some percentage set by the
company. For example. suppose a company with $250000
of sales tn 2019 estimates that it will not collect 4 per cent
of those sales. The estimate for bad debt expense at the
end of 2019would be$10000 ($250000 x 4%). The entry
to record the estimate is shown below.
End of Bad Debt Expense 10000
2019
Allowance for Doubtful Debts
{To record bad debt expense)
Assets liabilities + Equity
-10000
The advantages of this approach are its sompltcity and the
fact that it results in very good matching. Bad debt expense
for a period tS primarily a function of sales for that penod. The
main dosadvantage is that no consideration tS gtven to the
resulting balance in the Allowance for Doubtful Debts
account. It os simply the existing balance plus the current
estimate. Since the allowance account is used to calculate
net realisable value. the percentage-of-sales approach results
in a less meaningful net realisable value of receivables.
PERCENTAGE-OF-RECEIVABLES APPROACH
Under the percentage-of -receivables
percentage-
of-receivables app roach. bad debt expense is a
approach
Method that estomates
function of a company's recetvables
bad debt expense as a balance. It is calculated in two steps. The
percentage of recervables. first step is to calculate what the balance
in the Allowance for Bad Debts account
I
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__..;.;;.;;
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should be. This tS accomplished by mult iplying accounts
receivable by a percentage set by the company. The
second step is to adjuSt the allowance account to that
calculated balance. The amount of the adjustment tS bad
debt expense for the period.
To illustrate. suppose that a company has a
receivables balance of $24 000 at the end of 2019. Based
on past experience, the company expects that 2 per cent
of its receivables ba lance will b e unco llectib le. As a
result, t he balance in the allowance account at year-end
should be 2 per cent of receivables. o r a $480 credit
balance ($24000 x 2%). The next step is to make the
adjustment.
Since the allowance method for bad debts relies on
estimates. a company's allowance ba lance pnor to
adjustment can have either a debit or credit balance. A
debit balance means that the company has experienced
greater write-offs during the year than expected. A credit
balance indicates that write-offs have been less than
expected . Whether the balance is a debit or credit does not
require a company to correct its bad debt expense from
the prior year. However. it does affect t he adjustment for
the current year.
To illustrate. assume that the allowance account has a
$100 credit balance prior to adjustment. To get the balance
to a $480 credit requires a $380 credit entry. Therefore. bad
debt expense for the period is $380. This is illustrated as
follows:
Allowance for
Bad Debts
100 Existing balance
10000
380 Adjustment required = Bad Debt Expense
480 Desired balance ($24 000 x 2%)
-10000
End of Bad Debt Expense 380
2019
Allowance for Doubtful Debts ~
!To record bad debt expense)
Assets liabilities + Equoty
- 380 -380
In contrast. assume that the allowance account has a
$50 debit balance prior to adjust ment. In t hat case. the
necessary adjustment is a $530 credit entry. Therefore. bad
debt expense for the period is $530. This is illustrated as
follows:
Allowance for
Bad Debts
50 I Existing balance
----+·___530
__ AdjUStment required= Bad Debt Expense
480 Desired balance (S24 000 x 2%)
 End of Bad Debt Expense
530
2019
Allowance for Doubtful Debts
(To record bad debt expense)
Assets Liabilities + Equity
-530
The major advantage of the percentage-of-receivables
approach is that it results in a very meaningful net realisable
value. This is because the allowance account is determined
as a set percentage of receivables. The disadvantage is that
it does not match expenses as well as the percentage-of-
sales approach. This is because the adjustment necessary
is a function of both the set percentage and a company's
prior experience w ith write-offs. As a resu lt, current
expenses are affected by prior-year experiences.
Ageing of accounts receivable
Many companies use a more refined version of the
percentage-of-receivables approach. Recogn ising that
rece ivables become less collectible as they get o lder,
compan ies often prepare ageing sdledules for
their receivables. An ageing schedule is a
ageing schedule
A listing of accounts listing and summation of accounts receivable
receivable by tlleir
by their ages. Normally, receivables that are
ages.
outstanding for 30 days or less are considered
current and are grouped together. Receivables outstanding
longer than 30 days are considered past due and are grouped
together in 30-day increments. Compan ies then apply
increasing uncollectible percentages to older receivables.
To illustrate, suppose that SC Works prepares an ageing
schedule at the end of 2019 as shown in Exhibit 6.1. SC
Works reports $66 000 of receivables and breaks them into
'current' and several categories of 'past due'. Each category
is assigned an expected percentage of uncollectible
rece ivables that rises as the age of the receivables
increases. The necessary allowance balance is then
calculated by summing the totals from each category.
You may remember from our earlier example from
CPA Australia's Annual Report 2016, where it was stated
530 that ' historical experience has been that receivables that
are past due beyond 90 days are d ifficult to recover'.
Assum ing that SC Works has a credit balance of $870
in the allowance account prior to recording bad debt
-530
expense. the company would make the following entry to
record bad debt expense.
Allowa nce for
Bad Debts
870 Existing balance
- - - - - + - - - -3_1.:..87_ Adjustment required= Bad Debt Expense
4 057 Desired balance
End of Bad Debt Expense 3187
2019
Allowance for Doubtful Debts 3187
(To record bad debt expense)
Assets Liabilities + Equity
-3 187 -3 187
As you can see. the entry to record bad debt expense
is the same as previously described. The difference is
that an ageing schedule provides a more accurate
estimate of the allowance for doubtful debts and
therefore a better estimate of bad debt expense. But an
age ing schedu le has another benefit . It is a good internal
control activity.
Recall from Chapter 5 that control activities are one of
the five elements of a good internal control system. They
are procedures put in place to assist companies in operating
and reporting efficiently and effectively. Keeping track of
receivables and their ages helps meet these objectives.
For example. an ageing schedu le provides the information
a company needs to pursue its receivables effectively. It
also provides information for future credit decisions. A
company may hesitate to provide credit to customers who
have past due receivables.

Number of days past due

Customer Current 1-30 31-«1 61- 90 Over 90 Total
Ma Manufacturing $4100 $ 4100
Chen Company $2400 2400
WAG, Limited $2750 2750
Others 44450 10400 1000 1200 300 57350
Totals 44450 10400 5100 3950 2700 66600
• % Uncollectible 1% 3% 15% 30% 50%
Allowance Balance s 445 s 31 2 $ 765 $1185 $1350 s 4057
~ Agemg schedule of accounts rece1vable - SC Works

• Ttva perc:a1tages will ~00 on tfle busiOOSS' past 8lq)E!ri~JU. tOOr credit pd q an:1 oorrent eo:110mc con:lib:lns.

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Rece•vables 1,;:;
..; 0.;:;
3 __
 2017 2018
ANALYSING ACCOUNTS Source Accounts
$000 $000
RECEIVABLE Statement of Rewnue 176374 175672
Profit and loss

Any 1nvestor. cred1tor, or manager of a company should be Amooot wntten 0 38

off as uncollectible
interested in how well a company manages its accounts (Note7)
-••-••-••-••-••- ••- ••-•·-·-·-·-·-·-"-"_,,_,,_,_,,_,,_,,_,_,_,_,_,,_,,_,,_,_,_,_,_,_,_M
receivable. Because a receivable is an uncollected sale, the
Statement of Trade and Other 2451 2474
main question that should be asked of a company is how Financial Position Receivables
well it collects its receivables. In general, better collection
Total Assets 207315 195390
means better management of receivables. I

Non-financial companies usually do not disclose bad [iiiiiiii] Account balances from the CPA Australia's
L.!!J Integrated Report 2017
debts expense because it is immaterial as part of total
expenses. However, in 2017 CPA Australia provided more
ins1ght 1nto its receivables. The analysis reqwres Information Given the CPA:s fmancial information in Exhi bit 6 .2.
from the 'statement of financial position' (balance sheet) horizontal and vert1cal analyses of accounts receivable and
and ·statement of profit and loss and other comprehensive sales result in the calculations below. Note that the net
income' and the notes to the accounts.8 realisable value of receivables, as reported on the statement
of f inancial position, is used in the calculations.
HORIZONTAL AND VERTICAL ANALYSES
A good place to start the analysis of accounts receivable is
w ith horizontal and vertical analyses. Recall from Chapter Dollar change Percentage
change
2 that horizontal analysis calculates the dollar change in an Trade and Other Receivables 2451 =(23) ..Jm .1'J(,
account balance. defined as the current-year balance less -2474 -2474
the prior-year balance, and divides that change by the prior-
Rewnue
year balance to yield the percentage change . Vertical
analys1s diVIdes each account balance by a base account,
yield1ng a percentage. The base account IS total assets for
2017 2016
financial pos1tion and net sales or total revenues for
Trade and Other Receivables 2451 2474 ; 1.3%
statement of income accounts. These calculations are 2iiffi5 = 1.2%
195390
summarised as follows:
Bad Debts Expense 0
176374 =OO% ~ =0.02%
175672
HORIZONTAL ANALYSIS
Source: CPA Ausu1lla.. 2017. ~t.egtated Flepcr12017, ~s:Jfwt'M'.c;~stral llc:otn au/

Dollar Change in Current-year Ba lance- The calculations show a small decrease in the CP.tis
Account Balance Prior-year Balance
receivables. Horizontal analysis shows that CP.tis
Percentage Change Dollar Change receivables balance decreased by only $23 000, or 1 per
in Account Balance = Prior-year Balance cent. in 2017. Honzontal analysis of sales shows growth
in sales of under $1 million. or less than half of 1 per cent.
during the year, so 1t does not appear that receivables are
lower because of sales. which were higher. But the
change in the numbers is very small and lim1ted
Percentage = For the balance For the income conclusions can be drawn. Vertical analysis also shows
sheet statement
that receivables as a percentage of assets were lower.
Account Balance or Account Balance 1.3 per cent in 2016 to 1.2 per cent in 2017. Bad debts
Total Assets Net Sales or Revenue appear not to be a problem for the CPA even in 2016 they
still make up less than $1 for every $4600 of revenue!

RECEIVABLES TURNOVER RATIO

The preceding analysiS Indicates that the CPA appears to be
managing its recervables very well. Another means to assess
the management of receivables is to calculate a company's

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4 ACCTJ Flnanco&!
receivables receivables turnover ratio. The receivables Beyond the issue of not knowing how many sales
tumover ratio turnover ratio compares a company's credit are on credit. the receivables turnover
A comparison ol cr1!drt days-in-receivables
sales to receivables
sales during a period to its average receivables ratio is sometimes difficult to interpret. A conversion of the
that measures a balance during that period. It is calculated as so it is often converted into the days-in- recervables turnover
company's abrhty to ratio that elljWESS!!S
follows: receivables ratio . The days- in - a company's ability to
generate inl collect
receivallles. r eceivables (ratio) d1vides the generate inl collect
receivables turnover ratto into 365 days receM!bles in days.

to express. in days, how long It takes a company to

generate and collect its rece1vables. Thus. the days-in·
receivables is calculated as follows:

DAft.M.MCEIVDLEI

. . R . -~3~6~
5 _______
Days-m-Recervables atro =
Receivables Turnover Ratio

365 = 60 03 days
6.08
A ratio of 60.03 indicates that it takes CSL about sixty
days between selling an item and collecting the receivable.
• Although we do not know. if we assume 50 per cent of
CSL:s sales were on credit. then its days-in-receivables
w ould be 120 days. Whether this is good or bad requires
RICEIVAILEilURNOVER RAOO some comparison. looking at the prior year as well as
similar businesses. But caution would still be needed
Receivables Turnover Ratio = Credit Sa les
Average Receivables because some businesses anract customers by advertising
'easy credit'. obviously expecting higher bad debts and
Where average receivables is:
slower receivable turnover. and possibly compensating by
Beginning Receivables + Ending Receivables/2
selling at higher prices than competitors not offering such
generous buy-now-pay-later cond1t1ons. Because
Because the ratiO drvides credrt sales during a period governments are notoriously slow payers. CSL may be
by the average receivables balance during the period, it prepared to wait six months for some governments to pay.
indicates how many ttmes during a period a company
generates and collects receivables. In general. companies ALLOWANCE RATIO
want this ratio to be higher rather than lower because a
One additional ratio that IS useful1n analysing a company's
higher ratio indicates that the company collects. or turns
management of rece1vables is the
over. its receivables faster.
allowance ratio. The allowance ratio allowance ratio
For most reporting entit1es (financial statements are
compares the allowance account to gross A comparison of the
allowance account
publicly available) it IS not possible to calculate receivables
accounts receivable to determine the to recervables that
turnover because the percentage of sales made on credit measures the percentage
percentage of receivables that are
is unknown. For CSL most sales are probably made on of recervables that are
expected to be uncollectible in the future. expected to be uncollectible
credit. For CSL. if we assumed all operating revenue was m the future.
It is calculated as follows:
on credit. the figure is likely to be overstated:
6922.8 . ALLOWANCE RAnO
(1107.2+ 1170.4)/2 =6.0Btrmes
. Average for Doubtful Debts
The 6.08 ratio indicates CSJ.:s 2017 sales were just over A llowance Ratro - Gross Receivables
six times its average receivables balance. In other words, Where gross accounts receivable is:
the company was able to generate and collect it s
Net Account Receivables+ Allowance for Doubtful Debts
receivables balance over six times in 2017. every sixty days.

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i~~~~ R-n.ables .:,
10 :::;5:.,__
 A higher ratio indicates that a company expects more
receivables to be uncollectible. In general. a company would analysis indicates that a high proportion of CSL's assets
are in the form of receivables. If you read all of its annual
want this ratio to be as low as possible. The CSL allowance
report this would be expected given CSL's major customers
(provision) ratio for 2016 and 2017 is calculated as follows
are governments and large medical companies. Finally,
from the information in 1ts balance sheet and Note 15 trade CSL makes the vast majority of its revenue from the sale
receivables. This shows a marked improvement in 2011 of goods; some comes from royalties and licence fees.
2017 2016
22.6 31.1 When a company accepts a promissory note. n has a note
= 1.9% = 2.8%
1170.4 (11071) receivable. like other assets, a note receivable IS reported on
the balance sheet. However, 1ts classrf1cation depends on its
Download lhe Enrichment terms. If the note is due wrthin a year. 1t IS class1fied as a
Modules for further practice
current asset. Otherwise, rt IS a norH:urrent asset.
Accounting for a note rece1vable usually requ1res entries
to record the following:
e issuance of the note
e interest earned on the note
An account receivable is an amount owed by a customer e collection of the note.
who has purchased the company's product or service. To illustrate, suppose that on 1 November 2018, Tata
Sometimes, because of a customer's poor credit rating or Industries sells industrial robots to Zjax for $184000. Tata
because of the size of the transaction. a company will enter accepts a six-month, 6 per cent promissory note from Zjax
into a more formal agreement w ith the customer beyond for payment. The note stipulates thatTata will receive both
a normal account receivable. This is often principal and interest from Zjax on 30 April 2019.
promissory note accomplished through a promissory
A writtflfl pmmise to pay
a specific sum of money note, which is a written promise to pay a
on demand or at some
RECORDING THE NOTE
specifiC sum of money on demand or at
specific date in lhe future. A note receivable is recorded at its face value.
some specific date in the future. note receivable
Promissory notes can be used to formalise a receivable or which is $184000 in this example. Therefore. An asset aeated when
Tata would record the sale of the robots and a cxwnpany aca!pts a
to loan money to another entity. In most cases, promissory promissory note.
notes require the payment of both principal and interest. the resulting note receivabl e as follows:
The company that w ill receiV8 the princ1pal and interest is 1 Nov. Note Recervable 1841XXl
called the payee. The customer or borrower who will pay 2018
the interest and pnnc1pal IS called the maker of the note. Sales 1841XXl
We focus on accounung for the payee. (To record sale rn exchange for a
promissory note)
Assets Liabrlr~es + EqUity
+1841XXl +1841XXl

In this entry, Tata increases the Note Receivable account

to reflect the receipt of the promissory note and increases
Sales to reflect the earning of revenue. As a result both assets
and equity increase. As in previous examples in this chapter,
the effects on inventory and cost of goods sold are ignored.

RECORDING INTEREST
Most promissory notes require that the maker pay interest
to t he payee. The amount of interest is a function of the
principal or face value of the note, the annual interest rate
and the length of time the note is outstanding. The
calculation is as follows:
In this example, Tata's note receivable is outstanding
for only six months. As a result, interest of 6 per cent will
be charged for six of the twelve months of the year.

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Interest Earned= Principal x Annual Rate of Interest
x Time Outstanding
Therefore, interest over the life of the note is $5520,
calculated as follows:
Interest • Principal x Annual rate of interest x Time outstanding
• $184000 x 0.06 x 6/12 months
; $5520
According to the calculation, Tata Will recerve $5520 of
rnterest at the maturity of the note. HO\/Veller, the revenue
recogmt10n principle requires companies to record interest
revenue when it is earned, even if cash will not be received
untrl later. Assuming that Tata has a fmancial year-end prior
to the maturity of the note, it must make an adjusting journal
entry to record interest earned during the year. Recall from
Chapter 4 that such an entry is an accnual adjusting entry
To illustrate, suppose that Tata prepares financial
statements on 31 December. Tata has not yet received any
interest payment from Zjax because payment is not
required until 30 April 2019. However, Tata has earned two
months of interest, calculated as follows:
Interest earned • Priocipal x Annual rate of interest x Tlllle outstandlllQ
• $184 000 x 0.06 x 2/12 months
·$1840
On 31 December Tata would record this interest
revenue as follows:
31 Dec. Interest Receivable 1840
2018
Interest Revenue
(To record interest earned on note)
Assets Uabihtres + Equity
+1840
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This entry rncreases Interest Receivable to reflect the
additional receivable Tata now has from Zjax.Tata will report
this receivable on ItS balance sheet until the interest rs pard
in April 2019. The entry also increases Interest Revenue to
reflect the inflow of assets attributable to the year 2019. As
a result, both assets and equity increase.
COLLECTING THE NOTE
The collection of a note receivable is much like the collection
of an account receivable. When a note is collected, the note
receivable is decreased and cash is increased. However,
when a note recervable requires interest to be paid, the
collection of the note often includes the collection of
interest as well. This is the case for Tata.
On 30 Apnl 2019, Tata collects cash and interest from
Zjax. The total interest over the six months Tata held the
note is $5520. The principal is $184000. Therefore, Tata
receives $189 520 in cash, recorded as follows:
30April Cash 189520
2019
Interest Receivable 1840
Note Receivable 184000
Interest Revenue 3600
(To record collection of note)
Assets Uabilities + Equrty
+189520 +3600
- 184000
- 1840
This entry has four parts. First, t he entry increases Cash
for the amount of cash collect ed by Tata . Second, it
decreases Interest Receivable to eliminate the asset that
was created by the 31 December adjusting entry. Third, the
entry decreases Note Receivable by its principal value
because the note has been collected and is no longer
outstanding. Finally, the entry increases Interest Revenue
for the four months of interest (January through April)
earned in the current period ($184000 x 6 % x 4/12). Thrs
interest revenue w rll be reported on lata's 2019 statement
of comprehensive income. The result of the entry is a net
increase to assets of $3680 and an increase to equity of
$3680. If this seems low to you, remember t hat equity was
increased substantially when the sale was made and the
note created. When Tata collects t he note, it is simply
1840 exchanging one asset for another. The net $3680 increase
to assets and equity results from the interest earned during
the three months of the current year.
+1840
Tes1 your understanding with rile
online revision qaim!s lor tllis chapter
CHAPTER 6 Receivables .:.; 7_ _
1 0::,;
 5 Recording bad debt expense
While reviewing outstanding accounts receivables, Frankie
determines that a receivable of $5000 is now uncollectible.
REQUIRED
Journalise the entry to record bad debt expense assuming
Frankie uses the direct write-off method. Why might the
direct write-off method be used? What are the limitations of
1 Recording accounts receivable the direct write-off method on the balance sheet and
On 4 March, Cole Company sells office supplies to a income statement.
customer for $60000. Terms of the sale are 1/15, n/30. On
10 March, the customer returns $6000 of the goods. The 6 Estimating bad debt expense
customer pays on 15 March.
A company uses the percentage-of-sales approach to
REQUIRED estimate bad debts. Sales for the year were $750000 and
Prepare all journal entries to record the sale, its return and gross profit was $450000. The company estimates that
the collection of the receivable. Ignore any effects on 5 per cent of sales are uncollectible.
inventory or cost of goods sold. REQUIRED
What is the company's estimated bad debt expense for the
2 Recording sales returns year? Would your answer change if the company was able to
On 5 March, Monica's Cooking Company sells inventory to a increase its gross profit from its sales?
customer for $3000. On 13 March, the customer returns
$750 of merchandise. The accountant recorded the return 7 Allowance method
with the following entry:
le uses the allowance method to account for bad debt
13 March Sales 750 expense. Le makes credit sales of $170000 during the year.
At year end, Le estimates that $9000 of those sales will not
Accounts Payable 750 be collected. The next year, Le determines that a $2500
receivable is uncollectible and should be written off.
REQUIRED
Prepare the entry the accountant should have made when REQUIRED
the merchandise was returned on 13 March and explain why Prepare the journal entries to record the cred it sales, bad
the accountant's entry was incorrect. Ignore any effect on debt expense and the write-off of uncollectible accounts.
cost of goods sold or inventory.
8 Estimating bad debt expense
3 Reporting accounts receivable Rachel's Clothing Company has a receivables balance of
The following records the receipt of cash from a debtor $105000 at the end of the year. Based on past history,
within the discount period : Rachel estimates that it w ill not collect 2 per cent of its
receivables balance. Prior to any year-end adjustment, the
Cash 2425 balance in the allowance account was $200 debit.
Sales Discounts 75 REQUIRED
Accounts Receivable 2500 a Prepare the journal entry to record bad debt expense for
the year. Show your calculation of bad debt expense in
REQUIRED T-account form.
Explain why the customer has paid only $2425 yet has their b Assume that the balance in the allowance account was a
debt reduced by the full $2500? $100 credit instead of the $200 debit. What is bad debt
expense in this situation? Show your calculation in
4 Direct write-off method T-account form.
Masters sells $7500 of goods to Johnson during January. In
April, Masters determines that it w ill be unable to collect the 9 Horizontal and vertical analyses
receivable from Johnson. The following information pertains to Lara Limited:
REQUIRED
2020 2019
Prepare the journal entries to record the sale and the bad
Net sales $350000 $342000
debt expense if Masters uses the direct write-off method.
Ignore any effect on cost of goods sold or inventory. Net accounts receivable 189000 197000
Bad debt expense 8200 7000
Total assets 410000 425000

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1
_......;.;;.;;.
REQU IRED
Prepare horizontal analyses of all four accounts and vertical
analysis for bad debts expense and net accounts rece1vables.
Round percentages to one dec1mal point (e.g. 23.9%).
10 Analysing receivables
The following 1nformat1on perta1ns toTh1rroui Theme Parks:
Cred1t sales S9001XXJ
Net accounts receivable. beg1nnu19
Net accounts receivable. eod111g
Allowance for doubtful debts. end111g
--~--~---------------
REQUIRED
Calculate Th1rroul's recervables turnover ratio, days-in-
receivables ratio and allowance ratio.
11 Effects of recording bad debt expense
You are the company secretary and shareholders are asking
about how some of the accounting methods have impacted
the figures in the financial statements. The chairwoman has
passed you a note during the annual meeting asking you to
fill out the information below so she can explain the effect of
the allowance method:
Net Amount In Amount of R-ivables
Income accounts accounts turnover
receivable receivebles ratio
account reported on
the financial
statements
Effect of
bad debt
expense
enuy
REQUIRED
F1ll out the gnd With mcrease. decrease or no effect.
12 Accounting for n otes recei vable
On 1 March, Abby Actuanal accepted from Nguyen
Networks a six month. 8 per cent, $120000 note receivable
and $30 000 m cash. 1n payment for professional services.
The note and interest were pa1d at matunty on 1 September.
Abby has a 30 June year end.
REQUIRED
Prepare all journal entries Abby would make to properly
account for the service and note.
13 U n coll ectible receivables
Le Ma reported the following mformation in its latest annual
report:
Allowance for bad debts. beginmng balance
~~------------------
Bad debt expense for the year
Accounts receivable wrmen off dunng the year
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REQUIRED
Determ1ne which method of accounting for bad debts Le Ma
uses. record all journal entnes assocrated wrth the allowance
account for the year. and determme the endrng balance 1n
the allowance account.
14 Uncollectible receivables
At 31 December. Duong Des~gners had gross accounts
rece1vable of $346000. H1storrcally. Duong's Des1gners has
631XXJ estimated bad debt expense as 3 per cent of gross
rece1vables.
541XXJ
REQU IRED
SIXXJ
a Calculate bad debt expense for the year. assumrng that
the allowance account currently has a cred1t balance of
$5000. Aga1n, calculate the expense assuming a debrt
balance of $1200.
b Assume that on 29 December an account recervable of
$1000 was deemed uncollectible and wnnen off. Prepare
the journal entry to record this event. What effect does
this have on (i) profrt or loss this financial year (ii) the net
realisable value of receivables?
15 Ageing schedule for account s receivabl e
Outdoor Living has the following accounts receivable at year
end. broken down by age:
Age Amount
Current $150000
One month overdue 40000
Two months overdue 18000
Three months overdue 8000
Four months overdue 111XXl
Pnor expenence has shown that the company w1ll
probably collect 95 per cent of rts current rece1vables.
Furthermore. the collection percentage w1ll fall by 10 per
cent (85%. 75% etc.) for each addrtronal month an account
receivable remarns outstandrng past ItS due date.
REQU IRED
Develop an estimate of Outdoor Livrng's allowance account
balance and prepare the JOurnal entry for bad debt expense,
assuming frrst the allowance has an ex1sting $4000 cred1t
balance and second $1000 deb1t balance.
16 Recording n otes receivabl e
On 1 April. Choi Corporation accepted cash of $15000 and a
six month. 6 per cent. $85000 interest-bearing note from
Palaza. Inc.. as settlement of an account receivable. Choi
has a fiscal year end of 30 June. and Palaza paid the
principal and the interest at matunty.
REQUIRED
$5 325
Identify the note's maker and payee and prepare all
975 appropria te journal entnes from the acceptance of the note
795 to the maturity date for the payee.

17 Interest on notes receivable
Cons1der the follow1ng Independent scenarios:
On 1 September last year. a company accepted a
$20000, 8 per cent. SIX-month note receivable.
ii On 15 December last year. a company accepted a
$15000, 10 per cent. four-month note rece1vable.
iii On 1 Mard1 th1s year. a company accepts a $10 000.
5 per cent, e1ght-month note receiVable.
REQUIRED
Assum1ng a 30 June (thiS year) fmanc1al year-end. calculate
current-year Interest revenue for ead1 of the above.
18 Accounts receivable entries
During the 201 ~20 financial year EI-Kheir Electronics
entered into the followmg transactions :
Sales on account
Collections of cred1t sales
Write off accountS deemed uncollectible
Received payments on accounts prev1ously wnnen off
- - - ' ' - - - - - - -- - -
On 1ts balance sheet for the year ended 30 June 2020.
EI-Khe1r reported gross accounts rece1vable of $707 000
cred1t and an allowance account of $43000 deb1t.
REQUIRED
Prepare all1ournal entnes to record each of the transactions
that occurred in 201~20 and the 1ournal entry to record bad
debt expense at 30 June 2020. assum1ng that 5 per cent of
accounts rece1vable at 30 June are uncollectible.
19 Comparing methods for uncollectible
receivables
The followmg data perta1ns to the operations of Knight
Kiters for 2021:
Net credit sales
Net operating income {before bad debt expense)
Write-offs of uncollectible accounts
Estimated uncollectible percentage of net credit sales
- - - -- - - -
ACCD Fon~lll 2019 Cengajle L.umlng. AU Rlghta R--...ci.!Uy not be copied. scanned, 0< ~iealed,ln wholo Otln part. WCN 02·200-202
110
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The chartered accountant is trymg to dec1de which
method of account1ng for bad debts to use. Knight K11ers 1s
attempting to max1m1se total comprehensive 1ncome to
meet proJected f1gures. The bad debt expense 1s mater~alto
the company's fmancial statements.
REQUIRED
a Calculate bad debt expense for 2021 under the direct
wnt~H>ff method and the allowance method.
b Calculate profit or loss under both methods (assume a
tax rate of 25 per cent).
c As a reportmg entity does Kn1ght K1ters have the opt1on
of wh1ch method to use under Australian Accounting
Standards?
20 Analysing receivables
The followmg information was taken from the annual reports
of two high-end Jewellery retailers:
Company A Company B
Net accounts receivable, 2021 $584000 $460000
Net accounts receivable, 2020 505000 398000
Net revenues. 2021 2425000 2195000
Net revenues. 2020 2200000 1500000
REQUIRED
a Calculate the 2021 receivables turnover ratio for both
companies.
$1400000
b Compare the two compan1es. Which one 1s more
1225000 efficient with its receivables?
20000 c What other methods and factors would you cons1der
7500 when evaluating receivables? What other companson
demonstrates one company's eff1c1ency over the other?
21 Recording notes receivable
On 15 February, Tran Corporation sold eqUipment to Aclams
Corporat1on on account for $40000. On 1 November, Tran
deemed the account uncolleCtible and wrote 11 off. On 31
December, Adams offered Tran a SIX month. 10 per cent.
$40000 promiSsory note 1n payment of 11s obligation, wh1ch
Tran accepted. Adams pa1d the pnnc1pal and the Interest at
the maturity date. Tran uses the allowance method for bad
debts.
REQUIRED
a Prepare all ofTran's necessary journal entnes from the
date of the equipment sale to the maturity date of the
note. Ignore any effect on inventory or cost of goods
$925000 sold.
135000 b What would be Tran's motives for offering a promissory
note in settlement of such an old debt?
17500
2%

22 Research and analysis
Access the latest annual repon for Cochlear llm1ted (ASX:
COH) (or a company chosen by your lecturer).
REQUIRED
a Examine the company's statement of comprehensive
1ncome and balance sheet and conduct horizontal and
ven1cal analyses of what you consider to be the four
most relevant accounts in both statements.
b Examine the company's rece1vables note. Answer as
many of the followmg as the information provided in the
notes to the accounts allows:
What is the company's current year balance in its
allowance for doubtful debts (allowance for
impairment loss or similar-named) account?
ii What factors are considered when estimating the
balance?
iii How often is the balance reviewed?
iv What likelihood does the company requtre before it
wntes off a rece1vable?
v Why are there rece1vables 'past due' but not
1mpa1red?
vi How does the company assess the risk and/or make
estimates/judgements?
c With the gathered 1nformauon, calculate the company's
receivables turnover and days.1rwecetvables rat1os for the
current ftnanctal year, and the company's allowance rat10
for the current and IJ(8VIOUS f1nanctal year. Why should you
be careful1n 1nterprettng these results (th1nk - do you
know sales on credtt or JUSt total sales)?
d Based on your answers above, wnte a paragraph
expla1n1ng your op1n1on of the company's receivables
position. Use your answers as supponing facts
(remember all sales may not be credit sales).
Copyright 2011 c.ng.g. Laamlf111. AI Rights R---llay not be cop;ed scannod, or dUI>IJcaocl,ln whole or In part
23 Ethics in accounting
The Cho Corporation 1s 1n the process of closing tts books
for the year. The company has been growmg at an
unexpected rate. The ch1ef accountant at Cho IS currently
determ1n1ng the applicable percentage for the allowance for
bad debts and believes 1t should be based on 3 per cent of
net credtt sales. The CEO of the company has expressed
concerns about ach1evtng future market expectattons and
approached the ch1ef accountant wtth a request to mcrease
the allowance for bad debts to 6 per cent of net cred1t sales
wtth the expectation that the lower net 1ncome w1ll
decrease the pressure to perform tn future years.
REQU IRED
a What factors should be cons1dered when determm1ng
the applicable percentage to apply when us1ng the
income statement or balance sheet approach?
b Should the ch1ef accountant be concerned with the
company's growth rate when determ1n1ng the allowance
for bad debts? Explain.
24 Written communication
The Chief Financial Officer (CFO) of a manufacturing plant
that sells light machinery throughout Austra las ia is
currently training new employees. In today's tra1n1ng
session the group is told that total credit sales for the
year is $900 million, accounts receivable total
$ 120 millton less a $3 m1lllon allowance for bad debts,
and bad debt expense is $2 m1lllon. At the end of the
session the group 1s asked 1f they understand everything
discussed; and all say yes except one tramee who is still
somewhat confused about why bad debt expense and
the allowance balance d1ffer.
REQUIRED
As one of the tra1nees who understands the tra1ntng
sess1on. the CFO asks you to research thiS 1ssue and
prepare a presentation expla1ntng the d1fference to present
to the other tra1nees tomorrow. The presentatton should run
between three and ftve m1nutes and should tnclude some
PowerPomt slides.

Afte r studying the material in this chapter, you
should be able to:
Describe inventory and how it is recorded,
expensed and reported.
Calculate the cost of sales using different
inventory costing methods.
Understand the profrt and loss effects of
inventory cost flow assumptions.
Demonstrate how inventory
can be estimated.
Apply the lower-of-cost-and-net-rea lisable-
va lue ru le to inventory.
Evaluate inventory through the calculation
of horizontal, vertical and ratio analyses.
Appendix: record purchases and calculate
the cost of sales under a periodic system.
apply this-........ - .
Copyrlght2019 Cengage Loa nlng A R ght Rnervecl May not
112
This chapter examines the accounting for inventory. In
particular, it examines how businesses record their
inventory and how they determine the cost of the
inventory that is sold. It also examines how inventory can
be estimated if needed and how inventory must be
adjusted if tiS market value falls below its cost. The
chapter then concludes with an analysis of a business'
inventory position. The appendi x covers inventory
accounting under a peri odic (sometimes known as a
physica l inventory) system.
Lo RECORDING, EXPENSING
AND REPORTING
INVENTORY
Inventory is a tangible resource that is held for resale in
the normal course of operations. For a
retailer. inventory is the stock (merchandise. inventory Atangible
resource that is held for
goods) on the shelves or in the warehouse. resale in the normal
For a car dealership the cars are inventory course of operattons.
while for most businesses cars are non-
current assets. When a business decides to sell a norH:urrent
asset. such as a car. 1t IS not considered to be inventory
because it was not purchased and held as 'intended for
resale'. For a manufacturer. tnventory also includes the raw
materials and work-tn-process related to producing a fimshed
product. which you may
study in managerial Checkoutlhevideosummary
accounting. for Chapter 7
RECORDING INVENTORY
Following the cost principle, inventory is recorded at its
acquisition cost. This includes all costs incurred to get the
inventory delivered and. if necessary, prepared for resale.
Like buying on eBay, we are interested in how much 1t
costs in total (iS 'postage' 1ncluded, will we need to buy
batteries separately) not just the 'price'. Cost also includes
any reductions granted by the vendor or supplier after
purchase. Examples of 1tems affecting the cost of inventory
would include, but is not limited to, the following:
• purchase price
• taxes or duties paid
e cost of shipping and transit insurance
e labour required to assemble the product
e returns to, allowances from (including purchase
discounts) from the supplier.
While inventory is recorded at cost. how it is recorded
in the accounting system depends on the inventory
system that a busmess uses. A
perpetual inventor y syst em updates perpetual inventory
the Inventory account each time inventory system Updates the
·1s b oug ht an d so ld - t hat ·IS, perpetually. inventOJy account each Of
time inventocy is bought
col~~.r~{.9~~. ~~~.,Alhbitl&illf&Y. ~ 02·~<02
 10 Oct. Inventory 300
Cash 300
ITo record transponatJon-ln)
Assets Liabilities + Equ1ty
+300
- 300

Sometimes, a bustness w1ll return Inventory to the

vendor (supplier) or seek some reduCtiOn 1n the cost of
the inventory due to defective merchandiSe (inventory).
The former is called a purchase return, purchase returns
while the latter is a purchase allowance. and allowances 1>11
Both reduce the cost of the inventory account that accumulates
tile cost of an VMlntory
purchased. returned to vendors as
To illustrate, suppose that on 12 October well as tile cost reductions
from vendor allowances.
reco rded directly into the Inventory Thirroul is granted a $1000 reduction in the
periodic (physical) cost of the goods (inventory) due to blemishes on the
inventory system account. In contrast, a per i odic
Updates the inventory (physical) inventory system updates inventory. Even though Thirroul keeps the inventory, its cost
account only at tile ood of has decreased due to the purchase allowance. Therefore,
an accounting period. the inventory account only at the end of
a n accoun t ing per iod - that i s. Thirroul would reduce the cost of the inventory and the
periodica lly. Instead of recording purchases into the amount payable to the vendor with the following entry:
inventory account, they are recorded in an account called Accounts Payable
12 Oct. 1000
purchases Anaccoont
Purchases, which is a temporary
Inventory
---- 1000
used to accumulate tile account that is closed to Inventory at t he ------
cost of all purchases. end of the period. This chapter will ITo record purchase allowance granted
by vendor)
demonstrate inventory accounting under
Assets Liabilities +_ _:E:q::;U;;.:Ity!..
a perpetual system. The periodiC system is demonstrated
in the appendix to this chapter. - 1000 - 1000
To illustrate the record1ng of inventory, suppose that
In addition to returns and allowances, companies
Th1rroul Takeaway purchases $20000 of inventory on
sometimes receive discounts from vendors 1f payment is
account (on cred1t) on 10 October. The purchase would be
made within a certatn time penod. Such purchase discounts
recorded as follows:
reduce the cost of the inventory. To illustrate, suppose that
10 Oct. Inventory 20000 Thirroul pays its rematning $19000 b1ll to the vendor on 15
Accounts Payable 20000 October, which qualifies Thirroul for a 1 per cent d1soount. As
ITo record purchase of inventory) a result, Thirroul would save $190 ($19000 x 1%) and pay only
$18810. The entry to record payment would be as follows:
Assets Liabilities + Equity
+20000 +20000 15 Oct. Accounts Payable 19000
Inventory 190
Both assets and liabilities increase as a result of this
Cash 18810
transaction.
ITo record payment)
In some cases. a business must pay for the
transportation ('postage'). Such additional costs are called Assets Liabilities + Equity
t ransportation -in and are added to the - 190 - 19000
transportation-in An
account tilat accumulates overall cost of the inventory. To illustrate, -18810
the transportation costs of suppose that Thirroul pays a third-party
obtaining the 1nventory.
carrier $300 to transport t he inventory to The entry decreases Accounts Payable for the full
its warehouse. Thirroul would record the payment with the $19000 (since the debt is paid in full) and decreases Cash
following entry: by the $18810 paid. The difference is a reduction to
Inventory because the purchase d1scount of $190 has
reduced the cost of the inventory. Both assets and
liabilities decrease.

Copyrlgh12019 CensJa9e L.umlng. AU RlghU R--..cl. l&ay not be copied. scanned. 0< ~iealed I n - 0< In part.
 In some circumstances the supplier may allow a long
period before payment is requi red. The purchase price
could then be considered to contain a f inancing element
and, in accordance w ith Accounting Standard AASB 102
Inventories pa r. 18, 1 some of the purchase price would be
considered an interest expense. Consistent w ith this
treatment, early payments resu lting in any purchase
d iscount is considered to be a reduction in inventory, not a
revenue or contra expense.
Given t he preceding activity; Thirroul's net purchases of
inventory can be calculated as follows:
Gross purchases
Add: Transportation· in
Less: Purchase returns and allowances
Less: Purchase discounts
Net purchases (Inventory balance)
EXPENSING INVENTORY
Inventory becomes an expense when it is sold. The account
Cost of Sales (COS) or Cost of Goods Sold (COGS) is used to
capture the amount of inventory expensed during a period.
Like the recording of inventory purchases, the recording of
cost of sales depends on a business' inventory system. Under
a perpetual system, COS is updated each t ime inventory is
sold- that is, perpetually. Under a periodic system, COS is
calculated and recorded only at the end of the period - that
is, periodically. Again, this chapter w ill demonstrate inventory
accounting under a perpetual system, w ith the periodic
system demonstrated in the appendix to the chapter.
To illustrate the recording of cost of sales, suppose that
on 2 November Th irrou l sells inventory that cost t hem
$400, to a customer for $600 cash . Thirroul wou ld record
the sale w ith the following two entries:
2 Nov. Cash 600
Sales (Revenue)
(To record sale of inventory)
liabilities
Assets
+600
2 Nov. Cost of Sales
Inventory
(To record sale of inventory)
Assets
-400
liabilities
400
The first entry records the effect of the sale on Thirroul's
cash and revenues. Both Cash and Sales increase for the
amount of the sale. As a result, both assets and equity
(revenue) increase by $600 (we cou ld think of this as the
'money' f low).
_ 114
_..;..;...;.
ACCTJ Fi n~c!ll(lght 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In whole or In part. WCN 02·2iJ0.202
The second entry records the effect of t he sale on
Thirroul's inventory and expenses. Cost of Sales increases
for the cost of the inventory sold. Inventory decreases for
the same amount (we could t hink of th is as the 'goods'
flow). As a result, both assets and equity decrease by $400
(remember an expense is a decrease in equity). The net
effect of both entries on assets and equity is a $200
increase, which is equa l to the gross profit that Thirroul
earned on t he sale.
In contrast a service business on ly has a 'money' f low,
they do not have the corresponding 'goods' flow.
$20000
300
(1 000)
REPORTING INVENTORY AND COST OF SALES
Inventory is expected to be sold w ithin a year. Therefore, it
is reported on the balance sheet as a current asset. Because
cost of sales is usually a large and important expense for a
retailer or manufacturer, it is normally reported as a separate
line item on the income statement just below sales.
600 To illustrate, examine the balance sheet and income
statement for CSL in Appendix B. Inventory is an important
Equity asset. CSL reported Inventories of over $2 billion in both 2016
+
and 2017 - its largest current asset. It also reported over
+600
$3 billion in Cost of Sales in both years, its largest expense.
+
400
Equity
-400
INVENTORY COSTING
METHODS
Review this content with thee-lecture
•
,.....
The previous section demonstrated the manner in wh ich
inventory and cost of sales are recorded under a perpetual
system. When a sale is made, Inventory (asset) is decreased
and Cost of Sales (expense) is increased for the cost to the
reta iler of the inventory that is so ld. This section
 demonstrates how companies determine the cost of the inventory is unique; for example. a jewellery store that sells
inventory sold, the 'Cost of Sales'. expensive individually designed jewellery.
For illustration purposes, suppose that Koala specifically
identifies each of its inventory items and provides the
CS[ ANALYSIS detailed inventory activity as shown in Exhibit 7.1.
Ex hibit 7.1 shows that the 10 September sale consisted
of 30$12 units and 35$13 units for a total cost of $815.The
30 September sale cons1sted of 10$12 unns. 20$13 units.
10 $14 units. and 10 $15 units for a total cost of $670.
Together. cost of sales for September is $1485 ($81 5 +
$670). The 60 units remam1ng 1n end1ng mventory, as shown
in the bottom right corner of Exhibit 7.1, have a cost of $870.
CSL. because of the nature of its product is likely to use
specific identification. Each batch of medicine will be able
to be identified from manufactunng to customer (i.e.
hospital. chemist, doctor) and in many cases consumer
('medicines to patient' as CSL describes its business).
Because most companies cannot track the actual cost
of every inventory item that is sold. they cannot use the
specific identification method. Instead. they must make an
assumption about the cost of inventory sold. They can
To determine the cost of inventory sold, companies can assume that the cost of the inventory sold is the cost of the
use one of the following four inventory costing methods. first unit purchased, the last unit purchased or an average
In Australia, AASB 102 does not permit the use of the third of all pu rchases .
~,IJ ,,,,
method (LIFO); however. this method is used in other parts Each of these three
of the world, primarily Japan and the US: assumptions is Check out lhe animated summary •
on Specific ldelllificalion
e specific identification described as follows.
e first-in, first-out (FIFO)
first-in, first-out
e last-in, first-out (LIFO) FIRST-IN, FIRST-OUT (FIFO) (FIFO) method
e moving average. The fi rst-in, first-out (FIFO) method Calculates cost of sales
To illustrate each method. the following example will be based on the asstJ11lllon
calculates cost of sales based on the that the first oort of
used. Suppose that Koala General Store sells goanna oil
assumption that the first umt of Inventory IMlfltory available for sale
that it purchases from Bandicoot Manufacturing. During is the first tnt sold.
available for sale is the first unit sold.That
the month of September, Koala expenences the following is. inventory is assumed to be sold 1n the order that it is
inventory actiVIty:
purchased. For many compan1es, the FIFO assumption
Unit may match the actual phys1cal flow of the1r inventory.
Units cost Total
However. companies are not requ1red to choose the
1 Sep. Beginmng uwentory 40 $12 $480 assumption that most closely matches their physical flow.
4 Sep. Purchase 60 $13 $780 Remember this is an assumptiOn because the actual items
- · - - ·-- -- -- · sold cannot be identified, they cou ld be the oldest, the
10Sep. Sale (65)
15Sep. Purchase 30 $14 $420 newest or any combination.
Exhi bit 7.2 illustrates the calculation of cost of sales
23 Sep. Purchase 45 $15 $675
under the FIFO method.
30 Sep. Sale (50)
At each sale, the FIFO method requires Koala to assign
the costs of the first units purchased (the oldest stock on
SPECIFIC IDENTIFICATION hand) to cost of sales. On 10 September Koala sold
65 units. It therefore assumes that it sold all 40 units of
specific The specific identification method
beginning inventory and 25 of the units in Purchase #1. The
identification determines cost of sales based on the
method Oeterm•nes total cost of those 65 units was $805.
cost of sales based on the actual cost of each inventory item sold.
For the 30 September sale, Koala assumes that it sold
actual cost of each To use this method, a retailer must know
the 35 units remaining from Purchase #1 and 15 units of
inventory item sold. specifically wh1ch inventory item is sold
Purchase #2. The total cost of those 50 units was $665.
and the exact cost of that particular item. As a result, the
As a result of these two calculations. cost of sales for
method is most likely to be used by companies whose
September is $1470 ($805 + $665). The 60 unrts remaining
 Inventory purchased Inventory sold Inventory on hand
1 Sep. 40 $12 s 480
4 Sep. Purchase #1 60 $13 $780 40 $12 $ 480
$13
100 $1260
Sell65 units $12 $360 10 $12 s 120
$13 25 $13

- -- - - -- - - - - --- - - ---- - - -- - - - - - - - - - - - - - - ·- · ~5- - - - - - - - - -~ - - ·- _3~ - - - . - - - - _ _ §_<1~5- .

15 Purchase 12 30 $14 $420 10 $12 s 120
25 $13 325
$14
65 s 865
23 Purchase 13 45 $15 $675 10 $12 s 120
25 $13 325
30 $14 420
$15
110 $1540
-···- ···-···-···-···- ··- ···--···-···-···-···-··- ··-···-···-···-..-··-···-···-···-···-····-····-····-·-····-···-···-···-·-···-···-····-···-···-·····-····-···-···-··~···-···-···- ...·-····-··-····-···- ···-····- ··-···-····-···- ···- ···-····- ···- ···-...·-···- ·-··-···-··-...-....
30 Sell 50 units 10 $12 $120 0 $12 s 0
20 $13 260 5 $13 65
10 $14 140 20 $14 280
-···- ··- ···-···- ··- ··- ···--···- ··-···-··- ··- ··-···-···-..- ··- ··- ··-···-···- ···- ···- ···- ···-····-···-···-···-·-···-···-···-···-···-· ···-···-···-···-··~···-···-···- ...·-····-··-···- ···- ···- ···- ··-···-···- ····-···- ···-····- ···- ···- ···-···- ·-··-··- ··-··- ····
---------------------- --- - - -- ---------·-· J.!.L __ _~1~- - __1_S.~. - ...3.~ --- - -~~S.. ----~~S...
50 $670 60 s 870
Err:] Calculatoons for the specofoc odentof ocat oon method

Transaction Inventory purchased Inventory sold Inventory on hand

1 Sep. Beginning inventory 40 $12 S 480
-···-···-···-···-···-··-···--···-···-···-···-··-··-···-···-···-··-··-···-···-··~-···-···-···-····-·-····-···-···-···-·-···-···-···-···-···-····-····-···-···-··~···-···-···- ...·-····-··-···- ···- ···- ···- ··-···-...·-···- ···- ···-····- ···- ···-...·-···- ·-··-··- ··-···-····
4 Purchase #1 60 $13 S780 40 $12 $ 480
$13
100 $1260
-···- ···-···-···-···- ··- ···--···-···-···-···-··-···-···-···-···-··- ..-···-···-···- ···- ···-...·-·······-····-···- ···- ···-··-···- ···-···- ···- ···-·····-····-···- ... ...·-····-··-····-···- ···-····- ··-···-····-···- ···- ···-····- ···- ···-...·-···- ·-··-···-··-...-....
·-··~···-···-···-

10 Sell65 units 40 $12 $480 0 $12 S 0

---------------------- ----- ------------·-·Jt __ _~ 1 ~----~-- __3.~ --- --~~3-----~~S.. .

65 35 s 455
15 Sep Purchase 12 30 $14 $420 35 $13 s 455
····-···············-·······-···················-·················-··············-·············· ·············-···-······-···-············-··················-···········-···-·············-···········-···-···· ........3..~·-·-···-········-~-~~---··········-······~-~.0......
65 s 875
23 Sep Purchase 13 45 $15 S675 35 $13 s 455
_,,_,_,,_,,_,,_,_,,....,_,,_,,_,,_,,_,_,,_,,_,,_,,_,_,_,,_,,_, ,.._,,_,,_,,_ ..•,_,..,_,,_,,_,,_,.,._,,_,,_,,_,,_,,,_,. ,_ ..,_..,_..,_.. ,.,,_,,_,,_,,_,,__,..-....-...-...-....- .......-30
...-...-...-...-....-$14 420
...-....-....-...-......,_,,_,_,,_,,.
····-···············-·······-···············-·····················-······························ ·············-···-······-···-············-·············-···-···-······-···-·············-···········-··················-~-~----·············-~-~~---·······-·-······.?..~.S......
_,,_,_,,_,,_,,_,_,,....,_,,_,,_,,_,_,_,,_,,_,,_,,_,_,,_,,_,,_ .. ,.._ ..,_..,_..,_......,_..,_..,_..,_..,_.. ..._..,_..,_..,_..,...,_..,_..,_..,_.. ..
.,._,,_,,_,,_,,_,.,_, .. .....110
,__, _,,_,,_,,_,,_ ,~ .. .....$1550 ....
,_,,_,,_,,_,,_,. ,_ ,_,,_,,_,,_, ,_,,_,_,,_

30 Sep Sell 50 units 35 $13 $455 0 $13 S 0

-···-··-···········-··-···-···········-··-··-·············-··-··-·········-··-··-··-··-··-··-··-······-····-···-·······-···-········~---·-···-······~·1·~·-··········-····~1-~·-················-~-~----···-····· ·-~-~~---·······-·-·····3.~.0......
-···-··-·······-···-··-···-···········-··-··-·············-··-··············-··················-·········-···-····· -···-·······-···-········~---·-···-·····-···-············-·-~~S..~.---····-·········-~-~----···-···-· ·-~-~S...........__......?..~.s-····
60 s 885
~ Calculatoons for the FIFO method

_ 116
_..;..;.;;,
ACCTJ Fin~c!ll(lght 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated. In whole or In part. WCN 02-200-202
 in ending inventory, as shown in the bottom right corner of assumes that it sold all 60 units of Purchase #1 and five of
Exhibit 7.2, have a cost of $885. the units from beginning inventory. The total cost of those
Remember with FIFO we are not tracking the sale of each 65 units was $840.
item. Because we do not know if we have sold the oldest For the 30 September sale, Koala assumes that it sold
item in stock or the newest, FIFO is an assumption. Even for all 45 units of Purchase #3 and five units of Purchase #2.
items where a retailer may attempt to sell the oldest stock The total cost of those 50 units was $745.
first e.g. milk. Nothing stops a customer taking the newest As a result, cost of sales for September is $1585
milk from the back of the f ridge; all milk of the same brand,
type and size will have the same barcode, regardless of the
use-by date. Milk that expires in two days is indistinguishable
($840 + $745). Ending inventory, as shown in t he bottom
right corner of Exhib it 7.3, has
a cost of $770. Check out the animated
summary on UFO
11 ~

from the milk expiring in 12 days to the computer program

perpetually tracking inventory. The same is likely to apply to MOVING AVERAGE
refrigerators, each brand and model
The moving average met hod calcu lates cost of sales
~·\1 ,~., will have the same barcode whether
based on the average unit cost of all
Check out the animated manufactured last week or last year. moving average
• summary on RFO inventory available for sale. That is. the method Calculates cost
cost of each inventory item sold is of sales based oo the
I LAST-IN, FIRST-OUT (LIFO) assumed to be the average cost of all
average unit cost of all
l ast-in, f irst-out inventory available for sale.
(LIFO) method The l ast -i n, first -out (LIFO) method inventory available for sale at t hat time.
Calculates cost of sales
calcu lates cost of sales based on the To calcu late cost of sa les at each sale date, a retailer
based on the assumption
that the last unit of assumption that the most recent must calculate the average unit cost of the inventory
inventory available fo< salepurchases (the newest stock on hand) available for sale on that date. This calculation is conducted
is tile first unit sold.
are sold first. As previously mentioned, as follows:
while not currently permitted in Australia, this method is
used in other parts of the world, primarily Japan and the
US. Exhib it 7.3 illustrates the calculations under the LIFO .. AVERAGE UNIT COST
method. A U . C Cost of Goods Available f o r Sa le
At each sale, the LIFO method requires Koala to assign verage nrt ost = Unit s Available for Sale
the costs of the last or most recent units purchased to cost
of sales. On 10 September, Koala sold 65 units. It therefore

Tran saction Invent ory purchased Inventory sold Inventory o n hand

1 Sep Beginning inventory 40 S12 $ 480
... -···-··-···-···-···-··-· ·····-···-··-··-··-···-···-··-··-··-···-···-··-··~····-···-···-···-·-···-···-···-···-········-···-···-··-···-····-···-····-····-·······-···-···-···-···-··-···- ..·-···- ···- ···- ·..- ···- ···-···- ···- ····-···- ···- ···- ···-········-··- ··-··- ··-·
4 Purchase #1 60 $13 $780 40 $12 $ 480

. ... ... ._.,_.,. . .-..-....... ... _. .. ... ... ... ... -..... .. ... ... _. . -.. -.. -.. -·~. .-.. -.. -.. _. ._. ._. .-.. -.. -.. _. __. ... . .. . . . ....._. .-.. -.. .. _. ... . .. .-·· -. ·-····-·~0.. .. ._. ._. ... . ~1-~...- .................?.S..O.... .
.. .. ..•
,,._,.,_,,._,.,_,,._,.,_,,._, ,.,_,.,_,._,._,,._,.,_,.,_,.,_,._,._,,._,,._,.,_,.....,.,,._,.,_,,._,,._,,...,.,_,,._,.,,_,,._,.,_ ,,.._,,._,,._,.,._,,._,., _,,.,_,.,._,,.,_
100 . $1260 ,_,.,._,,._,.,_,,._,.,...,,,_,,.,_,,._,,._,,._, , ,._,.,_,,.,_,,.,_,,._,., _,,.,_,,._,,._,,._,,.,.,,,._,._,._,,._,._ ,

10Sep.
, ,._,.,_,.,_,.,_,.,_,.,_,,._, ..
Sell65 units 5 ..•
,.,_,.,_,._,._,.,_,.,_,.,_,.,_,._,._,.,_,.,_,.,_,.,_,,.,_,.,_,.,_,.,_,,...,.,_,,.,_,.,_,.,_,.,_ ,,._,.,_,.,_,.,._,,._,.,.._,,.,_,.,._,.,._
$12 s 60 35 $12 $ 420 ,_,.,_,.,_,.,_,.,_,.,...,.,_,,.,_,,._,.,_,.,_, , ,._,.,_,.,_,.,_,.,_,.,, _,,.,_,.,_,.,_,.,_,.,, ,.,_,._,.,_,._,._ ,

........-...............-..........-..................-..............._. ._. ,_. ,_. ,_.~. .-...........~. .-.. -.. -.. -..............~....... · - -~-~~-. .-..... _. .!.~. -..~. ·-·_....0...........-.. ....~1-~.. - ....... ....- ......0.....
.........._. _. . . . . .-... . . . .-.....................-................._. ._. ,_. ,_. ,_.~. . . . . . _. ,_. ._. _. ,_. ,_. . . . -.. .-.~~......... . .....-.. -.. -.. . _~ _. ,_. ,_ ,-..~S.. . . -.. -.. ... . -.. -.. -.. . . ... ~.-~2..0.....
15 Sep.
. ,._,.,_,,_,,_,,_,,_,,_,
Purchase
..........,.....
#2 .._,.. 30 $14 ,_..,,....-$420
......................
_,_,,_,,_,,_,_,_,,_,,_,,_,,_...-...-.........,_.....-..................... .........,_..,_..,_..,_......................
,_,,_,,_,,_,,... ..35
,_......... $12 .............. 420 __ ,_,,_,,_, , ,._ ,_,,_,,., _,,_,,_,,_,,_ _,,_,_,

... . ._. _. _. ,_. ,_. _.,. . . . . .-.............-.. . .-............._. _. . -.. -.. -.. -·~. . . . . . -.. -.. ... .-.. -.. -.. .-.. -.. .. . . . . . . . . . .......-.. -.. -.. . . _. . . . . . -.. -........-.~-0.. . . -.. -.. ... . ~1-~...- ......._......-~2..0.....
65 $ 840
23 Sep. Purchase #3 45 $15 $675 35 $12 $ 420

........,_,__,_........._.._....._.. _,_..__ .._,_,_.._..............

,_,,_ _,_,,,,_ ---
..,_..._..,_....................._..,_........ ... ... .........._....-........................... ......._..._..,_..__, _ ,__,,_..,_..,_.......... ...30
-.........,_..._.... ....$14 420 __
_..._..,_,,_,__,.._,_,_,_, -
45 $15 675
. ........_ .._,.._,.._..._ .._, . ........_ .._,_,_,.,_.._,_.._ .._..............- ..-.. ....................,_._................. ~......... ....- ...- ...- ...- ...- .... - ........................... .......- ........- ......... .................- ...- ........ ...=::=........- ...- ... . ....- ........- .........- ....~.... .

- - -- -
........,_.._.._..,,....,_.._, .......... .._.._.......,....._.._.. ................... .. ....-... ...-...-.......-...-...-...-... ... ... ... ...-... - - - - -....-.......................... .......-...-...-.............................-...-..........-110
...-...-...-...-..... ...-...-...-...-...-........-.......-......
$1515
~

30 Sep. Sell 50 units 5 $14 S 70 35 S12 $ 420

. ......., _ , _ , _ , ,..........., _. . ........._ , _ , _ . , , _ , , _ , _ , _ , _ , _ . , , _ , , _ , _ ,, . . ., , . _ , _ , _. ., _. ., _. . . ., ............................. >0. ., _. ., _. ., _. ., _. ., _. . .. _ ........................... ......, _. ., _. ., _. ., _......................, _. ., _. ., _ , , , , _. ., _. ., _. ., _. ., _. . . .. ~ . . .- . . .- . . .- .......... .. ., ....._ . ._ , _ ,_ _

25 $14 350
........,_.._.._,.,_..,_.._, .........._.._.._.......,....._.._.._.............,....._.._.,,_.._.._.._...........................................,_..,_..,_..,_..,_..,.._................................,_..,_..,_..,_.. .._..,_.._..,_..,_..,_,.,_..,_..,_..,_..,_..... ... ...-...-...................-.......-...... ~ -
45 $15 675 0 $15 0
. . . . . . . . . . . . . ., _ , _ , ,. . . . . . . . . . ., _. .. . . . . . . . . . . . . . .- . . . . . . . . . . . . ., . . . . ._ , _ , _ ,. . ., . . . . . . ., . . . . ._ . .. . . ., . ., _ , , _ , , _ , , _ ,. . .. . . . . . . . . . . . . . . . . . . . . ., _. . . .. . ., _. ., _. ., _. . ., . . . . ., _. ., . . _; :::::::. . . . . . . . . . . . . . . . . .. .. . . . . ._ . ., _ , , _. ., _. . . . . . .; : : : : : : : : : : : : :
. _. ., _. ., _ , . . ...::::::::::-. . . . . . . ._ , , _. . . .. 4 . ., _ , , _ , , _ , , _ ,. .. .. . ..:::::::::::::=..... .
50 ~ 60 $ 770
rn:l Ca lculations for t he LI FO method

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7
Inventory __
.;...;.;..
117
 Inventory purchased Inventory sold Inventory on ha nd
1 Sep. 40 $12.00 $ 480
4 Sep. 60 $13 $780 40 $12.00 $ 480
$13.00
100 $1260
-- ··-···-···-··-···-···-··- -····-··- ··- ··-···-···-···-··- ··-···-···-···-··- ··-···-···-...-···-···-·-···-···-···-···-··-·-···-···-···-···-···-···-···-··-··-··-···-·-·- ··-···-··- ··-···-··- -···- ···-···- ···-···- ·····-···-···-···-···-·-··-··- ··- ··-···-···-···--··-··- ··-··- ··-··
Sell 65 units 65 $12.60 35 $12.60 $ 441
Purchase #2 30 $14 $420 35 $12.60 $ 441
30 $14.00
................................_ ..................................................... 65 $ 861
...................... ························- ·························- ...................... _ ·························-
23 Purchase #3 45 $15 $675 35 $12.60 $ 441
30 $14.00 420
-·-··-···-··- ··- ··-···-··- -····-··- ··- ··-···-···-···-··- ··-···-···-···-···-··-··-..·-···-···-···-·-···-···-···-···-···-·-···-···-···-···-···-···-···-··-··-..-···-·-·- ··-···-···-··-···-···--···- ···-···- ···-···- ·····-···-···-···-···-·-··-··- ··- ··- ··-···-···--··-···-··-·..-··-··
$15.00
110 $1536
··-··-···-···-··- ··-···-··- -···-··- ··- ··-···-···-···-··- ··-···-···-···-···-··- ··-···-···-···-···-·-···-···-···-···-···-·-···-···-···-···-···-···-···-··-··-··-···-·-·- ··-·..-···-··-···-···--...- ···-···- ···-···- ·····-···-···-···-···-·-··-···-··- ··- ··-···-···--··-··- ··-···-··-··
30 Sep Sell 50 units 50 $13.96 $698 60 $13.96 $ 838
1:[] Calculatoons for the moving average method

Once the average unit cost is known. it is multiplied by the freshest and best but may end up with some pieces
the units sold to determine cost of sa les. Exhi b it 7.4 delivered last month ~'\1 ' <r
contains Koala's calculations under the moving ave rage and others yesterday. Check outthe animated summary •
on Moving Average
method. Note that the average unit cost is rounded to the
nearest cent, wh ile inventory sold and inventory on hand
is rounded to the nearest dollar. ~ COMPARING INVENTORY
At t he 10 September sale, Koa la has 100 units
available for sale at a total cost of $1260. Therefore. the
'iii' COSTING METHODS
average unit cost is $12.60 ($1 260/ 100). Koa la uses that
The previous sections show that a business' choice of
unit cost to determine t he costs of the inventory sold and
inventory costing methods affects both its cost of sales
the inventory that remains. Having sold 65 units. Koala's
and its ending inventory. To summarise these effects,
cost of sales on 10 September is $819 (65 x $12.60). The
Exhi bit 7.5 puts Koala's inventory data in a form known as
cost of the 35 units on hand after the sale is therefore
the cost-of-goods-sold model and compares the resu lts of
$441 (35 X $12.60)
each of the three cost f low assumptions. The specific
For the 30 September sale, Koala must recalculate the
identification method is omitted from the comparison
average unit cost because it has purchased additional units
because of its infrequent use.
of inventory. This is why the term 'moving average' is used.
because the average cost per unit can dlange during the
Units FIFO Moving UFO
period as new purdlases are made. average
At 30 September. Koala has 110 units available for sale Beginning inventory 40 $480 $480 $480
at a total cost of $1536. Therefore. the new average unit Add: Net purchases 135 1875 1875 1875
cost. rounded to the nearest cent. is $13.96 ($1536/110). -··-··-··-···-···-···-···-···-···-···-···-···-····-···.:::::=··-···--··-=-··~-····---::::=::::::::···-·-··=····
Cost of goods 175 $2355 S2 355 S2 355
Having sold 50 units. Koala's cost of sales on 30 September available for sale
is $698 (50 x $13.96).
Less: Ending inventory 60 885 838 770
As a result of these two calculations, cost of sales for -··-··-··-···-···-···-···-···-···-···-···-···-···-···.:::::=··-····--···-=-··~-···-=-····-·-·=····
Cost of sales
September is $1517 ($819 + $698). Ending inventory, as
shown in the bottom right corner of Exh ib it 7.4, has an rn:J Compa roson of inventory costong methods

average unit cost of $13.96, for a total cost of $838 (60 x

$13.96).
The cost-of-goods-sold model summarises a business'
While moving average provides a comprom ise. giving
inventory activity during a period by adding purchases to
closing inventory and COS f igures between the extremes
beginning inventory to yield cost of goods available for
of FIFO and LIFO. in reality most products cannot be
sale. This represents the total cost of the inventory that
mixed, and the average products are sold or remain. Most
could have been sold during the period. That cost is then
products come in their own package, one exception is fruit
allocated to either what was sold (cost of sales) or what
and vegetables where the customer attempts to select
was not sold (ending inventory).
_ 1 18
_.;.;.;;.
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 In Koala's case, it began the month of September w ith FIFO Moving LIFO
40 units costing $480 and bought an additiona l 135 units average
costing $1875 during the month. So, it cou ld have sold up Sales $5240 $5240 S5 240
····-···-··- ··- ··-···-···-···-··- ··-···-···-···-···-··-··-···-···-··- ··-···-··- ··..·-··- ..-...-···-··- ··- ··-···-···-···-···-···-···-···
to 175 units w ith a tota l cost of $2355. Th is is the case Cost of sales (1470) (1517) (1 585)
regard less of the inventory costing system chosen . Gross $3770 $3723 $3655
However, the cost of the 115 units sold and the 60 units
Operating expenses (1850) (1850) (1 850)
unsold depends on the cost flow assumption.
The FIFO method assigns the costs of the first and,
in this case, less expensive units purchased to cost of
sales, thereby yie lding the lowest cost of sales. It also
mProfit before tax
Comparat1 ve statements of income
$1920 $1873 $1805

assigns the costs of the last and more expensive units

to ending inventory, thereby yielding the highest ending concern w ith usi ng L1 FO is not the lower profits
(accountants like prudent accounting methods); it is often
inventory.
the out-of-date va lue placed on closing inventory.
In contrast, the LIFO method assigns the costs of the
last and, in this case, more expensive units to cost of sales, Under a perpetual inventory system, the inventory
account is updated each time inventory is bought or sold.
resu lting in the highest cost of sa les. The costs of the first
However, many businesses take a physical count of
and less expensive units are assigned to ending inventory,
resulting in the lowest ending inventory. inventory at least once a year to confirm that the inventory
balance from the accounting system matches the actual
The moving average assigns the average costs of all
inventory on hand. Taking a physical inventory is an example
units purchased to cost of sales. Therefore, it yields cost of
sales and ending inventory that fall in between the FIFO of an internal control procedure discussed in Chapter 5. By
counting inventory, a business can determine if it has lost
and LIFO extremes.
inventory due to theft, damage or errors in accounting.
When a business experiences rising prices for its
inventory, these relative differences w ill continue. These
relationships are summarised as follows:

Ending inventory Cost of sales

FIFO yields: Highest Lowest
···-···- ··- ···-···-···- ··- ···-···-···-···- ··- ···-·-···-···-···-···-···-···-···-···-···-···-...-···-·-···-···-···-··- ··- ··- ··-···-
Moving average yields: Middle Middle
···-···- ··- ···-···-···- ··- ···-···-···-···- ···-···-·-···-···-···-···-···-···-···-···-...-···-·..-···-·-···-···-···-··- ··- ··- ··-···-
LIFO yields: Lowest Highest

Because of these differences in both the income

statement accounts and balance sheet accounts, a reporting
entity (a business required to lodge financial statements
with the Australian Securit ies and Investments Commission
[AS IC)) must disclose the inventory costing method that it
uses. 2 1t should use the same method consistently. These
requirements allow for meaningful comparisons of inventory
activity across different businesses and across different
periods within the same business.

~ ESTIMATING ENDING
In the US, companies can use any of the four costing
methods. Some choose the LIFO method because of the
resulting tax benefits. In Australia LIFO cannot be used for 'iii' INVENTORY
either financial reporting or tax.
To illustrate, suppose that Koala generated revenues of A business must sometimes estimate its inventory
$5240 from its sale of inventory during September. balance. One example is when inventory is destroyed by
Suppose further that it incurred $1850 in operating fire. Another example is when a business may not be able
expenses during the month. Ex hibit 7.6 conta ins to rely on its perpetual inventory records, for example if
comparative multi-step statements of income prepared there is high theft or wastage rates. In
under each inventory costing method. such cases, a business can estimate its retail method A
Comparing the profit before tax under the LIFO and ending inventory w ith the gross profit method of estimating the
cost of inventOf)l knowing
FIFO assumptions (which are the two extremes), you can (margin) method or reta il method. Both the selling price and
see that Koala could report $115 less profit if it uses the rely on gross profit margins (the 'mark- reducing it by the gross
profit percentage.
LIFO method rather than the FIFO method. Generally, the up') to determine closing inventory values.

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7
Inventory __
.;...;..;.
119
 AASB 102 paragraph 22 states: Beginning inventory (actual) S200
..-·..-.._,,_,_,_,..
.,_,_,_,_,,_,,_,,_,,_,,_,_,_,_,,_,,_,,_,,_,,_,_,_,_, ~

The retail method is often used in the retail industry 90

for measuring inventories of large numbers of rapidly ... Add: Net purchases (actual) ..-"_.._,,_,_,_,, .
,_,_,_,_,,_,,_,,_,,,_,,_,_,_,_,_,,_,,_,,_,,_,,_,_,_,, ~

changing items with similar margins for which it is Cost of goods available for sale (actual) S290
····-··-··-··-···-···-···-···-···-··-··-··-···-···-···-···-···-··-··-··-··~··-··-··-···-..- ··-··'"
impracticable to use other costing methods. The cost
of inventory is determined by reducing the sales value . . ~~.:. ~.~s.:.?!. :~Le.:.!::ti.r:n..~~-~-~L.. -··-· -·· ---~~2~)- ·
of the inventory by the appropriate percentage gross Ending inventory (estimated) $70
margin. The percentage used takes into consideration ~,\1 ,,/,
inventory that has been marked down to below its
Review this content with the e-leciUre •
original selling price. An average percentage for each
retail department is often used.3

With the retail method, once ending inventory is

counted (stocktake) and the selling price recorded (selling LOWER-OF-COST-AND-NET
price may be determined from the price docket on the item REALISABLE VALUE
or f rom the computer records that provide the cash register
w ith the price to charge the customer when the item is The cost principle requires that inventory be recorded at its
scanned), the total sales value of inventory is reduced by cost However, because of the principle of prudence, accounting
the profit margin. To illustrate, CSL has a gross profit margin rules require that inventory be reported on the balance sheet
of 51.9 pe r cent in 2017 (gross profit of $3596m/total at its net realisable value (NRV) if the market value is lower than
operating revenue of $6922.8m), and 50.1 per cent in 2016. the inventory's cost. This is sometimes referred to as the
The COGS is then 48.1 per cent (100% - 51.9% ). lower-of-cost -and -net-real isable-value
lowei'Of-cost-and-
To illustrate the gross profit method, assume that (LCNRV) rule. The LCNRV rule is applied at net -realisable-value
Howard Hardware is preparing financial statements and the end of each accounting period by (LCNRV) rule
Requires inventa<y to be
needs to estimate cost of sales and ending inventory. comparing inventory oosts to NR\1. According reported on the balance
Howard has generated sales of $400 m illion. In the past, to the accounting standard AASB 102, NRV sheet at its market value if
the market value is lower
Howard's gross profit percentage has ave raged 45 per 'refers to the net amount t hat an entity than the inventory's cost.
cent. Assum ing that this financial period is sim ilar to prior expects to realise from the sale of inventory
periods, Howard can estimate that gross profit on cu rrent in the ordinary course of business'• When the cost is lower
sa les is $180 million. All figures are in millions: than the NRV. we do not recognise the potential gain, nothing
further is done. However. when the NRV is lower than the cost,
Current quarter sales (actual) $400 the business must adjust its inventory down to the lower NR\1.
. _fl~s~or~C.~I_g~o:s.P.~O.~I.iJ~r:e~t~g!. _ _x_4~~ - To illustrate, suppose that Loyeung Company provides
Gross profit (estimated) $180 the 30 June inventory information shown in Exh ib it 7.7.
Although the gain in item A is greater than the loss in
Current quarter sales (actual) $400 item B, the standard does not allow losses in one inventory
···- ··-···-···-···-···-··- ··- ··- ··-···-···-···-···-··- ··- ··- ··-··-··-··- ··-···· item to be offset by gains in another. Only in lim ited
. ~~O.~S_P~O~tJe_s.~~a.~~~)- ---- ____!1~-~---
circumstances can sim ilar items of inventory be treated as
Cost of sales (estimated) ~
a group of the same type. For Loyeung the two items of
Howard can then estimate cost of sa les for the period inventory report a net gain of $30, but prudence requ ires
as $220. the recogn ition of the loss, although the item is yet to be
Now that Howard has estimated cost of sales, it can sold, but not the potential (unrealised) gain. Therefore, we
calculate its ending inventory by plugging the cost of sales record the above info rmation as follows:
estimate into the cost-of-goods-sold model. Based on past
30 June Loss on Inventory 120
f inancial reports and purchase records, Howard knows that
it starts this period with $200 in invento ry and bought $90
Inventory 120
of inventory. This means that Howard had $290 in inventory [To record loss on inventory item B)
available for sa le during the period. W ith $220 in estimated Assets Liabil ities + Equity
cost of sales. the cost-of-goods-sold model yields a $70 -120 -120
estimate for ending inventory.

Item Units Unit cost Unit NRV Total cost Total NRV LCNRV Gain or (Loss)
A 5 $40 S 70 S 200 $ 350 S 200 S 150
_,,_,_,,_,_,_,_,...,.,,_,,_,_,_,,_,,_,,_, . ,_,,_,,_,,_,,_,,_,,_,_,_,..,,_,,_,,_,_,_,_,_,,_,,_,,_,_,_,_,_,,_,,_,,_,,_,,_,,_,. ,_,,_,,_,,_,,_,_,_,,_,_,,_. ._,,_,_,,_,,_,,_,_,_,,_ ,.._,,_,,_,_,_,_,,_,_,_,

B 8 $ 65 S 50 S 520 $ 400 S 400 (S 120)

EEl LCNRV calculation for Loyeung Company as of 30 June

_ 1 20
__,.;;;;.;;
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 The journal entry increases Loss on Inventory to reflect account. yielding a percentage. The base account is total
the loss in value of the inventory and decreases Inventory assets for balance sheet accounts and net sales or total
to adjust the account down to the $600 lower of cost and revenues f or i ncome statement accounts. These
net realisable value. As a result, both assets and equity calculations are summarised as follows:
decrease. Loyeung's inventory is now ready to be reported
on the balance sheet at its more prudent LCNR\1. HORIZONTAL ANALYSIS

Do llar Change in Account Balance = Cu rrent-year Balance

CS[ ANALYSIS Percentage Change in Accou nt _

- Prior-year Ba lance
Dollar change
Balance - Prior - year balance

.. VERTICAL ANALYSIS

For the For the income

balance sheet statement
P Accou nt Ba lance Accou nt Ba lance
ercentage = Total Assets or Net Sales o r Revenue

EVALUATING A BUSINESS'
MANAGEMENT OF
INVENTORY
Any investor, creditor or manager of a business should be
interested in how well the business manages its inventory.
A business manages its inventory by buying and selling
efficiently and effectively.
The following sections examine the effectiveness of a Given A raya Accessories' f inancial information in
retailer - let's call it Araya Accessories Limited- in managing Exhibit 7.8. horizontal and vertical analyses of inventory and
its inventory. The examination w ill require information from cost of sales result in the following:
the company's balance sheet and income statement. The
..
required information is found in Exh ib it 7.8. excerpted from
the Araya Accessories Annual Report 2019.

Source Accounts 2019 2018

l Change
6705
Percentage change I
Inventory -£780 ..!lli=u%
Income Net Sales $62884 $61471 6780
_,,_.,_,,_,,_,,_,,,_,,_,,,_,,_, (75)
,_,._,,_,,_,,_,,_,,_,,_,,_,,,_,,_,, , ._,,_,,_,,_,_,,_,,_,,_,,_,_,,_,, __
statement Cost of Sales 44 157 42 929 44157
··- ··-···-···-··- ··-···-··- ··-···-···--···-···-···-···-···-···-···-··- ··- ··- ..--···-····-·...-···- ···---···-···- ··- ···-···-···-·
Balance Inventory 6705 6780 Cost of Sales -42929 1228 = 2.9%
42929
sheet Total Assets 44106 44560 1228

~ I
[ialij] Account balances from Araya Accesso ries' annual
L!:!.J report (all figures m thousands) 2019 2018

Inventory 6 705 = 15.2% 6780 = 15 2%

HORIZONTAL AND VERTICAL ANALYSES 44106 44560 .
-···- ···-···- ···-···- ···-···-···- ···-· ·- ···-···-···- ···-···-···- ···-···- ···-···-··· ..- ···-···-···-···- ···-···-···-···- ··- ···-···--
A n easy and useful p lace to start an examination of Cost of Sales 44157 = 702% 42 929 = 69.8%
62884 . 61471
inventory is with horizontal and vertical analyses. Recall
from Chapter 2 t hat horizontal analysis calcu lates t he dollar The calcu lations show a fairly stable inventory position.
change in an account balance. defined as the current-year Horizontal analysis o f inventory shows a $75 m illion
balance less the prior-year balance. and divides that change decrease, wh ich equals a 1.1 per cent reduction. Vertical
by the prior-year balance to yield the percentage change. analysis indicates that inventories made up 15.2 per cent
Vertical analysis divides each account balance by a base

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7
Inventory __
..;.;;..;.
121
 of total assets in both 2018 and 2019. So. although
inventory stocks were down slightly, the decrease mirrored
an overall decrease in Araya Accessories' total assets.
The analysis of cost of sales shows an mcrease of
$1228 million, which equa ls a 2 .9 per cent increase.
Furthermore, vertical analysis indicates that cost of sales
$43052.8) I $3052.8 = 9.0%
was 69.8 per oent of sales in 2018 and 70.2 per oent of
sales in 2019. The reason for this increase is that cost of
sales increased faster than sales. This is a trend that should
warrant observation in the future.
$2575.8 I $9122.7 = 28.2%

INVENTORY TURNOVER RATIO

While horizontal and vertical analyses are useful for generating
information about inventory, a more direct way to assess a
business' ability to sell 1ts 1nventory is to
inventory tumover
ratio Cclrr!lares cost of calculate the inventory turnover ratiO. The
sales dunng a penod to inventory turnover ratio compares the
the average 1nventooy
balance dunng that period cost of sales during a period to the average
and measures the ability inventory balance during that period. It is
to sell inventory
calculated as follows:

· INVIN10RYTURNOVIR RAno

Inventory Turnover Ratio= ~st of G~ods Sold

verage nventory

Where average inventory is:

Beginning Inventory+ Ending Inventory
2

Because this ratio compares the cost of all inventory

sold to the average cost of inventory on hand. it indicates
how many times a business can sell its inventory balance
in a period. All other t hings being equal, a higher rat io
indicates that the business sold more inventory while
maintaining less inventory on hand. This means that the
business generated more sales revenue while reducing the
costs of stocking inventory on the shelves.

Araya Accessories' 2019 inventory turnover ratio IS

calculated as follows:
44157
((6705 + 6780)/2) - 6·5
The 6.5 ratio indicates that Araya Accessories' cost of
sales for 2019 was 6.5 times its average inventory balance.
For every dollar of inventory on its shelves. on average, it
was able to sell over $6 of inventory during the period.
Because the turnover ratio i s days-in-inventory
sometimes d1ff1cult to interpret, it is ratio Converts the
onventoly turnover oatoo
ohen converted into the days-in·
onto a meaSU"e of days l1f
inventory rat1o. The days-in-inventory dovdong the turnover oatio
ratio converts t he inventory turnover into 365 days

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122
-~;;;
 ratio into a measure of days by dividing the turnover ratio purchases $20000 of inventory on account on 10 October.
into 365 days. Thus. the days-in-inventory ratio is The purchase would be recorded as follows:
calculated as follows:
10 Oct. Purchases 20000
~=562 Accounts Payable 20000
(To record purchase of Inventory)
A ratio of 56.2 ind1cates that it takes Araya Accessories
about 56 days to sell as much inventory as it keeps on hand. + Equity
Naturally, 1t would want this rat10 to be as low as possible. +20000 +20000

Suppose further that Th1rroul pays a th1rd-party carrier

$300 cash to transport the tnventory to 1ts warehouse
(debit Purchases orTransportat1on-1n and cred1t Cash). On
12 OctoberThirroul is granted a $1000 reduction 1n the cost
of the merchandise due to blemishes on the inventory
(debit Accounts Payable and credit Purchases or Purchases
Returns and Allowances).
Finally, suppose thatThirroul pays its remaining $19000
A periodic inventory system does not update the inventory bill to the vendor on 15 October, which qualifies Thirroul for
and cost of sales accounts during the period. When a 1 per cent discount. As a result, Thirroul would save $190
purchases are made. they are recorded in a temporary ($19000 x 1 o/o) and pay only $18810. The entry to record
account called Purchases . When sales are made, the payment would be as follows:
resulting revenue (and increase in assets, cash or accounts
receivable) is recorded, but not the cost of sales (and t he 15 Oct. Accounts Payable 19000
decrease in inventory). As a result, businesses that use a Purchases {or Purchase Discounts} 190
periodic system must calculate and update the Inventory Cash 18810
and the Cost of Sales accounts at the end of the period.
(To record payment)
The following sections demonstrate the recording of
Assets Liab1l111es + Equity
purchases and the determination of ending inventory and
cost of sales under a periodic system. -190 - 19000 - 18810

The entry decreases Accounts Payable for the full $19000

RECORDING INVENTORY
and decreases Cash for the $18 810 net purchases The
In a periodic system the following four temporary accounts may payment. The difference (the purchase v.We of 111ventory
be used to capture the cost of 1nventory purchases during a discount) is a reduction 1n P\Jrchases. JUthased am
transporta!Jon.1n less
period. The P\Jrchases account accumulates the cost of all Given the preceding actrvrty, Thirroul's poo:11ase retuns am
purchases. The Transportation-In account aocumulates the net purchases of inventory can be allowances am purchase
diSCOIIlts.
transportation costs of obtaining the 111ve11tory. Both increase calculated as follows:
the cost of inventory. The Purchase
Purchase Retums Returns and Allowances account Purchases $20000
and Allowances Add: Transportation-In 300
accumulates the cost of all inventory
account Anaccount -·- ··- ·-·-·-·-·-·-·-··-··-·-·-·-·-·-·-----·-·-·-·-·-·-..- ..-·--·- ·- ·-·-···
that acrumulates the cost returned to vendors as well as the cost Less: Purchase returns and allowances (1 000}
of all inventory returned to reductions from vendor allowances. The
vendors as well as the cost
reductions from vendO< Purchase Discounts account accumulates Net purchases
allowances. the cost reductions generated from
Purchase Discounts suppliers (vendor) discounts granted for This is the same cost of net purchases as calculated
account An account
that acwmulates d1e cost prompt payment; both reduce the cost of under the perpetual system discussed earlier in the chapter.
reductions generated from inventory. Each of the four accounts would Whether using a periodic or perpetual system, the cost of
vendor discounts granted
for prompt payments. then be closed at the end of the period net purchases is the same, just captured in different
when the Inventory and the Cost of Sales accounts.
aocounts are updated.
To illustrate the recording of inventory, the example INVENTORY COSTING METHODS
used earlier in the chapter is repeated. Whi le the four
A periodic system does not update the Inventory and the
accounts could be used, a simpler approach would be to
Cost of Sales accounts dunng the period. Thus, the
record all costs associated with purchasing inventory to the
balances in these accounts must be calculated at the end
Purchase account. Suppose that Thirroul Takeaway

R R_..... May no< be copMd scanned. or dUI'lieaod, In wholo or 1" pan. ~ cJA'I>fER 7 Inventory __
.;.;;.;;
123
 of the period. This is accomplished in the following three First-in, first· ou (FIFO)
steps:
Under the FIFO method. Koala assumes that the first umts
1 Count the inventory on hand at the end of the period.
of inventory purchased are the first units sold. As a result.
2 Use an inventory costing method to assign a cost to
the costs of the last (most recent) purchases are ass1gned
the end1ng inventory.
to ending inventory. It can therefore calculate the cost of
3 Calculate cost of sales using the cost-of-goods-5ald model.
ending inventory as follows:
To illustrate this process. the example used earlier in
the chapter is repeated. Suppose that during the month of Units Unit cost Total cost 1
September, Koala General Store experiences the following 23 Sep. purchase 45 $15 $675
inventory purchases: 15 Sep. purchase
Units Unit cost Total Ending inventory
1 Sep Beg1ming inventory 40 $12 $480
The cost of all45 units purchased on 23 September and
4 Sep Purchase 60 $13 $780
15Sep Purchase
- -- ---·
30 $14
·- -·
$420
15 of the units purchased on 15 September are ass1gned
to ending inventory, y1ekhng a cost of $885. Plugg1ng thiS
23Sep Purchase 45 $15 $675 into the cost-of-goods-sold model yields Koala's cost of
sales of $1470.
At the end of the month, Koala counts 60 un1ts on hand.
Koala's cost-of-goods-sold model for September is Units Cost
therefore as follows: Cost of goods available 175 $2 355
for sale
Units Cost
Beginning inventory ··-··-··-··-··-··-··-···-··- ..· .... 40 $480 =Cost of sales
Add. Net purchases 135 1875
- ·- - -·-·-·- ·--·-··-- -
Cost of goods available for sale
---- 175 $2355 Last-in, first· out (~FO)
less EndlllQ 1nventory 60 m Again, LIFO is not used in Austral ia. but accounting
Cost of sales 115 standards may change. Furthermore. management may
want COGS calculated us.ng LIFO because LIFO prOVIdes
To calculate the cost of the 60 units 1n end1ng Inventory
the most up-to-date COS values.
and therefore the cost of the 115 units sold, Koala must Under the LIFO method, Koala assumes that the last
use one of the four inventory costing methods. units of inventory purchased are t he f irst units sold. As a
Specific identification result. the costs of the oldest inventory are assigned to
ending inventory. Koala can therefore calculate the cost of
Under the specific identification method, Koala determines
ending inventory as follows:
the cost of ending inventory based on the actual cost of
the units on hand. Suppose that Koala knows the ending Units Unit cost Total cost
60 units of inventory are five $13 units, 20 $14 units and Beginning inventory 40 S12 $480
35 $15 un1ts. It can therefore calculate the cost of ending 4 Sep. purchase 20 S13 S260
.nventory as follows: Ending inventory §!! ~
Units Unit cost Total cost
The cost of all 40 un1ts of beginning inventory and 20
4 Sep. purchase 5 $13 $ 65
of the units purchased f1rst in September are assigned to
15 Sep. purchase 20 $14 $280
23 Sep. purchase
- ·-··-·-·- ·-·-·-·-··-·--··
35 $1 5 $525_
ending inventory, yielding a cost of $740. Plugging this into
..
. -··-··- ··-··- ··-··-.._,.,_,_ , _ ,_ , ,_ the cost-of-goods-sold model yields Koala's cost of sales
Ending inventory 60 WQ of $1 615.

