Comprehension questions

6.5 Explain  whether  the  following  statements true or false for an entity using the accrual method of accounting.

a. Statements of profit or loss are used only by investors.

b. Revenue from sales is included in the statement of profit or loss when it is received, not when it is earned.

c. At the end of the reporting period, prepaid expenses need to be included in the profit or loss determination.

d. At the end of the reporting period, revenue not received for services not yet provided needs to be included in the profit or loss determination.

a. Statements of profit or loss are used only by investors.

False. Internal users such as management also need the statement of profit or loss to assess the profitability of their investment decisions and the appropriateness of their financing decisions. Further, there are external users other than investors who use the information.

b. Revenue from sales is included in the statement of profit or loss when it is received, not when it is earned.

False. Since financial statements are prepared on the basis of accrual accounting rather than cash accounting, it is not necessary for cash to have been received for an item to be recognised as sales revenue. Under accrual accounting, revenue from sales is recognised when it is earned.

c. At the end of the reporting period, prepaid expenses need to be included in the profit or loss determination.

False. Based on the accrual basis of accounting, all expenses incurred in the reporting period are recognised in the statement of profit or loss. Expenses prepaid at balance date should not be included as an expense. They are an asset as the future benefit is still to be derived.

d. At the end of the reporting period, revenue not received for services not yet provided needs to be included from the profit or loss determination.

False. Under the accrual accounting, revenue should be recognised when the earning process is complete. If the services have not been rendered or provided, irrespective of the cash being received, the earnings process is incomplete and the revenue should not be recognised in the current period.

6.7 Explain why an entity should depreciate items.

Depreciation is the allocation of the cost of an asset over its useful life and represents the future economic benefits of the depreciable assets that have contributed to earning income in the period. Depreciation reduces the value of the asset in the statement of financial position and consequently decreases the equity during the reporting period.

Exercises

6.16 Consider each of the following transactions and examine whether they satisfy the income definition criteria using the accrual method of accounting.

a. Received cash for services to be provided in the next reporting period. b. Borrowed money from a bank.

c. Credit sale of goods.

d. Received cash for goods sold.

e. Owner contributed cash to fund a new product line.

f. Received a grant from a government body to assist with an export program.

To satisfy the income definition criteria there must be:

日 an increase in economic benefits during the reporting period via an increase in assets or reduction in liabilities

日 resulting in an increase in equity

日 which must not be related to contributions from equity participants (i.e. owners).

a. Received cash for services to be provided in the next reporting period

This does not satisfy the income definition, because the services have not been provided. There is an increase in assets (i.e. cash), but there is no increase in equity. Rather, the corresponding entry is an increase in liabilities in the form of unearned revenue. Therefore, revenue received in advance is not recognised as income in the current reporting period.

b. Borrowed money from a bank

This does not satisfy the income definition, because although there is an increase in economic benefits through an increase in assets (cash), there is no increase in equity. Instead, the increase in assets results in the increase of liabilities (bank loan).

c. Credit sale of goods

This satisfies the income definition, because it results in increase in an entity’s assets (its accounts receivable) that increases equity and does not relate to contributions from equity participants.

d. Received cash for goods sold

This satisfies the income definition, because it results in increase in an entity’s assets (cash) that increases equity and does not relate to contributions from equity participants (i.e. the cash is from customers).

e. Owner contributed cash to fund a new product line

This does not satisfy the income definition, because although there is an increase in economic benefits through an increase in assets (cash) that increases equity, the cash injection relates to contributions from equity participants (i.e. owner).

f. Received a grant from a government body to assist with an export program

This satisfies the income definition, because unlike a loan, a grant results in an increase in assets but no change in liabilities. This presumes that the grant is received in the period in which the export program is conducted. Consequently, there will be an increase in equity. Accounting standards require that government grants must be recognised as income, on a systematic basis over the periods necessary to match them with the related costs which they are intended to compensate.

