Module 6 – The Accounting System: Concepts and Applications

Can you think of more examples of assets? How does each of these examples meet the definition
of assets?
Cash is one very important asset that any business must have. Cash is something of value that the
business uses to operate. Others will include motor vehicles, furniture and fixtures, plant and
machinery. These are all fixed assets which the business uses to operate and earn revenue.

Why are at least two effects of each transaction recorded in a business’s accounting system?
A business’s accounting system is designed so that two effects of each transaction are recorded
in order to maintain the equality of the accounting equation. Under the dual effect of
transactions, recording a transaction involves at least two changes in the assets, liabilities and
owner’s equity of a business.

What are revenues and expenses, and how is the accounting equation expanded to record these
items?
Revenues are the amounts earned by a business charging customers for goods or services
provided during an accounting period. Expenses are the costs of providing the goods or services
during the period. Net income is the excess of revenues over expenses for the period. The
accounting equation is expanded as follows to record revenues and expenses: Assets = Liabilities
+ [Owner’s capital + (Revenues – Expenses)].

Is it possible to prepare basic financial reports for a business from the running totals of the
accounting equation?
We use the totals for revenue and expenses in the owner’s equity section of the equation to
calculate net income. We use the totals in the assets section to find total assets and relate this to
total liabilities plus owner’s equity total after adding or subtracting the net income (profit) or
loss.

What are the monetary unit and historical cost concepts? How do they affect the recording of
transactions?
The monetary unit concept means that transactions are recorded in terms of money. The
historical cost concept states that a business records its transactions based on the monetary value
exchanged (the cost) at the time the transaction occurred and that the business’s accounting
records continue to show the cost, regardless of whether the value has changed over time. So
transactions are recorded in monetary terms based on the cost exchanged at the time of the
transaction.
Define liabilities. Give two examples.
Liabilities are the economic obligations (debts) of a business. Examples include bank overdrafts,
accounts payable, salaries payable, notes payable and mortgage payable.

Define owner’s equity. What items affect owner’s equity positively? What
items affect owner’s equity negatively?
Owner’s equity comprises the capital that the owner has invested into the business. It is what the
business is worth to the owner.
Profits made will increase owner’s equity and will further injections of capital. Losses made will
decrease owner’s equity as will any drawings that the owner takes from the business.

What is meant by the dual effect of transactions? How does it relate to the accounting equation?
The meaning of the dual effect of transactions is that when each transaction of a business is
recorded, at least two changes must be made in the assets, liabilities or owner’s equity of the
business in order to keep the accounting equation in balance.

What is accrual accounting, and why is it important?

When a business uses accrual accounting, the business records its revenue and related expense
transactions in the same accounting period that it provides goods or services, regardless of
whether it receives or pays cash in that period. Accrual accounting is important because it makes
accounting information helpful to external users by not letting cash receipts and cash payments
distort a business’s net income.

The financial balances for Steve’s Car Rentals on 31st May, 2019 are provided below in a table
in accounting equation format. You are required to:
a draw up the table and list the balances for May
b record the effects of each of the transactions listed. Show the total of each column
after each transaction to ensure the accounting equation balances.
c calculate the profit or loss made by comparing revenues with expenses.

Asset = Liabilities + Equity

Transactions for the month of May:
- Collected $2800 of accounts receivable. +$2800 cash and -$2800 accounts receivable
- Billed customers for services performed on credit $13 700. +$13700 accounts receivable
and +$13700 equity (revenue)
- Paid $1200 of accounts payable. -$1200 cash and -$1200 accounts payable
- Purchased supplies worth $700 on credit. +$700 supplies and +$700 accounts payable
- Purchased another motor vehicle for $21 000. Paid $1000 in cash and borrowed the rest
as a loan. +$21000 motor vehicle, -$1000 cash and $20000 loan payable
- Steve withdrew $650 in cash. -$650 cash and -$650 equity
- Received $3900 cash for services performed. +$3900 cash and +3900 equity (revenue)
- Paid wages $1500 and advertising $200 in cash. -$1700 cash and -$1700 equity
(expenses)
- Recorded supplies used of $600. -$600 supplies and -$600 equity (expense)
Steve's Car Rentals
Cash at Accounts Office Motor Accounts Loan
Supplies Equity
Bank Receivable Equipment Vehicle Payable Payable
Balances 12000 13800 1800 93700 200 3000 13500 105000
i 2800 2800
ii 13700 13700
iii 1200 1200
iv 700 700
v 1000 2100 20000
0
vi 650 650
vii 3900 3900
viii 1700 1700
ix 600 600
x 235 235
14150 24700 1800 114700 300 2500 33735 119415
155650 155650
- Recorded interest on loan $235. +$235 loan payable and -$235 equity (expense)
c. Profit = Revenue – Expenses
Revenue
Services Revenue 17600
less Expenses
Wages 1500
Advertising 200
Supplies Expense 600
Interest on Loan 235 2535
PROFIT 15065