Plugging this cost of ending inventory into the cost-of- Units Cost
goods-sold model yields Koala's cost of sales of $1485: Cost of goods available 175 S2355
for sale
Units Cost - Endmg inventory 60
- - -740
- -·
Cost of goods available for sale 175 $2355
=Cost of sales ~ $1615
- End1ng inventory 60 870
=Cost of sales m ~

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1 24
-~;.;.
Wei hted average Koala can therefore calculate the cost of ending
inventory as follows. rounded to the nearest dollar:
Under the weighted average method. Koala assumes that
the cost of each unit in ending inventory and each unit sold Units Unit cost Total cost
is the average cost of all units available for sale during the Ending 1nventory 60 S13.46 $808
period. The weighted average cost per unit IS calculated as
follows: Plugging th1s into the cost-of-goods-sold model yields
Koala's cost of sales of $154 Z

Units Cost
Cost of goods available for sale 175 $2 355
Weighted Average _ Cost o f Goods Avail able for Sale ......_
.._,_,,_,,,_,,,_,,,,...._ ,,_ ,,_ ,,,_ ,,,_ ,,_ ,,, ···-· ...
U nits Avai lable for Sa le
- Ending in~ntory_ --·-·-·-·-·-·-·----~0-
Unit Cost -
. 808
= Cost of sales ill ~

Note here that under a periodic system, the average

unit cost is based on the entire inventory available to be
sold dunng the period. As a result, the average unit cost
does not change during the period. Therefore, It 1s called a
weighted average instead of a moving average (as under
the perpetual system).
Koala's weighted average cost per unit, rounded to the
nearest cent, is ca lculated as follows:
~~g5 = $13.46
Determinmg ending inventory quantities requires a
physical count (stocktake) at the end of the penod. Errors
in the counting of mventory affect both the balance sheet
(through inventory) and the income statement (through
cost of sales). Moreover, because ending inventory in one
period becomes beginning inventory in the next period, an
error can affect not only the current period, but also the
next period. If only one error is made, t hen the over (under)
statement of COGS w ill be counterbalance in the next
period.
~·\1 ,,~

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7
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125
 6 Record ing purchases and sales
of inventory
Lowder Company purchased 275 u011s of 1nventory on
account for $5775. Due to early payment, Lowder reoe1ved a
discount and paid only $5225. Lowder then sold 150 unlls
for cash at $55 each, purchased an add1t1onal 65 unlls for
cash at a cost of $1430, and then sold 100 more unlls on
1 Describe inventory credit for $58 each. Lowder uses a perpetual 1nventory
system.
How would you describe the phys1cal nature of CSt:s
mventory? (Th1s may reqwe some research beyond REQUIRED
Append1x B m th1s book.t a Prepare all JOurnal entnes to record lowder's purchases
and sales assum1ng the FIFO Inventory costing method.
2 Classifying inventory costs b Wh1ch JOurnal entnes would be different 1f lowder used
If transponauon-1n IS mcluded 1n the cost of Inventory, how the LIFO 1nventory cost1ng method? How would they be
should the cost of freight-out (the cost of delivering the different?
goods to the customert be classif1ed? Why?
7 Inventory costing methods
3 Determining inventory costs Bond's November inventory activity IS as follows. Bond uses
Matthews Electronics purchased 1000 tablet computers a perpetual inventory system:
from a vendor for $75000. The vendor gave Matthews a Date Transaction Units Unit cost Total cost
$1500 discount because of scratches on the cases of some
1st Beginning inventory 32 $55 $1760
of the laptops. The cost to ship the tablets was $500.
7th Purchase 45 60 2700
REQUIRED
9th Sale 50
Determme Matthews' cost of inventory.
14th Purchase 52 65 3380
4 Recording inventory purchases 30th Sale 61
On 20 March, Hazelwood Humatics purchased on account
REQUIRED
$112000 wonh of sensors with a list pnce of $123000.
Hazelwood pays the vendor on 30 March, wh1ch qualifies Calculate the end1ng Inventory and cost of sales under the
them for a 2 per cent d1scount. Hazelwood uses a perpetual FIFO. LIFO and movmg average costing methods.
inventory system.
8 Effects of inventory method s
REQU IRED
Record Hazelwood's purchase of the Inventory and payment Assume that you are an accountant at a local computer
for the mventory. retailer and your boss asks you to expla1n the f1nanc1al
statement 1mpact of mventory costing methods. In
panicular, she 1S mterested 1n whether the busmess should
5 Inventory purchases use the FIFO or LIFO method. She would hke to use the
Consider the followmg separate SitUations. method that results 1n the highest net income, the h1ghest
inventory balance and the lowest taxes. Note the purchase
Lucy's Sarah's Chan's price of computers has been fallmg over the last decade and
Lounll!s Sofas Chairs
that trend is expected to continue.
Beginning inventory $4000 $2 350 S(et
REQUIRED
Purchases (grosst 4230 (ct 7340
Explain the effects of using the LIFO and FIFO methods on
Purchase returns 470 800 550 income, inventory and taxes. Can your boss get all that she
Purchase discounts (at 458 310 wants?
Transportation·in 150 500 420
9 Invento ry costing methods
Cost of goods available {bt 7320 8790
for sale Huang Hardware provides the following information relating
to its July inventory activity. Huang uses a perpetual
Ending inventory 1890 1750 {fl
inventory system.
Cost of sales 5220 (d) 7590

REQUIRED
Calculate the missmg amounts.

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126
_.....;.;;.;;.
 Date Transaction Units Unit cost Total cost inventory and purchased $150000 dunng the year. It also
13 $8.00 $104.00 shows sales of $310000 for the year. Normally, Marshall
1st Inventory
experiences a 55 per cent gross profit percentage on
7th Purchase 22 9.50 209.00 sa les.
12th Sale 20 REQUIRED
18th Purchase 10 1015 102.50 Use the gross prof1t method to estimate Marshall's cost of
20th Sale 14 sales and end1ng Inventory.
26th Purchase 16 11.00 176.00
13 Applying lower-of-cost-and-net-
30th Sale 15 realisable-value
REQUIRED Kay Man Company IS prepanng f1nanc1al statements and
a Enter Huang's 1nformat1on mto a cost-of-goods-sold prov1des the follovv1ng mformat1on about several of 1ts maJor
model. What is unknown? inventory 1tems.
b Calculate the end1ng Inventory and cost of sales us1ng
the FIFO. LIFO and mov1ng average costing methods.
Round dollar amounts to the nearest cent. Unltoo.t
c Calculate the sum of the end1ng inventory and cost of When
sales for each method. What do you notice about the
differences in COS. end1ng inventory and the sum of $15
COS and endmg inventory for each method? s 60 22 20
T 34 30 33
10 Invent ory costing met hods
u 50 10 11
Harrison. Charles and Company sells flower planters for $7
each. On its first day of business in July, the company
v 13 50 55
purchased 2000 planters for $3 each. The company sold 300 REQUIRED
units during the first month of operations and sold an additional
If Kay Man uses the LCNRV rule, what should it report as
1300 umts the next month. To prevent inventory stod<outs
the balance of inventory?
during summer, the company bought an additional 700 units
for $4.50 each 1n October. The company sold 850 un1ts from
November through June. The company uses a perpetual 14 Analysing inventory
1nventory system and the FIFO Inventory costing method. The follow1ng informatiOn is provided for three d1fferent
REQUIRED companies: A. B and C.
a Calculate Hamson. Charles and Company's 1nventory in millions A B c
balance at the end of the f1nanoal year and 1ts cost of Beginning inventory $569 $774 $989
sales for the f1nanc~ai year.
Ending inventory 423 214 356
b Would those balances be d1fferent 1f the company had
used the FIFO cosung method under a penod1c Cost of sales 1376 1232 1771
mventory system? Sales 2232 1836 3025

11 Estimating inventory REQUIRED

Susan's Shop reported the following Information for the Calculate the mventory turnover ratiO and days 1n inventory
current year: ratio for each company. How do the companies compare?

Sales $1800000 15 Analysi ng inventory

Beginning inventory 50000 Comparative statements of income for Wells Company are
Purchases 1004000 given as follows:

Gross profit percentage 40%

REQUIRED
Using the gross profit method. estimate Susan's cost of sales
for the year and the end1ng inventory at year-end. Explain why Net sales $812 000 $812 000
a business might need to est1mate 1ts ending inventory. Cost of sales 649 600 664 364
Gross profit
----- $162400 $147636
12 Estimating inventory and cost of sales
Operating expenses 84 448 79 724
Marshall experiences a f1re 1n 1ts warehouse at the end of ~~~-----~~~---~
the year, which destroys its entire inventory. Marshall's _N _ro_fi_t _ _ _ _ _ _ $77952 _ _ _ _ $67912
_e_t P
records show that it started the year With $35000 of

Copyrlgh12019 Cengajle L.umlng. AU Rlghta R--...ci.!Uy not be copied. scanned, 0< ~lealed, ln wholo Ot ln part.
 REQUIRED b Calculate the ending inventory and cost of sales
Prepare horizontal and vertical analyses of Wells' statement using the FIFO, UFO and weighted average costing
of income data and comment on the current status of the methods.
company. c Calculate the sum of the ending inventory and cost of
sales for each method. What do you notice about the
16 Analysing inventory answer for each method?
During the current year, Norlander implemented an inventory
management system that it believes will result in greater 19 Appendix: Inventory costing methods
efficiencies and profits. Norlander's CEO was therefore Bond's November inventory activity follows. Bond uses a
disappointed when she saw the following condensed income periodic inventory system.
statement showing no increase in net income:
Date Transaction Units Unit cost Total cost
2019 2018 1 Nov Beginning inventoJY 32 $55 $1760
Sales $650000 $775000 Purchase 2700
7 45 60
Cost of sales 372500 451800 14 Purchase 52 65 3380
Operating expenses 232500 278200 30 Ending inventOJY 18
Net income 45000 45000
REQUIRED
REQUIRED a Calculate the ending inventory and cost of sales under
Using horizontal and vertical analyses, provide reasoning to the the FIFO, UFO and weighted average costing
CEO that the inventory management system was effective. assumptions.
Round percentages to one decimal point (e.g. 4.8%). b Which costi ng assumption gives the highest ending
inventory? Highest cost of sales? Why?
17 Appendix: Recording and reporting c Explain why the average item cost is not $60 under the
inventory weighted average costing assumption.
Lowder Company purchased 275 units of inventory on
account for $5775. Due to some defects in the merchandise,
Lowder received a $2 per unit allowance and paid only
$5225. Lowder then sold 150 units for cash at $55 each,
purchased an additional 65 units for cash at a cost of $1430,
and then sold 100 more units for cash at $55 each. Lowder
uses a periodic inventory system.
REQUIRED
a Prepare all journal entries to record Lowder's purchases
of inventory.
b Calculate Lowder's cost of sales and ending inventory 20 Effects of inventory costing methods
under the FIFO, UFO and weighted average inventory on profits after tax
costing methods. For the weighted average method,
round all values to the nearest cent. Martin Merchandising Company has hired you to examine
whether the company should use the UFO or FIFO inventory
costing assumption. The company uses a perpetual inventory
18 Appendix: Inventory costing methods system and has supplied the following information for the
(periodic system) month:
Huang Hardware provides the following information relating
to its June inventory. Huang uses a periodic inventory Beginning inventOJY 2000 units at $40 $ 80000
system and sold 49 units during the month. Purchases on 4 June 12 000 units at $45 540000
Date Transaction Units Unit cost Tot al cost Sales on 18 June 10500 units at S77 808500
1st lnventOJY 13 8.00 $10400 Operating expenses 148000
7th Purchase 22 9.50 209.00 Small company tax rate 27.5%
18th Purchase 10 10.25 102.50
REQUIRED
26th Purchase 16 11.00 176.00 Martin requires you to prepare income statements under
Totals 61 $591.50 the UFO and FIFO costing assumptions to show what
profits he might report and taxes he may pay. Explain to
REQUIRED Martin the reasons why such an analysis is irrelevant in
a Put Huang's given information into a cost-of-goods-sold Austral ia.
model. What is unknown?

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1 28
_....;.;;.;;.
 2nd Purchased 15 addttional boxes for $22 each. Patd
21 Recording inventory activity wnh cash
Campbell Company starts the month of January wtth 40 4th Patd fretght costs of $30 on 2 January purchase
boxes of Bear Bars costing $20 each. The followtng 10th Sold 45 boxes for $40 each
transactiOnS occurred during the month.
27th Purchased 10 addtttonal boxes on account for
2nd Purchased 15 addittonal boxes for $22 each; patd $23 each
wtth cash
REQUIRED
4th Patd fretght costs of $30 on 2 January purchase
10th Sold 45 boxes for $40 each Assuming that Campbell uses a periodic inventory system.
prepare all necessary journal entries related to Campbell's
27th Purchased 10 additional boxes on account for inventory activity. Calculate the cost of sales and the ending
$23 each inventory under the FIFO, LIFO and weighted average
REQUIRED costtng methods.
Assume Campbell uses a perpetua/tnventory system and
the FIFO costtng method. Prepare all necessary JOurnal 24 Appendix: Inventory errors
entnes related to Campbell's tnventory actiVIty. Suppose that an organtsatton's preliminary finane1al
Suppose that the tnventory has a replacement value of statements show profrt of $230000 and endmg tnventory of
$375 at the end of the month. What entry. tf any, ts $39500. Several years later tt was discovered that endtng
reqwed? inventory should be $42 500.
REQUIRED
22 Analysing inventory
a Descnbe the error tn the inventory account (for example,
The following is comparative financial data for JK Martin
inventory was over/under stated by $XYZ) and calculate
Company and Stranon Company. All balance sheet data are
the organisation's correct net income for the year.
as of 30 June 2017 and 30 June 2018.
b What impact would the error have on the next year's
profrt?
c Gtven the tmpact on the two years of proftts. ts the error
2018 2017 2018 2017 matenal?
Net sales $2000000 $550000
Cost of sales 1100000 240000
Opera~ng expenses 305000 75000
Income tax expense 52000 6500
Cash 85070 $82508 16100 $15777
Inventory 250000 225000 70000 65600
Property & equipment 525000 500000 140000 125000
Current liabilities 65000 75000 35000 30000
Long term liabilities 109000 88000 29000 24800 25 Research and analysis
Ordinary shares. $10 par 490000 490000 115000 115000 Access the latest annual report for Cochlear Ltmited (ASX
Retatned earnings 173000 147520 40756 30289 Code: COH).
REQU IRED
REQU RED
a Examme the company's tncome statement and balance
a Prepare a verttcal analysts of the 2018 tncome data for JK
sheet and conduct horizontal and verttcal analyses of the
Marttn Company and Stratton Company. Is one company
company's cost of sales and inventory balances.
more profttable than the other? Compare to CSL.
b Prepare a horizontal analysis of the 2018 financtal data
b Examine the company's inventories note to its ftnancial
for JK Martin Company and Stratton Company using
statements. Do they reveal the inventory costing
2017 as the base year. What does this analysis show?
method(s) used to account for its inventory? Does the
c Calculate the inventory turnover and days in inventory company follow the lower-of-cost-and-net-realisable-
ratios for 2018 for JK Martin Company and Stratton value rule? Is there any other information given about
Company. Do these ratios change your conclusions inventory?
about these companies? c Calculate the tnventory turnover and days-tn-inventory
rattos for the latest year.
23 Appendix: recording inventory activity d Based on your answers above, write a paragraph
Campbell Company starts the month of January wtth 40 explamtng your optnton of Cochlear's inventory postttOn.
boxes of Bear Bars costing $20 each. The followtng Use facts to support your answer.
transacttons occurred during the month:

Copyright 2019 Cengage Learning. All Right& R...rved. May not be copied, scanned, or duplicated, in whole or In part. WCN Ot~~ Inventory _ __
7 129

After studying the material in this chapter, you
should be able to:
Describe non-current assets and how they
are recorded, expensed and reported.
Calculate and compare depreciation
expense using straight-line, reducing-
balance (diminishing value) and units-of-
activity methods.
Understand the effects of adjustments that
may be made during a non-current asset's
useful life.
Record the disposal of non-current assets.
Evaluate non-current assets through the
calculation and interpretation of horizontal,
vertical and ratio analyses.
Depict the cash flow effect of acquiring and
disposing of non-current assets.
Describe intangible assets and how they are
recorded, expensed and reported.
apply this -·······-·
Copyrlght2019 Cengage Loa nlng A R ght Rnervecl May not
130
This chapter examines the accounting for non-current
assets- primarily property, plant and equipment (PPE)-
or as it is sometimes called, 'fixed assets'. For most
companies, t he objectives associated with non-current
assets are fairly simple. They want to acquire non-current
assets, use them productively for some period of time
and t hen dispose of them. Thus, the chapter examines
t hese th ree activit ies: the acquisit ion of non current
assets, the depreciation (or amortisat ion for intangible
assets) of non current assets over their useful lives and
t heir disposal. It also examines a few issues that arise
during the life of a non-current asset, such as additional
expenditures and revisions of origina l estimates. The
chapter then focuses on how to analyse a company's
non-current asset position. It concludes with the
accounting for intangible assets and emphasising the
concept of 'impairment'.
LO RECORDING , EXPENSING
AND REPORTING NON-
CURRENT ASSETS
A norH:urrent asset is any tangible resource that is expected
to be used in the normal course of operations for more than
one year and is not Intended for resale. Examples include land.
buildings. eqUipment. furmture and fixtures. Non-current
assets are reported on the balance sheet (statement of
financial position) and are classified as norH:urrent assets
because they are used for more than one year.
As you consider the definition of a non-current asset.
note that the phrase 'not intended for resale' differentiates
a non-current asset from inventory. A computer that Dell
Corporation makes for sale is inventory, while that same
computer used by a lecturer at university is a non-current
asset Also. note that the phrase 'used in the normal course
of operations' differentiates a norH:urrent asset from an
investment. Land on wh1ch a oompany builds its office IS a
non-current asset, while land bought to be sold to a developer
is an investment. The
company's intended use ~·\'f ''•
Check out the video summaoy ~
of the asset dictates how
for Chapter 8 VlffiJI
the asset is classified.
RECORDING NON-CURRENT ASSETS
Following the cost principle, non-current assets should be
recorded at the cost of acquiring them. This includes all
costs incurred to get the asset delivered. installed and
ready to use. Examples of expenditures to include in the
cost of a non-<:urrent asset would therefore include, but
not be limited to, the following:
e purchase pnce
e taxes paid on the purchase
e fees such as legal (conveyancing) costs paid to a solicitor
C"Ci"''cfe'lii)~~ \':d!ffillcotod, In whole or In part. WCN 02·20().202
• insurance costs during transit
• installation costs.
To illustrate. suppose that Gavaskar Building Supply
buys a delivery van w ith a purchase price of $63 000 and
addit ional state stamp duty of $3600. Prior to receiving the
van, Gavaskar has a revers1ng camera and GPS w ith vehicle
tracking installed for $2400. Finally. Gavaskar pays $1400
for one year's msurance. Given the preceding items. the
cost of Gavaskar's van IS determmed as follows:
f'lxchase pC'ICe $63 !XX)
Stampduty
-------3600
2 400
Camera and GPS Tracker
- - --==-
Totalcost ~
All of the costs except for the insurance are necessary
to get the asset 1nto ns cond111on and location for intended
use and are therefore 1ncluded 1n the cost of the van. The
insurance covers the van dunng 1ts operations and is
therefore an operating expense during the year (debit
Insurance Expense $1400, cred1t Cash $1400). Assuming
that Gavaskar paid cash. the entry to record the purchase
of the van would be as follows:
Delivery Van (or Equ1pment) 69000
Cash
(To record the purchase of van)
Assets Liabilities + Equity
+69000
-69000
Consider another example. Suppose a company
purchases a block of land for a new building site. The
purchase price is $525400 including stamp duty (taxes).
The land requires $112000 in clearing and removing waste
before it can be used. The timber harvested from the
clearing is sold for $20 000. The total cost of the land is as
follows:
Purchase pnce $525400
Clearing and removal 112!XXl
Less. Sales of t1mber
Total cost
In this case, each cost 1s 1ncluded 1n the asset because
the land is not in the cond1t1on for use until each of the
activities is completed. Notice also that the proceeds from
the sale of the timber reduce the cost of the land.
EXPENSING NON-CURRENT ASSETS
A non-current asset converts to an expense as it is used or
consumed. The expensing of non-current assets is
accomplished through depreciation.
Depreciation is the process of allocating depreciation The
t he cost of a non-current asset over its process of systematically
useful life. Depreciation is an application and rationally allocating
the cost of a non-current
of the matching principle- because a non- asset Oll!!f •ts useful life.
current asset is used to generate revenues depreciation
expense The portion of
period after period, some of its cost a non-current asset·s cost
should be expensed in, or matched to, that IS recognised as an
those same periods. The amount of expense m the current
periOd.
expense recogn ised 1n each period is accumulated
known as depreciati on expense. The depreciation The
cumu lative amount of depreciation cumulaiM! onooot of
depeciation e.pense
expense recognised to date IS known as recogn<sed to date on a
accumulated depreciation. llOIH:Went asset
Some students experience some
confusion with depreciation because of 1ts everyday use in
our language. For example, 1t is often sa1d that a new car
'depreciates' substantially 1n value once it is driven out of
the dealer's showroom. When used in th1s way, the term
'depreciation' implies the price it could now be sold for is
much less than was paid. For our purposes. depreciation
is a process of allocating an asset's cost, not a method of
69000 determining an asset's market value.
While depreciation applies to non-current assets, not
all non-current assets are depreciated. Depreciation applies
only to those assets with limited useful lives. An asset has
a limited useful life when its revenue-generating potential
is limited by wear and tear and/or obsolescence. Most non-
current assets such as equipment and buildings have
limited useful lives and are therefore subject to depreciation.
The major exception to this is land, which has an unlimited
useful life. As a result, land is not subJeCt to depreciation.
 Depreciation expense is normally calculated at the end
of an accounting period and is recorded w ith an adJUSting
journal entry. Regardless of the non-<:urrent asset being
deprec1ated or the facts of the calculation, the general form
of the entry is the same: depreciation expense and
accumulated depreciation are increased.
To illustrate. suppose that Gavaskar calculates its van's
depreciation as $10 000 for the f irst year. At year-end,
Gavaskar would make the following entry:

Year-end Depreciation Expense 10000

Accumulated Depreciation 10000
(To record the depreciation expense)
Assets Liabilities + Eq01ty
-lO!XXI -IO!XXI

Th1s entry increases Depreciation Expense for the

$10000 of cost allocated to the current period. However,
instead of decreasing Delivery Van, the entry increases
Accumulated Depreciation. which is a contra-asset account
that accumu lates all depreciation recorded to date. Its
balance is subtracted from the non-<:urrent asset account
to yield the carrying amount or net book value of the non·
current asset. We will see an example of thiS later in the
chapter. The result of this entry is a decrease to both equity
and assets.
Like other expenses, depreciation expense IS reported
on the 1ncome statement. Most companies report 1t as a
separate line item in the notes to the accounts.
REPORTING NON-CURRENT ASSETS
Non-<:urrent assets are reported on the balance sheet. as we
have seen with CSL. just below current assets. Notice CSL
does not includes the word 'net' in the balance sheet for PPE.
but in Note 8 the $2943 m1lhon at 30 June 2017 is described
as 'net carrymg amount', which is the canying amount
carryi ng amount representing the cost of The UleXJ)Ifed cost of a
the PPE that has not yet been depreciated/ non-current assel
calculated by subtract.ng
amortised. It is calculated by subtracting the accumulated depreciation

CSL ANALYSIS p accumulated depreciation to date from the

cost of PPE. For example. an asset costing
from the cost of the non-
current asset.

$5000 with $1000 of accumulated depreciation would have

a carrying amount •
(net book va lue) Checkouttheanimatedsummarv ,......
of $4000. on Depreciation

CALCULATING
DEPRECIATION EXPENSE
When a company owns depreciable assets, it must
calculate depreciation expense each period. Doing so
requires the following information about the asset:
• Cost - the historical cost of the asset cost The historical cost of
being depreciated. This is the amount a non-current asset being
that was recorded when the asset deprecrated.
was purchased.

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132
-~;.;;;
residual value An • Residual value (or salvage value)- • · · : ITRAIGHMINE ME1'HOD
estimate of the value of a the market value of the asset at the
non<urrent asset at the end . . Cost - Salvage Value
of its useful life.
end of its useful life. It is the amount Deprectatton Expense = Usefu l Life
useful life The length of the company expects to receive when
time a non<urrent asset is the asset is sol d, traded in. or
expected to be used in
scrapped. For Gavaskar's delivery van. annual depreciation expense
operations.
• Useful life - the length of time the under the straight-line method would therefore be:
depreciable
amount The difference asset w ill be used in operations.
between an asset's cost Depreciation Expense - $65000 - $15 000 - S10 000
and its residual value. Depreciable amount - t he
• 5
difference between an asset's cost Gavaskar would record the depreciation expense with
and its residual value is t he asset's
the following adjusting journal entry at the end of the first
net cost to the company. It is the total
year:
amount that should be depreciated
over the (useful) life of the asset. 31 Dec. Depreciation Expense 10000
2018
depreciation Depreciation method refers to
method The method
the method used to ca lculate the Accumulated Depreciation 10000
used to calctJiate
depreciation expense, such depreciation expense. Generally (To record the depreciation expense)
as the straight-line. Accepted Accounting Principles allow Liabilities Equity
Assets +
reducing-balance and units-
of-activity methods. t he use of several different methods for -10000 -10000
calculating depreciation expense. This
chapter focuses on the following: The same entry would be made at the end of each year
e straight-line method until the end of 2022. Exhib it 8.1 illustrates depreciation
e reducing-balance method for the entire useful life of the asset.
e units-of-activity method. The depreciation schedule highlights several items.
To illustrate how depreciation expense is calcu lated First. depreciation expense is the same each period. This
under each method, the Gavaskar Building Supply will always be true under the straight-line method. Second,
example w ill be continued. The following information the accumulated depreciation account grows each year by
about Gavaskar's delivery van is available: $10000 until the balance equals the depreciable amount
e Purchase date: 1 January 2018 of t he asset. This is no coincidence. The final balance in
e Cost: $65000 accumulated depreciation is the total of all depreciation
e Estimated residual value: $15000 expense recorded during the asset's life. Therefore. the
e Estimated useful life: f ive years or 100000 kilometres. balance should equal the asset's depreciable amount. This
will be tnue regardless of the depreciation method used.
STRAIGHT-LINE METHOD Finally, the carrying amount decreases each year by
The straight-line method of $10000 until it equals the residual value estimated for the
straight-line
method A depreciation depreciation spreads depreciation asset. This is no coincidence either. Carrying amount
method that results in the expense evenly over each year of the represents the rema ining unexpired cost of the asset.
same afOOIJnt of Therefore. an asset's final carrying amount should always
de~eciation expense each asset's useful life. It is a very simple
year of the asset's useful life.
calculation. The depreciable amount of equal the estimated residual value at the end of the asset's
the asset is divided by the useful life of the useful life. This w ill be true regardless of the depreciation
asset {in years) to yield the amount of depreciation expense method used.
per period. This calculation is shown in Key formu la 8.1.

Accumulated
Year Calculation Depreciation expense Carrying amount
depreciation
so $65000
2018 ($65000-$15000)/ 5 $10000 10000 55000
....- ··-···-···-··- ··- ··-···--··-···-···-···-···- ··- ··- ···-···-···-···-···-···-···- ··- ··- ··- ···--···-···-···-···-··- ··- ··-···-···-···-···-··- ··- ··- ··-···-···-·-···-···- ··- ···-···-···-···-···- ··- ···-···-···-···- ··- ··- -···-···-···-··- ··- ··- ··-···-···-···-···-··- ··- ··-..·-
2019 ($65000-$15000)/ 5 10000 20000 45000
....- ··-···-···-··- ··- ··-···--··-···-···-···-···-···- ··- ···-···-···-···-···-···-···-···- ··- ..- ···--···-···-···-···-··- ··- ··-···-···-···-···-···-··- ··- ··-···-···-·-···-···-···- ···-···-···-···-···- ··- ···-···-···-···-···- ··- -···-···-···-··- ··- ··- ··-···-···-···-···-··- ··- ··-...-
2020 ($65000 -$15000) I 5 10000 30000 35000
2021 ($65000-$15000)/ 5 10000 40000 25000
····-···-···-···-··- ··- ··-···--··-···-···-···-···- ··- ··- ···-···-···-···-···-···-···-···- ..- ..- ·..·-···-···-···-···-··- ··- ··-···-···-···-···-···-··- ··- ··-···-···-·-···-···- ··- ···-···-···-···-···- ··- ···-···-···-···- ··- ··- -···-···-···-···-··- ··- ··-···-···-···-···-··- ··- ··- ..-
2022 ($65000-$15000)/ 5 10000 50000 15000
Err! Deprectatton schedule - stratght-ltne method

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-----
1
33
 REDUCING-BALANCE METHOD
reducing-balance The reducing-balance method of
method A depreclatJOil depreciation is an accelerated
rrethod that aa:elerates
dep-eciaboo expense onto the method that results in more
eafly years of an asset's hfe depreciation expense in the early
years of an asset's life and less
depreciation expense in the later years of an asset's life.
As a result. the reducing-balance method is thought to
more accurately reflect the pattern of use and the value of
the benefit gained from the use or using up of the asset
than the straight-line method. More depreciation expense
is recorded when the asset is more useful.
To calculate depreciation expense under the reducing-
balance method, the rate of depreciation IS determined by
a formula: 1 m inus the nth root of the res1dual value diVIded
by the cost (where n = useful life). For Simplicity and to be
consistent w ith the suggested tax depreciation rate. this
may be approximated by taking the straight-line rate of
depreciation and multiplying it by 1.5 (or 2). For example, if
an asset has a four-year life. it has a 25 per cent straight-line
depreciation rate (calculated by dividing 100 per cent by
four years). The straight-line rate is then multiplied by 1.5 to
get 37.5 per cent. An asset with a five-year life would have
a 20 per cent straight-line rate. which would be a reducing-
balance rate of 30 per cent. This rate is then multiplied by
the carrying amount (not the original cost less the res1dual
value, as w ith straight-line) of the asset to g1ve the amount
of depreciation expense for the period. This calculation is
as follows:
-=:;:i~
. =ffi!iD{ij;iiRIDUCIN-..ALANCI MmtOD
Depreciation = Depreciation Rate x Carrying Amount
=(Straight-line Rate x 1.5}
x (Cost- Accumulated Depreciation}
Because an asset's carrying amount declines as the
asset is depreciated, the amount of depreciation expense
w ill therefore d iffer each period. In fact, depreciation
expense w ill become smaller and smaller each period as
the depreciation rate is applied to a smaller carrying
amount. This stands in contrast to the stra1ght-line method
and is why t he name of this method contains the words
reducing balance.
Under the reducing-balance method, Gavaskar's
depreciation expense for the first year of the asset's life is
calculated as follows:
DepreciatiOn Expense for 2018 =(20% x 1.5) x ($65 000- $0)
=$19500
You can now see how the reducing-balance method
accelerates the depreciation. Instead of $10 000 of expense
as under the straight-line method. depreciatiOn expense in
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_ _..;1;.;;
3;.;.
4 ACCTJ Flnanco&!
t he fi rst year is $19500. In other words. $9500 of
depreciation expense IS accelerated to the first year by
using the reducmg-balance method instead of the straiQht-
line method.
In the second year of the asset's life. the same formula
is used. However, the resulting depreciation expense IS
lower because the depreciation rate is applied to a lower
carrying amou nt. With $19500 in depreciation to date, the
accumulated depreciation balance is $19500, yielding a
carrying amount of $45 500 ($65 000- $19 500). Therefore.
depreciation expense in the second year would be:
Depreciation Expense for2019= 30% x($65000- $19500)
=S13650
As you can see, depreciation expense for the second
year is lower than the f1rst year, but it is still more than
would be calculated under the straight-line method. In
other words, deprec1at1on expense is still being accelerated
to the early years of the asset's life.
In the f ifth year of the asset's life, the same formula is
again used, but this time the carrying amount is $15606
(cost of $65000 less accumulated depreciation of $49394).
Therefore, the calculation of depreciation expense for the
fifth year is as follows:
Deprec~auon Expense for2022 =30% x$15606 =$4682
Now, at th1s po1nt we need to be careful. Over an
asset's life, an enttty cannot record more total deprectatton
than the asset's depreciable amount. Regardless of how
much depreciatiOn expense is calculated to be, an asset's
accumulated depreciation balance should never exceed the
asset's depreciable amount. In our example, Gavaskar's
depreciable amount is $50000. Accumulated depreciation
after 2021 is $49394. Therefore, depreciation expense in
2022 is limited to $606. This calculation is as follows:
Depreciable amount of asset ($65000 - $15000) $50000
Less: Accumulated depreciat•on at the end of 2021 49394
Remammg depreciation to be taken s 606
Even though the calculation yields $4682. depreciation
expense cannot reduce the carrying amount below the
residual value. A schedule of depreciation for all five years
is shown in Exh ibit 8.2. The calculated amounts in 2022
are struck through and are replaced with the necessary
amounts.
Note that, as expected, depreciation expense is
accelerated to the early years of the asset's life. Note also
that. like the straight-line method, the reducing-balance
method results 1n a total of $50 000 of depreciation expense
and a resulting carry1ng amount that is equal to the estimated
residual value of $15000. The only difference between the
methods is when depreciation expense is recognised.
 Year Calculation Depreciation expense Accumulated depreciation Carrying amount
so $65000
2018 (2Q% X 1 5) X ($65QQQ- $Q) $19500 19500 45500
2019 ..3Q% X ($65QQQ- $195QQ) 13650 33 150 31850
_,_,_,,_,,_,,_,,.,... ,_,,_,,_,,_,,_,,_,,_,,_,_,_,_,_,,_,_,,_,,_,,_,. ,_,,_,,_,_,_,,_,,_,_,_,,_,,_,_,_,,_,,_,,_,_,,.,_,_,,_,,_,,_,,_,_,,_,,_,,_,,_,_,_,,_,,_,,_,_,_,,_,,_.,,_,,_,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,.

2020 30% x ($65000-$33150) 9555 42750 22295

2021 30%x 22295 6689 49394 15606
_,_,_,_,,_,,_..,.,.....,_,,_,,_,,_,,_,,_,,_,,_,_,_,_,_,,_,,_,,_,,_,,_,. ,_..,_,,_,_,_,,_,,_,_,_,,_,,_,_,_,,_,,_,,_,_,,.,_,_,,_,,_,,_,,_,_,_,,_,,_,,_,_,_,,_,,_,,_,,_,_,_,,_. ,,_,,_,_,,_,,_,,_,,_,_,,_,,_,,_,,_,,_,,.

2022 Cannot be 30% x $15606 4-SBr 54-im ffi924

606 only 50 000 maximum 15 000 minimum
~ Deprecoat oon schedule - reducong-balance method

UNITS-OF-ACTIVITY METHOD limited vehicle use. but this includes all costs, fuel,
maintenance and depreciation.
Both the straight-line and reducing-balance methods are a
function of the passage of time rather than the actual use E.xpense per Unit = S65 000- $15000
of the asset. Eadl method assumes that the calculated 200 000 kilometres
depreciation is a reasonable representation of the actual = $0.25 per kilometre
usage of the asset. In contrast, the
units-of-activity un it s- of- activ ity method of W ith a $0.25 per kilometre rate, the actual kilometres
method Adepreciation
method in which depreciation calculates depreciation driven in a given year is needed to calculate depreciation
depreciatioo expense is a based on actual asset activity. Because it expense. Assume that Gavaskar drives the van 48000
functioo of the actual usage kilometres in 2018. Its depreciation expense for 2018 would
of the asset. relies on an estimate of an asset's
lifetime activity, the method is limited to therefore be $12000.
those assets (such as a photocopier) where units of activity Depreciation E.xpense = $0.25 x 48 000 = $12000
can be determined precise ly or w ith some degree of
Similar ca lculations would be made for the next four
accuracy.
years of the asset's life. A depreciation sdledule, complete
Calculating depreciation expense under t he units-of-
with the actual kilometres driven in each of the five years.
activity method starts by ca lculating depreciation per unit
is shown in Exhib it 8.3.
of expected activity. Depreciation per unit of expected
As you review the schedu le. note that depreciation
activity is t he depreciable amount of the asset divided by
expense fluctuates as the asset's activity fluctuates. As a
the estimated units of activity over the life of the asset.
result, depreciation expense is a function of usage. Second.
note that the total number of kilometres driven over the
UNII'S-OF-ACTIVITY MDHOD
f ive years equals 200000 kilometres. This assumption is
. . . Cost- Residual Value made for simplicity. However, had Gavaskar driven the van
Deprecoatoon Expense per Unot = Usefu l Life in Units
more than 200 000 kilometres. total depreciation expense
Depreciation Expense = Depreciation Expense per Unit over the life of the asset would still be limited to $50000,
x Actual Units of Acti v ity the asset's depreciable amount.

Note that this calculation is very simi lar to the straight- COMPARING DEPRECIATION METHODS
line calcu lation. Depreciable amount is divided by estimated
The calculations in the previous sections demonstrate that
life. But, instead of calculating depreciation expense per
a company's depreciation expense in a given year w ill
year. depreciation expense per unit of activity is calculated.
depend on the depreciation method chose n. For
Once depreciation expense per unit is known, depreciation
comparative purposes, Exh ibit 8.4 summarises the annual
expense is determined by mult iplying the per unit rate by
depreciation for Gavaskar's van as well as the resulting
the actual units of activity during the period.
carrying amounts under the th ree methods.
For Gavaskar's van. depreciation expense per unit w ill
The summary demonstrates that total depreciation
be a function of kilometres driven. Since Gavaskar
expense over the life of the asset is $50 000 regardless of
estimates that the van w ill be driven 200000 kilometres.
the method chosen. Howeve r, each method arrives at
its estimated depreciation per kilometre would be
$50000 differently. The straight-line method depreciates
$0.25 per kilometre. In passing, the Austral ian Taxation
the same amount eadl year. The reducing-balance method
Office allows a deduction of $0.66 per kilometre for
accelerates depreciation into the early years of the

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..;,;;.;;.
1 5
 asset's life. The units-of -activity metho d d epreciates
different amounts each yea r depending on the asset's
usage. No depreciation method is right - they are just
different; and companies choose to use one over another
for different reasons. For taxation purposes t he depreciation
method w hich is allowed and provides the earliest, largest
deduction is usually chosen. The depreciation method used
in the f inancial reports does not need to be the same as
chosen to calculate taxable income. Like all tax-deductible
expenses, depreciat ion reduces taxable income, which in
turn reduces income taxes. Assuming a 30 per cent tax
rate in the example above, the $50000 of depreciation on
the van will low er taxes by $15000. The advantage of the
reducing-balance method is that more of t he tax savings
are realised in t he earlier yea rs. This is benef icial to a
company because the company can temporarily use t he
statements so that comparisons ca n be made among
cash t hat w ould otherwise be paid to the Australian
different compan ies.This is an application of the qualitative
Taxation Office.
characteristic of comparability. The disclosure is usually
Regardless of the met hod chosen, compan ies should
found in a note dedicated solely to PPE.
disclose their choices in the notes to their financial

~Year Calculation Depreciation expense Accumulated depreciation Carrying amount

$0 $65000
2018 S0.25 x 48000 km $12000 12000 53000
-···-···-···-···-···-··-·····-··- ··- ··-···-···-···-···-···-··- ··- ··-···-···---···- ··- ···-·..-···-···-···-··-···-···-···-···-···-··-···-···-·· ····-··-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-··-··-··-··~-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-

2019 S0.25 x 44 000 km 11 000 23 000 42 000

-···-···-···-···-···-··-·····-··- ··- ··-···-···-···-···-···-··- ··- ··-···-···---···- ··- ···-·..-···-···-···-··-···-···-···-···-···-··-···-···-·· ····-··-··-···-···-···-···-···-···-···-···-···-···-···-···-···-··-··-··-··-··~-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-

2020 S0.25 x 54 000 km 13 500 36 500 28 500

-···-···-···-···-···-···-·····-··- ··- ··-···-···-···-···-···-··- ··- ··-···-···---···- ··- ···-·..
-···-···-···-··-···-···-···-···-···-··-···-···-·· ····-··-··-···-···-···-···-···-···-···-···-···-···-···-···-···-···-··-··-··-··~-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-

2021 S0.25x34000km 8500 45000 20000

-···-···-···-···-···-··-·····-··- ··- ··-···-···-···-···-···-··- ··- ··-···-···---···- ··- ···-·..-···-···-···-··-···-···-···-···-··-··-···-···-······-··-··-···-···-···-···-···-···-···-···-···-···-···-···-···-··-··-··-··-··~-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-

2022 S0.25x20000km 5000 50000 15000

~ Dep reciation schedule- un1ts-of-activ1ty method

.. ... . ....
rYear Depreciation Carrying Depreciation Carrying Depreciation Carrying
expense amount expense amount expense amount
2018 $10000 $55000 $19500 $45500 $12000 $53000
2019 10000 45000 13650 31850 11000 42000
2020 10000 35000 9555 22295 13500 28500
2021 10000 25000 6689 15606 8500 20000
2022 10000 15000 606 15000 5000 15000

~ ~ ~
~ Companson of th ree depreciatio n methods

_ 136
_..;.;;.;;.
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Since non-current assets are used for multiple years,
companies sometimes must make adjustments as new
information is available or as new activity occurs. These
adjustments can anse from the following:
• changes in estmnates
e additional expendrtures to 1mprove the non-current asset
e declines 1n the asset's reSidual value (recoverable amount).
CHANGES IN DEPRECIATION ESTIMATES
Calculating depreciatiOn expense requ1res that a company
estimate the asset's useful life and its residual value. These
esti mates are normally based on previous company
experience with Similar assets as well as factors such as the
manufacturer's reoommendatiOI'IS. As a result. they are usually
fair and reasonable. However, estimates can differ from
actual experience. When such errors are small and will not
affect decision-making (i.e. are immaterial), they are usually
ignored. When the estimates are materially w rong, though,
revisions can be made. We call this a change in estimate.
When an estimate is changed, the change is made
prospectively, meaning that the change affects on ly the
calcula tion of current and future depreciation expense.
Depreciation expense for prior years is not (retroactively)
corrected. Once an estimate is revised, current and future
depreciation expense is calculated with the new est imate.
This is done by determining the remaining depreciable
amount of the asset at the time of the revision and
depreciating that cost over the remaining useful life using
the same depreciation method.
To illustrate, suppose that Bachmann Supply purchased
a machine for $90000 on 1 January 2016. Bachmann
estimated at the time that that the machine would have a
1G-year useful life and a $10000 residual value. Bachmann
used the straight-line method of depreciation and recorded
$8000 of depreciation expense (($90000 - $10000) /10)
each year as follows:
31 Depreciation Expense 8!XXI
Dec.
Accumulated Oepreciatoo 8!XXI
(To record depreciauon expense)
Assets Lia~htoes + Equity
--8!XXI -8000
Now suppose that on 1 January 2020, Bachmann
decides that the machine w ill last only eight years (another
fou r years) rather than the ten years originally estimated
and will have a residual value of only $6000 rather than
$10000. When these revisions are made, Bachmann does
not correct t he four previous depreciation expense entries
of $8000 becau se they were based on reasonable
estimates at the t ime. Instead, Bachmann calculates t he
remaining depreciable amount of the asset and spreads it
out over the remaining useful life.
To do this. we must first calculate the net book value
of the asset on the date of revision. This represents the
unexpired cost of the asset.
Carrying amount at the tune of esumate revisoon
Cost of the asset. 1 January 2016 SOO!XXI
less. Accumulated depreciauon for four years (4 x $8000) 32 !XXI
Carrying amount on 1January 2020 ~
Next, we subtract from the carry1ng amount the asset's
residual value. which w ill result 1n the asset's remaining
depreciable amount. Keep 1n m 1nd that we use the revised
residual value. This is shown as follows:
Depreciable amount for future depreciatiOn:
Carrying amount on 1 January 2020 $58000
less. Estimated residual value 6000
Remaining depreciable amount ~
Finally, under t he straight-line method we calculate
depreciation expense by dividing the remaining depreciable
amount by the remaining useful life. In this case. the total
useful life is now estimated to be eight years instead of
ten, which means that there are only four years remaining
instead of six.
Depreciation expense under rev1sed estimates
Remaining depreciable amount $52000
Divided by rema1mng useful life 4
Annual depreciation expense $13000
 W1th this new depreciation expense calculated,
Bechmann would make the following journal entry at the
end of Years 5 to 8:

31 Depreciation Expense 13(XX)

Dec.
13000
---Accumulated Depreciation
(To record depreciation expense)
Assets Liabilities + Equity
13000 13000

So, Bachmann depreciates $8000 per year in Years

1 to 4 and $13000 per year in Years 5 to 8. This results in
$84 000 of total depreciation over the hfe of the asset,
which IS equal to the original cost of the asset less its
rev1sed res•dual value ($90000 - $6000 = $84000).
When a company has a material change 1n a non-<:urrent Given th1s information, the $1000 is a 'revenue'
expenditure and should be expensed as follows:
asset estimate, it will disclose the dlange in the notes to
its financial statements. AASB 108 Accounting Policies, 1 Jan. Maintenance Expense 1000
Changes in Accounting Estimates and Errors (lAS 8} requires 2020
the disclosure of the nature and amount of a change in an Cash 1000
accounting estimate. This is done to enhance the relevance, (To record normal maintenance)
reliability and comparability of the f inancial statements.
Assets ______
liabilities
+ EqUity _;_..:..
~(XX) ~000
EXPENDITURES AFTER ACQUISITION
Most non-current assets require expenditures throughout In contrast, the $8000 for upgrades meets the
the1r useful hves. The purdlasing price of a car IS only the recognit ion cnteria m AASB 116 since the asset's useful hfe
first cost. Expenditures for servicing, mmor repairs and is extended two years. It should therefore be cap1tahsed
even major repairs come with ownership. So. how are with the following entry:
these additional expenditures treated from an accounti ng
1 Jan. Air ConditiOning Unit 8000
standpoint? 2020
The accounting t reatment for expenditures made during
Cash 8000
the useful life of a non-current asset depends on whether
they meet the 'recognition criteria' in AASB 116: 'The cost (To record upgrade to asset)
of an item of property, plant and equipment shall be _ _ _ _....:A-=..:.se
s :.:ts:.__ _ __ ..:L..:
iab.:..i....:
lit....:
ie.:..s_ _ . .:.+_ _....:EqUity
recognised as an asset if. and only if: (a) it is probable that +8000
future economic benefits associated with the item will flow ~000

to the entity; and (b) the cost of the item can be measured
Notice that thiS entry results in an increase (All
reliably'.' Repa1rs and m aintenance (someumes called
Conditioning Umtl and decrease (Cash) to assets rather
revenue expenditures) m aintain the expected useful hfe or
than a change in equ1ty. This is because the company is
productivity of the asset. Repairs and maintenance are
capitalising the expenditure rather than expensing it.
expensed in the period in which they are incurred. They are
With this addition to the cost of the asset. depreciation
not added to the cost of the asset.
expense for 2020 must be recalculated. To do so. the company
To illustrate. suppose that a company purdlases an air
follows the same general procedures used in the change of
conditioning unit for $50000 on 1 January 2016. The
estimate scenario. It first calculates the carrying amount of
company estimates the asset's useful life and residual
the asset and then adds the capital expenditure to obtain the
value at five years and $0, respectively. Using the straight-
updated carrying amount. This is shown as follows:
line depreciation method. the company records $10000 of
deprec1at10n expense eadl year. Now suppose that on Carrying amount after the cap1tal expenditure:
1 January 2020, during the fifth year of the asset's life, the Cost of the asset. 1Janual'( 2016
company incurs $1000 in ordinary maintenance and $8000 Less. Accumulated depreciation for four years 40(XX)
for upgrades. The upgrades allow the madl1ne to be used Carrying amount on 1...,J.:..an:-:
ua1'(.:..2_02_0_ __ __ _ _ _S
_1O(XX)
7 7
productively 1n 2021 and 2022. Add. Upgrades ma_d_e_•n_2_ 020
_ _ _--::-:-:-:---- - - - ' 8000
Updated carl'(1ng amount on 1 Janual'( 2020 $1 8000

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138
-~;;.;.
 Next, the company subtracts the asset's residual value reports so t hat t hey can be confident and informed in
to get the remaining depreciable amount. Under the straight- making investment and other decisions'.2
line method of depreciation, the depreciable amount is then
divided by the remaining useful life to obtain depreciation
expense. In 2020, 2021 and 2022, the company will record
CSL ANALYSIS
$6000 of deprec•at•on expense each year. .. .. - .
Look at CSL's Note 8 in

Depreciation expense alter cap1tal expenditure

Updated carrying amount on I January 2020 SIBOOO
Less. Estunated res1dual value 0
Remaining depreciable amount on I January 2020 SIBOOO
Oivoded by remaomng useful life 3
Annual depreciation expense s 6000
While the classification of post-acquisition expendit ures
may seem rather unimportant. it is actually an area of great
interest because of the potential for fraudulent behaviou r
by companies . One of the largest corporate frauds in recent
history centred on the treatment and reporting of revenue
expenditures. In 2002, it was discovered that WorldCom
Loss on Impairment 100000
was treating operating expenses asso ciated w it h
telecommunication lines as capital expenditures. Inst ead Non-current Asset 100000
of appearing on the income statement (statement of (To record permanent impa1rmen1of asset)
com prehensive income) as expenses. these costs w ere Assets = Liabilities + Equity
recorded as assets on the balance sheet. This resulted in
-
-100000 - 100 000
a g ross understatement of current expe nses and
overstatement of profrts. Over the seven quarters that it
committed th1s fraud, the company overstated its results
by several bill1on dollars .

ASSET IMPAIRMENT
Sometimes, a non-current asset's 'recoverable amount' will
fall substantially due to changing market cond it ions.
technologicalomprovements, or other factors. In Australia,
renewable energy targets may make some assets (e.g.
some coal-fired power stat•ons) reduce substantially in
value. When a non-<:urrent asset's recoverable amount falls
materially below its carrying amount, the asset is
considered impaired. Accounting Standard AASB 136
Impairment of Assets requires reporting entities to write
impaired assets down to the higher of an asset's fair value ASSET REVALUATIONS
(selling price) less costs to sell and its value in use. This,
The Accounting Standard AASB 116 allows
like the lower-of-<:ost-and-net-realisable-value ru le with cost model After
either the 'cost model' or t he 'revaluation recognitioo as an asset. an
inventory, is an application of t he concept of prudence item ol plant. property and
model' as an entity 's accounting policy to
(conservatism). The Australian Securities and Investments equipment shall be carried
measure plant, property and equipment. at its cost less any
Co mmission released 'Impairment of non-financial asset s: accumulated depreciation
The cost model states 'after recognition
M aterials for directors', which stated : 'Impairment testing and any ompairment loss.
as an asset, an item of plant, property and
is the process of reviewing the values of assets shown in revaluation model II
equipment shall be carried at its cost less la1r value can be measured
the balance sheet of a company (known as the " carrying reliably the asset shall be
any accumulated depreciation and any
amount") to determine whether those values cont inue to earned at a revaluation
impairment loss'. 5 The revaluation amount.
be supportable or should be reduced '. It also stated that:
model states if 'fair value can be
'Financial reports should provide useful and meaningful
measured reliably the asset shall be carried at a revaluation
information for .nvestors and other users of those financial
amount'.6 If the revaluation model •s used, assets should
 be revalued regularly to ensure the carrying amount does
not differ materially from fair value at the end of the reporting
period.
Assets are sometimes 1mpa1red because they are no lon&er popular
There are a number of restrictions on management
simply revaluing assets to boost the business' profits. One
is that all assets in a 'class' must be revalued. So we cannot
have a case where some machinery is revalued and other
machinery is not. Examples of other classes of assets are
sh ips, furniture and fittings, office equipment, land and
buildings. But the sign ificance of 'comprehensive' in a
statement of comprehensive income (rather than the
simple income statement) may now become a little clearer.
Upward revaluations are included in 'other comprehensive
income' not in the income statement. CSL includes 'actuarial
gains/(losses) on defined benefit plans' (see note 18) as part
of 'other comprehensive income'. It is not important what
an actuarial gain is, but the fact that it is in comprehensive
income indicates the fair value has increased, but they have
not been sold and the gain actually made or 'realised'. For
many people who own their own house, the increase in
the fair value of their house makes them feel wealthier, but
until the house is sold and the gain realised it is part of their
income, not profit.
Over the years the way different increases in an entity's
value have been accounted for has changed, but the
accounting standards divide income into two parts: 'profit
or loss' and 'comprehensive income'. Upward revaluations
of assets are included in comprehensive income, while the
sale of an asset above its carrying amount would be
(normal) profits.
~ DISPOSING OF
. . , NON-CURRENT ASSETS
When a company decides that it no longer needs a non-
current asset, it usually disposes of the asset in one of
three ways. When the asset has no value, it will simply be
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140
_.....;..;.;;.
discarded, and sometimes there will be a cost in disposing
of t he asset. When the asset still has value, it will either be
sold or traded in for another asset, often a newer model.
Since the accounting for t rading an asset is beyond the
scope of this book, we will focus on t he first two cases -
discarding or selling the asset.
The accounting for the disposal of a non-<:urrent asset
consists of the following three steps:
1 Update depreciation on the asset.
2 Calcu late gain or loss on the disposal.
3 Record the disposal.
The f irst step is to record any necessary depreciation
expense to update the Accumulated Depreciation account.
Usually, this means that depreciation expense must be
recorded for a partial period. For example, a company that
records annual depreciation expense on 31 December and
sells equipment on the following 15 February must record
depreciation expense for one and a half mont hs at the t ime
of disposal.
The second step is to calculate any gain or loss on the
disposal by comparing the asset's carrying amount to the
proceeds from the asset's sale, if any. When the proceeds
exceed the carrying amount, a gain on disposal is
recognised. When the carrying amount exceeds the
proceeds, a loss on disposal is recognised. This is
summarised below:
Gain on Disposal = Proceeds from Sale> Carrying Amount
Loss on Disposal = Proceeds from Sale< Carrying Amount
The th ird and final step is to prepare a journal entry that
decreases the asset account and its related accumulated
depreciation account. If the asset is sold and cash is
received, the entry must also record the increase in cash.
Finally, any gain or loss on the disposal must be recorded.
To illustrate, suppose that a company purchases a
machine on 1 January 2018 for $30000. The company
estimates the useful life and residual value to be four years
and $2000, respectively. The company uses the straight-
line method of depreciation and records depreciation
expense annually on 31 December. Given these facts,
annual depreciation expense for t he machine is $7000
[($30000- $2000) I 41.
LOSS EXAMPLE
Suppose further that the company sells the machine on
30 June 2020 for $12000. To account for th is sale, the
company must first update the accumulated depreciation
account. The asset has been used for six months since the
last t ime depreciation was recorded (31 December), so the
company must record six months of depreciation expense.
Since annual depreciation expense is $7000, six mont hs GAIN EXAMPLE
of depreciation wou ld be half of that, o r $3500. Therefo re,
the fo llowing entry would be made o n 30 June 2020: To illustrate a gain example, suppose t hat t he company
sells t he machine on 3 1 March 2021 for $8000. A fter
30 June Depreciation Expense 3500 updating dep rec iation, t he Accumulated Depreciation
2020
account w ould have a balance of $22 750:
Accumulated Depreciation 3500
(To record the depreciation expense) Three full years (2018, 2019. 2020) $21000
Liabilities Equity One-quarter of 2021 (S7 000 x 14) 1750
Assets +
-3500 -3500 Accumulated depreciation at 31 March 2021

As a result of t his entry, t he accumu lated depreciation Therefore, the madline's carrying amou nt and t he gain/

account is updated to a balance of $17 500 ($7000 in 2018, loss on disposal at 31 M arch 2021 can be calcu lated as
$7000 in 2019 and $3500 in 2020). W ith this balance, the follows:
gain/ loss on disposal can be calcu lat ed as fo llow s : Proceeds from sale $8000
Proceeds from sale $12000 Cost of machine $30000
Cost of machine $30000 Less: accumulated depreciation 22750
Less: accumulated depreciation 17500 Carrying amount at 31 March 2021 7250
Canying amount at 30 June 2020 12500 Gain on sale $ 750
Loss on sale $ (500)
Because the sale proceeds of $8000 exceed t he asset's
Because t he asset's carryi ng am ount o f $12 500 carrying amount of $7250, the company generates a $750

exceeds the sa le proceeds o f $12000, the company gain (revenue). W ith this informat ion, the following journal
generates a $500 loss (expense). With this informatio n, t he entry can be prepared to record the disposal:

company can prepare t he following journal entry to record 31 Mar. Cash 8000
the disposa l: 2021
Accumulated Depreciation 22750
30 June Cash 12000
2020 Gain on Disposal 750
Accumulated Depreciation 17500 Machine 30000
Loss on Disposal 500 (to record the sale of the machine)
Machine 30000 Assets liabilities + Equity
(To record the sale of the machine) +8000 +750
Assets liabilities + Equity +22750
+12000 -500
-30000
+17500
-30000 Li ke th e loss example, the e ntry de creases the
Machine account by $30 000. It also decreases t he
The ent ry first d ecreases t he Machine account by madline's Accumu lated Depreciation account by $22750
$30000 to elim inate t he account. A common m istake is to elim inate the account and increases the Cash account
to t hink that t he Madline account should be decreased by $8000 to reflect the asset received from selling t he
by it s carrying amount of $12 500. But remember that madline. Finally, the en try increases a Gain o n Disposal
non-cu rrent assets are recorded and m ai ntained at thei r accou nt to reflect t he gain on sale . Like the loss example,
costs, so t he balance in t he Machine accou nt is $30000 t he net effect on the account ing equation is an equal
prior to disposal. Second, the entry decreases Accum ulated change in assets and equity, w ith th is exam ple resu lting
Depreciation by $17 500. Because t he company no longe r in a $750 increase to both. r.
has the asset , it should no longer maintain accumu lat ed ~·~~ lq
depreciation fo r the asset. Third, t he entry increases t he Review this content with thee-lecture •
Cash accou nt to ref lect the asset received f rom selling
the machine . Finally, t he entry increases a Loss on
D isposal account to ref lect t he loss o n sale. As a result of
the entry, assets and equ ity decrease by $500, the amount

__
of the loss.

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1
14
 income statement accounts. These calcu lations are
EVALUATING A COMPANY'S summarised as follows:
MANAGEMENT OF
Horizontal ana lysis
NON-CURRENT ASSETS
Dollar Change in Current year Balance- Prior year Balance
Account Balance
Because non-current assets comprise the largest category
Percentage Change Dollar Change
of assets for most companies, it is usually a good idea to in Aocount Balance Prior year Balance
evaluate a company's management of its non-current
assets. A company manages non-current assets by Vertical analysis
acquiring them, using them productively and then Account Balance
replacing them . Therefore, two issues of importance for Account Balance or Net Sales or
Percentage
Total Assets Net Sales or
any company w ith non-current assets wou ld be as
Revenue
follows:
1 How productive are the company's non-current assets Given the f inancial information in Exhi bit 8.5, horizonta l
in generating revenues? and vertical analyses of non-current assets and depreciation
2 What is the condition of the company's non-current expense result in t he following. Note t hat the carrying
assets? amount of prope rty and equipment is used in the
The following sections examine these issues for the calculations. Note also t hat vertical analysis is conducted
non-current assets of a hypothetical vegetarian restaurant on both years of data.
chain, Kale Me Crazy (KMC). The examination w ill require
information f rom the company's ba lance sheet, income
statement and notes to the financial statements. The Dollar change Percentage
change
required information is found in Exh ibit 8.5, excerpted from
Property and equipment 20254.5 __.illQ1)
KMC's 2019 Annual Report. -20984.7 20 984.7 =15%
(730.2)
HORIZONTAL AND VERTICAL ANALYSES Depreciation expense 1161.6 16.6 1 5%
1145.0 1145.0= .
A good place to start an analysis of non-current assets is ---;s:s
with horizontal and vertical analyses. Recall from Chapter
~.t\utiU'Iifb
2 that horizontal analysis calculates the dollar change in an
2019 2018
J
account balance, defined as the current-year balance less
the prior-year balance, and divides that change by the prior- Property and equipment 20254.5 7 2% 20984.7 - 71 4%
28461.5 = 1. 29391r ·
year balance to yield the percentage change. Vertical
Depreciation expense 1161.6 1145.0
analysis divides each account balance by a base account, 23522.4 = 4·9% 22 786.6 = 5·0%
yielding a percentage. The base account is total assets for
balance sheet accounts and net sales or total revenues for The calculations show a fairly stable non-current asset
position. Horizontal analysis shows a slight decrease of
3.5 per cent in non-current assets and a slight increase of

Source Accounts 2019 ($m) 2018($m)

Income statement Total revenues $23522.4 s 22786.6
Property and equipment. at cost 31152.4 32203.7
·-···-···- ..- ···-···-···-···-···- ···-···-···-···-···-···- ···-···-···-···-···- ··- ···---···-..·-···-···-···-···-···-···-···- ··- ··- ···-···-···-···-···-···-···-···-···-···-···-···-···.·-···-··-···-···-··- ··-···-···-··-···-···-··- ··-···-···-···-···- ···-···-···-···-···- ···-·..-···-···-···-·.
Less: Accumulated depreciation (10897 .9) (11219 0)
Balance sheet Net 20254.5 20984.7
Total assets 28461.5 29391.7
Notes to financial statements Depreciation expense 1161.6 1145.0
~ Kale Me Crazy account balances from the 30 June 2019 Ann.ual Report

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14 2
_......;.,;,;;
 1.5 per cent in depreciation expense from 2018 to 2019.
Vertical analysis shows that non-current assets make up a
large part of KMC's asset base. In each year, slightly CNer
CS[ ANALYSIS p
71 per cent of the assets are non-current assets. Furthermore.
deprecratron expense is shown to be about 5 per cent in each
year. This tells us that for every dollar rn sales revenue. the
company incurs about 5 cents in depreciation expense.
Overall, both of t hese analyses indicate fairly stable non- non-current asset turnover ratio
current assets over the two-year period. average life and average age of

NON-CURRENT ASSET TURNOVER RATIO

The preceding analyses indicate that KMC's non-current
assets are stable. But they do not indicate whether the I •

company is using those non-current assets productively DeP.reciation (amortisation and imP.airment charges)
to generate revenues. One way to find
non-current asset out is to calculate the non-current asset
tu m01rer ratio A
companson of total turnover ratio. The non-current asset
revenues to the average net turnover ratio compares total revenues
carrying amount of non-
curroo t assets that during a period to the average carrying $4520.6 I $9122.7 = 49.6%
measures the produC1ivrty amount of non-current assets during that
of non-current assets.
period. It is calculated as follows:

NON-CUIIIIINT AIIIT
TURNOVIR RAno

Non-current Asset Tumover Ratio =

Total Revenues
Average Net Carrying Amount of Non-current Assets

Where average net book value is:

Beginning Net Carrying Amount+ Ending Net Carrying Amount
2

Because this ratio compares total revenues to non-

current assets, it indicates the productivity of every dollar
invested in non-current assets. In general, companies want
thrs ratro to be higher rather than lower. All other things
being equal, a higher ratio indicates that the company is
using rts non-current assets more effectively to produce
more revenue.
The 2019 non-current asset turnover ratio rs calculated
as follows:

23522.4
----:----:----- = 1.14
(202545 + 209847).;. 2

The 1.14 ratio shows that KMC's total revenues for 2019
were 1. 14 times the average carrying amount of its non-
current assets. In other words, for every dollar of
non-current assets. on average, the busrness was able to
generate $1.14 in revenue during the period. Whether this
rs good or bad requires some comparrson . Its major
competitor's non-current asset turnover ratio was 1.60.
while another competitor's was 2.67. KMC lags its two
rivals rn generating revenues from its non-current assets.

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----
143
 AVERAGE LIFE AND AGE OF
NON-CURRENT ASSETS
NON-CURRENT ASSETS
AND CASH FLOWS
In addition to understanding the productivity of non-current
assets. it is useful to understand the condition of a company's Another important aspect of non-<:urrent assets is their
non-current assets. Non-current assets 1n poor condition are effect on a company's cash flows. Non-<:urrent assets
usually less productive and normally require significant affect cash flows the most when they are purchased.
expenditures to erther repa1r or replace. While a user of most Because companies often purchase s1gmf•cant amounts of
companies' finanaal statements cannot physically examine non-<:urrent assets each year. the cash pa1d for them is
their non-<:urrent assets, one way to get a rough idea of the reported as a separate line 1tem 1n the 1nvest1ng activities
general condition of a company's non-current assets is to section of the statement of cash flows. The line 1tem 1s
look at the age of the assets in companson to their useful often labelled as capital expenditures or something s•milar.
lives. This can be accomplished by KMC is a little more spec1fic, report1ng the follow1ng on the
average useful life
of non·curTent calculating the average useful life and first line of its investing activities section:
assets A companson ol average age of the assets.
the cost ol noiH:Urrent
assets to deprecoation The average useful life of non - I •

expense that estimates current assets represents the number

the number ol years. on in m illions 2019 2018 2017
of years, on average, that a company
average. that a ~ny
expects to use rts non· expects to use its non-current assets. It Property and equipment $(2135.7) $(19466) $(1 741.9)
current assets. expenditures
is calculated as follows:

• : • AVERAGE USEFUL UFE RATIO The negative number signifies a cash outflow. In 2019,
KMC spent over $2.1 billion in cash to purchase non-<:urrent
f U Cost of Non-Current Assets assets. In the two previous years, the company spent
Average Use u1 1 e = Depreciation Expense
about $ 1.9 bi llion and $1.7 billion. For the three years
combined. this totals over $5.8 billion in cash paid for non-
The ratio divides the total cost of non-current assets by current assets.
the amount of annual depreciation expense to approximate
the number of years that It will take to fully depreciate the
assets. A higher number represents a longer useful life. You
may notice that this ratio IS basiCally a rearrangement of the
calculation of stra1Qht·hne depreoation. Therefore, the ratio
11110rks best when the company uses the straiQht..Jine method.
In the case of CSL a more useful calculation
average age of non· may be to exclude: deferred tax; goodwill;
curTent assets A
C0111J11Rson of land; capital works 1n progress as these non-
iDl.IITlllated deprecra!J)n current assets are not amortised or
to depreciation expense
that estimates the deprecl3ted.
runber of years. on The average age of non -current
average. that the
company has used rts assets represents the number of years, on
norH:urrent assets. average, that the company has used its non-
current assets. It is calculated as follows: A natural question arising from this data is where the
company got the $5.8 billion it needed for these investments
in non-current assets. Did it borrow the money or did it have
Accumu lated Depreciation it on hand? We can get an idea of where the money came
Average Age
Depreciation Expense from by looking one line above the capital expenditures.
There we find the cash provided by operating activities.
The ratio divides the accumulated depreciation balance by which is summarised as follows:
the amount of annual depreciation expense to approximate
the number of years that the assets have already been
depreciated. A higher number means that the assets are
older. Like the average useful life ratio, the average age ratio
Cash provided by
works best when the company
·l;s''v o~ratio~n~s--------~------------------------
a\ Download the Enrichment uses the straight-line method.
V/f# Modules for further practice
I
Coovllgllt 2018 Cengoge laml119- AU Rights R~ May noc be copMd scanned. or dUI'lieaod, ln whole or n pan. WCN 02·200-202
144 ACCT3 Fw>~,
 other company, without permission from Cengage. can
lawfully use the content of this book.
A third Intangible with which you may be familiar IS a
franchise. which IS the right. granted by franchise The rqrt to
the franch1sor to a franchisee to operate a operate a business under
the trade name of the
business under its trade name. Examples franchosor
of franch ises are all around you . For
example. whenever you visit a McDonald's, you may be
entering into a restaurant that is owned by an individual (the
franchisee) who has purchased f rom McDonald's Corporation
(the franchisor) the right to operate the restau rant.

RECORDING INTANGIBLE ASSETS

Like all other assets. intangible assets are recorded at their
acquisition costs. HOYJever, what is included as an acqUISitiOn
cost can vary given the type of intangible asset and how it
is acquired. Two accounting standards relate directly to the
recognition. recording, expensing and disclosure of
intangibles - AASB 138 (lAS 38) Intangible Assets and AASB
3 Business Combinations. AASB 136 Impairment of Assets
is concerned with ensuring that assets, including intangibles,
are not carried at more than their recoverable amount (able
to be recovered through use or sale).
o INTANGIBLE ASSETS Externally cquired
The easiest case IS when an intangible asset is acqwed
intangible asset A resource In addition to plant. property and
through an external transaction. For example. suppose that
that is used '" opetat1ons for equipment. compan1es often possess
ITlOil! than one year but that has a company purchases a product patent from another
no phys~~:al substance non-current assets known as intangible
company for $100000. Because the patent is purchased 1n
patent The nght to assets. An intangible asset is a resource
an arm's length transaction with another company, the cost
manufacture, sell or use a that is used in operations for more than
particular product or process of the patent is the purchase price. In general, if an
one year but has no physical substance.
eJCX:Iusively for a limited penod of intangible asset is acquired through an external transaction,
time. A patent is a good example. A patent is
its cost is the purchase price.
the right for the holder of the patent to
manufacture, sell or use a particular product or process
exclusively for a limited period of time. Although the right
of exclusive use has no physical propert1es. it can be a very
valuable resource to the holder. Consider the pharmaceutical
Industry. When a company develops a new drug, which will
be more valuable - the equipment that manufactures the
drug or the patent that provides for exclusive manufacturing
and selling rights to the drug? Pharmaceutical companies
will likely tel l you that the patent is most valuable to them.
You are probably familiar with other
trademali< (trade
name) The right to use intangible assets. For example. a
exclusively a name. symbol trademark or trade name is the right
or phrase to •dentrfy a
company for a company to use exclusively a name,
copyright The r9Jtto symbol or phrase to identify the company. A common example of an intangible that is created
reproduce or sell an ar!Js!JC Often. you can tell 1f something is through an external transaction is goodwill. Goodwill is
or published WOft or created when one company buys another company and
software coqJUter code registered as a trademark 1f 1t has a small
™ or e beside the name or symbol. The pays more than the value of the net assets goodwill An 1ntangoble
N1ke swooshTM is an example of a trademark. as is the of the purchased company. Goodwill is asset eq.Jal to the BJa:eSS
equal to the excess of the purchase price that one company pays to
script Coca-ColaTM or the apple with a bite out of the side. acquore the net assets of
This book is protected by copyright, which means no over the va lue of the purchased net another company

Copyright 2019 Cengage Learning. All Roghta R...rvod. May not be coplod, scanned, or dupllce:'ll1P'?Ef1'§''J.f~~~~ntV::~~fs2a~~p~ngible assets
----
145
identifiable assets. For example, suppose that Buyer
Company purchases Seller Company for $8 million
when the value of Seller Company's net identifiable
assets is $6 million. In this transaction. Buyer Company
pays $8 million and records $6 million of new assets
and $2 million of goodw1ll. A condensed form of the entry
Buyer Company would make to record this transaction
would be as follows:
Net Assets of Seller Company 6000000
Goodwill
--~-------------------
2 000 000
Cash 8000000
(To record deprec1ataon expense)
Assets liabahl.les + Equity
6000000
+2000000
--8000000 -----------------------
The above entry records the decrease in cash resulting
from the purcha se and the increase in net assets acquired
through the purchase. The difference of $2 million is debited
to Goodwill, which increases that asset account. The result
of the entry is an increase and decrease to assets.
To understand what goodwill represents, think about
why a company would pay a premium for another company.
The purchasing company might want to acquire the other
company's customers, its reputat1on. its employees, its
market share or its research. Whatever the reason, the
purchasing company IS paying for something intangible that
the other company possesses. Th1s Intangible value is what
goodwill represents. Note here that goodwill can be
recorded by a company only when it purchases another
company. Goodwill created internally by a company cannot
be recorded as an asset because 1ts cost cannot be reliably
determined. Only through an andependent purchase can
the value of goodwill be ObJeCtively measured. CSL has
over $1 billion of intang1ble assets (over 10 per cent of total
assets) made up of almost $700 million of goodwill,
$170 million of intang1ble capital works in progress and over
$100 million of intellectual property. You can see CSL only
recognises goodwill as 'any excess of the fair value of the
purchase consideration of an acquired business over the
fair value of the identifiable net assets . .. recorded as
goodwill'. 7
lntemally generated
In the previous examples, intangible assets were purchased
externally and therefore recorded at their purchase prices.
When an intangible asset is developed internally, the
accounting is more conservative. AASB 138 divides
the internal generation of an intangible into two phases:
the research and the development. Expenditure on research
is recognised as an expense when incurred. In the
development phase, six criteria must all be demonstrated
before an asset can be recognised. These include:
e the technical feasibility of completion for use or sale
e how the intangible asset will generate probable future
economic benefits
e the ability to measure reliably the expenditure
attri butable to the intangible asset during its
development.
This may be easier for a biOtechnology company that has
procedures in place to assess and measure many
developments than for a company develop1ng a s1ngle idea
for the first time. Surprisingly CSL has less than 5 per cent
of total assets as nolliJoodwllllntangibles.
While some disagree with this account1ng treatment,
it is another application of prudence. It IS very difficult to
know whether particular research and development costs
will result in productive assets and how long those assets
might last. Given this uncertainty, expensing research, and
often many or all of t he development costs. resu lts in
intangible assets not being overstated.
AMORTISING AND IMPAIRING
INTANGIBLE ASSETS
Like non-current assets that are
amortisation The
depreciated, intangible assets with limited process of speading oot
the cost of an antangible
useful lives are amortised. Amortisation
asset aver Its useful life.
is the process of spreading out the cost
of an intangible asset over its useful life. Two examples of
intangible assets with limited lives are patents and
copyrights. Patents are granted for up to 20 years. and
copyrights are granted for the life of the creator plus
70 years. Companies usually use the stra1ght-lane method
for amortisation.
To illustrate. suppose that a company possesses a
$60000 patent that has the maximum legal life of 20 years.
The company believes that the patent will be useful for only
12 years and will then be worthless. Amortisation expense
at the end of each year would be $5000 ($60 000 .;- 12) and
would be recorded as follows:
End of Amortisation Elqlense 5000
year
Accumulated Amortisation Patent 5000
---
(To record the amortisation expense)
Assets Liabilities + Equity
-5000 - 5000
The result of this entry is an increase to expenses and
a decrease to assets. Notice that the entry records
amortisation expense based on the 12-year useful life. not
the 2G-year legal life. Amortisation should be based on the
shorter of the legal life or useful hfe. We use an accumulated
amortisation contra-account because AASB 138 paragraph
118 requires disclosure of accumulated amortisation.
 Amortisation applies on ly to intangible assets with
limited lives. Assets with indefi n ite lives such as
trademarks and goodwill are instead examined regularly
(at least annually) to check for impairment. This is similar
to the impairment of non-current assets. In general, if
t he fair value of t he intangible asset falls below carrying
amount, then the asset is impaired . In such a case, the
company records a loss on impairment and reduces the
asset to its fa ir value. As you can imagine, determining
whether an in tang ible asset is impaired can be very
subjective. In Note 7, CSL states : 'The impairment
•
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Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or dupllci:~EftB''lfciJ?cli':'r~nt~~,'!R2;,~~flngibie assets
assessment process requ ires management to make
significant judgements. Determining whether goodwill
has been impaired requires an estimation of the
recove rable amount of t he cash generating units using
a discou nted cash flow methodology .. .' (discounted
cash flows are covered in Appendix A) ' ... [that] uses
cash flow projections based on operating budgets and a
three-year strategic business plan after which a terminal
va lue ... is applied.' 8 Finally, intangibles wit h limited lives
are subject to the same ru les as plant, prope rty and
equipment w hen accounti ng for reval uat ions.
~,\1 ,,y
Test your understanding with the •
online revision quizzes for this chapter
__
.;..,;,;,
1 47

1 Acquisition cost
li Pl Co. purchases equipment With a hst pnce of $22 000.
Regard1ng the purchase. U :
rece1ved a 2 per cent discount off the hst pnce
ii pa1d sh1pp1ng costs of $800
iii pa1d $1750 to •nstall the equ1pment, $1200 of which
was for a unique stand for the eqUipment
iv paid insurance: $2800 for equipment; $300 for
delivery and $2500 for a two-year policy to cover
operat•ons disruption
v pa1d $600 to have the manufacturer tram employees
on safety features.
REQUIRED
Determine the acqu•sition cost of the equipment. Comment
on why the $600 of safety training was mcluded or not
included 1n the cost.
2 Acquisition cost
Emily incurred the follow•ng expenditures when purchasmg
land: $470000 purchase price. $35000 in stamp duty and
$19000 for cleanng. She sold a bu1lding on the land for
$8000.
REQU IRED
Determ•ne the acqu•s•uon cost of the land.
3 Determine net carrying amount
Equ1pment IS purchased for $100800. It has an estJmated
useful hfe of 10 years and a res1dual (salvage) value of $800.
REQUIRED
Assuming stra1ght-hne depreciation, determ1ne the net
carrying amount of the asset after three years.
4 Depreciation methods
Xing Pty ltd purchases a delivery van on 1 January for
$50000. The van has an estimated useful hfe of five years
and an estimated residual value of $5000.
REQUIRED
For both the straight-line and reducing-balance methods of
depreciation (at tw•ce the straight-line rate). prepare a
schedule of depreciation expense. accumulated depreciation
and carrying amount over the life of the asset. Advise Xmg
of the advantages/disadvantages of the two depreciation
methods.
5 Depreciation methods
Pon Kembla Steel purchases a mach1ne on 1 July for $60000.
The mach1ne has an esumated useful hfe of seven years.
dunng wh1ch ume •t is expected to produce 57400 units.
ACCD Fon~ " u R _ . _ ihynotbecopied.scanneu O"d\4>lealed,lnwholoorlnpatt. WCN02·20C>-202
148
_.....;.;..;;.
Residual value is estimated at $2600. The mach1ne produces
15500 and 16200 un1ts 1n its first and second f~nancial years
of operation, respectively.
REQUIRED
Calculate deprec1ation expense for the mach~ne's f1rst two
years us1ng the stra•ght-l~ne, reduc~ng.!)alance (double
straight-line rate) and units-of-actiVIty methods of
deprec1at10n.
6 Change in useful life
A company purchases plant w1th an estimated useful hfe of
15 years and a resiCfual value of $35000. When the plant has
seven years of hfe rema1n1ng, the company estimates the
remaining useful life IS only f1ve years- all else rema1ns the
same. The asset's net carry~ng amount at the ume of
revision is $60000.
REQU IRED
Using the stra1ght-line method, calculate deprec•at•on
expense for the first year after the revis•on .
7 Change in estimates
On 1 July 2019, Ab Activators purchases gymnasium
equipment for $90000 and estimates a useful life of eight
years and a residual value of $6000. On 1 July 2020, Ab
Activators revises the equipment's useful life from e1ght
years to five years. It uses the straight-line method of
depreciation.
REQUIRED
a Calculate deprec1allon expense for 2019-20 and 2020-21
financial years.
b Recalculate 2020-21 deprec•at•on expense assum1ng
that Ab Activators leaves the useful hfe at e1ght years but
reduces the res1dual value to $0.
8 Expenditures after acquisition
Tiger logiStiCS acqUired a new van for $75000 1n 2018. At
the end of 2021, accumulated depreciat•on on the van was
$25000. On 1 January 2022, Tiger pa1d $2000 for rouune
service on the van and $8000 to overhaul the eng<ne. The
engine work 1S anticipated to extend the useful hie of the
van by five years.
REQU IRED
Calculate the net book value of Tiger's van immediately after
the service and overhaul.
9 Capital/revenue expenditures
A business incurs the following expenditures rela ted to
currently owned non-current assets:
annual pressure washmg of building, $10000
i i new front door lock $250
iii new compressor for the a•r conditiOner, $9000
iv repair of water damage caused by leaking roof, $7000
v new tyres on tractor, $4000
v i replacement of standard windows w1th double
glazed energy-eff•c•ent w indows. $18000
vii add1t10n of 100 square metres of off1ce space, $44000
viii mod•fica110ns to mach1nery to 1mprove eff•c•ency,
$14400.
REQU IRED Revenues Non -current asset carrying amount
Identify each expenditure as a capital or revenue expenditure 2014 $4889 Sl!iO
and explam why the accountant should class1fy the
expenditure as an 'expense' or 'asset'.
2015 5897 201
2016 6583 245
10 lmpainnent entry 2017 8563 395
Fung Factories acquired equipment for $450000. On 2018 10589 524
15 March 2020. Fung determines that the equipment IS
2019 13584 687
impaired by $65000.
2020 14555 793
REQUIRED
Prepare the entry to record the impa1rment of the REQU IRED
equ1pment. Calculate the non-current asset turnover ratio for the years
presented. What does the trend in the ratio tell you about
11 Disposal the company's performance?
Ell1s lndustnes sells a build1ng that has an ong1nal cost of
$300000 and an accumulated deprec~auon balance of 15 Intangible assets
$200000. Phoebe Pharmaceuticals 1ncurred the followmg
REQUIRED expenditures:
Research costs of $600 000 were incurred to
Prepare the journal entry to record the sale assummg the
sales price was (a) $100000. (b) $95000 and (c) $108000. discover a cure for the common cold.
ii Phoebe paid $170000 in development costs before it
knew if it was technically feasible to make it as a
12 Disposal
product available for sale.
On 1 January 2018, A&G Company pays $40000 for iii Phoebe paid about $120000 on development but
equipment w1th a 1Q.year est1mated hie and a $5000 was not able to reliably measure the expenditure.
esumated res1dualvalue. On 1 January 2022. A&G sells the
iv Phoebe 1ncurred $180000 exactly 1n costs once it
equ1pment for $18500 (assume A&G use a calendar year as
knew 11 would be able to produce and sell the drug
1ts accounting financ1al reportmg periOd).
for btlhons.
REQUIRED REQUIRED
Calculate the gam or loss on the sale assum•ng A&G uses
Determme the total cost of the patent and comment on the
the stra•ght-hne method of deprec1at1on. Where should the
carrymg amount the accountants would place on the patent
ga1n or loss on the sale be presented on the 1ncome compared to its potential market value.
statement?

13 Evaluate non-current assets

In its 2020 annual report. Mike reported the following
information (in thousands) :
I beg1nmng total assets $6821
ii end1ng total assets $7891
Iii beg1nn1ng PPE $2988 (at cost)
iv end1ng PPE $3132 (at cost)
v beg1nmng accumulated deprec1at10n $1293
vi revenues $12253
16 Acquisition cost
v ii depreciation expense of $252.
Sarah purchases an M RI machine w ith a list pnce of
REQUIRED
$922000. Regard1ng the purchase. Sarah:
a Calculate the non-current asset turn011er ratio of Mike's received a 5 per cent discount off the list price by
busmess. paying before delivery
b Calculate the average useful life of M1ke's non-current ii paid shipping costs of $8000
assets at the end of the 2020 flnanc1al year. iii paid $175000 to install the equipment. $120000 of
c Calculate the average age of Mike's non-current assets which was to re1nforce the floor to withstand the
at the end of the 2020 financial year. we1ght of the MRI
iv pa1d $3000 to have the story of the mstallat1on of the
14 Evaluate non-current assets MRI featured on the local news
The foUowmg data was taken from the annual f1nanc1al v pa1d $2800 to msure the MRI
statements of Sk1ppy Company (all f1gures m m1lhons): vi pa1d $230 for a w 1reless safety cut-off sw1tch
vi i pa1d $6000 to have the manufacturer tra1n employees
on the umque operating procedures.

Copyright 2019 Cengage Learning. All Right& R...rved. May not be copied. scan nod, or dupllce:HAP?Ifll'BI'I.J'6~~nt"!~s't,R2;,~~flngiblo assets 14_9 _ _
 REQUIRED
Determine the acquiSitiOn cost of the equipment (show
19 Non-current asset transactions and
calculations). reporting
A partial port1on of the balance sheet at 31 December 2018,
17 Depreciation methods for San limited is presented below:
Sunnse Development lndustnes purchased a depreciable land $500000
asset for $150000 on 1 July 2019. The asset has a f1ve-year
useful hfe and a $30000 est1mated residual value. The Buildings $630000
company will use the stra1ght-l1ne method of deprec1a11on Less. Accumulated Deprec1auon 250000 380000
for book purposes. However, Sunnse will use the reducmg- Equipment $65000
balance method for tax purposes. Assume a tax rate of
30 percent. Less. Accumulated Deprec1a110n 22000 43000

REQU IRED Total Property and Equ1pment $923000

a Prepare deprec1at1on schedules us1ng the straight-line
and reducmg-balance methods (at 1.5 umes the stra1ght·
line rate) of depreciauon for the useful hfe of the asset.
b Calculate the tax savings for the f1nancial year ended 30
June 2020 from the use of the accelerated depreciation
method for tax purposes.
c Under the stra1ght·line method of depreciation, what is
the gam or loss if the equipment is sold (i) at the end of
June 2022 for $90000 or (iii at the end June 2023 for
$48000?
d How is the gain or loss on the disposal of the equipment
presented in the fmancial statements assuming no
revaluations?
The following transactions occurred dunng 2019:
1 January • Retired eqUipment w11h a net book value of $2000.
The equipment was purchased for $8000. No
value was received from the retirement.
1 January • Sold a building with an original30·year useful
life and no est1mated salvage value for $90000
cash. The building was originally purchased on
31 December 2008 for $120000 and depreciated
using straight·line.
30 April • Purchased land for $90 000.
1 July • Purchased equipment for $30000 by signing a
_____long·term note payable.
__:

31 December • DepreciatiOn IS recorded. Depreciation expense

18 Various transactions for the year was $40000 for buildings and $4500
On 1 January 2019, Ravioli Foods purchased a buildmg for a for equ1pment.
cash pnce of $1192000 and accrued land tax of $114950. REQUIRED
The build1ng IS est1mated to have a useful life of 10 years
a Prepare JOurnal entries to record all the above
and $500000 res1dual value. On the same day, Ravioli pa1d
$25450 1n cash plus stamp duty of $2290 for a new delivery transactions.
van that is estimated to have a useful hfe of f1ve years and a b Prepare the property and equ1pment portiOn of San's
residual value of $2200. Another $1100 was pa1d to pa1nt the balance sheet at 31 December 2019.
van company ccllours With the company logo. Over the next
several years. the follOWing events related to these non- 20 Evaluate non-current asset s
current assets occurred. The follOWing mformallon was available from the 2020
1{1{2020 New informauon caused the estimated life of the financial statements of Papa John's P1zza:
van to be reduced to three years total mstead of 2020 2019
five years
Net property and equipment $ 189992 s 198957
17/12{2020 Repa1red air cond1110mng system 1n the building
wll1ch broke down for one week. $5000. Total assets 386468 401817

1{1/2021 Renovated bottom floor of the buildmg for $1 15000. Depreciation expense 31 BOO 30600
adding three years useful life to the building. Cost of property and equipment 388080 408074
1/1/2022 Sold van for $5350 Accumulated depreciation 198088 209117
1{1/2022 Sold building for $1 163000. Total revenues 1132087 1063595
REQUI RED REQU IRED
Prepare all entnes for 2019 to 2022. Ravioli Foods' annual Calculate and interpret:
depreciation expense is calculated on 30 June each a horizontal and vert1cal analyses of non-current assets and
financial year. depreciation expense
b non-current asset turnover ratio
c average life and average age of non-current assets.

ACCD Fon~lli2019Cengajle1Aamlng. AU Righta R--...ci.IUynotbecopied.scanned, OI'~iealed.ln wholo orlnpatl. WCN02·20C>-202

150
_....;.;;.;.