6.17 Consider each of the following transactions and examine whether they satisfy the expense definition criteria under the accrual method of accounting. a. Paid salaries owing from the previous reporting period.

b. Owner withdrew money to purchase a motor vehicle for private use. c. Money owed to Optus for internet charges this reporting period.

d. Office equipment is depreciated.

e. Paid shareholders a dividend.

f. Purchased a digital system  to computerise the inventory records.

To satisfy the expense definition there must be:

日 a decrease in economic benefits during the reporting period via a decrease in assets or an increase of liabilities

日 resulting in a decrease in equity

日 which must not be related to distributions to equity participants (i.e. owners).

a. Paid salaries owing from the previous reporting period.

This does not satisfy the expense definition. Although there is a decrease in economic benefits via a decrease in assets (cash), there is no corresponding decrease in equity. Rather, the decrease in assets is offset by a reduction in liabilities (accrued salaries/salaries payable). Under accrual accounting, an expense would have been recognised through an adjusting entry in the previous reporting period when it is incurred (i.e. in the previous period, salaries expense would have been increased and salaries payable would have been increased).

b. Owner withdrew money to purchase a motor vehicle for private use.

This does not satisfy the expense definition, because it relates to a distribution to equity participants (the owner) in the form of owner’s withdrawal of money.

c. Money owed to Optus for internet charges this reporting period.

This satisfies the expense definition, because the phone has been used in the period and there is an obligation for the entity to pay Optus in the future. Thus, there is a decrease in economic benefits for the entity via an increase in liabilities (accrued internet expense) which decreases equity, and payment for the internet charges does not relate to distributions to equity participants.

d. Office equipment is depreciated.

The carrying amount (book value) (which is the dollar value assigned to the asset in the statement of financial position) of the asset must be allocated over the asset’s useful life, representing future economic benefits of the asset that have been consumed during the reporting period. This allocation is known as depreciation and it meets the definition of an expense. Depreciation results in a decrease in economic benefits in the form of decrease in asset (e.g. carrying amount of office equipment) which decreases equity, and the loss does not relate to distribution to equity participants.

e. Paid shareholders a dividend.

This does not satisfy the expense definition. Although there has been a decrease in economic benefits via the reduction of cash at bank, and a decrease in equity, an expense must not be a distribution to the owners.

f. Purchased a digital system to computerise the inventory records.

This does not satisfy the expense definition because the purchase can be treated as an investment in a fixed asset. As such, the decrease in cash is offset by the increase in non- current assets. Overall, equity remains the same.

6.19     Solve the missing items for each independent case. The cost of sales is 50 per cent of sales revenue for each case.

General formula:

Profit = Sales revenue – (Cost of sales + Other expenses), where cost of sales is 50 per cent of sales revenue

Total assets = Total liabilities + Share capital + Retained earnings

a)   Cost of sales = 50% * 90 000 = 45 000

b)  Other expenses = 90 000 – 45 000 – X = 20 000 where solving for X gives 25 000 c)   Total assets = 294 500 + 125 000 + 12 500 = 432 000

d)   Sales revenue = 51 000 * (100/50) = 102 000

e)   Other expenses = 102 000 – 51 000 – X = 19 000 where solving for X gives 32 000

f)   Total liabilities = 310 500 – (112 500 + 100 500) = 97 500

g)  Cost of sales = 50% * 102 250 = 51 125

h)  Profit = 102 250 – (51 125 + 57 500) = –6 375

i)   Retained earnings = 90 000 – 37 500 – 40 000 = 12 500

j)   Cost of sales = 50% * 437 500 = 218 750

k)  Other expenses = 437 500 – 218 750 – X = 47 500 where solving for X gives 171 250

l)   Share capital = 322 500 – 225 000 – 25 000 = 72 500

m) Sales revenue = 33 000 * (100/50) = 66 000

n)  Profit = 110 000 – 33 000 – 16 000 = 61 000

o)  Total assets = 93 000 + 200 000 + 14 500 = 307 500