Module 7 – Managing and reporting working capital

What is a bank reconciliation, and what are the causes of the difference between a business’s
cash balance in its accounting records and its cash balance on its bank statement?
A bank reconciliation is an analysis that a business uses to resolve the difference between the
cash balance in its accounting records and the cash balance reported by the bank on its bank
statement. The causes of the difference are deposits in transit, outstanding payments/cheques,
deposits made directly by the bank, charges made directly by the bank and errors.

Why does a business need to manage its working capital?

A business manages its working capital because it wants to keep the right amount on hand to
finance its day-to-day operating activities plus an extra amount in case something unexpected
happens, such as an opportunity to buy inventory at a reduced price or when a customer
doesn’t pay its account when expected.

Briefly discuss the controls over inventory.

There are three controls over inventory:
 First, a business should control the ordering and acceptance of inventory deliveries.
 Second, a business should establish physical controls over inventory while it is being
held for sale.
 Third, a business should periodically take a physical count of its inventory.

Module 8 – The Income Statement

Identify the parts and subsections of a retail business’s classified income statement. What is
included in each part?
A retail business’s classified income statement has two parts: an operating income section
and another items section. The operating income section has three sub-sections:
 revenues
 cost of goods sold
  operating expenses.
The operating income section includes all the revenues earned and expenses incurred in the
primary operating activities of the business. The other items section includes any revenues
and expenses not directly related to the primary operations of the business.

When do businesses normally recognise and record (a) revenues and (b) expenses?
Under the accrual system, when they are accrued. Revenue and expenses are recognised in
the period that they are incurred, regardless of whether cash has been received or paid.

What is the link between the income statement and the statement of owner’s equity?
The net profit or loss that is calculated in the income statement is transferred to the owner’s
equity statement as the owners are the recipients of all profits and must also bear all losses.

What is ratio analysis and what is it used for?

Ratio analysis consists of computations in which an item on a business’s financial statements
is divided by another related item. Ratio analysis is used to compare a business’s current
operating performance with previous periods or with other businesses.

Explain how to calculate a business’s profit margin. What is this ratio used for?
A business’s profit margin is computed by dividing its net income by its net sales. The profit
margin is used to evaluate how well a business is doing in controlling its expenses in relation
to its sales.

Explain what is included in a business’s statement of changes in owner’s equity and how the
statement is used.
A business’s statement of changes in owner’s equity summarises the transactions that
affected owner’s equity during the accounting period. The statement starts with the owner’s
beginning capital balance, to which any additional investments and net income are added.
Any withdrawals are subtracted to determine the owner’s capital balance at the end of the
accounting period. External users use this information to evaluate the changes in the claims
on the business’s assets, which have an impact on its risk, operating capability and financial
flexibility.

State whether you think a business would recognise the following as revenue. When would it
be recognised?
a Cash sale by business $20 000
b Sale of excess equipment by a restaurant $350
c Hairdressing services for which clients paid cash $120
d Sale of goods on credit by a retailer $180
e A printer received deposit on an order to print stationery for a client $200
f A real estate business receives commission on advance of a sale of a house $3000.
a) Yes, would be recognised as revenue in the period the sale was made.
b) Yes, profit on the sale would be recognised in the period the sale was made.
c) Yes, would be recognised as revenue in the period the service was delivered.
d) Yes, would be recognised as revenue in the period the sale was made.
e) No, would be recognised as unearned revenue until the service is performed.
f) No, would be recognised as unearned revenue and held in trust until the sale settles.