21 Amo rtisation of intangible assets
Ramon Producttons purchased the copynght to a film scnpt
for $264 000 on 1 July. The copynght protects the owners'
legal nghts for the next 20 years. but producers at Ramon
esttmate 11 will only be able to use the copynght for the next
15 years. Ramon Productions uses the stratght-line method
of amon•sallon and has a 30 June year-end.
REQUIRED
Prepare the journal entry to record amonisation expense for
the first year.
22 Research and analysis
Access the annual repon of a company of your lecturer's
choos~ng.
REQU IRED
a Examtne the company's balance sheet (statement of
ftnanctal posttJonl and conduct hortzontal and ventcal
analyses of net PPE.
b Calculate the company's non-current asset turnover ratto.
Also. calculate the company's average age and useful hfe
rattOS at the end of the current f~nanctal year. Cost and
accumulated depreciation data. and deprectatton and
amon•sation expense should be found in one or more of
the Notes to the financial statements .
c Examine the company's statement of cash flows. How
much cash did the company spend on PPE over the two
years presented?
Copyright 2019 Cengage Learning. All Right& R...rved. May not be copied. scan nod, or dupllce:HAP?Ifll'B''I.J'6~~n."!~s't,R2;,~~flngiblo assets
d What intangtble assets does the company have and are
they amontsed and/or tmpatred?
e Based on your answers above. write a paragraph
explatmng your optnion of thts company's non-current
asset posttlon. Use your answers as suppon~ng facts.
23 Written communication
Play Hard Fttness Centre is a chain of gymnastums. Play's
financial analysts have forecasted sales to remain at a
constant level for the next three years. bu t income taxes are
forecasted to grow by 5 per cent a year for the next five
years. Play Hard is about to refurnish 50 per cent of its
centres with new equtpment that will have an estimated
usefulltfe of five years. As a consulting accountant, you
know that compantes can use one method of deprec18tton
for tax purposes and another for book purposes. The two
methods under constderaiiOn are the reduCing-balance
method and stratght-llne method of deprectatlon.
REQUIRED
Wnte a shon memo recommending the method you would
use for tax purposes and the method you would use for
book purposes. Be sure to dtscuss the advantages and
disadvantages of both methods as well as the associated
effects on income. depreciation over time. cash flows, etc.
24 SMS Communication
In 144 characters or less explatn what impatrment is when
related to an mtangtble asset of indefinite hfe.
25 Ethics in accounting
A fnend of yours clatms that he likes accounting because
there is always a right and wrong answer to a question and
therefore there is no temptatton for wrongdoing .
REQU IRED
Using capital and revenue expenditures as an example.
explain how judgement can be involved in accounting
decisions and how an indivtdual's ethics can affect the
manner in which he or she accounts for a pantcular item.
15_1 _ _

After studying t he material in t his chapter, you
should be able to:
Describe the recording and reporting of
current liabilities.
Describe the reporting of non-current
liabilities and the cash flows associated with
those liabilities.
Understand the nature of bonds
(debentures) and reco rd a bond's issue,
interest payments and maturity.
Account fo r a bond that is redeemed prior
to maturity.
Recognise other liabilities such as leases
and contingent liabilities.
Evaluate liabilities through the calculation
and interpretation of horizontal, vertical and
ratio analyses.
Appendix: determine a bond's issue price.
Appendix: record bond interest payments
under t he effective interest method.
apply this -·······-
Copyrlght2019 Cengage Loa nlng A R ght Rnervecl May not
152
The creation and payment of liabilities is common to most
businesses. Some are generated daily and paid quickly.
Others are paid over time and often require the payment
of interest. Still others must be estimated and some may
never be paid. This chapter focuses first on how some
common current liabilities are generated and reported. It
then examines non-current liabilities with a specific focus
on the issue of bonds (sometimes known as debentures),
the interest and eventual payment. We also discuss the
obl igations associated with leases and cons ider the
treatment of potential obligations that may or may not
become liabilities. As in previous chapters, the final section
of the chapter focuses on the analysis of a company's
position regarding its obligations. The appendix covers
bond pricing and the effective interest method for bond
amortisation.
a CURRENT LIABILITIES
A current liability is an obligation of a business t hat is
expected to be pa id (or satisfied) within one year (or the
accounting cycle). Current liabilities can arise from regular
business operations such as the purchase of inventory,
the work of employees, and the incurring of taxes . Most
current liabilities, such as accounts payable (and notes
payable), liabilities to employees and utility (e.g. electriCity,
internet) prov1ders will be satisfied through the payment
of cash . Others, such as deferred revenues, in wh1ch a
customer prepays for a service to be performed later, will
be satisfied through the performance of the service.
The following sections present the accounting for
some of the more ~·I'J ''~
common types of Checkoutlhevideosununaries •
9
current liabilities. forChapter
copied. scanned, or dupllcotod, In whole or In part. WCN 02·200-202
TAXES PAYABLE CURRENT LIABILITIES WITH PAYROLL
W hen conducting business, compan ies generate a variety W hen discussing payroll there are two terms often used:
of tax ob ligations to t he Commonwealth and State gross pay, the total amount of salary o r
gross pay
governments. One example is income tax. Like individuals, wages, and net pay or 'take home pay' - The total pay befO<e any
companies are subject to federal taxation of their taxable th e gross pay minus deductio n s. deduction; in the simplest
fonn it is hours Wllfked
income. Like individuals, they are often g iven t ime to pay Deductions com e in t w o forms, times the agreed hourly
the bill, wh ich creates a current liabi lity. For example, required deductions. such as rate.
suppose a company has $205000 of annual income tax employee income tax in w hich the net pay
Gross pay less deductions
expense and is not required to pay it until t he next period. employee (the worker) does not have a such as tax.
The company would make the following journal entry at choice, an d optional deducti ons o r requined deductions
year-end to record the expense in the proper period: volu n tary deductio n s wh ere t h e The amount(s) the
employer is legally obl iged
employee may ask t heir employer (the to take out. such as tax.
Year-end Income Tax Expense 205000 before depositing tile net
boss) to pay extra superan nuation,
Income Tax Payable 205000 pay in the employee's
insurance, etc. on t heir be half. W hen bank account.
(To record the income tax expense) paying employee wages, employe rs optional deductions
must withhold income taxes ow ed by The amounts tile
Assets liabilities + Equity
employee asks the
t he employee. The employer then remits employer to take out. such
+205000 -205000
(sends) the with held tax to the ATO. To as extra superannuation,
before depositing the net
The entry increases both Income Tax Expense and illustrate, suppose that an employee pay in the employee's bank
Income Tax Payable. The resu lt of the ent ry is a reduction earns a monthly salary of $1 0000. Based account.
to equity (an expense) and an increase to liabilities. on the employee's tax situation, the
Another type of tax payable is t he Goods and Services employer must w ithhold 27 per cent of the sa lary for
Tax (GST). A business does not pay GST; it collects GST income tax. Also suppose the employee has asked for $765
f rom its customers and passes it o n to the Austral ian to be paid into their superan nuation fund (this is known as
Taxation Office (ATO). If a business provided a service or a voluntary deduction and is a contribution out of salary and
sold goods that were subject to GST it would add 10 per o n top of the compu lsory superannuation of 9.5 per cent
cent to the total price it charged the customer. Imagine the for employees earning more than $4 50 a m o nth). On
drone f ilming business f rom Chapter 1, Aerial Film ing, has payday, the company w ould prepare the following entry:
expanded, so you are now registered for GST if you carried
Salaries Expense 10000
out a large job for a custom er and you wanted to receive
Income Tax Payable 2700
$1000 for the work you d id, you would dlarge the customer
$1100 ($1000 for you and $100 for t he ATO). The following Superannuation Payable 765
entry record s the customer being billed or paying you: Cash 6535

Accounts Receivable or Cash 1100 (To record payment of salary)

Service Revenue 1000 Assets liabilities + Equity

GST Payable 100 --6535 +2700 -10000

(To record service provided plus GST) +765

Assets liabilities + Equity
+1100 +100 +1 100
The advantage for a business of being registered for
GST is being able to claim back t he GST paid on those
goods and services for w hidl they have been dlarged GST
In the above example t he business that purchased t he
service f rom you would pay you $1100 but $100 of that
wou ld be 'GST Receivable', an asset for them. Although
they pay you $1100, they w ill claim back the $100 of GST
from the ATO and so the resulting cost for your customer
is on ly $1000. Individuals and businesses not registered
for GST cannot cla im back the GST they pay, so t he
government does not miss out com plet ely (e.g. w hen you
buy clothes, takeaway food etc.).
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In whole or In part. WCN Ot~g~
The entry increases Salaries Expense for t he $10000
salary earned by the employee for the month. However, the
em ployee is paid only $6535 (this is the amount deposited
in the employee's bank account - their 'take-home pay').
The difference is the am ount that the employee owes in
taxes and superannuation the employee contributed . On
behalf of the employee, the employer w ithholds the tax and
superannuation and records the resulting liabilities. As a
resutt of this entry, assets decrease, liabilities increase, and
equity decreases for the amount of the total salaries expense.
In addition to wit hholding taxes on behalf of em ployees.
employers m ay also pay other t axes such as state payroll
tax. Each state has different rates and th resholds. Small
businesses w ith only a few employees generally do not
have to pay payroll tax, but as a business expands they will
liabilities
9 153
.:.=- -
 reach the threshold. Payroll tax may be seen as a
disincentive to employ more people. Let's imagine the
threshold is $1 million, and once total employee benefits
rise above that level a 7 per cent payroll tax is pa id on all
employee benefits. This is an additional tax; it is not
deducted from employees' wages like income tax shown
above. If your business had gross employee benefits of say
$3.5 m illion, in the year you would incur $245000 of
additional employment expenses. The following entry
records the expense and the result ing liability:
Payroll Tax Expense 245000
Payroll Tax Payable
(To record payroll tax)
Assets liabilities + Equity
+245000
These are called labour 'on costs' and would include
workers' compensation insurance and compulsory
superannuation (although superannuation paid by the
employee may be included in the 'package' an employee
is offered).
NOTES PAYABLE
Chapter 6 introduced the concept of a promissory note,
wh ich is a written promise to pay a specific sum of money
at some date in the f uture. That chapter focused on the
party that accepted the note in exchange for cash. That is.
the accounting for notes receivable was demonstrated.
This chapter focuses on the party that accepts cash in
exchange for the note. That is, the accounting for notes
payable is now demonstrated.
When a company issues a promissory note to borrow
money (or delay payment for goods or services- effectively
the same thing), the company generates
note payable a note payable. If the note is payable
A liability generated by w ith in a year. it is a cu rrent liability.
the issue of a promissOI)'
note to borrow money. Otherwise, it is a non-current liability. The
account ing for a note payable consists of
recording the note, recording any interest that must be paid
to the creditor and recording the payment of the note.
To illustrate, suppose that on 1 March Bugeja Company
borrows $100000 by signing an 8 per cent, six-month note
with Murray River Bank. The note calls for interest to be
paid when the note is repaid on 31 August. On 1 March,
Bugeja would make the following entry to record the note:
1 Mar. Cash 100000
Note Payable
(To record the note)
Assets Liabilities + Equity
+100000 +100000
_ 154
_...;.;;.;.
ACCTJ Fi n~c!ll(lght 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or In part. WCN 02·21J0.202
In this entry, Bugeja increases both Cash and Note
Payable by $100000. As a result, both assets and liabilit ies
increase. Since this note matures w ith in a year, the note
payable would be reported as a current liability.
On 31 August, Bugeja must pay Murray River Bank the
original $100000 borrowed plus the interest on the note.
Interest over the six months is calculated as follows:
Interest= Principal x Annual Rate of Interest x Time Outstanding
= $100000 x 0.08 x 6/12 months
= $4000
Therefore, Bugeja wou ld pay $104 000 to the bank and
245000 make the following entry on 31 August:
31 Aug. Note Payable 100000
Interest Expense 4000
-245000 Cash 104000
{To record payment of note and interest)
Assets liabilities + Equity
-104000 -100000 -4000
In th is entry, Bugeja increases Interest Expense to
reflect the cost of borrowing the $100000 over the six
months. Bugeja also decreases the Note Payable account
because the note is being paid. Finally, Bugeja decreases
Cash for the payment of principa l and interest. Because of
the entry, Bugeja's assets, liabilities and equity decrease.
If Bugeja's f inancial year ended on 30 June, an adjusting
entry wou ld be needed to recogn ise the expense for four
months and the liability at the end of the fou r-month period
- Interest expense of $2667 and Interest payable of $2667
($100000 X 0.08 X 4/1 2).
CURRENT PORTION OF NON-CURRENT DEBT
A company that borrows long term may only pay interest
during the term of the loan and repay the principal (the
amount borrowed) at the end of the loan. To illustrate,
suppose a company borrows $500000 through a 1G-year
prom issory note. Because the note is payable in 10 years,
the company classifies the note as a non-current liability.
In year 10, the note is reclassified as a current liabi lity
because it will all be repaid in year 10). The
current portion of non-current debt current portion of non-
represents the portion of a non-current current d ebt
The portion of a non-current
liability that w ill be paid w ithin one year. liability that will be paid within
Many long-term borrowings require a one year.
set amount to be repaid each month. At
the beginn ing of the loan the majority of the payment is
100000 interest and a smaller amount of principa l is repaid. (On a
thirty year $500000, 5o/o mortgage the monthly payment
would be approximately $2684. For the first payment
$2084 is interest and $600 repayment of principal.) In the
first year about $7500 of the principa l w ill be repaid;
therefore. at the beginning of the year $492 500 of the
mortgage will be reported as a non-current liability. $7500
current. At the beginning of the last year of the loan all the
outstanding pnncipal of $31350 will be reported as a
current liability. In the last year only $858 of the repayments
is interest. (These numbers are not important. they can be
verified using online calculators.) As you consider these
two examples. keep in m1nd that regardless of how the
liability IS class1fied on the balance sheet, the company is
borrOWing and repaymg $500000. The classification of the
note payable as current or non-current does not affect the
borrowing or repayment of the note. It only affects how the
payable is reported (disclosed and classified) on the balance
sheet. However. this balance sheet reporting is important
because it tells users of the financial statements what
obligations will require payment in the short term. During
the Global Financial Crisis a number of companies. including
ABC Learning and Centro Properties. incorrectly reported
current liabilities as non-current and in doing so misled
users of their financial statements. These companies'
short-term borrowings had previously been renewed (rolled
over) every three or so months for several years by their
lenders. When it became difficult to borrow money, the
lenders asked for their money back and the companies
were faced with having to find hundreds of millions of
dollars within a few months. The misclassification of
liabilities as non-current rather than current. misled the
users of the f1nancial statements.
REPORTING CURRENT LIABILITIES
Current liabilities are reported 1n a separate section on a
balance sheet. The follow1ng IS the current liabilities section
of the balance sheet (as at 30 June 2017) of the Chartered
Accountants Australia and New Zealand (CAANZ):'
a NON-CURRENT LIABILITIES
A non-current liability is any obligation of a business that is
expected to be satisfied or paid 1n more than one year or
beyond one account1ng cycle. Like current liabilities. the
type and size of non-current liabilities can vary across
companies. However. the most common and largest non-
current liabilities often anse from borrOWing money. While the
CAANZ had aver $70 million in current liab1hnes. they have
just aver $2 million in non-current liabiht1es. This is not
surprising given they use members' fees to prOVIde services
to members (including attracting students like
you into the profession). Most bus1nesses use shareholders'
and borrowed money to provide goods and serVIceS to clients/
customers in order to earn a profit for their shareholders.
While the balance sheet reports the balance in non-current
liabilities, the cash flow statement reports the cash flows
associated with
those liabilities in the
~\'1 ,1/,
f inancing activities Review this content witll the e·lecture •
section.
a BONDS
A f inancial instrument that companies use to borrow money
on a long-term basis is a debenture or bond. The term
debenture is becoming less common in Australia, so we use
the term 'bond', which is generally used in global financial
markets. The advantage of bonds IS they prOVIde the flexibility
of borrowing from a range of lenders and often at the most
competitive interest rates. The disadvantage when compared
with borrowing from a bank IS the adm1n1strat1ve work in
issuing bonds and pay1ng interest to many lenders.

CSL ANALYSIS
11 9254 13291
Provisions 12 5254 4592
Total

CAANZ reports over $70 million in current liabilities in

2017 (down a little on 2016). This total is made up mostly of
fees received in advance, primarily members who have paid
their annual membership fees for the next financial year in
the previous financial year. It also includes payments
received in advance for professional development courses
and students undertaking the CA Program who have paid
on or before 30 June for courses to be conducted on or after
1 July (so they can cia 1m a tax deduction when paid - if you
were wondering why they would pay in advance). Notes 10
to 12 of the financial statements provide more detail.

Copyrlght2019 CensJa9e L.umlng. AU RlghU R--..cl.l&ay not be copied. scanned. 0< ~iealed I n - 0< In part.
~9 U..tlo1ities 1 55
~--
 bond A bond is a financial instrument in be annually or semi-annually.The maturity date is t he date
A financial instrument w hich a borrower promises to pay f uture on wh ich the face value must be repaid to
in which a borrower maturity date
promises to pay future
interest and principal to a cred itor in the creditor. These three terms, w hich do The date on which the face
interest and principal to exchange for the creditor's cash today. The not change over the life of the bond, are value must be repaid to the
a cred~or in exchange fO< creditO<.
borrower 'sells' or 'issues' t he bond and disclosed on the certificate that is given to
the creditors cash today.
records a liability. The creditor 'buys' the t he creditor or the creditor's t rustee w hen the bond is
bond and record s an investment. purchased.
The terms and features of a bond are determined by An example certificate is shown in Exhibit 9. 1. This
the borrower (the issuer of the bond) and can vary w idely, bond was issued by t he Commonwealth Government
but they need to be competit ive or no one will buy the bond through the Reserve Bank of Australia and had interest
(lend the borrower money). However, all bonds have a face coupons attached. It was a 'bearer bond' entit ling the
value. a stated interest rate and a maturity date. person who had physical possession of t he certificate to
face value The face value is t he amount that the claim the interest and redeem the bond on maturity (or at
The amount that is repaid borrower company wants to borrow. but any stage if all f uture interest coupons were attached).
at maturity of a bond.
more accurately the amount that must be Note t his was from a different era when interest rates were
stated interest rate
The contractual rate at repaid to t he creditor (len der) upon considerably higher.
wllich interest is paid to maturity of the bond. Another name for While these terms establish both t he amount to be paid
the creditO<.
face value is principal value. The stated at maturity (the face value) and the amount of interest to
interest rate is t he contractual rate at be paid each period (the stated interest rate), they do not
which interest is paid to the creditor. Other names for the establish the issue price for w hich the bonds are issued. A
stated rate include face rate, nominal rate, contractual rate bond's issue price is a function of these terms as well as
or coupon rate. Along with t his stated rate, a bond will a f ourt h item. t he market rate of interest given the
specify t he t iming of interest payments. These w ill usually borrower's risk.

22A00041 I $20
THIS 801'10 eotitk$ the 8cam lO I)I)"J'IIal ac tbe Rttt-rvt 8tllk of \\.!ltra.t!.. •t
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TWENTY D OLl ARS

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lntu«t thcttoa at the ntc d M -1~ per ~Phna per &ftl,.._nt lO .t"<.'Ot.J..nt-r whh 1he &l.1adw4
'-.cb Sums ·~ lo«ur'td t'ltl the C"a,JO! datfd RCTCnYC l( ltlc ("('GIIDDII'tC.t~llil
COOI)Oftt.. and
ol Aumalia.
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19!9 a~ bjut to ~c with the COGd.iJ.iOO$ ~ ndortcd t'ln the rncnc o1 thk ac..t._

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0.1ed til~ ~114 di.Y of lllt,r. l9tJ

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l

~ Example of a bond cer!Jficate

_ 156
_..;.;;.;;,
ACCTJ Fi n~c!ll(lght 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In whole or In part. WCN 02·200-202
 Market rate Bond price
6% ~ Discount

Stated rate
591 5%

4% ~

~ Prem ium or d1scount

market (or The market (or effecti ve) rate of

effective) rate of i nt erest is the rate of return that investors
interest in the bond markets demand on bonds of
The rate of return that
investO<S in the bond sim ilar risk. The market rate is based on many
markets demand for complicated factors, including current and
bonds of similar risk.
expected economic conditions. However, its
relation to a bond's issue price is relatively
straightforward. See an example of these concepts in
Exh ibit 9.2 .
When a bond pays interest at a rate that is equal to what
creditors require in the market, the creditors w ill buy the
bond at its face value. Creditors are getting the return that
they require, so no adjustment to price is needed. As a BONDS ISSUED AT FACE VALUE
resu lt, the borrower receives face value. We say that such To illustrate a bond issued at face value, suppose that on
bonds are issued at par or face value. 1 July 2019, Ma Manufacturing sells bonds with a face value
When a bond pays interest at a rate that is lower than of $100000. The bonds carry a 6 per cent interest rate and
what creditors demand, the creditors will purchase the a 1 July 2029 maturity date. Interest is to be pa id sem i-
bond on ly if the price is discounted. By discounting the annually on 1 July and 1 January. Because the market rate
price, the borrower is effectively increasing the rate of of interest is also 6 per cent, the bonds sell at face value.
interest that the creditor earns. In fact, the bond will sell
only when the price is reduced enough so that the effective Recording the issue
interest rate that the creditor earns equals the market rate In this example, Ma wou ld record the bond issue with a
of interest. Bonds that are issued for less than face value simple and straightforward entry to increase Cash and
are issued at a discount. Bonds Payable:
When a bond pays interest at a rate that is higher than
1 J ul. Cash 100000
what creditors expect, the borrower w ill sell the bond on ly 2019
if the price is raised. By raising the price, the borrower
Bonds Payable 100000
effectively lowers the rate of interest that the cred itor
(To record bonds issued at face value)
earns. In fact, the bond w ill be able to be sold at a higher
price so the effective interest rate that the creditor earns Assets liabilities + Equity
equals the market rate of interest. Bonds that are issued +100000 +100 000
for more than face value are issued at a premium.
Actual issue prices are calculated using present value Note that this entry is practically the same as the entry
calcu lations. The chapter appendix illustrates these recording the note payable earlier in the chapter. This should
calculations. Here, you shou ld simply understand that make sense s ince a bond is really just a more formalised
bonds sell for whatever price is necessary to make the note payable.
effective rate of interest equal to the market rate of interest.
Recording interest pavments
The following sections demonstrate how to account for a
Once the bond is issued, Ma must pay interest on 1 July
bond's issue, the periodic interest payments and the
and 1 January of each year. For any bond, the amount of
maturity of bonds under each scenario.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In whole or In part. WCN Ot~g~ liabilities
9 157
.:.=- -
 interest paid each period is a product of the face value. paid. Thus, the total cost of borrowing the $100000 over
the stated 1nterest rate and the length of the payment the 10 years is $60000.
period. In this example. interest is paid every s1x months.
or semi-annually, so the amount paid is $3000, calculated
Recording t e maturity
as follows: On the 1 July 2029 maturity date. Ma would record the
repayment of the bonds in addition to the last interest payment.
Interest Pa1d; Face Value x Stated Interest Rate x Time Outstand.ng
;$100000 x 0.06 x 6/12 months
1 Jul. Bonds Payable 100000
;$3000
2029
Therefore. on 1 J anuary, Ma wou ld record its interest Cash 100000
payment with the follow ing entry: {To record repayment of the bonds)
1 Jan. Interest Expense 3000 Assets liabilities + Equ1ty
2020
-100000 -1000CKJ
Cash 30CKJ
(To record payment of interest)
Assets liabilit1es + Equity
-3000 -30CKJ
BONDS ISSUED AT A DISCOUNT
M a increases Interest Expense to reflect the cost of
borrowing over the six months and decreases Cash to reflect To illustrate a bond issued at a d iscount, suppose that on
the payment made to the bondholders. The overall effect of 1 July 2020, Nguyen Company issues bon ds w ith a face
t he t ransaction is a decrease to Ma's assets and equity. value of $ 200000. a stated interest rate of 7 per cent and
The next $3000 interest payment is scheduled for 1 a m aturit y date of 30 June 2025. Int erest is payable
July 2020. However. assu ming t hat Ma has a 30 June annually on 30 June. At the time of issue, the risk-adjusted
year-end, two entries are required. The first is a 30 June m arket rate of interest for Nguyen is higher than the
adjusting journal entry that accrues the mterest expense stated rate of 7 per cent, and the bonds sell at a price of
and records the related payable so that the expense is $196000, or a $4000 d 1scount. At such a price, the bonds
properly recorded in the period in which the money was are said to have sold at 98, meaning that they were issued
used. The second entry records Ma's payment on 1 July at 98 per cent of face value ($200 000 x 98% = $196 0001.
2020. These two entries are s hown as follows:
Recording the assue
30 Jun. Interest Expense 3000 Nguyen would record the issue as follow s:
2020
1 Jul. Cash 196000
Interest Payable 3000 2020
(To record accrual of interest) Discount on Bonds Payable 4000
Assets liabilitoes + Equity --------Bonds Payable ~---------------
200000
+30CKJ -30CKJ (To record bonds issued at a disrount)
Assets liabilities + Equoty
1 Jul. Interest Payable JOCK) +1960CKJ +2000CKJ
2020
-4000
Cash 3000
(To record payment of interest) In this entry, Nguyen increases Cash for the $1 96000
received from the investors. Nguyen also increases Bonds
Assets liabilities + Equity
Payable to reflect the new obligation t hat it has. Not ice that
-3000 -3000
Bonds Payable is recorded at the bond's face value of
$200000. The Bonds Payable account is always recorded
Note the overall effect of t he two entries is to decrease
at the amount that will ultimately be repaid, which is face
assets and equity by the amount of the Interest paid . This
value. The difference of $4000 is recorded in an account
is the same overall effect as the 1 January interest entry.
called Discount on Bonds Payable. which is a contra-liability
Interest IS paid and recorded in the same manner
account. Its balance IS subtracted from the Bonds Payable
every 30 June/1 July and 31 December for 10 years until
account to yield the net carrying amount (book value) of
the 1 July 2029, maturity date. Over time. Ma w1ll make
the bonds. As a result, both assets and liabilities increase
20 payments of $3000 for a total of $60000 of 1nterest
by only $196000.

_ 1 58
_...;.;:;.:.
ACCTJ Finf.1'J1lf'ght 2019 Cengage learning. All R1ght1 R...rvod. May not be coplod, scanned, or dupllcalod,ln whole or In part. WCN 02·2Q0.202
 After issue, the bonds would be reported on the balance
sheet as follows:

1 July 2020
Bonds payable
Less 01scount on bonds payable
Carry1ng amount
Notice that the carrying amount of $196000 at the time
of issue is equal to the cash received at issue. This w ill
always be the case at issue. regardless of the price of the
bond.
Recording interest paymen
Nguyen's bonds call for annual interest payments over the
hfe of the bonds. Each payment is calculated as follows:
• · -~~ MYAILI ON
lotaMYAILI
Interest Paid = Face Value x Stated Interest Rate
x Time Outstanding
= $200000 x 0.07 x 12/12 months
= $14 000
Note that this $14 000 interest payment is calculated
the same way as the bond issued at face value. Whether
a bond •s issued at face value. at a discount or at a premium,
Interest paid on a bond is always:
Face value X Stated Interest Rate X Time Outstanding
However, unlike the face value scenario, interest
expense will be greater than interest paid. Recall that
Nguyen received only $196000 at issue but must repay
$200 000 at maturity. That $4000 di scount is therefore an
additional cost to Nguyen that must be amortised over the
life of the bond. To amortise the discount is to gradually
reduce the discount balance and add the amount
amort•sed to interest expense. Therefore, at each interest
payment date, interest expense w ill be greater than
•nterest paid.
There are two methods to amort1se the discount on
bonds payable: the straight-line method and the effective
interest method. Because the straight-line method is easier
to calculate and is often not substantially different from the
results from the effective interest method, the straight-line
method is demonstrated here. However, the effective
interest method is also demonstrated in the chapter
appendix.
Under the straight -lin e method of
straight-line
method of amortisation. an equal amount of the
amortisation discount is amortised each ume interest is
Method that amortJses
an equal amoll1l paid. The amount amortiSed •s calculated as
of the dlsccoot 01 follows:
prem11m each t1me
interest IS pa1d
Discount at Issuance
Discount Amortised = - -- - - -- -- -
$200000 Number of Interest Payments
4000
~ With a $4000 discount and five annual interest
payments, Nguyen must amortise $800 ($4000/5) each
payment. As a result, Nguyen's interest expense for each
period is $14800. With this information, Nguyen can make
the following entry to record the first annual interest
payment on 30 June 2021.
30 June Interest Expense 14800
2021
Otscount on Bonds Payable 800
Cash 14000
(To record the payment of interest)
Assets Liabilities + EQUity
- 14000 +800 - 14800
The entry affects three accounts. First, Cash is
decreased for the amount paid to the creditor. Second, the
Discount on Bonds Payable account is decreased (or
'amortised') by $800, resulting in a remaining balance of
$3200. Thtrd, Interest Expense is increased by $14800 to
record the expense associated with the interest pa1d and
the discount amortised. It may be counterintuitive that
liabilities would mcrease as a result of the preceding interest
entry. However, remember that the contra-liability Discount
on Bonds Payable, which was first created for $4000, is
now only $3200. Therefore, the carrying amount of the
bonds has increased by $800 because of the interest
payment entry. This is illustrated as follows:
Issue 30 June 2021
Bonds payable S200000 $200000
Less. D•scount on bonds payable 4000
Carl'(ing amount
The carry1ng amount will continue to increase by $800
with each interest payment date as the discount is
amortised. After five interest payments, the discount will
be fully amortised (that is, it will have a zero balance) and
the carrying amount of the bonds will equal the face value
of $200000.
This movement of the carrying amount
amortisation
from issue price to face value is best schedule
illustrated m the schedule found in Exhibit A schedule that illustrates
the amortJsatoon of a bond
9.3. 1t is called an amortisation schedule discount 01 prem~um fHf!l
because it prov•des the details of the the hfe of a bond
discount amortiSation and the resulting
expense amounts and carrying amount.

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9 159
,;,..;..o._ _
 Interest payment Interest paid Discount Interest expense Una mortised Carrying amount
amortised discount
$14000 s 800 $14800 $4000
~
$196000
2 14000 800 14800 3200 196800
3 14000 800 14800 2400 197600
4 14000 800 14800 1600 198400
5 14000 800 14800 800 199200
~

$70000 $4000 $74000 -2 ~

rnJ Amortosatoon schedule - bonds ossued at a d oscount

As you review the amortisation schedule, note that it BONDS ISSUED AT A PREMIUM
provides the dollar amounts for each annual interest entry.
To illustrate t he accounting for a bond issued at a prem ium,
The first three columns provide the amounts of cash to be
suppose that on 1 January 2019, Amber Arbitrators issues
paid, discount to be amortised and interest expense to be
bonds with a face value of $50 000, a stated interest rate
recognised each year. Because the straight-line method of
of 8 per cent and a maturity date of 31 December 2021.
amortisation is used, the amounts are the same each year.
Interest is payable annually on 3 1 December. At the time
Thus, Nguyen would make the same interest entry every
of issue, the market rate of interest is lower than the stated
year until the bonds mature.
rate of 8 per cent, and the bonds sell at a price of $50600,
Note also that the schedu le confirms that t he total cost
or a $600 premium. At such a price, the bonds are sa id to
of borrowing is a combination of the interest paid and the
have sold at 101.2, meaning t hat they were issued at 101.2
o riginal discount. Tota l interest expense over the life of the
per cent of face value ($50000 x 101.2% = $50600).
bonds is $74000, wh ich is the sum o f interest paid
($70000) and t he o riginal discount ($4000). When bonds Recording the issue
are issued at a discount, t otal interest expense w ill always Amber would record the issue as follows:
exceed interest paid by the amount of the discount. An
alternative calculation of the total cost of borrowing is as 1 Jan . Cash 50600
2019
follows:
Premium on Bonds 600
Interest payments ($200000 x 7%) $ 14000 Payable
x Number of payments x5 Bonds Payable 50000
= Total interest paid $70000 (To record bonds issued at a premium)
+Discount 4000 Assets liabilities + Equity
Total cost of borrowing +50600 +50000
+600
Recording the maturity
In this entry, Ambe r increases Cash for the $50600
In addition to the interest payment (and amortisation of
rece ived f rom creditors. Amber also increases Bonds
discount), Nguyen must repay $200000 on 30 June 2025
Payable for the face value of $50 000. The $600 received in
to satisfy its obligation . The entry to repay the bonds
excess of the face value is recorded in an account called
requires a decrease to both Cash and the Bonds Payable
Premium on Bonds Payable. The balance in Prem ium on
account.
Bonds Payable is added to the Bonds Payable account to
30 J un. Bonds Payable 200000 yield the bond's carrying amount. The calculation of Amber's
2025 carrying amount after issue is shown as follows:
Cash 200000
1 J a n. 2019
(To record repayment of the bonds)
Bonds payable $50000
Assets liabilities + Equity
Plus: Premium on bonds payable 600
-200000 -200000
Carrying amount
~1\Y 11q
Check out the animated summary As a result of this entry, Amber's assets and liabilit ies
• on Bonds Issued at a Discount increase by $50600.
I
_ 160
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Recording interest payments
Amber's bonds call for annual interest payments over the
life of the bonds. Each payment is calculated as follows:
Interest paid= face value x stated interest rate x time outstanding
= $50 000 x 0.08 x 12/12 months
= $4000
As in the discount example, Amber's interest payment
wi ll d iffer from its interest expense. Amber received
$50600 at issue but must repay only $50000 at maturity.
The $600 premium is a reduction in Amber's cost. Like the
discount example, the premium shou ld be amortised over
the life of the bond. As a result, at each interest payment
date, interest expense w ill be less than interest paid.
The following is the amortisation ca lculation using t he
straight-line method.
IOND DISCOUNT OR PREMIUM
AMORliiED EACH PAYMENT
(STRAIGHJ.UNE MDHOD)
Premiu m amortised = _ _..:..:...:..:======:._-
Premium at Issuance
Number of Interest Payments
W ith a $600 p remium and three annual interest
payments, Amber must amortise $200 ($600/3) each
payment. Therefore, interest expense for the year is $3800
($4000 interest paid- $200 premium amortised). This leads
to the following entry to record the first (and subsequent
two) interest payment on 31 December.
31 Dec. Interest Expense
Premium on Bonds Payable
Cash
(To record the payment of interest)
Assets liabilities
-4000 -200
The entry affects three accounts. First, Cash is
decreased for the $4000 payment. Second, the Premium
on Bonds Payable account is amortised or decreased by
$200, leaving a remaining balance of $400. Third, Interest
Expense is increased by $3800 to record the expense
associated with the interest paid and the prem ium
amortised. After the entry, the carrying amount of the
bonds would be reported as follows:
Issue 31 Dec. 2019
Bonds payable $50000 $50000
Plus: Premium on bonds payable 600 400
Carrying amount
The bonds' carrying amount is $200 less after the first
interest payment. The carrying amount w ill continue to
decrease by $200 each interest payment date as the
premium is amortised. After three payments, the premium
wi ll be fully amortised and the carrying amount of t he
bonds w ill equal the face value of $50000. The amortisation
schedule in Exh ibit 9.4 illustrates the change in the carrying
amount of the bonds over time.
Like t he amortisation schedule for bonds issued at a
d iscount, the first three columns in the schedu le provide
the amounts of cash to be paid, premium to be amortised
and interest expense to be recognised each year. Because
of the straight-line method of amortisation, the amounts
are the same each year. Thus, Amber would make the same
interest entry every year until the bonds mature.
The schedule also illustrates that the tota l cost of
borrowing is comprised of interest paid an d t he original
premium. Total interest expense over the life of the bonds
is $11400, wh ich is t he amount of interest paid ($12000)
3800 m inus the original premium ($600). When bonds are issued
200 at a premium, total interest paid will always exceed interest
4000 expense by t he amount of the prem ium. An alternative
calculation of the total cost of borrowing is as follows:
+ Equity Interest payments (S50000 x 8%) $ 4000
-3800 x Number of payments x3
=Total interest paid 12000
-Premium 600
Total cost of borrowing $11400

Interest payment Interest paid Premium Interest expense Unamortised Carrying amount
amortised premium
0 $600 $50600
1 $ 4000 S200
+·
s 3800 400 50400
2 4000 200 3800 200 50200
+·
3 4000 200 3800 0 50000
+
$12000 S600 $11400
~ Amortosatoon schedule - bonds ossued at a premoum

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9
liabilities
161 __
..:.::.,:
 Recording the maturity months after the last interest payment date, the bond would
be amortised for those three months to update the carrying
Amber must repay $50000 on 31 December 2021 to
amount. Interest payable for the three months would also
satisfy its obligation. The entry to repay the bonds requires
be recorded and wou ld be paid in addition to the call price.
a decrease to both Cash and Bonds Payable:
The second step is to calculate any gain or loss on
31 Dec. Bonds Payable 50000 retirement by comparing the carrying amount to the call
2021 price. When the carrying amount exceeds the call price,
Cash 50000 the company is paying less than the value of the liability. In
(To record repayment of the bonds) that case, the company records a gain on the redemption.
In contrast, when the ca ll price exceeds the carrying
Assets liabilities + Equity amount, the company is paying more than the va lue of the
-50000 -50000 liability. In that case, the company records a loss on the
redemption . This is summarised as follows:
~1\Y 11q
Check out die animated sunvnary
• · GAIN OR LOSS
• on Bonds Issued at a Premium
ON REDEMPnON

Gain on Redemption = Carrying Amount> Call Price

REDEEMING A BOND Loss on Redemption = Call Price> Carrying Amount

BEFORE MATURITY
Sometimes a bond is redeemed or retired before maturity.
This can occur when the bond has a feature that allows the
borrowing company to ·call' or retire the bonds at a certain
price. The call price is usually stated as a percentage of face
value. For example, a call price of 105 means that the bonds
can be retired by paying the creditor 105 per cent of the
face value of the bonds.
Bonds are retired early for various reasons. A company
may simply want to reduce future interest expense o r take
advantage of falling interest rates by replacing existing
bonds w ith less costly (lower interest rate) bonds. Whatever
the reason, the accounting for the early reti rement of a
bond consists of the following three steps:
1 Update the carrying amount of the bond.
2 Calcu late gain or loss on the retirement.
3 Record the retirement.
To illustrate, suppose that Wollongong Waterworks
issues a $20 m illion eight-year bond on 1 January 2020 to
fund the conversion of a pump station to an arts centre.
The bond has a stated interest rate of 5 per cent and is
callable at 103 any t ime after 2024. The bond pays interest
on 31 December each year. The bond sells for $19.2 million,
or an $800000 discount. A condensed amortisation
schedu le is presented in Exhibit 9.5.
Now suppose that Wollongong decides to retire the
bond a year early on 31 December 2026. The bond's call
price of 103 means that Wollongong can retire the bond by
paying the bondholder 103 per cent of face value, or $20.6
million ($20 million x 103% ). According to the amortisation
schedu le, the 31 December 2026 carrying amount of the
bond is $19.9 m illion (after the interest payment).Therefore,
the gain or loss on redemption is calculated as follows
(figures in thousands):

The first step is to update the carrying amount of the Call price $20600
bond. Often this means that the bond must be amortised Less: Canying amount on 31 Dec. 2026 19900
for a partial period. For example, if a bond is retired three Loss on redemption

Interest Interest paid Discount Interest expense Unamortised d iscount Carrying amount
payment amortised
$800 $19200

100 2100 100 19900

31/12/27 2000 1000 2100 0 20000
rn:J Condensed amortisation schedule (in thousands of$)· bon d issued at a discount

_
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1 62
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 Wollongong would record the redemption with t he
following journal entry (figures in t housands):

31 Dec. Bonds Payable 20000

2026
Loss on Redemption 700
Discount on Bonds 100
Payable
Cash 20600
(To record redemption of the bond)
Assets Liabil ities + Equity
-20600 -20000 -700
+1 00

This entry f irst decreases t he Bonds Payable account

by its face value of $20 m illion. Because Wollongong no
longer has the bond, it also decreases t he remain ing
$100000 balance in the Discount on Bonds Payable. The
entry then reduces Cash for t he amount paid to retire the
bond an d records a $700 000 Loss on Redemption to
reflect t he loss on reti ring the bond. This loss account is
reported on the statement of income as an expense. The
overall effect of the entry is to decrease assets, liabilit ies
and equity.

a ADDITIONAL LIABILITIES
The next two sections examine two additional types of
CLASS ACTION AGAINST
CLASS ACTION LAW FIRM liabi lities that are common to many organ isations: lease
liabilities and contingent liabilities.

LEASE LIABILITIES
W hen companies acquire non-cu rrent assets. they have a
few ways to pay for them. One opt ion is to pay w ith cash
on hand. Another option is to issue bonds o r additional
equity (shares) to raise the necessary capital. A third option.
w hich is t he focus of this section of the text . is to use lease
f inancing.
A lease is a contractual agreement lease
in w hich the lessee obtains the right to A contraciiJal agreement
in whicll the lessee
use an asset by making period ic
obtains the right to use
paymen ts to t he lessor. One o f the an asset by making
major advantages of lease financing is periodic payments to the
lessor.
its flexibili ty. Terms of usage, t ime limits
an d payments are a f ew of t he many aspects of lease
contracts that can vary. As a resu lt, one lease ca n look
ve ry d ifferent f rom another. However, according to t he
accou nting standard AASB 16 Leases, alt hough there

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9
liabilities __
..;.;;;.;;.
163
 are t wo main types of lease: operating leases and
fi nance leases, the Standard introduces a single lessee
accounting model and requ1res a lessee to recognise
assets and liabilities for all leases w ith a term of more
than 12 months, unless the underlying asset is of low
value. A lessee is required to recognise the right to use
the underly ing leased asset and a lease li ability
representing the obligations to m ake lease payments.2
Operatmg leases were popular w ith compan ies
because they were a form of off-
off-balance-sheet
balance-sheet financing, which occurs
financing
Occt.rs when a COOlpany's when a company's future obligat ions
lutUJe oiJiogations regard1ng an asset are not reported as a
regarding an asset are
not reported as a liab11ity
liability on the balance sheet. A common
on the balance sheet. example was a non-cancellable operating
lease. Although such lease obligations
were not reported on the balance sheet, the old Accounting
Standard {AASB 117), did requ ires future lease commitments
to be disclosed in the notes to the financial statem ents.
CSL in Note 13 reports Operating Lease commitments in
2017 of $668.1 million, but only $25.4 million in Finance
Lease commitments.
In contrast to operat ing leases, a
finance lease f i nance l ease is a contract in whidl
Acon!Iact in which the the lessee obtains enough rights t o
lessee obtains enough
rights to use and control an use and control an asset such that the
asset such that the lessee
lessee is m substance the owner of
is in substance the owner of
the asset. the asset - they obtain the risks and
rewa rds of ownership. Because of this
effective ownership, accounting rules require that the
leased asset and the lease obligatio n (liabilit ies) be
recorded by the lessee and reported on the balance sheet.
The asset IS deprec1<1ted and the lease payments include
interest expense and the repayment of the loan. This is
why sudl contracts are called fmance leases - because
the asset has been fi nanc ed by way of a lease rather than
by reducing cash, other borrow1 ngs or issuing shares. The
actual entries associated with a finance lease and t he
criteria for determining whether a cont ract is a finance
lease will be left to more advanced accounting courses.
Circumstances
1m Pot ent1 al llabll1ty
ACCD Fon~l 2019 CensJa1le L.umtng. AU RtghU R--..cl. May not be copied. scanned.
164
_....;.;;.;.
CONTINGENT LIABILITIES
A contingent liability is an obligation that contingent liability
arises from an existing condit1on but the An oiJIIQatJon that
anses from an I!Xlsting
outcome is unoertain and the resolution
cond1bon ..rose outoome
depends on a possible future event as IS li1Certalll and wOOse
resolution depends on a
evidenced in Exhibit 9.6. A good exafTl)le
full.re event
of a contingent liability is legal action aga1nst
a business (e.g. a media company be1ng sued for defamation),
which is an uncertain condttion, whose resolutiOn depends
on future events (e.g. a jury verdiCt).
The Accounting Standard. AASB 137 Provisions.
Contingent Liabilities and Contingent Assets; ensures:
that appropnate recogn1t1on cntena and measurement
bases are applied to prOVISIOns, contingent hab1bt1es
and cont1ngent assets and that suff1ctent 1nforma110n
is disclosed in the notes to enable users to understand
their nature, llm1ng and amount. 2
Additionally:
'contingent' is used for liabilities and assets that
are not recognised because their ex1stence w 1ll be
confirmed only by the occurrence or non-occurrence
of one or more uncertain future events not wholly
w ithin the control of the en tity. In addition, the term
'contingent liability' is used for liab1hties that do not
meet the recogmtion criteria.
The Standard d1stingu1shes between .
(a) provisions - wh1ch are recogn1sed as habd1t1es
(assuming that a reliable estimate can be made)
because they are present obligations and 11 IS
probable that an outflow of resources embody1ng
economiC benefrts Will be reqwed to settle the
obligations; and
(b) contingent liabd1ties - wh1ch are not recogn1sed as
llabilit1es because they are e1ther
fll poss1ble obligat1ons. as 11 has yet to be
confirmed whether the ent1ty has a present
obligation that could lead to an outflow of
resources embodying economiC benefrts; or
(iii present obligat1ons that do not meet the
recogmllon cntena 1n th1s Standard (because
e1ther 11 1s not probable that an outflow of
resources embodymg econom1c benefrts
w1ll be reqUired to settle the obl1gat1on, or a
suffic1ently reliable est1mate of the amount of
the o bligat1on cannot be made) 3
Treatment
0< ~iealed In - 0< In part. WCN 02· 20C>-202
 ~
Provisions are recognised as a liability, although there is
no certainty as to when they will be paid or the amount They EVALUATING A COMPANY'S
should be recorded and reported on the balance sheet 'ii1 MANAGEM ENT O F
because they are present obligations that can reasonably be LIABILITIES
estimated and it IS probable an outflow of resources will be
required to settle the obligation. A warranty meets these As a company operates its bus1ness. it will generate
two conditions. Most retailers and manufacturers will have liabilities.The generation of habihtles IS usually the easy part
defective products that customers return, and most can of a business, it is the repayment of those liabilities that
reasonably estimate the1r future warranty claims by takes substantial work and can create s1gmf1cant problems.
reviewing hiStorical cla1ms. As a result. most companies The following sections exam1ne the liabilities of a
include warranty obligatiOns among their liabilities. These business we will call Aussie Beach Christmas (ABC) to see
kinds of liabiliues are often referred to as estimated liabilities. how well it can meet 1ts obligations. The examination will
In Note 16 CSL reports that employee benefits of $135.9 require information from the company's balance sheet. The
million in 2017 is the major provision. required information is found in Exhibit 9. 7, excerpted from
While probable liabilitieS are recorded as provisions ABC's 2019 Annual Report .
under current or non-<:urrent liabilities in the balance sheet,
those that have only a remote probability of occurring can Source Accounts 2019 2018
be ignored. In between probable and remote is an area (figures in (figures in
thousands) thousands)
called possible. Possible liabilities are disclosed in the notes
as contingent liabilities. Contingent liabilities also include Current Assets $1808 $1683
probable liabilities that cannot be measured with sufficient Balance Total Assets 2964 .... 2806
..,_,,_,,_,,_,_,
··~·_,_,_

reliability. Contingent liabilities are not recorded and sheet Current Liabil ities 1365 1226
reported in the balance sheet because their existence will Total liabilities 1889 1782
be confirmed only by the occurrence or non-occurrence of
fiiiiiiiil Account balances from Auss•e Beach Chnstmas'
one or more uncertain future events not wholly within the l....!2J 2019 Annual Repon
control of the entity.
Obviously objectivity or professional judgement is
needed to separate what is probable, possible and remote HORIZONTAL AND VERTICAL ANALYSES
and to determ1ne if a reliable est1mate can be made. An easy and useful place to start an examination of liabilities
This objectivity could allow management to move the is with horizontal and vert1cal analyses. Recall from Chapter
boundaries between these categories which would result 2 that horizontal analys1s calculates the dollar change in an
in more or less liabilities be1ng reported on the balance account balance, defined as the current-year balance mmus
sheet. 01sclos1ng somethmg m the notes brings it to the the priOF·year balance, and diVIdes that change by the prior-
attention of Investors, but it does not result in a change to year balance to yield the percentage change. Vertical
a company's liabilities. analysis divides each account balance by a base account,
yielding a percentage. The base account IS total assets for
balance sheet accounts and net sales or total revenues for
income statement accounts. These calculations are
summarised as follows:

HORIZONTAL ANALYSIS

Dollar Change in Current Year Balance-

Account Balance PriorYear Balance

Percentage Chang e in Dollar Change

Account Balance Prior Year Balance

VlllmCAl ANALYSIS

Balance sheet Income Statement

~l\1 ,,q Account Balance or Account Balance
a\ Review lhis content Percentage = Total Assets Net Sales or Revenue
V!/f# with 1he e-lectwe
I
Copyright 2018 Cengoge L.amJnv. AU R lghts R~ May no< be copMd scanned. or dUI'lieaod, In wholo or In part. ~ ~ER 9 Uabifoties 165_ _
.;..;..o,
 Given ABC's financia l information in Exhibit 9.7. 2018 ratio was almost exactly the same ($1683/ $1226 =
horizonta l and vertica l analyses of liabilities result in the 1.37). When interpreting the current ratio, it is a good idea
following: to gauge whether a company can turn its current assets
into cash. For example. a company that cannot se ll its
l:!.!if%.!.11tli!.F!Nli1 I inventory cannot generate cash to pay its obligations. This
Change Percentage Change could be a risk for ABC. Over $1.6 million (figure not
Total liabilities 1889- 1782 = 107 107 11782= 6 0% previously given) of its $1.8 million of current assets is
inventory. One way to gauge the impact of inventory is to
2019 2018 calculate the inventory turnover ratio.
Recall from Chapter 7 that the inventory turnover ratio
Total liabilities 1889 I 2964 = 637% 1782 /2 806 = 63.5%
is calculated as f ollows: Cost of Goods Sold I Average
The calcu lations show a fa irly stable position w ith Inventory. ABC's inventory turnover ratio is 1.7. meaning
regard to liabilities. Horizontal analysis shows a 6.0 per cent that the company sel ls its average level of inventory 1. 7
increase in liabilities. However. vertical analysis shows that times during the year. If this is similar to industry standards.
total liabilities as a percentage of total assets was virtually then it would appear that ABC shou ld not have a problem
unchanged over the two years. In both years. almost two- turn ing its inventory into cash and paying off its current
thirds of every dollar of assets was generated through liabilities.
debt. So, although liabilities are increasing, they are doing
so at the same rate as assets. DEBT TO ASSETS RATIO
Solvency refers to a company's ability to
CURRENT RATIO solvency
continue in business in the long term by A company's ability to
Liquidity refers to a company's ability to satisfying its total liabilities or obligations. continue in business in the
liquidity long term by satisfying its
A company's ability to pay pay off its current liabilities or obligations While predicting whether a company will liabilities.
its curr811t liabilities in
in the near future. Many parties are survive in the long term is very difficult, debt to assets ratio
the near future.
interested in a company's liquidity. For we can get an idea of a company's Compares a company's
current ratio total liabilities to its total
Compares a company's example, a loan officer wou ld be prospects by calculating the debt to assets and measures its
curr811t assets to its ability to pay its liabilities
interested in whether a company could assets rati o. which compares a
curr811t liabilities and in the long term.
measures its ability to pay monthly interest. A supplier would company's total liabilities to its t otal
pay current liabilities. want to know if it cou ld expect prompt assets. It is calcu lated as follows:
payment. Employees are concerned with
their employer's ability to satisfy payroll. One way to • · · · : DEIT TO AISEII RAno
measure a company's liquidity is to calculate the current
ratio. Debt to Assets Ratio = T~al ~~bil ities
The current ratio compares a company's current ota ssets
assets to its current liabilities as follows:
This ratio takes all the obligations a company reports
and divides by all of the assets the company report s,
• CURRENT RAnO
yielding the percentage of assets that are provided by debt.
Thus, the ratio is a good indicator of a
Cu rrent Assets capital structure
Current Ratio= Current Liabilities company's capital structure - the mix The mix of debt and equity
of debt and equity that a company uses to that a company uses to
generate its assets.
generate its assets. Since debt must be
By comparing what a company expects to turn into
repaid, a company that uses more debt has a riskier capital
cash within a year to what it expects to pay within the year.
structure and therefore a greater risk of being unable to
th is ratio suggests how well a company can pay its short-
meet its obligations.
term liabilities. A higher current ratio indicates a greater
ABC's 2019 debt to assets ratio is calculated as follows:
ability to satisfy current liabilities.
ABC's 2019 current ratio is calculated as follows: ~=0.637
$1808 = 1 32 The 0.637 ratio shows that in 2019. 63.7 per cent of
$1365 .
ABC's asset s were generated th rough debt . Whether a
The 1.32 ratio shows that in 2019. ABC had $1.32 in ratio of 0.637. 0.437 or 0.837 is good or bad for a company
current assets for every dollar of current liabilities. That is. depends on many factors. Some companies willingly
ABC had more than enough current assets to satisfy its expose themselves to liabilities and the risk that comes
obligations coming due in the following year. The company's with them in order to provide a greater chance of significant

_ 1 66
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profits. Others purposely reduce their risk by limit ing t he
use of debt. Neither strategy is right o r w rong - t hey are
just different. This issue w ill be d iscussed in more detail in
Chapter 12. At this point, you shou ld simply recognise that
ABC appears to have more risk o f insolvency than a
competitor w ho has a 0.437 ratio and less risk than one
w ith 0.837!
As you consider t he debt to assets ratios, you may
recognise t he numbers f rom earlier in the chapter. They are
the same as t hose generated in t he vertical analysis of total
liabilities. In fact, the debt to assets ratio is equivalent to a
vertical analysis of total liabilities. Both the debt to assets
ratio and vertica l analysis divide total liabilities by tota l
assets and are interpret ed t he same. So, when you conduct
a vertical analysis, you already have t he debt to assets ratio.
CS[ ANALYSIS
Current Liabilities ($1618.1
• •I :
: .
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3 Debt to assets ratio
$4340.8 I $9122.7 = 64.9%
You will note the 64.9 per cent debt to assets ratio is the
same as the vertical analysis above. This could be
expressed as a debt to equity ratio of 1.9 to 1. Is this a
reasonable capital structure or (as investment guru Ben
Graham used to say) should the company own more than
it owes? So, this may be regarded as medium risk, but
should CSL be using more of other people's money?
Obviously the directors think so or they would issue more
shares or buy back fewer shares (covered in Chapter 11)
and borrow less or repay more. Share price increases over
the period show shareholders appear happy with the
share price going from $27 in 2011 to $140 in 2017.
~ APPENDIX: DETERMINING A
Viii# BOND'S ISSUE PRICE
Calculating the issue price of a bond requires t he conversion
o f a bond 's future cas h flows into today's dollars. A
conventional interest-paying bond has two types of future
cas h f lows: t he one-time principa l payment made at
maturity and the periodic interest payments made each
year. The bond's issue price w ill always be the present
value of those future cash flows discounted back at the
current market rate of interest.
To illustrate, suppose that t he market rate of interest is
8 per cent w hen the Bergomi Company issues a $100000
four-year bon d tha t pays interest annually at a rate of
10 pe r cent. The future cas h flows of this bond are
represented g raph ically in Exhibit 9.8.
The $100000 principal payment is a single payment
made at the end of year four. Therefore, it is discounted
back fou r periods at an 8 per cent rate using t he appropriate
factorfound in Appendix A. ExhibitA4 on page 260: present
value of $1 . The factor for fou r periods (n = 4) and a rate of
8 per cent (r = 8 %) is 0. 7350. Therefore, the present va lue
of t he $100000 payment in four years is $73 500 ($100000
X 0.7350).
The $10000 interest payments are made at the end of
each of t he next four years. Therefore, they constitute an
annuity that is discounted back fou r periods at an 8 per cent
rate using the appropriate factor found in Appendix A:
present value of an ordinary annuity. A n an nuity is a stream
of the same dollar amount at set interva ls for a number of
periods. The factor fo r four periods (n = 4) and a rate of 8
per cent (r = 8 %) is 3.3121. Therefore, the present value of
t he four $10000 annual payments is $33 121 ($10000 x
3.3121 ).
9
liabilities __
..;.;;.;.
167
 rn:l BergomoCompany futu re cash flows

~ Calcu lations of bond issue pnces

Add ing these two present va lues together yields percentage of the bond's carrying amount. Under th is
$106621: so, the bond sells for a premium. This calculation, method, interest expense is calcu lated by multiplying the
along w ith similar calculations for 10 per cent and 12 per bond's carrying amount by the market rate of interest at
cent market rates are shown in Exhi bit 9.9. issue by the time outstanding.
Note that the prices calcu lated confirm that bonds are
issued for a premium when the stated interest rate exceeds • · · · · INTEREST EXPENSE (EFFECnVE
the market rate. face value when the two rates are equal. INTEREST METHOD)
~1\Y TIJ., and a discount when the Interest Expense = Carrying Amount x Market Rate
Download die Enrichment market interest rate exceeds o f Interest at Issue xTime Outstand ing
• Modules for further practice the stated rate.

Once interest expense is known, the amount of

discount or premium amortised is the difference between
APPENDIX: EFFECTIVE interest expense and interest paid.
INTEREST METHOD OF
• o DISCOUNT OR PREMIUM
AMORTISATION AMORnSED EACH PAYMENT
( EFFECnYE INTEREST METHOD)
When a bond is issued at a discount or premium, the
Discount Amou nt Amortised = Interest
discount or premium must be amortised over the life of the Expense - Interest Paid
bond. The following sections demonstrate
Premium Amount Amortised = Interest Paid- Interest
effective interest the effective interest method of Expense
metho d of
am ortisat ion amortisation.
Method that amortises the The effective interest met hod of
bood discount or premium To illustrat e. we use examples with the f ictiona l
so that interest expense a m ortisat io n amortises the bond organ isation Bergomi, starting first w ith the discount
each period is a constant discount or premium so that interest
percentage of the bond's example.
canying amount.
expense each period is a constant

_ 1 68
_.;.;;;.;;.
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DISCOUNT EXAMPLE Because the Discount on Bonds Payable account is
reduced by this entry, the carrying amount of the bonds
For the Bergomi bonds, the market rate of interest was 12
will increase. As a result, the amount of interest expense
per cent and the $100000 bond was issued for $93923,
for the second interest payment will increase as well. In
resulting in a discount of $6077. The issue would be
fact, interest expense will continue to increase each
recorded with t he entry below:
period as t he bond 's carrying amount increases toward
1 Jan. Cash 93923 the face va lue of $ 100 000. To illustrate this fact, a full
amortisation schedule for t his bond is shown in Exhib it
Discount on Bonds Payable 6077
9.10 (with the numbers rounded for p rese ntation
Bonds Payable 100000 purposes).
(To record bonds issued at a discount) Note that, like the straight-line method of amortisation,
Assets Liabi lities + Equity the effective method amortises the bond discount to zero,
resulting in an ending carrying amount equal to the face
+93923 +100000
value. But, unlike the straight-line method, interest expense
-£077 and the amount amortised under the effective interest
method are different each period. Aga in, this is because
At the end of the first year, interest expense, interest
the effective interest method makes sure that interest
paid and the amount of the discount amortised would be
expense is a constant percentage (12%) of the current
calcu lated as follows. Note that 'time outstanding' is
carrying amount.
om itted from the calcu lations because inte rest is paid
annually:
PREMIUM EXAMPLE
Interest Carrying $93923 X $11 271 The market rate of interest was 8 per cent and the $100000
expense Amount x 12%
Market Rate bond was issued for $ 106621 , resulting in a premium of
Interest paid Face Value x $100000 X $10000 $6621. The issue would be recorded w ith the following
Stated Rate 10% entry:
Discount Interest $11271- s 1271 1 Jan. Cash 106621
amortised Expense- $10000
Interest Paid
Premium on Bonds Payable 6621
With these values, Bergomi would record the following Bonds Payable 100000
entry on the first interest payment date:
(To record bonds issued at a premium)
Payment 1 Interest Expense 11271
Assets liabilities + Equity
Discount on Bonds Payable 1271
+106621 +100000
Cash 10000
(To record the payment of interest) +6621
Assets Liabilities + Equity
-10000 +1271 -11271

Interest Interest Discount Interest expense Unamortised Carrying amount

payment paid amortised discount

$6 077 s93 923

$10000 $1271 $11 271 4806 95194
2 10000 1423 11423 3383 96617
3 10000 1594 11594 1789 98211
4 0 100000

~ Amortosatoon schedu le of bond doscount usong effectove onterest method

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In whole or In part. WCN Ot~g~
9
liabilities __
.;.;;.;.
169
 At the end of the first year, interest expense, interest Because the carrying amount of the bonds decreases
paid and the amount of the discount amortised would be as a result of this entry, the amount of interest expense for
calculated as follows: the second interest payment will also decrease. Interest
expense will continue to decrease each period as the
Interest paid Face Value x $100000 X $10000
bond's carrying amount decreases towards the face value
Stated Rate 10%
of $100000. To illustrate, a full amortisation schedule for
Interest Carrying Amount $106621 X s 8530 t his bond is shown in Exhi bit 9.11 (wit h the numbers
expense x Market Rate 8%
Premium Interest Paid- $10000- s 1470 rounded for presentation purposes).
amortised Interest Expense $8530 Note t hat like the straight-line method of amortisation,
the effective method amortises the bond premium to zero,
W ith t hese values, Bergomi would record the following resu lting in an ending carrying amount equa l to the face
entry on the first interest payment date: va lue. But, unlike the straight-line method, interest
expense and the amount amortised are different each
Payment 1 Interest Expense 8530 period under the effective method. Again, this is because
the effective inte rest method makes sure that interest
Premium on Bonds Payable 1470
expense is a constant percentage (8%) of the current
Cash 10000 carrying amount.
~'\J ,,,
(To record the first bond payment) Test your understanding with the •
online revision quizzes for this chapter
Assets Liabi lities + Equity

-10000 -1470 -8530

Interest Interest Discount Interest Unamortised Carrying

payment pa id amortised expense discount amount
$6621 $106621

_ ,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_..,_,,_,,_,,_,,_,,_,,_..,_,,_,,_,,_,,_,,_,_,_,_,,_,,_,,_,,_,
_,,_,,_,_,,_,,_,,_,_,,_,,_,,
$10000
__,,_,,_,_,,_,,_,,_,_,,_,,_,, $1470
.._,,_,,_,,_,,_,,_,,_,._,,_,,_,,_,, $8530
__,,_,._,_,,_,,_,,_,,_,_,_,,_, 5151 105151
2 10000 1588 8412
_,,_,,_,_,,_,,_,,_,_,,_,,_,,__,,_,,_,_,,_,,_,,_,_,,_,,_,,..,._,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,__,,_,,_,_,,_,,_,,_,,_,_,_,,_, .. 3563 103563
,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_.,.,_,,_,,_,,_,,_,_,,_,_,_,_,,_,,_,,_,

3
_ ,,_,,_,_,,_,,_,,_,_,_,,_,,__
10000 1715
,,_,_,_,,_,,_,,_,_,,_,,_,..__,,_,,_,,_,,_,,_,_,,_,,_,,_,,_,,__
82B5 .. 1848 101848
,,_,,_,_,,_,,_,,_, ,_,_,_,,_, ,_..,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,__,_,,_,,_,,_,,_,,_,,_,_,_,_,,_,,_,,_.

4 10000 1848 8152 0 100000

_,,_,_,_,_,,_,_,_,_,,_,,_.,,_,_,_,,:::::::::=;:::.,,_,_,M_,,_,,_,,_,,_,= .,_,,_,,_,,_. ,,_,_,_,::::-::::::;:-=,_,_,,_, ..,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,__,_,,_,,_,_,_,_,_,_,_,_,,_,,_,,_,

~ Amortisation schedule of bond prem1um usmg eflect1 ve interest method

Express for ACCT3 F

•
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1 70
_....;.;;.;;,

1 Current liabilities
Stu Software Store has total receipts for the day of $7326.
Thts total includes 10 per cent GST on all sales.
REQU IRED
Calculate GST payable and prepare the JOUrnal entry to
record the sales. (Hint: although you add 10 per cent to the
priCe to calculate the GST payable. for pnces that include
GST you diVIde the total price by 11.)
2 Current liabilities
The followtng list represents liabilities on the 30 June
balance sheet of Martin Motors:
i money owed to employees for work performed in
the last two weeks in June
ii money owed to a supplier for goods purchased
based on the terms net 30
iii money owed to the government, based on the
annual incorne of the bus111ess
iv money owed to the bank on a note due 1n July
v money owed to the ATO for GST collected.
REQUIRED
Identify the liab1lity account that would hkely be used to
report each item.
3 Current liabilities
On 1 March Powani Power People borrows $900000 on a
six-month, 6 per cent note from Darwin Bank. Assume
Interest is pa1d at the maturity of the note.
REQU IRED
a Prepare the JOurnal entry to record the rece1pt of cash
from the note.
b Prepare the JOurnal entry to record the accrual of Interest
1f Powam prepares finanCial statements on 30 June.
c Prepare the journal entry to record the repayment of the
note at maturity.
4 Current liabilities
The employees of Pinehurst Company earned wages of
$80000 during the month of June. The following were
w1thhold1ngs related to these salanes: $5000 for health
msurance. $3000 for voluntary superannuation contnbut1ons
by the employees and $9000 for mcome tax.
REQU IRED
a Prepare the journal entry to record the payment of these
salanes assummg they are pa1d on 30 June.
b Prepare the journal entry to record Pinehurst Company's
additional payroll tax expense for June of $9800.
Copyrlghl 2019 Cengage l earning. All Righi I R...rved. May not be c opied. scan nod, or duplicated. In whole or In part. WCN O~mfg~ l iabilities
5 Recording and reporting notes payable
On 1 July 2019. Wllhams Company borrows $100000 from
the bank by s1gmng a $100000, 8 per cent. two-year note
payable. Annual Interest IS pa1d on 30 June. W111iams has a
31 December fmanc1al year-end.
REQU IRED
a Prepare the journal entries to record the issue of the
note on 1 July 2019.
b Prepare the journal entry for the accrued interest at
31 December 2019.
c Prepare the journal entry for payment of interest on
30 June 2020. assuming a reversing entry was not made
on 1 January 2020.
d How would Williams report the note payable on 1ts
31 December 2019 and 2020 balance sheets?
6 Recording bonds and interest
Gazal Gallenes ISSued $500 000 of 10-year bonds on 1
January 2019. The bonds pay 8 per cent interest semi-
annually on 1 July and 1 January. The market rate of Interest
on the date of issue was 8 per cent.
REQUIRED
a Prepare all JOurnal entries necessary in 2019 assuming a
30 June end of fmancial year.
b How would the ISSue pnce change if the market rate
was lower than 8 per cent? Higher than 8 per cent?
c What Will be recorded m 2019 in the financ1ng sectiOn of
the statement of cash flows?
7 Recording bonds at a premium
and a discount
On 1 January 2020, Tran Ltd issues $3 million. five-year.
10 per cent bonds with mterest payable on 1 July and 1
January. Tran prepares financials on 31 December and
amortises any discount or premium using the straight-line
method.
REQU IRED
Prepare the JOU(nal entnes on 1 January, 1 July and 31 December
2020 assumng the bonds vvere ISSued at (a) 96 and (b) 103.
8 Bond amortisation
On 1 July 2019. 'XYZ Company issues $4 mllhon, frve-year,
8 per cent bonds w1th Interest payable on 30 June and 31
December. Thompson amortises any discount or premtum
using the stratght-hne method.
REQUIRED
Prepare a bond amortisation schedule assuming the bonds
were issued at (a) 101 and (b) 97. Why is it necessary (or at
least destrable) to amort1se the discount or prem1um rather
than stmply account for 1t at the beginning or end of the
bond?
9 17_1_ _
 9 Bond redemption 12 Evaluate liabilities
After mak1ng a semi-annual 1nterest payment, the carrying The following financ1al data were reported by Wang W1reless
amount of ABC Company's bonds was as follows: for two recent years ($ 1n thousands) :

Bonds payable $1500000

Less. Oiscooot on bonds payable 80000
Carrying amount _ _ __,S1420000
Current assets $2290 $ 669
REQU IRED
Current liabilities 2257 2172
a Calculate the ga1n or loss on redemption, assum1ng ABC
redeems the bonds at 101. Total liabilities 9801 9854
b Prepare the JOUrnal entry to record the redemption. Total assets 5131 6200
c Can a company redeem the bonds 1t 1ssues at any 11me?
Explam. REQUIRED
d Why m1ght a company want to redeem its bonds before Conduct honzontal and vert1cal analyses of Wang's
matunty7 accounts and calculate the current and debt to assets ratios
for each year. How would the most recent ratiOS change if
Wang dec1ded to pay off $1 m1llion of current liabilities w1th
10 Leases
cash?
Yang needs a new piece of equipment for her factory.
Instead of purchasing the asset, the business chooses to 13 Appendix: calculate bond issue price
enter into a twelve-month operating lease with monthly
payments of $5000. The market rate of interest was 7 per cent when Greene
Corporation issued a $100000 five-year bond that pays
REQUIRED interest annually at a rate of 10 per cent. Present value of
a Prepare the journal entry to record the f1rst lease the principal is $71 300. The present value of the interest
payment. payments is $37 908.
b What are the fmanc1al reportmg advantages of an REQU IRED
operating lease over a fmance lease?
Calculate the amount of prem1um or d1scount at the bme of 1ssue.
c Why m1ght Yang have chosen to lease the eqUipment
1nstead of buying 1tl
14 Appendix: bond interest and
amortisation
11 Contingent liabilities
On 1 July 2019, Tallakson Company 1ssues a $50000, five-
Tanner Toys had sales of $2 500000 dunng the 201~20 year, 8 per cent bond w1th Interest payable annually on
financ1al year. In 2018-19. 5 per cent of sales were returned 30 June. The marketmterest rate at 1ssue IS 10 per cent.
for a refund because of defects, but Tanner believes that Tallakson uses the effective Interest method of
recent product changes w 1ll reduce sales returns (warranty) amort1sat1on.
expense to about 3 per cent of 201~20 sales.
REQUIRED
REQU IRED
a Determ1ne the 1ssue pnce of the bond by usmg the
a What amount IS Tanner expecting to refund customers appropnate table(s) m AppendiX A.
for purchases made 1n 201~207
b Prepare the entry for the f1rstmterest payment on
b Should th1s amount be reported as a liability on the 30 June 2020.
f1nanc1al statements 7 Why or why not?
c Prepare an amortisation schedule for the bond.
c Is Tanner us1ng a reasonable means to estimate warranty
expense?
d If Tanner was being sued because one of its toys are
alleged to have mjured several children, what would be
the financial reporting implications?

__
.-..:;;
172
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 REQUIRED
a Prepare the JOurnal entry to record the payment of bond
mterest on 1 July 2021.
b Prepare the JOUrnal entry to amortise the bond d1scovnt
and pay the Interest on 1 January 2022.
c Prepare the journal entry to record the redemption of the
bonds on 1 January 2022, after the interest has been
paid .
d Prepare the adJUSting JOurnal entry for 30 June 2022,
15 Recording and reporting current assuming that the bonds were not redeemed.
liabilities
The following is a list of liability accounts on the ledger of 17 Bond issue, interest, redemption
Chew House on 1 January: and reporting
Gateway Unhm1ted sold $2 million of six-year, 10 per cent
GST Paya,;_;b.,..
le_ _ _ _ _ _ _ _ __ $ 7500 bonds on 1 January 2019. The bonds pay interest semi-
Accounts Payable 9500 annually on 1 July and 1 January. The bonds sold at 97. The
stra1ght-lme method IS used to amortise any bond prem1um
Unearned Service Revenue 16500
or d1scount.
The follow1ng transactions occurred during the month of REQUIRED
January: a Prepare all JOUrnal entries related to the bonds for 2019
1 Janua ry Borrowed $25000 from Perth Bank on a six- and 2020 and show how the bonds would be reported
month, 6 per cent note. on the 3 1 December balance sheet.
9 Provided service for customers who had paid b How would the 2019 statement of cash flows be
$6000 in advance (including GSn. affected by the bonds?
15 Paid ATO for GST collected m December, c Prepare a bond amortisation schedule.
$7500. d On 1 July 2023, after the Interest payment, Gateway
18 Bought inventory on cred1t for $12000 plus redeems the bonds for 101. Prepare the entry to record
GST. the redemptiOn.
23 Sold goods on cred1t for $3000, plus 10 per
e How 11110uld the 2023 statement of cash fl01111s be
cent GST. affected by the redemption?
The employees of Chew House earned gross salanes of
$45000 dunng January. W ithhold1ngs were $4000 for
18 Analysing liabilities
mcome tax and $1900 for voluntary superannuatiOn
contributions. In addition state payroll tax was $2500. Explorer Limited's board of d1rectors is having Its annual
Salaries earned in January will be paid during February. meeting to analyse the performance of the firm. One area
the board is focusing on is total liabilities. The following are
REQUIRED selected items of the 30 June 2020 balance sheet:
a Prepare journal entries for the January transactions.
b Prepare adJuSting entries at 31 January for the salaries 30June 2020 30 June 2019
expense, payroll tax expense and notes payable. Total assets $935870 $902225
c Create the current liability sectiOn of the balance sheet
Totalliabihues 575430 562855
at 31 January.
Total eqUity 360440 339370
16 Bo nd presentation, interest and REQUIRED
redemption Conduct honzontal and vertical analyses of total hab1hties
The follow1ng is an excerpt taken from the 30 June 2021 and mterpret the results. Expla1n whether or not Explorer
balance sheet of the Wimbledon Company: should be pleased w 1th 1ts financial position based on these
calculatiOns.
Current liabilities
~------
Bond interest pay'-a.,..
bl_ e_ _ _ _ _ _ __ $ 64000 19 Appendix: comparing amortisation methods
Non-current liabilities On 1 January 2019, LED issues bonds with a face value of
Bonds payable_ _-----------~
_ __ _ _ _ _ _ _ _1.,..
so:-::-
o.,..ooo
:-::-_ $300000. These bonds have a stated interest rate of 4 per
Less 01scount on bonds payable (300001 cent and Interest IS pa1d annually on 31 December. The
Carrying amount 1570000 bonds mature in four years. The market 1nterest rate at the
date the bonds are 1ssued 1S 5 per cent.
The bonds have a stated interest rate of 8 per cent and
mature on 1 July 2026. Interest IS pa1d semt-annually on 1
July and 1 January. The bonds are callable at 105 on any
semi-annual interest date.

Copyright 2019 Cengage l earning. All Right& R...rved. May not be copied. scan nod, or duplicated. In whole or In part. WCN O~mfg~ liabilities _ __
9 173
 REQUIRED
a Determ1ne the amount of discount on the bonds at
ISSUe.
b How much of the d1scount wdl be amomsed m the f~rst
year under (It the straight-line method and (li) the
effective Interest method?
c Does Interest expense each year d1ffer under the
stra1ght-line and effective interest methods of
amortisation 7
d Does total interest expense over the life of the bonds
d1ffer under the straight-line and effective interest
methods of amortisation?
20 Research and analysis
Access the latest annual report for a company of your
lecturer"s choos1ng or the latest CSL annual report.
REQU IRED
a Exam1ne the company's balance sheet and conduct
honzontal and vert1cal analyses of all liability account
balances, 1nclud1ng total liabilities.
b Examme the flnancmg activities sect1on of the
company's cash flow statement. Over the past two
years, d1d the company borrow or repay debt more 7
c Calculate the company's current ratio and debt to assets
ratios for the most recent and the previous financial year.
d Examine the company's non-current liability note. What
type of debt was eliminated during the current financial
year? Did the company use cash to retire? Was any of
the rema1nder retired?
e Based on your answers above, write a paragraph
expla1nmg your opm1on of the company's llab11ity
pos1t1on. Use your answers as supporting facts.
ACCTJ Fin~Jilflght 2019 Cengag<o l earnlng. All Rights R...rvod. May not be coplod. scanned, or duplicated, In whole or In part. WCN 02·200-202
174
_.....;.;~
21 Written communication
lara Lawn and Le1sure manufactures and sells all types of
yard equ1pment. The company was recently sued by a
plamt1ff who cla1med that a defect1ve lawnmovver caused a
senous 1n1ury. The company was made aware of th1s at the
end of 1ts f1scal year, but 11 IS not sure how to report 1t 1n 11s
financial statements.
REQUIRED
Write a brief memo explaining the possible treatments of
this lawsuit for financial reporting purposes. Also, provide
some ideas on how to estimate the potentialliab11ity if the
company believes that liability is probable.
22 SMS Communication
In 144 characters or less expla•n the difference, 1f any,
between debt and ltablltttes.
23 Ethics in accounting
You are the accountant for a med1um-size manufacturer. Your
company has some existing debt that requires the company
to mainta1n a current ratio of 1.50 or higher. If the ratio drops
below that value. the lender can increase the interest rate
from 6 to 9 per cent. Recently, the company's current ratio
has been hovering around 1.50, and the CEO believes that
when some long-term debt maturing in the followmg year is
reported as current, the rat10 will fall below 1.50. The CEO
asks you to keep the long-term debt as a non-current liability
instead of reclass1fy1ng 11 as a current liability. 1\fter all', he
says, '•t is still reported as a hablhty'.
REQUIRED
a Is there an eth1cal1ssue w1th the CEO's request? How
should you respond 7
b Research 'Centro liabilities' or :A.BC Learning liabilities' or
1\llco Finance Group liabilities' and discuss if the
classification of liabilities is more than an ethical issue.
 This chapter examines the accounting for partnerships.
From an accounting perspective, partnerships are more
complex than sole traders because we need to track the
contributions by each partner, distributions to each partner
and capital remaining of each partner. Because a
partnership ends if a partner leaves and a new partnership
is formed with the remaining partners or with the addition
of a new partner, the accounting is critical in both all ocating
benefits to each partner and keeping the records associated
with these benefits. Unlike companies, partnerships are
private business arrangements and usuall y do not have
publicly available financial statements.

PARTNERSHIP ACT 1891

TABLE OF PROVISIONS
Soctlon
Sbott thlc •• , • , , , , • •• • • . . . . • • . . • • . . • . . .. •• , ••• , , •... , .
After studying the material in this chapter, you
Commc.nct-mtJ'It of Ac1 •• • • .. • • .. .. • • • • • , .. • • . • • • • • • .. • .. , ..
should be able to: hUCrJ~neWiooclclbiK " ' ' ' ' "' ''' ···· ·••••••••••• ... "
Nt~~~~n•flH""'«J/Y
Describe the characteristics of the Dchldoo ., •.,..,_,,.. .. .. .. .. .. .. .. • .. . . .............. .
$
partnership form of business. 6
Account for a partner commencing a
partnership.
_.,,..... .......,....,_, ....
,_,_._.. ol np.oi~ lr:alch&« M:W.C •COM~ of

·~,_,...~,.,..nf •,.,...,u ..........

..
Calculate the allocation of profits and losses
to the partners. 10
or,.,-
,_....,....,._
Pow•
..ee_.,
._ ................ .
•t.M
............... .
Parua •"' cndat olhlor pri~ PJtPC*S. . . . . . . • . • . • • • • • • •••
II etrm of 11iCM1U M h wiD DO( be boatld by ec:u ol putnu . • • •••••• ,
Record the admission and withdrawal of 12 u ...lky or~""""' .. .. . .. .. .. .. .. .. . .. .. .. .. . .. . .. .. .. ..
partners. I) Uabilhy of 1M Arm f« WfOCIII. • • •• • • • • • • • • • •• • • • • • • • • • • •••••••
I< Mi.Mppllcadon ol money or property reeeh'ed for or in o.as.•ody or lho 1\rm
Explain the liquidation of a partnership. Ll.abUhy for wronaajoint 111d several .. . . . . .. •.•••.•••••••••••••• 10
ll
lmproptt emplo,rnen1 or m~n Pf1)9e"Y fOt ptru)trship f'lrpos.u • • • , . 10
Prepare the financial statements for a 16
17 10
partnership. AGniJI.oM and Rprac:IKMiooS of patU'I(O ••••• , , , , , •
II , ,, , , II
19 N4cicuo ad.lna plr1ftCt 10 be: noctcc. ro tbc b • . • .. . • .. • • • • • • • II
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21 . . _ . , . . . . ,_ _ ..,..._,..,_ .... ............ II
.,._, .,,_,.~n".,.. ..-,.,
:12 v.w-..,._ol_ol_.aoip, . .. 12

LOl THE PARTNERSHIP FORM

apply this - .....··-
Copyrlght2019 Cengage Loa nlng A R ght llnervecl May not be c
OF BUSINESS
Chapter 2 introduced the three major forms of business:
the sole proprietorship (sole trader). the partnership and
the corporatiOn (company). The following sections describe
some of the characteristics of the partnership form of
business that diStinguish it from sole proprietorshipS and
companies. The English Partnership Act 1890 defined a
partnership as 'the relation which subsists between
persons carrying on a business in common w ith a view of
profit'. In the 1890s, most state governments in Australia
ed. scanned, or dupllcotod, In whole or In part. WCN 02·200-202
1 75
 enacted similar legis lation. The characteristics of a
partnership are as follows:
• ease of formation
e partnership agreement
e mutual agency and co-ownership of property
• unlimited liability of owners (partners)
• transferability of ownershtp
• no partnershtp taxatton
e capital account (and somettmes also current accounts)
for each partner.
~·\'l11q
Check out the video summary
for Chapeer 10
•
EASE OF FORMATION
Partnerships require no formal agreement and no registration
with a government agency. Partnerships are attractive
because they combine the financial and human resources of
two to 20 individuals. often gaining synergistic benefits.
Partnerships often have only two partners; but in some
professional groups, like large accounting firms. several
hundred partners are permitted (limit is 1000). You cannot be
forced to join a partnership, nor can you be forced to accept
a new partner in the partnership. A business partnership is
somewhat like a marriage, requiring cooperation and mutual
respect to work successfully. You do not need a partnership
agreement, but without one the provisions in the relevant
partnership Act wtll determine any dtsputes. A partnership is
not a separate legal or taxable entity. A partnership does not
Owtn assets tn rts name; they are JOtntly owned by the partners.
PARTNERSHIP AGREEMENT
Although a partnershtp does not reqwe a formal agreement.
it is highly advisable to have one. While a business is
prospering, partners are friends and partners' memories of
the arrangements entered tnto are similar, there may be no
disputes. But when partners fall out and are no longer of
one mind, memories differ and the sharing of risks and
rewards often can no longer be agreed on. In these cases
the provisions of the relevant partnership Act usually take
precedence. One of those provisions - equal sharing of
profits and losses -can become contentious. This w ill often
be the case where substantially d ifferent amounts of
capital have been contributed and vastly different amounts
ACCD Fon~l 2019 CensJa9e L.umlng. AU RlghU R--..cl. May no< be copied. scanned.
176
_....;.;;.;;,
of personal effort put into the partnership. Not surprisingly,
when disputes arise each partner sees their contribution
as being critical to the success of the partnership business
or the other partners' decisions as leadtng to financial
failure. The court will be left to dectde if a partnership exists.
and how business success or failure wtll be returned to or
burdened upon each partner.
MUTUAL AGENCY AND CO-OWNERSHIP OF
PROPERTY
An advantage and disadvantage of a partnershtp tS mutual
agency. Any partner can contract on behalf of the partnership.
The advantage is partnershtps do not need to have every
partner sign a contract; the disadvantage is any partner can
bind the partnership in an agreement which could reasonably
be believed to be partnership business. So, a partner in an
accounting partnership could buy an office building on behalf
of the partnership- each partner then becomes responsible
for the repayments and each partner becomes a co-owner of
the building. But when buying their own home, a partner does
not share the liability and asset ownership with the other
partners. Assets contributed to a partnership become the joint
assets of each partner. There can be legal disputes about
whether both debt and assets are personal or partnership.
Not surprisingly, when debts are large and difficult to repay,
the claim by individual partners is that the debts are shared,
and when assets have substanttally increased in value, the
claim is that the assets are the individual's.
UNLIMITED LIABILITY OF OWNERS
Under a sole proprietorshtp and a partnership, owners are
personally liable for the actions and obligattons of their
businesses. As a sole trader. accepttng personal hability for
your own actions is understood. However, tn a partnership,
personal liability for the partnershtp debts tS sometimes
overlooked, especially when tt is the result of the actions
of one partner and that partner may not have been acting
as mutually agreed. Further. if other partners cannot pay
their share of the debt, one partner may end up losing their
home and all their other personal assets.
Because of unlimited li ability in partnerships,
professionals, such as auditors. who may conduct their
business without the benefit of the limited liability afforded
by a company, will usually place their personal assets in a
0< ~iealed I n - 0< In part. WCN 02·20C>-202
trust to protect them from the actions of creditors and
other partners. It is not unknown for an auditor in one city
to be sued for negligence and the damages to be paid by
other partners from the same partnership who conduct
business in a different city. Apart from ensuring personal
assets are not legally available to pay partnership debts,
two other mechanisms are available to protect partners of
professional partnerships. First, professional indemnity
insurance is avai lable to pay in cases of professiona l
negligence: second, liability capping sdlemes are now in
place in all states in Australia, protecting professionals from
large damages claims. Limited partnerships only limit the
liability of a non-managing (sleeping) partner and are not a
vehicle for limiting the liability of partners in business.
TRANSFERABILITY OF OWNERSHIP
A major disadvantage of a partnership is the need to have
all partners agree on any partner leaving a partnership,
selling their place in the partnership to a new partner and
the admittance of any new partner to expand the
partnership. In large professional partnerships much
attention is given to partners leaving. If terms and
payments are too harsh, it can be difficult to attract new
partners who cou ld feel trapped into working with people
they may discover do not share the ir business values.
Independent va luations of the partners' share of net
assets can avoid undesirable situations; for example, a
partner who wishes to leave being forced to accept a
small fraction of what their share is worth, or a partner
who the rest of the partnership wants to leave being able
to extract substantially more than their fair share.
accounting for contributions, advances, profit (or loss
sharing) and drawings. The purdlase and recording of assets,
borrowings and repayments, the earning of revenue and
incurring of expenses are accounted for in the same way for
all business entities. For a sole proprietor there is no need
to keep separate records of who contributed capital,
expertise, clients, etc. because the benefit of all contributions
goes to the single owner. Equally it is not important to have
a record of why distributions were made because all
withdrawals go to the single owner. For companies one main
account is kept for all shareholders. Detailed records are kept
for ownership and dividends to every shareholder, but these
are not part of the main accounting system and the only
thing that distinguishes one shareholder from another is the
number of shares they hold. For a partnership, detailed
accounting records need to be kept for eadl partner. To
facilitate this, accountants maintain a Capital account for
eadl partner. Accountants may also have a Current (or
Retained Earnings) account for each partner to deal with the
day-to-day transactions between a partner and the
partnership. Further, a Drawings account may also be used
for eadl partner in the same way drawings were used for a
sole trader in Chapter 3 (and an Advance account if money
is borrowed from the partnership by one of the partners).
The reason for using several equity accounts for each partner
is to reflect the transactions between the partnership and
each partner as transparently as possible. Remember,
accounting is an information system.

