Professional Documents
Culture Documents
Unit 2
BAC 501
COURSE TEAM
Course Team Coordinator: Dr. Teoh Ai Ping Content Writers: IGNOU Course Team Content Adapters: Dr. Wong Thian Soon, Dr. Teoh Ai Ping and Mr. Loo Choo Hong Course Team Members: Professor Dr. Ng Wai Kong and Professor Dr. Madhulika Kaushik
COURSE COORDINATOR
Mr. Ravindran A/L Raman
PRODUCTION
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Wawasan Open University is Malaysias first private not-for-profit tertiary institution dedicated to adult learners. It is funded by the Wawasan Education Foundation, a tax-exempt entity established by the Malaysian Peoples Movement Party and supported by the Yeap Chor Ee Charitable and Endowment Trusts, other charities, corporations and members of the public.
Indira Gandhi National Open University, 2002 All rights reserved. No part of this work may be reproduced in any form, by mimeograph or any other means, without permission in writing from Indira Gandhi National Open University. Further information on the Indira Gandhi National Open University courses may be obtained from the Universitys Office at Maidan Garni, New Delhi 110 068.
UNIT 2 D
Understanding financial statements
Contents
Unit 2 Understanding Financial Statements
Overview Objectives 4 Construction and analysis of statement of financial position
Objectives Introduction 4.1 Conceptual basis of a statement of financial position 4.2 Constructing a statement of financial position 4.3 Statement of financial position contents 4.4 Form and classification of items Keywords Suggested answers to activities Suggested answers to self-assessment exercises 1 1
3 3 3
9 13 14 29 30 34
37
37 37 37
39 44 48
5.5 Methods of depreciation 5.6 Form of statement of comprehensive income 5.7 Cost of goods sold 5.8 Methods of inventory valuation 5.9 Gross profit 5.10 Operating profit 5.11 Net profit Keywords Suggested answers to activities Suggested answers to self-assessment exercises
52 58 61 62 65 67 68 72 72 74
75
75 75 76 81 83 86 87 89 93 94 96
UNIT 2 F
Understanding financial statements
Summary of Unit 2
UNIT 2 1
Understanding financial statements
Overview
he main purpose of accounting is to provide useful information for better decision making. After all business transactions are identified, analysed and recorded, financial reports are prepared for the internal and external users. These reports are the end product of the accounting process and are known as the financial statements. Unit 2 aims to expose you to the basics of financial statements such as the statement of financial position, the statement of comprehensive income, the fund flow and statement of cash flows. This unit consists of three sections, being section 4, section 5 and section 6. Section 4 introduces you to the statement of financial position as well as how to construct and analyse a statement of financial position. Section 5 discusses the preparation and analysis of the statement of comprehensive income. In Section 6, you will explore the statement of cash flow and how to interpret it.
Objectives
By the end of this unit, you should be able to: 1. Explain the content of a statement of financial position. 2. Prepare a statement of financial position. 3. Discuss the measurement of income. 4. Prepare an statement of comprehensive income. 5. Prepare the statement of cash flow. 6. Interpret the statement of cash flow.
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Understanding financial statements
Introduction
One of the basic objectives of accounting is to convey information. This is achieved by different accounting reports prepared by an entity. One of the most important reports is the statement of financial position. Statement of financial position is concerned with reporting the financial position of an entity at a particular point in time. This position is conveyed in terms of listing all the things of value owned by the entity and also the claims against these things of value. The position as represented by the statement of financial position is valid only until another transaction is carried out by the entity.
