Seminar 3: The Accounting Cycle and Preparation of Financial Statements

Depreciation Journal Entry Dr Inventory

Cr Cash
Dr Depreciation Expense
Cr Accumulated Depreciation
Prepaid Expense Journal Entry Dr Prepaid Rent
Cr Cash
Dr Rent Expense
Cr Prepaid Rent
Accrued Expense Journal Entry Dr Salary Expense
Cr Salary Payable
Dr Salary Payable
Cr Cash
Unearned Revenue Journal Dr Unearned Revenue
Entry Cr Sales Revenue
Dr COGS
Cr Inventory
Accrued Revenue Journal Entry Dr Accrued Revenue/ Dr Accounts Receivable
Cr Sales of Revenue
Dr COGS
Cr Inventory
Cash-basis Accounting Records only cash transactions (cash receipts and cash payments)
Accrual Accounting Records events in the period in which they occur, regardless of when cash receipts or payments occur

Accrual vs Cash-basis Accrual Cash Basis

Gives a more accurate picture of a company’s economic
conditions
By recording expenses in periods which they occur, we
can show the true profit earned by entity in that period
Does not match revenues which expenses incurred to
generate those revenues but recognises revenue when
cash is received and records expenses when cash is paid
Not allowed under the Generally Accepted Accounting
Process (GAAP)
Opportunities for improperly
reporting net income under
cash-basis accounting
Non-controlling interests
1. Can yield inaccurate results because revenues may be recognised in a different period than the period in which
related expenses are recognised  results can be incorrectly high or low reported profits, leading to an
impression that the profits of a business vary by large amounts from month to month when that is not
necessarily the case
2. Does not record account/notes receivables  not representative of the actual state of the company
3. Company may deliberately hold onto their payables by taking a longer time to pay their creditors so that their
net income in that period appear to be higher. However, these debts have to eventually be paid, and thus the net
income calculated by cash-basis is not accurate of the company’s profitability and net income for a period 
net income overstated
4. if a company wants to decrease their net income in that period, by using cash-basis accounting, company may
choose to pay and clear all of their debts in this period so that the net income appears to be low for that
particular period  net income understated
Equity
Week 4: Revenue and Other Income
Revenue Recognition Revenue is recognised when G&S have been transferred to the customer in an amount which reflects the consideration
expected in exchange for G&S

Key steps in applying the principle

1. Identify contract with customer
2. Identify separate performance obligations in contract
3. Determine transaction price
4. Allocate transaction price to separate performance obligations
5. Recognise revenue when (or as) each performance obligation is satisfied

Revenue is recognised OVER TIME or AT A POINT IN TIME

Core principle of FRS 115
(SFRS(I) 15) Revenue from
Contracts with Customers
Transaction price
Distinct goods
An entity shall recognise revenue when promised goods or services are transferred to customer in an amount that
reflects the consideration to which the company expects to be entitled in exchange for those goods and services.
Amount of consideration the seller expects to be entitled to, in exchange for transferring promised goods or services to a
customer, excluding amounts collected on behalf of 3rd parties (eg GST)
1. The customer can benefit from the goods / service on their own or in combination with other resources readily
available to him / her
2. The entity’s promise to transfer goods or services is separately identifiable from other promises in the contract
Week 5: Valuation of Accounts Receivable
Average Collection Period 365/Receivable Turnover Ratio
Receivable Turnover Ratio Net Credit Sales/Net Average Accounts Receivable
Impairment Loss Beg Balance + IL + Write-off = End Balance

Dr Impairment Loss of Accounts Receivables

Cr Allowance of Impairment of Accounts Receivables
Cash Collected Gross AR of year 1 (opening) + Gross Credit Sales of year 2 – Gross AR of year 2 (closing) – Write-off