NO PARTNERSHIP TAXATION
No taxation sounds wonderful, but this does not mean
partnership inoome is tax free. While companies pay income
tax and, as we will discover in the next dlapter, shareholders
are taxed on dividends received (although they may get the
benefit of franking credits), partnerships are not taxable
entities. Partnership tax returns are prepared as a convenient
way to present the earnings of the partnership and show the
distribution of taxable inoome to each partner. All partnership
income must be fully distributed to the partners; unlike in a
trust, there is not the option to retain income in the partnership.
Each partner then adds partnership income to all their other
taxable inoome. For taxation purposes, in many circumstances i.l!!i COMMENCING A
a partner who works in the business may be paid a salary ' - ' PARTNERSHIP
(wage) and have tax withheld like any other employee; for
accounting purposes, we treat all payments to partners (other One of the distinguishing characteristics of a partnership
than return of capital) as distributions of profits. is multiple owners/managers. Unlike shareholders in a
company who contribute cash and are not involved in
CAPITAL ACCOUNTS FOR EACH PARTNER busin ess operations beyond attending and voting at
Accounting is very similar for sole traders, partnerships and annual general meetings, partners may contribute assets
companies. The major difference for a partnership is in and liabilities and, as discussed above, are entitled to

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.;.;..;.
177
 partic ipate in the management of the bu siness. In large Let us add com plexity by imag ining Emma w as in
p rof essiona l part nersh ip s, many of th e day -to-day business as a sole proprietor with the balance sheet shown
m anag em e nt f unctio ns are delegat e d to a se nior in Exhib it 10.1 (borrow ed f rom the Aerial Filming example
m anagem ent tea m. Partners hips are often t he result of in Chapter 1).
co m bining two existing busi nesses w ith assets su ch as
accounts receivable; plant, property and equipm ent; and
possibly goodwill, as w e ll as liabilit ies like accou nts
payab le and bank loans . The value of t hese item s in t he
Cash $1940
books of the sole traders b efore the partne rs hip is
Accounts receivable (money customers owe) 1200
formed is irrelevant ; it is the value o f t hese it em s to the
partnership that is import ant . The new partne rs hip is Supplies 100
buyi ng t he asset s and assuming respons ibility fo r t he Drone 1950
liabi lities: w e therefore value each cont ribution at current Total assets $5190
m arket (agreed) v alue. Loan from bank $2000
Total liabi lities $2000
CAPITAL ACCOUNT FOR EACH PARTNER $1000
Contributed capital
The capital account for each partner Retained earnings 2190
capital account for
each partner Records records the fair m arket va lue of ne t
Total equity 3190
the current market value asset s con tr ib uted . The s im ples t
of net assets contributed.
investm ent woul d be cash, as it requires Total liabi lities and equity ~
no valuation. Imag ine Emma an d James ~ Balance sheet for Emma Aenal Film ing
each contribut ed $ 10000 cash. This entry is very s im ilar
to the f irst t ra nsaction w e recorded w hen w e deb ited
cash and c redit ed capit al in Chapter 3 . In this case w e The current m arket value of t he assets and liabilities is
c redit each partner's capital accou nt. th e s ame as the c arry ing am ount except acco unts
receivable, of w hich t hey on ly expect to collect $ 1000;
Cash 20000
Supplies, which are w orth $150, and the drone, w hich cost
Emma. Capital 10000 $2600, had accu mulated depreciation of $650 and has a
James. Capital 10000 current market value of $ 1900. W hen Emma combines her
(Emma and James invested cash in the partnership) aerial f ilm ing business w ith James' graphic design, w e
Assets Liabilities + Equity w ould record the fo llow ing jo urnal entry fo r Emma's
contribution:
+20000 +20000

Cash 1940
Accounts Receivable 1200
Drone 1900
Supplies 150
Allowance for Bad Debts 200
Note Payable 2000
Emma. Capital 2990
[To record Emma's investment in the partnership)
Assets Liabilities + Equity
+4 990 +2 000 +2 990

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178
_.....;.;;.;;.
 A few matters to note: Chapter 4) the balance in the Retained Earnings account is
• The drone was entered at the current market value- no $100000 and Geoff and Howard have agreed to share
accumulated deprectation was recorded because the profits equally.
partnership was 'buytng' the asset from Emma. and The final closing entry would be as follows:
with the purchase of any asset, the previous owner's
Retained Earnings HXHXXl
accumulated depreciatton is trrelevant. ---
• Accounts receivable are recorded at their full amount Geoff. Capital or Current !iO!XXJ
and an allovvance for bad debts IS established because Howard. Capital or Current !iO!XXJ
the partnership is unsure whiCh accounts will not be (To record profit allocatoon)
recetved. Assets liabiLtoes + Eqwty
• The ongtnal value of Emma's capital and retained
+100!XXJ
earnings is trrelevant because she is contributing net
assets which are recorded at their value to the new -IOO!XXJ
business.
The entry decreases Retained Earnings because
With James' contnbutton of assets and liabilities. the
allocations are the transferring of profrts to each partner.
partnership balance sheet will be prepared once the journal
thus increasing each partner's capital account. It is not
entries are posted to the ledger and a trial balance is
uncommon for each partner to also have a Current account
extracted. The statement is the result of the journal entries
where short-term changes in their owner's equity are
in the books of the partnership and not a combining of
transacted.
Emma's and James' previous balance sheets.
A partner may then withdraw cash (or other assets)
~,u rf/,
from the business. This entry is similar to a sole proprietor.
Review Ibis content
• with the •·lecture but a record needs to be kept of which partner has
w ithdrawn the cash. In this case let us imagine Geoff
withdraws $15000.
• ALLOCATE PROFITS The distribution of cash on the payment date would be
recorded as follows:
AND LOSSES
CashDrawings
30 Jun. Geoff. IS!XXJ _ _
_ ___::_ _ _ _ _ ____;_:..:.:;:.._
If there is no partnershtp agreement or the agreement is
silent on the sharing of profits and losses, then they will be ---- 15000
(To record w•thdrawal of cash by Geoffl
shared equally. Much care and attention is usually given in
Assets liabilities + Equny
a partnershtp agreement to the sharing of profits and
losses. To be persuaded to jotn a partnership, each partner
-----15000 -----~~
-15!XXJ
must believe they are betng fatrly revvarded for the different
contributions made. Equally, extsting partners are likely to We now have two (or three tf we also use a current
accept a new partner only if they believe the new partner account) partner's equity accounts for Geoff. At the end of
will add to the earning potenttal of the partnership and will the year each drawings account will be closed to the
not be overcompensated to the detriment of existing current account or retained earnings account. If the
partners. partnership does not use current or retained earnings
Factors commonly chosen to compensate partners and accounts for each partner. then drawings would be closed
base distributions on are capital contributed. partners' to the specific partner's capital account. This is the same
service and set percentages. In professional partnerships, as accounting for profits, drawings and retained earnings
payments will often be based on a partner's abilit y to of a sole trader except there are now accounts for each
generate profits and/or revenue for the partnership. partner, and some partnerships may use a current account
in addition to a capital account.
SHARING PROFITS BASED
ON A SET PERCENTAGE SHARING PROFITS BASED ON CAPITAL
BALANCES AND ON SERVICE
Regardless of the capital contributed and the partner's
human resources applied to the business, the relevant Often partners seek to be rewarded according to the
partnership Act applies in the absence of agreement on contributions made: capital, service, abtlity, talent, etc. This
profit and loss sharing and says they will be shared equally. becomes a mathematical exercise in following the
Imagine that on 30 June, after all adjusting and closing partnership agreement and allocating profits accordingly.
entries (to and from the Profit and Loss Summary account Imagine Geoff and Howard had contributed capital of
or Income Summary Account, as 10 Closing Entries in $300000 and $200000 respectively for a total of $500000.

c A R_...... May no< be copied. scanned. "' ell.!>' lealed

 They agree the f irst $100000 of profits are to be d istributed
on the basis of capital contributed. the next $180000 on
the basis of service (where Geoff is to receive $70 000 per
annum and Howard $ 110000) and any remaining profit or
loss shared equally. This year the pa rtnersh ip made a profit
of $250000.
these changes can have a major impact on the business.
but for large professional partnerships, sudl dlanges are
regular and the business continues much as before. There
are several ways of admitting a new partner and a current
partner withdrawing. In each case it requires the consent
of the other partners. From the perspective of ease in
account ing, let's look at the simplest case first.

Geoff Howard Total PURCHASING A CURRENT

Total profit 250000 PARTNER'S INTEREST
First $100 000 share based When purchasing an existing partner's interest. the new
on capital contributed
partner pays the former partner directly. The amount paid
Geoff (300 000 I 500 000) x 60000 is a private arrangement and has no effect on the dollar
$100000
amounts in the partne rship accounts. The partnership
Howard (200 000 I 500 000) x 40000
records the dlange in partners by debiting t he o ld partner's
$100000
Capital (and Current) account an d c redit ing the new
(100000)
partner's Capital (and Current) account. Imagine on 3 1 July
Share based on service as agreed the o ld partne r sells their partnership share to the new
Geoff 70000 partner for $9.8 m illion dollars. At t he time the balance in
Howard 110000 the old partner's Capital account was $1000 (t here was no
(180000) Current account).
Balance remaining (30000) The journal entry wou ld be as follows:

Profit or loss to be shared 31 Jul. Old Partner. Capital 1000

equally
New Partner. Capital 1000
Geoff (15000)
(To record the sale of partnership interest)
Howard (15000)
Assets liabi lities + Equity
30000
-1000
Balance remaining 0
+1 000
Profits allocated to partners $115000 $135000 $250000

Note that the $9.8 million is not recorded; th is was a

The journal entry would be as follows:
private transaction between t he new and old partners and
30 J un. Retained Earnings 250000 had nothing to do w ith the partnership. The entry in the
Geoff. Capital 115000 books of the partnership simply records one partner leaving
and the new partner entering. The same journal ent ry
Howard, Capital 135000
would be made if the new partner paid the former partner
(To record profit allocation)
$200. Why would a new partner pay anything other t han
Assets liabilities + Equity $1000 when they are receiving capital of $1000? As seen
+250000 above in the sharing of profits. a partner is entitled to share
-250000 profits in a particular way and in this partnership the share
of profits may have no relation to the dollar amount of
capital. Imagine the partnership is expected to have
$3 million of profits in the next financial year and the t hree

~ ADMISSION AND partners share prof its equally. Although the capital balances

1iiiil WITHDRAWAL
OFA PARTNER
Admitting a new partner or the withdrawal of a current
partner dissolves the old partnership and a new partnersh ip
commences. For pa rtnersh ips w ith two o r three partners.
of each partner may only be $1000, each is entit led to a
$1 million profit allocation. Further. as we will d iscover later,
if t he partnership is liquidated. each partner w ill receive a
share of the excess assets. and th is partnership may own
assets worth tens of millions of dollars.

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1 80
_.....;.;;;.;;.
 INVESTING IN THE PARTNERSHIP
A new partner may invest in the partnership, thus expanding
the size of the partnership and adding to the resources of
the partnership. This is relatively straightforward when the
amount of resources contributed is equal to the capital of
the new partner. Imagine a partnersh ip with three existing
partners w ith equal shares. Each partner has a capital
account with a credit ba lance of $100 000 (but for
simplification we w ill ignore the thousands). Imagine the
new partner contributes $100 cash on 31 August for an
equa l share in the partnersh ip.
The journa l entry would be as follows:

31 Aug . Cash 100

New Partner, Capital 100
(To record the admission of a new partner)
Assets liabilities + Equity
+100 +100

In the o ld partnersh ip, each partner had a one-th ird

share and a capital balance of $100. In the new (expanded)
partnersh ip each partner has a one-quarter share and a
capital balance of $100. This does not mean profits and
losses will be shared equally; that will depend on the terms
in the new partnership agreement.

INVESTING IN THE PARTNERSHIP:

BONUS TO NEW PARTNER
To attract a new partner, the current partnership may be
w illing to allow the new partner a greater amount of capital
than the new partner contributes. This could be the case
when a f inancial planning partnership accepts a high-profile
business journalist who m ight be expected to attract many
more clients to the f irm . When a new partner pays less
than the capital received, this is known as
bonus to the new
a bonus to the new partner. partner When a new
Imagine the current partnersh ip's partner pays less than tile
capital received.
simplified balance sheet is as below:

Assets Liabilities
Cash $500 Loans $700
Other assets $400
Partners' equity
Sharma. Capital $100
Wang. Capital S100
Total assets $900 Total liabiliti es and equity $900

Sharma and Wang share profits and losses: 60 per cent

to Sharma and 40 per cent to Wang. On 30 September they
decide to adm it Haddad with a 33.33 per cent interest in
the partnership upon the payment by Haddad of $70.

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..;.;;..;.
18 1
 Before Haddad is admitted according to the profit and loss sharing arrangement,
the cap1tal in the partnership is $200 ($100 + $100) unless agreed otherwise:
-- -
After Haddad IS admitted Bonus to existing partners $40
the cap1talm the partnership is $270 ($100 + $100 + $70)
60% to Sharma 24
Haddad receives a one-third share $90 (S270!3)
40%toWang 16
Bonus to Haddad as new partner $20 ($90 - $70)
The journal entry would be as follows:
The bonus to Haddad comes from the existing partners
who share the decrease 1n the1r capital according to the 30 Sep. Cash 160
profit and loss sharing arrangem ent, unless agreed Sharma. Capital 24
otherwise:
Wang. Cap1tal 16
Bonus to Haddad S20 Haddad. Cap1tal 120
60% from Sharma 12 (To record the admission of a new partner w1th bonus
40% from Wang to old partners)
8
Assets Liabilities + Equ1ty
The new Capital balances would be Sharma $88, Wang ------------ +160 +120
$92 and Haddad $90, total $270.The profit and loss sharing
+24
would depend on the new partnership agreement.
+16
The journal entry would be as follows:

30 Sep. Cash The new balance sheet would appear as below.

70
Sharma. Cap1tal 12 Asset s Uabllltles
Wang, Capi tal 8 Cash $660 Loans $700
Haddad. Cap1tal 90 Other assets $400
Partners' equity
(To record the admiss1on of a new partner with bonus
to new partner) Sharma. Cap1tal $124
------
Assets Uab1ilt1es + Equity
Wang, Ca_p1tal $116
Haddad. Cap1tal $120
+70 Total assets $1060 Total liabilili8$ and equity $1060
-20
Just to check, did Haddad end up w ith 33.33 per cent
of the capital?
INVESTING IN THE PARTNERSHIP:
BONUS TO EXISTING PARTNERS Total capital $360 ($124 + $116 + $120)
One third share $120 ($360/3)
Often the advantage in JOining a successful partnership
outweighs th e cap1tal the new partner is w illing to And that is Haddad's Capital balance 1n the balance
accept. In these cases th e new partner is w illing to sheet above.
contribute more - th is is known as
bonus to the bonus to the existi ng (ol d) WITHDRAWAL OF A PARTNER
existing (old) partners. Assume the original balance
partners \1\>TMma new Partners leave for many reasons: retirement, moving, other
partner pays moll! than sheet above where Sharma and Wang
the capital received. had $100 of capital each. Now imagine business opportunities, disagreements, etc. When a partner
Haddad is w illing to contribute $160 to leaves. the old partnership is dissolved and a new one is
receive a 33.33 per cent share in the partnership. created. From an accounting perspective the simplest
situation is the old partner selling their interest to a new
Before Haddad is admitted partner. This is the same as illustrated above where the new
the capital in the partnership is _ __ $200 ($1 00 + $1 00) partner buys the old partner's share in the partnership. The
After Haddad is admitted amount paid is not relevant to the accounting of the
the capital in the partnership is $360 ($100 + $100 + $160)
----~---~ partnership; we simply debit the old partner's capital account
Haddad receives a one-third share $1 20 (360/3) (with the credit balance amount immediately before leaving)
----~~~~~
Bonus to existing partners $40 ($160- $120) and credit the new partner's capital account.
If a partner leaves with cash equal to the balance in their
The bonus to the existing partners comes from the new
capital account. the accounting IS also simple. We debit the
partner and it is shared as an increase in their capital
old partner's capital account and credit cash.

ACCT3 Fw>~f lgllt 2018 Cengoge l.aml119- AU Rights R~ May no< be copMd. scanned. or dUI>licaod,ln wholo or In pan. WCN 02·200-202
1 82
_......;.;;;;
 Complexity arises when the partner who is leaving The journal entry would be as follows:
takes more (or less) cash than their cap1tal balance. This
30 Nov. BuildingS 110
could be accounted for by adjusting the capital balances of ~~---------------
Goodwill IDl
the rema1ning partners as we have done above. Assume
the cap1tal balances for Sharma, Wang and Haddad are as
----- --------------------- ---
Equlpm..;,
e_ nt_ _ __ _ _ _ __ 10
before: $124, $116 and $120 respectively. Now imagine the Sharma. Cap1tal 300
partners share profits and losses equally.The partners agree Wang, Ca:.:p~it_
al_ __ _ _ _ __ 300
to Wang leaving on 3 1 October with $200 cash. Wang's
Haddad, Capital 300
capital account has only a $116 balance. Th e extra $84 -'------ - - - - -
(To record revaluation of assets and profit on
would need to come from the remaining partner capital revaluauon to partners equally)
accounts. shared equally as per their agreement. ---- -Assets Equ1ty
Liabilities t
The journal entry would be as follows:
- 10 +300
30 Oct . Wang, Capital 116 t910 +300
Sharma. Capital 42 +300
Haddad, Capital 42
Cash 200 The new balance sheet would appear as below:

(To record the withdrawal of a partner with bon~ Assets Uabilities

Assets LiabilitieS + Equity Cash $ 660 Loans $ 700
- 200 -116 Eguipment ($150 - $10) $ 140
Bui ldings ($250t $110) $ 360 Partners' equity
-42
Goodwill (newly $ BOO Sharma. Capital $ 424
-42 recognised) (S124 + $300}
Wang, Capital $ 4t 6
(S116 t $300)
REVALUATION OF ASSETS BEFORE
Haddad. Cap1tal $ 420
WITHDRAWAL OF A PARTNER ($120 + S300)
Partners may take assets other than cash when they leave. Total assets $1960 Total liabilities $1960
and equity
The partnership agreement w ill often specify the revaluation
(or valuation) of assets before a partner leaves. Some assets, Such a revaluation IS often necessary when personal
such as the clients of the business. often simply called relationships end and assets need to be divided up. In
goodwill, may not be recorded among the assets of the many cases arbitration is needed to determine how the
business. Consider the above example (before Wang assets are divided and in some cases t he court may be
withdrew). Imagine this business was a property required to decide. This is also the case in some business
management business. They do not own the property, but partnerships if there is no written partnership agreement.
find tenants and collect rent on behalf of the landlord. In a dispute as to how the agreement should be interpreted or
business such as this, the clients (known as the 'rent roll') such changed circumstances that one partner believes
are the main asset of the business. The business may be parts of the agreement should not apply.
valued at current market value of other assets plus I'M> times
the annual gross revenue from commiSSIOn on rent collected. WITHDRAWAL OF A PARTNER
Listed in the partnership ba lance sheet before AT CARRYING AMOUNT
revaluation is cash $660 and other assets $400 (being
Imagine the partners agreeing to Sharma leavmg on
equipment- carrying amount $150, and build1ngs- carrying
30 November and taking $124 in cash and part of the rent
amount $250). An independent valuation places the
roll (Goodwill} valued at $300 to set up his own business.
following value on the partnership assets at 29 November:
The journa l entry would be as follows:
Cash $660
30 Nov. Sharma, Capital 424
Equipment (reduced Sl 0) 140 ~--------
Cash 124
Bu1lding (increased SilO) 360
Goodw1ll 300
Goodwill (value of me 'rent roll' newly recogmsed) 800 ------ - - - -
(To recool the willldrawal of partner Sharma}
The partnership agreement states profns and losses Assets Liabilities + EqUity
are shared equally. In total there has been an increase in ~~ -4~
asset value by $900 (-10 + 110 + $800).
-300
---------------- -
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183
~--
 WITHDRAWAL OF A PARTNER AT MORE THAN
THE CARRYING AMOUNT
Instead tmagine the partners agreeing to Sharma leavmg
a LIQUIDATION
Partnerships dtssolve and are reformed each time a partner
on 30 November and taking $199 in cash and part of the leaves or joins the partnership. But in most cases the
rent roll (Goodwill) valued at $300. This is known as a business continues much as it had
bonus to the bonus to t h e w ithdrawing p artner before.The liquidation o f a partnership liquidation of a
withdrawing because the departing partner takes is different; it involves the closing down partnership The closrng
partner When the down ol a bus1ness that
departtng partner takes more than their capital balance ($500 - of the business. and partners may take involves partners taking any
more than thetr caprtal $425 = $75). Th is loss or shortfall assets other than cash. In an orderly remaining assets
balance. reduces the remaining partners' capital liquidation three basic things happen:
in proportion to their partnership non-cash assets are sold. liabilities are paid and the partners
agreement. which is usually according to thetr sharing receive their share of any cash remaining. This should
of profrts and loss. In this case let us imagtne that the reduce the balance tn all accounts to zero.
shanng ratto before Sharma leaves is 40 per cent
Sharma, 40 per cent Wang and 20 per cent Haddad. After SALE OF ASSETS
Sharma leaves the ratio is 4:2 (40%:20%) or more simply
Consider the partnership above after revaluation but before
2:1 (2/3:1/3).
any partners leave (w1th total assets of $1960).
The journal entry would be as follows:
Imagine the partners decide to liquidate the partnership
30 Nov. Sharma. Capital 424 at the end of December. Further imagine all non-cash
---
Wang, Capi tal (2/3 x S751 assets (equipment. property and goodwill) are sold on
50
27 December for $1500. which is $200 above the carrying
--- Haddad. Capital (1/3 x $751
Cash
25
199
amount. The profit on sale is shared among the partners in
proportion to thetr profit and loss sharing ratio. In this
Goodwill 300
-------------
------ (To reoord !he withdrawal of partner Sharma) - example (and for the benefit of a different calculation) let
us imagine it is: Sharma 10 per cent. Wang 20 per cent and
Assets liabilities + Equrty Haddad 70 per cent.
-----~
-499 -424 The journal entry would be as follows:
-50 27 Dec. Cash 1500
-25 Equipment 140
Build1ngs 360
WITHDRAWAL OF A PARTNER AT LESS THAN Goodwill 800
THE CARRYING AMOUNT Sharma. Capital (10% of $2001 20
Now imagine Sharma was willing to leave with only $350 Wang. Cap1tal (20% of S200) 40
in assets. The calculations and journal entry would be very Haddad. Cap1tal (70% of $2001 140
-
similar to the above, except in this case assets would be
(To record the sale of non-cash assets and profit on
credtted only $350. Sharma. Capital would still be debited sale)
$424 because Sharma is no longer a partner and has no Equity
Assets Liabilities +
capttaltn the partnership. The bonus would be credtted to
+1500 +20
the remaining partners' capital account. again tn accordance
with their agreement to share profits and losses (Wang -140 +40
credit $50. Haddad credit $25). This is known as a b onus -360 +140

bonus to the
t o the rem aining p artners because -800
remaining the withdraw ing partners take less than
partners When the their capital balance. Let's imagine a less happy outcome where the assets
wii!Oawrng partner
takes less !han therr could only be sold for $900, a loss of $400. In this case
cap tal balance Cash would be debited $900. Each of the assets would be
credited as before, but the $400 shortfall would be dtvtded
as a loss among the partners and debited to their caprtal
~\'I T~
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1 84
accounts: Sharma $40 (10 per cent of $400), Wang $80 (20 The journal entry would be as follows:
per cent of $400) and Haddad $280 (70 per cent of $400).
The balance sheet as at 28 December would show:
27 Dec. Cash 400
__:.:__ ___
Sharma. Capital (10% of $900) 90
Assets liabilities -----
Wang, Capo tal (20% of $900) 1BO
Cash ($660 + $900) s 1560 Loans $ 700
Haddad. Capo tal (70% of $900) 630
Equopment s 0
Build ngs s 0 Partners' equity Equipment 140
Goodwill $ 0 Sharma. Capotal s 384 Buildongs
($424 - $40)
Goodwill
Wang, Capotal s n;
($416 - SBOI (To ll!CUd 1he sale of 11011-QSh assets and loss on sale)
Haddad, Capotal
($420 - $280)
s 140 ____ Assets
;..:.:...:;.:;__ liabolotoes + Equoty
+400 -90
Total assets $1560 Total liabilities $1560
and equity - 140 -180
- 300 ~0
PAYING THE LIABILITIES --800
Legally this can be difficult because the partners may be
This leaves Haddad's capital account capital deficiency A
responsible for debts again st the partnership into the partners capotal account
with a negative (debit) balance, a capital
futu re. As with the finalising of an estate or the winding up with a negative (debit)
d eficie ncy. balance.
of a company, advertisements may need to be placed in
newspapers. For our example the accounting is easy, so Partners' equity
let's imagine on 29 December we repay t he loans. The Sharma, Capital ($424 - $90) $334
journal entry would be as follows:
Wang, Capital ($416 - $180) 236
29 Dec. Loans 700 Haddad, Capital ($420 - $630) (210)
Cash 700
If Haddad is willing to contribute $210 cash, the
(Repaod all loans)
accounting becomes easy. The debot to Cash and credit to
Assets Liab lotoes + Equity Haddad. Capital. increases cash and 'increases' Haddad's
- 700 - 700 capital from minus (debit) $210 to zero. When the loans are
repaid, the cash exactly equals the sum of Sharma and
The partnershop now has $860 cash which exactly Wang 's capital account balances. The partnership is
equals the oombtned total of the capotal accounts. liquidated by debiting the rematntng capital accounts and
crediting cash. All partnershop accounts have a zero balance.
PARTNERS RECEIVE REMAINING CASH But what happens of Haddad cannot cover the capital
We have now amved at a simple solution. With cash deficit? Over 110 years ago an English case known as
equalling capital, we debit each of the capital accounts with Garner v. Murray established the princople that capital
the amount shown as the balance in the above balance deficits are not shared accordong to profit and loss ratios
sheet and credit cash $860. All partnership accounts -
assets, liability and equity accounts- have a zero balance.
But what wou ld happen if the partnership was
liquidating because the business had recently appeared on
an investigative television program with a journalist and
camera operator chasing the three partne rs down the
street? The non-cash assets would be almost worthless.
Now imagine we sold these assets on 27 December for
$400, a loss on sale of $900. The loss will be shared in the
same proportion as before.

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 (un less spec ified in the pa rtnership agreement) but Original cash (before liquidation began) $660, plus sale
according to the capital balances prior to liquidation. of assets {in last example above) $400, less the repayment
Before the liquidation process commenced and the of the loan $700, gives a final cash balance $360. The f inal
assets were revalued, capital ba lances were: act is to repay the two remaining partners on 30 December.
The journal entry wou ld be as follows:
Partners' equity
Sharma, Capital $124 30Nov. Sharma, Capital 225.5
Wang. Capital 116 Wang, Capital 134.5
Haddad, Capital 120 Cash 360
(Pay remaining partners)
Therefore, if the partnership agreement is silent on
Assets Liabi lities + Equity
sharing 'capital' losses, the loss will be shared 124:116. The
$210 deficit is shared: Sharma $108.5 ($210 x 124/240) and
-360 -225.5
Wang $101.5 ($210 x 116/240). -134.5
The journal entry would be as follows:
This is of course the opposite of the very first journal
29 Dec. Sharma, Capital 108.5 entry; when a business was establ ished, we debited
Wang, Capital 101.5 Cash and credited Capital. Now to end the business with
Haddad, Capital 210 all accounts at zero balance we debit Capital and cred it

(To record the sharing of the capital deficit) Cash.

Assets liabilities + Equity

+210
-108.5
~ PARTNERSHIP FINANCIAL
. . , STATEMENTS
-101.5

Because a partne rship differs f rom a sole proprietor only

Capital balances before and after Haddad's deficit was
in the number of owners, it is with the multiple owners
allocated:
where the d ifferences in f inancial statements arise. As
Partners' equity Partners' equity we have already seen in th is chapter, the balance sheet
before deficit after deficit
allocated allocated shows a capital account for each partner. In the income
Sharma. Capital $334 Sharma. Capital $225.5 statement, the allocation of profits is shown at the
($424-$90) ($334- $1 085) bottom. The statement of changes in equity is the most
Wang, Capital $236 Wang, Capital $134.5 informative of partners' relationship to the partnership.
($416- $180) {$236- $101 5) We commence with the opening balance of each
Haddad, Capital ($210) Haddad. Capital 0
{$420- $630) {$21 0- $21 0) partne r's cap ital. A ny additiona l capital and profits
allocated are added and drawings are deducted to give
If the calculations are correct, after the loans {liabi lities) the closing balance. Complexity is increased when
are repaid, the cash should equal the combined capital partne rs join or leave, assets are reva lued, or the
balances. liquidation process commences.

4,\Y Ttq
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1 86
_.....;.;;;,;;,

1 Partnership form of business
How do each of the following characteristics relate to the
partnership form of business?
a not a separate legal entity
b unlimited liability of owners
c ability to raise capital
d limited life
e taxation
mutual agency
g co-ownership
h partner's individual equity account
partnership agreement.
2 Partnership taxation
Most pannerships prepare a pannership tax return. Explain
why a partnership tax return would be prepared when a
partnership is not a taxable entity. What information is likely
to be included in the tax return?
3 Account for partners' investment
Two sole traders, Amber and leo, decide to form a
partnership and contribute the following:
Amber
Cash $ 3000 $11000
Equipment (at cost) 42000
Accounts payable 13000
The market value of the equipment is $47 000 and $1000
respectively.
REQUIRED
Prepare the journal entries to record the investment by both
partners.
4 Recording partnership formation
Sarah and l ucy formed a partnership by combining their sole
trader businesses, contributing the following to the new
partnership (all figures in thousands). Sarah contributed cash
of $54 and land with a fair value of $390 that had cost $108.
The pannership also assumed Sarah's business overdraft of
$144. l ucy contributed cash of $120 and equipment that
cost $146, and she had accumulated depreciation of $70
with a fair value of $84. The pannership also assumed l ucy's
accounts receivable of $22 and the provision for bad debts
(which upon review is believed to be adequate) of $2 .
REQU IRED
Prepare the journal entries to record the investment by both
partners.
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5 Allocate profits
The XYZ partnership recorded a profit of $540 000.
REQUIRED
a If the three par1ners had nothing in their partnership
agreement on profit sharing, how would profits be
distributed?
b If the partners agreed on a $144000 salary allowance for
each partner and the remaining balance divided 3:2:1,
calculate the amount owed to each partner.
c Assume the same information as in (b) above except
profit before salary allowance was only $372000. What
would be the amount owed to each partner?
d Record the journal entries to allocate profits in (c) above.
6 Allocate profits and losses
Thien and Thu form a partnership. Thien contributes
$450000 andThu $300000. Thien spends up to 80 hours
per week working on growing the business and servicing
their clients. Thu drops into the office from time to time, but
spends most of his time studying. In a complex formula they
have agreed to share profits: first, $300000 allocated
according to capital contributed; second, the next $300 000
allocated 75 per cent to Thien and 25 per cent to Thu based
on their service to the partnership; and any remaining
amount to be allocated equally.
REQUIRED
a If the partnership profit before any allocation is $660000
how much will be allocated to each partner?
b If the partnership had a profit of $372 000 before any
allocation, how much would be allocated to each
partner?
Leo
c If the partnership had a loss of $420000 before any
allocation, how much would be allocated to each
1500 partner?
4000
7 Admission of a new partner
Peter and Paul are partners; they share profits and losses
equally. Their capital balances are $19 200 and $13 200
respectively. They admit Mary to a 25 per cent share of the
partnership.
REQUIRED
a Prepare the journal entry or entries if Mary pays $10800
to become a par1ner.
b Prepare the journal entry or entries if Mary pays $12800
to become a par1ner.
c Prepare the journal entry or entries if Mary pays $3800
to become a par1ner.
8 Withdrawal of a partner
Nguyen, Tran and Le are partners sharing profits and losses
equally and w ith capital balances of $225, $675 and $450
respectively. Tran decides to leave the pannership and go
into business on her own.
REQUIRED
a Prepare the journal entries to record the retirement of
Tran if she is allowed to take $675 in cash.
__
.;,;;.;.
187
 b Prepare the journal entries to record the retirement of
Tran 1f she IS allowed to take $375 1n cash.
c Prepare the JOurnal entries to record the retirement of
Tran 1f she IS allowed to take $825 1n cash.
9 Asset reva luation and withdrawa l
of partner
Nguyen, Tran and le are partners shanng profits and losses
equally and w1th capttal balances of $225, $675 and $450
respectively. Before Tran leaves the partnership the assets
are revalued. Equ1pment IS worth $12 less than the carry1ng
amount (book value), and property $147 more than the
carry1ng amount.
$3 000 000. Other assets are cash, $378 000; accounts
receivable. $858 000 and offtce equipment $1 200000 with
accumulated deprectatton of $210000. lt also has a loan
from the bank of $1455000 and accounts payable of
$330 000. Before Zh1j1e Yang enters the partnership an
independent valuation has all assets and habthttes at current
carrying amount except the apartment block that has a
current market value of $6336000. For a on&half share of
the new partnershtp Yang w tll put tn cash equal to the net
assets li has 1n the current bus1ness.
REQUIRED
Prepare the JOurnal entnes for the entry of both partners tnto
the partnership.

REQUIRED
12 Distribution of profits
a Prepare the journal entnes to record the revaluation of
property and equ1pment. lara and Matthew are partners. They share proftts 2/3 lara.
1/3 Matthew (all ftgures tn thousands)- capttalts ftxed at
b Prepare the journal entnes to record the revalua tion of
$540 and $360, respectively. Interest ts calculated on
property and equ1pment 1f the partnership agreement
partners' drawings, advances and capital at 6 per cent per
spec1fies proftts and losses are alloca ted on the basis of
annum.
the capttal balances.
The trial balance for the f1nanc1al year. after adjusttng and
c Prepare the journal entries to record the departure of
non-equity closing entries IS (all figures in thousands):
Tran (after revaluation and profits and losses are allocated
on the ba sis of capital balances as in lbl above) if she is
The Lara and Matthew Partnership
allowed to take $842.50 in cash (record to the nearest Trial balance
cent). as at 30 June 2020

10 Liquidation of a partnership
Accounts Receivable $ 306
The followtng IS the balance sheet for the Hildebrand
Inventory 504
Partnershtp (all ftgures tn mtllions):
Buildings 450
Assets U1bllltles
Accumulated Depreciation Build1ngs $ 54
Cash $ 98 Loans
$-
-- Short-Term Banlt Loan 64
Equipment 20
_!'ropeny $ 72 Partnel$' equity Acoounts Payable 144
Oi. Captta s 24 Profit and Loss Summary 422
Sue. Capttal s 16 Lara. Salary 216
Gazza. Captta s 10
Manhew. Salary 144
Total assets $ 190 Total liabilities and s 190
equity Lara. Current 36
Matthew. Current 108
The partners share proftts and losses equally. Non-cash
asse ts are sold for thetr carrying amount. Lara. Advance (long term} 180

REQUIRED lara. Capital 540

Prepare the journal entnes for the liqutda tion of the Matthew. Capital 360
Htldebrand Partnership. TOTAL $1 764 $1 764

lara withdrew $36 on 1 January 2020 and Ma tthew

11 Fonnation of a partnership
Man li has operated a successful student short-term
accommodation bustness. Currently she has a small
apartment block w tth a book value (carrying amount) of
withdrew $72 on 1 November 201 9 and $36 on 1 March
2020.
REQUIRED
a Prepare a schedule for the proftt distnbution for the
financial year (ignore the thousands).
b Prepare the current accounts for both partners at 30
June 2020.
c Prepare the balance sheet at 30 June 2020.

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_....;.;;.;;.
13 Admission of a partner
Chris is admitted to the Mary and Peter partnership. Before
her admission the partnership accounts show capital
balance of $170 000 and $85 000 for Mary and Peter,
respectively.
REQUIRED
Prepare the journal entries for the admission of Chris if:
a Chris pays $95000 directly to Peter for his share of the
partnership.
b Chris invests $85000 for a 25 per cent interest in the
new partnership.
c Chris invests $105000 for a 25 per cent interest in the
new partnership.
14 Withdrawal of a partner
Emily, Judy and Katt are partners. They share profits and
losses 5:3:2. Their equity balances are as follows:
Capital account Current account
Emily $270000 $ 81000
Judy 315000 108000
126000 36000
Katt
Before Emily leaves the partnership they have the assets
valued at current market value. Land and Buildings is
increased by $243 000 and Accounts Receivable decreased
by $63000. Emi ly is to receive $495000 when she leaves
the partnership.
REQUIRED
Prepare the journal entries for the revaluation of the assets
and the withdrawal of Emily from the partnership.
15 Liquidation of a partnership
Refer to the Hildebrand Partnership balance sheet in
Question 10 above. In the process of liquidation, the
partnership sells the non-cash assets for $150 million more
than the carrying amount. The partnership shares profits on
the basis of Capital account balances.
REQU IRED
Prepare the journal entries for the liquidation of the
Hildebrand Partnership.
16 Liquidation of a partnership with capital
deficiency
Refer to the Hildebrand Partnership balance sheet in
Question 10 above. In the process of liquidation, the
partnership sells the non-cash assets for $32 million only.
The partners share profits and losses equally, but the
partnership agreement has nothing on capital deficiency.
REQU IRED
Prepare the journal entries for the liquidation of the
Hildebrand Partnership if {a) Gazza contributes his deficit and
(b) Gazza contributes nothing.
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17 Partnership, comprehensive example
X, Y and Z form a criminal investigation partnership and call
the business 'Partners in Crime' {PIC). Eadh partner brings
different skills, experience and contacts to the business, but
each contributes $70000 cash. They agree to share profits in
two steps. FirstY w ill receive $70000 and Z w ill receive
$105000 since they do most of the investigations and this
reflects their respective abilities. The money paid to the
partners in this first step would be withdrawn monthly. Any
remaining profits w ill be shared 1:2:3 (X:Y:Z). The business
started on 1 July 2019. By 30 June 2020 the business had
made a loss (after the first-step distributions) of $56000 and
X decided to w ithdraw from the partnership on 1 July 2020.
This leftY and Z w ithout their 'inside contact' and it was
mutually agreed that X would take only $21 000 for her
equity interest.
REQUIRED
a Prepare the journal entries for the formation of the
partnership and the contribution of capital on 1 July 2019.
b Prepare the journal entries for the two stages of profit
and/or loss distribution.
c Prepare the journal entries for the withdrawal of X.
d Calculate the ending balance in Y and Z's capital
accounts.
e Prepare the balance sheet for the new Y and Z
partnership (i.e. after X has withdrawn).
18 Advising partners: formation
You are a first-year accounting student and also one of the
most recognised rowers in the world, having won gold in the
coxless pairs at the 2018 Commonwealth Games on the
Gold Coast in a time of 5:59.98, the first pairs to ever break
the six-minute barrier, smashing the world record by over
eight seconds. You have been approached by a highly
respected and experienced business advisory firm to join
their partnership. This will allow you to apply your business
knowledge, gain valuable work experience and potentially
earn excellent money. The partnership will only require a
modest investment of your money and time, but in
recognition of the contribution your name and face w ill give
to the business, it is proposed that profits w ill be shared
equally. The current partnership has profits of over $900000
per year shared by just two partners; you w ill become the
third partner. You are unsure what to do. You intend to seek
legal/accounting advice but first you need to work through
this proposal systematically. That way when you pay for
professional advice you don't pay for a lot of basic
information you could find out yourself.
__
.;,;;.;.
189
 REQUIRED
a Ust and explain the advantages and disadvantages of
form1ng this partnership.
b l1st the 1tems you would hke to see specifically included
10the partnership agreement.
c When you seek professional adv1ce, what other 1ssues
would you hke clanf1ed?
d What alternative bus1ness arrangements miQht you
propose (unfortunately th1s busmess cannot be
conducted by a company)?
19 Advising partners: profit distribution
Dang and Tran have worked together on and off smce 2018.
Initially they fUSt brought the1r equ1pment and d1d some of
the landscapmg when the other had a fOb that was too big
or was gettmg beh1nd schedule. They usually agreed on a
price or agreed to do the same amount of work for the
other. They worked so well together that they started to
tender on larger jobs and share the risks. These larger jobs
needed more equ1pment and during the 2020/21 financial
year Dang contributed $176000 of equipment and Tran
$144000. Dang has an excellent reputation. having worked
for 20 years in the local area, while Tran is acknowledged as
the quicker and better designer. During 2020/21 they 'paid'
themselves a wage of $104000. After drawing this wage
they est1mate they have probably made around $480000 in
profits for the 2020/21 financial year and rather than spoil
their friendship they have approached you to determme how
their prof1ts should be div1ded. g1ven they don't currently
have a partnership agreement. not even a verbal one.
REQUIRED
a Adv1se Dang and Tran of the potential ways that profits
could be d1v1ded.
b Recommend one partiCular formula and why you would
propose th1s as a fa~r and eqUitable bas1s for sharing
profrts.
c Respond to the~r proposal that profrts be diVIded
accord1ng to the~r respectiVe age.
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190
_....;.;;.;.
d Suggest why a client m1ght be able to sue them as a
partnership, although they do not thmk of themselves as
partners.
e Explain the consequences of them not agreemg on a
distribution of prof1ts and havmg the matter settled by
the courts.
20 Partnership cha racteristics
Your mother has been good fnends for a number of years
with Jonathan, a fellow amateur pastry cook and coffee
connoisseur. They have both won several cookmg
competitiOns and th1s season appeared together on
MasterKitchen and have JUSt won. She has JUSt sent you an
SMS announc1ng: 'OMG the most amaz1ng news Jonathan
and I (BFF) are go1ng 1nto partnership 1n the most elegant
and stylishly fash1onable coffee paussene 1n the Southern
Hemisphere'. You are concerned that she may enter 1nto a
partnership based on her euphoria from the show's success
and you want to warn her about the potential dangers.
REQUIRED
Reply to her SMS starting with: 'Congrats Mum, so proud of
you, please not a partnership .. .'.You can write a maximum
of another 97 characters (spaces don't count) to persuasively
warn her of the dangers of a partnership form of business.
21 Partnership profit distribution
In 2006 Mr Mulvany, a former partner of the law firm Maron
and Gould took legal acuon aga1nst his former partners
alleging a $1 million bonus pa1d to the founding partner was
a distributiOn of prof1ts not 'post settlement expenses' as 1t
was class1fied.
REQUIRED
a Explain how such a bonus could be 1ncluded 1n a
partnership agreement?
b From an accounting perspective, d1scuss the eth1cs of
class1fy1ng a bonus payment (dlstnbuuon of profits) as
'post settlement expense'.

After studying the material i n th is chapter, you
shou ld be able to:
Describe the characteristi cs of the corporate
fo rm of busi ness.
Discuss equity and show how it is recorded
and reported.
Understand cash d ividends, share dividends
and share splits.
Investigate preference shares and how t h ey
receive p ref erence in dividends and
other ways.
Examine sh are b uybacks and how they are
recorded and reported .
Evaluate equity through the calculation and
interpretation of horizontal, vertical and
ratio analyses.
Copyrlghl2019 Cengage Loa nlng A R ghl Rnervecl May not be c
This chapter examines the accounting for shareholders'
equity. We begin with a discussion of the corporate form
of business.We then examine how companies account for
issuing shares and cash or share dividends distributed on
those shares. Then some of the interesting aspects of
shares, such as share splits and buybacks are explored.
After discussing preference shares and preference share
dividends, the chapter concludes with a discussion on how
to analyse a company's equity position.
Lo THE CORPORATE FORM
OF BUSINESS
Chapter 2 introduced the three major forms of bus1ness:
the sole proprietorship, the partnership and the corporation.
The follow1ng sections describe some of the characteristics
of the corporate form of business that distinguish it from
sole proprietorships and partnerships. These corporate
characteristics are as follows:
• separate legal entity
• ability to raise capital
• limited liability of owners
• transferability of ov.mership
• dividend 1mputat1on
• regulation.
SEPARATE LEGAL ENTITY
A corporation is a separate legal entity. It is formed under
the Corporations Act 2001 (as amended) and administered
by the Australian Securities and Investments Commission
(ASIC). After the promoter has lodged an application, ASIC
registers t he company and issues an Australian Company
Number (ACN). This costs around $500. All companies
must have at least one member (shareholder). Proprietary
companies must have no more than fifty members that are
not employees of the company. In most cases, th1s new
legal entity can buy, own and sell assets in its name and
can also borrow money. It can sue and be sued. In other
words, it has most of the rights and responsibilities of an
individual in society.
ABILITY TO RAISE CAPITAL
Many sole proprietorships and partnerships have limited
access to the capital needed to successfully operate or
expand their businesses. In contrast. corporations can
access cap1tal through the sale of shares to investors, who
then become shareholders. Many companies beg1n by
selling shares pnvately to a few owners. And while many
corporations stay privately owned. others 'go public' by
offering shares to the public t hrough an lnit1al Public
Offering (IPO}. Such public offerings can generate
substantial amounts of capital. In Australia the federal
ed. scanned, or dupllcotod. In whole or In part. WCN 02·200-202
191
 government sold Telstra in three instalments (Tl: 1997 TRANSFERABILITY OF OWNERSHIP
$3.30. T2: 1999 $7.40andT3: 2006 $3.60) in the 'privatisation'
Another advantage of the corporate form of business is the
of the telecommunications business. CSL completed its
ease with wh1ch ownership can be transferred. When a
IPO 1n 1994 at 77 cents per share (the shares were originally
sole proprietor wants to transfer his or her ownership to
issued at $2.30 but a three-for-one share 'split' 1n 2007
another individual, the business itself must be sold. When
makes current share equivalence price 77c).
a partner wants to transfer an ownership interest to another
A great example familiar to most, if not all of you, is
investor {as we found in Chapt er 10), usually all other
Facebook. When 'going public' Facebook's IPO sold less
partners must agree. Once t he t ransfer occurs, a new
than 20 per cent of the company and raised $16 billion at
partnership is formed. In both c ases, the transfer of
$38 per share and made Mark Zuckerberg's (who retained
ownership can be burdensome.
ownership of a little over 20 percent) stock worth $19 billion
In contrast. when shareholders of a publicly traded
in May 2012. The shares did not see the spectacular 'stag
company want to transfer ownership to another investor,
profrt' of Linkedln which had doubled on its first day's
they need only to sell the shares to other investors. Such
tradmg . Google Inc. raised over $1.6 billion 1n its 2004 IPO.
sales usually occur through an open share exchange such
If needed, a corporation can continue to ra1se capital in the
as the Australian Secunt1es Exchange (ASX). They can be
future by selling additional shares. Google followed 1ts IPO
accomplished by call1ng a broker or logging onto a website
with a second share offering in 2005. rais1ng another
such as CommSec and executing a sell order. Hundreds of
$4.2 billion 1n capital. The ability to access capital through
millions of shares are bought and sold every trading day.
the sale of shares is certainly an advantage of the corporate
form of business.
DIVIDEND IMPUTATION
W hile the corporate form has several advantages over sole
proprietorships and partnerships. dividend imputation
places companies on an equal footing by the removal of
the double taxation of 1ncome.
A company's mcome is taxed by the Commonwealth
Government at the flat tax rate, currently 30 per cent for
all but small compan1es. Dividends paid to shareholders
are added to its other mcome {wages. interest) and is also
taxed on the shareholders' personal tax returns. But 1f
company income tax has been paid on t he income out of
which dividends are paid, those dividends are said to be
'fran ked' and have the tax paid 'attached ' to them. As a
result, a company's after-tax income pa id in dividends is
LIMITED LIABILITY OF OWNERS not taxed twice.
To illustrate dividend imputation. suppose that a
Under a sole proprietorship and a non-limited liability
company earns $1000 in pre-tax earnings and is subJeCt to
partnership, owners are personally liable for the actions
a 30 per cent company tax rate. The company would pay
and obligatiOns of their businesses. However. shareholders
$300 in company tax. Suppose further that the company
normally have no personal liability for the company's
distributed all $700 of 1ts remaining profits to its only
obligations beyond their investment in the company's
shareholder, who had a marginal personal tax rates of
shares. If a company defaults and cannot meet its
39 per cent. The shareholder would pay $390 (because the
obligations. creditors cannot seek the assets of the
dividend and company tax of $1000 is included in the
shareholders as compensation for the company's default.
complexity of the imputation tax calculations) in personal
They can only pursue the assets of the company. As a
tax on the dividends but would be rebated the $300. Better
result of this limited liability, shareholders stand to lose
still, if the shareholder has a marginal tax rate of only
only the amount of their investments. This limited liability
21 per cent, she would pay $210 tax and be rebated the
of owners is a significant advantage of the corporate form
$300, meaning she would pay $90 less tax than if she had
of business.
not received the $700 dividends.

2
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( § [ ANALYSIS
L:ook at front cover of CSL:s
REGULATION
A disadvantage of a company is the extent of regulation .
Consider some of the reporting requirements of a publicly
traded company such as CSL. These companies must file
numerous reports with ASIC and the ASX if they are a listed
company. These include audited annual financial statements,
unaudited half-yearly financial statements and any
notifications of significant events, sudl as the hiring of a
new dlief executive officer, the announcement of a dividend
or the closing of a factory under the continuous disclosure
regime . Adherence to and compliance with laws and
regulations consume significant amounts of the time, labour
and resources of companies, but are necessary because
stakeholders (especially creditors), due to limited liability,
on ly have the company (and not all the owners as with a
sole trader or partnership) to pay debts and compensation.
~,u rl/,.
Review til is content
• wilh the e-lecture
One of the distinguishing characteristics of a company is
its ability to sell shares to investors to raise funds. The
amount raised by issuing shares is called issu ed capital
(or contri b u ted equity) because the
issued capital
(contributed funds are contributed by investors
equity) The amoont of (through the company issuing shares) in
capital raised by issuing
shares to investors in exchange for an ownership claim on
exchange fO< an ownership company assets. The most common type
claim on c~ny assets. of shares are called ordi nar y shares.
It is also known as paid-up
capital or share capital. Investors who purdlase ordinary shares
ordinary shares The are called shareholders and are the
most common type of share
owners of the company. The other part of
capital.
equity is the retained earnings. These
are, as the name suggests, earnings (total comprehensive
income) of the company that have not been paid to
shareholders in the form of dividends, but have been
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In whole or lneAaM !f·~~~lde rs' equity
retained (kept) by the company. Sometimes the directors
of the company may decide to signa l that some of the
retained earnings may not be available for future dividends
by transferring them to a reserve. It is important to
remember that neither retained earnings nor reserves are
a 'store of cash'. The liability and equity sections of the
balance sheet show the sources of the entity's resources;
the asset section shows how those resources have been
used. In most circumstances the retained earnings and
reserves have been used to buy plant, property and
equipment or inventory. CSL has almost $300 million in
reserves and over $7.4 billion in retained earnings, but mudl
less than $1 billion in cash.
The asset and liability section of a company's balance
sheet is the same as for sole proprietors and partnerships; it
is the equity section that is different. Issued capital is known
by various names: paid-up capital, share capital or contributed
equity. It refers to the money raised directly from new owners
when the company issued shares to them. Notice that the
description 'sold shares' is not used. Ordinary shares are not
always distributed via a sale. For example, some shares are
issued to employees (usually senior
management) as part of their compensation. issued shares The
Thus, the description 'issued shares' (or number of shares a
company has distributed
'paid-up capital', 'shares issued and fully to owners to date.
paid') may be used.
SHAREHOLDER RIGHTS
When a company issues ordinary shares, it usually grants
to shareholders the following three rights:
e The right to vote - ensures that a shareholder can
participate in company governance by voting on issues
and actions that require owner consent or approval.
Examples of such action are the election of directors
and approval (or not) of the 'remuneration report'.
• The right to participate proportionally in dividends -
ensures that shareholders receive an appropriate
amount of any dividends declared by the company. For
example, if a shareholder owns 25 per cent of a
company's ordinary shares, they have the right to receive
25 per cent of any dividend the company distributes.
e The right to participate proportionally in residual assets -
ensures that shareholders receive an appropriate
amount of assets upon liquidation of the company. For
example, if a shareholder owns 10 per cent of a
company's ordinary shares when the company ceases
operations and liquidates, they have the right to receive
10 per cent of all residual assets.
The right of pre-emption is related and ensures that
shareholders can maintain their ownership percentage
when new shares are issued.This is important in companies
with a small number of shareholders and where shares are
not easily obtained on the open market as they are with
listed companies.
1 __
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193
 RECORDING ORDINARY SHARES shares and is therefore called :Application'. On 1 January
the application money was received for 10000 shares.
In Australia and New Zealand shares no longer have a par
value. Par values were once used to determine a company's 1 Jan. Cash Trust 5000
legal capital and are still used in some other count ries. For Application 5000
Australian accounting students, thiS reduced the difficulty {Recerved apphcat1onS for 10 000 shares)
of accounting for the ISSue of shares and means overseas
Assets liabihtJeS + Equoty
or old textbooks can appear unduly complex.
+5000 +5000
To illustrate, suppose that a company issues 100 shares
for $5 per share on 5 April. The company would record this
This entry increases the asset Cash Trust and increases
issuance as follows:
the liability Application . We class1fy It as a liability because
SApr. Cash 500 the money must be paid back or the applicant given
Contnbuted Equ1ty 500 shares .
When the shares are issued or allotted, the applications
(To record 1ssue of 100 shares at $5 per share)
are accepted as purchasing the shares {contnbuted equity),
Assets liablhtoes + Equity
the allotm ent money becomes due and the money in the
+500 +500 trust account is transferred into the company's normal bank
account . O n 2 February Madison issued {allotted) t he
This entry increases Cash for the amount received
10 000 shares:
and in creases Co ntributed Equity {Ordin ary Share
Capital, Issued Capital) by the same amoun t. {Note th is 2 Feb. Application 5000
is very sim ilar to th e jo urnal entry made whe n a sole Allotment 3000
tra der c ontrib uted money to the b usiness, back in Contributed Equity BOOO
Chapter 3.)
{AIIoned 10 000 shares}
Assets liab1hties + Equity
ISSUING SHARES BY INSTALMENT ---
+3000 -5000 +8000
Sometimes shares are issued by instalment, requiri ng
applicants for shares to pay some money when they apply
and more money later 1n the process. All three issues of
Telstra shares were by Instalment, requinng a part payment
with the application and a further payment {a call) one year
later. Most compan1es require the full amount to be paid
with the application {on appllcauon); but a few may require
some money on application, more on
application Bolh lhe
the allotment o r i ssue of shares and
request to buy shares and
lhe rroney payable when further payments, appropriately called
shares are applied fo1. calls . Compan1es 1ssue a p rospect us
allotment or issue
1nvit1ng the public to apply for shares by
The JIOteSS of giving
shares to (SOOle oO !hose filling out the application form and
wto have aflllied for d1em prov1ding the appropriate application
and also the ooney
required at this stage frOOl money.
sharelloldels. M adison forms a company and issues
call The request for a prospectus seeki ng applications for This entry increases the asset Allotment, decreases the
further paymen~s) and
lhe ooney with those 10 000 sha res: 50 cent s payable on liability Application and increases the equity Contributed
further paymen~s). application, 30 cents on allotment and Equity {or Paid-up Capital). W e have classified allotment as
prospectus The legal an asset because once the shares are issued, the company
document offering shares
20 cents call. The applicat ion m o ney
fD< sale and providing should initially be banked in a separate has a legal right to receive the money. At the same time,
details of the company, bank account {a trust account- for ease Madison can now claim application money as the company's
past financial
performance and future we call it 'Cash Trust'). because some or and the m oney in Cash Trust can be credited and Cash
prospects. all of it may be refunded . The money debited .
received is from investors applying for

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194
_......;.~
 On 3 March Madison receives the allotment money: 8 Feb. Applicauon 1000
3 M ar. Cash 31XXl Allotment 11XXl
Allotment 31XXl {Apply excess application to allotment)
{Received application money) Assets liabilities + Equ1ty
- 1000 -1 000 _ _ _...;_-'-
Assets + Equity
+3 000
This entry decreases the liability Applicat ion and also
-3 000 decreases the asset Allotment. Or we could combine the two
transactions- the refund and the allotment - in one entry.
This transaction reduces one asset - Allotment - and
increases another asset - Cash. 8 Feb. Application 6000
When the call is made, it follows the same pattern as Allotment 2000
the allotment: debit Call and credit Contributed Equity. The Contnbuted EQUity BIXXl
rece1pt of the cash follows the same pattern: debit Cash.
{Allotted 10 IXXl shares)
cred1t Call.
Assets liabilities + Equ1ty

OVERSUBSCRIPTION +21XXl --£000 +8000

The process of selling shares by asking for applications often This entry decreases the liability Application by the full
oversubscription results in more shares being applied for $6000 received, increases the asset Allotment {recognising
Wllet1 moreshares are than are available for sale.This is known as the new shareholders have only $2000 to pay on allotment)
applied fOf than are and increases the equity Contributed Equity by the amount
oversubscription. Let us assume
available to be issued.
Madison received applications for 12000 of the application and allotment monies. Later, when the
shares on 2 February. The company would record the cash is received for allotment and call, less will be received
application as before by debit ing Cash Trust and crediting because some or all has been paid on application.
Application, but this time with $6000 {12000 shares x 50c).
Depending on the conditions set out 1n the prospectus, the
company has two options in how 1t treats the excess
applicatiOn money.

Option #1
On 8 February the company gives the excess money back
to the investor {i.e. refund). Madison also accepts the
application for 10 000 shares and in addition to refunding
the excess application money it will allot the shares as
above on 2 February.

8 Feb. Application l!XXl

Cash Trust 1000
{Refund excess applicatoon money)
Assets liab lotoes + Equity
- 1000 -1000

This entry recognises the refund part of the transactions

on 8 Febru ary by decreasing the asset Cash Trust and
decreasing t he liability Application.

Option#2
Alternatively, on 8 February, rather than refund the
money and then ask for the allotment money, Madison
applies the excess Application to Allotment {and Calls in
Advance 1f there were applications for more than 16000
shares).

Copyright 2019 Cengage Learning. All R1ght1 R...rvod. May not be coplod, scanned, or dupllcatod. In whole or lnC'I'Il~ q2-~~g~ ders' equity
1 1
-----
195
 FORFEITURE This entry increases the asset Cash. decreases the
equity account Forfe1ted Share Account and increases
If the allotment or call money is not paid, the company
the equity aocount Contributed Equity.
usually has the power to cancel the shares and the
After paying the cost of reissue, any amount left in the
shareholder forfeits the shares. Money Forfeited Shares Account may be refunded to the original
forfeit Whena
shareholder does not already paid is. at least initially, kept by the shareholder.
pay the allotment and/or company and recorded as part of
call they lose the shares
they have pa1d some ol shareholders' equ ity (Forfeited Shares
the money to buy Account). but not contributed equity.
Assume Madison made a call on 3 March
DIVIDENDS
(debit Call $2000 and credit Contributed Equity $2000) but
The goal of any company is to generate profits. Once
by the closing date of 4 April. money for only 9500 shares
generated, a company must decide whether or not to
had been received (debit Cash $1900 and credrt Call $1900).
distribute those profits to its owners through dividends. A
ThiS leaves a debit balance in Call of $100. But for the
dividend is a distribution of profits to owners. The decision
500 shares for which the call has not been paid, the
to distribute any dividend rests with the company's board
application of 50 oents (500 x 50c =$250) and the allotment
of directors, which is the group of individuals elected by
of 30 cents (500 x 30c = $150) has been pa1d. On 5 May shareholders to govern the company and represent the
the shares are forfeited; the shareholder who paid the
interests of all owners.The board will consider many factors
application and allotment on those shares loses their in its decisions, including the financial condition of the
money and is no longer a shareholder. company, the cash available for dividends and the
5 May Contributed Equity ($1 x 500) company's past history of d ividends. When dividends
500
are distributed, they are stated as a per-share amount and
Call 100
are paid only on issued shares and paid to the owner of the
------ Forfeited Share Accoont (S250 +$150)
~---------
(forfeiture of 500 shar.;.es;.;l_ _ _ __
400 they on the date of record. If shares are
sold the day after the date of record, they date of record The
date that detenmnes who
-----Ass:-e-ts liablli~es + Equity are sold ex.<Jividend (without the dividend) recerves the diVIdend -
- - - - -100-----------=-so o=- and the previous owner will receive the the shares' owner on the
date or record recerves
dividend when paid weeks or months the diVidend
later. although they have not owned the
shares for some time. This is why the market value of
This entry decreases t he equity Contributed Equity,
shares (the price they are bought and sold for on the ASX)
decreases the asset Call and increases the equity Forfeited
usually falls by an amount approximately equal to the
Share Account.
dividen d per share when the shares start trading ex-
The shares may later be reissued, often at a discount,
dividend (without the dividend). Market value of shares will
with the discount effectively being paid
reissue When forfe1ted be discussed at the end of the chapter. but suffice to say
shares are aga1n sold. by the original sha reholder. Madison market value has linle relation to the price at which shares
often at a d1scooot to the reissues the shares on 6 June for 85
orig1nai1SSUe priCe were originally issued.
cents as being fully pa1d: When and how a company distributes dividends is
6Jun. Cash (500 x 85c) 425 called a company's dividend policy. A company's policy can
often be found on ItS website. Dividends are normally pa1d
Forfe,ted Share Aa:oum 75
(500 X 15c) in cash, but they can also be paid in other forms such as
shares. The following sections discuss the practice of
Contributed Equiry ($1 x 500) 500
distributing dividends, starting with the most common
(Reissue 500 at a 15c discount)
type -the cash dividend.
Assets liabilities + Equity
+425 -75 CASH DIVIDENDS
t500 As the name suggests, a cash dividend cash dividend A
is a distribution of cash to shareholders. distributoon of cash to
shareholders
When a company's board decides that a
cash dividend is warranted, it will declare publicly that a
dividend will be diStributed. The date on which the board

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196
_....;.;;.;.
ACCTJ Flnanco&!
declaration decl ares the dividend is called the Reporting cash dividends
date The date on declaration date. On this date, the board
which a oompany's Companies usually report their dividends on two financial
legally obl igates the company to pay the
board of directors statements. Dividends declared during the year are
declares a dMdend. dividend, so a liability is created. The board's
reported on the statement of changes in equ11y. Recall that
payment dec laration wi ll also include the date of
date The date on dividends reduce retained earn1ngs, so they are reported
record and the payme nt date. The payment
wlich a oo.!end Will in the retained earnings column. The follow1ng is the
be distriOOted date IS the date on which the dividend will
retained earnings column of CSL.:s 2017 statement of
be d is trib u ted . The date of record
changes in equi1y.
determines w ho rece1ves the dividend. The shares' owner
on the date of record rece1ves the d iv1dend. Retained Earnings Sm
Balance at the beginn1ng of the year 6592.3
Recording ca tl d vid nds
Profit for the penod 1337.4
The recording of cash d ividends usually requires two
Other comprehensive income 75.5
entries. The first entry records the declaration of the
dividend and the resultlngl•ab•lity. The second entry records Dividends pa1d
the actual distnbut1on on the payment date. Balance at end of year
To illustrate, suppose that a company w ith 100000
issued shares declares a 50 cent per share dividend on
Dividends are presented as negative numbers because
1 November. The dividend is payable on 30 November to
t hey are subtracted from retained earnings.
shareholders of record on 15 November.
D ividends paid during the year are reported on the cash
On the date of declaration, the company obligates itself
flow statement. Because a cash dividend is a distribut ion
to pay a $50000 dividend {100000 x $0.50). This obligation
of assets to an owner, dividends are considered to be a
would be recorded as follows:
financing activity. Therefore, they are reported in the
1 Nov. Retained Earmngs 50000 financing activities of the cash flow statement. The
Dividends Payable 50000 following is the tina ncing activities section of CSLS 2017
cash flow statement.
no record declaration of dividend)
Assets Liabilit1es + Equity
------------------- +50000 -50000

The entry decreases Reta 1ned Earnings because

dividends reduce reta1ned eam1ngs.The entry also increases Cash flows from financing actiVIties
Dividends Payable, which is a current liabdi1y. The result of Proceeds from the issue of shares 127 17.4
the entry is a reductiOn 1n equ1ty and an increase in liabilities. Dividends paid (6014) (5790)
The distributiOn of cash on the payment date would be Proceeds from borrowangs 1381.4 1564.3
recorded as follows:
Repayment of borrowmgs (5813) (7169)
30 Nov. D1v1dends Payable 50000 Payment for shares bought back (3149) (64B.2)
Cash 50000 Net cash outflow from financing act1V1t1es (10351 (362.41
no record payment of dividend)
Assets Liabilities + Equity
--------50000 - 50000
Because d ividends are cash outflows. they are shown
as negative numbers on the cash flow statement. The
dividends paid as shown in the cash flow statement is the
This entry is simply a payment of an obligation. Both
same as t he amount of dividend (declared) in retained
Dividends Payable and Cash are decreased for the amount
earnings. This is because CSL declares and pays its dividends
of the payment. As a result. both assets and liabilities
in the same f inancial period {Final dividend declared 88.67c
decrease.
August 2016, Paid October 2016, Interim declared 83.78c
Note that no entry is made on the date of record
February 2017. paid April 2017). The dividend declared
because no accounting transaction occurs on that date. The
(retained earnings) and the dividend paid (cash flow) are
date of record only determines who w ill receive the
often different because of some d tvidends declared in the
dividend. Therefore, it is a date w ith administrative
current financial year being paid in the next financial year,
importance only.

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.:..:.:,
197
 and dividends declared in the previous period paid in this
period. CSL does not have a dividend reinvestment scheme.
In a way they have the reverse: semi-regular share buybacks
(discussed in L05: Share buybacks).
SHARE DIVIDENDS
While cash dividends are by far the most common type
of d ividend, some compan ies d istribute share dividends.
share dividend A share d ivi d end is a distribution of a
Adistributioo of a company's ord inary shares to existing
company's O<dinary shares shareholders. Share dividends are
toexisting shareholders.
declared by a company's board of
directors and are usually stated in percentage terms or one
share for every number held. For example, a 10 per cent
share dividend (one for 10) means that the company w ill
issue additional shares equal to 10 per cent of the issued
shares. So, an investor owning 10000 shares will receive
1000 additional shares (10000 x 10%).
At first glance, a share dividend appears to be of great
value to shareholders because they receive more shares.
However, some argue that a share dividend has very little
value to shareholders because they are not receiving any
cash - they are receiving only shares. Furthermore,
because all shareholders receive the same percentage
increase in shares, a share dividend does not change a
shareholder's ownership percentage, but the ownership is
in a company wh ich has not decreased its cash by paying
it out in dividends. Finally, a share dividend usually results
in a reduction to the market price of individual shares such
that the total market value of a shareholder's holdings
remains little changed. For example, a company d istributing
a 100 per cent share dividend will double the shares issued,
but th is will usually result in the share's market value being
cut in half. As a result, each shareholder will have a higher
number of shares but no additional monetary value. Share
splits, d iscussed below, also reduce the market value of
shares
DIVIDEND REINVESTMENT
PLANS IN AUSTRALIA
A Dividend Reinvestment Plan (DRP), allows a shareholder
to take some, or all, of their dividend in the form of additional
shares. Dividend Reinvestment Plans are similar to share
dividends, but it is the shareholder who decides to receive
shares not cash rather than it be ing imposed on all
shareholders w ith a share dividend. The investor can
nominate what percentage they wish to split between cash
and shares. Often the DRP shares are offered at a discount.
Many companies have DRPs: the five large banks (CBA.
Westpac, ANZ, NAB and Macquarie); Wesfarmers
(not 2003-2007); Woolworths andTelstra (not 2008-2015).
CSL is the only Top 10 company in Austra lia that does not
have a DRP
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1 98
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MAKING IT REAL
DIVIDEND REINVESTMENT PLAN
Commonwealtn Banli, Australia's largest company,
offers one of the best known DRPs. Below is a brief
extract of information the bank l'rovides about
their DRP.
The DRP allows Shareholders to reinvest all or f>"rl
of any dividend paid on their Shares in additional
Shares instead of receiving the dividend in cash.
Shareholders are still entitled to franking credits on
dividends reinvested under the DRP. Participation in
the DRP is entirely optional. The DRP. is administered
in accordance with these DRP Rules. You can find
out how to participate in the DRF' under the FAQs.
It is important that you read these DRP. Rules
carefully before deciding whether to particiP.ate in
the DRP. For the avoidance of doubt, the offer of
the DRP is made in compliance with Australian law
and any code, rules or other requirements relattng
to the offer of the DRP in Australia. If you have any
questions or need advice on whether you should
participate in the DRP, please contact an
indeP.endent P.rofessional adviser.
Each Share issued or transferred under the
DRP w1ll be issued or transferred at the Market
Pnce of Shares less such discount (if any) as the
Dtrectors may determtne from time to time and
notify to ASX (rounded to the nearest cent).2
If you had perfect timing or had perfect foresight you
could have purchased one hundred Commonwealth Bank
of Australia (CBA) shares in early 2009 for just under $2400
(the lowest price during the Global Financial Crisis). Over
the next ten years each share has paid over $36 in dividends.
If you fully participated in the DRP after ten years you would
own over one hundred and seventy shares, probably worth
around $15000.
In the first six months you would have received a dividend
of $1.13 per share or $113 for your one hundred shares. Th is
$113 would have been reinvested in shares at the t ime
valued at just over $28, giving you four addit ional shares. The
next d ividend of $1.15 per share would be received on the
one hundred and four shares, as you now owned the original
investment plus the four shares from your first dividend
reinvestment. An additional two to five shares are received
every six months when the dividend is paid; the more recent
the more shares because your portfolio is growing each time
the dividend is received and reinvested.
If this strategy was adopted from the IPO in September
1991 when shares were issued for $5.40 (or $540 for one
hundred shares) you would, by the end of 2018 own almost
five hundred shares worth (based at the time of writing on
an estimated share price of around $80 per share) about
$40000. Depending on your personal tax situation you may
have also received an imputation credit of over $5000.
Hindsight makes the very best investors I
 Shares acquired through a DRP are treated as though
the investor received a cash dividend and then used th is
cash to buy additional shares in the company; as such the
dividend is taxable (but subject to the same 'fran king credit'
as cash dividends). Wh ile the shares acquired from DRP
are treated for capital gains tax as if purchased for cash at
the date they are alloted.
So why do companies distribute share dividends or have
DRP?There are a couple of potential reasons. First, they can
substitute for a cash dividend when a company does not
have enough cash on hand and would otherwise be forced
to borrow or reduce investing activities. This motivation can
be especially strong when a company is trying to maintain
a long and uninterrupted history of dividends. Second, share
dividends often reduce the market price of shares and like
a share split keep them in an 'affordable' range for the
average investor. Distributing more shares in the marketplace
brings down the price of each individual share.
Li ke cash dividends, a share dividend is paid out of
Retained Earnings. However, unlike a cash dividend, a share
dividend is not a distribution of assets. It is a distribution of
ordinary shares. As a result, a share dividend simply transfers
an amount from Retained Earnings to Contributed Equity. In
contrast, a share split does not reduce Retained Earnings
and increase Contributed Equity; it simply increases the
number of shares in the same contributed equity.
SHARE SPLITS
When a company wants to decrease the market price of
its shares to make them more affordable, it can use a
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share split instead of a share dividend. share split An increase
A share split is an increase in a in the nurrb!r of a
company's issued shares
company's shares according to some according to some
specified ratio; for example, a company specified ratio.
tha t declares a 2-for-1 sp lit recalls all
shares from existing shareholders and issues two shares
in return, effectively doubling the number of issued
shares. As a resu lt of th is increase in the number of
shares, the market price of the shares usually fa lls
proportionally. In a 2-for-1 split, the share price would be
approximately halved. In Australia share splits are
common, with companies like BHP 2-for-1 (in 1989, 1995,
2001) and CSL 3-for-1, splitting their shares to reduce the
market price to a level the company believes would be
more attractive to investors. In Austral ia companies
appear to want to keep the market price under $100; but
interestingly, in 2015 CSL did not spl it its shares when
the price approached $100 despite spl itting its shares in
2007 (see the Making it Real box 'Share split' for more).
In the US, shares sometimes have a market value in the
thousands. Famously, Berkshire Hathaway valued at over
US$400000 in 2018.
Share splits are very similar to share dividends in that
they both result in an additional number of issued shares.
In fact, a 2-for-1 share split is the same as a 100 per cent
share dividend. However, there are important differences.
A share split is not an accounting transaction, so no
accounting entry is recorded. Second, while both do not
change total equity, a share dividend transfers amounts out
of Retained Earnings into Contributed Equity.
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199

Review this content
with the t ·lecture
PREFERENCE SHARES
While all companies issue ordinary shares. some also issue
p reference shares. which are a form of shares that
receive one or more pnonues over
preference shares
A form of shares that ordinary shares. Usually, preference (or
receives one or more preferred) shareholders give up the right
pnonties over ordu1afY
shares. to vote in exchange for preference to
dividends and preference to assets upon
liquidation of the company. Preference to dividends means
that preference shareholders receive t heir dividends before
ordinary shareholders receive any dividends.
RECORDING PREFERENCE SHARES
Because rt is a form of contributed equrty, preference
shares are recorded in the same manner as ordinary
shares. To illustrate. suppose that a company issues 500
preference shares for $15 per share on 23 August. The
company would record this issuance as follows:
23 Aug. Cash 7500
------
Preference Shares
{To record sale of preference shares)
Assets liabilities + Equity
+7500
Thrs entry increases Cash by $7500. whrch rs the
amount pard by the investor and Preference Shares
(Contnbuted Preference Equity) are increased by $7500.
As a result of this entry, both assets and equity rncrease.
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CASH DIVIDENDS ON PREFERENCE SHARES
When a company has both preference and ordinary shares
issued, cash drvrdends must be allocated between the two.
Because preference shareholders have dividend preference,
they are paid f1rst. followed by ordinary shareholders. The
amount that is allocated to p reference shareholders
depends on the dividend rate and whether the shares are
cumulative or non-cumulative.
The dividend rate refers to t he annual dividend amount
that preference shareholders normally receive. The rate is
usually set as a dollar amount per share or as a percentage
of issue price. For example, preference shares may carry
a dividend of 90 cents per share or a dividend of 6 per cent
of issue price.
Preference shares are either cumulative or non-
cumulative. Cumulative preference cumulative
sha res carry the right to receive current- preference shares
Shares that carry lhe nght
year dividends and all unpaid dividends to rece1ve current-year
from prior years before dividends are dividends and all unpa1d
pa id to ordinary shareholders. Th is dividends from prior years
beflxe drvidends are paid to
means that if a company fails t o pay a ordinary shareholders.
dividend one year. the missed dividend dividends in arrears
The accumulated value of
will be paid the next time dividends are
unpaid tyior-year diVidends.
declared. The accumulated value of
unpaid prior-year dividends is called dividends in arrears.
Note that divid ends in arrea rs are not a liability because
dividends are declared at the discretion of the board of
directors and become a legal obligation only when
declared. Nonetheless, because d ividends in arrears are
informative. they are disclosed in the notes to the
financial statements.
N on-c um ulative preference
non~umulative
shares carry the right to receive current- preference shares
year dividends only. If a company does not Shares that carry lhe nght
to receive current-year
declare a dividend in a particular year. non- dividends only.
cumulative preference shareholders lose
the right to that annual dividend forever. As a result, a
company Wlth non-cumulative preference shares will not
have dividends rn arrears.
To illustrate the allocation of dividends to preference
and ordinary shareholders. suppose that a company has
the following two types of shares:
e Ordinary shares: 100000 shares issued.
7500 e 5 per cent preference shares: 20 000 shares issued
at $10.
Suppose further that they do not pay dividends in 2017
or 2018 but declare $64000 of dividends in 2019. The
+7500 allocation of the 2019 d1vidend depends on whether the
preference shares are cumulative or non-cumulative.
Cumulative preference shar s
If the shares are cumulative, the preference shareholders
recerve not only the current-year annual divtdend but also
the t\'110 years of dividends in arrears. The annual dividend
on preference shares is 50 cents per share ($10 x 5% ) and
$10 000 in total {$0.50 per share x 20 000 shares). Therefore.
$30000 is allocated to preference shareholders. w ith the
remainder going to ordinary shareholders.These calculations
are illustrated as follows:
Preference shares are cumulative Preference Ordinary
$10000
DIVIdends tn arrears: year 2018 10000
Current-year preference dividend 10000
Oistnbute remaulder to ordinary
($64 000 - $30 000)
Total allocated in 2019 $~000
Once the allocation of dividends is calculated. they
would record the declaration and payment of the dividend
as follows:
Date of Retained Earnings 64000
declaration
- - - -- - -
Ordinary Share Dividend Payable
Preference Share Dividend Payable
(To rerord dedaratioo of dMdend)
Assets Liabiltttes + EqUtty
+34000
+30000
As is the case with any cash dividend, the net overall
result of the declaration and payment of the dividend is a
decrease in a company's equity and its assets.
Non-cumulative preference shares
If the company's preference shares are non-cumulative.
the preference shareholders receive only the current-year
annual d tv tdend. The m issed dividends tn 2017 and 2018
are Irrelevant to the calculation for the current year.
Therefore. only $10 000 i s allocated to preference
shareholders. with the remainder going to ordinary
shareholders. These calculations are illustrated as
follows:
Preference shares non-cumulative Preference Ordinary
Current-year preference dividend $10000
Otstrtbute rematnder to ordinary
shareholders ($64 000 - $10000)
Total allocated in 2019
Copyright 2019 Cengage l earning. All Rtghta R...rvod. May not be coplod, scanned, or dupllcatod In whole or ln J>art. WCN 02·200-202
Like any tnvestor, a company can purchase (buy back)
shares of tiS own tn the marketplace. The practice of a
company purchasing its own shares is commonplace in
publicly traded companies today. One reason why a
company purchases its shares is to provide a tax-effective
return to some shareholders and increase future returns to
the remaining shareholders. Another reason may be to
acquire shares from shareholders who hold small parcels
of shares. who are expensive to service and who may not
know how to (or want to) incur the cost of selling through
a broker. Other purchases of shares may be for an employee
share scheme or a management incentive scheme. Share
$34000
buybacks are usually done 'off-market' where a company
offers to buy and the shareholder needs to simply stgn the
~ form and all transfer details are handled by the company.
'On-market' buybacks involve the company purchasing
shares put up for sale on the ASX. For example. CSL buys
the shares just like any investor; the seller, as usual, has no
knowledge of who the buyer is and CSL reports to the ASX
how many shares they have purchased each day. Exhibit
11.1 is the announcement of CSL.:s on-market share
34 000 buyback.
30 000
RECORDING SHARE BUYBACKS
Apart from removmg the shareholders or reductng thetr
-64000 holdings on the share register so they no longer recetve
dividends (or fewer dividends if they did not sell all thetr
shares) and have their voting rights removed or reduced, it
is also necessary to reduce the shareholders' equity and
t he cash paid out.
In October 2016 CSL notified shareholders of its share
buyback. The sale of shares {to CSL or another investor) will
be attractive to some shareholders as the buyback tends to
support the share price as the company is creating further
demand for the shares. On-market buybacks do not have the
advantage of some off-market buybacks where some current
investors take advantage of the tax implicattons of the
buyback price be1ng a substantially 'fully franked' dividend.
To illustrate, suppose that a company buys back 1000 of its
own ordinary shares on 3 May when the shares are trading
for $32 per share.They would record the purchase as follows:
3May Contributed Equity 32000
Cash 32000
(To record share buyback)
Assets liabilities + Equtty
- 32000 - 32000
•
C HAPTER 1l Shareholders' equoty 20
;;; 1_ _
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 APPENDIX JC
Rule 3.8A

Announcement of buy-back (except minimum holding buy-back)

Information and documents given to ASX become ASX:s property and may be made public.
Introduced 1/9/99. Origin: Appendix 78. Amended 13/3/2000. 30/9/2001, 11 /01/10

Name of entity ABN/ARSN

CSL Limited 99 051 588 348

We (the entity) give ASX the following information.

lnfonnation about buy-back
1 Type of buy-back: 6 Whether shareholder/unitholder:
On-Marf<et. No approval is required for buy-back.
2 Class of shares/units which is the subject of the buy-back (eg. ordinary/ 7 Reason for buy-back:
preference): Ongoing capital management.
Ordinary. 8 Any other information material to a shareholder's/unitholder's decision
3 Voting rights (e.g., one for one}: whether to accept the offer (e.g., details of any proposed takeover bid}:
One for one. None. apart from any infonnation publicly disclosed by CSL Limited (the
4 Fully paid/partly paid (and if partly paid. details of haw much has been Company) through ASX on or prior to the date of this notice.
paid and how much is outstanding):
Fully paid.
5 Number ol shares/units in the class on issue:
455,920,280
On-market buy-back
9 Name of brokef who will act on the company's behalf: 12 If the company/ trust intends to buy back shares/units within a period
To be advised to ASX no later than the trading day prior to the date of of time - that period of time; if the company/trust intends that the buy-
the first trade undeJ the buy-back. back be of unlimited duration - that intention:
10 Deleted 30/9/2001 . The Company intends to buy-back shares in the period 27 October 2016
11 If the company/ trust intends to buy back a maximum number ol shares • to 25 Octobef 2017 (inclusive) or earlier it the maximum number of
that number: shares in Item 11 above is bought back prior to that date.
Note: This requires a figure to be included. not a percentage. The Company reserves the rights to suspend or tenninate the buy-back
Up to that number of shares fO< which the total buy-back consideratioo at anytime
paid or payable is 13 If the company/ trust intends to buy back shares/units if conditions are
A$500 million. The Company reserves the right to suspend 0< terminate met- those conditions:
the buy-back at any time. N/A
Employee share scheme buy-back
14 Number of shares proposed to be bought back: 15 Price to be offered tor shares:
N/A N/A
Selective buy-back
16 Name of person or description of class of person whose shares are 18 Price to be offered tor shares:
proposed to be bought back: N/A
N/A
17 Number of shares proposed to be bought back:
N/A
Equal access scheme
19 Pe1centage of shares proposed to be bought back: 21 Price to be offered tor shares:
N/A. N/A
20 Total number of shares proposed to be bought back it all offers are 22 Record date for participation in offer:
accepted: Cross reference: Appendix 7A, clause 9.
N/A. N/A

Compliance statement
The company is in compliance with all Corporations Act requirements relevant to this buy-back.
or. for trusts only:
The trust is in compliance with all requirements of the Corporatioos Act as modified by Class Order 07/422, and of the trust's constitution, relevant to this
buy-back.
2 Thefe is no informatioo that the listing rules require to be disclosed that has not already been disclosed, 0< is not contained in, or attached to, this form.

Sign h e r e : - - - - - - - - - - - Date: _ _ _ __
(DirectO</Company secretary)
Print name:

~ CSL:s 2017 share buyback notoce to the Austra lian Securotoes Exchange

Source: CSli.Jmrted 2007 Nota ofbcJy-back.

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 Calculations .....
share
For 1000
shares
Marlcet value $1020 $10200
Dividend 1.40 1400
Marlcet value minus dividend 8.80 8800
less cost base 6.00 6000
................ ... ...
'

Capital gain (before applying any discount) 2.80 2800

In 2016 when Telstra conducted its off-market buyback,

the buyback price was $4.43 per share (a 14% d1scount to
the market price), of whidl $1.78 per share was the capital
component and $2.65 the d1v1dend component (fully
franked). The buyback was less than 3 per cent of Telstra's
issued capital. Demand was so great that the highest
discount was applied, and Telstra also needed to scale back
the buyback for those ~t\1 '!II
offering to sell more than Download the Enrichment •
880 shares. Vl!flll
Modules lor further practice
SHARE BUYBACKS

I MANAGEMENT OF EQUITY
ATO Eu mple : Off-m• rke t buyback induding
divide nd•
EVALUATING A COMPANY'S
Because a company's equity represents the owners' claim
on oompany assets, shareholders are particularly interested
in a company's ability to manage its equity. Some of the
issues that are important to most shareholders are as follows:
1 Howdoes the company generate wealth for shareholders?
2 How does the company reward its shareholders
through dividends?
3 How does the company's equity affect its cash flows?
The following sections examine these three issues for
a hypothetical biotechnology company. The examination
requires information from all four of the company's financial
statements. The required Information is found in
Exhibit 11.2, excerpted from the company's 2020 annual

~ "' cli'.l'Pt~ 11 ~~~dets' equity :,

20::;3:,__
 Source Account 2020 2019
Balance sheet Total Assets $2241 $ 1931
1287 1110
216 204
Income statement Earnings per Share 2.18 2.06
···-··- ··-···-···-···-··- ··-···-···-···-··- ··- ··-···-···-···-··- ··-···-···-···-··- ··- ···-···-···-···-···-··- ···-··- ···-··- ···-··- ···-··- ··- ··-···-···-···-··- ··-···-···-···-···-··- ··..
Cash Dividends Declared 40 33
Statement of changes in equity Dividends per Share 0.40 0.33
···-··- ··-···-···-···-··- ··-···-···-···-··- ··-···-···-···-···-··- ..-···-···-···-··- ··-····-··- ···-···-···-··- ···-··- ···-··- ···-··- ··- ··- ··-···-···-···-···-··- ··-···-···-···-···-··- ····
Ordinary Shares Issued 99 99
~ Account balances from a biotechnology company's 2020 annual report

report. All amounts are rounded to the closest million The horizontal analysis reveals that total equity increased
except the per-share data. by $177 million during 2020, wh ich is an increase of
15.9 per cent from the prior year. The vertica l ana lysis
HORIZONTAL AND VERTICAL ANALYSES shows that total equity as a percentage of total assets was
stable at a little over 57 per cent in each year. So, while total
A good place to start the analysis of shareholders' equity
equity increased, it stayed t he same when compared to
is horizontal and vertical analyses. Recall from Chapter 2
assets. A lthough not reported here, a closer look at specific
that horizontal analysis calculates the dollar change in an
equity accounts would reveal whether the increase in
account balance, defined as the current-year balance less
equity was due to an increase in reta ined earnings or
the prior-year balance, and divides that change by the prior-
contributed equity.
year balance to yie ld the perce ntage change. Vertical
analysis divides each account balance by a base account,
yielding a percentage. The base account is total assets for EARNINGS PER SHARE
balance sheet accounts and net sales or total revenues for The preceding analysis did not show if the biotech's total
income statement accounts. These calcu lations are equity grew due to issuing new shares or to profitable
summarised as follows: operations. Shareholders want greater cla ims on assets
result ing from profitable operations. Another measure of
HORIZONTAL ANALYSIS the ability to generate equity through profitable operations
is earnings per share (EPS). Calcu lating
Dollar Change in = Current -year_ Prior-year Balance earnings per share
Account Balance Ba lance EPS is technica l; so technical in fact that (EPS) A comparison of
an accounting standard AASB 133 a company's total
Percentage Change _ Dollar Change
comprehensive income to
in Account Balance - Prior-year Ba lance Earnings per Share has been issued and the number of ordinary
requires Austral ian companies to report shares issued that
measures the ability to
'basic' and 'diluted' EPS. This is more generate wealth through
VERliCAL ANALYSIS
complex than we need at th is level and profitable operntions.
For the For the income we wi ll stay w ith a simple calculation.
balance sheet st at ement
EPS compares a company's total comprehensive income
Percent a e = Account Balance or Account Balance
g Total Assets Net Sales or Revenue to the number of ordinary shares issued. It is calculated
as follows:

Given the biotech's f inancial data in Exhibit 11.2, EARNINGS PER SHARE
horizontal and vertical analyses result in the following:
Earnings _ Tot al Comprehensi ve Income
per Share - Average N umber of Ord inary Shares Issued

Change Percentage change

Where average ordinary shares issued is:
1287
Total equity - 1110 ..!.ZL: 15.9%
1110 · AVEUBE ORDINARY SHARES
177 OUJITANDING

Beginning Shares Outst anding+ Ending sha res Issued

2
Total equity 1287 = 57.4% .1J..!.Q. = 57 5%
2241 1931

_ 204
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 Earnings per share is a useful ratio because it
'standard1ses' earnings for a company, but because each
company has a different number of 1ssued shares it cannot
be used to compare different compames, only the same
company over time. The percentage change in the ratio can
be used to compare the relative change in profitability of
companies of vastly different sizes.
The biotech's earnings per share is calculated as follows
using the information in Exh ib it 11.2:
216
(99+99).,.2=2.18
The 2.18 ratio reveals that the biotech earned $2.18 in
profit for every ordinary share issued. Is this an improvement
over the previous years? For a company like BHP or the
Commonwealth Bank earning billions of dollars a year. it is
d1ff1cult for a shareholder to comprehend. But converting
that to an EPS of $2 or $3 makes it easy to understand. As
a holder of a small number of shares you can easily see if
the company is earning m ore or less each year for you.
Telstra had earnings (total comprehensive income) in 2017
of around $4 billion and an EPS of 33 cents while CSL:s
earnings of around $2 billion and an EPS of $3.81, reflecting
the number of shares issued.
RETURN ON EQUITY
Another measure of a company's ability to generate wealth
is return on equity. Return on equity
retum on equity A
oompanson of a companys compares a company's total
net tncome to ;r.oerage
comprehensive income to its average
shareholders' equtty !flat
measures the abilrty to use shareholders' equity and provides an
extsbng eqUity to generate indication of how well a company uses
addrtiooal equity.
its existing equity to generate additional
equity. Shareholders naturally want this ratio to be as high
as possible. It is calculated as follows:
Return on equity= Total Comprehensive Income
Average Shareholders' Equity
Where average shareholders' equ1ty is:
Average Equity= Beg inn ing Equity+ Ending Equity
2 pa id out more of its earnings than its competitor. Thus,
The biotech's return on equity is calculated as follows
from the Information in Exhibit 11.2:
216
18
(1287 + 1110V21 - 0%
The 18.0 per cent ratio indicates that for every dollar of
equity held during 2020, the biotech generated almost
Copyright 2019 Cengage learning. All Rtghll R""rvod. May not be coplod, scanned, or dupllcatod,ln whole or lnJ>art. WCN 02·200-202
18 cents of additional wealth through profitable operations.
How does th1s compare to other biotechs?
DIVIDEND PAYOUT RATIO
In addition to exammmg how well a company generates
additional equity, shareholders often examine how a
company pays out that equity through dividends. One ratio
to do t his is the dividend payout ratio.
The dividend payout ratio dividend payout
compares a company's dividends to its ratio A c~riSOil of a
company's divtdends to its
earnings. The ratio demonstrates the earnings !flat measures
percentage of earnings a company has the percentage of curnant
ea~mngs distnbuted to
decided to distribute to owners through
O\M1IliS
cash dividends. The dividend payout ratio
is calculated by d1viding total dividends by total
comprehensive income. or by dividing dividend per share
by earnings per share. Either way, the result will be the
same (except for small differences due to the round1ng of
per share values). Both calculations are as follows:
DMDIND PAYOUI' RAno
Dividend Payout Ratio=
Sh
Dividend D. 'd d
~: rn~~g ~=~ Sh:~:
1
Total Comprehensive Income or
Most companies report both total and per share
earnings on their 1ncome statement, total dividends on
their statement of changes in equity and per-share
dividends in the notes to the financial statements. These
amounts are included in Ex hib it 11.2 and are used to
calculate the biotech's dividend payout rat io as follows:
Calculation based on totals:
39
216=181%
Calculation based on per share amounts:
~:~= 18.3%
A ratio of 18.3 per cent (or 18.1 per cent- the d1fference
due to rounding) 1nd1cates that for every dollar of earnings
during 2020. the btotech declared about 18 cents in cash
dividends. But is an 18.3 per cent ratio better or worse than
a competitor with a 93.8 per cent ratio 'The ratios simply
reflect each company's dividend policy. For 2020, the biotech
shareholders who want to receive more of the profits in
dividends would prefer a higher ratio. However, shareholders
who want the company to plough more earnings back into
operations instead of paying more dividends would prefer
a low p<¥>ut ratiO. The problem some compames face when
earnings fall and/or they wish to maintain an mcreas1ng
dividend is that the payout ratio rises.
•
C HAPTER 1l Shareholders' equoty 5_ _
20;.;;
;;;
 SL's information in
CS[ ANALYSIS p

DIVIDEND YIELD
In addition to knowing what percentage of earnings is
paid in dividends. shareholders want to know how much
their investment in a company returns to them . Shareholders
generate a return on their investment in two ways: an
increase in the share pnce and a receipt of dividends. The
return from receiving dividends can be
dividend yield ratio
calculated w ith the dtvtdend yield ratio. Aoompanson of dMdends
The d ividend yield ratio divides per share to the market
pnce per share !hat
dividends per share by the market price measte; the percentage
(at the beginning of the period) per share return from dtvodends
as follows:

: DMDIND YIILD

Dividend yield = Dividends per Share

Market Price per Share

According to Exhibit 11.2, the biotech reports dtvtdends

per share of 40 cents on tts 2020 statement of changes tn
equity. We will use a share price of $10. which is the clostng
price on the last day of the previous financial year (30 June
2020). As a result. the dtvidend yield reveals the return to
a shareholder who bought the shares at the beginning of
the financial year.