______________________________________________________________________ Things of value owned by me Amount owned by me ______________________________________________________________________ RM Balance with bank Fixed deposits Other personal belonging 350,000 150,000 500,000 __________ Personal loan from friend RM 100,000 __________
1,000,000 100,000 __________ __________ ______________________________________________________________________ This implies that I own RM1,000,000 worth of things of value, of which RM350,000 of this could be withdrawn at any time in cash. I have RM350,000 in liquid form. Another RM150,000 is in monetary investment and the remaining RM500,000 is in non-monetary property. Furthermore, I owe RM100,000 to a friend of mine. In other words, he has a claim against the things of value owned by me to the extent of RM100,000. In brief, I can say that I am worth RM1,000,000, claim against my worth of RM100,000 and hence my net worth is RM900,000. This implies that RM900,000 is my own claim against the things of value owned by me or my net worth. Now I can present my financial position in the following form: Financial position statement 1 ______________________________________________________________________ Things of value owned Claims against things of value ______________________________________________________________________ RM Balance with bank Fixed deposits Other personal belongings 350,000 150,000 500,000 __________ Personal loan from friend Own claim or net worth RM 100,000 900,000 __________
1,000,000 1,000,000 __________ __________ ______________________________________________________________________ Now the bank grants me the loan of RM500,000 and I buy the car for RM800,000. After the purchase of the car, my financial position statement will change as follows: Financial position statement 2 ______________________________________________________________________ Things of value owned Claims against things of value ______________________________________________________________________ RM Balance with bank 50,000 Personal loan from friend RM 100,000
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Understanding financial statements
1,500,000 1,500,000 __________ __________ ______________________________________________________________________ Now, as a result of this transaction, my worth has increased from RM1,000,000 to RM1,500,000. However, since there is also an equal increase in claims against my worth in the form of mortgage loan from the bank, my net worth remains the same. Things of monetary value possessed by an entity are referred to as assets. Accountants use the term assets to describe things of value measurable in monetary terms. The amount owed by an entity or individual which represents claims against it or his/her assets by outsiders are liabilities. It is the claims of outsiders which are legally enforceable claims against an individual or entity that are referred to as liabilities. The assets owned by the entity, less liabilities or outsiders claims, is the net worth. Since the net worth represents the claims of owner(s) in case of an entity, it is referred to as owners equity. Now we can understand that the position statement is a summary of the assets, liabilities and net worth as of a specific point in time. A comparison of the two position statements before and after the purchase of the car will help to clarify some of these ideas better. Comparative financial position statement ______________________________________________________________________ Assets Before I Balance with bank 350,000 Fixed deposits 150,000 Car Other personal belongings 500,000 _________ After II Liabilities and net worth Before After I II Personal loan from friend 100,000 Mortgage loan from bank Net worth 900,000 _________
The following points may be noted from the above example: 1. Even after purchasing the car, my net worth remains the same. This is due to the fact that the increase in assets of RM500,000 was balanced by the increase in liability of RM500,000. However, it could be noticed that the RM300,000 spent from my savings amount to only a transformation of my assets from bank deposit to car. 2. Outsiders claim has priority over the owners claim on the assets and hence the net worth or owners equity is a residual claim against assets. It follows from this that at any point in time, owners equity and liabilities for any accounting entity will be equal to assets owned by that entity. This idea is fundamental to accounting and could be expressed as the following equalities: ASSETS = LIABILITIES + OWNERS EQUITY OWNERS EQUITY = ASSETS LIABILITIES (1) (2)
It could easily be visualised that the position statements we prepared are nothing but the equality (1). In simple terms, a position statement which shows the balance between assets owned by an entity and its liabilities and owners equity is referred to as a statement of financial position. Our position statements were based on a personal situation and a single transaction. In a business situation, there can be scores of such transactions. However, these impacts could be reflected on the fundamental equality in the same way. This equation represents the corner-stone on which the accounting edifice is built. It shows the duality represented by `benefit-sacrifice from the point of view of an entity. In other words, assets of an entity, are always equal to the claims of the outsiders and owners. This equality enables us to reduce the impact of all transactions in terms of the following possibilities:
1. An increase in assets is followed by an increase in liabilities and/or equity and vice versa. 2. A decrease in assets is followed by a decrease in liabilities and/or equity and vice versa. 3. An increase in an asset is followed by a decrease in another asset and vice versa. 4. An increase in a liability is followed by a decrease in another liability and vice versa.
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Understanding financial statements
Activity 2.1
Please answer by filling in the blanks. 1. An increase in assets in a position statement is possible: a)___________________________________________________________ b)___________________________________________________________ c)___________________________________________________________
Activity 2.2
Mark whether the following statements are True or False by circling T or F opposite each statement. 1. An increase in assets always results in increase in owners equity. T/F
T/F
T/F
T/F
T/F
6. All assets in the statement of financial position are valued at their realisable realisable value. T/F
Activity 2.3
Answer the following questions by filling in the boxes with figures or words. 1. The fundamental accounting equation could be written as: = +
2. Assets
3. Owners equity
4. Liabilities
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Understanding financial statements
Cash RM200,000 Owners equity RM200,000 ______________________________________________________________________ On January 2, the store purchases a shop for RM500,000 paying RM100,000 cash and signing a mortgage for RM400,000. This transaction changes the statement of financial position as on January 2, as follows: 1. Cash is reduced by RM100,000 on account of payment for the shop premises, hence cash balance is RM100,000. 2. A new shop worth RM500,000, is acquired as an asset. 3. A new liability (mortgage on the shop) is contracted in the amount of RM400,000. 4. Owners equity = Total assets Liabilities = RM600,000 RM400,000 = RM200,000.