Module 9 – The Balance Sheet

Why is it important to classify assets and liabilities into groups when preparing a balance
sheet?
Current assets are cash and other assets that a business expects to convert into cash, sell or
use up within one year. Current assets include cash, marketable securities, receivables,
inventory and prepaid items. Non-current assets are assets other than current assets; these
include items such as long-term investments, and property and equipment. Current liabilities
are obligations that a business expects to pay within one year by using current assets. They
include accounts payable and salaries payable, unearned revenues and short-term notes (and
interest) payable. Non-current liabilities are obligations that a business does not expect to pay
within the next year, and include items such as long-term notes payable, mortgages payable
and bonds payable.

Explain the meaning of the term ‘current assets’.

Current assets are those assets that will be converted to cash quickly i.e. in the current
accounting period which is normally 1 year.

Explain how to calculate the debt ratio and what it is used for.
The debt ratio is computed by dividing the total liabilities by the total assets. It is used to
show the percentage of assets contributed by creditors, as a measure of a business’s financial
flexibility.

Module 10 – The Cash Flow Statement

Think of additional examples of each type of transaction that causes cash inflows. How
would each of these transactions affect the business’s accounts?
1. Decrease in assets other than cash:
 Transaction: sale of land for cash. Effect: asset land decreases and cash increases.
 Transaction: cancellation of a prepaid rental agreement. Effect: asset prepaid rent
decreases and cash increases.
  Transaction: sale of inventory or supplies for cash. Effect: asset inventory or supplies
decreases and cash increases.
2. Increase in liabilities:
 Transaction: issue a note payable in exchange for cash. Effect: liability note payable
increases and cash increases.
 Transaction: issue of debentures for cash. Effect: liability debenture payable
increases and cash increases.
3. Increase in owner’s equity:
 Transaction: issue of shares for cash. Effect: owner’s equity increases and cash
increases.

Write out a cash flow equation that links the beginning and the ending cash balances.
The equation of cash flows that links the beginning and ending cash balances is as follows:
Beginning cash balance + Cash inflows – Cash outflows = Ending cash balance

Identify the three sections of a business’s cash flow statement and briefly
explain what is included in each section.
The three sections of a business’s cash flow statement are:
 cash flows from operating activities – includes cash inflows and outflows from the
primary activities of buying, selling and delivering goods for sale, as well as from
providing services. The cash flows also include those from the activities that support
the primary activities, such as administrative activities
 cash flows from investing activities – includes cash inflows and outflows from
lending money and collecting on the loans, investing in other businesses, and buying
and selling property and equipment.
 cash flows from financing activities sections – includes cash inflows and outflows
from obtaining capital from the owner and providing the owner with a return on the
investment, as well as obtaining capital from creditors and repaying the amounts
borrowed.

Module 11 – Short-term Planning Decisions

‘If a product line is making a loss, should it be discontinued.’ Why or why not?
No, it should not necessarily be discontinued. A business determines when to drop a product
line not by whether it is making a loss but by estimating whether the costs that it would not
have to incur – that is, the avoidable costs – would be greater than the revenues that it would
not earn if production and sale of the product were discontinued. The business would also
consider the customer’s interest in the product, its safety record, the impact the product has
on the environment and other similar issues.

Suppose your friend tells you, ‘My colleague offered me $200 to rent my boat over the
weekend, but I decided that I would use it myself to go water skiing at a cost of $90.’ What
costs are involved in making this decision? Would you have rented the boat or used it
yourself? Why?
If your friend’s colleague rents the boat, the incremental revenue is $200 and there are no
incremental costs. If she takes the boat and goes skiing herself, then she will have no
incremental revenue but incremental costs of $90. Financially, I would rent the boat to the
colleague as it saves me $90 and earns me $200. But there might be other non-financial
reasons for me taking the boat myself – for example, best friend is here for a visit and wants
to go, or might need to go skiing to de-stress.

What is a make or buy decision and what must be considered in the decision?
This is the decision of whether to purchase parts or a product from an outside supplier, or
whether to manufacture the parts or product internally. If the business has to purchase the
equipment required to manufacture the item, or must develop the skills to manufacture the
item, this may make it more costly to manufacture the item. If the business has unused
manufacturing capacity, it may be better to produce the item internally. The business must
consider how the decision will impact other business relationships. The quality and reliability
of the outside parts supplier must be considered. Finally, the relevant costs must be
considered.

Module 12 – Trends and Issues in Accounting

What is meant by corporate social responsibility (CSR)?
Corporate social responsibility (CSR) calls into question the role of business in facilitating
environmental and social change. A business’s social licence to operate is underpinned by the
strength of its engagement with social, community and environmental issues.