0.40 = 4%
10.00
The 4 per cent ratio indicates that an investment in the
biotech on 30 June 2019 would yield a return from dividends
equal to 4 cents for each dollar invested. This may be
considered a htgh dtvidend yield for a biotechnology company
which is likely to be reinvesting earnings in research and
development. If these diVIdends were fully franked (they
have the benefit of diVIdend imputation), they would have a
before-tax return for the tnvestor of almost 6 per cent.

_ 206
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SHAREHOLDERS' EQUITY AND CASH FLOWS
When examining a company's equity, it is always important
to analyse how equity has been used to generate or use
cash . Equity can significant ly affect a company's cash
through the issuance of shares, the buyback of shares and
the payment of cash dividends. Each of these activit ies is
reported in t he financing activities section of the statement
of cash f lows.
In addition to examining the statement of cash flows,
it can be beneficial to examine the notes to the financial
statements to find additional information w ith cash flow
consequences.
~,\1 ' <r
Test your understanding with the •
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207

1 Corporat e form of business
How does each of the following characteristics relate to the
corporate form of business?
a formalton/registration
b separate legal entity
c ltabtltty of owners
d abtllty to ratse capttal
e transferability of ownership
taxation
g regulation.
2 Recording ordinary shares
Steggles Lim•ted issued 4000 shares for $10 per share on
1 March and 7500 shares for $5 per share on 1 June.
REQUIRED
Prepare the journal entries to record the share tssue.
3 Recording share transactions
Lucy Ltmtted reg1stered her company on 1 Apnl and entered
tnto the followmg equtty transactiOns:
5 Apr. Issued 30000 ordinary shares for $180000.
31 May Purchased 1000 shares tn a buyback for $50000.
1 Oct. Issued 3000 preference shares for $65 per share.
3 1 Dec. Paid a $1 dtvidend on all shares.
REQUIRED
Prepare the journal entries to record the transactions.
4 Recording share transactions, instalments
Gross L1m1ted released a prospectus seeking 100000 ord1nary
shares. The prospectus required investors to pay 80 cents on
application, 70 cents on allotment and a call of 60 cents.
Apphcauons for 100000 shares were rece1ved on 1 July and
the shares were allotted on 2 August. The allotment money
was rece1ved on 3 September. A call was made on 4 October
and the call money was received on 5 November.
REQU IRED
a Prepare the journal entries to record the above transactions.
b Assume the above information, except on 1 July
applications were received for 123 000 shares. The
prospectus allowed Gross to reject any application the
company deemed Inappropriate and to scale back other
applications and apply the excess appllcat1on money to
allotment. Gross rejected applications for 13000 shares,
refundmg the money to the applicants. and scaled back
one application for 30 000 shares to 20 000 shares.
applymg the excess applicatiOn money to allotment.
c Prepare the JOurnal entries to record the rece1pt of the
applicatiOn money. the refund, the 1ssue of shares and the
rece1pt of the allotment money for the above transactions.
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208
5 Recording forfeiture and reissue of shares
Given the tnformauon tn Ouestton 4, assume when the call
was made a shareholder of 2000 shares did not pay the call.
In accordance wtth the prospectus the shareholder forfetted
the shares and the company retssued the shares at a
20 cent per share dtscount.
REQUIRED
Prepare the JOUrnal entries to record that the call money was
not received the forfeiture of the shares and the reissue of
the 2000 shares.
6 Share terminologies J
The shareholders' eqUtty sectton of Ma Company's balance
sheet follows:
Equity
Contributed equtty $4020(XX)
Retained equ1ty 1425000
Total shareholders' equity 5445000
Note 11 Contributed equity
Number of ordinary shares 450000
REQU IRED
a How many ordtnary shares are tssued?
b How much tn total equ1ty has Ma received from the
ISSue of shares?
c What was the opemng balance 10 retained earn1ngs 1f
dunng the year Ma had total comprehensive 1ncome of
$1191 000 and declared div1dends of $666000?
7 Cash dividends
On 15 December Taylor Limited declared a cash div1dend of
$1.5477 per share to be paid on 15 January to shareholders
of record on 31 December. Taylor has 77 million ordinary
shares issued.
REQUIRED
ldent1fy the date of declaration, the date of record and the
payment date. Prepare JOUrnal entnes on those dates as
appropnate. Expla•n why no JOurnal entry is reqUited on one
of the dates.
8 Cash d ividends
Chen Company declares a $90000 dividend. Chen has
80000 ord1nary shares ISSued. Chen's 20000 preference
shares are cumulative. 5 per cent and had a $12 per share
issue price. Chen has not paid dividends in the past three
years.
REQU IRED
a Determ1ne how the $90000 in dividends should be
allocated to preference and ord1nary shareholders.
b Prepare the JOUrnal entry that would be recorded on the
declaratiOn date.
c Determ1ne how the $9000010 diVidends should be
allocated to preference and ordinary shareholders,
assuming that the preference shares are non-cumulattve.
9 Share dividends 13 Evaluate equity
Maxf1eld Manufactunng declared a share d1vidend of The following is selected financ•al 1nformauon for Lee Ltd:
$1.50 per share on 1 July to be distributed on 1 August to
shareholders of record on 15 July. On 1 July, Maxfield has (in millions) 2020 2019
250 000 •ssued and pa1d-up ord•nary shares. Maxfield's Average ordinary shareholders' eQUity $3 430.5 S2 921.6
shares are tradmg at $15 per share on 1 July. Dividends declared on ordmary shares 125.5
-
- - -104.3
REQUIRED Total CompC'ehensive •ncome aher tax 775.9 691.4
a Prepare all necessary tournai entnes to record the share
d1v1dend. REQU IRED
b Show your calculat•ons 10 determm1ng how many shares a Calculate the return on equ1ty for Lee for 2020 and 2019.
would the holder of 1000 shares expect to rece•ve m the b Calculate the d1v1dend payout rauo for both years.
share d•v•dend? c Compare the financial performance for the two years
and comment on wh1ch year was more successful based
10 Share dividends versus share splits on these measures and poss•ble reasons why.
Chan Lim1ted IS lookmg to increase 1ts number of issued
shares to bnng down •ts current share pnce of $11. The 14 Evaluate equity
board of d•rectors •s try•ng to decide 1f a 2-for-1 share split or Laura Limited is try1ng to calculate d•fferent f1nancial
a 100 per cent (or one-for-one) share dividend is more measures to analyse its performance. The total
appropriate. Chan's equity is as follows (all figures in comprehensive income for the year was $80 m1ll1on. There
m•llions): are 150 million shares •ssued.

Contributed equity (430 000 shares) $ 860000 REQUIRED

7775000 a Calculate earnings per share (EPS) for the year.
Retained earnings
b What does the EPS indicate about the company's
Total shareholders· equity
financial performance? What could the EPS be compared
REQU IRED to. what could it not be compared to? Why?
a Assess the advantages and disadvantages of the share c What m1ght the company do to 1mprove th1s financ1al
split versus the share diVidend. measure?
b Create a new equ•ty sect1on based on Chan choosing
(i) a share dividend or (11) a share spht. 15 Evaluate equity
The followmg is from the fmanc•al statements of Bond
11 Preference shares and preference Boomerangs from the last two years:
dividends
2021 2020
The shareholders' equny section of Restaurant Electronics
Limited's balance sheet shows: Total assets $1685 $1730
Total liabilities 900 875
Ordinary shares (190000 shares 1ssued) $1440000
Total shareholders' eQUity 785 855
Preference shares (cumulat•ve. 28c 600000
annual dividend, 150 000 shares •ssued} REQUIRED
---'--- - - -- -
Conduct a honzontal analysiS, and vert1cal analys1s for both
The company pa1d d1v1dends up to and 1ncluding 2018.
years.
but no d1v1dends in 2019.

REQU IRED 16 Evaluate equity

a Calculate the dividend on the ordmary and preference Beatson Boutiques provided the following mformat1on from
shares m 2020 if total div1dends are $559000. its financial statements:
b Prepare the journal entry to record the above dividend
Total comprehensive income $164500
transactions if the dividends were declared on 8/8/20
and paid on 10/10/20. Average number of ordinary shares 235000
Average shareholders' equity 576000
12 Share buyback
REQUIRED
On 15 January, Capital Company purchased on market
10000 shares of •ts own ord1nary shares when the shares Calculate the earn1ngs per share and return on eqUity for
were trading at $45. Beatson Boutiques. How are the two profitability ratios
different?
REQUIRED
Prepare the tournai entry to record the share buyback

Copyrlgh12019 Cengajle L.umlng. AU Rlghta R--...d.!Uy not be copied. scanned, 0< ~iealed. ln whol
 1 May All allotment money due was received.
1 June The call was made for the rematntng
outstand•ng money.
1 July All call money except that owmg on 40000
shares was recetved.
1 August The shareholders who did not pay thetr call
had thetr shares forfeited.
1 September The lorfetted shares were reissued at a
17 Recording and reporting equity 5 cent per share discount.
Czernkowski Company had the following balances in its REQUIRED
shareholders' equity at 1 January:
Prepare the journal entries to record the above transacbons.
Contnbuted equity (450 0000 $2100000
ordinary shares) 19 Evaluating equity
Retamed earntngs 2225000 The lollowmg are ftnanctal measures from the financtal
-'---- - - - statements of Browmng Brothers lor the past two years:
During the year, Czernkowski had the followmg transactions:
1 Mar. Issued 200000 ordinary shares lor cash at $8 per This year last lear
share. Total assets $4255350 $3895700
1 Jul. Declared a 1 lor 10 share dtvtdend, payable Totalliabilittes 2050150 1980300
1 August. The shares were tradmg at $7 per
share on 1 July. Total shareholders' equ1ty 2205 200 1915400
15 Aug . Declared a 50 cent per share cash d•vidend of REQUIRED
record on 1 September, payable 15 September.
a Conduct a horizontal analysis of Browning Brothers.
1 Oct. Bought baCk 6000 ordinary shares lor $45000. Comment on your findings and possible reasons for
31 Dec. Revenue lor the year $1 620 000, expenses for these ftndings.
the year $1100 000. b Conduct a vertical analysts for both years for Browning
REQUIRED Brothers. Compare and bnefly tnterpret the results of the
a Prepare the JOurnal entries to record the transactiOns. two years.
b Prepare Czernkowski's 31 December shareholders'
equtty sectton of the balance sheet. 20 Evaluating equity
c Calculate earntngs per share lor the year. Olson Outlet is trymg to determtne if its equtty ts
comparable to other outlets in the area.
18 Issuing shares: instalments, 2021 2020
oversubscription, forfeiture and reissue
Total assets $1374000 $1 506000
The following information is available for Liu Limited lor 2019:
Total liabilities 588000 732 000
1 January Liu Limited was registered as a new
company. Total equity 786000 774000
1 Febnuary A prospectus was tssued tnvttmg Total comprehenstve 1ncome 198500
applications for 900 000 ordtnary shares at Average number of ordinary 266000
$1 per share. The prospectus spectfted shares issued
50 cents payable on apphcattOn, 30 cents
Average eqUity 780000
on allotment and the 20 cents balance
when called. Market price of shares 21
1 March Applications were recetved lor 1400000 Total dividends 59000
shares.
Dividends per share 025
1 Apnl Dtrectors accepted applications for 700 000
shares and allocated those shares. As per REQUIRED
the provision of the prospectus. applications a Conduct horizontal and vertical analyses for Olson.
lor 300 000 shares were scaled back and
b Calculate the earnings per share and return on equity.
allocated 200 ooo shares (wtth the excess
application money applied to allotment) and c Calculate the divtdend payout ratio and the dtvtdend
the directors rejected apphcattons for yield.
400000 shares and refunded the money to
the applicants.

_ 210
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21 Research and analysis
Access the latest annual report for a public company of your
lecturer's choosing .
REQU IRED
a Exam1ne the company's balance sheet and conduct
honzontal and venical analyses of the company's total
(shareholders') equity.
b Calc\Jiate the company's retum on equ1ty rauo. Ustng the
dMdend and price data from the /ISX website (or a ftnanctal
servtces webstte). calculate the company's dMdend YJeld,
assuming that an investor purchased the shares on the last
day of the previous financial year.
c Examine the company's statement of retained earnings
and determine the value of share dividends declared
during the financial year.
d Examine the financing activities section of the company's
cash flow statement. How would you characterise the
company's acttvity over the past two years?
e Based on your answers above. wnte a paragraph
expla1ntng your opinion of the company's posrtron. Use
your answers as supportrng facts.
22 Raising the money to expand
a business
Lara Steele is an entrepreneur and owner of 'Wood by
Steele', a sole proprietorship. The busrness. which
manufactures tables. chairs. cabinets and other furmture
Copyright 2019 Cengage Learning. All Right& R...rved. May not be c opied, scan nod, or duplicated. In whole or lnei'\'J.:M ~·~~~Idero' ~uity
from recycl1ng wooden fences, is growing, and Lara IS
explonng the 1dea of purchasrng a brand-new manufactunng
facility. Because she does not have the money to do so, she
believes her optiOns are to borrow the money or to conven
the busrness to a corporation and sell shares.
REQUIRED
Describe the alternatives ava1lable to Lara. Wh1ch alternative
would you consider best? Make sure to expla1n the
advantages and disadvantages of the course of action that
you recommend .
23 Ordinary or preference shares,
investors' perspective
A friend has ema1led you to ask for some Investing adv1ce.
She 1s constdenng buyrng shares in a cenarn company and is
try1ng to determ1ne whether she wants to rnvest 1n the
company's ord1nary or preference shares.
REQU IRED
Draft an email to your fnend explaining the Similarities and
differences between ord1nary and preference shares. Include
reasons why you feel one m1ght be preferable.
24 Ethics
Explain the advantages and disadvantages of rnvesting
(buying shares. becoming a shareholder) in compames.
Beyond seekrng f1nanc1al return, what other matters might
you cons1der when choosrng companies to 1nvest 1n?
1 2 1_1 _ _

After studying the material in this chapter, you
should be able to:
Describe the purpose and format of the
statement of cash flows.
Understand the process of preparing the
statement of cash flows.
Prepare the operating activities section of
the statement of cash flows using the
direct method.
Prepare the operating activities section of
the statement of cash flows using the
indirect method.
Outline the investing activities section of the
statement of cash flows.
Summarise the financing activities section
of the statement of cash flows.
Evaluate the statement of cash flows
through the calculation and interpretation of
ratio analyses.
apply this
Copyrlght2019 Cengage Loa nlng A R ght Rnervecl May not
212
As discussed in Chapter 1, the statement of cash flows
provides information on how a company generates and
distributes cash over a period of time. This chapter
examines the purpose and format of the statement of cash
flows and demonstrates how the statement is prepared.
Emphas1s is given to the two approaches to preparing the
operating section. The chapter concludes with an ana lysis
of how to use the statement to generate useful information
about a company and its cash. Guidance is provided by
AASB 107 Statement of Cash Flows.
~ THE STATEMENT OF
1fil CASH FLOWS
One of the most 1mportant resources of any company IS
cash . If a company cannot generate sufficient cash, its
ability to continue operations is significantly limited. As a
result, management. investors and creditors want to know
how a company is managing its cash . How does the
company spend its cash? How does it generate cash?
What are the prospects of the company paying a cash
dividend?Will the company be able to satisfy its upcoming
interest and loan obl igations? Does the company have
enough cash to expand its research facilities? Answers to
these and other q uestions can be found through an
examination of the statement of cash flows.
The statement of ca sh flows is a st atement of cash
financial statement that summarises a flows A financaal
company's inflows and outflows of cash statement that summanses
a company's inflows and
over a period of time . Its purpose is to outflows of cash Ollllf a
inform users on how and why a company's period of time wrth a
purpose to inform USSfli on
cash changed during the period. So that it how and why a company's
is as informative as poss ib le, t he cash changed dunng the
period.
statement groups and reports cash flows
i n three major categories: operating, investing and
financing. Cash flows from each of the three categones are
then combined to determine the company's net change 1n
cash and cash equivalents. This net change will be equal to
the difference between the beginning and ending cash and
cash equivalents balances from t he balance sheet
(statement of financial position). Note that f rom this point
forward. the term cash will be used to represent cash and
cash equivalents.
The basic structure of the statement of cash flows is
as follows:
+ 1- Cash Flows Provided {Used) by Operating Activities
+1- Cash Flows PrOVIded {Used) by Investing Activities
+1- Cash Flows PrOVIded {Used) by Financing Activities
=Net Increase tOecrease)1n Cash
+ Cash. Beginmng of Year
-----------------------
=Cash. End of Year - -- - - - - -- - - - - -
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 Operating cash flows are reported first on the statement
of cash flows. Like most companies, CSL reports operating
cash f lows using the direct met hod. AASB 107 allows the
indirect method but encourages entities 'to report cash
flows from operating activities using the direct method''
The indirect method calculates operating cash f lows by
adjusting profit or loss from an accrual basis to a cash basis.
This calculation will be demonstrated later. In Australia
when reporting entities use the direct method they are
required to disclose a reconciliation of cash flows from
operating activit ies to profit or loss, which is similar to the
' I
ca lculation of cash f lows from operations used for the

(jo indirect method. CSL:s reconc iliation is in Note 14,

reproduced in Exhibit 12.2.

Cochlear® CASH FLOWS FROM INVESTING ACTIVITIES

Cash flows provi ded (used) by cash flows provided
One of the k~ys to succ.ess ior a compa~y like CSL is investing activities are those cash (used) by investing
to convert its products (medicines) into cash ·· activities Cash inflows
inflows and outflows arising from the and outflows arising from
acquisition and disposal of non-current the acquisition and
The following sections discuss the three groupings disposal of non-current
of cash flows. For illustration purposes, Exhibit 12.1 asset s. They are often called investing assets; often called
conta ins CSL:s statement of cash flows for the year cash flows and wou ld include t he investing cash flows.

~,\Y TIJ, endi ng 30 June 2017. All following:

Checkoutthevideosummary dollar amounts are in US e cash inflows from the sale of property, plant, equipment
• for Chapcer 12 millions. or investments
e cash outflows for the purchase of property, plant,
CASH FLOWS FROM OPERATING ACTIVITIES equipment or investments.
Investing cash flows are reported after operat ing
Cash flows provi ded (used) by
activities. Exhib it 12.1 reveals CSL had net cash outflows
cash flows provided operati ng activities are those cash
(used) by operating from investing activities of $862.9 million in 2017. The main
activities Cash inflows inflows and outflows arising from the
contributor to that tot al in both years was payments for
and outflows arising from company's operations. These inflows and
the company's operations; property, plant and equipment (PPE).
sometimes called operating outflows are sometimes called operating
cash flows. cash flows and wou ld include the
following:
CASH FLOWS FROM FINANCING ACTIVITIES
e cash inflows from collection of receivables and cash Cash flows provi ded (used) by cash flows provided
financing activities are those cash (used) by financing
sales or services activities Cash inflows
e cash outflows for operating items such as payments to inflows and outflows associated w ith the and outflows associated
generation and return of capita l. These are with the generation and
creditors, salaries and rent paid and tax paid.
return of capital; often
Basically, any cash flow associated w ith a company's often called financing cash flows and called financing cash flows.
revenues or expenses should be considered an operating wou ld include the following:
cash flow. Because of this, the net cash f low from e cash inflows from borrowings or share issues
operating activities can be thought of as net profit or loss e cash outflows to satisfy debt obligations or to
on a cash basis. CSL in 2017 reports a 'Net cash inflow repurchase shares
from operating activity' of $1246.6 million, up over 5 per e cash outflows for dividends to shareholders.
cent on 2016. Basically, any cash flows associated w ith non-<:urrent
liabilit ies or equity (other than interest paymen ts) are
considered to be financing cash f lows.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In whole o(:J!l£Pf\:R~~N~~i~e'n~2 f cash flows
0 __
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21 3
 CONSOLIDATED STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED 30 JUNE 2017

Consolidated Entity
2017 2016
US$m USSm

Cash flows from Operating Activities

Receipts from customers (inclusive of goods and services tax) 6,749.2 5,982.7
Payments to suppliers and employees (inclusive of goods and services tax) (4,946.9) (4,417.0)
1,802.3 1,565.7
Income taxes paid (468.3) (326.2)
Interest received 6.7 14.1
Borrowing costs (94.1) (75.0)
Net cash inflow from operating activities 1,246.6 1,178.6
Cash flows from Investing Activities
Proceeds from sale of property, plant and equipment 0.1 0.1
Payments for property, plant and equipment (689.1) (495.1)
Payments for intangible assets (171.5) (70.6)
Payments for business acquisition (Net of cash acquired) (244.6)
(Payments)/receipts from other financial assets (2.4) 0.1
Net cash outflow from investing activities (862.9) (810.1)
Cash flows from Financing Activities
Proceeds from issue of shares 12.7 17.4
Dividends paid (601.4) (579.0)
Proceeds from borrowings 1,381.4 1,564.3
Repayment of borrowings (581.3) (716.9)
Payment for shares bought back (314.9) (648.2)
Net cash outflow from financing activities (103.5) (362.4)
Net increase in cash and cash equivalents 280.2 6.1
Cash and cash equivalents at the beginning of the finandal year 555.3 555.5
Exchange rate variations on foreign cash and cash equivalent balances 7.5 (6.3)
Cash and cash equivalents at the end of the financial year 843.0 555.3

The consolidated statement of cash flows shouldbe mdin conjunction with the dccompanying notes.

~ CSt:s Statement of cash fl ows 2017

Source: CSLI.imited, Atroal Report 2017. p. 84.

Financing cash f lows are reported after investing cash NET INCREASE (DECREASE) IN CASH
flows. Exhibit 12.1 revea ls CSL had net cash outflows
After a company reports its ope rating, investing and
from f inancing activities in 2017 of $103.5 million, due to
f inancing cash f lows, it sums t he th ree and reconciles the
dividends pa id, repayment of borrowings and payments
company's beginning and ending cash balances. The
for shares bought back. In both 2017 and 2016 CSL
following is a condensed version of CSt:s Statement of
borrowed around $1.5 billion but repaid almost half the
cash flows, showing only t he major subtotals:
borrowings.

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_ 214
...;;..;..;.
EFFICIENCY OF OPERATION
Note 14:
Cash and Cash Equivalents, Cash Flows
2017 2016
USSm USSm

Reconciliation of cash and cash equivalents

Cash at bank and on hand 562.7 442.0
Cash deposits 281.8 114.6
Less bank overdrafts (1.5) (1.3)
Total cashand cash equivalents 843.0 555.3
Reconciliation of Profit after tax to Cash Flows from Operations
Profit after tax 1,337.4 1,242.4
Non·cash items in profit after tax:
Depreciation, amortisation and impairment charges 279.2 220.3
Loss on disposal of property, plant and equipment 8.7 2.3
Gain/(loss) on acquisition (176.1)
Share· based payments expense 12.2 6.1
Changes in assets and liabilities:
Increase in trade and other receivables (72.5) (45.3)
Increase in inventories (389.2) (216.5)
(lncrease)/decrease in retirement benefit assets (0.4) 2.3
Increase in net tax assets (111.0) (12.7)
Increase in trade and other payables 153.9 116.0
(Oecrease)/increase in deferred government grants (0.6) 4.5
Increase in provisions 21.4 19.7
Increase in retirement benefit liabilities 7.5 15.6
Net cash Inflow from operating activities 1,246.6 1,178.6

Non-cash financing activities

Acquisition of plant and equipment by means of finance leases 4.0 3.2
~ CSt:s Reconcoliatoon of Profit after tax to Cash Flows from Operatoons

Source:CSL lill'l~ed. AnnualReport2011. Note 1•: Cash an:l Cash ~ival«rts, Cash Flows. p. 108.

In 2017 CSL showed a subst antial increase in cash. This

increase consisted of the sum of operating, invest ing and
financing cash f lows. In the statement of cash flows the
cash and cash equivalents are shown 'net of bank overdraft'.
Cash and cash equivalents at the beginning s 555.3 In the balance sheet the cash figures are a little over one
of the financial year
Net cash provided by operating activities 1246.6 1178.6 million higher as we do not subtract the overdraft (part of
interest bea ring current liabilities) f rom the current asset
Net cash used in investing activities (8629) (810 1)
cash.
Net cash used in financing activities (1035) (3624)
Exchange rate variation on foreign cash (not 7.5 (63)
important)
ADDITIONAL DISCLOSURES
Cash and cash equivalents at the end of the 555.3 All reporting entities prepare a statement of cash f lows
8430
financial year using a format sim ilar to what has been described. In
CSlAmual Repon 2017, p. 84. addition, as required by AASB 107:

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 lnvestong and fonancong transactions that do not requore
the use of cash or cash equivalents shall be excluded
from a statement of cash flows. Such transactoons shall
be dosclosed elsewhere in the fonaooal statements in
a ~ that prOIIIdes all the relevant onforrnatoon about
these onveshng and financing aciJVlbeS.'
In Note 14 CSL reports 'non-cash financing activities
- acquisition of plant and equipment
Review lhis content by means of f inance leases' of $4.0
with doe e-lecture
million 2017, $3.2 million 2016.

is. they are prepared by rearranging numbers already

provided by the accounting system (trial balance).
The preparatiOn of the statement of cash flows is different.
Chapter 4 d1scussed the preparation of the statement of
First. informatiOn IS collected from a variety of sources.
comprehensive income. the statement of dlanges in
Second. prepanng the statement requires an examination of
equity and the balance sheet. Eadl of these statements is
the dlanges in all non-cash accounts. To understand why,
prepared with numbers f rom an adjusted trial balance. That
consider the fundamental accounting equation:
Assets = Liabilities+ Equity

Cash can be isolated by breaking it out f rom other

assets to yield the following:
Cash+ Non-Cash Assets= Liabilities+ Equity

Moving non-cash assets from the left side of the

equation to the nght side then results in the followmg :
Cash = i.Jabohues + Equity - Non-Cash Assets

Using 6 to denote a change, t his equation can also be

rewritten to show that the dlange in cash for a given period
is equal to the changes in all other non-cash accounts
(liabilities. equity and non-cash assets):
fl Cash= flliabilities + ll Equity- fl Non -Cash Assets

As a result, to explain a company's dlange in cash. you

must explain the changes in the company's non-cash
accounts. And to do that. you need the following three
items:
• a comparative balance sheet
• an income statement
e additional1nformation on changes in account balances.
A comparative balance sheet provides the beginning
and ending balances of all accounts. but of interest now
are the non-cash accounts. from whidl changes for the
period are ca lculated. A statement of comprehensive
income provides a company's reven ue and expense
balances for the period. These balances are used to
prepare the operating activities section of the statement
of cash flows. Add1t1onal information on changes in
account balances IS needed to determine if a balance
dlanged because of non-cash activity. For example. the
issue of shares to sat1sfy a debt obligation dlanges both
equity and liability balances. but cash is not affected.
Knowledge of such significant non-cash transactions
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216
-~;.;;.
 keeps one from e rroneously concluding that t he com pany will be used. Note that the Sunshine Company prov ides
received cash for the issue of sha res and paid cash for t he both a statement of co mprehens ive income and a
ret irem ent of the debt. co m pa rative balance s heet and that all numbers are in
m illions, but for sim plicity, references t o the m illions will
DIRECT AND INDIRECT METHODS FOR be om itted in t he discussions. Addit ional inform ation will
OPERATING CASH FLOWS be provided as needed.

W hen preparing the statement of cash flow s, all companies The Sunshine Company
report cash flow s from operating, investing and f inancing Income statement for year ended 30 June 2020
(in millions)
activities. The manner in w hich cash f low s from investing
and financing activit ies are reported is t he sam e for all Sales $432
companies. How eve r, com panies can repo rt t heir cash Cost of goods sold 281
f low s f rom operating act iv ities using one of two m ethods: Gross profit $151
e t he d irect method Expenses:
et he indirect method .
Depreciation expense $25
Under the direct method, a company
direct method Method calculates and reports its cash inf lows
Insurance expense 14
of reporting casll flows from Salaries expense
operating activities in ~MUch from opera tions follow ed by its c ash 63
cash inflows ard outflows outf low s f or ope ratio n s . Typ ically, Electricity expense 28 130
from operations are reported
separately on the statement cash inf low s come from cash sa les (o r Profits before tax $ 21
of cash flows. cash received f rom services paid in cash) Income tax expense 8
and collections of accounts receivables, $ 1
Gain on sale of equipment
but are often reported as one figure. Cash out flow s are
Total comprehensive income ~
broken o ut into a few categories including cash payments
for: inventory, operating expenses, and interest and tax. The
difference between inflow s and outflow s is the com pa ny 's
net cash flow from operating activit ies. The method is called
'di rect' because both inflow s and o utflows are s hown
directly on the statement.
U nder the i ndirect method, a
Cash and cash equivalents
2020
$ 18
: 2019
$ 45
Accounts receivable 45 41
indirect com pany repo rts its cash flow s from
method Method of Inventory 101 92
reporting cash flows from operating activities by adj usting its net
operating activities in Prepaid insurance 11 15
income from an accrual basis to a cash
which net income is $193
adjusted from an accrual basis. The method is called ' ind irect ' Total current assets $1 75
basis to a cash basis. because it does not directly report cash Investments 22 0
i nf low s an d c as h ou t flows f ro m Property and equipment. at cost 232 166
operations. Rat her, it reports t he adjustments necessary Less: Accumulated depreciation (57) (37)
to convert net income (profit or loss) to the net cash flow
Total assets $372 $322
fro m operating activities. Adjust ments t ypically arise from
Accounts payable $ 37 $ 29
non-cash revenues and expenses (gains and losses) and/
or dlanges in cu rrent assets and current liabilit ies. Salaries payable 21 21
Both t he indirect and direct methods will y ield the same Electricity payable 27 22
net cash f lows f rom operating activ it ies.The only difference Taxes payable 0 7
between the methods is the manner in wh ich cash flow s Total current liabilities $ 85 $ 79
are reported. Because the Australian account ing standards 0
Non·current liabilities 45
require com panies t hat use t he direct method t o also
Total liabilities $130 ~
disclose t he reconciliation of cash f low s f rom operations
Contributed equity $1 55 $165
to net profit, w e concentrate on t he indirect method, whidl
calculates cash flow f rom operations in t he sam e w ay as Retained earnings 87 78
the reconciliat ion is prepared. Total equity $242 $243
Total liabilities and equity $372 $322
EXAMPLE DATA ~ The Sunsh ine Company financoal statements
To demonstrate how to prepare a statement of cash flow s,
the inform ation for a hypothet ical company in Exhi bit 12.3

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217
 Receivable account 1ncreases when sales are made but no
REPORTING CASH FLOWS cash is collected. Therefore. a $4 increase means that $4
FROM OPERATING of its $432 of sales were not collected during the year.
ACTIVITIES: DIRECT Therefore, cash collections were $428.

METHOD Sales for the period $432

Less. Increase 1n accounts rece1vable _4
This section demonstrates the calculation of cash flows
from operating activities under the direct method.
Cash collected from sales ~
Note that had Sunshine's accounts receivable decreased
during the year. the decrease would have been added to sales.
The conversion of sales to cash collections can be
summarised as follows:

Balance from Adjustment Balance for

statement of statement of
comprehensive cash flows
income
-Increase in accounts
receivable =Cash collected
Sales or
from sales
+ Decrease in accounts
receivable

A second approach for calculating cash receipts from

sales is to prepare the journal entry that Sunshine would
hypothetically make if it recorded its annual sales and the
\ change in receivables 1n only one entry.
Given sales of $432, Sunshine would credit Sales for
$432. It would also debit Accounts Receivable for $4 to
reflect the increase 1n the account. To balance the entry, 1t
would debit Cash for $428.Thus. cash collections from sales
When reporting operating cash flows under the direct
are $428.
method. companies calculate and report cash receipts
from operating activities and cash payments for operating Hypothetical entry Accounts Receivable 4
activities. Cash receipts are calculated by convert ing Cash 428
revenues from the statement of comprehensive income Sales 432
to cash collections. Cash payments are calculated by ~-----

converting expenses to cash payments.

The following sections demonstrate this conversion
process. The first section considers cash rece1pts from
customers. The next sections consider cash payments in
three nnam groups: cash paid for inventory, for operating
expenses and for income taxes. Rn each calculation. two
approaches are demonstrated - one focusing on the
changes in account balances and another using a debit/
credit approach.
CASH RECEIVED FROM CUSTOMERS
The Sunshine Company's statement of comprehensive
income shows that the company generated $432 in sales
dunng the year. To determine cash rece1pts from those
sales, the balance sheet account related to sales - accounts
rece1vable - must be examined.
Sunshme's balance sheet shows that accounts
receivable increased $4 during the year. The Accounts
CASH PAID FOR INVENTORY
Sunshine shows $281 of cost of goods sold dunng the
year. To convert th1s expense to cash paid for inventory, 1t
must first calculate total purchases for the period and then
calculate the cash paid for those purchases.
To calculate purchases. Sunshine must examine the
inventory account. Inventory increased by $9 during the
year. An increase in inventory means that it bought more
inventory than it sold. Therefore, it must have purchased
$290 of inventory during the year.
lnventol'( sold dur1ng the period $281
Plus. Increase m 1nvent0!\' -----------= 9
lnventol'( purchased dunng the penod ~
Note that had Sunshine's inventory decreased dunng
the year, the decrease would have been subtracted from
inventory to calculate purchases.

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218
Balance from statement of Adjustment Adjustment Balance for statement
comprehensive income of cash flows
Cost of goods sold + Increase in inventory -Increase in accounts payable
or = Purchases or =Cash paid for inventory
- Decrease in inventory + Decrease in accounts payable

To calculate cash paid for these pu rchases, Sunshine Prepaid insurance decreased $4, meaning that Sunshine
must examine accounts payable. Accounts payable used $4 of insurance it had purchased in a previous period.
increased $8 during the year. The accounts payable account As a result, cash paid for insurance in the current period
increases when purchases are made but no cash is paid. was only $10.
Therefore. it must have paid for only $282 of its $290 in
Insurance expense for the period $14
purchases.
Less: Decrease in prepaid insurance 4
Inventory purchased during the period S290 Cash paid for insurance
Less: Increase in accounts payable 8
Cash paid to suppliers for the period Note that had Sunshine's prepaid insurance increased
during t he year. t he increase would have been added to
Note t hat had Sunshine's accounts payable decreased insurance expense.
during the year. the decrease wou ld have been added to The conversion of insurance expense to cash paid for
purchases to calculate cash paid. insurance is summarised in t he following table:
The conversion of cost of goods sold to cash paid for
Balance from Adjustment Balance for
inventory can be summarised as shown in the following statement of statement of
table. comprehensive cash flows
income
Cash paid f or inventory can also be determined by
+ Increase in prepaid
preparing the entry that Sunshine would hypothetically insurance
make to record the activity in the Cost of Goods Sold, = Cash paid for
Insurance expense or
insurance
Inventory and Accounts Payable accounts. - Decrease in prepaid
insurance
Given cost of goods sold of $281, Sunshine would debit
Cost of Goods Sold for $281. It wou ld also debit Inventory Using the entry approach to calcu late cash payments
$9 for its increase during the year and credit Accounts for insurance. Sunshine wou ld debit Insurance Expense for
Payable $8 for its increase during the year. To balance the $14 and credit Prepaid Insurance for $4. Cash would then
entry, it would credit Cash for $282. Thus, cash pa id for be credited to balance the entry, showing cash payments
inventory is $282. for insurance to be $10.
Hypothetical Cost of Goods Sold 281
entry Hypothetical Insurance Expense 14
entry
Inventory 9
Prepaid Insurance 4
Accounts Payable 8
Cash 10
Cash 282
Salaries expense and
CASH PAID FOR OPERATING EXPENSES electricity expense
Sunshine shows $63 of salaries expense and $28 of
Sunsh ine's statement of comprehensive income shows
electricity expense during the year. To determine the cash
several operating expenses. The f ollowing sections
paid for these operating expenses, the related accounts -
demonstrate how operating expenses are converted to
Salaries Payable and Electricity Payable- must be examined.
cash paid. The first section illustrates an expense related
Salaries payable did not change during the year, so it
to a current asset. The second section illustrates two
must have paid exactly $63 to employees.
expenses relating to current liabilities.
Salaries expense for the period $63
Insurance expense
Change in salaries payable 0
Sunshine's Statement of comprehensive income shows
Cash paid to employees
$14 of insurance expense during the year. To determine t he
cash paid for insurance. the related balance sheet- prepaid
Electricity Payable increased $5 during the year,
insurance- must be examined.
meaning that Sunshine used electricity during the year for

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219
 which it did not pay. Therefore, it paid only $23 for electricity Income tax expense for the penod $ 8
during the year. ------------------~
Plus: Decrease 1n taxes payable 7
ElecUICity expense for the period S28 Cash paid for taxes W
Less. Increase in electncity payable 5
Note that had the taxes payable increased during the
Cash pa1d for electricity
------- year, the increase would have been subtracted from
income tax expense.
Note that had Sunshine's electricity payable decreased
The conversion of income tax expense to cash pa id for
during the year. the decrease would have been added to
taxes is summarised in the following table:
electricity expense.
The conversion of these operating expenses to cash Balance from Adjustment Balance for
paid for salaries and electricity can be summarised as statement of statement
comprehensive of cash flows
follows: income

Balance from Adjustment Balance for - Increase in taxes

statement of sUtementof payable
= Cash pa1d for
comprehensive cuh flows Income tax expense or
taxes
income + Decrease in taxes
-Increase in salaries payable
payable
= Cash pa1d for To calculate cash payments using the entry method,
Salanes expense or
salaries
+Decrease in salaries Sunshine would debit Income Tax Expense for $8 and debit
payable Taxes Payable for $7. Cash would be credited to balance
-Increase in electricity the entry, showing cash payments to be $15.
payable
or
= Cash paid for
Electricity expense Hypothetical Income Tax Expense 8
electnctty
+ Decrease in electricity entry
payable
Taxes Payable 7
Ustng the entry approach to calculate the cash payments Cash 15
for salanes, Sunshine would debit Salaries Expense for
$63. Nothtng is recorded for Salaries Payable because the
OTHER REVENUES AND EXPENSES
account balance was unchanged. Cash is then credited to
balance the entry, showing cash payments to be $63. Sunshine's Statement of comprehensive income contains
two additional items: depreciation expense and gain on
Hypothetical Insurance Expense 63 sale of equipment. For the following reasons, these items
entry
-------
Cash
- - - ---- 63
are ignored under the direct method.
Recall from Chapter 8 that depreciation expense is a
non-cash charge, meaning that cash is not affected when
For electricity, Sunshine would debit Electricity Expense
depreciation is recorded. As a result. depreciation expense
for $28 and credit Electricit y Payable for $5. Cash would be
is not included when preparing the operating activities
cred1ted to balance the entry. showing cash payments to
section under the direct method. This is always the case.
be $23.
Recall also from Chapter 8 that a gain on the sale of

Electricity Expense equipment occurs when cash received from the sale
Hypotl1atical 28
entry exceeds the equipment's carrying value. Because the sale
Electricity Payable 5 of equipment is an investing activity, all cash received from
the sale w ill be reported as a cash inflow from investing
Cash 23
activities. As a result. the gain on the sale is not included
when preparing the operating activities section under the
CASH PAID FOR TAXES direct method. The same would be true for a loss on the
Sunshine's statement of comprehensive income shows sale of equipment.
$8 of income tax expense during the year. To detennnine
the cash paid for taxes. the related balance sheet account NET OPERATING CASH FLOWS
- taxes payable - must be examined . Based on the prev~ous calculations. Sunshine's operating
Taxes payable decreased $7 during the year, meaning activities sectiOn of 1ts statement of cash flows is shown
that Sunshtne paid not only current-year taxes of $8, but in Exhi b it 12.4 . A summary of adjustments used to
also $7 of prior-year taxes. Thus, taxes paid in this period generate the numbers is found in Exhibit 12.5.
were $15.

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 Jhe Sunshine Company ADJUSTMENTS FOR NON-CASH ITEMS
activities 2020 Accrual-based profit or loss (or net incom e) often includes
Cash receipts from customers $428 expenses t hat have no related cash consequences. The
Less cash payments: most common example is depreciation expense, wh ich is
To suppl iers $282 an allocation of the historical cost of a fixed asset. Wh ile
depreciation reduces accrual-based profits, it does not
To employees 63
resu lt in any cash payment. Therefore, to adjust prof its to
For insurance 10
a cash basis, t he effect of depreciation must be removed.
For electricity 23 This is accomplished by adding depreciation expense back
For taxes 15 393 to profits. Other examples of non-cash expenses are
Net cash provided by operating activities U§ amortisation expense, bad debt expense and impairment
losses. Some therefore mistakenly th ink these are inflows
[iiiiiiT]
Jhe Sunshine Company's operating cash flows
of cash, but they are not. Depreciation and the like are
~ using the direct method
expenses that reduce profits, but they are not cash outflow s
that reduce c ash from operating activities.
Review this content The general adjustment for all non-cash expenses is
with thee-lecture
therefore as follow s :

Adjustment rule for non-cash expenses

~ REPORTING CASH FLOWS
'iii' FROM OPERATING
ACTIVITIES: INDIRECT
METHOD
This section demonstrates t he calculation of cash flows
from operating activit ies under the indirect method .
When reporting operating cash flows under the indirect
method, companies calculate and report net cash flows from
operating activ ities by adjusting t he prof it or loss f rom an
accrual basis to a cash basis. This requires many adjustments,
but they can be grouped into three main types:
e non-cash effects on net incom e
e ga ins an d losses from investing an d/or financing
activities
e changes in current assets and liabilit ies.
The f o ll owi ng sect io n s demonstrate t h ese
adjustments using the Sunshine Company inform ation
in Exh ib it 12.3.
Add back to profit all non-cash expenses
Sunsh ine's statem e nt of comprehensive incom e in
Exh i b it 12.3 s hows o n ly one no n-cas h exp ense :
depreciation expense of $25. Therefore, the $25 w ou ld be
added back to profits.
ADJUSTMENTS FOR GAINS AND
LOSSES FROM INVESTING AND
FINANCING ACTIVITIES
Sometimes, a company's profits will include a gain or loss
aris ing from an investing or f inancing activity. Fo r example,
a company m ight gene rate a ga in f rom the sa le of
equipment or a 'loss on d isposa l of property, plant and
equipment' o r 'reconciliation of prof it after tax to cash flow s
from operations' (see Exhibit 12.2 taken from CSL Note
14). Another company m ight generate a gain f rom t he early
ret irement of debt or a 'loss o n acquisition' (agai n see
Exhibit 12.2).

Balance from statement Adjustment Balance for statement of

of comprehensive cash flows
income
Sales - Increase in accounts receivable OR + Decrease in accounts receivable = Cash collected from sales
Cost of goods sold + Increase in inventory OR -Decrease in inventory = Cash paid for inventory
and
-Increase in accounts payable OR + Decrease in accounts payable
Operating expenses + Increase in current assets OR -Decrease in current assets = Cash paid for operations
or
- Increase in current liabilities OR + Decrease in current liabilities
Income tax expense -Increase in taxes payable OR + Decrease in taxes payable = Cash paid for taxes
~ Summary of adjustments used 1n the direct method

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221
 When such activity occurs, the entire cash inflow
associated with the transaction will be reported as either
an investing or a financing cash flow. As a result, the effect
of the gain or loss must be removed from profits so that
operating cash flows are not affected by the transaction.
Gains must be subtracted from profits, and losses must be
added back to profits.
Adju stmen t rules for gains and losses from investing
and financing activities
Subtract from profits any gains arising from investing or financing
activities.
Add back to profits any losses arising from investing or financing
activities.
Sunshine's Statement of comprehensive income
shows on ly one gain or loss from an investing or financing
activity: a $1 gain on the sale of equipment. Because the
cash received from the sale w ill be reported as cash inflow
in investing activit ies, the effect of the gain must be
subtracted from profit to determine cash flow from
operations. Therefore, profits are reduced by $1 to arrive at
the cash f low from the operating activities figure.
ADJUSTMENTS FOR CURRENT ASSETS AND
CURRENT LIABILITIES
The third type of adjustment involves the changes in a
company's current assets and current liabilities. Current
assets and current liabilities change during a period because
a company's revenues do not equal cash received and its
expenses do not equal cash paid.
For example, a change in accounts receivable means
that a company's cash collections do not equal its sales
revenue. If accounts receivable increases, sales revenue is
greater than cash coll ections. If accounts rece ivable
decreases, cash collections are greater than sales revenue.
Likewise, a change in sa laries payable means that a
company's cash payments do not equal its salaries
expense. If salaries payable increases, salaries expense is
greater than cash payments. If salaries payable decreases,
cash payments are greater than salaries expense.
Because the indirect method adjusts accrual-based
income to cash-based income, these d ifferences must be
removed from the accrual-based profit or loss to arrive at
cash flows from operating activities. That is, the revenues
and expenses must be adjusted so that they reflect cash
receipts and cash payments. This is accomplished w ith the
following adjustments:
Adju stmen t rules for current assets and cu rren t liabilities
Add a decrease in current assets to net income.
Subtract an increase in current assets from net income.
Add an increase in current liabilities to net income.
Subtract a decrease in current liabilities from net income.
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Sunshine's balance sheet shows changes in several
current assets and current liabilities. The following sections
describe the adjustment that each change requires.
Change in accounts receivable
Sunshine's balance sheet shows a $4 increase in accounts
receivable. Accounts receivable increases when sales are
made without receiving cash. Therefore, $4 of the reported
sales revenue was not collected in cash and must be
removed from revenues. Removing $4 from revenue is
accomplished by subtracting $4 from profits.
Change in inventory
Sunshine's inventory increased by $9 during the year.
Inventory increases when a company purchases more
inventory than it sells. Therefore, it must have purchased
$9 more in inventory than it sold during the year. So that
cash flows reflect all payments for purchases, the $9 must
be added to cost of goods sold. This results in a reduction
to profits of $9 to reflect the cash flow associated w ith
inventory.
Change in prepaid insurance
Sunshine has a decrease in prepa id insurance of $4.
Prepa id insurance decreases when a company uses
insurance that it has already purchased. Thus, a decrease
of $4 means that it used $4 of insurance that it purchased
in a previous period. As a result, insurance expense is $4
greater than the cash pa id for insurance and should be
reduced to reflect the cash paid for insurance. Reducing
cash paid for expenses by $4 is accomplished by adding
$4 to profits.
Change in accounts payable
Sunshine's balance sheet shows that accounts payable
increased by $8 during the year. Accounts payable increases
when inventory is purchased w ithout paying cash, so an
$8 increase means that it did not pay for $8 of its purchases
calculated previously. Therefore, the $8 must be removed
from expenses. This is accomplished by adding $8 to profit.
Change in electricity payable
Sunshine has an increase of $5 in electricity payable.
Electricity payable increases when a company incurs
electricity expense but does not pay cash . Thus, the $5
increase means that the expenses are $5 greater than the
cash paid. As a result, the $5 of expenses must be removed
from profits. Th is is accomplished by adding $5 to profits
to reflect the cash outflow associated with electricity.
Change in taxes payable
Sunshine's balance sheet shows that taxes payable
decreased $7 during the period to end at a zero balance.
Taxes payable decreases when a company pays not only
for current-period taxes but also prior-period taxes. The $7
decrease therefore means that it paid $7 more than it
expensed. As a result, the $7 should be added to expenses.
This is accomplished by subtracting $7 from profits.
You will note there is a certain repetitiveness to these
payables. Rather than trying to learn this as a formula
(increase in payable, less cash outflow etc.) try to think of
the logic.
A t11p down lo&IC lane: the IO&IC of sav1ne cash by not paym& your bi llS
(mcreaslll& payabl es), by &ettlll& those who owe you to pay qUICkly ~
(reducm& receivables) and runn~ne down mventory levels (reducm&
mventory) are Important 1n prepa11ne the cash flow from operations-
but may be c11t1cal for the surv~val of your busmess _ •.....-.~
NET OPERATING CASH FLOWS
The six adjustments from changes in current assets and
current liabilities, along with the two adjustments for non-
cash items, are shown in Exhibit 12.6 . The adjustments
result is $35 in net cash prov1ded by operating activities. If
you are learning both the d1rect and indirect methods, you
should note that the $35 IS the same as calculated under
the direct method. Note this is the same as shown in CSt:s
reconciliatiOn earlier m Exhibit 12.2 and in Appendix B
(Note 14: Cash and cash equivalents).
CALCULATING CASH
FLOWS FROM INVESTING
ACTIVITIES
This section demonstrates the calculation of cash flows
from investing activities. Recall that mvestmg activities
include the purchase and sale of non-current assets such
as PPE. intangible assets and long-term investments.
To calculate cash flows from 1nvest1ng activities, all
changes in non-current assets must be exammed. In
general. an increase in a non-current asset suggests a
purchase and therefore a cash outflow. A decrease
suggests a sale and therefore a cash inflow. However, to
be sure, any available information on the changes must be
examined to determine whether the change resulted f rom
a non-cash transaction or whether the change was the net
effect of both increases and decreases to the account.
To illustrate, consider again Sunshine's balance sheet
in Exhibit 12.3. It shows three non-current asset accounts:
Investments, Property and Equipment, and Accumulated
Depreciation. In the following sections, each account
balance is examined to determine Sunshine's cash flows
from investing activities.
INVESTMENTS
Accord ing to Sunshine's balance sheet (Exhibit 12.3),
investments increased $22. Wtthout any information to the
contrary, it is assumed that It purchased investments for
$22 cash. Thus, a cash outflow of $22 from the purchase
of investments is reported 1n mvesung activ1t1es.
EQUIPMENT

ICash ftows from=~~:~·~

Profits
Adjustments to reconc1le profits aher 1ncome tax to
net cash inflows from opera110g act1v1ties
Depreciation expense
Gain on sale of equ1pment
Increase in accounts receivable
Increase in inventol'{
Decrease in prepaid insurance
Increase in accounts payable
Increase in electricity payable
Decrease in taxes payable
Net cash provided by operating act1v1ties
[iiiiiiiil
The Sunsh1ne Company's operat1ng cash flows
~ us1ng the 1nd~rect method
Sunshine's balance sheet shows a $66 increase in
property and equipment dunng the year. Thus, 1t must
2020
have purchased equipment during the year. The statement
$14
of comprehensive income shows a $1 ga1n on the sale
of equipment. Thus, it must have sold equipment during
the year. As a result, there are both cash inflows and
$25
outflows related to equipment. Eaoh will be considered
(1)
separately.
(4)
(9) Cash inflows
Although the information is not in the financial statements
4
presented. let's assume Sunshine discloses that the $1
8
gain on the sale of equ ipment arose from selling equipment
5 with a cost of $10 and accumulated depreciation of $5 for
(7) 21 $6. Thus. a $6 inflow from the sale of equipment should be
~ included in investing activities. Note here that the gain from
the sale is ignored. Only the cash flow from the sale is of
interest at this point. The gain has already been accounted
for previously in cash flows from operating activities.
 Cash outflows
Sunshtne's equipment account increased $66 during the
year. Wtthout any additional information, rt would be assumed
that it purmased $66 in equipment for cash. However, the
additional information discloses that equ1pment wtth a cost
of $10 was sold during the year. Therefore, it must have
purmased $76 in equipment during the year.
ACCUMULATED DEPRECIATION
Recall from Chapter 8 that Accumu lated Depreciation is
the account that 'collects' the depreciation expenses.
Therefore, it manges when either depreciation expense is
recorded or depreciating non-current assets are sold.
DeprectatJon expense does not affect cash, and any sale
of equtpment ts already considered when examtntng the
equtpment account. Gains or losses on the sale of non-
current assets are backed-out (taken out) in the
reconciliation. Therefore, the mange in the accumulated
depreciation account can be ignored.
SUMMARY OF INVESTING CASH FLOWS
The three cash flows f rom investing activities are shown
in Exhibit 12.7 . The three items resulted in a net cash
outflow from investing activities of $92. Sunshtne was
ustng tts cash to invest in additional non-<:urrent assets.
"he Sunshine Company
CIISh flows from Investing activities
Purchase of equtpment S(76)
-~~--------------~~
Sale of equipment s
-------
Purchase of investments
Net cash used in investing activities
~ The Sunsh1ne Company's investmg cash flows
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This section demonstrates the calculation of cash flows from
financing activities. Recall that financing activities include
borrCNVing and repaying debt (non-current liabilities) and cash
inflows and outflows from/to the shareholders/investors
(equrty). Connmon financing activities include the tssutng of
shares or debt and the repurchase (buybac:k) of shares. the
payment of civdends and the repayment of debt. Note that
although payments of dividends to shareholders are considered
a financing activity, payments of interest to credrtOI'S are not.
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Because interest is an expense that is reported on the statement
of comprehensive income, payments for interest are reported
as operating activrtJes rather than financing activities.
To calculate cash flows from financing acttvttles, the
balances for non-current liabilities. equity accounts and
dividends must be examined. In general, an increase in a
liability or an equity account sum as ordinary shares suggests
a cash inflow from either borrowing or selling shares. A
decrease in a liability or dividends suggests a cash outflow
from payments to creditors or investors. However, to be
sure, any available information on the changes must be
examined to determine whether the change resulted from
a non-cash transaction or whether the change was the net
effect of both tncreases and decreases to the account.
To illustrate, consider again the Sunshine Company's
balance sheet in Exhibit 12.3. It shows one non-current
liability and two equtty accounts. It provides no addttional
information regardtng the accounts. In the following
sections, eam account balance is examined to determine
Sunshine's cash flows from financing activities.
Jm
NON-CURRENT LIABILITIES
(~)
Accord ing to Sunshine's balance sheet, non-current
liabilities increased $45 during the year. Without any
information to the contrary, it is assumed that it borrowed
$45 in cash. Thus, a cash inflow of $45 from the borrowings
is reported tn ftnanctng activities.
CONTRIBUTED EQUITY
Sunshine's balance sheet shows a $10 decrease in
shareholders' equity. Thus, without any additional information,
it is assumed that Sunshine must have repurmased (bought
back) shares for $10 cash. Thus, a cash outflow of $10 from
the share buyback is reported in f inancing activities.
The issue of shares and the buying back of shares are
relat ively uncommon activities (CSLs semi-regular
buybacks are an exception). After the initial public offer
(floating the company), some companies may never tssue
more shares or repurchase shares. Many companies
would only undertake these activities every few years.
This is not to be confused with the daily trading on the
Australian Secunties Exchange (ASX) where current
owners sell their shares to other owners who wish to
increase their sharehold ing or new owners (investors).
None of t he money f rom th is daily trading enters or leaves
t he company.

RETAINED EARNINGS
The fourth and final account is retained earnings. Reca ll
from earlier chapters that the retained earnings balance
is affected by two things; profits or losses and dividends
declared. Profits increase the balance while dividends
decrease the balance. Sunshine's balance sheet shows
that retained earnings increased $9 during the year,
from $78 to $87. Th e statement of comprehensive
income shows that pro fits were $14. The refore,
dividends declared can be ca lculated as follows:

Retained earnings. beginning balance S78

I I
Plus: Profits 14
Less: Dividends declared ?? X ?? = $5 Cash flows from operating activities
Profits after income tax $ 14
Retained earnings, ending balance $87
Adjustments to reconcile profits after tax to
Now that dividends declared are known, the amount net cash provided by operating activities
paid can be calculated. If dividends were not paid, t he Depreciation expense $ 25
balance sheet would show a ba lance in dividends payable Gain on sale of equipment {1)
in current liabilities. Neither year shows a balance, so all $5 Increase in accounts receivable (4)
of the dividends must have been paid. Thus, a cash outflow
Increase in inventory (9)
of $5 from the payment of dividends is reported in f inancing
Decrease in prepaid insurance 4
activities.
Increase in accounts payable 8
NET FINANCING CASH FLOWS Increase in electricity payable 5

The three cash flows from f inancing activities are shown Decrease in taxes payable _flJ 21
in Exhi b it 12.8. The t hree items resulted in a net cash Net cash provided by operating activities $ 35
inflow f rom f inancing activities of $30. Sunshine generated Cash flows from investing activities
$30 more from f inancing activit ies than it paid. Purchases of equipment $(76)
Sale of equipment 6
ii#fi,ll.tjiju,IIUEliW
I
Cash flows from financ1ng activities
Long·term borrowings $45
Purchases of investments
Net cash used in investing activities
Jlll
{92)
Cash flows from financing activities
Payment of dividends (5)
Long·term borrowings $ 45
Repurchase of shares
Payment of dividends {5)
Net cash provided by financing activities
Repurchase of ordinary shares _1J.QJ
~ The Sunshine Company's financ1ng cash flows Net cash provided by financing activities 30
Net decrease in cash $ (27)
Cash, beginning of the year 45
COMPLETE STATEMENT OF CASH FLOWS: Cash, end of the year 1..lJ!
INDIRECT METHOD
IDiliiiTl The Sunshine Company statement of cash flows
Sunshine's final statement of cash flows, using the ~ l 1 nd~rect method)
indirect method, is shown in Exhibit 12.9. The net
decrease in cash of $27 corresponds to the change in the
cas h account from Sunshine's ba lance sheet. Like the
t ide, cash flows bot h ways.

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0
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225
 For CSL, the cash flow information is summarised in a company's ability to generate cash for expansion, for
Exhibit 12.10 below. other forms of improved operations, for the repayment of
debt, or for increased returns to shareholders.
Source Accounts 2017 2016 While free cash flow can be defined in many ways, the
Statement Cash flows from operating $1247 $1179 most straightforward definition is as follows:
of cash aCt lVIIIeS
flows Cash flows from opera~ng ac~v,11es
Net cap11al expendnures 689 495
(on PPEI less. Capital expend11Ufes on PPE (and poss•bly •ntang1bles and
businessacq::u.::is::iti.::on.::s:.__ _ _ _ _ _ _ _ _ _ _ __
Expend1ture on mtang bles 172 315
and busutess acqu1S111ons less: Dividends (and possibly share buybacksl
D1vidends pa1d 601 579 = Free cash flow
Shares bought back 315 648
The calculation starts w1th cash flows from operating
Notes Average debt matunng •n ($1373 + ($1 133+
11 (d) next five years $22591/5 16361/ 5 activities, which is a measure of a company's ability to
= 126 =554 generate cash from its current operations. It then subtracts
capita l expenditures, which refers to the cash that a
[iiiiiiiT] Account ba lances from CSL.:s 20t7 Annual Report
l..!:!..J (rounded to nearest$ m 1ll1on) company spends on PPE (and in CSt:s case it could be
argued purchase of intangibles and business acquisitions
could also be included because of the regularity of this as
a means of expansion). and payments to shareholders
during the year. The cash that remains is 'free' to be used
ANALYSING A COMPANY'S as the company chooses.
STATEMENT OF CSt:s free cash flow is calculated as fol lows from the
CASH FLOW S information in Exh ibit 12.10:

2017 2016
The statement of cash f lows reports how a company
Cash flows from operating actiVIties $1 247 $1 179
generated and used its cash during the year. As a result,
-Capital expenditures on PPE 689 495
the statement can be used to answer many questions
about a company's cash. Two of the broader questions that - Dividends 601 579
can be addressed are as follows: Free cash flow ($ 431 llQ§
1 Is the company able to generate enough cash to grow?
2 Is the company able to generate enough cash to satisfy In 2017. CSL had negative free cash flow. That is, it
its obligations? generated less cash from operations than rt paid for PPE
and dividends. If we included expenditure on Intangibles,
The following secuons examme these questions
business acquisitions and share buybacks the figure
for CSL.
would be negative $530 m rllion (- $858 million 1n 2016).
The examination w ill reqwe the mformation from CSt:s
To maintain a similar financing and expansion strategy
statement of cash flows and notes to the fi nancial
CSL will need to have net borrowings of well over half a
statements.
billion dollars each year.

FREE CASH FLOW

CASH FLOW ADEQUACY RATIO
When assessing a company's cash flows, a commonly
A second ratio that is commonly used to cash flow adequacy
used calculation is free cash flow. This is the cash a
assess a company's cash is the cash flow ratio Compares free cash
company generates in excess of its investments in flow to llle average amount
adequacy ratio. The cash flow adequacy of debt matunng in llle next
productive capacity and payments to shareholders in the
ratio com pares f ree cash flow to the five years and measures the
form of dividends (and in CSt:s case it could be argued abrlily to pay maturing debt.
average amount of debt maturing in the
share buybacks because of the regular buybaoks and the
expectation this has built). Free cash f low is a measure of

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next five years. Details are given in Note 11 (d) of CSt:s
Annual Report 2017 where 'Contractual payments due' are
divided into '1 year or less', 'Between 1 year and 5 years'
and 'Over 5 years'.
CASH F&OW ADIQUACY RATIO
Cash Flow Adequacy Ratio = Free Cash Flow
Average Amount of Debt
Maturing in Five Years
Because th1s ratio compares free cash flow to maturing
debt, 1t represents a company's abihty to generate enough
cash to pay its debt. In general, companies may like this
ratio to be higher rather than lower. All other things being
equal, a higher ratio indicates a greater ability to generate
sufficient cash from operations to pay upcoming debt.
For CSL in 2017 the calculation is meaningless and in
2016 less than 20 per cent.
The negative free cash flow in 2017 indicated an
apparent inability to repay any debt from operations after
buying PPE and paying dividends. In fact, cash would need
to be raised to maintain the same dividends in 2018. Even
in 2016, less than 20 per cent of debt could be repaid from
free cash flow. Despite th1s apparent cash shortage, CSL
undertook $387 million in other capital expenditure and
share buybacks in 2017. Such an analys1s is limited and
misses the richer informatiOn contained In cst:s statement
of cash flows.
During the 2016/17 financ1al year CSI.S share price
increased from $111.93 to $138.03, over 23 per cent, while
the Australian share market mcreased on average (All
Ordinaries Index) less than 9 per cent. CSL is a large rapidly
growing biotechnology company, wh1ch warrants deeper
analysis; this is undertaken in the next chapter.
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1 Classify cash flows
A business enters into the following independent
transactions:
issued $290000 of ordinary shares in exchange for
cash
ii borrowed $480000 from the bank
iii received $270000 in cash from accounts receivable
iv $76000 is paid to an account payable
v exchanged (issued) $55000 of ordinary shares upon
conversion of debentures (bonds) with a face
value of $55 000
vi declared and paid a cash dividend of $748 000
vii sold an investment costi ng $130000 for $130000 in
cash
v iii bought back shares, $920 000
ix paid tax, $110 000
x purchased property, $800000.
REQUIRED
Classify each of the preceding transactions as a cash inflow
or a cash outflow from operating, investing or financing
activities, or as a non-cash transaction.
2 Classify cash flows
A company enters into the following transactions:
interest is paid on a note payable
ii salaries are paid to the company's employees
iii bonds are issued in exchange for cash
iv income taxes are paid by the company
v new heavy machinery is purchased with cash
vi convertible bonds are issued in exchange for land
vii cash dividends are paid to shareholders
v iii the shares of another company are purchased as an
investment
ix the company buys back its own shares on the market
and retires them
x shares are given to the bank in return for cancellation
of a loan
xi an amount due from a customer is collected
xii intangible assets are purchased from another
company for cash.
REQUIRED
Indicate whether each transaction would appear under
operating, investing or financing activities. Also note if a
transaction is a significant non-cash transaction that would
require additional disclosure.
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3 Classify cash flows
A business entered into the following transactions:
purchased new machinery for $24 000 cash
i i paid an account payable relating to inventory of
$2500 with cash
iii recorded cash sales of $52 000 for the period
iv purchased a new warehouse for $275000. The seller
of the building accepts 10000 shares as payment
v issued debentures at face value of $25 000
v i repurchased 200 of the company's own shares on
the open market for $7000
vi i purchased a new light truck for $18000 by signing a
180-day note payable
vii i collected cash of $3000 from a customer in
satisfaction of accounts receivable
ix sold 550 BHP shares for their book value of $25000
x paid $200 for renewal of the meteor insurance policy
x i paid dividends of $5000 in cash.
REQUIRED
Classify each transaction as a cash inflow or outflow from
operating activities, investing activities or financing activities,
or as an item reported in a supplemental schedule of the
statement of cash flows.
4 Direct versus indirect method
Illustrate with an example the additional information
contai ned in the indirect method of calculating the cash flow
from operations compared to the direct method. In you r
example show at least one increase and one decrease in
current assets and the same in current liabilities that
highlight the differences. Also include a profit on sale of
property and depreciation of equipment.
5 Calculate cash paid for salaries
Calculate the cash paid:
Salaries expense was $250000 for the year. During
the year salaries payable increased $25000.
i i COGS was $980000. Inventory at the beginning of
the year was $66 000 and ending inventory $85000.
iii Rent expense $99000. Opening balance of prepaid
rent $8000, closing balance $9000.
REQUIRED
Determine the amount of cash paid for salaries, inventory
and rent during the year.
6 Calculate cash collections
Emma's balance sheet showed an accounts receivable
balance of $75000 at the beginning of the year and $97000
at the end of the year. Emma reported sales of $1150000
on her incom e statement.
REQUIRED
Using the direct m ethod, determine the amount that Emma
will report as cash collections in the operating activities
section of the statement of cash flows.
 decrease in accounts payable
7 Calculat e cash paid for purchases ii oncrease on accounts receovable
The Kapyong Company's balance sheet oncluded an iii purchase of a new conveyor belt system
onventory balance of $105000 at 30 June 2019 and $142000 iv buyback of shares
at 30 June 2020. Accounts payable balances were $78000 v gaon on the sale of old conveyor belt system
and $47000 at 30 June 2019 and 30 June 2020.
vi deprecoatoon expense
respectively. Kapyong's accounts payable only relate to
onventory purchases. Cost of goods sold as reported on the vii increase on inventory
2020 oncome statement was $885000. viii increase in bank loans
ix bad debt expense.
REQUIRED
Using the direct method. determine the amount that REQUIRED
Kapyong woll report as cash paid for inventory in the Indicate whether each item should be added to profit,
opera tong acuvoties section of the statement of cash flows. deducted from profot or not reporled in the reconciliation of
profits to cash flow from operations.
8 Calculate cash paid for operating
expenses 11 Prepare operating cash flow s u nder t he
The following onformation is available for a company's rent
indirect method
and oncome taxes: The followong onformatoon was reported by lmma Imports:

Prepaod rent. begonning of year $25000 2019 2018

Prepaod rent. end of year 31000 Accounts receovable $1 10000 $94000

Rent expense 40000 Inventory 70000 90000
Cash paid for rent during the year (a) Prepaid insurance 24000 20000
Income taxes payable. beginning of year 25000 Accounts payable 44000 30000
Income taxes payable. end of year 31000 lnoome taxes payable 20000 28000
Income tax expense 40001 Interest payable 24 001 18000
Cash payments for oncome taxes (b) Profit after tax 490001
Accounts payable. begiMing of year 800 Oepreciatoon expense 50001
Accounts payable. end of year 300 REQUIRED
Inventory purchased during the year 25500 Prepare the opera tong actovotoes section of the statement of
(c) cash flows usong the ondorect method and explain why cash
Cash paod for inventory
flows from operating activoties is more or less than profots
REQUIRED after tax.
Calculate the missing information.
12 Reporting cash flow s from sale of
9 Identify ind irect method adjustm ents equipm ent
A company expenences the followong items during the year: A company sells equipment with a book value of $23000 for
$25000 cash .
I deprecoatoon expense
ii oncrease on oncome taxes payable REQU IRED
iii decrease on aooounts receovable a How would the sale of equopment be reported on the
iv increase on prepaid expenses cash flow from operatong activities under the (i) ondorect
v decrease on onventory method and (oi) the dorect method?
vi oncrease on accounts payable b Where else on the statement of cash flows would the
vii gaon on sale of investments. sale be reported and how?

REQUIRED
13 Classifying tra nsactions under t he
a Identify whether each item would be an addition to or indirect m et hod
subtraction from net income when calculating operating
The followong is a lost of transactions and changes in account
cash flows usong the indirect method.
balances that occurred dunng the year:
b Choose one of the items and explaon on your Facebook
oncome taxes payable decreased
wall why the otem is treated the way you have stated
above. ii paod cash on sahsfactoon of a matured bond payable
iii declared a cash dovodend
10 Classify adjust ments under t he indirect iv accounts payable oncreased
method v accounts receovable doubled before returnong to the
begonnong of the year balance
A company that uses the indirect method to reporl operatong
vi sold equopment for cash and made a substantoal gain
activotoes experiences the following events:
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0 229
 vii purchased a new warehouse by 1ssumg debentures iv $250000 was paid to buy back the company's own
viii purchased Inventory for cash shares
ix bought baok own shares in open market. v depreciatton expense for the year was $300 000
vi notes of $250 000 were issued.
REQUIRED
Assum1ng the md1rect method for operatmg acuvit1es. REQUIRED
indacate whether each transaction would be mcluded in Use this informatton to calculate cash flows from fmancmg
operattng actlvalles. 1nvesung ac!Jv1t1es. f1nancmg actiVIties. activities.
non-cash d1sclosures or not reported. Note that some
transactions may tmpact mult1ple sections. 17 Analysing cash flows
Duong and Dmh are both online retail companaes. The
14 Calculate cash flows from investing following financ1al1nformat10n regarding each company ts
activities available:
The followmg tnformatton IS taken from the balance sheet of
The Cheese Board: Duong Dlnh
Cash flows from operating act1Vtt1es $450000 $450000
2021 2020
$85000 $120000 Profits alter income tax 250000 250000
Equipment
Capital expenditures 100000 130000
Accumulated depreciation {equ•pment) 50000 55000
Dividends declared and paid 60000 20000
Depreciation expense of $15000 was reponed on the Average amount of debt maturing in five 40000 60000
statement of comprehensive income for 2021. Equipment years
with an original cost of $35000 was sold for $500 profit
(gain). REQUIRED
REQUIRED a Indicate which company generated more free cash flow.
Calculate the amount of cash received from the sale of the b Indicate which company has the better cash flow
equipment. adequacy ratio.

15 Calculate cash flows from investing 18 Interpreting investing and financing cash
activities flows
The followtng transactions occurred dunng the year: Pazmandy reports the followmg cash flows from invesung
a A new warehouse was purchased for cash m the amount and financing act1vrties over the past three years (1n
thousands):
of $330000.
b The company's own shares were purchased (bought 2020 2019 2018
back) on market for $280 000. Cash flows from investing actrv1tres
c An old warehouse cosung $240000 was sold for ${752)
Purchase equipment $(803) $(2768)
$135000, resulung 1n a ga1n of $15000.
Sales of investments 1204
d The company purchased shares m Howard and Company
for $22 500 cash. Purchase of investments (1204)
e Shares of Samantha Stores were sold for $37 500. Net cash used by investing actrvrtres {803) (2768) (752)
resulting 1n a gatn of $22 500. Cash flows from financing act1v1tres
REQUIRED Issuance of long-term debt 3200
Use this mformat•on to calculate cash flows from mvesting Payment of dividends (50) (50) (66)
acttvities.
Share buyback {1200)
Net cash used/provided by financing (50) {1250) 3134
16 Calculate cash flows from financing
activities
activities
The following transactions occurred during the year: REQUIRED
ordinary shares were issued in exchange for new From the information above. describe the major ways in
equ1pment which Pazmandy used investing and financing cash flows
ii a cash div1dend of $200000 was pa1d over the last three years.
iii a 90-day note payable was issued for $50 000 cash

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 Total assets ~ ~
Accounts payable $110000 $105000
Unsecured syndicated bank loan 180000 200000
(long-term)
Total liabilities $290000 $305000
Ordinary shares $350000 $280000
Retained earnings 260000 235000
Total shareholders' equ1ty 610000 515000
19 Prep are operati ng cash flows under the
di rect m ethod Total liabilities and shareholders' eQUity ~ ~
The followmg 1nformatoon IS prov1ded for the Hildebrand
The followmg add1tlonal 1nformat1on IS ava1lable:
Company:
Profits after tax for 2022 were $50000.
Balances at 30 June 2021 2020 ii Cash d1v1dends of $25000 were pa1d dunng the year.
iii A port1on of unsecured syndiCated bank loan matured
Accounts Receivable $2500 $ 1500
and was repa1d during the year.
Inventory 26000 32 000 iv Ordmary shares were ISSued for cash.
Maintenance Supplies 2000 1000 v Property and equ1pment were purchased for cash.
Accounts Payable 4000 3000 No non-current assets were sold durmg the year.
vi The change in accumulated depreciation IS a result of
Taxes Payable 2000 3500 depreciation expense.
Interest Payable 1500 2500
REQUIRED
2021 income st atement Prepare a statement of cash flows for the year using the
Revenue $80 000 direct method for the operatmg activitieS section and
prepare a reconciliation of profits after tax to cash flow from
Cost of goods sold 55000
operations.
Gross profit 25000
........
General and adm1mstrative expense 6000 21 Prepare a statement of cash f lows ~
Oepreciat1on expense 2000 Available fmancial mformation for 2RAR Company 1s as
follows (figures 1n thousands):
Total opera~ng expenses 8000
Profit before interest and tax 17000
Interest expense 4000 r $ 75000 s 45000
Profit before income tax 13000 Cash and cash eqUivalents

Income tax expense 4000 Accounts receivable 45000 55000

Profit after 1ncome tax s 9000 Inventory 200000 175000

Prepaid insurance 30000 35000
REQU IRED
Total current assets 350000 310000
Prepare the operatmg act1V1t1es sectoon of the statement of
cash flows us1ng the d~rect method. Prepare the Property, plant and equipment 800000 720000
reconciliation of profrt after income tax to net cash inflow Accumulated depreciation (240000) (170 000)
from operating activities.
Total property. plant and eqUipment 560000 550000
Total assets
- ..1lQ.QQg
20 Prepare a statement of cash flows ..]2Q.QQQ
using the indirect method Accounts payable 110000 115000
The balance sheets for the Intelligence Company are as follows: Accrued salaries 10000 35000
Total current liabilities 120 000 150000
Loans 180 000 230000

Cash and cash eQuivalents Total liabilities 300000 380000

Accounts receivable Contributed equity (shares) 350000 250000

Inventory 125000 175000 Retained earnings 260000 230000

Property, plant and equ1pment Total equity 610000 480000

930000 745000
Accumulated deprec1at10n Total liabilities and eQUity ~ 860000

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 Income statement for the year ended Attounts payable s 120 $135
30 June 2021
Income taxes payable 155 175
Sales r~M!nue s 450!XXJ Total currentliabiht1es s 275 s 310
Cost of goods sold (225!XXJ) Bonds payable 400 325
Gross profit $ 225000 Total liabilitieS s 675 s 635
Deprec1at1on expense (70000) Contributed equ1ty 525 475
Other operating expenses {30000) Retained earnings 322 217
Profit before interest and tax $ 125000 Total shareholders' equity s 847 $ 692
Interest expense (20000) Total liabiliues and equity ~ $1 327
Profit before income tax $ 105 000
Income tax expense {30000) The following additiOnal Information is available:
operating expenses 1nctude $35 million of
Profit after 1ncome tax ~ deprecaauon
ii property and equ1pment were acquired for cash
The follow1ng add111onalmforma1Jon is available.
iii add1t1onal contnbuted equ1ty was shares issued for
Cash d1v1dends of $45000 were declared and pa1d
cash
dunng the year.
iv add1t1onal cash was obtained by issu1ng bonds
ii Equipment was purchased for cash {no PPE was sold).
v d1v1dends were paid.
iii A portion of the loans were repa1d with cash.
iv Shares were issued for cash. The CEO has posed some questions regarding this year's
results. She is pleased that the profit margin is approach1ng
REQUIRED 15 per cent. However. the decrease in the cash balance
Prepare a statement of cash flows for 2RAR for 2021 using during such a profitable year troubles her.
the d1rect method and a reconciliation of profrt after income REQUIRED
tax to net cash flow from operations.
a Prepare a statement of cash flows for Complete
Company us1ng the d1rect method for operat1ng cash
22 Prepare a statem ent of cash flows flows. Prepare a separate schedule show1ng the
The follow1ng IS Complete Company's two f1nanc1al reconciliation of profit after tax to cash flows from
statements (In m1ll10ns): operataons.
b Based on your work, expla1n to the CEO why cash
Income statement for the year ending decreased dunng a profitable year.
30 June 2019

Sales $750
Cost of goods sold 450
Gross profit $300
Operat1ng expenses 100
Income before interest and taxes $ 200
Interest expense 15
Income before taxes s 185
Income tax expense 75
Profits 23 Research and analysis
lll!!
Balance sheet as at 30 June
Access the latest available annual report for both CSL and
--~~~- . Cochlear. Please note, both companies financial year ends
2019 2018 30 June, w1th the latest annual reports usually available in
Cash $ 45 $ 80 September. They are easy to find by doing an internet search
Accounts receivable 155 115 for the company name and 'annual report' and the

Inventory 225
-
- -190 appropriate year.

Prepa1d insurance
--- REQUIRED
___1! 32
a Examine the compan1es' statements of cash flows.
Total current assets $447 $417 ldentafy the maJor cash 1nflows and outflows 1n 1nvest1ng
Property and equ1prnent 1250 1050 and financ1ng actiVIties. Bnefly discuss how these have
changed from those shown Ill th1s chapter and Appendix B.
Accumulated depreciation {175) {140)
b Calculate the companaes' free cash flow 1n the current
Total propeny and equipment $1075 $ 910 year. Has th1s 1mproved?
Total assets llill $1327 c Where have both companies obtained their cash?