Gross AR = Net AR + Allowance for impairment of AR

Lower receivable turnover ratio
and higher average collection
period
More receivables
When net AR increase but
allowance for impairment of AR
declined
Writing off accounts receivable
as uncollectible
Accounts receivables
Impairment Loss
Accounts receivables are not collected as frequently  weaker cash flows
Suggests company is allowing more credit sales  traps more revenue in the form of accounts receivable, which is not
as liquid as compared to cash
Cause of concern because management overstate AR by understating allowance for impairment of AR, thus presenting a
higher asset balance and a higher net income
Dr Allowance for impairment of accounts receivable
Cr Account Receivable
Beg balance + sales on credit – sales in cash
Percentage x Accounts Receivables after writing off
Week 6: Inventories and Cost of Goods Sold
Net Sales
Gross Profit Margin
Gross Profit
COGS
FOB Shipping point
If COGS understated
Inventory turnover ratio
Total Sales - Returns
Gross Profit/Net Sales
Net Sales - COGS
Beginning inventory + Purchases – Ending Inventory
Title of ownership transfers from seller to buyer when goods are onboard the vessel at the port of loading
Inventory Error when goods in transit purchased from a supplier FOB shipping point were not recorded nor included in
ending inventory
- Statement of Profit or Loss: Closing balance of inventory is understated, purchases are unstated hence no net
effect on COGS and Profit or Loss
- Statement of Financial Position: Closing balance of inventory is understated  inventory understated  cash is
either overstated or AP is understated
Overstate profits  overstate retained earnings
COGS/Average Inventory
Week 7: Fixed Assets – PPE, Intangible Assets
Depreciation (Cost-Residual Value)/Useful Life

Dr Depreciation Expense
Cr Accumulated Depreciation
Effects of changing useful Changing the useful life of an asset will not alter the previous total accumulated depreciation amount of the machinery but
life it will affect the depreciation expense

On the other hand, the change in useful life affects the balance sheet where the increase in depreciation expense leads to a
higher accumulated depreciation amount (contra-asset). Thus, the value of machinery (net book value) will decrease more
and the total asset value will decrease

Increased depreciation expense also leads to a decrease in retained earnings. Thus, equity decreases.
Financial Leverage Ratio Average Total Assets/Average Equity
Cost Model Carried at cost less any accumulated depreciation and accumulated impairment losses

Impairment Loss is recognised when carrying amount > recoverable amount

Revaluation Model Carried at revalued amount, being its fair value at the date of revaluation, less any subsequent accumulated impairment
losses

Dr Land
Cr Revaluation Reserve

Dr Loss on Revaluation
Dr Revaluation Reserve
Cr Land
Research costs As per para 54 of SFRS 38, “No tangible asset arising from research (or from the research phase of an internal project)
shall be recognised. Expenditure on research (or on the research phase of an internal project) shall be recognised as an
expense when it is incurred.” In research phase of an internal project, an entity cannot demonstrate that an intangible asset
exist will generate future economic benefits. Hence, this expenditure is recognized as an expense when it is incurred.
Week 8: Investment Property, Financial Asset Investments, Subsidiary and Associated Companies and Non-Controlling Interests
Cost Model Cost less accumulated depreciation less accumulated impairment
Fair value is disclosed in the notes to financial statement
Fair Value Model On reporting date, investment property is marked to fair value
Gain or loss from change in FV recorded in P/L
Fair value may be based on transacted prices or discounted cash flow

Dr Investment Property
Cr Cash
Dr Investment Property
Cr Fair Value Gain of Investment Property
Net Assets Assets-Liabilities = Owner’s Equity
Associate company – Equity 1. Recognise acquisition as associate company
Method o Dr Investment in associate companies
o Cr Cash
2. Recognise share of Alpha Ltd’s net income
o Investment in associate companies
o Share of income in associate companies
3. Recognise share of dividends
o Dr Cash
o Cr Investment in associate companies
FVPL 1. Recognise acquisition
o Dr Investment in FVPL
o Cr Cash
2. Mark to Market Value
o Dr Investment in FVPL
o Cr Unrealised gain on FVPL

Subsidiary company – 1. Recognise acquisition

Consolidated Method o Dr Investment in subsidiary
o Cr Cash
2. Consolidate financial position
FVOCI 1. Recognise acquisition
o Dr Investments in FVOCI
 o Cr Cash
2. Recognise share of dividends
o Dr Cash
o Cr Dividend income
3. Mark to Market
o Dr FV Reserve
o Cr Investment in FVOCI
Why FVPL will maximise The unrealised gains of the investment on Balance Sheet Date are transferred to the statement of profit or loss under the
profits FVPL method but FVOCI records unrealised gains in the FV Reserve which is under OCI reported under Stockholder’s
Equity
Week 9: Current and Long-term Liabilities, Lease Liabilities and Deferred Taxes
Issuance price of bond Present Value of Interest Payment + Present Value of Principal Amount
Bonds Journal Entry Dr Bond Interest Expense
Cr Bonds Payable
Cr Bonds Interest Payable
Possible reasons for Assumption: Same face value, same date of issue and same nominal rate
difference in issuance price
Payment frequency: An increase in payment frequency will lead to a higher insurance price
Coupon rate: A higher coupon rate will lead to a higher insurance price
Maturity: A shorter maturity will lead to a higher insurance price
Credit rating: A lower credit rating will lead to a higher insurance price
Debt ratio Total liabilities/Total assets
Asset Turnover r ratio Net sales/Average Total Assets
Taxes fixed charge (income before interest and taxes + fixed charge before)/(interest expense + fixed charge before taxes)
coverage ratio
Amortisation schedule