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_ 232
...;;.;;.::;
24 Ethics in accounting
You are the accountant of a small company that wants to
expand. The CEO is negotiating a loan w ith the bank and the
bank requires a statement of cash flows. The CEO is
concerned because operati ng cash flows are down
compared to prior years. The main reason is deteriorating
collections from accounts receivables. The CEO presents
three options to address the situation prior to year-end and
the preparation of the statement of cash flows:
convert some of the oldest receivables to long-term
notes receivable
ii sell some receivables to a collector for $0.65 per $1
of receivables
iii delay payment of all outstanding accounts payable
until the next year.
REQU IRED
a Comment on the appropriateness of each option.
b Is there an ethical dilemma involved?
c How would you respond to the CEO?
25 SMS Communications: Statement of
cash flow (SCF)
During the CEO's address at the an nual general meeting the
Chair of the Board of Directors. sends you the following
SMS: 'why do we have a stupid@#%& SCF?'. In 140
characters or less prepare a sentence the Chair could read
to the meeti ng simply explai ning the reason why the annual
report includes a statement of cash flows (SCF).
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole O(:J!lJP&.R~~N~~i~e~~2of cash flows
26 Free cash flow and financing options
Sarah is an entrepreneur and the fou nder of Chemical
Supply Company. Duri ng the last year. Chemical Supply
generated $400000 in operating cash flows. paid $250000
in capital expenditures (as it does almost every year). and
paid $50000 in dividends. Sarah is interested in sig nificantly
expanding this year. To do so. she needs to spend $ 1 mill ion
on eq uipment in add ition to her normal capital expenditures.
She believes that if she buys the equipment, her operating
cash flows w ill increase by at least 50 per cent and could
possibly double. She has spoken w ith the bank. w hich has
offered the following two note options where an equal
amou nt of principal is due each year:
two-year, 5 per cent. $1 000000 note
ii six-year. 7 per cent. $ 1 000000 note.
REQUIRED
a What is Chemical Supply Company's current free
cash flow.
b Identify the advantages and disadvantages of each
option the bank provides.
fu@ c Which option should Sarah choose and why?
d What other alternatives are available for expansion and
w hat are the advantages and disadvantages of these?
=--
233

After st udyin g t h e material in t h is chapt er, you
should be able to:
Underst and t h e nat ure of fi nancial
statement analysis.
Calculate and int erpret horizontal and
vertical analyses.
Assess p rofitability t hrough t he calculation
and interpretation of rati os.
Assess liquidity th ro u gh the calculation and
interpretation of ratios.
A ssess solvency t h ro u g h the ca lcu lation and
interpretation of ratios.
Calculate and in terpret a DuPont analysis.
The first 12 chapters of this book examined the various
aspects of financial accounting - the process of identifying,
measuring and communicating economic information to
external stakeholders to permit informed decisions. Thos
chapter demonstrates how to analyse the products of this
process - the statement of comprehensive income.
balance sheet, statement of cash flows and statement
changes in equity- to make informed decisions about a
company; that is, it focuses on financial statement analysis.
We w ill use the financial statements of th e biotechnology
company Coch lear. wh ich helps 'people hear and be
heard'. Cochlear is aTop 50 company, about one-sixth the
size of CSL (and not a direct competitor). Although
substantially different in size, financial statement analysis
allows us to compare and contrast the two companies .
This brings together much of the analysis conducted at the
end of most chapters, making it more coherent and
extending the analysis.
Financial statement analysis can help investors and
creditors understand how effectively and efficiently
companies like Cochlear and CSL are conducting their
b usinesses and the resulti ng fi nancial performance.
especially in comparison to each other.

l,l!i FINANCIAL STATEMENT

'liil' ANALYSIS
Financial statement analysis is the
apply this -··· ··-· process of applyong analytical tools to a
business' (usually a company's) financial
financial statement
analysis The process of
applyln,j analytocal tools to
a canp;wr{s filliWlt1ill
statements to understand the business' statements to ooderstand
financial health. The goal of such an the busr.ess• financoal
health.
analysis is to provide some context for

Copyrlght2019 Cengage Loa nlng A R ght llnervecl May not copied. scanned, or dupllcotod, In whole or In part. WCN 02·200-202
234
 understanding the accounting numbers on the financial
statements. Ultimately, f inancial analysis should help all
stakeholders (investors, creditors, employees even
management), or any other interested party, better understand
a business' financial performance and position, and therefore
make better decisions for, and about, that business. Enabling
good decisions is one goal of financial accounting, and it
should be the product of f inancial statement analysis.
Financial analysis requires the following:
e financial information
e standards of comparison
• tools of analysis.
4,\J ,,,
Check out die video summary
• lor Chapter 13
FINANCIAL INFORMATION
Reporting entities must file their annual financial statements
w ith the Australian Securit ies and Investments Commission
(ASIC). All publicly listed companies must also p repare
audited financial statements eadl year and f ile them with the
Australian Securities Exdlange (ASX). These statements
include the income statement, balance sheet, statement of
dlanges in equity and statement of cash f lows. Financial
statements contain current and prior-year data for comparative
purposes and are the starting point for any analysis.
In addition to financial statements, reporting entities
p rovide other information that shou ld be consulted to
enhance a financial analysis. For example, a company's
notes to its financial statements (as you have seen in
Chapter 2) provide further explanation of items on the
financial statements and additional disclosures not included
on the statements. A company's management's discussion
and analysis will contain the most sen ior insiders (usually
the dlairpe rson and CEO) commentary on aspects of
company operations, corporate governance, risk analysis
and futu re plans. Even company press releases, earnings
- • CSL Limiled
e Cochlear
- • ASX 50 Index
c __ _ _ _ _ .J_ ----------------------- ------------
Jul 14
~ Comparoson of CSL, Cochlear and theASX 50 Index for the five years 2013 to 2017 onclus1ve
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In who~A~~~1"J Vffn'!~~;,:r.ti,~~ ent analysis
conference calls and notifications of shareholder meetings
can contain useful information. Finally, it is always a good
idea to consult independent, third-party analysis.
For publicly listed companies it is also useful to look at
the share price history as investors have a vested interest
in knowing all they can about the companies in wh ich they
are buying and selling shares.
Ex h i b it 13. 1 shows a five-year increase by CSL
of arou nd 160 per cent, and by Cochlear of around
120 per cent, whi le the weighted average of the top
50 companies listed on the ASX 50 Index is just over
20 per cent.
In th is chapter, the financial information provided by
Coch lear will be used to illustrate the process of financial
analysis. Our focus will be predominantly on information
from the income statement and the balance sheet. As a
result, only those two statements are shown in the text.
However, when information beyond these two statements
is required, it w ill be provided. The most recent financial
statements for listed companies are available in their
annual reports, on line.
STANDARDS OF COMPARISON
When conducting a f inancial analysis, there shou ld be
some benchmarks for comparison. The most common
bendlmark is the prior year(s) of the same company. This
is often called an intracompany comparison because it is a
comparison with in a company. Horizontal analysis (time
series) is an excellent example of intracompany analysis.
Another common benchmark is competitors.
Comparisons among competitors are often ca lled
intercompany comparisons (cross-sectional analysis)
because they are between companies, usually for the
same t ime period. Vertical analysis is an excellent tool for
intercompany analysis because it removes the effect of
company size.
160%
Jul 15 Jul 16 Jul 17
=--
235
 A final benchmark is industry standards. Often, industry
benchmarks can be obtained from financial websites and
are especially useful when there is more than one main
competitor.
The analysis in this text will use both intracompany and
intercompany comparisons. Codllear and CSL are used for
intercompany comparisons. Even though comparison
seems less ideal because they supply very different types
of medical products (hearing Implants versus vaccines and
plasmal. they are 1deal to demonstrate the advantages of
fi nancial statement analys1s due to their substantially
different sizes. A comparison of the raw data in the financial
statements may not y1eld much 1ns1ght as Codllear had
total comprehensive income in 2017 of A$222 million
compared to CSt:s US$1510; however. analysis we have
conducted in previous chapters. such as return on assets,
makes the size and currency differences irrelevant.
ANALYSIS TOOLS
There are many tools used to conduct a f inancial analysis.
Three of the more common are:
e horizonta l analysis
e vertical analysis
e ratio analysis.
Horizontal analysis is a comparison of a company's
financial results across time . Vertica l analysis is a
comparison of each line in the financial stat ement to a
base account from the same fmancial statement. Ratio
analysis is the compa rison of Items from the financial
statements (and other hnancial mformation. such as share
price) that are thought to be related (li ke a person's
height and weight) to prov1de a more comprehensive
understanding of the hnanciCII results. Typically, individual
ratios are grouped together to assess various aspects
(profitability, solvency etc.) of a company's financial
performance and prospects.
The remainder of thiS chapter demonstrates and
discusses horizontal, vertical and ratio analyses o f
Cochlear's 2017 fmancia l statements and draws
com parisons with CSL.
l,l!!i HORIZONTAL AND
~ VERTICAL ANALYSES
HORIZONTAL ANALYSIS
Horizontal analysis was first introduced in Chapter 2. Recall
t hat horizontal analysis is a technique t hat compares
account balances over time . Horizontal analysis is a
technique that calculates the change in an account balance
from one period to the next and expresses that change in
ACCT3 Fw>~flgllt 2018 Cengoge l.aml119- AU Rights R~ May no< be c opMd scanned. or dUI'lieaod,ln wholo or In pan. WCN 02·200-202
236
_.......;;;;;.;;
bot h dollar and percentage terms. The actual calculations
are as follow s:
HOIIIZONTAL ANALYSIS
Dollar Change
in Account =Current-year Balance- Prior-year Balance
Balance
Percentage Dollar Change
Changein = .
Account Balance Proor·year Balance
Horizontal analysis is a simple but powerful analytical
tool. It reveals significant changes 1n account balances and
t herefore identifies items for further Investigation. For
exam ple. a large increase in say carbon capture expense
focuses attention on why this expense increased so much
or how environ mentally active the company has become.
That is the nature of horizontal analysis -it often provides
the right q uestions to ask. but care needs to be exercised
not to immediately jump to obvious conclusions. Some
large percentage changes may be the result of a very small
expense in the previous financial year.
Horizont al ana lysis is calculated for both the balance
sheet and the income st at ement. Changes in critical
account balances. such as inventory for a manufacturer or
liabilities for a company in fmancial trouble. are usually
examined first. We also examine any significant changes
in ot her account balances. lns1gnif1cant changes are often
ignored because they would not affect decis1on-making.
For example. an account that grows from $1 million to
$3 m illion experiences a 200 per cent 1ncrease. but such
an increase is immaterial to a $50 billion company.
Balance sheet horizonta n •sis
Exhib it 13.2 contains a horizontal analysis of Cochlear's
2017 (and 2016) balance sheet. The analysis was undertaken
on an Excel spreadsheet where the 2016 figure was
subtracted from the 2017 figure to obta1n the dollar change
(=B5-C5( and then the percentage change by dividing the
dollar change by t he 2016 figure and rounding to two
decimal places (= ROUND(D5/C5,2)). We see Cash has
increased 19 per cent.
The analysis shows mixed changes in asset accounts.
Overall. Coch lear increased tota l assets by almost
$180 m illion in 2017. w hich represents a 19 per ce nt
expansion. Cochlear experienced the largest dollar change
in intangible assets - increasing almost $116 million (52%)-
but the largest percentage increase on the balance sheet
was (current) loans and borrowings up over 2000 per cent
(but less than $81 m) increase. Caution must be exercised
in looking only at t he dollar change or only looking at the
percentage change.
 A B c 0 E

2017 2016 $change % change

2 $000 $000 $000
ASSETS
Current assets
5 Cash and cash equivalents 89540 75417 14 123 0.19
6 Trade and other receivables 292139 281925 10214 0.04
7 FoJWard exchange contracts 18430 11454 6976 0.61
8 Inventories 160011 154103 5908 0.04
9 Current tax assets 7278 6208 1070 0.17
10 Prepayments 18562 13921 4641 0.33
11 Total current assets 585960 543028 42932 0.08
12 Non-current assets
13 Other receivables 906 1507 -601 -Q.40
14 FoJWard exchange contracts 7760 10713 -2953 -o.28
15 Property, plant and equipment 120107 86878 33229 0.38
16 Intangible assets 339976 224338 115638 0.52
17 Investments 15064 13755 1309 0.10
18 Deferred tax assets 66586 77144 -10558 -Q.14
19 Total non-current assets 550399 414335 136064 0.33
20 TOTAL ASSETS 1136359 957363 178996 0.19
21 LIABILITIES
22 Current liabilities
23 Trade and other payables 13091 1 110354 20557 0.19
24 FoJWard exchange contracts 2041 12643 -10602 -o.84
25 Loans and borrowings 84687 3978 80709 20.29
26 Current tax liabilities 26326 13701 12625 0.92
27 Employee benefit liabilities 52412 45485 6927 0.15
28 Provisions 24992 33675 -6683 -o.26
29 Deferred revenue 25246 31264 -6018 -Q.19
30 Total current liabilities 346615 251 100 95515 0.38
31 Non-current liabilities
32 Trade and other payables 33917 - 33917 100
33 FoJWard exchange contracts 3111 3547 -436 -0 12
34 Loans and borrowings 134235 189260 -55025 -029
35 Employee benefit liabilities 11038 13750 -2712 -020
36 Provisions 54711 44027 10684 0.24
37 Deferred tax liabilities 5837 7122 -1285 -018
38 Deferred revenue 3248 - 3248 1.00
39 Total non-current liabilities 246097 257706 -11609 -005
40 TOTAL LIABILITIES 592712 508806 83906 0.16
41 NET ASSETS 543647 448557 95090 0.21
42 EQUITY
43 Share capital 169367 158940 10427 0.07
44 Reserves -12801 -14662 1861 -{) 13
45 Retained earnings 387081 304279 82802 0.27
46 TOTAL EQUITY 543647 448557 95090 0.21
~ Horozontal analys1s of Cochlear L1m1ted balance sheet as at 30 June 2017 and 2016

__
Source: Co:hlsar Uruted, AmualReport 2017, p_ sa.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In who~A~~~1'3 Vffn'!~~;,:r.ti,~~ent analysis ;;.;;.;.
237
 Overall. total liabilities increased by 16 per cent (almost Income statement horizontal analysis
$84m) -a little less than total assets (19%). However,
The analysis shows that revenue increased 11 per cent
because the percentage increase in total liabilit ies was
while cost of sales increased on ly 7 per cent (but it shou ld
smaller than total assets, the percentage dlange in equity
be noted COS is a relatively small percentage of sales
was greater (21 %). In effect, Cochlear grew its assets by
(as we wi ll explore later). Th is led to an 18 per cent
increasing equity ($95m) more than liabilities ($84m).
increase in net profits, but on ly 13 per cent in total
Caution needs to be exercised when looking at percentage
comprehensive income due to changes in the fair value
and dollar dlanges. If liabilities were $10 and equity $90, a
of cash flow hedges (but not shown in the condensed
$10 increase in liabilities would be 100 per cent. wh ile a
version in Exh ib it 13.3) -whidl is beyond our discussion
$45 increase in equity wou ld only be 50 per cent. A more
in this book.
detai led examination of equity shows t he increase in
Revenue increased by 11 per cent w hile t he percentage
reta ined earnings (27%, $83m) was the main driver on
increase in expenses was lower, leading to a 20 per cent
increasing total equity. The fall in reserves. alt hough
increase in results from operating activities. Th is
13 per cent (about half of the increase in retained earnings).
demonstrates how smaller increases in expenses below
was minor in dollar terms (less than $2m). The analysis of
t he increases in revenue can have a substantial impact
the ba lance sheet alone raises more questions: why did
on results.
inventory increase on ly 4 per cent when total assets
increased 19 per cent? The income statement may shed
VERTICAL ANALYSIS
more light.
Exhibit 13.3 contains a horizontal analysis of a Vertical analysis was also introduced in Chapter 2. Recall
condensed version of Cochlear's 2017 and 2016 income that vertical analysis is a tedln ique that compares account
statement and statement of comprehensive income. balances within one year. Formally, vertical analysis is an

2017 2016 $change % change

2 $000 $000 $000
3 Revenue 1253838 1130552 123 286 0.11
4 Cost of sales -358373 -333593 -24780 0.07
5 Gross profit 895465 796959 98506 0.12
6 Selling and general expenses -348928 -324 144 -24784 0.08
7 Administration expenses -83474 -79287 -4187 0.05
8 Research and development expenses -151929 - 145080 -6849 0.05
9 Other income 4466 14 156 -9690 -{)_68
10 Results from operating activities 315600 262604 52996 0.20
11 Finance income- interest 742 468 274 0.59
12 Finance expense- interest -7517 -8806 1289 -{).15
13 Net finance expense -6775 -8338 1563 -{).19
14 Profit before income tax 308825 254266 54559 0.21
15 Income tax expense -85209 -65345 -19864 0.30
16 Net profit 223616 188921 34695 0.18
17 Other comprehensive (loss)/income. net of tax - 1608 6904 -8512 - 1.23
18 Total Comprehensive Income 222008 195825 26183 0.13
loiliiTl Honzontal analysos of Cochlear Lomoted (condensed) oncome statement (and comprehensove oncome) for the
~ 2017 fonancoal year
Sotl'ce: Ma~ed tromCo:Near lAMed. Annual Repat 2017, Rl· 56-57.

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_ 238
....;;;;.;;.
analytical technique t hat states eadl account balance on a
financial statement as a percentage of a base amount on
the statement. The base account is total assets for t he
balance sheet and revenues for the income statement. The
actual calculation is as follows:

.. VERTICAL ANALYSIS

For the balance For the income

sheet statement
p Account Balance Account Balance
ercentage = Total Assets or Net Sales or Revenue

Like horizontal analysis, vertical analysis is a simple but

powerful tool. The divid ing of each account balance by
either assets or revenues accomplishes two purposes.
First, it shows the relative importance of eadl account to
the company. Second. it standardises the account balances
by firm size so that companies of different sizes can be
compared.
To illustrate, suppose a company w ith $10 million in
tota l assets has $1 million in cash while another company
with $100 billion in assets has $2 billion in cash. The
$100 billion company has more cash, but it is also a much
bigger company. A vertical analysis would show that the
smaller company has 10 per cent of its assets in cash
($1 / $10 = 10%) while the larger company has only
2 per cent of its assets in cash ($2/$100 = 2%). By dividing
by total assets, t he analysis makes possible a meaningful
comparison of two companies of vastly different sizes.
Because vertical analysis removes the effect of size (and
for CSL and Cochlear, currency differences), an analysis
conducted on a financial statement is appropriately called
a common-size financial statement.

Balance sheet vertical analysis

Exh ibit 13.4 contains a vertical analysis of Cochlear's 2017
and 201 6 balance sheet. Percentage dlanges have been
rounded to the closest 1 per cent.
The analys is shows large percentages of assets in
trade and other receivables (2016 29%, 2017 26%) and
intangible assets (2016 23%, 2017 30%). In contrast CSL
in 2017 had 13 per cent of total assets in receivables and
12 per cent in intangibles. Here the advantage of vertical
analysis is highlighted: Cochlear has $292 million in
receivables: CSL (when converted to Austral ian dollars)
has $1560 million, wh ich reveals t hat Cochlear is holding
over double t he receivables of CSL as a percentage of
total asset s.

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In who~A~~~1"3 Vffn'!~~;,:r.ti,~~ ent analysis __
;;.;;..;.
239
 A 8 c D E

~
2017 %Total 2016 %Total
2 $000 assets $000 assets
3 ASSETS
4 Current assets
5 Cash and cash equivalents 89540 0.08 75417 0.08
6 Trade and other receivables 292139 0.26 281925 0.29
7 FoJWard exchange contracts 18430 0.02 11454 0.01
8 Inventories 160D1 1 0.14 154 103 0.16
9 Current tax assets 7278 0.01 6208 0.01
10 Prepayments 18562 0.02 13921 0.01
11 Total current assets 585960 0.52 543028 0.57
12 Non-current assets
13 Other receivables 906 0.00 1507 0.00
FoJWard exchange contracts 7760 0.01 10713 0.01
Property. plant and equipment 120107 0.11 86878 0.09
Intangible assets 339976 0.30 224338 0.23
Investments 15(])64 0.01 13755 0.01
Deferred tax assets 66586 0.06 77 144 0.08
19 Total non-current assets 550399 048 414335 0.43
20 TOTAL ASSETS 1136359 1.00 957363 1.00
21 LIABILITIES
22 Current liabilities
23 Trade and other payables 130911 0.12 110354 0.12
24 FoJWard exchange contracts 2041 0.00 12643 0.01
25 Loans and borrowings 84687 0.07 3978 0.00
26 Current tax liabi lities 26326 0.02 13701 0.01
27 Employee benefit liabilities 52412 0.05 45485 0.05
28 Provisions 24992 0.02 33675 0.04
29 Deferred revenue 25246 0.02 31264 0.03
30 Total current liabi lities 346615 0.31 251 100 0.26
31 Non-current liabilities
32 Trade and other payables 33917 0.03 0.00
33 FoJWard exchange contracts 31 11 0.00 3547 0.00
34 Loans and borrowings 134235 0.12 189260 0.20
35 Employee benefit liabilities 11(])38 O.Dl 13750 0.01
36 Provisions 54711 0.05 44027 0.05
b 7 Deferred tax liabilities 5837 O.Dl 7122 0.01
38 Deferred revenue 3248 0.00 0.00
39 Total non-current liabi lities 246 097 0.22 257706 0.27
40 TOTAL LIABILITIES 592712 0.52 508806 0.53
41 NET ASSETS 543647 048 448557 047
42 EQUITY
43 Share capital 169367 0.15 158940 0.17
44 Reserves ·12801 ·0.01 ·14662 ·002
45 Retained earnings 387081 0.34 304279 0.32
46 TOTAL EQUITY 543647 048 448557 0.47
~ Vertocal analysos of Cochlear Lom oted balance sheet as at 30 June 2017 and 2016

Sotl'ce: Co:tiear Limited. Annwl Repat 2017. p. 58.

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_ 240
....;;.;.;;,
 The analysis of liabilities and equity shows in 2017 over
half (52 %) of the company's assets are generated by liabilities,
but this is a small decrease from 2016 (53%) w ith the majority
of those liabilities in current trade and other payables (1 2%)
and non-current loans and borrowings (also 12 %). Between
2016 and 2017 the percentage of assets generated through
equity increased marginally from 4 7 per cent to 48 per cent,
w hich is exactly as expected given the marginal reduction in
total liabilities.This takes us back to Chapter 1 where we first
discussed Assets = Liabilities + Equity.
Overall, t he vertical analysis show s a different balance
s heet in cont rast to CS L (see Chapter 2), where property,
plant and equipm e nt (PPE) (32 %) and inventory (28%)
w e re the largest assets. It also highlights CSL:s g reater
rel iance on debt (65 %) compared to Cochlea r (52 %).
Income statement vertical analysis
Exh ibit 13.5 contains a v ertical analysis of Cochlear's
2017 an d 2016 income stat ement (an d comprehensive
income).
The analysis s how s cost of sales is only 29 per cent
of revenue, leaving a gross prof it of 7 1 per ce nt . This is
m uch t he sam e as 2016, but a higher (better) gross profit
marg in than CSL (54%). While both com panies are in t he
healt h sector this difference reflects the d ifferent products
that each company s upplies, and no con clusions c an be
drawn about efficiencies.
A t this point com parisons becom e m ore difficult . Both
have research and development expenses - CSL 10 per
c ent; Cochlear 12 per c ent. Othe r expenses are listed
diffe rent ly - CSL: selling and market ing expe nses, and
general and administration expenses: Cochlear: selling and
g eneral expenses, and adm inistratio n expenses. Even a
com pa rison of total com prehensive incom e requ ires care.
Again, alt ho ugh both are health sector companies t he
23 per cent for CSL compared to t he 18 per cent for
Cochlear may ref lect different business m odels as much
as different products. Some businesses rely o n sm all profit
margins and larg e tu rnovers (the sale of fuel by a service
station), wh ile others survive on high profit margins and
sma ll turnover (the convenience store side of a service
station). Supermarkets thrive o n low profit margins (around
5 per cent for the m ajor Australian superm arkets) and very
large tu rnov ers. In all this analys is it is important t o
remem ber t hat when annual reports are available to the
g eneral public t hey ~,\'1 ,,/,
are also available to
Review dlis content with die e-leCiure •
com petito rs.

A B c D

2017 % 2016 %
$000 Revenue $000 Revenue
Revenue 1253838 100 1130552 100
4 Cost of sales -358373 -0.29 -333593 -0.30
5 Gross profit 895465 0.71 796959 0.70
6 Selling and general expenses -348928 -0.28 -324 144 -0.29
7 Administration expenses ~3474 -007 -79287 -007
8 Research and development expenses - 151 929 -0.12 - 145 080 -0.13
9 Other income 4466 0.00 14 156 0.01
10 Results from operating activities 315600 0.25 262604 0.23
11 Finance income- interest 742 0.00 468 0.00
12 Finance expense- interest - 7517 -001 -8806 -001
13 Net finance expense -6775 -0.01 -8338 -0.01
14 Profit before income tax 308825 0.25 254266 0.22
15 Income tax expense ~5209 -007 -65345 -0.06
16 Net profit 223616 0.18 188921 0.17
17 Other comprehensive (loss)[income. net of tax -1608 0.00 6904 0.01
18 Total Comprehensive Income 222008
- -
0.18
-
195825 0.17
-

~ Vertocal anal ysts of Coch lea r's oncome stat ement

Sotl'c e: Pdap:ed fr!Jll Co:Near Un•~ed. Amlal Repcr1 2017, Al· 56-7.

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3 __
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241
 PROFITABILITY ANALYSIS
.. PROFITABIUTY RAnOS:
PROFIT MARGIN

One of the most important aspects of any financial analysis Total Comprehensive Income
Profit Margin = _ _ ____:_ _ _ _ _ __
is profitability. Everyone associated w ith a company - Revenue
shareholders, creditors, employees and suppliers- all want
the company to generate profits; because without profits
1~~ 17.7%
2
Cochlear 2017:
the business w ill (eventua lly) cease . To determine a
company's profitability, one can look at profits (or total
comprehensive income); but t hat tells only a portion of the 2017 2016
story. It does not revea l how efficiently and effectively Cochlear 17.7% 17.3%
those profits were generated. To f ind out, one must
CSL 21.8% 17.1%
compare profits to other company values such as sales,
assets, equity, share capital and market prices. Cochlear's 2017 profit margin is 17.7 percent, meaning
The following ratios are commonly used to analyse that the company generated a little under eighteen cents
profitability. Note that each ratio compares profits to some of p rofit for every dollar of revenue in 2017. This is a
other financial aspect of the company. In each case we w ill marginal improvement on 2016, but shows Cochlear did
use 'total comprehensive income', because this is the not have the substantial increase experienced by CSL.
figure usually quoted as a company's 'bottom line profit'. Both companies' annua l reports highlight improvement
Because each ratio reveals something different about a in 2017. especially CSL; its first 'Business Highlight' was
company's profit, they are best used in tandem so that a 'CSL reports net profit after tax . .
broad understanding of a company's profitability can be
obtained. RETURN ON EQUITY
Profitability ratio Relationship The return on equity ratio compa res return on equity
comprehens ive income to the average ratio Compares
Profit margin
_,,_,,_,,_,,_,,_,,_,_,_,_,_,_,,_ . ...Profit to sales
, _,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,,.
balance in (shareholders') equity during
comprehensive income to
Return on equity Profit to average total (shareholders') equity average shareholders'
_,,_,,_,,_,,_,,_,_,_,_,_,_,_,,_ .....,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,,. the yea r. The ratio rep resents how equity and measures the
Return on assets Profit to average total assets effectively a company uses the resources ability to generate profits
_,,_,,,_,,_,,_,,_,,_,_,_,_,_,,_,,_,, ...._,,,_,,_,,_,,_,,,_,,,_,,_,,_,,_,,_,,_,,_,,_,,_,,_,,,_,,_,,_,,,_,,_,,_,,,.
from equity.
Earnings per share Profit to issued shares (equity) provided by shareholders during
-···-···-···-··-···-··-··-··-··-··-··-···-······-···-··-···-···-···-···-···-..·-···-···-···-···-...-···-···-···-···-···-···-···-···-·····
Price to earnings Profit to share price the year to generate additiona l resources for its owners.
-···-···-···-···-···-··- ··- ··- ··- ··-···-···-······-···-···-···-···-···-···-···-···-···-···-..·-·..-···-···-···-···-···-···-···-···-···-·····
Shareholders naturally want t his ratio to be as high
In the following sections, the text w ill explain each ratio as possible.
and show the calcu lations for Codllear. Unless otherwise
noted, data for each calcu lation is obtained from · PROFITABIUTY RAnOS:
Exhibits 13.2 and 13.3. After the ca lculation of Coch lear's ROURN ON EQUITY
ratios, CSL:s ratios w ill be provided for compa rison
Total Comprehensive Income
purposes. Then a summary of what was learned from the Return on Equity = - - - - - - ' - - - - - - -
Average Shareholders Equity
ratios about the two companies' p rofitability w ill be
discussed. Where average shareholders' equity is as follows:
(Beginning equity+ Ending equity)
PROFIT MARGIN 2

profrt margin The p rofit margin rati o compares

ratio Compares p rofits to net sales. A higher rat io 222
comprehensive income to Cochlear 2017: - 44.7%
net sales and measures indicates a greater ability to generate (449 + 544)/2
the ability to generate profits from sales. Figures are rounded
profits from sales.
to t he nearest m illion dollars, for ease 2017
of ca lcu lation . The round i ng al so Cochlear 44.7%
acknowledges judgement and dloices in accounting, wh idl
CSL 52.7%
means the numbers are often not mathematically precise,
but not materially misstated. Results are usually reported In Australia compan ies are required to show the figures
to one decimal place because ratios are guides, unlike, for for the current and previous year. This means if we w ished
example, Olympic resu lts where gold medals can be to calculate any ratio involving averages, we wou ld need
decided by one thousandth of a second. the previous f inancial statements to obtain the open ing
balance for th is year.
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242
_...;;.,;,;;
 The 2017 ratio of 44.7 per cent shows that Cochlear
generated almost 45 cents in profits for every dollar of
resources provided by shareholders. This is lower than CSL.
but still substantially higher than the average return on
equity for Australian compan1es of around 10 per cent.
The result may be due, at least in CSL:s case. to the
semi-regular share buybadcs and for both companies
the high 'gearing ', as d 1scussed later in the chapter
(LOS Solvency analys1s).
RETURN ON ASSETS
return on assets The retu rn on assets r atio compares
ratio Canpares returns (comprehensive i ncome) to
c~s1ve ulCOme to
average total assets during the year.
average total assets and
measures the ability to It represents a company's ability to
generate profits from generate profits from its entire resource
assets.
base. not just those resources provided
by owners. Like the return on equity, investors would like
the ratio as high as possible.
PRORTAIIUTY RA1101:
RIIUAN ON AIIIIS
Total Comprehensive Income
Retu rn on A ssets =
Average Total Assets
Where average total assets is as follows:
(Beginning Total Assets+ Ending Total Assets)
2 57
222
Cochlear2017. =21.2%
(11:!6 + 957)/2
2017
Cochlear
21.2%
CSL 18.9%
The 2017 ratio of 21.2 per cent shows Cochlear
generated over 21 cents in profits for every dollar of assets
possessed during the year; slightly more than CSL. This
result is not surprising given Cochlear has large intangible
assets that it has researched and developed rather than
purchased, and as such a large amount of intellectual
property is not recorded on the balance sheet. CSL has
similar resea rch and development. The accoun t ing
standards do not allow research costs to be recorded as
an asset or 'capita lised' to a limited extent, but does
allow this w ith all development costs.
Sometimes the return on assets is calcu lated using
earnings before interest and tax (EBID. This is used to
measure how efficiently management is using assets and
to remove the effect of borrow1ngs (interest expense) and
taxes that are lev1ed on taxable income rather than
accounting profrt.
Copyrlgh12019 CensJa9e L.umlng. AU RlghU R--..cl.l&ay not be copied. scanned.
EARNINGS PER SHARE
Earnings per share (EPS) compares a company's profit to
the average number of ord1nary shares issued during the
year. The ratio represents the retum on each share owned
by an investor. Although companies normally disclose EPS
on thei r income statement. the calculation w ill be
demonstrated nonetheless.
The beginning and ending outstandmg shares m ight be
collected from the notes to the accounts but th1s does not
give a weighted average. Most compan1es show how their
EPS are calculated and the weighted average number of
shares is given (for Cochlear. Note 2.5: Equ1ty and reserves.
shows the weighted average shares in 2017 as 57.4 million
shares issued).
. S Total Comprehensive Income
Ea rmngs per hare =-:----:-'-----:--:---
Average Number of O rd inary
Shares
Where the average number of o rdinary shares is as follows:
(Begin ning Balance of Ordinary Shares+
Ending Balance of Ordinary Shares)
2
Cochlear 2017. (all figures 1n millions) 222
= $3.89 per share
This is very similar to the f1gure provided by Cochlear
who calculated EPS on 'net profrts attributable to equity
holders of the parent entity' and d1d not mclude other
comprehensive income of mmus $1.6 m1llion. wh1ch m 2017
was immaterial. This was not the case 1n 2016 when other
comprehensive income added almost 4 per cent to total
comprehensive income. nor for CSL when 1t added over
11 per cent. Therefore. the f1gure shown here for CSL is
significantly different to CSL5 calculation 10 1ts annual report
which is based on net profits. Cochlear, like other listed
companies, also reports 'diluted EPS'. Diluted EPS takes
into account options that have been issued. but is beyond
the scope of our analysis here.
Note that an EPS has not been included for comparison
with CSL. While it is very useful comparing Cochlear's 2016
figure ($196 I 57.1 =$3.43 per share) to the 2017 f igure to
show the substantial increase ($0.46 or 13 .4 %), comparing
CSL EPS of $3.31 (or $2.94 as calcu lated in its annual
report, not including comprehensive income) is meaningless
because ownership in companies is divided into different
numbers of shares. If a company were to split its shares
as we saw in Chapter 11 and profits were to remain the
same, the EPS would halve. Further CSL5 EPS is in US
dollars. which could be easily converted mto Australian
0< ~iealed t
 dollars, but a simple comparison of figures from the annual
report makes such a comparison even more meaningless.
EPS is useful because it reduces a number such as
$222 million or 1.5 billion into an easily comprehensible $2
or $3 per share figure. For a shareholder w1th 1000 shares,
they know their share of the profit is only $2000. EPS is
vital for probably the single most quoted ratio of a Iisted
company; price earnings ratio.
We have chosen to use total comprehensive income
rather than net profits because Accounting Standard
AASB 101 Presentation of Financial Statements:
prescr~bes the bas1s for presentatiOn of general purpose
flnanc1al statements to ensure comparability both w1th
the entrty's f•nanc~al stat ements of pre111ous penods
and With the financial statements of other ent1t1es
It sets out 011erall requirements for the presentallOn of
flnanciCII statements, guidelines for thelf structure and
m1n1mum reqUirements for thelf content 2
All public companies need to report comprehensive
income.
CS[
PRICE TO EARNINGS RATIO
price t o earnings The price to ear nings ratio (PI E) ratio
(PIE) ratio Compares compares profits to the current market
comprehensive income to
a company's share pnce
price of t he company's ordinary shares.
and provides an IndiCation Because a company's share price
of investor percept1ons of
represents the value per share, the ratio
the company.
uses EPS rather than total profits. It is
also the f~rst ratio in which profits are in the denominator
rather than the numerator. That is why the ratiO is called
pnce to earnings rather than earnings to pnce.
Because the PIE ratio uses share pnces, it prOVIdes an
indicat1on of current investor perceptions of the company.
For example, a P/E ratio of 10 means that investors are
willing to pay 10 times current EPS to buy one share.
A higher P/E ratio generally indicates that investors are
more optimistic about the future prospects of a company,
and a lower ratio is the reverse. (If you. as a student. sold
your future earnings stream you could expect a very high
PIE ratio as you are forgoing current earnings to invest in
yourself, which should result in substantially h1gher future
earmngs compared to current earnings.)
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244
Current Share Price
Price to Earnings Ratio = -------
Earnings per Share
The following calculation of Cochlear's 2017 P/E ratio
uses the $155.45 share price at the close of business on
30 June 2017, the end of the company's financial year (and
the last trading day of the financial year) .
2017
Cochlear 40
est 42
Cochlear's rauo of 40 shows that a share of Cochlear
was selling for 40 t1mes EPS at the close of the 2017
financial year. While we cannot compare one company's
EPS to another. we can make valid comparisons of P/E
ratios . It would appear investors have marginally more
confidence in the future prospects of CSL (P/E 421 when
compared to Cochlear. but the difference is small and you
should not read too much into this. The higher the P/E ratio
the more confidence shareholders have in the future. These
two companies can be expected to have substantially
increased earmngs in future years. These PIE ratios are
unlikely to be the same as current quoted PIE rauos,
because it is no longer 30 June 2017 and the rat1os are
usually calculated on profits not comprehensive income as
we have done here.
These ratios are significantly higher t han the average
P/E ratio of 16 for the top 50 companies listed on the ASX.
For comparison, let us look at the supermarkets;
Woolworths and Wesfarmers (Coles) had P/E ratios of 22
and 19 respectively at the same time. This indicates either
their current profrts are prudently (conservatively) calculated
and/or investors expect the future earnings of these
retailers to be better than present earnings, but not as
prudent as/better than our two health sector compan1es.
Cochlear's and CSt.:s earnings are likely to be prudently
st ated because much of the research and development
expenditure is currently expensed when it is likely to (1) not
yield immediate benefits and (21 only be undertaken if the
expected future payoffs are greater than the expenditure.
SUMMARY OF PROFITABILITY
Based on the five ratios examined, it is clear that Cochlear
is profitable and that its profitability has increased over the
two years. The Chairman's report began with 'Cochlear
reported a record net profit of $224 million. an increase of
18% on the FY16 result .. .' 3 This is a trend to watch closely,
especially in an 1ndustry that depends on prospenty and
health priorit ies.
 Uquidity ratios Relationship
CSL ANALYSIS Current assets to current liablltttes
Current ratiO
Quick ratiO Cash-like assets to current liabillues
Receivables turnover rauo Sales {RevenueIto accounts receivable
lrrventory turnover rat to Cost of goods sold to inventory

As in the previous section on profitability; the following

sections will explain and calculate each ratio for Cochlear
using data from Exh ibits 13.2 and/or 13.3. A comparison
of Cochlear's and CSI.S ratios will follow each calculation.
After all ratios are presented. a summary of what has been
learned about Cochlear's liquidity will be provided.

CURRENT RATIO
The current ratio is one of the most frequently used ratios
in financtal analysis. It compares current assets to current
liabilities. It therefore compares assets that are cash or
should be turned into cash within one year to liabilities that
should be paid within one year. A higher ratio indicates
more assets available to satisfy current obligations and
therefore greater liquidity.

Current A ssets
Current Ratio = - - - - --
Current Liabilities

586 1.7 times

Cochlear 2017. =
347

2017 2016
Cochlear 1.7 2.2
CSL 2.8 2.8

Review lhis eoment
withlhee-lecture
LIQU IDITY ANALYSIS
A major concern in any financial analysis is an assessment
of a company's liquidity, which refers to the ability of a
company to satisfy its short-term obligations. A company
must maintain the ability to pay its liabilities as they come
due. Failing to do so can result in additional expenses and,
ultimately, bankruptcy. As a result, everyone associated
w ith a company - shareholders. creditors, employees.
suppliers -wants to see adequate liqutdtty.
The following ratios are commonly used to assess a
company's liquidity. While each ratio reveals tnformation on
tiS own, using the ratios together provides a much richer
understanding of liquidity. Note that each ratto focuses on
some aspect of either current liabilities or current assets.
Cochlear's ratto of 1.7 shows that it had $1.70 in current
assets for every dollar of current liabilit ies. This is less than
both the p nor year. and CSt:s ratios. This means that
Cochlear is becomtng more liquid over time.
While the trend in liquidity should be monitored, a
ratio near two may, by some unsophisticated analysts.
be considered ideal. Some investors may be critical of
maintaining a current ratio that is too high. They would
rathe r the company keep only an adequate amount of
assets in current assets and invest the rest in more
productive and higher-yielding assets such as PPE, or
intangibles like intellectual property. Current ratios w ill
'improve' when sales slow. because inventory {current
asset) increases. Further for most individuals and
businesses future earnings are likely to be the mam
source of resources to pay future debts. We may need
to look at a more critical liquidity measure such as the
quick ratio.

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CHAPT~R ,.3 Flnanc1al statement analys•s
• __
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245
 QUICK RATIO
While the current ratio is a useful measure of liquidity, it
does have some limitations. In particular, current assets
often include inventory that must be sold before cash
can be generated to pay off current liabilit ies. Because
of this, severa l additional ratios are used to provide
more detail regard ing a company's liquidity. One is
t he quick ratio, which compares a
quick ratio Compares
cash and near-cash assets company's cash and 'near-cash assets',
to amen! liabilities and ca lled quick assets, to its current
measures the ability to
pay current liabilities liabilit ies. Qu ick assets include cash ,
immediately. short-term investments and accounts
receivable. Sometimes called the acid-
test ratio, the quick ratio measures the degree to which a
company cou ld pay off its current liabilities in a few weeks
rather than many months. Like the current ratio, a higher
quick ratio indicates greater liquidity.
· LIQUIDITY RAnOS:
QUICKRAno
Cash + Short-term Investments+
Accounts Receivable
Quick Ratio = - - - - - - - - - - - -
Current Liabilities
Current Assets-
Inventory
Quick Ratio Simple Calculation = - - - - - ' - -
Current Liabilities
We have adopted the simpler calculation of Current
Assets less Inventory divided by Current Liabilities which
gives us the same (or similar) answer:
Cochlear 2017: (586 - 1601- 1.2
347
2017
Cochlear 1.2
CSL 1.3
These low ratios are not surprising given manufacturers'
major current asset is inventory. Cochlear's ratio of 1.2
shows that at the end of its financial year, the company had
$1.20 in cash and near-cash assets for every dollar of
current liabilities. This indicates that Cochlear cou ld easily
pay its current liabilities if they came due in the next few
weeks, assuming it could rapid ly collect its accounts
receivable. Note in passing, the quick ratio for CSL is
substantially lower than its current ratio, while the impact
on Cochlear is not so pronounced. This is due to the larger
percentage inventory make-up of CSL.:s current assets
compared to Cochlear's.
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_ 246
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RECEIVABLES TURNOVER RATIO
The receivables turnover ratio compares a company's credit
sales during a period to its average accounts receivable
balance during that period. It measures a company's ability
to make and collect sales. A higher turnover ratio means
that the company is better able to generate and collect
sales. Therefore, a higher ratio generally leads to better
liquidity. The ratio uses net sales as a substitute because
credit sales are not usually reported by companies. In the
case of a biotechnology manufacturer such as Coch lear or
CSL, credit sales are likely to make up most of net sa les.
For a retailer like Woolworths net sales are likely to be a
very poor substitute.
• UQUIDITY RATIOS:
RECIIVABLD TURNOVER RAno
Net Sa les
Receivables Turnover Ratio = - - - - - - - - - -
Average Accounts Receivable
Where average accounts receivable is:
(Opening Balance of Accounts Receivable
+ Closing Balance of Accounts Receivable)
2
Cochlear 2017: (
282 +~2112 = a4.4turnover
12
times per year or
of 83 days
(365 I 4.4)
CSL has a turnover of 6.1 times a year or once every
60 days.
In a business where the majority of sales or services
are provided on cred it, trends in accounts rece ivables
turnover ratios often can indicate whether management
is keeping good control of the credit department
2016
(responsible for determining which customers are allowed
1.5 to buy now and pay later) and the collections department
1.2 (responsible for collecting the money from customers who
were supposed to pay later).
INVENTORY TURNOVER RATIO
The inventory turnover ratio compares a company's cost of
goods sold during a period to its average inventory balance
during that period. It reveals how many times a company
can sell its average inventory balance in a period. In general,
companies want this ratio to be higher because it indicates
that the company sold more inventory while maintaining
less inventory on hand. Th is means that the company
generated more sales revenue wh ile reducing the costs of
stocking inventory on the shelves: but a fast turnover might
also indicate a business is not holding some items and
missing out on potential sales. For CSL holding stock of
vaccines in case of epidemics may be important not just
for profits but for humanitarian reasons and also for
maintaining a reputation for reliability of supply.
UQUIDITY RAnOS:
INVENTORY TURNOVER RAOO
Cost of Goods Sold
Inventory Turnover Ratio = - - - - - - -
Average Inventory
Where average inventory is as follows:
Beginning inventory + Ending inventory
2 A company's solvency is related to its
Cochlear 2017: 358 - 6.3 times
(160 + 154V2
2 017
Cochlear 6.3
CSL 1.4
A 6.3 ratio shows that during 2017 Codllear sold over
$6 of inventory for every $1 of inventory it had on average
on its she lves. Unlike supermarkets that are likely to
closely examine their competitors' inventory turnover ratio,
companies in this sector have vastly different biotedlnology
inventory and no comparisons can be drawn. Inventory
turnover is product specific; newspapers turn over daily,
while car parts for older model cars may turn over once
every five or so years.
SUMMARY OF LIQUIDITY ANALYSIS
Based on the four ratios examined. it appears that Codllear
has sufficient liquidity.The largest current assets are tied to
accounts receivable, so for Codllear. keeping an eye on this
turnover is important. For CSL the major asset is inventory
and th is turnover is critica l. Wh ile it is commendable/
advisable to keep stocks for the good of humanity and
reputation for reliability of supply, having large quantities of
inventory approadling the use-by- date could be a concern .
( § [ ANALYSIS
.. . . . . Solvency ratios
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, In who~A~~~1'3 Vffn'!~~;,:r.ti,~~ ent analysis
SOLVENCY ANALYSIS
A third component of any financial analysis is an examination
of solvency, whidl refers to a company's ability to satisfy
its long-term obligations. If a company cannot satisfy its
obligations and becomes insolvent. it can fa ll into
bankruptcy, which can result in significant losses to
investors and creditors. Therefore. both investors and
creditors are interested in assessing solvency.
financial
use of f inancial l everage. wh ich is the leverage The degree
to IMlich a company
degree to wh ich a company obta ins obtains capital through
capital (funds) through debt rather than debt rather than equity in
an attempt to increase
equ ity in an attempt to increase returns to
returns to stockholders.
shareholders. Leverage is beneficial to
shareholders when the return on borrowed funds exceeds
the cost of borrowing those funds. In that case. leverage
is positive. It is harmful. or negative, when the cost of
borrowing the funds exceeds the return on those borrowed
funds. As a company uses more financial leverage, it
creates an opportunity for greater returns to shareholders.
but it also creates greater solvency risk.
A simple example w ill demonstrate this. If a company
commences by selling one $1 share and borrows $9 it
wou ld have $10 of assets f inanced 90 per cent from
borrowings and 10 per cent equ ity, and have a debt to equity
ratio of 9:1. If it invests the $10 and earns a return on assets
of 10 per cent it wou ld have $10 ($100 x 0.1) of revenue.
Further assume its only expense is interest of 5 per cent
on the money borrowed. Expenses are $4.50 ($90 x 0 .05)
and therefore profits $5.50 ($10 - $4.50). This provides a
return on equity of 55 per cent ($5.50 I $10). But what
happens if the assets only earn a 2 per cent return (ROA =
2%). Revenue is $2 ($100 x 0.02), expenses remain $4.50
giving a loss of $2.50 ($2.00 - $4.50). While ROA is sma ll
but positive, ROE is negative 25 per cent (-$2.50 I $10).
Financial leverage is neither good nor bad. just risky.
A lthough it is impossible to know whether a company
will or will not be able to pay future obligations and remain
solvent. the following three ratios can provide some
indication of a company's general solvency:
Debt to assets
Debt to equity
Relationship
Total liabil ities to total assets
Total liabil ities to total equity
Times interest earned Income to interest expenses
As in the previous sections. the following sections will
explain and calculate each ratio for Coch lear using data
from Exhibits 13.2 and/or 13.3. A comparison of Codllear's
and CSt:s ratios w ill follow each calculation. After all ratios
are presented. a summary of what was learned about
Coch lear's solvency w ill be provided.
__
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247
 DEBT TO ASSETS RATIO
The debt to assets ratio compares a company's total
liabilities to it s total assets and yields the percentage of
assets provided by creditors. As such, the ratio provides a
measure of a company's capital structure. Capital structure
refers to the manner in which a company has financed its
assets - either through debt or equ ity - and how much
financial leverage a company is using. Since debt and any
related interest must be repaid, compan ies w ith a higher
percentage of assets provided by creditors may be seen as
having a 'riskier' capital structure. In other words, it is using
more financial leverage, and therefore has a greater risk of
insolvency (but also potentially, the 'risk' of greater returns).
• SOLVENCY RAnOS:
Total Liabil ities
Debt to Assets Ratio = - - - - - -
Total Assets
59
Cochlear 201 7: ; = 0.52
11 6
2017 2016
Cochlear 52%
CSL 65%
Cochlear's ratio of 52 per cent (or 0.52) shows over half
its assets are financed by debt. For CSL the figure is close
to two thirds. These ratios have decreased marginally since
2016 for both companies. If there were not advantages in
borrowing then few businesses would have debt (liabilities).
From a personal perspective it may be considered 'good' to
be debt free, but many students w ith in 10 years of
graduating may borrow to buy their own home, pushing
their debt to asset ratio to 80 per cent (borrow $800 000 to
buy $1 000000 home) or even higher. Debt is not good or
bad, debt brings increased risk. W ith shareholders a dividend
is paid if a company makes a profit, but debt-holders require
interest regardless of the prosperity of the business.
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248
_...;;..;.;;.
DEBT TO EQUITY RATIO
The debt to equity rati o compares a debt to equity
company's total liabilities to its total equity. ratio C~res total
liabilities to total equity and
Exactly like the debt to assets ratio, this
measures a company's
ratio provides a measure of a company's capital structure and
capital structure and financial leverage, financial leverage.
but by d irectly comparing the two aspects
of capital structure: liabilities and equity. As w ith the debt
to asset ratio a higher debt to equity ratio indicates a riskier
capital structure and therefore greater risk of insolvency.
Companies w ith higher debt to equity ratios are also sa id
to have high leverage.
.. SOLVENCY RAnOS:
DBT 10 EQUITY RATIO
Total Liabilities
Debt to Equity Ratio = - - - - -
Total Eq u ity
Cochlear 2017: ~~ = 1.1
The 1.1 per cent indicates that for $1 of equity there is
$1.10 of debt. The debt to equity ratio is simply a rearrangement
of the debt to asset ratio. If assets are financed 52 per cent
by debt they must be financed 48 per cent by equity (given
the balance sheet equation from Chapter 1: A = L + E).
If debt is $52 and equity $48 then the debt to equity ratio is
52 I 48 = 1.08 or rounded to 1.1. The debt to assets and debt
to equity ratios are simply different perspectives of exactly
the same capital structure; therefore, the debt to equity ratio
tells us nothing more about Cochlear's and CSL:s solvency
than the debt to asset ratio. We could also calculate an equity
to asset ratio, which if added to the debt to asset ratio always
equals 100 per cent (because assets are financed by either
debt or equity- no other sources).
TIMES INTEREST EARNED
53% In addition to examining a company's capital structure. it is
66% wise to assess whether a company can pay the interest on
its debt. Simply because a business has a low debt ratio
does not mean it is generating enough revenue to pay all
expenses. To answer this question, many use the times
interest earned ratio.
The times i n terest earned rat io times interest
compares a company's profits to its earned ratio
Compares income to
interest expense. It shows how easily a interest expense and
company can pay interest out of current- measures the ability to pay
interest out of ament
year earnings. As such, it helps creditors
earnings.
and investors determine whether a
company can service its current debt by making its required
interest payments. The numerator is often expressed as
EBIT and calculated as profits plus interest plus tax (total
comprehensive income or profit s has already deducted
interest and tax, so we add them back to get EBIT). It is
what a company's profit (comprehensive income) wou ld
be if it paid no interest and no tax.
Let us return to the individual (or couple or group)
borrowing to buy a home. First, the financia l institution
(bank) w ill not lend more than the net proceeds from the
future sale of the home (in case it has to repossess and
se ll the property). Second, the financial institution w ill
usually have restrictions on the amount that repayments
are allowed to take up of disposable income. This is a
concept very similar to the 'times interest earned ratio',
especially at the beginning of a home loan when the vast
majority of the repayment is interest.
· SOLVENCY RAnOS: nMES
INTEREST EARNED RAno
Total Comprehensive Income+
Times Interest Interest Expense+ Income Tax Expense
Earned Ratio = Interest Expense
Note that the ratio adjusts income by adding back interest
expense (finance costs) and income tax expense. These are
added back to 'gross up' income to the amount of earnings
that were available to make interest payments (before
interest is paid and before tax because if you were paying
out all your EBIT in interest payments there would be no
earnings and so no tax to pay). Once this adjustment is
made, the ratio yields the number of t imes that current
interest payments could be made out of current earnings. A
higher ratio indicates a greater ability to make payments, and
therefore less risk of insolvency. A high ratio may also indicate
an overly cautious approach to the business and that excellent
available opportunities are not being taken advantage of.
EBIT is a difficult concept and may take some t ime to
grasp. Further when extracting the numbers from published
financial statements often the words 'interest expenses'
are not used more often than 'finance costs'.
2706 346 9391
Cochlear 2017: ( + + 222 + 8 +85 / 8 = 39 times
346
2017 2016
Cochlear 39 30
CSL 22 20
Cochlear's ratio of 39 indicates that the company earned
many times more than its interest expense. Specifically, for
every dollar of interest expense, the company earned almost
$40 in profits. CSL:s ratio, although lower, is still very high,
which is curious given its higher debt ratio. Financial
institutions often use a similar ratio when individuals seek a
home loan. The amount of monthly repayments is limited to
a percentage of disposal income. Because interest on home
loans is not tax deductible in Australia, after-tax income is
usually used and ratios of three may be considered prudent.
During the 2016 and 2017 property price 'boom' the Reserve
Bank of Australia was suggesting banks needed to be more
cautious with respect to both household debt ratios and times
interest earned ratios (usually referred to as the percentage
of disposable income consumed by repayments). The former
is important when (not if) property prices fall, and the latter
when interest rates rise and/or household income falls.
SUMMARY OF SOLVENCY
Based on the three ratios exam ined, it appears that both
companies' capital structure is trending toward a little less
debt. Thus, its solvency risk has decreased marginally. This
chapter is a brief introduction to f inancial statement analysis
and has involved a number of simplifications. Caution
should be exercised in reading too much into the superficial
analysis we have ~,VJ ,,/,
conducted on Cochlear Download the Enrichment •
and CSL. Modules for further practic
DUPONT ANALYSIS
A ll investors want to maximise the returns on their
investments in a company. An investor's return is measured
by the return on equ ity. To better understand how the return
was generated, investors may conduct a DuPont analysis.
A DuPont analysis provides insight
DuPont
into how a company's return on equity
analysis Decomposes
was generated by decomposing the a company's return 011
equity into measures of
return into three components: operating operating efficiency, asset
effectiVI!Iless and capital
efficiency, asset effectiveness and capital
struciiJre.
structure. The actual calculations of the
analysis are as follows:

• DUPONT ANALYSIS

Operating Asset Capital Retum on

Efficiency Effectiveness Structure Equity

Total Total
Comprehensive Comprehensive
Income Sales Assets Income
X X
Sales Assets Equity Equity

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;;..;..;.
249
 The f irst component is a company's operating
efficiency. It is calcu lated as comprehensive income
divided by sales, wh ich is also known as the profit margin
ratio. This component reveals a company's ability to earn
profits from sales. The higher the ratio, the more efficient
a company is at turning sales into profits. But remember,
different companies adopt different business models and
may achieve their f inancial goals by reducing profit margins
and increasing turnover (sales revenue) to more than
compensate. We calcu lated this ratio earlier in this chapter.
The second component is a company's effectiveness
at using its assets. It is calcu lated as sales divided by
assets. This ratio is commonly known as the asset turnover
ratio. It measures the ability of a company to generate sales
from its asset base. The higher the ratio, the more effective
a company is in generating sales given its assets (or the
lower the carrying amount of assets, due to old assets
being recorded at historic cost or assets such as internally
generated intangibles not being recorded). Both CSL and
Coch lear appear to have little of their intellectual property
recorded and as such have a low asset figure. In contrast
a company like Westfield, that owns many shopping
centres (PPE). has an asset turnover of less than 15 per
cent. Asset effectiveness is as much about the operating
model of a business and may explain why many businesses
lease property rather than buy. While Coch lear has 14 per
cent of assets in PPE, CSL has 32 per cent, which may be
a function of the requirement for specialist PPE or a
strategy of owning rather than renting.
Express for ACCT3 F
•
Interactive quizzes
Enrichment modules
Animations
E·lectures
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Flashcards and more
_ 250
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The third component is a company's capital structure.
For this analysis, it is calculated as assets divided by equity.
This ratio is similar to the debt to assets and debt to equity
ratios in that it measures how a company has financed its
assets. The higher the ratio, the more a company is
financing its assets w ith debt rather than equity. So, a
higher ratio means more financial leverage and a riskier
capital structure. Sometimes, this ratio is cal led the
leverage multiplier.
Another measure of performance is Economic Value
Added, which compares profits before interest with the
cost of capital on equity and interest-bearing liabilities.
The cost of capital is the return required by resource
providers. If a business cannot add va lue it should return
the funds to the providers to be used more economically
elsewhere.
For listed compan ies, current share price reflects all
publicly available information. It is unlikely from the simple
analysis undertaken in this chapter that you will discover
overpriced or underpriced shares. The aim of this chapter
as the conclusion to introductory financial accounting is to
better understand how the financial reports are used and
why production of the f inancial statements is critical to a
well-functioning capital market. This is on ly the start of
the journey.
Now you have made it to the end - welcome to the
wonderful world of accounting.
~,\J ,,/,
Test your understanding widl die •
online revision quizzes for dlis chapter
 5 Horizontal and vertical analysis
The statements of comprehensove income of the
Brancatosano company for the past two years are as follows:

1 Financial statement analysis

Financial statement analysis is defined as the process of Cost of goods sold 125000 100000
applying analytical tools to a company's fonancial statements
to understand the company's financial health. Gross profit $175000 $150000

REQUIRED Operating expenses 75000 50000

Identify and broefly describe the three otems requored to Profits before onterest and taxes $100000 $100000
conduct successful financial statement analysos. Why are Interest expense 35000 15000
these otems needed?
Profits before taxes s 65000 s 85000
2 Calculate inventory turnover ratio Income tax expense 25000 llOOO
In 2019, Rose Rug Rats generated net sales of $1136000 Comprehensove oncome net of tax 3000 7000
and cost of goods sold of $657000. Ralph's average Total comprehensive 1ncome $ 43000 $ 62000
inventory of rugs during the year was $86 600.
REQUIRED
REQUIRED
Calculate and interpret a horizontal and vertical analysis of
Calculate Rose's inventory turnover ratio for the year and
Brancatosano's oncome statements.
briefly explaon what the result means.

6 Vertical anal ysis

3 Calculate times interest earned ratio
The followmg asset onforma!Jon is available for Samantha
Chen Carpet Cleanong Service has total comprehensrve
Lomoted:
oncome of $125600 on 2019. Interest expense was $12550
during the year, and oncome tax expense was $42000. 2020 2019
REQUIRED
Cash $ 15000 s 10000
Calculate Chen's tomes interest earned ratoo and briefly
explaon the result. Accounts receovable 30000 25000
Inventory 75000 75000
4 Horizontal and vertical analysis Total current assets 120000 110000
--
The following asset information is available for Wakefield Property and equipment 205000 210000
Automotive:
Total assets $325000 $320000
2019 2018
REQUIRED
Cash $ 105000 s 180000 Calculate a vertocal analysos of assets for both years.
Accounts recervable 180000 165000 Comment on any dofferences that may be matenal.
Inventory 375000 525000
7 Interpret vertical analysis
Total current assets $ 660000 s 870000 A supermarket and a jewellery store provide the followong
Property and equipment 525000 450000 vertocal analyses of certaon accounts from theor oncome
Total assets $1185000 $1320000 statement and balance sheet:

REQUIRED Company A Company B

a Calculate a horizontal analysis of Wakefield's assets. Gross profit 26.0% 552%
b Calculate a vertical analysis of Wakefield's assets.
Operating expenses 22.2% 48.0%
Net income 3.8% 72%
Inventory 30.4% 68.2%
Property and equipment 57.8% 12.5%

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251
 REQUIRED
10 Interpret ratios
ldenufy whu:::h company os likely to be the supermarket and
which os lokely to be the Jewellery store. Explaon the reasons The followong informatoon os available for Radovoch
for your conclusoons. Researchers:

8 Vertical and horizontal analysis 2020 2019

Petrvhs Petroleum os applying for a substantoal oncrease in 1ts Profit margin 8.7% 8.3%
loan from Murray Bank. The income statements of Petrulis Return on assets 10.2% 10.4%
for the past year and expected (budgeted) results for the
Price to earnings ratio 13.5 12.0
following year are as follows (all figures in millions):
Quick ratio 0.8 0.9
Inventory turnover rat10 5.5 72
Receivable tumover ratiO 11.3 155
Times interest earned 7.2 6.4

Revenues $725 REQUIRED

Cost of goods sold 345 385 For each ratoo, ond1cate whether the change on the ratoo is
favourable, unfavourable or ondeterm1nate and why.
Gross profit $380 $315
Operat1ng expenses ..lli 180 Define ratios
11
Earnings before interest and taxes $205 $135 Identify the appropriate ratio or ratoos for each of the
Interest expense 45 40 following descriptions:
Earnings before taxes $160 $95 a shows the return to each share owned by an investor
Income tax expense 55 30 b measures the d1fference between current assets and
current liabilities
Comprehensive income net of tax 23 29
c measures the aboloty of a company to generate profits
Total comprehensive income $128 $94 from sales
REQUIRED d provodes a measure of a company's capotal structure
e shows a company's aboloty to generate profits from ots
As the accountong student on internshop at the bank you
en tore resource base
have been asked to calculate a venocal and honzontal
analysts of Petrulos' actual 2020 and budgeted 2021 gives 1nformauon as to how a company manages ots
statements of comprehensive income. Provode comment on inventory
any unexpected results the analysos reveals and that the g measures a company's capital structure using liabilotoes
bank may w1sh to discuss with Petrulis. and equity
h shows how effectively a company uses its current equity
9 Identify ratios to generate add1tional equity
ldent1fy each of the following ratios as a profrtabiloty, loquidoty measures a company's ability to meet its obligations in a
or solvency ratio. Wh1ch ratio is likely to best ondicate what few weeks rather than many months
equ1ty Investors believe is the future of the company shows how well a company can pay interest on debt out
compared to the present? Why? of current-year earnongs
a return on equoty k measures a company's ab1hty to collect sales on credot
b debt to assets raiJO provodes an ondocauon of current onvestor perceptoons of
c tomes onterest earned the company.
d qu1ck ratio
e onventory turnover ratio 12 Profitability ratios
accounts receivable turnover ratio The followong f1 nancoal onformatoon about Howard
g price to earnings ratio Enterprises is available:
h profit marg1n Sales $1 200000
current ratio 260000
Net profit
debt to equoty ratoo.
Average total assets 1800000
------------------------
Average shareholders' equoty 880000

The followong add1toonal onformatoon is available:

The contributed cap.tal was made up of 250000ordonary
shares. No shares were 1ssued during the year.
ii The shares were recently tradong for $10.00 (per share).

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_ 252
....;;.;;.::;
REQUIRED Revenues (sales)
Calculate the following ratios:
Connor Cookers 207349 194655
a profit margin
Olson Ovens 160123 176896
b return on equity
c return on assets Cost of goods sold
d earnings per share Connor Cookers 80153 79411
e price to earnings. Olson Ovens 76740 71561

13 Profitability ratios REQU IRED

a For each company, calculate the followi ng for 2019:
The following financial information is available about Li m
accounts receivable turnover ratio
Limited for the fi nancial year ended 31 December:
ii inventory turnover ratio
Net profits $ 150000 iii current ratio
Ordinary shares, 1 January 400000 iv quick ratio.
b Based on your calculations, discuss the liquidity of both
Ordinary shares. 31 December 500000
companies and indicate what caution needs to be
Share (market) price at 31 December 10.00 exercised in drawing conclusions about either company's
Sales 945000 ability to pay their debts in the short term.
Total assets. 1January 800000
15 Transactions affect.ing liquidity ratios
Total assets. 31 December 1000000
Taylor Tools has $50 000 of cash and accounts receivable.
Shareholders' equity, 1 January 450000 $135000 of total current assets and $100000 of total
Shareholders' equity, 31 December 475000 current liabilities prior to the following transactions:
sales on account of $10 000
REQUIRED
ii paid cash for accounts due to suppliers. $15000
Calculate and interpret the following:
iii received cash for accounts receivable of $1500
a profit margin iv prepaid expenses of $7500 with cash
b return on equity v purchased inventory of $20000 on account
c return on assets vi paid a $5000 cash dividend
d earnings per share vii repaid short-term loans of $10000 with cash
e price earnings ratio. viii purchased short-term investments of $15000
w ith cash
14 Liquidity ratios ix borrowed $25000 from the ban k by signing a
The following information was taken from the financial 90-day note
statements of Connor Cookers and Olson Ovens: x sold inventory of $30000 for cash.
REQU IRED
(in millions) 2019 2018 Indicate whether each transaction would increase. decrease
Tota l current assets or have no effect on Taylor's current and quick ratios. Treat
each transaction independently.
Connor Cookers $46448 $249664
Olson Ovens 155117 153188
16 Solvency ratios
Cash The following information was taken from the financial
Connor Cookers 24311 48936 statements ofTK Company:
Olson Ovens 28894 28406
2021 2020
Accounts receivable
Total assets $400000 $250000
Connor Cookers 8216 186766
Total liabilities 150000 150000
Olson Ovens 114645 114511
Total equity 250000 100000
Inventory
Earnings before interest and tax 70000 60000
Connor Cookers 13921 13962
Interest expense 14000 15000
Olson Ovens 11578 10271
Current l iabilities REQUIRED
Connor Cookers 74457 Calculate:
69036
a the debt to assets ratio
Olson Ovens 80220 85037
b the debt to eq uity ratio
c ti mes interest earned for both years.

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=--
253
 17 Solvency ratios
The followmg ftnanctalmformation regardtng Emtly's Edttors
Pty ltd tS available:

2019
Total assets _ _ _ _ _ _ _ __;_
$ _.:.;
530000
Total habillt•es 140000
20 Analysing financial statements
Total shareholders· equity 390000
The following financial information is available for Porch
Posers at 30 June:
2019 Statement of comprehensive Income

Revenue $ 250000
Cost of goods seld 125000
Gross profit 125000 Cash s 25000
Operaong expenses 40000 Accounts recetvable 30000 25000
Profits before tnterest and taxes 85000 Inventory 75000 75000
Interest expense 10000 Total current assets 130000 125000
Profits before taxes 75000 Property. plant and eqUipment 400000 315000
at carrying amount
Income tax expense 25000
Total assets 530000 440000
Comprehensive income (no tax) 12000
Accounts payable 40000 50000
Total comprehensive income $ 62000
Other current liablhtres 25000 40000
RE QUIRED Total current liabilities 65000 90000
a Calculate the folloWing ratios:
Debentures payable 75000 150000
debt to assets
ii debt to eqUity
Totalliabiii!Jes 140000 240000
iii equtty to assets Share equ1ty 290000 150000
iv t•mes mterest earned. Retained earnings 100000 50000
b Dtscuss the solvency of Emily Edttors. Does the Total shareholders· equtty 390000 200000
company rely more on equity or debt to finance tiS
operations? Total liabilities and equtty $530000 $440000
c What is the relation between the first three ratios?
During the period Porch issued 140000 shares in
addition to the 150000 already issued. The share price at
18 DuPont analysis 30 June 2020 was $11.00.
The followtng ftnancial information about Pazmandy
Pulmonary Proprietary is available: 2020 Income Statement
Revenue $400 000
2019
Costofgoodsso~ 210000
~rage assets $400000
Gross profit 190 000
Total average eqUity 250000
Operating expenses 55 000
Sales 70000
Profits before interest and taxes 135 000
Net profits 14000
Interest expense
- - - -- - - ----
15 000
REQUIRED Profits before income tax 120 000
Prepare a DuPont analysis for Pazmandy.
Income tax expense 50 000
Net profits $ 70 000
19 DuPont analysis
Dtscuss the hmitattons of DuPont analysts for a technology REQUIRED
company like Google. Apple. Facebook or Lrnkedln. wtry do a Calculate all profl!abollty, llqUidtty and solvency rattos.
accounung standards not generally recogmse mternally
b Comment on Porch Poser's overall profitabtllty. ltqutdtiY
generated mtangtble assets? and solvency.

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254
21 Analysing financial statements Issued capital 250000 250000
Amanda's Anchors has applied for a loan from a local bank. Retained earnings 100000 40000
The bank 1s basing 1ts decis1on on the following Information: Total shareholders' equ1ty 350000 290000

Ratio Industry werage

Total liabilities and
shareholders' equ1ty
~ ~
Current rauo 1.5
REQUIRED
Quick ratio 0.80
a For Amanda's Anchors. calct.llate the rauos for wtuch the
Receivable turnowr rauo 18 bank has an mdustry average. Alter comparing Amanda's
Inventory turnover ratio 20 ratiOS to the Industry averages. should the bank approve
the loan? Why or why not?
Debt to assets rauo 0.56
b As Amanda's accountant, present a case to the bank on
Times interest earned 6.52 why companng rauos to Industry averages as a hm1ted
Profit marg1n 10.25% way to analyse a busmess and the other factors the bank
maght consider an lendang the bus1ness money (such as
Return on assets 11.50%
secunty for the loan, future prospects and why some
Return on equity 20.30% ratios m1ght be more amportant than others). Use
Cochlear's or CSLs ratios calculated in thas chapter to
support your case.
Amanda's Anchors
Statement of comprehensive income c The bank has also asked why Amanda's earnings per
For the year ended 30 June 2020 share is only $0.83 when the industry average is $2.56.
Politely point out to the bank why this as irrelevant.
Sales revenues $600000
Cost of goods sold 350000
22 Using ratios to evaluate a business
Gross profit 250000 purchase
Other expenses 100000 You are a semor analyst for Xeon Zoom. a large corporation
Profits before interest and taxes 150000 whose sole activity is the acqUisiuon of quality subsid1ary
companies. Your manager has just come to you wath the
Interest expense 25000 following fananc1al statements for Ahem Bascuat Company
Profits before taxes 125000 (ABC). a confectionery business based 1n Tharroul, whach as
Income tax expense 65000 currently trad1ng at $5 per share. She wants you to analyse
the company and g1ve a recommendataon on whether or not
Net profits $ 60000 to submat a bad for ABC. All dollar f1gures are an thousands.

201t
Cash $ 10000
Cash Accounts receivable 30000 45000
Accounts receavable 30000 20000 Inventory 105000 75000
Inventory 30000 20000 Prepaid insurance 5000 15000
Prepaid 1nsurance 5000 5000 Total current assets 150000 155000
Total current assets 140000 105000 Property and equipment 220000 200000
Property and equipment 600000 550000 Intangible intellectual property 100000 85000
Accumulated depreciation
Total property and equipment
Total assets
(140000)
460000
(110000)
440000
Total assets
Accounts payable - 470000
60000
440000
50000
600000 545000 Notes payable 25000 25000
Accounts payable 60000 60000 Total current liabilities 85000 5000
Other current liabilities 40000 45000 Bonds payable 280000 280000
Total current liabilities 100000 105000 Total liabilities 365000 355000
Bonds payable 150000 150000 Issued equity (Avg. 100 000 shares) 75000 75000
Totalliabalit1es 250000 255000 Retained earnings 30000 10000
Total equity 105000 85000
Total liabilities and equity $470000 $440000

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 The follow1ng prehmmary financtal informatiOn has been
Income statement for ABC for the financial year
ended 30 June 2019 prepared by the accountants of Ktm Company. All figures
in mill10ns:
Sales $250000
Cost of goods sold 150000 Current assets $100
Gross profit 100000 Current liab1ht1es 75
Adm1nistrat1w expenses 25000 Income before mterest and taxes 25
Depreciation expense 15000 Interest expense 7
Total operating expenses 40000 Your senior accounting manager calls to your attention
Operating income 60 000 that the $100 million of current assets include $10 million
Interest expense 10000 worth of an investment 10 callable bonds, which do not
mature for five years but w1ll be callable if the company so
Income before taxes 50000 desires 1n 10 months. She also notes $5 million of the
Income tax expense 25000 current revenue IS annbuted to a service contract for which
Kim has rece1ved payment but has not yet performed
Net income $ 25000
the serv1ces. There IS no reason why the contract will not
be fulfilled.
REQUIRED
a Based on the f1nancial1nformation presented above, IS
Kim with1n the gu1dehnes 1n its credit agreement?
b Would you change the treatment of the two items your
senior manager brought to your attention? Do you see
any problem w ith the way these items are classified?
Explain your answer.
c Based on your response to (b), prepare revised fmancial
information 1f it IS necessary. If you revised the
23 Research and analysis information, IS K1m sull compliant with its loan
agreement?
Access the most recent publicly available annual report for
Coclllear and/or CSL (as 1nstructed by your lecturerl through
the company webs1telsL 25 Written comm unications
REQUIRE D You have been g1ven the following information about the
company you work for by your CFO (chief financial off1cert.
a Examine the company's financ1al statements and Analysts have been predicting a strong year in 2021.
calculate all profitability, liquidity and solvency ratios
(or a subset of these chosen by your lecturert for the 2020 2019 2018
most recent year. To calculate the P/E ratio, use the ASX
or similar website (or even an old-fashioned newspaper) Horizontal analysis of sales 37.0% 22.0% 15.0%
to determine current share price. Profit margin 8.2% 7.5% 6.8%
b Based on your answers to (at, write a paragraph Return on eqUity 13.1% 12.3% 111%
explaming your optmon of the fmancial health of the
company(sl. Current ratio 2.4 2.1 18
c If you have calculated selected ratiOs for both Quick ratio 0.6 1.0 1.2
compan1es, d1scuss their relat1ve performance. Is the lnwntOfY turnover rauo 2.6 4.0 47
change 1n share priCe over the last two or three years
conSIStent w 1th your analysis? Oebt to assets rauo 0.8 0.7 06
Times interest earned rauo 4.4 5.5 6.6
24 Ethics in accounting
REQUI RED
Kim Company currently has a line of credit with Murray a Prepare a brief press release highlighting the strong
River Bank. The interest rate on the line of credit increases performance of the company. Use the analysis above to
from 4.25 per cent to 8.25 per cent if the following terms of support your positive conclusions.
the credit agreement are not met:
b SMS your CFO express1ng concern about the press
K1m's current ratio must rema1n above 1.2 at all t1mes
release you have wnnen. Po1nt out the negative f1nanc1al
ii K1m's times mterest earned must be 3.0 or greater at ind1cators that would 1nd1cate the company's financ1al
all times. future may not be all pos1tive, especially g1ven
prediCtions of nstng Interest rates.

_
__;;,;;,;;
256
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INTRODUCTION
When decisions are affected by cash flows that are paid or
received in different time periods, it is necessary to adjust
those cash flows for the time value of money (lVM).
Because of our ability to earn interest on money invested,
we would prefer to receive $1 today rather than a year from
now. likew1se, we would prefer to pay $1 a year from now
rather than today. A common techmque used to adjust cash
flows rece1ved or paid in different t1me periods IS to d1scount
those cash flows by f1nd1ng the1r present
presen v lu PV
The amount of future cash val ue (PV), which IS the amount of
Hows d1scounted to the~r future cash flows diSCounted to their
eqwvalent wortl1 today.
equivalent worth today. To fully understand
the calculations involved in f1nding the PI/
of future cash f lows, it is necessary to step back and
examine the nature of interest and the calculatiOn of interest
received and paid. Interest is simply a payment made to use
someone else's money. When you invest money 1n a bank
account, the bank pays you interest for the use of your
money fOf' a period of time. If you 1nvest $100 and the bank
pays you $106 at the end of the year. 11 IS clear that you
earned $6 of Interest on your money (and 6 per cent Interest
for the year).
FUTURE VALUE
Mathematically, the relationship between your initial
investment (present value PV), the amount in the bank at
the end of the year (future value FV), and the 1nterest rate
(tl•s as follows:
In our example, FVcv..,,1 =100(1 + 0.06) =$106. If you
leave your money in the bank for a second year. what
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happens? W1ll you earn an additional $6 of interest? It
depends on whether the bank pays you simple interest or
compound interest. Simple interest is simple interest
interest on the invested amount only, Interest on the mvested
amount only
whereas compound interest is interest
compound onterest
on the invested amount plus interest on
Interest on the llvested
previous Interest earned but not amount plus •nterest on
preiiiOUS 1nterest earned
withdrawn. S1mple 1nterest is sometimes
but not Wlthdra>WI.
computed on short-term mvestments and
debts (that IS, those that are shorter than
six months to a year) . Compound interest is typ1cally
computed for financ1al arrangements longer than one year.
We will assume that 1nterest is compounded in all examples
in this book. Extending the future-value formula to fmd the
amount we have in the bank in two years gives us the
following formula:
or
In our example, FVcv- 21 = 100(1 + 0.06) 2, or $112.36.
We earned $6.36 of mterest in Year 2, which is $6 on our
original $100 mvestment and $0.36 on the $6 of Interest
earned but not Withdrawn in Year 1 ($6 x 0.06).
In this example, we have assumed that compound1ng
is on an annual basis. Compounding can also be
calcu lated semi-annually, quarterly, monthly, daily or
even continually. Go back to our original $100 investment
in the bank. If the bank pays 6 per cent interest
compounded sem1-annually instead of annually, we
would have $106.09 after one year. Note that the Interest
rate is typically expressed as a percentage rate per year.
We are really earnmg 3 per cent for each sem1-annual
period, not 6 per cent. It is usually easier to visualise the
concept of Interest rate compounding graphically, w1th
the help of t1mel1nes. Exhibit A. 1 graphically
257
 Annual compounding
$100.0 0 6% $106.00

0 1 year

Semiannual compounding
$100.00 3% $103.00 3% $ 106.09

0 6 months 1 year

Monthly compounding
$100.00 $ 100.50 $ 101.00 $ 101.51 $ 102.02 $102.53 $ 103.04 $ 103.55 $ 104.07 $ 104.59 $ 105.11 $105.64 $ 106.17
0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5% 0.5%

0 3 4 5 6 8 9 10 11 12 montl\s

~ T he tmpact of more frequent compoundmg on the fu ture val ue o f 5100

d emonstrates the impa ct o f annual, sem i-annual and combinations of n and r. These tables are still commonly
mont hly compounding o f t he 6 per cent annual rate on used, and an example is provide d in Exhi bit A.2 . The
our original $100 investment . fa ctors in t he Exh ibit are com monly refe rred to as
Mathematically, ou r formula for future va lue can once cumulative f actors (CFs) an d are simp ly calculations of
again be modif ied slightly to accou nt for interest rates (1 + !)" for va rious values of n and r.
compounded at differen t intervals. Fv;.
pe rlo<h '" the futu<el = Using this new terminology, the futu re value formu la is
P\lt1 + !)•, where n is t he number of compou nding periods simply:
per year mult iplied by the number of years. and r is the
~npetioctsinthefuturel = PV(CFn)
annual interest rate divided by the number of compou nding
periods per year. Before the advent of handheld calculators Wit h 6 p er cent annual compounding, our $1 00
an d computers, tables were developed to simp lify t he investment grow s to:
calculation of FVby providing va lues for (1 + !)• for several $100(CF,,6,.) =$100(1.060) = $106.00

nlr 0.5% 1% 2% 3% 4% 5% 6% 7% 8% 10% 12%

1 1.0050 1.0100 1.0200 1.0300 1.0400 1.0500 1.0600 1.0700 1.0800 1.1000 1.1200
2 1.0100 1.0201 1.0404 1.0609 1.0816 1.1025 1.1236 1.1449 1.1664 1.2100 1.2544
3 1.0151 1.0303 1.0612 1.0927 1.1249 1.1 576 1.1910 1.2250 1.2597 1.331 0 1.4049
4 1.0202 1.0406 1.0824 1.1255 1.1699 1.2155 1.2625 1.3108 1.3605 1.4641 1.5735
5 1.0253 1.0510 1.1041 1.1593 1.2167 1.2763 1.3382 1.4026 1.4693 1.6105 1.7623
6 1.0304 1.0615 1.1262 1.1941 1.2653 1.3401 1.4185 1.5007 1.5869 1.7716 1.9738
7 1.0355 1.0721 1.1487 1.2299 1.3159 1.4071 1.5036 1.6058 1.7138 1.9487 2.2107
8 1.0407 1.0829 1.1717 1.2668 1.3686 1.4775 1.5938 1.7182 1.8509 2.1436 2.4760
9 1.0459 1.0937 1.1951 1.3048 1.4233 1.5513 1.6895 1.8385 1.9990 2.3579 2.7731
10 1.0511 1.1046 1.2190 1.3439 1.4802 1.6289 1.7908 1.9672 2.1589 2.5937 3.1 058
11 1.0564 1.1157 1.2434 1.3842 1.5395 1.7103 1.8983 2.1049 2.3316 2.8531 3.4785
12 1.0617 1.1268 1.2682 1.4258 1.6010 1.7959 2.0122 2.2522 2.5182 3.1384 3.8960
24 1.1272 1.2697 1.6084 2.0328 2.5633 3.2251 4.0489 5.0724 6.3412 9.8497 15.1786
36 1.1967 1.4308 2.0399 2.8983 4.1039 5.7918 8.1473 11.4239 15.9682 30.9127 59.1356
48 1.2705 1.6122 2.5871 4.1323 6.5705 10.4013 16.3939 25.7289 40.21 06 97.0172 230.3908

~ Future valu e of $ 1

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258
 With 6 per cent semi-annual compounding: Keys Display Description
$100(CF23,.) =$100(1.0609) =$106.09
12 l!m) 12 Sets compounding periods per
year to 12.
With 6 per cent monthly compounding:
$100(CF,2•5,.) =$100(1.0617) =$106.17 12 ~ 12 Sets the number of compounding
periods to 12.

Most financial ca lculators will compute future value

after the user inputs data for P\1, the annual interest rate,
~ 106.17 Calculates the future value .

Likewise, many spreadsheet programs have built-in

the number of compounding periods per year, and the
functions (formu las) that calculate future value. The Excel
number of years. For example, using a business calculator
function called FV simply requ ires input of an interest rate
to compute the future value of $100.00 with 6 per cent
(Rate), number of compounding periods (Nper) and present
annual compounding requires the following steps:
value (Pv) in the following format: = FV(Rate, Nper, Pmt,
Keys Display Description Pv, Type)-' Entries for Pmt and Type are not applicable to
simple future-va lue problems. To calculate the future value
1.00 Sets compounding periods per
year to 1 because interest is of $100 in one year at 6 per cent interest compounded
compounded annually. monthly; enter = FV(0.5o/o, 12, - 100). Excel returns a va lue
of $106.17 (see Exhibit A.3).
1oo QQ -100.00 Stores the present value as a
negative number.

6.o [JJ 6.0 Stores the annual interest rate. PRESENT VALUE
1g Sets the number of years or
compounding periods to 1. A PV formula can be derived directly from the future va lue
formula. If:
106.00 Calculates the future value.
FV;npe.oioctsinthetucurel = PV(1 + r)n
Ca lcu lating the future value of $100 w ith 6 per cent
then:
monthly compounding simply requires changing both the
compounding periods per year (P/Yf{) and number of
compounding periods (/1/) to 12.
PV= ( 1 :~)" or PV= FV (( 1 ~ r)"l

functoon Arguments

v-------------------------------------------------.
Rate I.5% 3J ~ 0.005
r--2------------:31):-r~ 12
Nper jt

p~ ~ 31)-
Pv l-100 3J ~ -100
Type I 3J ~
~ 106.1677812
Returns the future value of an investment based on periodic, constant payments and a
constant interest rate.

Pv is the present value, or the lump-sum amount that a series of future

payments is worth now. If omitted, Pv = 0.

Formula result = $106.17

Help on this function OK Cancel

~ Fondong the future value usong the FV functoon on Excel

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9 259
 Just as a CF table was developed to calculate (1 + /}", 1
PV tables calculate 1 .;. (1 + /}" for various combinations of PV = $1000 ( ) = $857.34
(1 X 0.08)2
nand r. These factors are called discount factors, or OFs.
Or using the OF table:
An example of a OF table is provided in Exhibit A.4. Our
PV formula can now be rewritten as follows: PV = $1000(0F2• 0 .08) = $1000(0.8573) = $857.30 (rounded)
PV= FV(OFn)
Once again, the frequency of compounding affects our
Now we are ready to calcu late the PV of a future cash calculation. Just as more frequent compounding increases
f low. For example, how much must be invested today at 8 future values, increasing the frequency of compounding
per cent compounded annually to have $1000 in two years? decreases PVs. Th is is demonstrated in Exhi bit A.5 for
Mathematically: annual, semi-annual and quarterly compounding.

nlr 0.5% 1% 2% 3% 4% 5% 6% 7% 8% 10% 12%

1 0.9950 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9091 0.8929
2 0.9901 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8264 0.7972
3 0.9851 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7513 0.7118
4 0.9802 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.6830 0.6355
5 0.9754 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6209 0.5674
6 0.9705 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5645 0.5066
7 0.9657 0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835 0.5132 0.4523
8 0.9609 0.9235 0.8535 0.7894 0.7307 0.6768 0.6274 0.5820 0.5403 0.4665 0.4039
9 0.9561 0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4241 0.3606
10 0.9513 0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.3855 0.3220
11 0.9466 0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3505 0.2875
12 0.9419 0.8874 0.7885 0.7014 0.6246 0.5568 0.4970 0.4440 0.3971 0.3186 0.2567
24 0.8872 0.7876 0.6217 0.4919 0.3901 0.3101 0.2470 0.1971 0.1577 0.1015 0.0659
36 0.8356 0.6989 0.4902 0.3450 0.2437 0.1727 0.1227 0.0875 0.0626 0.0323 0.0169
48 0.7871 0.6203 0.3865 0.2420 0.1522 0.0961 0.0610 0.0389 0.0249 0.0103 0.0043

~ Present value of $1

Annual compounding
$857.30 PV = $ 1000(DF• .oo) $ 1000.00
8% 8%

0 1 year 2 years

Semiannual compounding
$854.80 PV = $ 1000(DF,,_..) $ 1000.00
4% 4% 4% 4%
0 1 year 2 years

Quarterly compounding
$853.50 PV = $1000(DFa.oal $ 1000.00
2% 2% 2% 2% 2% 2% 2% 2%
0 1 year 2 years

~ The 1m pact of more frequent compound1ng on the present value of $1000

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260
 Using a business calculator to compute PV is similar to
computing future value; for example, the PV of $1000
received or paid in two years at 8 per cent compounded
quarterly requires the following steps:
Keys Display Description
Simplifying by dividing each side by $100, 1 = 2 .;. (1 + /} 6
and multiplying each side by (1 + 1}6, the equation is simplif ied
to (1 + 1}6 = 2. The value of r can be calculated by using a
financial calculator or mathematically by using logarithmic
functions. 2 When using a business calculator, the following
steps are typical:

4 g 4.00 Sets the compounding periods

per year to 4. Keys Display Description

1000 IQ 1000.00 Stores the M ure value as a 1.00 Sets compounding

positive number. g
periods per year to 1.
8.o g 8.0 Stores the annual interest rate. 2oo 1Q 200 Stores the future value.
8 IQ 8.0 Sets the number of compounding 1oo Q I Q -100 Stores the present value
periods to8. as a negative number.

IQ -853.49 Calculates the present value. 2.0 Sets the number of

In M icrosoft Excel, the built-in function is called PV and
requires input of the applicable interest rate (Rate), number
of compounding periods (Nper), and future value (Fv) in the
following format = PV(Rate, Nper, Pmt, Fv, Type). In the
previous example, entering = PV(2o/o, 8, - 1000) returns a
value of $853.49. Note once again that Pmt and Type are
left blank in simple PV problems, as they were in future
value calculations (see Exhibit A.6).
When FVand PVare known, either formu la can be used
to calcu late one of the other variables in the equations (n
or/}. For example, if you know that your $100 bank deposit
is worth $200 in six years, what rate of interest compounded
annually did you earn? Using the mathematical PV formu la:
2 IQ
compounding periods
to 2.
g 0.122462 Calculates the annual
interest rate.
The tab les can also be used to solve for n and r.
Using our table formula, PV = FVI.DF.). if PV = 100 and
FV = 200, OF must be equa l to 0.5. If we know that n
is equal to 6, we can simply move across the table until
we find a factor close to 0.5. The factor at 12 per cent
is 0.5066. If we exam ine the factors at both 10 per cent
(0.5645) and 14 per cent (0.456), we can infer that the
actua l interest rate w ill be slightly higher than 12 per
cent. Our logarithm ic ca lculation is 12.2462 per cent.

( 1~) (~)
In Microsoft Excel, the RATE function requires input of
PV= FV or $100 =$200
Nper, Pv and Fv in the following format: = RATE (Nper,

Function Arguments •

Rate l2% ~ 0.02 3J

Nper lr-a-----------;31};-r ~a

p~ ~ 31}-
Fv 1-tooo 3J ~ -1000
Type I 3J ~
~ 853.4903712
Returns the present value of an investment: the total amount that a series of future
payments is worth now.

Fv is the future value, or a cash balance you want to attain after the last
payment is made.

Formula result ~ $853.49

Help on this function OK Cancel

~ F1ndmg the present value usmg the PV lunct1on m Excel

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9 261
 Functoon Arguments

ATE--~~========~-----::,
Nper l6 5j m 6
Pmt r,---------~jJ~-

Pv l-100 jJ ~ -100
Fv lzoo 5I) ~ 200
Type I Oil=
~ D.I22462D48
Returns the interest rate per period of a loan or an investment. For example, use 6%/4 for
quarterly payments at 6% APR.

Fv is the future value, or a cash balance you want to attain after the last
payment Is made. If omt ted, uses Fv =D.

Formula resul: = 12.2462%

Helo on tlos funcbon OK Cancel

~ Fondong the onterest rate usong the RATE functoon on Excel

Pmt. Pv. Fv. Type, Guess). Because Excel uses an
iterative trial-and-error method to calculate the interest
rate, Guess provides a starting point. It is generally not
necessary but may be required in complicated
problems. Entering = RATE(6, -1 00, 200) returns an
interest rate of 12.2462 per cent (see Exhibit A.7).
The calcu lation of n is done in a similar fashion. If we
know that our investment earns 12 per cent, but do not
know how long it will take for our $100 to grow to $200,
mathematically, we have the following:
Solving the equation by using logarithms or a financial
calculator gives us ann of 6.116years. 3 Using the DF formula,
OF must again be equal to0.5. 1f ris known to be 12 percent,
we simply move down the 12 per cent column until we find
a OF close to 0.5. Not surprisingly, we find a factor of 0.5066
for an n of 6. Examining the factors for an n of 5(0.5674) and
7(0.4523), we can infer that the actual time will be something
slightly greater than 6 years. The NPER function in Microsoft
Excel requires input of Rate, Pmt, Pv, Fv and Type in the
following format: = NPER (1 2%, - 100, 200), and returns a
value of 6.116 years. Note that Pv is entered as a negative

~ r)•Jor $100 =$200 ((1 + ~. 12 ).)

amount and that Pmt and Type are not necessary; as this is
PV= FV (11
essentially a PV problem (see Exhibit A.8).

Function Arguments

Rate 112% 5J = 0 .12

Pmt r~------------------~jJ~ -
Pv l-100 ::i} • - 100
Fv 1200 Oil- 200
~pel 5J=
- 6.11 6255374
Returns the number of periods For an investment based on periodic, constant payments and
a constant interest rate.

Fv is the future vakle, or a cash balance you want to attain after the last
payment is made. If omRted, zero is used.

F0111Ua result • 6.116

Help on this functlon OK Cancel

Err:~ Fondong the number of peroods usorng the NPER functoon on Excel

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262
 The mathematical formula for PVA can be derived from
ANNUITIES
the formu la for PV and is equal to:

annuity An annuity is a series of cash flows of

A series of cash flows
1 _ 1
equal amount paid or received at regu lar PVA =R ( - (1 + tl"
of equal amounts paid
or received at regular intervals 4 Common examples include ·~
r
intervals. mortgage and loan payments. The PV of
an ordinary annuity (PVA) is the amount where R refers to the periodic payment or withdrawal
invested or borrowed today that will provide for a series of (commonly called a rent). Calcu lated va lues for various
withdrawals or payments of equal amount for a set number combinations of nand rare provided in Exhibit A.9.
of periods. Conceptually, the PV of an annuity is simply the The PVA formula can therefore be rewritten as follows:
sum of the PVs of each withdrawal or payment. For PVA =R(DFA.)
example. the PV of an annuity of $100 paid at the end of
each of the next four years at an interest rate of 10 per cent As previously discussed. common examples of
looks like this: annuities are mortgages and loans. For example. say you
are thin king about buying a new car. Your bank offers to lend
PVA 10 %
$ 100
10%
$ 100
10%
$ 100
10%
$100 you money at a special 6 per cent rate compounded
monthly for a 24-month term. If the maximum monthly
0 1 year 2 years 3years 4 years
payment you can afford is $399, how large a car loan can
Although cumbersome, the PV of an annuity can be you get? In other words, what is the PV of a $399 annuity
calculated by finding the PV of eadl $100 payment. using paid at the end of each of the next 24 months, assuming
the PV table in Exhibit A.4. an interest rate of 6 per cent compounded monthly? Using
a timeline. the problem looks like this:
PVA =$100(0F1•. 10 ) + $100(0F,_, 0 ) + $100(0F3•• 10l +
$100(0F4 • 10 )
=$100(0.9091 ) + $100(0.8264) + $100(0.7513) +
$100(0.6830)
=$316.98
PI/A $399 $399 $399 $399 $399 $399 $399 $399 $399 $399 $399 5399 $399 $399 $399 $399 $399 $399 $399 $399 $399 $399 $399 $399
o5'*' l o.5% I o 5% l o 5% o 5% I o.5% I o5% o 5% o 5% o 5% o 5% I o.5% o 5% o5% o 5% o5% o 5% o 5% I o5% o5% I o 5% o.5% o.5% o 5%l
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
0 24 months

nl r 0.5% 1% 2% 3% 4% 5% 6% 7% 8% 10% 12%

1 0.9950 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9091 0.8929
2 1.9851 1.9704 1.9416 1.9135 1.8861 1.8594 1.8334 1.8080 1.7833 1.7355 1.6901
3 2.9702 2.9410 2.8839 2.8286 2.7751 2.7232 2.6730 2.6243 2.5771 2.4869 2.4018
4 3.9505 3.9020 3.8077 3.7171 3.6299 3.5460 3.4651 3.3872 3.3121 3.1699 3.0373
5 4.9259 4.8534 4.7135 4.5797 4.4518 4.3295 4.2124 4.1002 3.9927 3.7908 3.6048
6 5.8964 5.7955 5.6014 5.4172 5.2421 5.0757 4.9173 4.7665 4.6229 4.3553 4.1114
7 6.8621 6.7282 6.4720 6.2303 6.0021 5.7864 5.5824 5.3893 5.2064 4.8684 4.5638
8 7.8230 7.6517 7.3255 7.0197 6.7327 6.4632 6.2098 5.9713 5.7466 5.3349 4.9676
9 8.7791 8.5660 8.1622 7.7861 7.4353 7.1078 6.8017 6.5152 6.2469 5.7590 5.3282
10 9.7304 9.4713 8.9826 8.5302 8.1109 7.7217 7.3601 70236 6.7101 6.1446 5.6502
11 10.67700 10.3676 9.7868 9.2526 8.7605 8.3064 7.8869 7.4987 7.1390 6.4951 5.9377
12 11.6189 11.2551 10.5753 9.9540 9.3851 8.8633 8.3838 7.9427 7.5361 6.8137 6.1944
24 22.5629 21.2434 18.9139 16.9355 15.2470 13.7986 12.5504 11.4693 10.5288 8.9847 7.7843
36 32.8710 30.1075 25.4888 21.8323 18.9083 16.5469 14.6210 130352 11.7172 9.6765 8.1924
48 42.5803 37.9740 30.6731 25.2667 211951 18.0772 15.6500 13.7305 12.1891 9.8969 8.2972

1m Present value of an ordmary annUity

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated. in whole or In ~E~6f1<01·~2e~ue of money
9 263
 Mathematically: The PVA formula can also be used to calcu late R. r, and

~.5)24 )
n if t he other variables are known. This is most easily
1
PVA24,0.005 = 399 - (1 + accomplished using the DFA table or using a financial
0.005 calculator. If the car you want to buy costs $20 000 and you
can afford a $3000 down payment (your loan balance is
Using the DFA table:
$17000). how much will your 36 monthly payments be,
PVA24•0005 = $399(DFA,4•0 005 ) =$399(22.5629) =$9002.60 assuming that the bank charges you 6 per cent interest
(rounded)
compounded monthly?
The following steps are common when using a business Using the DFA table:
calculator: PVA... o.oos = R(DFA,._0.005 )
Keys Display Description
$17000 = R{32.871)
12 b[j 12.00 Set periods per year.
2x12 g 24.00 Stores number of periods R= $517.17
in loan.
The following steps are common when using a business
o[Q 0 Stores the amount left to pay
after 2 years. calculator:

6~ Stores interest rate. Keys Display Description

6

399 g g -399.00 Stores desired payment as 12 [)d 12.00 Set periods per year.
a negative number.
3x12 g 36.00 Stores number of periods
~ 9002.58 Calculates the loan you can
afford with a $399 per month
in loan.

payment. og 0 Stores the amount left to pay

after 3 years.
In Microsoft Excel, the PV function is used to calculate 6Q 6 Stores interest rate.
the PV of an annuity. with additional entries for the payment
amount (Pmt) and type of annuity (Type). The payment is
17000 [Q 17 000 Stores amount borrowed.

entered as a negative number, and the annuity type is 0 for [g!J -517.17 Calculates the monthly
ordinary and 1 for an annuity due. The format is therefore payment.
PV (Rate, Nper, Pmt, Fv, Type). Entering =
In Microsoft Excel. the calculation is simp ly
PV(0.5%,24, - 399,0,0) returns a value of $9002.58 (see
PMT(0.005, 36, - 17000,0,0) (see ExhibitA.11).
Exhibit A.10).

Function Arguments

Rate ].5% 3J ~ 0.005

Nper ;....]2-4- -========-----=;31);::::;.- 24
Pmt J-399 3J ~ -399
FvJo 3J ~ o
Type Jo 3J ~ o
- 9002.583622
Returns the present value of an investment: the total amount that a series of future
J)<!lyments is worth now.

Type is a logical value: payment at the beginning of the period= 1; payment at

the end of the period • 0 or omitted.

Formula result ~ $9,002.58

Help on this function OK Cancel

~ Fondrng the present val ue of an annurty usrng the PV lunctron rn Excel

ACCTJ Fina~J.lfrlght 2019 Cengage learning. All Rights Reserved. May not be copied, scanned. or duplicated. in whole or In part. WCN 02·200-202
264
 Function Arguments

T-------------------------------------------------.
Rate j.5% 3J = 0.005
Nper 1;....36--=======-...::;3J;:::;.- 36
py 1-17000 3J = -17000
Fvjo 3J = o
Type lo 3J = o
- 517.1729367
Calculates the payment for a loan based on constant payments and a constant interest rate.

Type is a logical value : paymernt at the beginning of the period= I; payment at

the end of the period m 0 or omitted.

Formula result = $517.17

Help on this function OK Cancel

~ Fondong the payment usong the PMT functoon on Excel

In a similar fash ion, assume that a used-car dealer offers In Excel, = RATE(48, - 350, 12.000,0) generates a
you a 'special deal', in which you can borrow $12000 w ith monthly rate of 1.4667 per cent and an annual rate of 17.60
low monthly payments of $350 per month for 48 months. per cent. The use of the RATE function requ ires that the
What rate of interest are you being charged in this case? payments are the same each period. Excel's IRR function
Using the DFA table: is more flexible, allowing different payments. However.
PVA48••11 =$350(0FA.._ 11)
each payment has to be entered separately. For example.
if the car is purchased for $17000 with annual payments
$12000 = 350(0FA48• 11) of $4000. $5000, $6000 and $7000 at the end of each of
the next four years, the interest rate charged on the car
loan can be ca lculated by using the IRR function (see
DFA48•.11 =34.2857
Exhibit A.12).
Looking at the row for an n of 48, we see that a DFA of
34.2857 is about halfway between an r of 1 per cent and r
e}fle (jtt ~ pert .. ~ QIU ~ ~ .I«Qei'Clf
of 2 per cent (closer to 1 per cent), which means that you • X .J $. • I 1·

are being charged an annual rate of almost 18 per cent A • c 0 G H

-
I ·17.(0)

(1.5% x 12) - not such a good deal after all! Using a

2 •rm
3 •rm
business calculator. observe the following:
...••
1
,.
•rm
1 ·-"'l"....i"'
..-1
,..-----~31- (•11!:riO,..a:JQ,~
31·
Keys Display Description ••
10
12 ~ 12.00 Set periods per year
II
t2
•.a- ~s .... ., ......
.v:... <*INI:~~fl!l'..tth.,w
...-ttt(tlci.Mtthi"C,~t.... f/<-.m.

4x12 g 48.00 Stores number of periods

in loan
..""
16

ol!:!J 0 Stores the amount left to

pay after 4 years
..
11
18

20

12,000
a:dl 12,000 Stores amount borrowed ~ Fondong the onterest rate usong the IRR

350 l!:!JIE) -350 Stores the monthly payment

l!EJ 17.60 Calculates the annual

interest rate

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated. in whole or In ~E~6f1<01·~2e~ue of money
9 265
 CSL

G 0
{J 0 ~
~
0
0
{} ()<Q>
0

Copyright :ZOt I Cengoge luml119- AI Rights R--...c! llay not be copMd scanned, or dupUQI... In whole Of n pan. WCN 02·200-202
... 266
 ...
"'u

'

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated. in w).\!'p'EJ~/dllf€'tsr"&~i?t~~e~ report
1 201 7 267
...
t

,
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a
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..!f
fI 02
OJ
AboutCSl
OUr BusmessM

j,.. 04 Bus1ness f!ighlights

=
I"..
I 06
01
Financal H1glll1g~ts
Ye.Jr in ReVIeW

•
" 16 CSL~hrong
- -l - ®,_
IJ I 24
28
SeQii\IS
Research and Development
~~'6 ~ 1:....

~ J2
J4
Directors
Global leadership Group
~=-··
i
n 36 Share Information

l J7
Jll
Shareholder Information
Corporate Governarn:e

i 52 Directors' Report
•
•
~ 60
81
Audttor's Independence Declaration
Consolidated Statement of
·- -·r:o • • •

I
ot.\,.I!;UI,~ •
Comprehensive Income \iOUP!UDOI"HU
8Z Consoijdated Balance Sheet
IJ Consolidated Statement of
!f

i
Changes ., Equ,ty
14 Consoijdated Statement of
CaSh Flows
...
e tWUw~
· ~Ciftl.r~
e uSI1113&-..ur.:.w
• ...r;YA!:CStrrnl
· ~Qr.OI
·-.
...,~~
·~SA.J$11Q

!! IS NoCes to the Financial Statements

S" 120 D1rectors' DeclaratiOn
l 121 Independent Auditor's Report

~ 127 Medocal Glossary

"
ij
~
 i..!f
ABOUT CSL

f Driven by our promise, CSL

is a global biotechnology
j company that develops
and delivers innovative
1:
medicines that save lives,
i protect public health
Dc4ivenng on pr01111Ses is what 'M! do at CSL.
Start1ng a century ago on Melbourne. Aus:raOa
we made a promise to save l1ves and protect
the healtn of people w"o were stnckcn w1th
a broad range of scnous mediC<l! con<f1tions.
Today. that same proml~e has rever been
stronger. As a lead1ng global biotechnology
company. CSL clclivef5 med1c1nes to patients
lnnovatoon has been in the DNA of CSl s•ncc
our beginnmg on 1916 and con:inues as the
core of evcryth1ng we do today. Innovation
CSL also in~ests in hfe!-cyde maragcment
and rrorket ~lopmrot tor our existing
products. and In the development or new
spans all across our organosation- ref'eded
in our 1.400 dedicated scientists who locus
product opportunities for the longer term We
understand the unique challenges laced by
every day on solving patients' unmet needs. people stricken w1th life thredtening med1cat
to our unique capabitity in creating one or the
largest and most efficient plasma collection
conditions becduse of our long experience.
deep knowledge and dedoC<lted focus on

i and help people with
life-threatening medical
J conditions live full lives.
Our Values guide us in
~ CSL focuses Its world class researd1
i creating sustainable value
in more than 60 countries. and employs nedrly
20.000 people who arc driven by a deep
passion to serve thou~nd~ of Pill lent~ dnd
other stakeholders around the world
and development (R&D>. high quality
networks in the world. right through to safely
<md eftedively producing medicines.
CSL supports patient, biomedical and
local communities by improving access to
therapies. advanc1ng scientific knowledge,
supporting future mediGll researchers.
preventmg and tredting seriousdbea:>es. We
expect that emerg'ng new innovdtions and
support prog1ams tdn provide unprecedented
opportunities to Improve patient wellbeing
unlike any other time in hbtory.
CSL's ope-rational excellence. commercial

i for our stakeholders. manufacturing, and p~tlent-centred

management to develop and deliver
Innovative blotheraples. Influenza vaccines
and engaging our staff 1n the support of
local communities_ We also contribute to
humanitarian programs and relief efforts
capability, combined with a focused global
R&D orgoniS<ltlon and proven m.1nagement.
give us the confidence to efficiently Identify

I
~
and support programs all to help save lives
and treat people With life thr!'atenlng medical
conditions.
around the world.
CSls contonumg priority is to ensure the
ongoong safety and quahty ot our medicines,
succ~sstully cl<'vclop, ilnd dPpPndably deliver
Innovations !hilt patients need and want
For more than 100 years. CSL has earned a

f while 1mprov1ng access to innovat1ve

theraptes that mal<e a real and lasting
difference to the l1ves of people who reed
reputation as a passionate yet responsible
organ sat ion which IS droven to care for
patients and deliver on 1ts commitments.
them To achieve this. we drrve a culture Today, our future has never looked brighter.
~· ot continuous improvement in quafity
~ and comploance and unoertake capacity
0
~ expansions around the world
a-
~~
~
i~
1
~
....
N
$
N
C3
1:;
8
::!! BUSINESS
~&' HIGHLIGHTS
~
~
~
;;; -- \ , "'
t
f: S "RAT oGIC OI,JECTIVE
GROWTH
S ATE'
EFFICIENCY
OBJ1 CTIVE S "R#TE' OIC OJ,JI CTIVE
INFLUENZA
TE• ,Jc OBJFCTIVE
INNOVATION
ST' :ATI'.;JC 01
PEOPLE & CULTURE
oCT IV~'

3
~ Maximise portfolio Be the most efficient, Deliver on Pursue new opportunities Create a culture that
~ highest quality influenza strategy to diversify portfolio
;u value & deliver new attracts, retains and
'§ product launches plasma player and enhance growth develops the best talent
;;;
;u
~
i CSL's reported net profit after tax Extended CSL Plasma's world Seqirus is on track to profitability. R&D investment this year reached More than 19,000 employees
f was US$1,337 million for the year leading plasma collection network
A broad product portfolio driving
US$645 million. in over 30 countries drive CSL's
2 ended 30 June 2017. On a constant opening a total of 29 new plasma
total revenue for the period Achieved successes in all four
performance.
i" currency basis', net profit after tax collection centres.
of US$900 million, up 23% at R&D strategic areas with new Publication of CSL's third edition
"
0
was US$1,427 million.
l CSL's total revenue reached
Capacity expansion proJects
to position CSL to meet future
constant currency'. registrations, positive results In
some of the largest clinical trlal.s
Code of Responsible Business
Practice, building on ourcullure of
~ US$6,923 million, up 15% on a demand continue across Australia,
Launched t hree new lnlluenza
products in the US:
ever conducted in rare diseases integrity and responsible business
i constant currency basis. Germany, Switzerland, the UK and and an exciting new collaboration. practice.
!>
g theU5. • FLUAD";
CSL Behring's strong performance Achieved US Food and Drug Measured one point above IBM's
t resulted in product sales of Exemplary track record of
• FLUCELVAX QUADRIVALENT';
and
Administration <FDA> approval, global benchmark for employee

.i
5"
US$5,811 million, up 12% on a
constant currency basis.
consistent and reliable supply of
medicines.
• AFLURIA QUADRIVALENT-.

Successful production of cell

including marketing exclusivity
for seven years, of HAEGARDA·,
engagement in our relaunched
employee feedback survey.
subcutaneous Cl-Exterase
,.f Acquired a majority stake in
based candidate Influenza vaccine Inhibitor (C1·1NH) replacement
~ Chinese plasma fractlonator Rulde.
g at commercial scale at Holly therapy to prevent Hereditary
;; Springs, US. Angioedema (HAE) attacks.

! Initiation of human trials

~z to Investigate three new

s breakthrough medicines Involving

monoclonal antibodies.

i
 CONSOLIDATED STATEMENT ComoMdilod Entoty
OF COMPREHENSIVE INCOME
{ FOR THE YEAR ENDED 30 JUNE 2017 Nolos
2017
US$m
2016
US$111

..!f ConbllWng OPer•tions

s. <>S!Ml'llf 6,615.8 5.909.5

f Pardemic Fad!~) IIeser-"'ton tees

Aov.ll~and Lbrn ~MID'
94.0
203.3
68.7
122.7

j OU~tr flw:O' •t

Total Of)ef•ting Rtwnue

9.7
6,922.8
14.4
6.11S.3
1: Costoi~"M (l,J26.8) (3,052.8)

i Gross profil
Rese~rcn and deo.elopmen: ~xpenses 6
3,596.0
(645.3)
3,062.5
(613.8)

J
i Seli"O at'(~ mdfke\1110 expenses
Gtnetal i"d admu1istrat•on exl)ellSes
Op.r.~Ung profit
(697.0)
(484.8)
1,768.9
(620.9)
(390.3)
1.437.5
~ Ana net COliS 2 (90.0) (71.6)
i
13.9
i
Finance lnccme 10.9
Gt1in on aCQUISition lb 176.1

I
~
Plofit before Income lu tXPtnst
Inc~ t.Jx expensP

Net profit for the PtiiOd

3
1,689.8
(352.4)
1,337A
1.555.9
(313.5)
1.242.4
Other comprehensiVe Income
f IIAms !Mt mlY bt rtduSifitd substqtMnlly to profit or loss
Ex•~ :dftrrnces on trolllSI.Jtoon of fore.gn operabOns, ~~ d hedges on foreig~ inves:menLs 12 97.5 (126.9)
~· 114ms !Mt Will not bt rtdassifitd substqutnayto profit or loss
~ ""-· ...,, ·t.l~ondt n..lb<n.!r.tp'"""-netol~ 18 75.5 (71.9)
0
~ Total d ot1te1 comoreltensr;t .ncomt}(eJope"':SeS) 173.0 (198.8)
a- Tot.JI comptthtnslvt income for 1M period 1,510.4 1.043.6
- -
~~ uss
~
EJmlngs Ptt Wrt (bistd on ntt profit for the PtriOd) US$

i~ Bask earn• ngs per lhatt

D•l.lltd ear11119S Ptrshare
10
10
2.937
2.9n
2.689
2.683

1
~
Thft~i~.JIIK¥nlofcw-IJift/'MIJM~f/OJtd~INdl/l~"'i!lttNM:CIJII'fJlt/'Yf10dtM

....

.....,
N
N
.....
N

,
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a
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CONSOLIDATED
BALANCE SHEET
Consolod•lod Enloly
ZOI7 Z016
AS AT 30 JUNE 2017 Holts USSm USSm

CURRENT ASSETS
C<>h•• td\t<,.Or•lellt~ 14 144.5 556.6

..
!f TrarJf illd 0\u• ft<..,alies
lnvmt«~
IS
4
1,110A
2,575.1
1.1072
2.152.0

f C... tni~USStU
01'-f•nenci'll~s
IOil'l Cm~ Asstts
6.2
5.2
4,60U
1.6
0.6
3.816.0

j,.. NON<URRENT ASSETS

Or'Horw.tr,~
Olloorfomncoal~\
IS 16.S
3.9
15.6
2.9
=
"I.. Pr<JI)ffty. pl.lnt J'ld f(JJC)IToOI'II
Oflf<Tod liiiii!S'""'IS
8
3
2,942.7
496.S
7.389.6
38l0
lnta~b~~s 7 942.6
" 1,055A

J
I RH~rmcnt be!itl 1a~cts
Tot.11 Non<wre"'t Assets
TOTALASSI'TS
CURRENT LIABILITIES
18 5.6
4.520.6
9,122.7
5.0
3.744.7
7.562.7

~ Tlade and other p,syablo>s lS 1,155.1 996.1

i lntirtst•bemlngloabllo toes 11 122.5 62.3
n

l Currenltax labiiUes
Prov~oons 16
202.5
134.1
207.3
99.6

i
Deterred oovemm•ntorants 9 3.2 3.1
DPriloaliw' lin.llld.11 W;lrumPn~ . 6.0
Tot •ICtrrentLI.lboiohPs
- 1,61.8.1 1.37U
~ -
NON<URRENT UABILIT1£S

I !f
Olloft non rurrent llobol<to>s
lntPresl r~Jring l•abihtoes
Delerrod tax ll.lblltles
Provisions
IS
II
3
16
25.8
3,852.7
1382
32J
18.8
3.081.0
1192
4J5

i
!!
9
18
35.9
2SS.3
35.0
326.6
!f 4,34U -~l.~i!
l 5,958.1
3,163.1 __
H95.S
2.5671

~ EOUITY
Con(TbJ(od t<lliol\' 12 (4.$3<1.3) (4115.01
"
ij ROStrVes
Rola.nodH<nflCJ\
u
19
2M2
7,403.9
187.9
6.592.3
~ TOTAl EOUITY-
---
3,163.1 2~71

rtillt~biW~It/WtW stPJidbti'NdllurPatCn "tllttJr~hgftd<A.

 ~
i ~
;;;
&'
~
:3
~ CONSOLIDATED STATEMENT
~
;u OF CHANGES IN EQUITY
'§ FOR THE YEAR ENDED 30 JUNE 2017
;;;
..
;u
[(: Foreign curr411<Y Shartbas.d

i Consolldilttd £ntly
Contributtd Equity
US$m
translation I"Htrvt
USSm
payrMnt rHern
USSm
R!tAintdtarnings
US$m
ToiJJ
USSm
f
~ 2017 2016 2017 2016 2017 2016 2017 2016 2017 2016
2
i' As at thebtglnnfng of tile year (4,213.0) (3,560.4) 285 155.4 159.4 151.1 6,592.3 6.000.8 2,567.2 2.746.9
"
0 Profit for the period - - - 1,337.4 1,242.4 1,337.4 1.242.4
l Other compre:llensive income - 97.5 (126.9) - 755 01.9) 173.0 (198.8)
~ Total comprehensive income for the full year 1,510.4 1,043.6
i
!> Transactionswith owners in tlleir capad ty as owners
g
g. Share based payments - - 8.8 8.3 8.8 a3
'2.
Dividends - - - (601.3) (579.0) (601.3) (579.0)
i
5'
Share buy back (334.0) (670.0) - - (334.0) (670.0)
Share issues
~ -Employee share sell erne 127 17.4 - - 12.7 17.4
~
~ As at theend of the year (4,534.3) (4,213.0) 126.0 28.5 168.2 159.4 7,403.9 6.592.3 3,163.8 2.567.2
-
~ lbcCOM1>1/II.:.d$!atrtntnCOicNngtS/Iltooi!YSI>C<iiCI/JtiNIIIfiCoey~OOII wiln/M~,fiiJnotts.

~
3Z
;:ro

~
~ ....
co
.......
1
~
:::;
N
;;l
N
~

§
~ CONSOLIDATED STATEMENT OF CASH FLOWS
Qg' FOR THE YEAR ENDED 30 JUNE 2017

1 ~
ConsoHdatod Ent1ty
;;; 2017 2016
&' US$m US$m

~ Cash flows from Operating Activities

:3 Receipts from customers (lnduslve of goods and services t~} 6,749.2 5,982.7
(4,946.9)
~ Payments to suppliers and employees (InclusiVe of goods and services tax} (4,417.0)
~ 1,802.3 1,565.7
;u
'§ Income taxes paid (468.3) (326.2)
;;;
..
;u
[(:
Interest received
Bolrowing costs
6.7
(94.1)
14.1
as.oJ
i Net cash Inflow from operating actlvhles 1,246.6 1.178.6
f
~
Cash flows from Investing Activities
2 Proceeds from sale of property. plant and equipment 0.1 0.1
i'
Payment~ for property, plan! and eQUipment (689.1} (495.1)
"
0

l Payments for intangible assets (171.5) 00.6)

~ Payments for bus1nes; acquis~1on (Net of cashil(quired) - (244.6)

i (Payments}/receipts from other f1nanc1al assets (2A) 0.1
!>
g Net cash outflow from investing activities (862.9) (810.1}
-
t Cash flows from Financing Activities

.i
5"
Proceeds from tssue ol shares
Dividends paid
U.7
(601.4)
17.4
(579.0)
,.f Procee!IS from borrow,ngs 1,381.4 1.564.3
~
g Repayment of borrowings (581.3) (716.9)
;;
Payment for shares bo\.ght llack (314.9) (648.2)
! Net cash outflow from financing activities (103.5)
- (362.4}
--------- -----

~z
~-

Net increase in cash and cash equivalents 280.2 6.1

s Cash and cash equivalents at the beginning of the financial year 555.3 555.5

i Exchange rate variat•ons on fore1gn cash and cash equivalent llalances

Cash and cash equivalents at the end of the financial year
7.5
843.0
(6.))
555.3
 NOTES TO THE FINANCIAL STATEMENTS
FOR THE YEAR ENDED 30 JUNE 2017
~
i~
CONTENTS ABOUT THIS REPORT b. Principles of consolidation
;;; About this Report 85 The consolidated financial statements comprise the financial
&' Notes to the financial statements: 85
Notes to the financial statements: statements of CSL and its subsidiaries as at 30 June 2017. CSL

~ Our Current Performance 86 Corporate information has control of Its subsidiaries when It Is exposed to. and has
the rights to. variable returns from its involvement with those
:3 Note 1: Segment Information
and Business Combinations 86
CSLlimited ("CSL") is a for·profit company incorporated and
domiciled in Australia and limited by shares publicly traded on
entities and when it has the ability to affect those returns. A list
of significant controlled entities {subsidiaries) at year-end Is
the Australian Securities Exchange. This financial report covers
~ Note 2: Revenue and Expenses 89
the financial statements for the consolidated entity consisting
contained In Note 17. During the year ended 30 June 2016 CSL
~ Note 3: Tax 90 assumed control of entitles acquired as part of the acquisition
;u of CSL and its subsidianes {together referred to as the Group).
Note 4: Inventories 92 of the Novartis Influenza business. Details of the acquisition are
'§ The financial report was authorised for issue in accordance
;;; contained In Note lb.
Note 5: People Costs 93 with a resolution of directors on 15 August 2017.
..
;u
[(: Our Future 96 A description of the nature of the Group's operations and its
The financial statements of the subsidiaries are prepared using
consistent accounting policies and for the same reporting
i Note 6: Research & Development
Note 7: Intangible Assets
96
96
principal activities Is included In the directors' report.
a. Basis of preparation
period as the parent company.

f~
Note 8: Property. Plant and Equipment g9
This general purpose financial report has been prepared in
In preparing the consolidated financial statements, all
intercompany balances and trans<~ctions have been eliminated
2 Note 9: Deferred Government Grants 99
i' accordance with Australian Accounting Standaros, other in full. The Group has formed a trust to aominister the Group's
Returns, Risk & Capital Management 99 authoritative pronouncements of the Australian Accounting employee share scheme. This trust is consolidated as it is
"
0
Standards Board, lntematior1al Financial Reportmg Standards controlled by the Group.
l Note 10: Shareholder Returns
Note 11: Financial Risk Management
99
100
(I FRS) and the Corporations Act 2001. It presents 1nformat1on
c. Foreign currency
~ Note 12: Equity and Reserves 106
on a historical cost basis. except for certain financial
instruments includmg derivatives, which have been measured While the presentation currency of the Group is US dollars,
i
!> Note 13: Commitments and Contingencies 107 at fair value. Amounts have been rounded off to the nearest entities in the Group may have other functional currencies,
g
Efficiency of Operation 108 hundred thousand dollars. The presentation of revenue items reflecting the currency of the primary economic environment
g.
'2. In the Consolidated Statement of Comprehensive Income and In which the relevant entity operates. The parent entity, CSL
Note 14: Cash and Cash Equivalents, Cash Flows 108
i
5.
Note 15: Trade Receivables and Payables
Note 16: Provisions
109
110
in the Segment Note has been changed from the previous full
year financial report. There are no new disclosures; however,
revenue Items previously disclosed in the Notes have been
Limited. has a functional currency of Australian oollars.
If an entity in the Group has undertaken transactions in foreign
currency, these transactions are translated into that entity's
~ Other Notes 110 moveo to the Statement. ThiS has been done to prov1de
a comprehensive picture of the components of operating functional currency using the exchange rates prevailing at
~ Note 17: Related Party Transactions 110 the dates of the transactions. Where the functional currency
~ revenue earned by the Group in the Statement. As a result
Note 18: Detailed Information - People Costs 111 of a subsidiary is not US dollars, the subsidiary's assets and
the calculation of Gross Profit has been amended. Prior year
~ Note 19: Detailed Information- Shareholder Returns 115 comparatives have been presented on a basis consistent with
the updated disclosure.
11ab1lities are translateo on consolioation to us oollars using the
exchange rates prevailing al the reporting date, and its profit
~
3Z
Note 20: Auditors Remuneration 116
The report is presented In US Dollars, because this currency is
and loss is translated at average exchange rates. All resulting
exchange differences are recognised In other comprehensive
;:ro Note 21: Deed of Cross Guarantee 116
the pharmaceutical industry standard currency for reporting income and in the foreign currency translation reserve in
~
Note 22: Parent Entity Information 118
purposes. It 1s the predommant currency of the Group's equity.
~ ....
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Note 23: Subsequent Events 118 worldwide sales and operating expenses.
....... Note 24: New and Revised Accounting Standards 119

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~
Directors' Declaration 120

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'!1
NOTES TO THE FINANCIAL STATEMENTS
FOR THE YEAR ENDED 30 JUNE 2017

..!f d. OtMr 1ccountmg policoes

Signofoca~t accounting policies that summarise the
OUR CURRENT PERFORMANCE
Note 1:
previously d1sclosed M unallocated lll'e now also included
in the CSL Behrong segment. Items previously disclosed in
t he CSL Intellectual Property segment and as unallocated

f measurement basis used and are rele•-ant to an understand1119

of the financial statements are prOVIded througtloot the notes
to the financial statements
Segment lnformat1on
and Business Combinattons
are managed by members of thP Global Leaders!lip Group,
excluding the President of Seq1rus. who report d1rectly to the

j • · Key judgements and estimates

In the process ot applying the Group's account 1ng policies
1:
management has made a number of jud9ements and estimates
i ot tuture events. Matenal judgements and estmates are found
in the followong notes:
Tht' Group·~ segmPnts represent strategic business units that
offer diffeient producb ood operclle in d•fferent industries
CEO and the p!'rformance of those elements 1s not reported
to the CEO separately from similar items included in the CSL
Behnng busoness. The Seqirus operating segment already
~nd markets. They are consiStent With the way the CEO (who contains all of the revenues and expenses relevant to the CEO's
is the d1ief opere~ ling decision·m.Jker) monitClfs and assesses
busoness p!'rformance in order to make decis•ons about
resource allocation Performance assessment is based on
monrtorong of financ1al performance of that bus·ness The
revised Segment disclosure therefore replicates the manner In
which the CEO monotors the business performance. Prior year

J
i Notelb:
Note3:
Note4:
Business Combination
Tax
Inventories
Page88
Page90
Page92
EBIT (earnings before interest and tax) and EBITDA (earnings
before Interest. tax. depreclutlon and i'lmorhsation) These
measures are different from the profit or loss reported in the
consolidated fonanclal statements which Is shown after net
comparatives have been restated ~o as to be presented in a
consistent manner with the current year segment results
The Group's operdtong segments dre.
~ NoteS: People Costs Page93
Interest and tdx expense. This is becc~use decisions that affect CSL Behnng - manufactures, markets. and develops plasma
i net Interest expense and tax expense are made at the Group therapies (plasma products and recombinants), conducb

i Note 7:
NotelS:
IntangiblE' AssE'ts
Trade Receivables & Payables
PageM
Page109
level It Is not considered c~ppropric~te to measure segment
performance at the net prof1t after tax level.
Dunng the f~rst half of the financial year the Company
early !>ldge rese,uch on plc~smd dnd non·plclSma therapies,
excludong Influenza. receives licence and royalty Income
from the commerclalisclt•on of Intellectual property and

I
~
f. The notes to the financial statements
The notes to these financial statements have been organised
Into logical groupings to help users find and understand the
conducted a review of Internill reporting to the CEO (the
chief operat1ng decision maker) and determined that the
reporting of CSL Intellectual Property scparate!y from the rest
undertakes the administratiVe and corporate function
requir<!d to support the Group
Seqirus- mdnUfd<.tures and dl~tnbutes non-plclSma

I
of the busoness was no longer relevant to the CEO's review blotherapeutoc products
Information they need. Where poss1be, related Information
of financial J)t'rformMce. As a consequence the number of
has been provided on lhe same place. More detailed OJ)I'ra!lng segments has been reduced from three to two. The
informatoon (for example. valuation methodologies and certain
!f revenues lind expenses of the prior CSL Intellectual Property
reconciliations) has been placed at the rear of the document segment have been combined with the financial resuks of
i
!!
and cross-referenced where necessary CSL has also reviev.ed
the notes for materiality and relell(lnce and provided additlorol
information where It is helpful to an understanding of the
the CSL BehriO!J segment. In aodrt10n. revenue and expPnses

:>
Group's pPrformance..
l g. Significant changes In the current reporting pPriod
~ There were no changes in accounting policy dunng the
:3 yeN ended 30 June 20T7. nor did the introductoon of new
~ account '"9 standards lead to any change in measurement or
disclosure m these financial statemerots. See Note 24 for deta>ls
~ of n<!W accounting standards introduced this financial year.
 ~
i
~
Note 2:
Revenue and Expenses Exponsos
2017
USSm
2016
US$m
Recognition and measurement of expenses
Finance costs: Includes interest expense and borrowing costs.
;;; These are recognised as an expense when Incurred. except
In prior years the Group disclosed the component parts of FinallCe costs 90.0 71.6
&' where finance costs are directly attributable to the acquisl·
revenue from continuing operations in this Note. In order to
~
Depreciat.on and amortisation of fixed assets 207.8 183.7 tion or construction of a qualifying asset. In this case they are
provide this mformation in a clearer manner these disclosures
AmortiSdtlon of intallQibk!s 71.4 36.6 capitalised as part of the cost of the asset. lnterest·beanng
:3 have been moved to the face of the Consolidated Statement of
Comprehensive Income. Total depreciation and amortisation expense 279.2 220.3
liabilities and borrowings are stated at amortised cost Any
difference between the borrowing proceeds (net of transaction
~ Recognition and measurement of revenue Write-down of KlVentory
189.8 57.3
costs) and the redemption value is recognised in the statement
~ to net realisable value of comprehensive income over the borrowings· period using
;u Revenue is recognised and measured at the fair value of the
Rental expenses relating to operating leases 57.5 the effective interest method.
'§ consideration that has been or will be received. The Group 47.4
;;;
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recognises revenue when I he amount of revenue can be
reliably measured and 1t is probable that the future econom1c
Employee benefits expei'ISe
Net foreign exchange loss
1,618.3
64.3
1.454.3
47.5
Depreciation and amortisation: Refer to Note 8 for details on
depreciation and amortisation of fixed assets and Note 7 for
benefits will flow to the Group. details on amortisation of Intangibles.
i Further information about each source of revenue and the Write·down of inventory to net realisable value: Included in
f
~
criteria for recogmiiOn follows. Cost of Sales in the Statement of Comprehensive Income. Refer
2 to Note 4 for details of inventories.
Sales: Revenue earned (net of returns, discounts and
i' allowances) from the sale of products Sales are recognised Employee benefits expense: Refer to Note 5 for further details.
"
0
when the significant risks and rewards of ownership of the
l goods have passed to the buyer
Rental expenses relating to operating leases: Operating leases
are leases In which a Significant port1on of the risks and re·
~ Royalties: Income received or receivable from licensees of CSL
intellectual property. Where the amount payable is based on
wards of ownership are not transferred to the Group. Payments
made under operating leases are charged to the statement of
i
!> sales of product , is recogmsed as it accrues which is when the comprehensive income on a straight·line basis over the period
g
g. Group has a legally enforceable claim. or the lease.
'2.
Finance revenue: Income from cash deposits is recogmsed as Goods and Services Tax and other foreign equivalents (GST)
i
5'
It accrues.
Licence revenue: Milestone income received or receivable
Revenues, expenses and assets are recognised net of GST.
except where GST Is not recoverable from a taxation author·
~ from licensees of CSL intellectual property is recogmsed as il ity, in which case 1t 1s recognised as part of an asset's cost or
~ accrues. acquisition or as part of the expense
~ Pandemic facility reservation fees: Income received from
~ governments in return for access to influenza manufacturing
facilities in the event of a pandemic. Contracts are time based
~
3Z
and revenue is accrued progressively over the life of the
;:ro relevant contract.

~
~ ....
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Other: Rent, proceeds from sale of fixed assets and other
income is recognised as it accrues.
.......
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8
::!!
~&' NOTES TO THE FINANCIAL STATEMENTS
~ FOR THE YEAR ENDED 30 JUNE 2017 D
~
~
;;; Current taxes Note 4:
KEY JUDGEMENTS AND ESTIMATES
f: Current tax assets and liabilities are the amounts expected to
be recovered from (or paid to) tax authorities, under the tax
rates and laws m each jurisdoclton. These onch.lde any rates
or laws that are enacted or substantively enacted as at the
Management regularly assesses the risk of
uncertain tax positions, and recognition and
Inventories
2017
ussm
2016
US$m
3 balance sheet date. recoverability of deferred tax assets. To do this Raw moterlals
~ requires judgements about the application of
631.4 5505
~ Deferred taxes Work on progress 995.2 816.9
;u
Deferred tax llabohties are recognised for taxable temporary
income tax legislation in jurisdictions in which
'§ Fonlslled pro<llcts 949.2 784.6
;;; differences. Deferred tax assets are recognised for deductible the Group operates and the future operating
Total inventories 2,575.8 2.152.0
;u temporary differences, carried forward unused tax assets and performance of entities with carry forward
~ unused tax losses, only if it is probable that taxable profit will losses. These judgements and assumptions,
i be dvailable to utilise them.
which include matters such as the availability Raw Materials
f The carrying amount of deferred income tax assets is l'l!Viewed
at the reporting date. If it IS no longer probable that taxable
and timing of tax deductions and the
Raw materials cornpnse collected and purchased plasma.
2 profit will be available to utilise them, they are reduced accord- application of the arm's length principle to chemicals, filters and other Inputs to prctduction that will be
i' Ingly. related party transactions, are subject to risk further processed into saleable products but have yet to be
"
0
and uncertainty. Changes in circumstances allocated to manufacturing.
l Deferred tax is measured usong tax rates and laws that are
enacted at the reporting date and are expected to apply when may alter expectations and affect the carrying Work in Progress
~ the related deferl'l!d income tax asset is reahsed or when the amount of deferred tax assets and liabilities. Work in progress comprises all inventory items that are
i deferred income tax liability ts settled. Any resulting adjustment to the carrying currently in use in manufacturing and intermediate products
!>
g Deferred tax assets and liabilities are offset only if a legally such as pastes generated from the initial stages of the plasma
value of a deferred tax item will be recorded
t enforceable right exists to set-off current tax assets against
current tax liabilities and if they relate to the same taxable
as a credit or charge to the statement of
production process

_i entity or group and the same taxation authority. comprehensive income.

5' Income taxes attributable to amounts recognised in other
,.f comprehensive income or directly in equity are also recognised
~ in other comprehensive income or in equity, dnd not In the
g
;; income statement.

! CSL Limited and Its 100% owned Australian substdlanes have

formed a tax consolidated group effective from 1July 2003.
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Finished Products
Finished products comprise matenal that is ready for sale and
Note 5:
People Costs
;;;
has passed all quality control tests.
&' a. Employee benefits

~
Inventories generally have expiry dates and the Group provides
Employee benefits include salaries and wages. annual
for product that is short dated. Expiry dates for r;nv material
leave and long-service leave. defined benefit and defined
:3 are no longer relevant once the materials are used m produc·
tion. At this stage the relevant expory date Is that applicable to
contribution plans and share-based payments incentive
awards.
~ the resultant intermed1ate or finished product.
~ Salaries and wages
;u Inventories are carried at the lower of cost or net realisable val·
'§ ue. Cost Includes direct material and labour and an appropriate Wages and salaries include non-monetary benefits. annual
;;; proportion of variable and fixed overheads. Fixed overheads leave and long service leave. These are recognised and
..
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are allocated on the basis of normal operating capacity. presented in different ways In the financial statements:

i Net realisable value is the estimated revenue that can be

earned from the safe of a product less the estimated costs of
The liability for annual leave and the portion of long
service leave expected to be paid within twelve months is
f ~
both completion and selling The Group assesses net realisa-
ble value of plasma-derived products on a basket of products
measured at the amount expected to be paid.
2 The liability for long service leave and annual leave
i' bas1s given their joint product nature. 2016
expected to be patd after one year is measured as the
"
0 present value of expected future payments to be made $1,.S4Jm
l in respect of services provided by employees up to the
reporttng date.
~ KEY JUDGEMENTS AND ESTIMATES
The liability for annual leave and the portion of tong servtce
i
!> Various factors affect the assessment of leave that has vested at the reporting date is included in
g
g. recoverability of the carrying value of the current provision for employee benefits.
'2. inventory, including regulatory approvals and The portion of long service leave that has not vested at the
i5'
future demand for the Group's products. These
factors are taken into account in determining
reporting date is included in the non-current provision for
employee benefits.

~ the appropriate level of provisioning for

~ inventory.
~
~
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~ =:=~ ·~~~
~ .... SeWitstndWOCY-"5
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8 NOTES TO THE FINANCIAL STATEMENTS
::!!
~&' FOR THE YEAR ENDED 30 JUNE 2017 t,E=D
~
~ Note 8:
~
;;; Property, Plant and Equipment
leased pro~rly,

f: v••, 2017
Land
USSm
2016
Bu1ldmgs

2017
USSm
2016
lcaSf'hold impro\cments

2017
USSm
2016
PIJnl and equipment

2017
USSm
2016
plant and eqUipment

2017
USSm
2016
Cap1tal work mprogress

2017
USSm
2016 2017
Toto!
USSm
2016
3 Cost 37.2 26.4 m.o 502.2 275.9 223.3 2,56L5 2.354 1 35.4 33.8 1,080.0 621.2 4,525.0 3.761.6
~ ACCL.mJiated delJ(eclai!On I amonlsatlon _ _ _ ___,(155.7) (1310) (15.5) (59.1) (1,331.4)_£!,_163 5) (19.7) (18.4) (1,582.3) (1.372.0)
~
;u Net carrying am0111t 37.2 26.4 379.3 371.2 20G.4 164.2 1,230.1 1.1912 15.7 15.4 1,080.0 621.2 2,942.7 2.389.6
'§
;;; Movement
;u
Net carrytngamoUlt at the start ot the year 26.4 19.6 37U 291.4 164.2 137.0 1,19L2 875.7 15.4 15.5 621.2 502.1 2,389.6 1.841.3
~ Transferred kom COJXtal work i1 Jllnoress 20.7 55.1 50.1 36.4 135.9 266.0 (206.7) (357.5)
i l!llllness AcquiSition 7.8 48.6 2278 284.2
f Other Addiltons' 10.0 0.3 0.7 3.4 2.3 55.8 11.3 4.0 3.2 65L9 493.8 125.4 511.3
2 Disposals (0.2) (0.1) (L3) (0.4) (36.6) (28.1) (2.8) (1.8) - (04) (40.9) (30.8)
i' Transrened to/rrom lntonolbles 0.4 0.2 0.4 0.2
"
0 Depredation I amortisation lor the ye¥ (20.9) (17.1) (17.6) (11.0) (166.5) (1530) (2.8) (2.6) (207.8) (183.7)
l AcC\JOOialed depredallon I
amortisatiOn on diSposals
Ol 0.1 L1 0.4 29.0 258 L8 1.2 32.0 27.5
~ Currency Translation differences. 0.8 (1.0) 8.1 (1.5) 0.5 (0.5) 2L3 .(_34 3) 0.1 (0.1) 13.2 (170) 44.0 .(_60.4)
i
!> Nel carrying am0111t at the end of the year 37.2 26.4 379.3 371.2 200.4 164.2 1,230.1 1.1912 15.7 15.4 1,080.0 621.2 2,942.7 2,389.6
g
1 TlrllOTlc.aptr,alworlt llt~SS addi!IOI'IS ar'iiMJWJJ/r olffldiOI tiDIC'fYINO.'«rs

t
.i
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Property, plant and equipment
Land. buildings, capital work in progress and plant and
Assets' residual values and useful lives are reviewed and
adjusted If appropriate at each reporting date. Items of
40% of the Holly Springs facility. acquired with the Novartis
Influenza business, is legally owned by the US Government. Full
property. plant and equipment are derecognised upon disposal legal title will transfer to CSL on the completion of the Final
,.
f equipment assets are recorded at historical cost less, where
or when no further economic benefits are expected from their Closeout Technical Report, expected in the next three to five
~ 3pplicable. depreciation and amortisation.
use or disposal. years. CSL has full control of the asset and 100% of the value of
g
;; Depreciatton is on a straight -line basis over the estimated the facility is included in the consolidated financial statements.
Impairment testing for property, plant and equipment occurs
Jsetulllfe of the asset.
! Buildings 5- 40years
if an tmpatnnent tngger 1s identified. No impairment tnggers
have been identified In the current year.
Assets under Finance leases

~z l eases of property, plant and equipment where the Group, as

Plant and equipment 3 - 15 years An impairment test was carried out on the Seqirus assets as at lessee. has substantially all the risk.~ and rewards of ownership
s 30 June 2017 and no impatrment was identified. are classified as finance leases. A finance lease is capttalised

i
Leasehold improvements 5 - 10 years
at the lease's Inception at the fair value of the leased property
Gains and losses on disposals of items of property, plant
or. if lower, the present value of the minimum lease payments.
and equipment are determined by compartng proceeds
The corresponding rental obligations. net of finance charges.
with carrying amounts and are included in the statement of
are included in interest bearing liabilities and borrowtngs.
comPrehensive income when realised.
 ~
i
~
Each lease payment IS allocated between the liability and
finance cost. The finance cost is charged to the statement
of comprehensive income over the lease period so as to
RETURNS, RISK & CAPITAL MANAGEMENT
Note 10:
Earnings per Share
CSL's b<Jsic and diluted EPS are calculated using the Group's
;;; net profit fort he financial year of US$1,337.4m (2016:
produce a constant periodic rate of interest on the remaining Shareholder Returns
&' balance of the liability for each period. The property. plant and
US$1,242.4m).

~ equipment acquired under a finance lease 1s depreciated over

the shorter of the asset's useful life and the lease term.
Dividends 2017 20t6

:3 Leasehold improvements
Dividends are paid from the retained earnings and profits of
CSL Limited. as the parent entity of the Group. (See Note 19
BaskEPS US$2.937 US$2.689

~ The cost of improvements to leasehold propertres is amortised

for the Group's retained earnings). During the year, the parent Weighted avaage numllef of ordinary Shares 455,331,196 461,999.573
~ entity reported profits of A$6,104.5m (2016: A$814 2m). The
;u over the unexpired period of the lease or the estimated useful parent entity's retamed eam111gs as at 30 June 2017 were DihrtedEPS US$2.931 US$2.683
'§ life of the improvement. whichever is the shorter. A$10.275.gm (2016: A$4,956.7m). During the financial year
;;; AdJuste<t we;~!Rd ail!'rage ntmber of 456,374,&48 463,117,064
..
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A$785.3m (the eQUIValent of US$601.4m) was distributed to
shareholders by way of a dividend, with a further A$413.1m
ordin<o shares. rep<esented by:
Weighted avaage 01dinary shiJres 455,331,196 461.999.573
(the equivalent of US$326.3m) being determined as a dividend
i Note 9:
Deferred Government Grants
payable subsequent to the balance date. Plus:
f
~
FY2017 FY20\6 EmPIOI'ee shareschemes 1,043,452 1.117.491
2 2017 2016 Divlcr.nd pold US$m US$m
i' USSm USSm
Diluted EPS differs from Basic EPS as the calculation takes into
"
0
Cunent deferred 1n<ome 3.2 3.1
Paid: Rnal ordtnary diVIdend of US$0.68 pe< 310.0 293.4 account potential ordinary shares arlsmg from employee share
l Non·rurrent deterred 1noome 35.9 35.0
share. unfranked. paid on 7October 2016for
rYI6 (prior yeac US$0.66 per <hare. W1fran~
schemes operated by the Group.

~ Total deferred government grants 39.1 38.1

paid on 2 October 2015 for FY15) On-market Share Buyback
i Paid; lntEiim ordirary div dend of US$().&4 P€1' 291J 285.6 Dunng the year, the Group completed the remaming A$91m
!>
g share, unfranked, paid on 13 Apnl2017 for FYI? of the A$1bn buyback announced in October 2015 and carried
g. (prior year: US$().58 pe< share, unfranked paJd on out an on· market share buyback of up to A$500m announced
'2. IS Aprt12016 for FY16) in October 2016 as an element of its capital management
Government grants are recognised at their fair value where
i
5'
there is reasonable assurance that the grant will be received
and the Group will comply wrth all attached conditions.
Total paid
Dividend determined, btJt not paid at year enct
601J
326J
579.0
310.5
program. As at 30 June 2017 shares to a value of A$349.7m
have been purchased under the October 2016 buyback.
Government grants relating to an expense item are deferred
~ Ftnal ord1cary diVIdend of US$().12 per share, The on-market buyback was chOsen as the most effective
and recognrsed rn the statement of comprehensive tncome method to return capital to shareholders after consideration
~ urfranked. expected to be paid on 13 October
over the period necessary to match them with the expenses
~ that they are intended to compensate. Government grants
2017 for FY17. based on shares on ISsue at
reporting da;e. The aggregate amount of tile
of the various alternatives. The on-market buyback provides
the Group with maximum flexibility and allows shareholders to
~ received for which there are no future related costs are
recognised in the statement of comprehensive income
p<o~d d!ll1dend w•ll de!l"nd on actual numllE<
of shares on ISSUe at diVIdend recDfd date (prior
choose whether to particrpate through normal equity market

~
processes
Immediately. Government grants relating to the purchase of Yt>ar: US$() 68 per share. unfooked pa<d on 7
3Z property, plant and equipment are included in current and October 2016 for FYI6) The Group's contributed equity Includes the Share Buyback
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~
non· current hablhtres as deferred mcome and are released to Reserve of (US$4.534.3m) (2016: (US$4,213.0m)). The Group's
The distribution in respect of the 2017 financial year represents ordinary share contributed equity has been reduced to nil from
the statement of comprehensive income on a straight line basis
~ ....
co a US$1.36 dividend paid for FY2017 on each ordtnary share previous share buybacks.
....... over the expected useful lives of the related assets.
held. These dividends are approximately 46.3% of the Group's

1
~
b<Jsic earnings per share ("EPS") of USS2.937.

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::!!
~&' NOTES TO THE FINANCIAL STATEMENTS
~ FOR THE YEAR ENDED 30 JUNE 2017 N D
~
~
;;; Note 12: b. Reserves

f: Equity and Reserves

a. Contributed Equity

2017 2016
Movement in reserves
Share-based p;ryments rewrve (I]
USSm
Fore1gn currency translatiOn reserv•<1>
USSm
Total
USSm
3
US$m US$m 2017 2016 2017 2016 2017 2016
~
~ Ordinarv shares issued and fully paid Opening balaOO? 159.4 151.1 28.5 155.4 187.9 306.5
;u
'§ S'lare buY·bclCk rese<l'e (4,534.3) (4.213.0) Sllare-based payments exPense 5.2 5.7 5.2 5.7
;;;
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Total <ontributed equity (4,534.3) (4.213.0) Defefred t.;x on share·based payments 3.6 2.6 3.6 2.6
~
i Ordinary shares receive dividends as declared and, in the event
Net exchange gains I (losses) on tiansfilt1on
of fweign subsidiaries. net of hedge
975 (U6.9) 97.5 (U6.9)

f of winding up the company. participate in the proceeds from

the sale of all surplus assets In proportion to the number of and Oosing balan<e 168.2 159.4 126.0 28.5 294.2 187.9
2 amounts paid up on shares held. Ordinary shares entitle their
i"
holder to one vote, eittwr in pers011 or proxy, at a rneetlflg of
"
0
the company. Nature and purpose of reserves
l Due to share buy-backs being undertaken at higher prices Share-based payments reserve
~ than the origrnal subscription prices, the balance for ordinary
The share-based payments reserve is used to recognise the
i share contributed equity has been reduced to nil. and a reserve
!>
created to reflect the excess value of shares bought over the fair value of options. performance rights and GESP rights
g issued to employees.
original amount of subscribed capital. Refer to Note 10 for
t further information about on-market share buy-backs. ii. Foreign currency translation reserve

.i
5"
Information relating to employee performance option plans
and GESP, including details of shares issued under the scheme,
Where the functional currency of a subsidiary is not
US dollars. 1ts assets and liabrlities are translated
,.f is set out in Note 5. on consolidation to US dollars using the exchange
~ rates prevailing at the reporting date, and its profit
g and loss is translated at average exchange rates. All
;; resulting exchange differences arc recognised in other
! comprehenSIVe Income and in the torergn currency
translation reserve in equity. Exchange differences arising
~z from borrowings designated as hedges of net investments
s in foreign entities are also included in this reserve.

i
 ~
i ~ Note 13: The present value of finance lease liabilities is as follows:
;;;
&' Commitments and Contingencies~ 2017 2016

~
US$m USSm
a. Commitments

:3 Operattng leases entered into relate predommantly to leased land and rental properties. The leases have varying terms and renewal
rights. Rental payments under the leases are predominantly fixed, but generally contain inflation escalation clauses.
Not later than one year
Later titan one year but not later than five years
3.1
8.4
2.5
7.4
~ Finance leases entered into relate predominantly to leased plant and equipment. The leases have varying terms but lease
~ Later titan five years 13.9 14.9
payments are generally fixed for the life of the agreement. In some mstances, at the end of the lease term the Group has the
;u
'§ option to purchase the equipment. Total 25.4 24.8
;;;
..
;u
[(:
No operating or finance lease contains restrictions on financing or other leasing activities.
Commitments tn relation to non-cancellable operating leases. finance leases and capital expenditure contracted but not provided b. Contingent assets and liabilities
i for in the ftnandal statements are payable as follows:
Litigation
f
~ Op@
rabngltnses flniiMCf l!aS@>S Cap1tatCommrtments Total
The Group is involved tn litigation In the ordinary course of
2 bustness.
i" US$m USSm USSm USSm
Durmg the penod ended 30 June 2017 the Group became
"
0 2017 2016 2017 2016 2017 2016 2017 2016 aware of two separate patent infringement actions brought by
l Not later thanonevear 57.9 46.4 3.9 354.0 222.8 415.8 272.5
competJtors. CSL ts htghly confident m our mtellectual property
~
3.3 positions which are the product of more than a decade of
i latPr tl\iln onP year but 205.4 163.9 11.1 10.3 111.0 7.9 333.5 182.1 innovative research by the Group. The Company IS vigorously
!> not later thiln five years defending against the claims.
g
g. Later tlliln five years 404.8 363.9 16.2 17.7 421.0 381.6
'2.
Sub·totat 668.1 574.2 31.2 m.o 1,170.3 836.2
i
5"
Futu~ ltnance charges
- .
- (5.8)
31.3
(6.5) .
230.7
(5.8) (6.5)

~ Total 668.1 574.2 25.4 24.8 m.o 230.7 1,164.5 829.7

~
~
~
~
3Z
;:ro

~
~ ....
co
.......
1
~
:::;

..
N
N
:
1:;
8
::!!
NOTES TO THE FINANCIAL STATEMENTS
~&' FOR THE YEAR ENDED 30 JUNE 2017 N D
~
~ EFFICIENCY OF OPERATION Cash, cash equivalents and bank overdrans
~
;;; Cash and cash equivalents are held for the purpose of meeting
Note 14:
f: Cash and Cash Equivalents, Cash Flows
2017
USSm
2016
US$m
short term cash commitments rather than for Investment or
other purposes. They are made up of:
Cash on hand.
3 At call deposits with banks or financial institutions.
~ Reconcllalion of cash and cash equivalents
~ cash at bank and on hand $62.7 442.0 Investments In money market Instruments with original
;u maturities of six months or less that are readrly convertible
'§ (ash deposits 281.8 114.6
to known amounts of cash and subject to insrgnrficant risk
;;; Less bank Ol'!'r<Wafts (l.S) (1.3)
;u of changes in value.
~ Total cash and cash eqtivalents 843.0 555.3 For the purposes of the cash flow statement, cash at the end of
i Reconclhtlon of Profit after tax to Cash Flows from Operadons
Profit afler tax 1,337.4 1.242.4
the frnancial year is net of bank overdran amounts.

f Non-casl11lems in profil after lax:

Cash Hews are presented on a gross basis. The GST component
of cash flows arising from rnvestlng and financing activities
2 Oepreciatiol\ amortisation and ill'4)airment charges 279.2 220.3 that are recoverable from or payable to a taxation authority are
i'
presented as part of operatmg cash flows.
"
0 Loss on dlSOOS<ll of property, plant and eqUJprnenl 8.7 2.3
l Gan/(klss) on ac(JJIStllon (1761)

~ Share-based payments expense 12.2 6.1

i Changes massets and llaboit,es:
!>
g i1crease In trade and o~r r~vables (72.5) (45.3)

t i1crease rninventories
(lnaease)/decrease in retirement benet~ assets
(389.2)
(0.4)
CZ16.5)
2.3
_i i1crease In nel tax assets (111.0) (12.7)
5'
,.f 11crease In trade and other payallles 153.9 116.0
~ (llecrease){inaease rn delimed govanment grants (0.6) 4.5
g llcrease In provrstons 21.4 19.7
;;
llcreasc in rcllrcmcnt benefit liabilities 7.5 15.6
! Net cash Inflow from operating activities 1,246.6 1.178.6
~z
s Non-cash flnandng actlvftles

i AcqUISIIton of plant and equpment by means of finance leases 4.0 3.2

 ~
i ~
Note 15:
Trade Receivables and Payables
Trade and other receivables are Initially recorded at fair value
and are generally due for settlement within 30 to 60 days
from date of invoice. Collectabillty Is regularly reviewed at an
Other current receivables are recognised and carried at the
nommal amount due. Non-current receivables are recognised
and carried at amortised cost. They are non-interest bearing
;;; a. Trade and other receivables operating unit level. Debts which are known to be uncollectible and have various repayment terms.
&' are written off when identified. A prov1sion tor impairment
~
2017 2016 As at 30 June 2017. the Group had made provision for
US$m USSm loss is recognised when there is objective evidence that all
impairment of $22.6m (2016: $31.1m).
amounts due may not be fully recovered. The provrsion amount
:3 Current is the difference between the receivable's carrying amount
2017 2016
Trade receivables 978.6 958.8 and the present value of estimated future cash flows that may US$m USSm
~ less: Ptovislon for ilf4li!lrment loss (22.6) (31.1) ultimately be recovered. Cash Mows relating to short-term
~ receivables are not discounted if the effect of discounting is Opening baldnceatl July 31.1 24.9
;u 956.0 '121.1
'§ immaterial. When a trade receivable for which a prov1sion for Adcltulnal allowance/(utrlised/WJitten bade) (8.7) 6.4
;;; Sun<Wy re<eivables 151.3 115.0 impairment has been recognised becomes uncollectible in a Currency toos'abon clffer~>nces (0.2)
..
;u
[(:
Prepayments
tarrying amount of wrr-ent trade
63.1
1,170.4
64.5
1.107.2
subsequent period, it is written off against the provis1on.
Closing balance at 30 June
0.2
22,6 31.1

i and o1her receivables

Non-trade receivables do not include any impaired or overdue
f
~
Non-current amounts and it is expected they will be received when due.
2
i"
Long termdePQ6its/other receiVables
carrylng amount of non-current
-- 16.5
16.5
15.6
15.6
The Group docs not hold any collateral In respect to other
receivable balances
"
0 other receivables•
l *ffwCiJfl)'l¥}4mouMd6CbSrtdMX>veiJatN$0Nbt.,approximaliOtloff*'~ Tltt

~ iN>t/mum UJK)SIJflroCiidiltl>k il//wfOI)Ofllngd.M•lS t/ltrilfry/~ilft)(MI/ o/-clim

offfCffYiiJittlis<losed•bove. ~.'<!r roN«ellformc."Oinla«rk111111onthe ro!Jrmo~
i fiOif<Yof IN G!OtJPMid/tl#<ffdiQI»/iiyof lril<kr<C<Ivalllt<.
!>
g
g.
"2.

i
5"

~
~
KEY JUDGEMENTS AND ESTIMATES
~
~ In applying the Group's accounting policy to trade and other receivables with governments and
related entities in South Eastern Europe as set out in Note 11, significant judgement is involved in first
~
3Z assessing whether or not trade or other receivable amounts are impaired and thereafter in assessing
;:ro
the extent of impairment. Matters considered include recent trading experience, current economic
~
~ ....
co
and political conditions and the likelihood of continuing support from agencies such as the European
....... Central Bank.

1
~
:::;

.."'
N
N
~

1:;
8 NOTES TO THE FINANCIAL STATEMENTS
::!!
~&' FOR THE YEAR ENDED 30 JUNE 2017 "'l.JF:J
~
~ b. Trade and other payables Note 16: OTHER NOTES
~
;;; 2017 2016 Provisions Note 17:
USSm US$m

f: Cu"tnt
Trade payables
Aocruals and other payables
399.0
732.1
303.5
669.1 2017 2016 2017 2016 2017 2016
Related Party Transactions
Ultimate controlling entity
The ultimate controlling entity Is CSL Limited, otherwise
3 described as the parent company.
~ Shau~·baleo paym~>rts (ED' P) 24-7 23.5
Current 103.4 30.7
~ Carrying amount ot current bade 1,155.8 996.1 99.0 0.6 134.1 99.6 Related party transactions
;u and other payables Non·CIJI~t 32.5 The parent company entered mto the following transactions
'§ 32.1 0.4 8.4 32.9 40.5
;;; during the year with related parties in the Group.
;u Non-current Other provisions are recognised when all three of the following
~ AccrualsaJd <II her payables 0.6 01 conditions are met:
Wholly owned subsidiaries

i Shate-baseo paymerts (£DIP)

Carrying amount ot non-cwrent
25.2 18.7
The Group has a present legal or constructive obligation
Loans were advanced and repayments received on the long
term intercompany accounts.
f other payables
25.8 18.8 arising from past transactions or events
Interest was charged on outstandmg 10tercompany loan
2 It is probable that an outflow of resources will be required account balances.
i' Trade and other payablcs represent amounts reflected at to settle the obligation.
Sales and purchases of products.
"
0
notional amounts owed to suppliers for goods and services A reliable esti mate can be made of the amount of the
l provided to the Group prior to the end of the hnancial year that
are unpaid. Trade and other payables are non· interest bearing
obligation.
Licensing of intellectual property.

~ and have various repayment terms but are usually paid within Provisions are not recognised for future operating losses.
Provtston of marketing servtces by controlled entitles.
i 30 to 60 days or recognition. Management tees were received from a controlled entity.
!> Provisrons recogmsed renect management's best est1mate of
g the expenditure required to settle the present obligation at the Management tees were paid to a controlled entity.
Receivables and payables Include the amount of GST
t receivable or payable. The net amount of GST recoverable
from, or payable to, taxation authorities is included in other
reporting date. Where the effect of the time value of money
is material, provisions are determ10ed by discounting the
The transactions were undertaken on commercial terms and
condttions.
.i
5'
receivables or payables in the balance sheet.
expected future cash flows required to settle the obligation at a
pre·tax discount rate that reflects current market assessments Payment for Intercompany transactions is through
of the time value of money and the rtsks specific to the liability. intercompany Joan accounts and may be subject to extended
,.f When discounting is used. the increase in the provision due to payment terms.
~ the passage of time is recognised as a borrowing cost.
g Ownership interests in related parties
;; Detailed information about the employee benefits is presented All transactions with subsidiaries have been eliminated on
! in Note 5. consolidation.
~z Other provisions include $29.8m (2016: nil) in respect of two
contracts deemed to be onerous. The contractual obligations
s under these contracts generated cash outflows that are greater

i than the expected cash inflows assodated with the contract

One of the contracts relates to a minimum purchase obligation
and the other to milestone payments.
 ~
INDEPENDENT AUDITOR' S REPORT
i~
FORTHEYEARENDED30JUNE2rn7
;;;
&'
~
:3 EY En'.UioY.;Iung
H lJ:h1bll101"1 ~-
u.tln•l"'f' VIC lCXJO AINI'IIIut
r..r. •61 3 9288 eooo
,.,,.,.,.
fall •613bb~ 11/J

~ S..lklinq • bottor
wortUil9 workl
GPO eo.. 67 MO:Ibourl'IC \1C 300'

~
;u
'§
;;;
..
;u
[(:
Independent Audi t or 's Report t o the Members of CSL Limi t ed

Report on the Audit of the Financial Report

i Opin1on
f ~
We haw aud1ted the financial roport of CSL Umited (the Company). and 1ts subsid10nos (collecwaly the Group), wnich compnsos the consolidated statement of financ.al
2 position as at 30 June 2017. the consolidated statement o f comprehensive income, the consolidated statement of changes in equ1ty and the consolidated statement of
cash flows lor the year than ended. no<es 10 the financial SU!tements. induding a wmmary or significant accoun~ng policies. and the directors· declaration
i'
"
0 In our Ojlinion. the aCCOfr4>8nying financ1al report of t11e Group is in accordance w•th t11e Corporations Aci 2001. 1ncluding:
l (I) giving a true and fair view of tha consolidated finandal position or the Group as at 30 June 2017 and or Its consolidated financial performance for tha year ended
~ on that date; and

i ~I) COI'I'I'iylng Ylitll Australlan Accounting Standards and tha Corporations Regula<lons 2001 .
!>
g
g. Basis for Opinioo
'2.

i5'
We conductad ot.r audit 1n accordance with AU$trahan A.udlt1ng Standards. Our responstbllttles undor those standards are furthor cktscnbed in the Auditor's R9SfJOI1S'bll1tJos
for the Audit of the financiBI Report section of our reJX)rl. We are independent of the Group in accordance w.th the auditor Independence requirements of the Corporations
Act 2001 and the ethical raq.~irements of tile Accounting Professional and Ethical Standards Board's APES 1 10 Code of Ethics for Professional Acccxmtants (the Coda) that
are relevant to oor audit of the financial rep:>rl in Alfitralia We have also fulfilk!d our other ethical responsibilities in accordaooe with the COda.
~ We belteVe that the a ud:t evtdenc:e we have obtatned rs suffic1ent and appropnate to provu:le a ba.s.1s ror our opmon.
~
~ Key Audit Matters

~ Key rudit matters are those matters that. in our professionalJudgement. 'Nere of most sign•ficaoce 10 our aud1t of the finar'ICial report of the current year. These matters
were addressed m the context of our audit of the financ1al report as a vA1ote. and 1n forming our opinion thereon, but we do not provide a separate opinion on these
~
3Z
matters. For each matter bek>w. our descnption of how our audit ad<kltssed the matter is provided in that context.
;:ro

~
~ ....
co
.......
A"*"''* l'lmofErn.t& YoufiVGI~.jfL"mi:W

1
~
Lill:lkty I tnlted t:y a schlrn• ~ed Wldet ~~~standard~ ~~flatten

:::;

.......
N
N
CD
CD

1:;
8
::!!
~&' INDEPENDENT AUDITOR' S REPORT
~ FOR THE YEAR ENDED 30 JUNE 2017
~
~
;;;

f: EY
8ulld!nqo.,_
3 wo~-'<1
~
~
;u
'§
;;; A further desenpuon of our responsibilities for the audit al the financial report is located at the Auditing and Assurance Standards Boord website at·
;u htt_p~//'NWW .1Ua'ib._ggv au/audiLor:. mcs.far2 mJf This ~saiption forms part of our auditor's report.
~
Report on the Audit of the Remuneration Report
i Oponion on the Rem~»eration Report
f We have audited the Remuneration Report included In pages 13 to 38 of the directors' report for the year ended 30 June 2017.
2 In our opinion. the ReiTU1Cration Report of CSL Limited for tho year ended 30 June 2017, compiles with section 300A of tho Corporouons Acl 2001
i'
"
0

l Responsibohties

~
The Directors of tho Company are responsible for the preparation and presentation of tho Remuneration Report In accordance with section 300A al the Corporalions Act
2001 Our responsobility iS to express an opon10n on the RemuneratiOn Report based on our audot ooncb:ted in aeeordanoe with Australian Audoti>g Standards.
i
!>
g
[~~~J
t ~rnst & Young

.i
5'
~~
,.f
~ Rodney Pill7
g Partner
;; Melbourne
15 Augusr 2017
!
~z
s
i Ament>« firm oC EIYl!t & Young G~lli'1•1t«t
u.o.tlf) ,,.,,'*'
by a td'l.-ne fiPP'Oi'ttd ~ ~- S1.,d8fdtl..eg!UIM

The running case for the book is CSL Limited Annual
Re{J(!II2017. Excerpts can be found in Appendix B. and
the company's online version at: http://annualrepon.csl.
oom.au/home.htm.
Chapter 1
1 Australian Government Auditing and Assurance
Standards Board. Auditing Standard. 'Auditing
Standard ASA 570: Going Concem·. Auditing and
Assurance Standards Board, 2015,
http://www.auasb.gov.au/adrrin/file/oontent102/
c3/ASA_570_2015.pdf.
2 'Understanding Financial Statements', from
Customer SeNice FADs. Copyright© 2000-2015
Dun & Bradstreet Inc. Used by permission. http://
www.dnb.comtcustomer-seNice/understanding-
financialstatements.html.
3 Australian Accounting Standards Board. ED264
'Conceptual Framework for Financial Reponing'.
paragraph 1.2. June 2015. http://Www.aasb.gov.au/
admin/file/content105/c9/ACCED264_00-15.pdf.
4 Australian Accounting Standards Board.©
Commonwealth of Australia 2004. All legislation
here;n is reproduced by permission but does not
purpon to be the official or authorised version. It is
subject to CoiM\Onwealth of Australia copyright.
The Copyright Act7968permits certain reproduction
and publication of Commonwealth legislation. In
particular. s.1B2A of the Act enables a complete copy
to be made by or on behalf of a particular person. For
reproduction or publication beyond that permitted by
the Act, permission should be sought in writing from
the Commonwealth available from the Australian
Accounting Standards Board. Requests in the first
instance should be addressed to the Administration
Director. AustralianAcoounting Standards Board.
PO Box 204. Collins Street West. Melbourne.
Victoria. 8007; Copyright© International Financial
Reporting Standards Foundation. All rights reseNed.
Reproduced by Cengage Learning Australia with the
permission of the International Financial Reporting
Standards Foundation• . No permission granted to
third pany users of this publication to reproduce or
distribute.
Chapter 2
1 Australian Accounting Standards Board. 'Accounting
Standard 1OB: Aocounting Policies. Changes in
Accounting Estimates and Errors·. http://Www.aasb.
gov.au/adrrin/file/oontent105/c9/AASB10B_07-
04_COMPmay11_07-11.pdf. Published by Australian
Accounting Standards Board. © 2011 .
2 CSL Limited. 'Independent Auditor's Repon for the year
ended30June2017'. Allll<lal Re{J(!II2017. p. 121.
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or In part. WCN 02-200-202
3 'Samsung makes record profit of $10~ a day as
chip demand soars·. The Guaflfian. Samsung. 31
October 2017, https://www.theguardian.cornt
technology/2017/ocl/31/samsung~ecord-profit-1 1 2m­
a-day-dlip-demand-soars; Sam Byford, 'Samsung
predicts record profits for second straight quaner'.
The Vetpe, 12 October 2017, https://www.theverge.
oom/20 17/1 0!12/1646762B/samsung-q3-2017 -record-
earnings-guidance; 'Samsung record profits mast
crisis without and within·. Financial Times. 13 October
2017. https://WMv.ft.oom/content/981 eed6c-9c4&-
11 e7-8cd4-932067fbf946; Richard Lawler. 'Samsung
oollects record profits. again', ENGadget, 31 October
2017. https:J/Www.engadget.com/2017/10/31/
samsung-q3-2017 -earnings-oled-iphone-x/: Sahel i
Roy Choudhury. 'Samsung predicts record profits for
third quaner as memory business booms'. CNBC. 12
October 2017, https://Www.cnbc.com/2017/10/12/
samsung-third-q uarter-earnings-guidance.html.
4 CSL Limited. 'Five Year Summary·. Annual ReiJ(Nl
2017, p.6.
5 Myer. Amlual Rep01120 17, p. 61; JB Hi-Fi. Annual
Report 2017. p. 64.
6 CSL Limited. 'Notes to the financial statements'.
Annual ReiJ(N12017. p. 86.
7 CSL Limited. 'Our Corporate Responsibility', http://
oorporateresponsibil ity.csl.com.au{ (aocessed
02103/2018).
8 ASX Corporate Governance Council. Corporate
Govemance Principles and Recommendations. 3rd
Edition. 2014.
Chapter 4
1 CSL Limited. AnnuaiRepott 2017, p.89.
2 Wesfarmers. 2017Annual Repott, p. 104.
Chapter 5
1 Warfield & Associates. Er!l>loyee fraud inAustralian
financial institutions. 2ll13. http://warfield.oom.au/
wp-oontenVuploads/2015/12/pub1.pdf.
2 CSL.Annua1Re{J(!II2017.p.125.
3 Ibid.. pp. 55-56.
4 Ibid.. 'Note 14: Gash and Gash Equivalents. Cash
Flows·. p. 108.
5 Ibid.. p. 101.
Chapter 6
1 CSL Limited. Annnual Repon 2017. p. 109.
2 CPA Australia. 'Notes to the financial statements:
7- Trade and Other Receivables', Allll<lal Re{J(!II
2016, p.84.
3 CPAAustralia.2017, 1nr~atedRepott2077.httpS://
www.cpaaustralia.oom.au/-/mediatcorporatetallfileS/
document/about/annual-repon-2017.pdf?la=en.
4 Nina Hendy, When will my invoice be paid? Chasing
late payers a big cost 1or small business·. Sydney
Morning Herald. 26 September 2017. http://Www.
smh.oom.autsmall-businesstfinance/when-will-my-
invoice-be-paid-dlasi ng-late-payers-a-big-cost-for-
small-business-20170926-gyp2 bk.html'
5 'How do f get a copy of my credit report?'. Published
by Office of the Australian Information Commissioner.
©Australian Government. For more information visit
the Office of the Australian Information Commissioner
(OAIC). http://www.oaic.gov.au{privacy/privacy-
topics/credi t-and-fi nance{how-do-i-get-a-copy-<lfmy-
credit-reporr
6 Chattered Accountants Australia and New Zealand,
'Notes to the financial statements: 7 - Trade and
Other Receivables·. Financial ReiJ(N12014. http://
www.chaneredaocountants.com.au/The-lnstitute/
Who-we-are-and-wha t-\Ve-do/Annual-report.aspx.
Chapter 7
1 Australian Accounting Standards Board. 'Accounting
Standard 1021nventories. 2015', paragraph 18.
http://www.aasb.gov.au{admin/filetcontent105/c9/
AASB102_07-15.pdf.
2 Ibid.. paragraph 36.
3 Ibid.. paragraph 22.
4 Ibid.. paragraph 7.
5 CSL Limited. Annual Repott 2017, p. 55.
Chapter 8
1 Australian Accounting Standards Board. 'Accounting
Standard 116 Reoognition. 2014', paragraph 7.
2 ASIC, Impairment of non-financial assets: Materials
for directors. http://asic.gov.au/regulatory~esources/
financial~eponi ng-and-audit/directors-and-financial­
reporting/impairment-<lf-non-financial-assets-
materials-for-directorS/ Accessed 19/12/2017
3 CSL Limited. Annual Repott 2017, p. 98.
4 Australian Accounting Standards Board. 'Accounting
Standard 1361mpairment of Assets. 2015'.
paragraph 9.
5 Australian Accounting Standards Board. 'Accounting
Standard 116 Reoognition. 2014'. paragraph 30.
6 Ibid.. paragraph 31.
7 CSL Limited. 'Note 7: Intangible Assets'. Annual Repott
2017, p. 97.
8 Ibid.
Chapter 9
1 Chattered Accountants Australia and New Zealand.
Annual ReiJ(N12017. p. 81.
2 Australian Accounting Standards Board. 'Accounting
Standard 137 Provisions. Contingent Liabilities and
Contingent Assets'. 'Objective', 2015, p. 6.
3 Ibid.. paragraph 12-13.
4 CSLLimited.AnnuaiRepott2077,p.107
Chapter 10
1 Trinkler v. Beale & Ors(2000) NSWCA 30;
Commissioner of State Revenue /Vic) v Oanvesr Pry
Ltd & Anor(Oecember 2017, Coun of Appeal, Victoria).
Chapter 11
1 CSL Limited. 'Note 12: Equity and RE·. Annual Re{J(!II
2017, p. 106.
2 Commonwealth Bank. 'Dividend reinvestment
plan·. https://www.commbank.com.au/about-us/
shareholderstmanaging-your-shares/dividend-
reinvestment-plan.html. The full document is
available at their website.
3 Australian Taxation Office. 'Share buy-backs', 2011.
https://WMv.ato.gov.au{Generai/Gapital-gains-tax/
Shares.-units-and-similar-investments/Share-buy-
badS/
Chapter 12
1 Australian Accounting Standards Board. 'Accounting
Standard 107 Statement of Gash Flows. 2016'.
Paragraph 19.
2 Ibid.. Paragraph 42.
289

Chapter 13
1 Peter Sivey. 'Health insurance: Don't blame young
people fo<your rising premiums·. ABC News. 19
October 2017. http:/twww.abc.net.au/news/
2017·1 0·18/health·insurance-dont-blame-young-
people-foHising-prerriums/9001936.
2 Australian Accounting Standards Board. Accounting
Standard 101 Presentation of Financial Statements.
2015. paragraph 1.
3 CtJchlear. Annual Report 2017.
'Chairman's report', p. 2.
Endnotes Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or In part. WCN 02-200-202
290
Appendix A
1 &Jilt-in functions can be aocessed in Microsoft Excel
by clicking on the Paste function icon. clicking on
financial. and then scrolling down to the desired
function.
2 In logarithmic form. (1 • ~ = 2can be rewritten as
1~1 • ~= log 2. or 61og(1 +I)= log 2. Therefore,
1~1 •I) =log 2 ~ 6. which simplifies to
1~1 •I) = 0.1155245. Switching back to the
equivalent exponential form. e0.1155245 =(1 +I).
11•1)= 1.122462. and r = 0.122462(12.2462%).
3 Using a business calculator. simply input 1P/YR.
200 FV, 1Oil PV. and 121/ YR and solve for n.ln
logarithmic form. (1 • 0.12)n= 2 can be rewritten as
1~1 • .12)n= log 2.or n log 1.12 =log 2.
Therefore. n= (log 21 ~(log 1.12) = 6.116.
4 Ali ordinary annuity is paid or received at the end
of each period. whereas an annuity due is paid or
received at the beginning of each period. In eJ<amples
throughout this book. we will assume the annuity is
ordinary.