Times Interest Earned (income before interest and taxes – operating profit)/annual interest expense
Retirements of bonds Dr Bonds Payable
 Cr Gains on Bonds Retirement
Cr Cash
Deferred tax liability A tax expense relating to the current period but is not currently payable

Deferral comes from the difference in timing between when the tax is accrued and when the tax is paid. A deferred tax
liability records the fact that the company will, in the future, pay more income tax because of a transaction that took place
during the current period, such as an instalment sale receivable
Income tax payable Classified as current liability
Compilation of taxed due to the government within a year
Week 10: Shareholder’s Equity and Dividends
Balance in retained earnings Accumulated income from the previous year less the dividends paid out of stockholders. Positive balance in the retained
earnings indicate that the company has earnings that can be reinvested back
Non-controlling interest
Possible reason for change in
Share Capital balance
Possible reasons for share
buybacks
Return on Equity
Book Value
Shareholder’s Equity
Retained Earnings = Beg Retained Earnings + Net Income/Loss – Cash Dividends – Stock Dividends
Retained earnings alone is not sufficient to determine the profitability of the company. The company may have issued more
dividends, resulting in fall of retained earnings hence you will require net income as well
The amount of equity investment made by shareholders in the subsidiaries that are owned directly or indirectly by a parent
As defined, NCI is EQUITY of the subsidiary in order for the NCI to have an negative effect, the equity of the subsidiary
must be negative. Equity consists of Share Capital, Retained Earnings and Other Reserves.
Share Capital can never be negative and Retained Earnings belongs to the parent company and hence these 2 components
have no effect on the reduction of NCI.
However, fair value reserves (other reserves) may result in a negative equity due to a huge net loss by the subsidiary
company and hence causing NCI to decrease.
Share buyback
- Cancelled immediately: This share buyback has an effect of reducing outstanding shares. In order to retire stock,
the company must first buyback the shares and then cancel them. Shares cannot be reissued on the market, and are
considered to have no financial value. They are null and void of ownership in the company
o Dr Share Capital
o Cr Cash
- Treasury shares: Company’s shares purchased from the market and not cancelled. It does not have an effect on
share capital unless it is sold back to the market
o Dr Treasury Shares
o Cr Cash
1. To increase Earnings Per Share by reducing the number of shares of stocks outstanding
o EPS: Net Income/Average number of shares outstanding
2. To return cash to shareholders
3. To reduce cash needed to pay future dividends
Net Income/Average Equity
Total Shareholder’s Equity/Number of Ordinary Share
Share Capital + Retained Earnings – Treasury Shares
Market Value Price at which assets or security can be sold in market calculated based on tangible and intangible assets the company
assets
Book Value Value recorded in the books of a firm for any assets calculated based on tangible and intangible assets present in the
company
Reasons why MV>BV 1. Investors have high confidence in the company’s abilities to generate revenue growth and earnings growth
2. Assets and Liabilities measured using different attributes
o PPE: Historical Cost or Revaluation
o Inventory: Lower of cost or NRV
o FVPL: Measured at Fair Value
Week 12: Financial Statement Analysis
Cash conversion cycle Receivable collection period + Inventory holding period – Payable outstanding period
Receivable collection period 365/Receivable Turnover Ratio
Accounts Receivable Net Sales/Average AR
Turnover
Gross profit margin Revenue – COGS/Revenue
Inventory holding period 365/Inventory turnover ratio
Inventory turnover Cost of goods sold/Average Inventory
Payable outstanding period 365/Payable turnover ratio
Accounts payable turnover Supplier Purchases/Average AP
Current ratio Current assets/Current liabilities
- Measure of liquidity
- Measure company’s ability to pay back its short term liabilities with its current assets
- Ratio <1: company’s debts due in a year or less > its assets
- Higher the current ratio, the more capable a company is of paying its obligations
o Has a larger proportion of short term asset value relative to the value of its short term liabilities
o Indicates high capability of company to pay off debts
o Indicate strong liquidity position
Limitations of current ratio Current ratio is not a good liquidity indicator when:
- The increase in current assets is mainly contributed by the increase in cash

To prove that the company has a strong liquidity position, it has to show that it is able to generate sustainable cash flows
from its core operating activities
Recapitalisation exercise When a company changes its debt to equity ratio in its capital structure