A to account balances 49
AASB 3 Business Combinations 145
AASB 15 Revenue from Contracts with
Customers 3, 61
AASB 16 Leases 163-4
AASB 101 Presentation of Financial
Statements 20, 25. 244
AASB 102 Inventories 114-15, 120
AASB 107 Statement of Cash Flows 212- 13,
215-16
AASB 108 Accounting Policies, Changes in
Accounting Estimates and Errors 20, 138
AASB 116 Property, plant and equipment 139-40
AASB 133 Eamings per Share 204
AASB 136 Impairment of Assets 139, 14 5
AASB 137 Provisions, Contingent Liabilities and
Contingent Assets 164
AASB 138 Intangible Assets 145-6
account balances 216
adjustments 49
division by base account as percentage
see vertical analysis
dollar change - current-year balance minus
prio>year balance see horizontal analysis
over time see horizontal analysis
recording rules 46-7
at a specific time see trial balance
within one year see vertical analysis
zeroed o ut at each period end 98
accountability 83, 88
accounting 1
dual nature of 42, 46
language of 11- 12
methods 10
accounting cycle 40-54, 60-74
accounting equation 6, 42, 216, 239
accounting transactions and 42- 5
accounting information 84
adequate documentation 83
independent verification 84
qualitative characteristics 9
reviewing and reconciling 84
transferred/posted to ledgers 48
accounting information systems 40- 2, 216
cloud 4!H;O
accounting period 2, 11, 49
accounting transactions 40-54
accounting equation and 42-5
affecting at least two accounts see dual
nature of accounting
arm's length transaction 145
joumalising see journals
accounts 40-1 , 50-3
listings see trial balance
offsetting 101
zero balance partnership accounts 185
accounts payable 5, 22. 152
change in 222
accounts receivable 21, 179
ageing of 103
analysis 104-6
cash from total see net realisable value
Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or In part. WCN 02-200-202
change in 222 Australian Company Number (ACN) 191
gross 105 Australian Securities and Investments
recording 97- 8 Commission (ASIC) 19. 119, 139, 191, 193, 235
reporting 98-9 Australian Securities Exchange (AS)() 2. 19, 31,
accrual basis of accou nting 3, 60-74, 222 192- 3, 196, 201 , 224-5, 235
accrued expense 67- 9 share buyback notice example 202
adjustment 70-1 Australian Taxation Office IATO) 135, 153, 203
general rule 68- 9 average age of non-current assets 144
accrued revenue 64-5 average cost of inventory 122
adjustment 70 average useful life of non-current assets 144
general rule 65
accumulated depreciation 66, 131-2. 140- 1,
179, 223-4 B
balance never exceeding depreciable bad debt expense estimates 102- 3
amount 134 bad debt expenses 99
depreciation expense totals 133 balance sheets 5-7. 11 - 12, 20- 2, 72. 89, 114,
accuracy 10 120, 130, 155, 165, 178-9, 236-50
acid-test ratio 246 horizontal analysis 236-8
acquisition costs 145 linking income statement with 7
adjustmenVadjusting entries 62- 9 reporting at a moment in time 6
third in financial statement preparation
accrual accounting and 60-74 7,54
of cash balances 85-6 vertical analysis 239-41
for current assets and current bank reconciliation 84- 7
liabilities 222- 3 bankruptcy 245
'fixed' to properly reflect expenses 66-7 bearer bonds 156
'fixed' to properly reflect revenues 63-4 Board of Directors 31 , 33
for gains and losses from investing and bond certificates 156
financing activities 221-2 bond issue
journalising and posting 70-1 determining issue price 167-8
made during noi'KUrrent asset's useful at a discount 158-80, 168
life 137-40 at face value 157-8, 168
measuring 'financial weight' 72 at a premium 157, 160-2, 168
for non-cash items 221 bonds 155-62
preparing adjusted trial balance 7 1 call price 162
advertising 4, 105, 185 carrying amount 160-1
ageing 103 future cash flow types 167
ageing schedule 103 redeeming before maturity 162- 3
allotment/issue 194-5 terms 156
allowance for doubtfu l debts 100, 102 bonus to the existing (old) partners 181
allowance method 100-1 bonus to the new partner 181
allowance ratio 105-6 bonus to the remaining partners 184
amortisation 2 1-2, 160-2 bonus to the withdrawing partner 184
effective interest method of 168-70 borrowing 4, B. 26, 90, 154-5, 158, 160, 224, 226
of intangible assets 146-7 from lender range 155
amortisation schedule 160-2, 169-70 'bottom line prof~' 24
annual reports B2 buildings 130
annuity 167-8 business
application 194, 195 assets cost- liabilities difference
arbitration 183 see equity
ASA 570 Going Concern 3 forms of 18- 19,175-7.191- 3
asset accounts 47 GST registration 153
asset effectiveness 2 49- 50 knowledge of see chart of accounts
asset impairment 139, 146-7 language of see accounting
asset turnover ratio 2 50 obligations 155
assets 1, 5-6, 11 . 21 - 2,40, BB. 97,100,106-7, policies and procedures see intemat
113-14, 141, 158, 163-4, 195, 197. 201 , 250 control
activity of 135 snapshots of see balance sheets
claimed 6
claiming see receivables
in a 'class' 140 c
conversion 2 1 call 194
current see current assets call price 162
generation from l iabilities versus equity capital 6, 191-2
see cap~al structure share or issued 22
intangible see intangible assets capital account for each partner 178
non-current see oon-current assets capital accounts 177, 179, 181
overstating 10 capital balances 179, 183, 186
revaluations 139-40, 183 capital deficiency 185-6
revenue-generati ng 8, 90 capital expenditures 90
safeguarding 84 capital structure 29, 166, 248-50
sales 184-5 carrying amount 132-4, 138-9, 142, 147,
at a specific point in time 5. 54 160-1, 169- 70, 178
theft of 83 comparison to call price 162
see also accounting equation; deferred partner withdrawal at/less than/more
expense than 183-4
auditing 81 , 84, 193 cash 5, 21, BB-9. 166
auditor's report 31 analysis 89- 92
Australian Accounting Standards 3 1 cash on hand 92
also under specific AASB Standard conversions 218-20
Australian Accounting Standards Board inflows and outflows 223-4
IAASB) 19 internal control and 81- 92
291
 management see cash flow statements corporation (or company) 19, 191-3 more ea ~ie r; less later 134
net increase (dee<ease) in 214--15 capital raising ability 191-2 recognition 134
paid for inventory 218-19 corporate collapse 81 depreciation methodS/comparisons
paid for operating expenses 2 19-20 dividend imputation 192-3 133, 135-7
paid for taxes 220 evaluating inventory management 121-3 depreciation schedules 133, 136
partners receiving remaining cash 185-ti evaluating liability management 165-7 d irect method 217
petty cash replenishing, cash Over and limited liability of owners 192 d irect write-off method 99-100
Short 88 'publicly listed' 19 d irectors' report 31
received from customers 218 regulation 193 d isclosure 10, 25. 104, 119, 165, 193, 2 15-16
safeguarding 84 separate legal entity 191 d iscount 98, 113
cash accounts 41 transferability of ownership 192 bond issue at 158-t>O. 169
cash balances 85-ti Corporations Act 2001 (Cthl 20. 191 d iscretion 10
cash basis of accounting 60-1 Corporations Regulations 31 d ividend imputation 192-3
cash controls 84--8 cost 2, 132 d ividend payout ratio 205-ti
cash dividends 198-8, 200-1 cost model 139 Dividend Reinvestment Plan (DRPl 198-9
cash equivalents 88-9 cost of capital 250 d ividend yield ratio 206
cash flow cost of sales 24. 114. 120 d ividends 6, 11, 47. 90, 177. 196-200
from financing activities 213, 224--8 as.sumptions 115-18 ex-dividend trading 196
free 90-2 cost principle 5, 11, 112, 120. 130 expense and dividend accounts 47-8
hedges 25 cost-benelit analysis 84 franked 192
inflows and outflows see cash flow cost-of-goods-sold model 118, 124 not 'double taxed' 19
statements C<edit 46,50 receipt of 206
from investing activities 213-14, 223-4 ·easy e<edit' 105 re investment plans in Australia 198-9
norrcurrent assets and 144--5 see also debit and e<edit rules right to participate proportionally in 193
from operating activities- direct and e<edit balances 102-3 as temporary account 72
indirect methods 213, 2 18-23 e<edit cards 88 d ividends in arrears 200
reporting see cash flow statements e<edit memoranda 85-ti documentation 83
shareholders' equity and 207 e<edit ratings 102 petty cash receipts as 88
cash flow adequacy ratio 226-7 e<edit reporting body (CRB) 101 dollar. the 2
cash flow statements 8-9, 89, 144-5, 197 e<editors 5. 8, 156 bond's future cash flow conversion to 167
Cash Over and Short 88 e<edits 182 dollar change in account balance 25-ti, 89,
cash payments 218 cumulative preference shares 200-1 104, 121, 165, 204, 236, 238
cash receipts 218 currency 2 gross dollar 'mark-up' 24
cash transactions 85 comparisons in one versus currency 'double taxed' 19
·cashless' society 85 conversions 26 drawings 6, 11. 4 7
chart of accounts, example 41-2 current assets 2 1, 89, 106, 114 dual nature of accounting 42, 46
cheques 85 current liabilities 22, 152-5, 166 dual-entry accounting system 46-9
'bounced' see non-sufficient funds (NSF) with payroll 153-4 recording transactions in 48-50
cheque current market value 178-9 DuPont analysis 249-50
double-signed cheque 87 current portion of non-current debt 154--5
choice 20 current ratio 166-7. 245
dosing entries 73, 98 E
dosing process 72-4 earnings before income taxes see prof~s
collusion 84 D before income tax expense
Committee of Sponsoring Organizations damages 177 earnings before interest and tax (EBtn 243,
(COS0)82 date of record 196 248-9
common-size financial statements 26 days~~nventory ratio 122-3 earnings per share (EPS) 25, 204--5, 243-4
communication 84 days~n-receivables ratio 105 economic entity 2. 11, 19
comparability 10, 12, 31, 136 debentures see bonds economic information 25
comparative balance sheets 216-17 debit 46,50 over short time periods 2
comparison 235-ti debit and credit rules 46-8 economic resources 5
comparisons 26. 92, 162 debit balances 102 Economic Value Added 250
of depreciation methods 135-7 debit cards BB effective interest method of amortisation
of gross accounts receivable to allowance debit memoranda 86 168-70
account 105 debits 182 d iscount example 169
of inventory costing methods 118-19 debt 22. 90, 166 interest expense/amounts each period
see also bank reconciliation norrcurrent debt 154-5 differing 169
competitors 235 repayment 224, 227. 249 premium example 169-70
comprehensive income. other 25 debt to assets ratio 166-7. 246 Electronic Funds Transfer (EFS) Code 86
Conceptual Framework for Financial Reporting 11 debt to equity ratio 248 employees B. 83
conservatism see prudence debtors see receivables salarieS/wages to 5
consolidated balance sheet 20 decision making 5, 9, 103, 139, 235-ti segregation of duties 83-4
consolidated statement of cash flows 91, 214 declaration date 197 work - liability creation 152
consolidated statement of comprehensive deductions 153, 155 ending inventory 118-20, 124
income 23-4 deferred expense 65-7 entry approach 219-20
Consumer Price Index (CPI) 26 adjustment 70-1 equipment 4, 130, 184, 223-4
contingent liabilities 184-5 general rule 67 see also plant and equipment; property,
contra-asset accounts 66, 101, 146 deferred revenue 62-4. 152 plant and equipment
contracts 164 adjustment 70 equity 6, 11 . 40, 47. 88, 90, 97. 100. 106-7. 114,
contra-liability accounts 158 general rule and exception 63-4 141, 158, 163, 166, 193,201,248, 250
contra-revenue accounts 98 subscription revenue 62-3 evaluating a company's management
contributed capital 6, 11 deferred tax assets 2 1 of 203-7
contributed equity 22, 199, 204 deposit in transit 85 liability and equity accounts 4 7
control activities 83-4 depreciable amount 133 movements in 25
control environment 82 depreciation 8, 21-2,61 , 131, 164 reporting see statement of changes in
co-ownership 176 acceleration of see reducing balance equity
copyrights 21, 145-6 method of depreciation sources 22
corporate culture 82 as asset cost allocation 131 at a specilic point in time 5, 54
corporate govemance 31,33 depreciation expense 4--5, 66-7. 131-ti, see also accounting equation
Corporate Law Economic Reform Program 139-40, 221 error 83, 86, 119
(Audit Reform and Corporate Disdosure) Act collection see accumulated depreciation bank erro rs 85
(CLERP9) 81 as function of usage 135 being erro~f ree 10, 83

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or In part. WCN 02-200-202
292 Index
 correction 87 Generally Accepted Accounting Principles components 82-4
omis.sions or misstatements 9 (GAAP) 19-20, 61. 100, 133 establishing responsibility 83
estimates 9-tO, 165 gift cards 64 limitations 84
of bad debt expense 102-3 Global Financial Crisis (GFC) 72, 101. 155, 198 Internal control - integrated framework
d'!anges in depreciation estimates 137- 8 global financial markets 155 (report) 82
of ending inventory 119-20 going concern 2-3. 11 internal transactions 40
ethics 82 goods 155 International Accounting Standards Board
evaluation 121-3, 142-4, 203-7 delayed payment for 154 (IASB) 20
expenditures 90, 138-9, 146 'goods flow' 114 International Financial Reponing Standards
expense and dividend accounts 47-8 Goods and Services Tax (Gsn 153 (IFRS) 20
expenses 3-4, 11. 22, 48. 87 goodwill 21-2, 145-7. 183-4 inventory 5, 19, 21 , 112-25, 193
match with revenue recognition period governance information 31 . 33 d'!ange in 222
see matd'!ing principle government evaluating a company's management
operating (other) expenses 24 Commonwealth :and State 153 of 121-3
over a specific period of time 4 as poor payers 105 gross dollar 'mark-up' 24
recurring 24 removal of double taxation of income see impact of see inventory turnover ratio
as temporary aocount 72 dividend imputation 'not intended for resale' norrcurrent asset
understating 10 taxes payable to see taxes differentiation 130
expensing gross margin see gross profit periodic counting of 84
inventory 114 gross pay 153 physical 119
non-current assets 131-2 gross profit 24 purd'!ase of 152
external transactions 40 margin 120 inventory costing methods 118. 123-5
gross profit method 120 inventory turnover ratio 166, 246-7
growth 26 investing activities 8, 89-90
F GST Receivable 153 investing in partnership 181 - 2
face value 156, 170 investing cash flows 213-14, 222-4
bond issue at 157-8 investment 21 . 156, 223
bonds payable always at 156 H investors 6, 8. 191
fair market value 178 hedges/hedging 25, 163 invoices 83
fair value 139-40 historical cost principle 5 issued capital 22
faithful representation 10, 12 horizontal analysis 25-6. 89-90, 104, 121 -2. issued capital (contributed equity) 193
feedback 10 142- 3. 165-7. 204. 236-8 issued shares 193
finance leases 164 human element 84
financial accounting 2-12 J
basic assumptions 2-3. 11- 12
journal entries
financial activities
immateriality 104 adjusting entries and example 62-72
personal-busines.s separation see
income 22 on petty cash fund replenishment 88
economic entity assumption
divisions- 'profit or loss' and recording to financial statements
financial information 9, 30-3, 235
flow of 5 'comprehensive income' 140 example 50-4
relevant and faithfully represented 10 double taxation of 192 journals 48
overstating 10 judgements 20
systems 40-2
income statements 3-5. 11- 12. 22-5,99, 216, caution under uncertainty see prudence
financial instruments, bonds 155-82
financial leverage 247 236-50
financial position reponing see balance sheets consolidated 23-4 l
financial statement analysis 234-50 first in financial statement labour 'on costs' 154
financial statements 2, 5, 18-33, 119, 155, preparation 541. 71 land 130-1
186, 235 horizontal analysis 238 lasHn. first-out (LIFO) method 117. 119. 124-5
format 20-1 linking balance slheet with 7 AASB 102'sAustralian use preclusion 115,
information beyond 30-3 'profit and loss' s-ection 4 117. 119
notes to 10. 30-1 structure 4 lease 163
preparing 7. 54. 71-2 vertical analysis 241 lease liabilities 163-4
publicly available 105 income tax expense .25 ledgers 48-9
recording journal entries example 50-4 independent auditor's report 31-2 posting to 48, 50-3
relationship between 7 independent veraication 84 reconciling business' books 85-8
financing activities 8. 89-90 indirect method 217 leverage 247
financing cash flows 213-14, 222. 224-6 industry standards 236 liabilities 5-8, 11. 22, 40,62-3. 113. 152-70,
firsHn. first-out (FIFO) method 115-17. 119, 124 information under accounting information 193. 197. 238, 248
fixed assets 130 Initial Public Offering (IPO) 191- 2, 198, 224 current 22
fixtures 130 insolvency 247-8 evaluating a company's management
forecasting 10 insurance expense 65-6. 131, 219 of 165-7
forfeiture (shares) 196 d'!ange in prepaid insurance 222 misclassification of 155
formulae 4, 6-8, 26. 89-90, 104-5, 107. 117. pre-paid 21 non-current 22
121 -2. 125, 133-5. 140, 143-4, 160-1, intangible assets 5, 2 1-2, 90. 130-47. 223 partners paying 185
165-8. 168, 204-6, 227. 236, 239, 242- 5 externally acquired 145-8 probable, possible and remote 164-5
frand'!ise 145 impairing of 146-7 at a specific point in time 5. 54
frand'!ise rights 21 internally generated 146 understating 10
fraud 81 . 139 integrated reponing 33 warranty obligation inclusion 165
free cash flow 226 integrity 82 see also accounting equation; accrued
furniture 130 inte~ intracompany comparisons 235-8 expense
future cash flows 167-8 interest 4, 106-7. 224 liability and equity accounts 47
future interest 156 market rate of see market (or effective) liability capping sd'!emes 177
rate of interest limited liability 19. 192
purd'!asing current partner's interest 180 liquidation 179. 184-6
G recording 106-7 liquidity 21 . 166
gains 162 interest expense 68-9. 170 liquidity analysis 245-7
example non-current assets 141 as percentage 169 long-term debt 22
potential (unrealised) gain 120 interest payments 157-61, 167 loss 3. 162
on sales 220 interest rates 155. 157. 249 example non-current assets 140-1
'gearing' 243 interest-bearing liabilities 22 'true and fair' 4
general journals 48 internal control 81-2, 103. 119 lower-of-cost-and-net-realisable-value (LCNRVJ
general ledgers 49, 54 cash and 81-92 rule 120-1

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or In part. WCN 02-200-202
Index 293
 ownership 164 property 5, 2 1, 184
M co-ownership 176 property, plant and equipment (PPEJ90, 130,
management's discussion and analysis 31-2 transferability of 177, 192 132, 136, 147, 193, 213, 223
market (or effective) rate of interest 157. 168 ownership interest 6 proprietary (private) companies 19, 191
mark-up 24 prospectus 194-5
matdling principle 4, 11 . 60, 100. 131 p provisions 165
materiality 9-10, 12 prudence 10, 12. 98, 100. 119-20, 146
maturity 107. 158, 160, 162 par values 194
public companies 19, 81, 163, 191, 235
maturity date 156 Partnership Act 1890 175-6, 179
purchase discounts 113
redeeming bonds befO<e 162-3 pannerships 175-9
purchases 113
misleading information 155 bonus to new and exi sting partners 181 -2
purchases returns and allowances 113
monetary unit 2. 11 capital accounts fO< eadl partner 177-9
money commencing 177-9
flows 42 day-to-day management functions 178 Q
·money flow' 114 ease of fO<mation 176 quick ratio 246
as receivable 5 financial statements 186
monitoring 84 formation 19
monthly service dlarge 87 lawand 181 R
moving average method 117-19 mutual agency and co-ownership 176 rate of retum 157
mutti-step income statement 22 no pannership taxation. but not ratio analysis 236
mutual agency 176 tax-free 177 raw materials 112
norrmanaging (sleeping) panner 177 receipts 88, 218
panner admission and withdrawal 180-4 receivables 5, 97-107
N pannership agreement 176, 179, 181 collection 87, 104
negligence 177 profit allocation 179-80 'current' and 'past due' 103
net assets 178-9 sharing profits 179-80 recording at time of sale 97
net book value 132 transferability of ownership 177 uncollectible 99-101, 103
net financing cash flows 225 unlimited liability of owners 176-7 receivables turnover ratio 104-5, 246
net income 22, 221 past experience 102 reconciliation 61,213,215
net increase (decrease) in cash 214-15 patents 21, 145-8 bank 84-7
net loss 7. 213 payment date 197 independent verification 84
net operating cash flows 220-1, 223 payments 90. 154, 218, 224 recording/recO<ds
netpay 153 to partners 177 for account balances dlange see debit and
net profit 7, 54, 2 13 from petty cash funds 87-8 cred~ rules
net purchases 123 payroll, current liabilities w ith 153-4 of accounts receivable 97-8
net realisable value (NRV) 98, 100. 120-1 percentage<>f-receivables approach 102-3 of bad debt expense 100
neutrality 10 percentage<>f-sales approach 102 bond issue 157-80
norrcancellabfe operating leases 184 percentages 26-9, 89-90, 102, 104, 121-2. of cash dividends 197
norrcash expenses 221 142-3, 165-7, 169, 204, 236, 238 detailed records fO< eadl partner 177
norrcumulative preference shares 200-1 periodic (physical} inventory system 113- 14, error-free accounting records 10, 83
norrcurrent asset turnover ratio 143 123-5 of expenses when incurred see matdling
norrcurrent assets 21, 66, 106, 130-47. 163 perpetualinventorysystem 112-14,1 23,125 principle
adjustments made during useful life petty cash funds 87-8 4-step process for accounting
137-40 plant and equipment 5, 21 transactions 50-3
average life and age 144 post-acquisition expenditures 139 of intangible assets 145
cash flows and 144-5 prediction 10 of interest 106-7
disposal 140-1 see also estimates interest payments 157-81
evaluating a company's management pre-emption 193 of inventory 112-14, 123
of 142-4 preference shares 200-1 in journal and posting to ledger 50-3
expenditure after acquisition 138-9 cash dividends on 200-1 journal entries example 50-4
infO<mation 132 premium 146 maturity 158, 160, 162
·not intended fO< resale' differentiation bond issue at 160-2 of norrcurrent assets 130-1
from inventory 130 present value 167 notes receivable 106
·recoverable amount' 139 price to earnings ratio (P/El ratio 244 of O<dinary shares 194
norrcurrent debt, current portion of 154-5 principal 106. 154, 156. 167 of preference shares 200
norrcurrent liabilities 22. 154-5, 224 principal value see face value of revenue and expense 60
norrsufficient funds (NSF) cheque 87 privatisation 192 of revenues when earned see revenue
norms 102 products 8, 112 recognition principle
notes payable 152, 154 profes.sional indemnity insurance 177 safeguarding 84
formalised see bonds profit 3, 6, 54, 250 of share buybacks 201-2
notes receivable 106-7 allocation 179-80 of transactions 40-54
notes to the financial statements 10, 207. 235 borrowed money to eam 155 a write<>ff/recovery 100-1
quantitative and qualitative information distribution 177 reducing balance method of depreciation
in 30-1 generation 179, 196, 242 134-5
gross prof~ 24 regulation (companieS/corporations) 193
overstating 139 reissue (shares) 196
0 reconciliation 61 relevance 9-10, 12
off-balance-sheet financing 164 reduction see expenses rent 4
operating (other) expenses 24 'stag profit' 192 reponing/reports 33
operating activities 8, 61, 89-90 'true and fair' 4 of accounts receivable 98-9
operating cash flows 213, 218-23 profit and loss statement .see income accrua~ and casMlased income 61
operating efficiency 249-50 statements annual reports 82
operating expenses 99 profit margin ratio 242 auditor's report 31
operating leases 164 profit sharing cash and cash equivalents 88-9
optional deductions 153 based on capital balances and of cash dividends 197-8
ordinary annuity 167-8 service 179-80 cash flows see cash flow statements
ordinary shares 193-8, 224-5 based on set percentage 179 cash flows from operating activities
other comprehensive income 22-3, 25 profitability 22 218-23
other infO<mation (management's discussion/ reponing see income statements of cost of sales 114
analysis) 31-2 profitability analysis 242-5 cred~ reports 101
outstanding dleque 85 profits before income tax expense 25 current liabilities 155
oversubscription (shares) 195 promissory notes 106, 154 directors' report 31

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or In part. WCN 02-200-202
294 Index
 equity see statement of changes in equity share buybacks 26, 90. 198, 201- 3, 224. 226 taxes 4-5, 22, 152, 177
error 83 on-market 201- 3 no pannership taxation 177
financial position see balance sheets share dividends 19B withheld 153
financial reponing objectives 9-10, B1 share price history 235, 250 taxes paysble 153
of inventory 114 share splits 199-200 change in 222- 3
of norrcurrent assets 132 shareholders 6, 22, 31 , 90, 177 tempO<ary accounts 113, 123
profitability see income statements annual repons to B2 reset to zero 72-3
susta inabil~y reponing 32- 3 borrowed money to earn profit for 155 zeroed out at each period end 73. 9B
required deductions 153 rights of 193 theft B3, 119
Reserve Bank of Australia 156 shareholders' equity 191 - 207 timeliness 10, 12
reserves 193, 238 shares 191, 193-8, 200-1 times interest earned 248-9
residual assets 193 franked 203, 206 time/timing expressions
residual value 133-4. 139 market price of 198-9, 206 chronological joumals 4B
resources 5, 193 shares issue 6, 22 of financial statements 7- B
of businesses see assets by instalment 194-5 specified timing of interest
combined with pannership 1/6 single-step income statement 22- 3 payments 156
decreases see expenses sole proprietorship (sole trader) 18-19 timing of revenue/expense recording
increases see revenues sole traders 18-19 60
retail method 119-20 solvency 166 'tone at the top' B2
retained earnings 6-7. 11, 22, 29. 54, 72- 3, solvency analysis 247- 9 total comprehensive income 24
179, 193, 197. 199, 204, 225 specific identification method 115- 16, 124 trade names 145
changes in 7 spreadsheets 26, 42- 5 trade receivables see receivables
voluntary d istributions out of see stakeholders 32-3, 193 trademarks 21, 145
dividends standards of comparison 235-6 transaction analysis 42- 5
retum on assets ratio 243 stated interest rate 156 transactions see accounting transactions
retum on equity 205, 242-3 statement of cash flows 212- 27 transponation-in 113
revaluation model 139-40 analysis 226-7 trends 25-8, 102. 122. 244-5
revenue accounts 47 complete statement, indirect trial balance 48-9
revenue expenditures 138 method 225-6 functions 49
revenue received in advance see deferred preparing 216-17 preparing 54
revenue statement of changes in equity 7-8, 11, 29-30, preparing adjusted 71
revenue recognition principle 3, 11, 60, 64, 107 1B6, 197
see also accrual basis of accounting
revenues 1. 3, 11, 22. 47,63-4, 220
second in financial statement
preparation 7. 54 u
over a specific period of time 4 statement of changes in equity (retained uncenainty 9-10, 146
as temporary account 72 earnings section) 7. 11- 12 material uncenainty 2. 9-10
see also retained earnings statement of compreh ensive income see uncollectible receivables 99-101 , 103
rights 21, 191 , 193 income statements understandability 10, 12
risk 164, 166-7 'comprehensive' significance 140 unearned revenue see deferred revenue
sharing with pannerships 1/6 statement of financial position see balance units-of-activity method 135
risk assessment 83 sheets unlimited liability (of owners) 176-7
rounding 125 statement of prof~ or loss and other useful life 133, 137-40, 144
comprehensive income 23-4 utilities 4, 219-20

s stock 112
stocktake 120. 125
v
salaries 5, 22, 177. 219-20 straight-line method of amonisation 146,
salaries expense 67-8 160-1 verifiability 10, 12
sales B. 22, 24, 97. 220 to zero 169-70 venical analysis 26-9, 89- 90, 104, 121 - 2.
of assets 184-5 straight-line method of depreciation 133, 142- 3, 165- 7. 204, 236, 238-41
cost of sales reponing 114 139-40, 144 see also debt to assets ratio
terms 9B superannuation 153-4 voluntary deductions 153
sales revenue 24 suppliers B. 22 voting rights 193
Sarbanes-Oxley Act 2002 (US) B2 accounts payable to 5
sector-wide data 239
security 84
sustainability reponing 32- 3
w
segregation (of duties) 83-4 wages 4-5. 22
selling price 120 T warranties 165
service revenue 64-5 '~'accounts 46, 49, 65-B. 70-1, 73, B5 weighted average 125
services 155 'take home pay' see net pay w ithholding tax 153
delayed payment fO< 154 tangible resources 112 work~rrprocess 112
monthly service charge B7 tax deductions 155 write-offs and recovery 99-102

Copyright 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or In part. WCN 02-200-202
Index 295
Copyright 2019 Cengage Learning. All Right·s Reserved. May not be copied, scanned, or duplicated, In whole or In part. WCN 02-200-202
Copyright 2019 Cengage Learning. All Right·s Reserved. May not be copied, scanned, or duplicated, In whole or In part. WCN 02-200-202
Copyright 2019 Cengage Learning. All Right·s Reserved. May not be copied, scanned, or duplicated, In whole or In part. WCN 02-200-202
Copyright 2019 Cengage Learning. All Right·s Reserved. May not be copied, scanned, or duplicated, In whole or In part. WCN 02-200-202
Copyright 2019 Cengage Learning. All Right·s Reserved. May not be copied, scanned, or duplicated, In whole or In part. WCN 02-200-202
Copyright 2019 Cengage Learning. All Right·s Reserved. May not be copied, scanned, or duplicated, In whole or In part. WCN 02-200-202
Copyright 2019 Cengage Learning. All Right·s Reserved. May not be copied, scanned, or duplicated, In whole or In part. WCN 02-200-202

accounting
Tho ptoeess ol idenlilyW>g.
measunng and communicating
economoc onfonnabon to permit
infonned rudgements and
decisions.
economic entity
assumption
The assumption made by
accountants that the financial
activities of a business can be
separated from the financial
activities of the business'
ownerjs).
accounting period
usumption
Tho assumptiOn made by
aCCO<Jntants that economic
inlonnabOn can be meaningfully
captured and communicated
over short penods of time.
monetary unit
assumption
An assumption made by
accountants that the dollar is
the most effective means to
communicate economic activity.
going concern
assumption
The assumption made by
accountants that a company
win continue to operate into the
foreseeable future.
income statem ent
!profit and loss
stat ement)
The income statement repoots
a company's revenues and
expenses and the resulting
profit or foss.
revenue
An increase in resources
resulting from the sale of goods
or the provision of services.
revenue r ecognition
principle
Tho ponciple that reveooe
should be recorded when
a resource has been earned
and not lUSt when the cash is
received.
expense
A decrease in resources
resulting from the operation of
a business.
matching principle
The principle that expenses
should be recorded ill the period
resources are used to generate
revenues.
KEY DEFINITIONS LEARNING OBJECTIVES
income statement
The financial statement that • Explain the four assumption s made when communicating
reports a e<>rnpany's revenues accounting information.
and expenses over a specific
period of time. • Describe the purpose and structure of an income
balance sheet statement and the term s and princip les used to create it.
A financial statement tl1at
reports a business' as.sets, • Describe the purpose and structure of a balance sheet and
liabilities and equity at a specific the terms and p rinciples used t o create it .
point in time.
asset • Describe the purpose of a stat ement of changes in
An economic resource that is eq uity and how it links the income stat ement and the
objectively measurable, resuns
balance sheet.
from a prior transaction and Will
provide futlJre economoc benefot
• Describe the purpose and structure of a cash flow
cost principle
statement and the te rm s and principles used t o create it.
The principle that assets sho<old
be recorded and reported at
tl1e cost paid to acquu them.
0 Appreciate the objectives of fina ncial reporting and t he
q ualitative characteristics that make accounting
Sometimes referred to u tl1e
'historical cost principle'. information useful.
liability
An obligation of a business tl1at
• Review the language of accounting.
resutts from a pasttran.saction
and will require the sacrifice or
economic resources at 8 future
KEY FORMULAS
date.
equity INCOME STATEMENT
The difference between a
busilless' assets and iabolotoes. Revenues- Expenses= Net Profit or Net Loss
representing tl1e share of usets
lor Income, more formally, Total Comprehensive Income)
that is claimed by the busoness·
ownerjs).
contributed capital
mATIONIHIP llllWEIN ASSITI,
The resources that investors lijjfiii.~·im!ii!nTHiiiEilii
contribute to a business 1n ~unu AND HlUnY
exchange for ownershop
interest Assets= Liabilities+ Equity
dividends
Profits that are distributed
to owners (usually cafted
drawings ff 1l1e business is not
a company).
retained earnings Retained Earnings, Beginning Balance
Profits tl1at are kept in 1l1e
business.
+1- Net ProfiVLoss
-Dividends
statement of changes
in equity = Retained Earnings, Ending Balance
A financial statement that
reports the change in a
busilless' equity(controbuted
equity, reserves and reta1ned
THI CASH FlOW STATEMENT
earnings) over a specific period
Cash Flows Provided {Used) by Operating Activities
of time.
cash flow st atement +1- Cash Flows Provided {Used) by Investing Activities
A financial statement tl1at +1- Cash Flows Provided {Used) by Financing Activities
reports a business' sources and
uses of cash over 8 specific =Net Increase I Decrease) in Cash
period of time.
+Cash at the beginning
= Cash at the end
not be copied. scanned, or duplicated In whole or In part. WCN 02·200-202
 KEY DEFINITIONS

r elevance to arrive at the same or similar

The capacity of accounting
information to make a drtference
in decisions.
materiality
The threshold at which a
financial item begins to affect
dedsion·making.
faithful representation
Finane~! information that is
presented in a way that is
complete. neutral and free from
error.
comparability
The ability to use accounting
information to be weighed
against or contrasted to the
financial activities of drtferent
businesses.
verifiability
When infonnation allows
different independent observers
outcomes.
timeliness
When lnformation is provided
quickly enough that the user
can take action.
understandabil ity
The ability of accounting
information to be
comprehensibleto those
who have a 'reasonable
understanding of business
and economic activities and
accounting and a willingness
to study the infonnation with
reasonable diligence'.
Conceptual Framework
for Financial Reporting
The objectives, characteristics
and concepts that guide the
manner in which accounting is
practised.
DEMONSTRATION PROBLEM
On 1 March. Sarah begins a tutoring service that she will operate for four
months. With $400 borrowed from a friend and $1000 of her own money,
she purchases a $1200 accounting licence and software and $80 of
supplies. Sarah promises to pay her friend $10 interest at the end of each
month and to pay back the full $400 at the end of June.
Sarah charges $50 per tutoring session. During March. she
conducted 40 sessions and bought $100 of additional supplies. At the
end of the month, Sarah has not collected on sixteen of the 40 sessions,
and she has $50 of supplies left over. Sarah withdrew $400 from the
business during March. Prepare Sarah's income statement and
statement of changes in equity for the month ending 31 March and her
balance sheet on 31 March.
DEMONSTRATION PROBLEM SOLUTION
Sarah's Tutoring Service
Income statement
for the month ending 31 March
Revenue: $2000
Expenses:
Depreciation {licence and $300
software Y, months)
Suppl ies 130
Interest 10
Total expenses 440
Net Income $1560

Sarah's TutOring Service

Statement of changes in equity
for the month ending 31 March
Retained earnings. 1 March $0
Add: Net income 1560
Less: Dividends 400
Retained earnings, 31 March

Cash $810
Accounts receivable 800
Licence and Software {net) 900
Supplies 50
Total assets $2560
Note payable $400
Total liabilities $400
Contributed capital S1 000
Retained earnings 1160
Total equity 2160
Total liabi lities and equity $2 560
FINANCIAL
ACCOUNTING May not be copied, scanned, or duplicated, In whole or In part. WCN 02-200-202
•
TERMS USED TO IDENTIFY AND DESCRIBE ECONOMIC INFORMATION
Tenn Definition Reported on the

Asset A resource of a business Balance sheet

Liability An obligation of a business Balance sheet
The difference between assets and liabi lities Balance sheet
Contributed equity {capital) Equity resulting from contributions from owners Balance sheet
. .................. _.._,___ .....................- ...-!~!~e-~~~~~S.=~~.:~a-~e,~·-·-·-.. -·_..___,_,_,_,_,________ ,___......................................_.._,_,_________ ,____ _
Retained earnings Equity resulting from profitable operations Balance sheet and statement of changes
in equity (change in retained earnings)
···-···-···-···- ··- ··- ···-···-···-···-···-···-···- ··- ··- ···--···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-·..-···-···-..·-···-···-···-···-···-··- ·-··-···-···-···-···-···-···-···-···-···-···-···- ··- ··- ··- ··- ···-···-···-···-···-···-···-···-···-···-
Revenue An increase in assets resulting from sell ing Income statement
a a service
Expense A decrease in assets resulting from selling Income statement
· --·--·-·-------·-·----~-~~~-~_or_P.~~~i~i~~-a.:.:':'~c_e. ____________ _ _______________________________ _
Dividend (Drawings) A distribution of profits to owners Statement of changes in equity

PRINCIPLES USED TO MEASURE ECONOMIC INFORMATION

Principle Definition Ramification

Revenue recognition Revenues are recorded when they are earned The receipt of cash is not required to record a revenue. If you
sell to a customer who will definitely pay you next week.
the revenue is earned when the sale is made, not when you
receive the cash
Matching E;qlenses are recorded in the time period For many assets. the cost of the asset must be spread over
when they are incurred to generate revenues the periods when it is used- we call this depreciation
···-··- ··-···-···-··- ··-···-···-··- ··-···-···-··- ··-··-··- ···-··- ··- ··- ··-···-..·-...-···-···-···-···-···-··-··-··-··-··-··-···-··· -···-··-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-··-···-··-···-··-··~

Cost Assets are recorded at their historical costs in a few cases. market values are not used for
asset values

ASSUMPTIONS MADE WHEN COMMUNICATING ECONOMIC INFORMATION

Assumption Definiti on Ramification

Economic entity The financial activities of a business can be accounted for We do not have to worry that the financial
separately from the business' owners information of the owner is mixed with the
financial information of the business
Monetary unit The dollar, unadjusted for inflation. is the best means of All transactions need to have a specific dollar
communicating accounting information value to be recorded

Accounting period Accounting information needs to be communicated effectively Most businesses prepare half-yearly and annual
over short periods of time financial statements
Going concern The company for which we are accounting wil I continue its If an entity isnot selling its assets, then assets
operations indefinitely (l ike the drone) are recorded at the value to the
business (cost less depreciation)

not be copied, scanned, or duplicated, In whole or In part. WCN 02-200-202

 QUALITATIVE CHARACTERISTICS THAT MAKE ACCOUNTING INFORMATION USEFUL

Tenn Definition Ramification

Relevance Accounting information should have the capacity to Information should have predictive or feedback value
affect decisions and should be
Materiality The threshold over which an item could begin to affect When an amount is small enough, normal accounting
decisions procedures are not always followed. Note CSL reports
to the nearest $0.1 million
Faithful Faithfully represent the phenomena that it purports to Financial reports represent economic phenomena in
representation represent words and numbers
Prudence When uncertainty exists, accounting information should An entity should choose accounting techniques that
(Conservatism) present the least optimistic alternative guard against overstating revenues or assets
-·-···-···-···-···-···- ··- ··- ···-···-···-···--···-···-··- ···-··- ··- ··- ..-···-···-···-···-...-···-···-···-···-···-··- ··- ··- ··-···-···-···-···-···-···-···-·-···-···-···- ··- ··- ··- ··- ···-···-···-···-···-···-···-···-···-···-···-···-···-···- ··- ··- ··- ··- ···-··- ···-
Comparabil ity Accounting information should be comparable across Entities must disclose the accounting methods that they
different businesses. This isaided by consistency where use so that comparisons across companies can be made
use of the same accounting method aids comparability
-·-···-···-···- ··- ··- ··- ··- ···-···-·..- ···-··-···-··-··-··-··-··-··-···-··-···-··-···-···-···-···-··-···-··-··-··-··-··-··-···-··-···-···-······-···-··-··-··-··-··-··-···-··-···-···-···-···-···-···-···-···-··-···-··-··-··-··-··-··-··-··-···~

Verifiabil ity Verifiability helps assure users that information is Different knowledgeable and independent observers
faithfully represented could reach consensus
Timeliness Information available to decision·makers before they The older the information generally the less useful it is
make decisions
Understandability Accounting information should be comprehensible by Users must spend a reasonable amount of time studying
those willing to spend a reasonable amount of time accounting information for it to be understood
it

FINANCIAL STATEMENTS USED TO COMMUNICATE ECONOMIC INFORMATION

Statement Purpose Structure links to other statements
Income statement Shows a company's revenues and Revenue- Expenses = Net Profit/ Net profit goes to the statement
expenses over a specific period of Loss of changes in equity to calculate
time retained earnings
··-···-···-···-···-···-···-···-···-···-···-···-·····-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-4·-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-···-...-·..-4.-···-··-··-··-··-···-···-···-···-··-··-···-···-···-···-···-···-··-···
Balance sheet Shows a company's assets, Assets= liabilities + Equity The balance in retained earnings
liabilities and equity at a specific comes from the statement of
point in time changes in equity
The balance in cash should agree
with the ending cash balance on
the cash flow statement
Statement of changes Shows the changes in a company's Beginning Retained Earnings + Ending retained earnings goes to
in equity (retained retained earnings over a specific Profits (or- Losses)- Dividends= the balance sheet
earnings section) period of time Ending Retained Earnings
.,_ .,,_ .,,_ .,,_ .,_ .,_ .,,_ .,,_ .,,_ .,,_ .,_ .,,_ .,, . , _ .,,_ .,,_ .,,_ .,,_ .,,_ .,,_ .,,_ .,,_ .,,_ .,,_ .,,_ .,,_ .,,_ .,,_ .,,_ .,,_ .,,_ .,,_ 4•- ...- ...- ...- ...- ...- ...- ...- ...- ...- ...- ...- ...- ...- ...- ...- ...- ...- ...
-4,_.,_.,_.,_.,_.,,_.,,_.,,_.,,_.,_.,_.,_.,,_.,,_.,,_.,,_.,_.,_.,_.,~

Cash flow statement Shows a company's inflows and Operating Cash Flows +/-Investing The ending cash balance on the
outflows of cash over a specific Cash Flows +/-Financing Cash cash flow statement should agree
period of time Flows = Net Change in Cash with the balance in cash on the
balance sheet

FINANCIAL
ACCOUNTING May not be copied, scanned, or duplicated, In whole or In part. WCN 02·2()0..202
•

sole proprietorship (sole
trader)
A IMJsu>ess owned by one
penon.
partnership
A business that is formed when
two or more proprietors join
together to own a business.
company (or
corporation)
A separate legal entity that is
established by registering wilh
ASIC.
Australian Securities
and Investments
Commission (ASIC)
The agency charged wCh
p<OiectJng onvestors and
maintaon01g the 1ntegr.y of
securioes markets.
public company
A separate legal entity in which
ownership is available to the
general public.
Generally Accepted
Accounting Principles
(GAAP)
The accountrng standards.
rules, prW~c iples and procedures
that compnse authoritative
pracUc:e lor financial
accounting.
Australian Accounting
Standards Board (AASB)
The standard·setllng body
whose mossion is 'to develop
and ma1nta1n high·quality
financial reporting standards'.
International Financial
Reporting Standards
(I FRS)
Standards issued by the
International Accounting
Standards Board.
International
Accounting Standards
Board (IASB)
A board, Similar to the AASB,
whose miSsion IS to develop
a single set of hogiHJuality
standards requinng transparent
and comparable information.
consolidated balance
sheet
A type of balance sheet that
groups together the parent
company and itJ subsidiaries as
one reporting entity.
current uset
Any asset that IS reasonably
expected to be converted to
cash or consumed wihin one
year of the balance sheet date.
KEY DEFINITIONS LEARNING OBJECTIVES
non·current asset
A resource that is used 1n a • Explore the three major forms of business.
cornpan'{s operations for more
than one veer and not 1ntended
for resale.
0 Define Generally Accepted Accounting Principles
(GAAP) and their origin s.
current liability
An obligation that is reasonably • Describe the main classifications of assets, liabilities
expected to be satisfied within and equity in a balance sheet.
one year.
non ·current lia bility • Discuss the main subtotals of income on an income
An obligation that is not statement.
expected to be satisfied within
one year. • Anal yse the balance sheet and the income statement
contributed equity using horizontal and vertical analyses.
The amount of equity a
company generates through
the safe ol shares to investors
0 Des~ribe the structure of a statement of changes in
equtty.
(shareholders).
multi·step income • l!.ook at the types of information usually disclosed alo ng
statement with financial statements.
Calculates income by grouping
certain revenues and expenses
together and calculating several KEY FORMULAS
subtotals of income.
other comprehensive
income
Includes gains and losses not Current Assets
included in traditional revenue
and expense items. + Non·current Assets
sales revenue =Total Assets
The resources that a compeny
generates during a penocl from
selling its inventory
cost of sales
The cost of tl1a inventory sold
during a period. Dollar Change in Current Year Balance-
gross profit (gross Account Balance Prior Year Balance
margin)
The prof~ that a company Percentage Change _ Dollar Change
generates when considering in Accou nt Balance - Prior Year Balance
only the sale price and the cost
of the product sold.
operating expenses
Recurring expenses that a VERTICAL ANALYSIS
company incurs during normal
operations. For the For tihe income
profits before income balance sheet statement
tax expense Account Balance Account Balance
The p<ofil that a company Percentage Total Assets Net Sales or Revenue
generates when considemg
both the cost of the inventory
and the normal expenses
incurred to operate the
business.
vertical analysis notes to the financial present fai~y. in conformity
income tax expense A meth<ld of comparing statements with Australian Accounting
The amount of income tax a comp.anys account The additional textual and Standards, the company's
expense for a given period. balances within one year numerical information financial condition and
by dividing each account immedoately following the results of operations and
horizontal analysis
A method of analysing a balance by a base amount to financial statement$. cash flows.
company's account balances yield a percentage.
independent directors' report
over time by calculating common-siz.e auditor's report Forms part of the financoal
abso~e and percentage fmaneial statement A repon. p<epared by a report and covers matters
changes in each account A statement in which reg~stened company auditor which are tho Board of
alaccounts have been for the shareholder. stating Directors' responsibility
standardised by the overeD an oponoon on whether t11a
size of the company. financial statements
not be copied. scanned, or duplicated, in whole or In part. WCN 02·200-202
DEMONSTRATION PROBLEM DEMONSTRATION PROBLEM SOLUTION
The follow1ng 1tems were taken from the fmanaal statements
of Susan's Sportswear Suppliers. Use the rtems to prepare a
mult1-step 1ncome statement for the year end1ng 30 June and
a class1fled balance sheet at 30 June. For each statement. Net sales $951786 1000'!b
prepare a vertiCal analysiS. All dollar amounts are 1n thousands Cost of sales 511101 53.7'!b
of dollars.
Gross profit $440685 46.3'!b
Accounts payable $ 62432 Selling, general and 250496 26.3'!b
Accounts rece1vable 206024 adminisuative expenses
Accrued liabll1t1es 43789 Other revenues and expenses.
Cash and cash eqUivalents 264585 Interest revenue 2107 0.2'!b
Contributed cap1tal 205465 Interest expense _l!.illl 0.2%
Cost of sales 511101 Profits before income tax $190669 20.0%
Current portion of long ·term debt 4596 Income tax expense 70548 7.4%
Delerred tax asset. current 17442 Net profit $120121 12.6%
Delerred tax liability, non·current 7716
Goodwill 12157
Income tax expense 70548
Income taxes payable 8069 Assets
Intangibles and other assets 24475 Current assets:
Interest expense 1627 Cash and cash equivalents $264585 33.8%
Interest revenue 2107 Accounts receivable. net 206024 26.3%
Inventories 126808 Inventories. net 126808 16.2%
Non-current loan 16335 Deferred tax asset 17442 2.2%
Net sales 951786 Prepaid expenses and other current assets 6028 0.8%
Prepaid expenses and other 6028 Total current assets $620887 79.2'!b
current assets
Property. plant. and eqUipment. net 126247 16.1'!b
Property. plant and equ prnent 126247
Intangibles and other assets 24475 3.1%
Reta ned earn ngs 435364
Goodwill 12157 1.6%
Selling, general and 250496
administrative expenses Total assets ~ 100.0%

Liabilities and shareholders' equity

Current liabilities.
Accounts payable $62432 8.0%
Accrued liabilities 43789 5.6%
Income taxes payable 8069 1.0%
Current portion of long-term debt 4596 0.6%
Total current liabilities $118886 15.2%
Non-current loan 16335 2.1%
Deferred tax liability 7716 1.0%
Total liabilities $142937 18.2%
Shareholders' equity:
Contributed capital $205465 26.2%
Retained earnings 435364 55.6%
Total shareholders' equity $640829 81.8%
 KEY DEFINITIONS LEARNING OBJECTIVES

accounting information dual-entry accounting

system system • Describe the purpose of an accounting information
The system thatldefllif~eS. A system olaccotltl!ing., which system.
recO<ds. summarises and
commun1cates the various
IJansacbons of a business.
f!Very accounting transaction
affects at least two accounts. 0 Analyse the effect of accounting t ransactions on the
accounting equation.
debit
accounting t ransaction
Any econO<nic event that affects
a business· assets, liabilities
A use of funds, recorded on the
left-lland side of a T·accounl 0 Understand how T-accounts and debits and credits are
used in a dual-entry accounting system.
credit
and/or equity at the time of
the evenL
A source of funds, recorded
on the right· hand side of a
T-accounl
0 Explain the purpose of t he journal, led ger and trial
balance.
account
An eceounting record that
accumulatu the activity of a
specific «em and yields the
journal
A chronological record of 0 Record and post accounting transactions, prepare a trial
balance, income statement , the changes in equit y and
transactions.
ilem's balance. balance sheet.
ledger
chart of accounts
A conection ol accounts and
The ist ol accooots that a
their balances.
business uses to capture its KEY EXHIBIT
business aciMtJes. trial balance
A listing of accounts and their
dual nature of Type of Normal Increase Decrease
balances at a specific poont
accounting in time. account balance with a with a
Every accounting transaction
Asset Debit Debit Credit
must affect at feast two
accounts. liability Credit Credit Debit
._,_,_,_··- ··-···-···-··-····· .. ......_,_,....,_,_,_..._,,_ ,,,_,,_,,,_,,,
Equity Credit
......._,_,,_,,_ ,,_ ,,_,,_,,_,, . Credit Debit
.,_,_,_,_,_,_,_..._,,_ ,_,,_,,_,, -
Revenue Credit Credit Debit
------·--·-·
Expense Debtt Debt! Credit
Dividend Debot Oebot Credit

Summary of debot and credot rules

DEMONSTRATION PROBLEM
The following transactions occurred during the first month of operations
for Clear Windows Ltmtted. Prepare all necessary journal entnes, post the
information to the ledger and prepare a trial balance at 31 March.

I Mar. Issued shares for S30 000 cash.

------
Purchase a used delivery van for $17 200 cash.
3 Purchased cleamng supplies for S5000 cash.
3 Paid $2400 cash on a one·year mstKance policy effective I March.
12 Billed customers $4800 for cleaning services.
20 Paid $2300 cash for employee salaries.
21 Collected $4000 cash from customers billed on 12 March.
25 Billed customers $5200 for cleaning services.
31 ----~---------------
For the month, paid for and used $600 of fuel. -
~~~----------------
31 Declared and paid $200 cash dividend.
-----------------------

RECORDING ACCOUNTING
TRANSACTIONS
• not be copied. scanned, or duplicated In whole or In part. WCN 02·200-202
 DEMONSTRATION PROBLEM SOLUTION
1 Mar Cash 30000 Accounts
Cash receivable Equipment
Contnbuted equity 30000
30000 17200 4800 4000 17200
(Initial investment by owner)
4000 5000 5200
1 Mar. Equipment 17200
2400 6000 17200
Cash 17200
2300
(Purchase of delivery van)
600
3Mar Supplies 5000
200
Cash 5000
6300
(Purchase of supplies)
3Mar Prepa1d Insurance 2400
Prepaid Contributed
Cash 2400 Insurance Supplies Equity
(Purchase of insurance policy) 2400 5000 30000
12Mar. Accounts receivable 4800 2400 5000 30000
Serv1ce revenue 4800
(Provide services on account) Service Salaries Fuel
20Mar. Salaries expense 2300 Revenue Expense Expense

Cash 2300 4800 2300 600

(Pay employees) 5200

21 Mar Cash 4000 10000 2300 600
Accounts receivable 4000
(Collect receivables from customers) Dividend
Note. th1s IS the exchange of one asset for another; 11 is not the earning 200
of revenue. Revenue was earned on 12 March when the customer was
billed 200
25Mar. Accounts receivable 5200
Service revenue 5200
(Provide services on account)
31 Mar. Fuel expense 600
Cash 600 Accounts rece1vable 6000
(Pay for fuel consumed) Prepaid insurance 2400
31 Mar DiVIdend 200 Supplies 5000
Cash 200 Equipment 17200
(Declared and pay dividend) Contributed eqUity $30000
Service revenue 10000
Fuel expense 600
Salaries expense 2300
Dividends ____zoo
Totals $40000 $40000

RECORDING ACCOUNTING
TRANSACTIONS . May not be copied. scanned, or duplicated In whole or In part. WCN 02· 200-202
•

cash buis of accounting
Records r....-..es wllen cash is
re<:eive<l and re<:ords expenses
wllen cash os ~ld.
accrual basis of
accounting
Records revenues when
IIley are earned and records
expenses wl1en they are
incurred.
adjusting journal entries
Entries made in the general
journal to record revenues
lhat have been eamed but not
recorded and expenses mat
have been I'ICurred but not
re<:orded.
closing process
The process oltransfermg al
revenue, expense and dividend
A......_ ACCRUAL ACCOUNTING
.....,... AND ADJUSTING ENTRIES
KEY DEFINITIONS
account balances to the
Retained Eernings accounl
t emporary accounts
Accounts that accumulate
balances only for the current
period.
closing entries
Entries made in the journal
and posted to the ledger that
eliminate the balances in
all temporary accounts and
transfer those balances to the
Retained Earnings accounl
accounting cycle
The sequence of steps on which
an accounting infonnabon
system caphlres. processes and
reports a c~no(s ICCOUntng
transactions during a periOd.
LEARNING OBJECTIVES
• Explain how profit is measured and repo rted under the
accrual and cash bases of accounting.
• !dentify the _fou_r maj or ci rcumstances in which adjusting
JOurnal entnes •s necessary.
• Record and post adjusting journal entries as well as
prepare an adjusted trial balance and financial
st atement s.
0 Underst and th e purpose of the closing process and
prepare closing entries.
• Describe the steps of the accounting cycle.
DEMONSTRATION PROBLEM
Goven the follouumg 31 March unadJusted trial balance for Company
Xiang and the addotionalonformatJon at the end of the month, prepare all
necessary adjusting journal entries and prepare an adjusted troal balance
as of 31 March.
Debit Credit
Cash $6300
Accounts receivable 6(XX)
Equipment 17200
Prepaid insurance 2400
Supplies 5000
Contributed equity $30000
(ordinaoy shares)
Service revenue 10000
Fuel expense 600
Salaries expense 2300
Divid ends 200
Totals $40(XX) ~
Additional Information:
1 Depreciation on equ opment os $250 monthly.
2 One-twelfth of the insurance expired during the month.
3 A count shows $1000 of cleaning supplies on hand at 31 March.
4 Earned but unpaid employee salaries were $350 on 31 March.
not be copied. scanned, or duplicated In whole or In part. WCN 02·200-202
 DEMONSTRATION PROBLEM SOLUTION

Oepreciatoon expense 250

Accumulated depreciation 250
(To record deprec1at1011 on the equ1pment: $250 as g1ven)
2 Insurance expense 200
Prepaid 1nsurance 200
(To record expired insurance. $2400 x 1/12)
3 Supplies expense 4000
Supplies 4000
(To record suppl1es used $5000 unadJusted- $1 000 counted)
4 Salaries expense 350
Salaries payable 350
(To record salaries earned but not paid. $350 as given)

..
Debit Credit
Cash $6300
Accounts rece1vable 6000
Equipment 17200
Prepaid insurance 2200
Supplies 1000
Accumulated deprec1at1on $250
Salaries payable 350
Contributed eqUity 30000
Service revenue 10000
Depreciation expense 250
Fuel expense 600
Insurance expense 200
Salaries expense 2650
Supplies expense 4000
Dividends 200
Totals ~ $40600

ACCRUAL ACCOUNTING
AND ADJUSTING ENTRIES 0< ~iealed
• May not be copied. scanned. In - 0< In part. WCN 02-201).202

internal control
Tho system of poiciH and
p<oc:eduru IJ$ed on a company
1D promote ellicrent and
effecbve operations. reliable
financial reporting and
compliance with laws and
regulations.
control environment
The etmosphere in which the
members of an organisation
conduct their activities and
carry out their responsibilities.
risk assessment
The idenllfication and analysis
of the nslcs that threaten the
achievement ol organisational
obtecwes.
control activities
The pol1crts and p<oc:edures
estabished 1D address the risks
that threaten the achievement
of organisetional objectives.
information and
communication
Required for the open llow of
relevant information throughout
an organisation.
monitoring
The assessment of the quality
of an organrsation's internal
control
A...... CASH AND INTERNAL
.....,... CONTROLS
KEY DEFINITIONS
bank reconciliation
Tho p<oc:ess of recontllr>g the
differences between the cash
balance on a bank statement
and the cash balance 1n a
business· records.
deposit in transit
A deposit that has been made
by the business but has not
cleared the bank as of the
statement date.
outstanding cheque
A cheque that has been
distributed by the business but
has not cleared the bank as ol
the statement date
petty eash fund
An amount of cash kept on hand
1D pay for minor expendtures.
cash
A medium of exchange.
cash equivalent
Any investment that is readily
convertible into cash.
free cash flow
The excess cash a company
generates beyond whet it
needs to invest in productiVe
capacity and pay dividends1D
shareholders.
LEARNING OBJECTIVES
• Identify the role of internal control in a business.
• Describe five components of internal control.
Understand two m ethods of internal control over
•
cash - bank reconciliations and petty cash funds.
0 Appreciate the reporting of cash and cash equivalents.
• Anal yse cash through the calculation and interpretation
of horizontal, vertical and ratio analyses and free cash
flow.
KEY FORMULAS
HORIZONTAL ANALYSIS
Dollar Change in Current Year Balance-
Account Balance Prior Year Ba lance
Percentage Change = Dollar Change
in A ccount Balance Prior Year Ba lance
Cash
Percentage = =-__:_:....:...._ _
Total Assets
fREE CASH FlOW
Cash Flows from Operating Activities
-Capital Expenditures
-Dividends
= Free Cash Flow
DEMONSTRATION PROBLEM
Bank reconciliation
At the end of January, Sarah (the oompany) shows a cash balance of
$65000. The 31 January bank statement shows a balance of $64170.
Sarah discovers the following:
1 deposits of $4250 and $2300 made on 30 January and 31 January,
respectively, do not appear on the January bank statement
2 cheques w ritten in late January for $620 (No 12983). $950
(No. 12986) and $1200 (No. 12989) do not appear on the
January bank statement
3 the bank showed a $200 customer cheque deposited by Sarah and
returned to the bank for non-sufficient funds (NSF)
4 the bank charged a $50 service fee
5 the bank collected a $500 recervable from one of Sarah's customers
6 a cheque that Sarah wrote cleared the bank at $300 but was
erroneously reoorded tn Sarah's books at $3000.
not be copied. scanned, or duplicated In whole or In part. WCN 02·200-202
 Prepare a bank reconciliation for Sarah.

DEMONSTRATION PROBLEM SOLUTION

Balance per bank statement $64170

Add deposits in transit:
30 January $4250
31 January 2300 6550
Deduct outstandong cheques.
No. 12983 s 620
No 12986 950
No 12989 1200 2770
Actual cash balance $67950
Balance per company (Sarah's) $65000
records
Add:
Collection of receivable $ 500
Error by Sarah 2700 3200
Deduct
Servoce fee s 50
NSF check 200 250
Actual cash balance
-
$67950

A...... CASH AND INTERNAL

......,... CONTROLS May not be copied. scanned, or duplicated In whole or In part. WCN 02· 200-202

account receivable
An omount owed by a customer
who has purchased the
company's product or service.
net realisable value
The amount of cash that a
company expects to collect
from its total accounts
receivable.
bad d ebt expense
The expense resulting from the
inability to collect all accounts
receivable.
direct write·off method
Method "' which bad debt
expense IS recorded when a
company de-es that a
receivable IS uncollectible and
remcM~s d from ItS records.
allowance method
Meth00 1n which companies
use two entries to account
for bad debt expense- one to
estimate the expense and a
second to wr~e off receivables.
allowance for doubtful
debts
The dollar amount of
receivables that a company
believes will ultimately be
uncollecbble.
percentage-of-sales
approach
Method that estlnates bad
debl expense as a percentage
of sales.
KEY DEFINITIONS
percentag•of·
receivables approach
Method that estimates bed debt
expense as a percentage of
receivables.
ageing schedule
A listing ef accounts receivable
by their agas.
receivables turnover
ratio
A comparison of credit sales
to receivables that measures a
company's ability to generala
and collect receivables.
days-in-receivables
A conversion of the recetVables
turnover ratio that exp<esses a
company's abilty to generate
and collect receivables on days.
allowance ratio
A comparison of the allowance
account to receivables that
measures the percentage of
receivables that are axpected to
be uncollectibla in the future.
promissory note
A written promise to pay 1
specific sum of money on
demand or at some specolic
date in the future.
note r eceivable
An asset created when a
company accepts a promossory
note.
LEARNING OBJECTIVES
• Describe the record ing and reporting of receivables.
0 Compare the m ethods used to account for uncollectible
receivables.
• Contrast the methods for estimating bad debt expen se.
0 Evaluate accounts receivable through t he calculation
an d interpretation of horizont al, vert ical and ratio
analyses.
• Underst and t he accounting for notes receivable.
KEY FORMULAS
Dollar Change in Current-year Balance-
Account Balance Prior-year Balance
Percentage Change Dollar Change
i n Account Balance
Prior-yea r Balance
VIRTICAI. ANALYSIS
Percentage = For the balance For the income
sheet statement
Account Balance or Account Balance
Total Assets Net Sales or Revenue
.. RICIIVAILII TURNOVER RAno
Cred it Sa les
Receivables Turnover Ratio =
Average Receivables
Where average receivables is:
Beginning Receivables+ Ending Receivables/2
Receivables Turnover Ratio
ALLOWANCE RAnO
Average for Doubtful Debts
A llowance Ratio = Gross Receivables
Where gross accounts receivable is:
Net Account Receivables+ Allowance for Doubtful Debts
• · · · 1NTB1E1T EARNED
Interest Earned = Principal x Annual Rate of Interest
x Time Outstanding
not be copied. scanned, or duplicated. In whole or In part. WCN 02·200-202
 DEMONSTRATION PROBLEM DEMONSTRATION PROBLEM SOLUTION
Accounts receavable 900
Bad debt estimation and write-off
Allowance for bad debts 900
Chen Ball Allocators (CBA) provides the followmg partial balance
2 Bad debt expense ($75 200 x 2%} 1504
sheet and ancome statement informataon for the fanancaal
year ended 30 June 2020. Assume that Chen Ball uses the Allowance for bad debts 1504
allowance method for recording bad debts. Net realisable value:
Gross accounts receivable at 30/06/2020 $11760 Gross accounts receivable $11760
Allowance for bad debts at 30!06/2020 Credat balance less: Allowance ($138 + $1504} ____1MZ
$138 Net realisable value $10118
Net sales for year ended 30!06!2020 $75200 3 Bad Debt &pense 450
ReceiVables wntten off during year ended 30106!2020 900 ((S11 760 X 5%}- $138)
Allowance for bad debts 450
Required Net realisable value .
1 Prepare the JOUrnal entry that CBA made dunng the year Gross accounts receavable $1 1760
to w rite off the $900 in receivables.
less: Allowance ~
2 Prepare the journal entry to record bad debt expense
Net realisable value $1 1310
for the financial year if CBA estimates that 2 per cent of
net sales w ill be uncollectible. Calculate the resulting net 4 The $900 that was written off
during the year as the direct
realisable value of receivables.
write-off method only recognises
3 Prepare the journal entry to record bad debt expense as an expense the receavables
for the financaal year if CBA estimates that 5 per cent of written off (as Wlth tax
receavables w all be uncollectible. Calculate the resulting deductibahty}
net realisable value of receivables.
4 Assume that anstead of the allowance method. CBA uses
the darect w rite-off method. What would CBA recognase
as bad debt expense for the financial year ended 30 June
2020 ?

• RECEIVABLES
May not be copied. scanned, or duplicated In whole or In part. WCN 02· 200-202

inventory
A tangible resource that is held
lor resale ., the normal course
of opereoons.
perpetual inventory
system
Updates the inventory account
each time inventory is b<lught
orsold.
periodic (physicel)
Inventory system
Updates the inventory account
only at the end ol an accounting
period.
pure hues
An account used to aecUIOOiate
the cost ol al purchases.
transportation-in
An account that accumtJiates
the transponabon cOSIS of
obtain01g the inventory.
purchase returns and
allowances
An account that accumulates
the cost olaD inventory returned
to vendors as wei as the
cost reductions from vendor
alowances.
specific identification
met hod
Determones cost ol sales based
on the actllal cost ol each
inventory rtem sold.
first-in, first-out (AFO)
method
Calculates cost of sales based
on !he assumption that the first
un~ of onventory available for
sale is the first unit sold.
last-in, first·o ut (LIFO)
met hod
Calculates cost of sales based
on the assumption that the last
unit of inventory available for
sale is the first unit sold.
moving average m ethod
Celculates cost of sales based
on the everage un• cost of al
inventory ava~able for sale.
KEY DEFINITIONS LEARNING OBJECTIVES
retail method
A melhod of estimating the cost • Describe inventory an d how it is recorded, expensed
ol inventory knowing the sallrlg and reported .
price and reducing it by the
gross profit percentage.
lower-of-cost-and·
0 Calculate the cost of sales using different inventory
costi ng methods.
net-rea lisable-value
(LCNRV) rule • Understand t he profit and loss effect s of inventory cost
Requires inventory to be f low assumpt ions.
reported on the balance
sheet at its market velue if the • Demonstrat e how inventory can be estimated .
martel value is fowar than the
inventory's coSL
inventory turnover ratio
0 invent
Apply the lower-of-cost-and -net-realisable-value ru le to
ory.
Compares cost of sales dunng a
period to the average onventorv
balance during that period and
CD vertical
Evaluate inventory through t he calculation of horizontal,
and rat io an alyses.
measures the abi rly to sel
inventory.
days-in-inventory ratio
0 sales
Appendix: record purchases and calculate the cost of
u nder a period ic system.
Converts the inventory turnover
ratio into a measure of days by
dividing the turnover ratio into
36Sdays.
KEY FORMULAS
net purchases
AVERAGE UNIT COlT
The value of inventory
purchased and transportation·
in less purchase returns and A U . C _Cost of Goods Available for Sale
Units Available for Sale
allowances and purchase verage not ost-
discounts.
Purchase Returns and
Allowances account
An account that accumulates
HOIIIZONTAl ANALYSIS
the cost olal inventory returned
Dollar Change in Account Balance= Current-year Balance
to vendors as wen os the
cost reductions from vendor - Prior-year Balance
allowances. Percentage Change in Account Dollar change
Purchase Discount s Balance Prior-year balance
accou nt
An account that accumulates
the cost reductions generated
from vendor discount$ granted VERTICAL ANALYSIS
for prompt payment$.
For the For the income
balance sheet statement
Percentage= Account Balance or Account Balance
Total Assets Net Sales or Revenue
INVIN10IIY TURNOVER RAtiO
. Cost of Goods Sold
Inventory Turnover Ratoo = -'A:-'-"-'--'7-'-'-:'--
verage Inventory
Where average inventory is:
Beginning Inventory+ Ending Inventory
2
WIIGHIID AVERAGE UNIT COlT
Weighted Average _ Cost of Goods Available for Sale
Unit Cost - Units Available for Sale
not be copied. scanned, or duplicated In whole or In part. WCN 02·200-202
DEMONSTRATION PROBLEM
B'Eianna began with 32 widgets that had cost $55 each, she then purchases another 45 widgets at $60 each,
she then sells 50 widgets. Calculate Cost of Sales using FIFO, UFO and Moving (Weighted) Average.

FIFO {assumes we sell the oldest first, the $55 widgets, and then the next oldest, the $60 widgets)

Transaction Inventory purchased Inventory sold Inventory on hand

Beginning Inventory 32 S55 $1760
Purchase 45 $60 $2 700 32 $55 $1760
§ $60 2 700
77 $4460
Sell 50 units 32 $55 $1 760 27 $60 $1620
w $60 1080
50 $2840

LIFO {assumes we sell the newest first, the $60 widgets, and then the next newest, the $55 widgets)

Transaction Inventory purchased Inventory sold Inventory on hand

Beginning Inventory 32 $55 $1760
Purchase 45 $60 $2 700 32 $55 $1760
~ $60 UllO
77 $4460
Sell 50 units 5 $55 $275 27 $55 S1 485
45 $60 2lWl
50 $2 975

Movin g average (assumes we sell the average $57.92 w idgets $4460 I 77 =$57.92 note it is not a simple
average of $55 + $60 =$115 I 2 =$57.50, because there is more $60 widgets)

Transaction Inventory purchased Inventory sold Inventory on hand

Beginning Inventory 32 $55.00 $1 760
Purchase 45 S60 S2 700 32 $55.00 $1 760
~ $60.00 .l.ZJl.Q
77 $4460
Sell 50 units 50 $57.92 $2 896 27 $57.92 $1 564

~ INVENTORY May not be copied, scanned, or duplicated, In whole or In part. WCN 02-200-202

depreciation
Tho p<ocess of systematically
and robOnally alocating the
cost of a non·current asset over
its usefullrfe.
depreciati on expense
The portion of a non-current
asse(s cost that is recognised
as an expense in the current
period.
accumul ated
depreciati on
The cumulative amount
of deprecoation expense
recognrsed to date on a non-
current asset
carrying amount
Tho une"'l'red cost of a non-
current assel calculated by
subtracbng accumulated
dep<ecrabOn from the cost of
the non-current asset
cost
The historical cost of a
non-current asset being
depreciated.
resid ual value
An estimate of the value of a
non-current asset at the end of
its usefullrle.
depreciable amount
Tho difference~ an
asse(s cost and tiS residual
vakJe
useful life
The length of IJme a non-current
asset is expected to be used in
operatJons.
depreci ati on method
The method used to calculate
depreciation expense. such
as the straight-line, reducing-
balance and units-of-activity
methods.
straight-line method
A deprecrabOn method that
results rn the same amount of
deptecrabOn expense each year
ol the asset's usel\lllife.
reducing-balance
method
A dep<acrabOn method that
accelerates depreciation
expense into the early years of
an esset's life.
units·of·aoti vity method
A depreciation method in which
depreciation expense is a
function of the actual usage of
thaassel
cost model
Alter recognrtron as an assel
an item of plant. ptopetty and
equrp<nent shaHbe carried at
NON-CURRENT ASSETS
AND INTANGIBLE ASSETS
•
KEY DEFINITIONS LEARNING OBJECTIVES
its cost less any acciii!Uated
depreciation and any • Describe non-current assets and how they are recorded,
impa irme nt loss. expensed and reported.
revaluation model
If fair value can be measured • Calculate and compare depreciation expense using
reliably the asset shal be straight-line, r educing-balance (diminishing value) and
carried at a revaluation amount units-of-activity methods.
non-current asset
• Understand the effects of adjustments that may be
turnover ratio
made during a non-current asset's useful life.
A comparison of total revenues
to the average net carrying
amount of non-current assets
that measures the produc!My
0 Record the disposal of non-current assets.
of non-current assets. • Evaluate non-current assets through the calculation and
average useful life of interpretation of horizo ntal, vertical and ratio analyses.
non-current assets
A comparism ol the cost of non- • Depict the cash flow effect of acquiring and d isposing of
current assets to deptecrabon non-current asset s.
expense tllat estimates tile
number of years. on average,
that a company expects to use
0 Describe intangible assets and how they are recorded,
expensed and reported .
its non-current auets.
average age of non·
current assets KEY FORMULAS
A comparison of accumulated
depreciation to depreciation
expense that estimates the ITRAJGHT-UNE MEIHOD
number of years, on average,
that tile company has used its . . _ Cost - Salvage Value
non-current assets. Deprecratron Expense - Useful Life
intangible asset
Aresource that is used 1n
operations for more than one
year but til at has no physical RIDUCING-IIALANCI MmtOD
substance.
Depreciation = Depreciation Rate " Carrying Amount
patent
The right to manufacture, sell =(Straight-Line Rate x 1.5)
or use a particular product or x (Cost - Accumulated Depreciation)
process exclusively for a i mited
period oftime.
trademark (t rade name)
The right to use exclusively
~--~DD•~·~iiDJ UNITI-OF-ACnVITY MEIHOD
a name, symbol or phrase to . . . Cost- Residua l Va lue
identify a company. Deprecratron Expense per Unrt = Useful Life in Units
copyright
The right to reproduce or seU Depreciation Expense = Depreciation Expense per Unit
an artistic or published wort or x Actual Units of Activity
software computer code.
franch ise
The right to operate a blnrness
under the trade name of the •
franchisor.
Gain on Disposal= Proceeds from Sale> Carrying Amount
goodwill
An intangible asset equal to tile Loss on Disposal = Proceeds from Sale< Carrying Amount
excess that one company pays
to acquire the net assets of
another company.
amortisation
• NON-CURRINT AISET1URNOYER RAnO
The process of spreading out
Non-current Asset Turnover Ratio=
the cost of an intangible asset
over its useful ife. Total Revenues
Average Net Carrying Amount of Non-current Assets
Where average net book value is:
Beginning Net Carrying Amount+ Ending Net Carrying Amount
2
not be copied. scanned, or duplicated In whole or In part. WCN 02·200-202
 . · AYERAGI US&Ul Ufl RAOO DEMONSTRATION PROBLEM SOLUTION
1 ($113250- $8250) /10 = $10500 depreciation expense
Average Useful Life = Cost of Non-_Current Assets
Deprecoatoon Expense per year.
2 Reducing rate = (100% + 10) x 1.5 = 15% Year 1: 15% x
$ 113 250 = $16988 depreciation expense Year 2: 15% x
• · : AVERAGE AGE RAno ($113250- $16988) = $14439 depreciation expense
Year 3: 15% x ($113250- $16988- $14439) = $ 12273
u l;.:;a.;.:tedc..:D:..;e~p:..:.r;::;ec::.:.ia::..t:;..;io=n
A~cc:::'u'-'m
Average Age = -.:... =
Depreciation Expense
7 depreciation expense.
3 ($113250- $8250) /17 500 = $6 depreciation expense per
hour 3000 hours x 6 = $18000 depreciation expense
DEMONSTRATION PROBLEM 4 Cost of the asset $113250
Matthew Robm lJmoted (MRU purchases a new machone less. Accumulated deprecoatoon for 52500
for $113250. The machone has a useful hfe of 10 years and a five years {$10500 x 5)
resodual value of $8250. MAL estimates that the machone woll
Carrying value at tome of revision S60750
be used for 17500 hours.
1 Calculate the machine's annual depreciation expense using less: Residual value 8250
the straight-line method. Remaining depreciable cost $52500
2 Calculate depreciation expense for the first three years Divided by remaining useful life ~7
of the asset's life using the reducing-balance method at (5 years + 2 more years)
1.5 times the straight-line rate (round to the nearest dollar). Depreciation expense for year 6 ~
3 Assuming that the machine is used for 3000 hours one
year. calculate depreciation expense for that year using the
unots-of-acuvity method. 5 Cost of the asset $113250
4 Suppose that after five years of straight-line depreciation. less. Attumulaled depreciat•on 63!XXl
MRL oncreases the machine's useful life an addotoonal two for six years ($10500 x 6)
years. Calculate depreciation expense for year SIX. Carrying value at tune of revision S50250
5 Suppose onstead that after six years of straoght-hne Sales price 48!XXl
deprecoatoon, MRL sells the machine for $48900. Calculate
the gain or loss on the sale.
loss on sale ~

NON-CURRENT ASSETS
AND INTANGIBLE ASSETS May not be copied. scanned, or duplicated In whole or In part. WCN 02·200-202
•

gross pay
Tho 111111 pay before any
deducoon; 1n the simplest form
• is houn wort.ed times the
agreed hourly rate.
net pay
Gross pay less deductions such
as tax.
required deductions
The amoun~sl the employer is
legally obliged to take out. such
as tax. before depositing the
net pay in the employee's bank
account
optional deductions
Tho amounts the employee asks
the employer to tale out. such
as extra supereMuation. before
depositing the net pay in the
employee's bank account
note payable
A hbihty generated by the issue
of a promissory note to borrow
money.
current portion of non-
current debt
The portion of a non-current
hbflity that wil be paid within
one year.
bond
A financ1af 1nstrume<lt in wllich
a born>Wer proniseslll pay
future 1nterest and principal to
a cred«or 11 exchange for the
credilor's cash today.
face value
The amount that is repaid at
maturity of a bond.
stated i nterest rate
The contractual rate at which
interest is paid to the creditor.
maturity date
The date on which the face
value must ba repaid to the
creditor.
market (or effective) rate
of interest
Tho rata ol retum that investors
in the bond mart.ets demand for
bonds of Slmiar nsk.
straight-line method of
amortisation
Method that amortises an
equal amount of the discount
or premium each time interest
is paid.
KEY DEFINITIONS LEARNING OBJECTIVES
amortisation schedule
A schedule that ilustratas the • Describe the recording and reporting of current
amortisation of a bond dlscO<II( liabilities.
or premium over the ife of a
bond. • Describe the reporting of non-current liabilities and the
lease cash flows associated with those liabilities.
A contractual agreement in
which the lessee obtains the • Understand the nature of bonds (debentures) and
right to use en asset by me king record a bond's issue, interest payments and maturity.
periodic payments to the lessor.
off-balance-sheet
financing
0 Account for a bond that is redeemed prior to maturity.
Occurs when a company's
future obligations regarding
0 Recognise other liabilities such as leases and contingent
I labilities.
an asset are not reported as 1
fiabiity on the balance sheet
• Evaluate liabilities through the calculation and
fmance lease interpretation of horizontal, vert.i cal and ratio analyses.
A contract in which the lessee
obtains enough rights to use
• Appendix: determine a bo nd's issue price.
and control an asset such that
the lessee is in substance the
owner of the asset • Appendix: reco rd bond interest payments under the
effective interest m ethod.
contingent liability
An obligation that arises from
an existing condition whose
outcome is uncertain and
KEY FORMULAS
whose resolution depends on a
future event INTERUT PAYAaU ON
liqu idity IONDS PAYAIILE
A company's abiityto pay 1ts
current hbilities in the near Interest Paid = Face Value x Stated Interest Rate
future. xTime Outstanding
current ratio = $200000 x 0.07 x 12/12 months
Compares a company's current = S14 000
assets to its current ftaboiOes
and measures its abiity Ill pay
current liabilities..
solvency ITRAIGHHJNE METHOD
A company's abii ty to continue OF AMORTISAnON
in business in the long term by
satisfying its liabilities.
Discount at Issuance
debt to assets ratio Discount Amortised = - - - - - - - - - - -
Number of Interest Payments
Compares a company's total
liabilities to its total assets and
measures its abiity to pay liS
li abililies in the long term.
IOND DISCOUNT OR PREMIUM
capital stn.octure
The mix of debt and equ«y that AMOimSED EACH PAYimfT
a company uses Ill generate liS (SIIWGtfJUNE METHOD)
assets.
effective interest Premium at Issuance
Premium amortised - _ __:__-:-:-----::---
method of amortisation
Number of Interest Payments
Method lhatamortises the bond
discount or premium so that
interest expense each period
is a constant percentage of the
bond's carrying amount
~-----~Bim•~·mifDOO· GAIN OR lOSS ON
REDEMPnON
Gain on Redemption = Carrying Amount> Call Price
Loss on Redemption = Call Price> Carrying Amount
not be copied. scanned, or duplicated In whole or In part. WCN 02·200-202
 HORIZONTAL ANALYSIS · DaTTO AS$111 RAllO

Dollar Change in Current Year Balance - . Total Liabilities

Account Balance Prior Year Balance Debt to Assets Rat1o = Total Assets

Percentage Change in
Account Balance
Dollar Change
Prior Year Balance
.. INIIRIST EXPENSE (EFFECTIVE
INIIRIST MOHOD)

Carrying Amou nt x Market Rate

Interest Expense of Interest at Issue x Time
Balance sheet Income Statement Outstanding

Percentage= Account Balance or Account Balance

Total Assets Net Sales or Revenue
DISCOUNT OR PIIEIIIIUM
AMORTISID EACH M'lll8tT

.. CURIIINT RAllO
(IFRCTIVIINTIIIEST MOHOD)
Discou nt Amount Amortised = Interest Expense-
In terest Paid
Current Ratio = Current Assets
Premiu m A m oun t Amortised = Interest Pa id -
Current Liabilities
Interest Expense

May not be copied. scanned, or duplicated In whole or In part. WCN 02·200-202


capital account for each
partner
Records the current martel
value ol net assets contributed.
bonus to the new
partner
When a new partner pays less
than the capital received.
bonus to t he existing
(old) partners
When a new partner pays more
than the capital received.
bonus to the
withdrawing partner
Wilen the depaning partner
takes more than their capital
balance.
• PARTNERSHIPS
KEY DEFINITIONS
bonus to the remaining
partners
When the withdrawing partner
takes less than thetr cap!t.al
balance.
liquidation of a
partnership
The closing down of a business
that involves partners telling any
remainingasset$.
capital deficiency
A partne(s capital account with
a negative (debit) balance.
LEARNING OBJECTIVES
• Describe the characteristics of t he partnership form of
business.
0 Account for a partner commenci ng a partnership .
• Calculate the allocation of profi ts and losses to the
partners.
0 Record t he admission and withdrawal of partners.
0 Explain the liquidation of a partnership.
0 Prepare the financia l statements for a partnership.
DEMONSTRATION PROBLEM
The following transacttons occurred; all figures are in tnlhons of dollars:
e January: Julius and Cleopatra decided to form a partnership. Jultus
contributed an Empire worth $810 and debts of $330. Cleopatra
contributed intangible assets that were said to be priceless. but the
accountants valued the goodwill at $720.
e February: They decided to admit Mark to the partnership. Mark
contributed $900 of ships for a 2/7 share in the partnership.
e March: The new partnership has agreed to share profits; the first
$300 according to the service each contributes (Cleo $150. Julius
$60 and Mark $90), the next $270 to be shared equally and any
remaining profit or loss accordtng to their capital balances before any
allocation of profit. The partnership earned a profit of $360.
e April: The partners wtthdraw thetr share of the profits in cash.
e May: Julius decides to leave the partnership taking 80 per cent of
the Empire and $300 of shtps. But before he withdraws the Emptre
is revalued from $810 to $1125.
e June: The Empire is now crumbling, Cleopatra and Mark dectde
to liquidate the partnershtp, the remaining ships are sold to the
Athenians for $30 in gold. Odoacer purchased the remainder of the
Empire for $15 of gold. the goodwill is sold to Tourism Egypt for a
handful of gold ($300 and the original debts were repaid in gold.
The remaining gold was distributed to the partners to take to their
afterlife.
DEMONSTRATION PROBLEM SOLUTION
Jan. Empire 810
Goodwill 720
Debts 330
Capital Cleopatra 720
Capital Julius 480
Feb. Original net assets 720 + 480 ; $1200 plus the new assets
$900 = $2140. 2/7 =Mark'sCapital= $600. bonus of $300
shared 2/Sto Julius 3/5 to Cleo (120:180).
--------~ --~-------
Ships 900
Capital Mark 600
Capital Cleopatra 180
Capotal Jultus 120
- --------''--
not be copied. scanned, or duplicated In whole or In part. WCN 02· 200-202

issued capital
(contributed equity)
TIM! amount of capital raised
by isSIJing shares to investo<s
in exchange for an ownership
claim on company assets. It is
also known as paid-up cap~al
or shara cap~al.
ordinary shares
The most common type of share
cepital
issued shares
The number of shares a
company has d.istrillllted to
owners to date.
application
Both lhe request to buy shares
and lhe money peyable when
shares are appled for.
allotment or issue
The process of giving shares
to (some oO those who have
applied for them and also the
money required at this stage
from shareholders.
call
The request lor further
pavmen~s) and the money with
those hJI1her pavmentlsl.
prospectus
TIM! legal document offering
shares for sale and providing
detais of the company, past
linancoal performance and
Muro prospects.
oversubscription
When more shares are appied
lor than are available to be
issued.
forfeit
When a shareholder does not
pay lhe allotment and/or cal
lhey lose the shares lhey have
paid some of the money to buy.
reissue
When lorlerted shares are again
sold, often ate discount to the
originalossue pnce.
date of record
TIM! date that detem0n8s who
receivnthe diVidend -the
shares' owner on the date of
record receives the dividend.
cash d ividend
A distribution of cash to
shareholders.
declaration date
The date on which a company's
board of directors declares a
dividend.
A....... SHAREHOLDERS'
.....,.. EQUITY
KEY DEFINITIONS LEARNING OBJECTIVES
payment date
TIM! date on which a diVIdend • Describe the characteristics of the corpo rat e form of
wil bec!istrillllted business.
share dividend
A distribution ole company's • Discuss equity and show how it is recorded and
ordinary shares to existing reported.
shareholders.
share split • Understand ca sh dividends, share dividends and share
An increase in tho number of splits.
a company's issued shares
according to soma specified 0 1nvest igat e preference shares and how t hey receive
ratio. preference in dividends and other ways.
preference shares
A form of shares that recer;es • Examine share buybacks and how they are recorded and
one or more priorities over report ed.
ordinary shares.
cumulative preference • Evaluate equit y through the calculation and
interpretation of horizontal, vertical and ratio an alyses.
shares
Shares thet cerry the nght to
receive cunent·year dMdends
and all unpaid dividends from KEY FORMULAS
prior years before dividends are
paid to ordinary shareholders.
HORIZONTAL ANALYSIS
d ividends In arrears
The accumulated value of Dollar Change in Current-year p B
unpaid prior-year dividends. Account Balance = Ba lance - nor-year a1ance
non-cumulative
Percentage Change Dollar Change
preference shares
in Account Balance = Prior-year Balance
Shares that canythe nghtto
receive current-year dMdends
only.
earnings per share i EPS)
A comparison of a company's
For the For the income
total comprehensive oncorne to
the number of ordinary shares balance sheet statement
issued that measures the abirty
P Account Balance Account Balance
to generate wealth through
ercentage = Total Assets or Net Sa les or Revenue
profitable operations.
return on equity
A comparison of a company's
net income to average lEARNINGS PER SHARE
shareholders· equity that
measures the ability to use Earnings _ Total Comprehensive Income
existing equity to generate
per Share - Average Number of Ordinary Shares Issued
additional equity.
dividend payout ratio
Acomparison ole company's
diVidends to its earnings that AVIRAGE ORDINARY IHARIS
measures the percentage of OUISIANDING
current earnings cfostributed to
owners. Beginning Shares Outstand ing + Ending Shares Issued
d ividend yield ratio 2
A comparison of dividends
per share to the maotet price
per share that measures
the percentage return from
dividends.
not be copied. scanned, or duplicated In whole or In part. WCN 02·200-202
 IIITURN ON H1IUITY DIVIDEND MlOUT RAllO

Return on equity= Total Comprehensive Income Dividend Payout Ratio =

Average Shareholders' Equity Dividends Dividend per Share
Total Comprehensive Income or Earnings per Share

' DIVIDEND YIELD

Average Equity= Beg inning Equity+ Ending Equity
2 Dividend yield = Dividend per Share
Market Price per Share

SHAREHOLDERS'
EQUITY
• May not be copied. scanned, or duplicated In whole or In part. WCN 02·200-202
 KEY DEFINITIONS LEARNING OBJECTIVES

statement of eash flows direct method

A linaneial statement that
summanses a compall'{s
inflows and ootflows of cash
over a penod of time wilh a
purpose to inform users on how
and wf1y a company's cash
changed during the period.
cash flows provided
(used) by operating
activities
Cash inflows and outflows
arising from the company's
operations; sometimes caled
operating cash flows.
cash flows provided
(used) by investing
activities
Cash inflows and oot11ows
arising from the aequisilion and
diSposal of non-current assets:
often called investing cash
flows.
eash flows provided
(used) by financing
activities
Cesh inflows and outflows
associated with the generation
and rewm of capitat often
called financong cash flows.
Method of reporting cash • Describe the purpose and format of t he stat ement of
flows kom opera~ng ae1JVCJes cash flows.
in which cash inflows and
outflows kom operations are • Understand the process of preparing t he statement of
reported separately on the
statement of cash flows.
cash flows.
indirect method • Prepare the operating activities section of t he st at ement
Method of reporting cash flows o f cash flows using t he d irect method.
from operating activities in
wf1ich net income is adjusted
from an accrual basis to a cash
0 Prepare t he operating activities section of t he stat ement
o f cash flows using t he indirect met hod.
basis.
cash flow adequacy
• Outline the investing act ivities section of the st atement
ratio of cash flows.
Compares free cash How 10
the average amount of debl
maturing in 1he next five years
• Summarise the financing activities section of the
stat ement of cash flows.
and measures the obi11y to PlY
maturing debl
0 Evaluate t he st at ement of cash flows through t he
calculation and interpretation of ratio analyses.
KEY FORMULA
Free Cash Flow
Cash Flow Adequacy Ratio
Average Amount of Debt
Maturing in Five Years

DEMONSTRATION PROBLEM
A company prov1des the follovv1ng comparative balance sheets and
income statement. Prepare the company's statement of cash flows
for the year using the d•rect method for operating cash flows. In a
supplemental schedule, show operating cash flows under the ind~rect
method. Assume that the change in equipment was caused by a purchase
of equipment for cash.

2021 2020
Servic:e revenue $40000 Cash and cash s 3000 $ 4000
eqUivalents
Depreciation (20000) Accounts receivable 7000 8000
expense
Salaries (13000) Equipment 100000 73000
expemse
Profits before $ 7000 Accumulated {55000) {35000!
taxes depreciation
Income tax 2000 $55000 ~
expense
Profits after tax ~ Salaries payable s 5000 $ 1000
Ordinary shares 24000 24000
Retauled earn·ngs 26000 25000
Total liabilities and ~ ~
A......_ STATEMENT OF shareholders' equity

W"""" CASH FLOWS not be copied. scanned, or duplicated In whole or In part. WCN 02· 200-202
 DEMONSTRATION PROBLEM SOLUTION
Cash received from customers: Cash paid for equipment
SeJVice Revenue + Decrease in Accounts Receivable Change in Equipment Balance is Attributable to Equipment
= $40000 + $1000 = $41000 Bought for Cash= S27 000

Cash paid to employees: Cash paid for dividends:

Salaries Expense- Increase in Salaries Payable Retained Earnings + Profits After Tax- Dividends= Ending Retained Earnings
= $13000-$4000 = S9000 $25 000 + $5000- ?? = S26 000 ?? = $4000

Cash paid for income tax:

Income Tax Expense+/- Changes in Income Tax Payable
= $2000 + so = $2000

Statement of cash flows

for the year ended 30 June 2021

Cash flows from operating activities

Cash receipts from customers $41 000
Less cash payments:
to employees $(9000)
for taxes (20001 (11 0001
Net cash provided by operating activities $ 30000
Cash flows from investing activities
Cash paid for equipment $1270001
Net cash used in investing activities (27 000)
Cash flows from financing activities
Cash paid for dividends $ (40001
Net cash used in financing activities {40001
Net decrease in cash and cash equivalents $(1000)
Cash. beginning of year 4000
Cash. end of year $ 3000

Reconci liation of profits after tax to net cash flow from operations
Profits after tax $ 5000
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation expense $ 20000
Decrease in accounts receivable I 000
Increase to salaries payable 4000 25000
Net cash from operating activities $ 30000

A....... STATEMENT OF
. . . . . , . . CASH FLOWS May not be copied, scanned, or duplicated, In whole or I n part. WCN 02-200-202

financial statement
analysis
The process of applying
analyocaltools to a company's
financoal statemencsto
undemand the business'
financial heafth.
profit margin ratio
Compares comprehensive
income to net sales and
measures lhe ability to generate
profot.s lrom sales.
retu m on equity ratio
Compares comprehensive
income to average
shareholders' equity and
measures the aboityto generate
proli!s from equity.
retum on assets ratio
Compares comprehensive
income to average totalassecs
and measures lhe ability to
generate profics from assets.
price to earnings
(PIE) ratio
Comperes comprehensive
income to a company's share
price and provides an indication
of investor perceptions of lhe
company.
A...... FINANCIAL STATEMENT
W"""" ANALYSIS
KEY DEFINITIONS LEARNING OBJECTIVES
q uick ratio
Compares cash and near-cash • Understand the nature of financial statement analysis.
assecsto current l11bilotoes and
measures lho abiity to pay • Calculate and interpret horizontal and vertical analyses.
current liabilities inmedoately.
financial leverage
The degree to wllich a company
0 Assess profitability through the calculation and
interpretation of ratios.
obtains capital through debt
rather lhan equity in an • Assess liquidity through the calculation and
attempt to increase returns to interpretation of ratios.
stockholders.
debt to equity ratio • Assess solvency through the calculation and
Compares totslliabiities to interpretation of ratios.
total equity and measures a
company's capital structure and
financial leverage
0 Calculate and interpret a DuPont analysis.
times interest eamed
ratio KEY FORMULAS
Compares income to i!terest
expense and measures the
ability to pay interest oil! of HORIZONTAL ANALYSIS
current earnings.
Dollar Change
DuPont analysis
Decomposes a company's in Account = Current-year Balance - Prior-year Balance
return on equity into measures Balance
of operating efficiency, asset
effectiveness and capital Percentage Dollar Change
Change in
structure.
Account Balance Prior-year Balance
For the balance For the income
sheet statement
Percentage =
Account Balance
Total Assets
or .Net c..:.:.==;,::,.=="--
. .cAccount Balance
Sales or Revenue
PROmAIIUTY RADOS:
PROm MARGIN
Comprehensive Income
Profit Margin = Total
___ _;__ _ __ __
Revenue
PRORTAIIUTY RAliOI:
IIITUIIN ON EQUnY
Total Comprehensive Income
Return on Equity = - - -- : - - -- - - . , - - , -
Average Shareholders' Equity
Where average shareholders' equity is as follows:
(Beginning equity + Ending equ ity)
2
not be copied. scanned, or duplicated In whole or In part. WCN 02·200-202
 PROFIYAaiiJTY RATIOS: LIQUIDITY RATIOS:
RIIURN ON AliOS RICIIVAIILIS TUIINOVIR RAno

Return on Assets= Total Comprehensive Income Net Sales

Receivables Turnover Ratio= .,-----:-:..:..:..:..:==:-- - -
Average Total Assets Average Accounts Receivable
Where average total assets is as foll ows: Where average accounts receivable is:
(Beginning Total Assets+ Ending Total Assets) (Opening Balance of Accounts Receivable+
2 Closing Balance of Accounts Receivable)
2

LIQUIDITY RAliOS:
INVINTORY TURNOVER RAno
. Total Comprehensive Income
Earnrngs per Share=-:-----'----- - -
Average Number of Ordinary . Cost of Goods Sold
Shares Inventory Turnover Ratro = -:--- - - - - -
Average Inventory
Where the average number of ordinary shares is as follows:
Where average inventory is as follows:
(Beginning Balance of Ordinary Shares+
Ending Balance of Ordinary Shares) Beginning inventory+ Ending inventory

2 2

PRORTA81UTY RATIOS: SOLVENCY RAliOS:

DEBT TO AlSEn RAno
PRICI EARNINGS RAOO

. . Current Share Price Debt to Assets Ratio= Total Liabilities

Pnce to Earnrngs Ratio = - : - - -- - - - - Tot aI Assets
Earnings per Share

SOLVENCY RAliOS:
DEBT TO EQUnY RAno

. R . Total Liabilities
Current Ratio = Cu rrent Assets Debt to Equrty atro = - - - - - -
Cu rrent Liabilities Total Equ ity

LIQUIDITY RATIOS:
~-----"ffi~·~·m!miii~·~ SOLVENCY RAliOS: nMU
QUICKRAOO INlERUT EARNm RAOO

Cash +Short-term Investments + Total Comprehensive Income+

Times Interest Interest Expense + Income Tax Expense
Quick Ratio= Accounts Receivable
Earned Ratio = Interest Expense
Current Liabilities

Current Assets -
Inventory DUPONT ANALYIII
Quick Ratio Simple Calculation = - - - - - ' - -
Current Liabilities
Operat ing A sset Capital Return on
Efficiency Effectiveness Structure Equity

Total Total
Comprehensive Comprehensive
Income Sales Assets Income
X X --
Sales Assets Equity Equity

A....... FINANCIAL STATEMENT

~ ANALYSIS May not be copied. scanned, or duplicated In whole or In part. WCN 02·200-202
 DEMONSTRATION PROBLEM DEMONSTRATION PROBLEM SOLUTION
The following Information was taken from past f1nanc1al Profitability ratios:
statements of the Ma Company:
Profit marg1n $4155 I $27756 15.0%
Cum~nt Return on equ1ty $4155 /1($6672 + $6780) I 2) 61.8%
Prior year
year
Return on assets $4 155 I (($29 865 +S29 5891 I 21 14.0%
Current assets $10950 $11391
- - - -- -
Quick assets
Earnings per share $4155 /1(3021 + 31321 I 21 $1.35
5856 6942
---------------
Total assets 29856
Price to earn1ngs $93.191 $1.35* 69
29589
• EPS is taken from the above calculation
Current liabilities 10975 10464
Total liabilities 23193 22809 Uquldlty ratios:
Total shareholders' equity 6672 6780 Current ra11o $10950IS10975 1.00
Quick rat10 $5856 I S10975 0.53
Net sales 27756
Solvency ratios:
Cost of sales 11124
Income before interest and taxes 6084 Debt to assets $23193 I S29 856 0.78
Interest expense 162 Debt to equity $231931$6672 3.48
Net income 4155 lime interest earned $6084 I $162 37.56

Other Information:
Qrdmary shares 1ssued 3021 3132
Share pnce at year end $93.19
Calculate all profitability, liquidity, and
solvency rauos for the current year.

A...... FINANCIAL STATEMENT

W"""" ANALYSIS not be copied. scanned, or duplicated In whole or In part. WCN 02·200-202
NOTES

Copyright 2019 Cengage Learning. All Rlghll Reserved. May not be copied, scanned, or dupllceted, In whole or In part. WCN 02·200-202
NOTES

Copyright 2019 Cengage Learning. All Rlghll Reserved. May not be copied, scanned, or dupllceted, In whole or In part. WCN 02·200-202
NOTES

Copyright 2019 Cengage Learning. All Rlghll Reserved. May not be copied, scanned, or dupllceted, In whole or In part. WCN 02·200-202