That is, there is no change in the owners equity since increase in an asset is followed by an increase in liability. Thus, the new statement of financial position will be as follows: Ramstore Statement of financial position as at January 2, 2008 ______________________________________________________________________ Assets RM Cash Shop premises 100,000 500,000 _________ Mortgage on shop Owners equity Liabilities and owners equity RM 400,000 200,000 _________
600,000 600,000 _________ _________ ______________________________________________________________________ On January 3, the store purchased RM50,000 worth of merchandise on cash and RM150,000 worth of merchandise on credit from Encik Abdul. The impact of these transactions is that the assets in the form of merchandise increase by RM200,000. These assets are intended for resale and hence have a short life span. However, part of this increase is accounted by the decrease in another asset, cash. The other RM 150,000 increase is accounted by the liability owed to Abdul. The amounts payable on account of purchases of merchandise are called accounts payable or sundry creditors. Usually these are short duration liabilities to be paid at the end of the normal credit period. The statement of financial position on January 3, 2008 reflects the position of the business after these transactions. Ramstore Statement of financial position as at January 3, 2008 ______________________________________________________________________ Assets RM Cash Merchandise inventory Shop premises 50,000 200,000 500,000 _________ Accounts payable Mortgage on shop Owners equity Liabilities and owners equity RM 150,000 400,000 200,000 _________
750,000 750,000 _________ _________ ______________________________________________________________________ On January 4, he sells half the merchandise inventory (that is RM100,000 worth inventory) for RM150,000 cash. Apparently, this transaction shows the transformation of an asset into another asset at a higher monetary value. This is yet another basis of economic transaction where business profits are earned in the process of exchange of utility differential for a monetary differential. The statement of financial position after this transaction will clarify some of the conceptual issues arising from this transaction.
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Understanding financial statements
Ramstore Statement of financial position as at January 4, 2008 ______________________________________________________________________ Assets RM Cash Merchandise inventory Shop premises 200,000 100,000 500,000 _________ Accounts payable Mortgage on shop Owners equity Liabilities and owners equity RM 150,000 400,000 250,000 _________
800,000 800,000 _________ _________ ______________________________________________________________________ Please note the change in the owners equity figure. Ever since we started following the transactions of Ramstore, the owners equity figure has changed. How did this come about? The answer is simple. We followed the equality of Assets Liabilities = Owners equity. Thus the increase in owners equity is the result of the increase in assets arising from the exchange of merchandise inventory for cash at a higher monetary value. Thus, we find that the owners equity increases to the extent of the revenue earned over the cost of earning that revenue. In this case, the revenue earned is RM150,000 (the amount realised from sales of merchandise is usually referred to as sales revenue). The direct cost of earning that revenue was the merchandise inventory within the amount of RM100,000. We refer to this as the cost of goods sold. Another important fact should also be noted in this context. All along we represented the assets on the statement of financial position at the original cost. The unsold inventory is still valued at the original cost. This is yet another concept we follow in the preparation of statement of financial position. As a general principle, all assets are valued at their original cost. The increase in the owners equity is equal to the profit earned out of trading. Normally, it is a profitable operation which increases the owners equity. Thus, owners equity could be understood as comprising of two parts, namely, contributed capital and retained earnings. Retained earnings is the profits earned and not withdrawn by the owners. This relationship could be expressed by yet another equality: OWNERs EQUIT Y = CONTRIBUTED CAPITAL + RETAINED EARNINGS (3) The above illustration would enable us to evaluate the statement of financial position in the context of accounting concepts. The dual aspect principle has a particular relevance to statement of financial position. This is shown by the equality of assets to liabilities and owners equity.
All the figures are expressed in monetary units irrespective of its nature. In our example, we had cash, merchandise inventory and shop premises all expressed in monetary quantities. All the transactions we reflected were in respect of only the business entity, Ramstore. All the valuations were based on the assumption of a going concern, and not based on the break-up value. All the assets were based on cost as the basis of valuation.
Activity 2.4
Fill in the following blanks: 1. Statement of financial position is prepared at the end of a specified period. This period in accounting is variously referred to as: a)___________________________________________________________ b)___________________________________________________________ c)___________________________________________________________
2. Statement of financial position prepared at the end of the year summarises the balances in: a)___________________ accounts. b)___________________ accounts. c)___________________ accounts.
3. Assets on a statement of financial position are usually grouped together as: a)___________________ assets. b)___________________ assets. c)___________________ assets.
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Understanding financial statements
4. Claims against the assets on the statement of financial position are summarised as: a)___________________ liabilities. b)___________________ liabilities. c)___________________ equity.
Long term liabilities Merchandise inventory Prepaid expense Total current assets Property, plant & equipment Land Buildings, plant Less: Accumulated depreciation 3,000 2,000 1,100 500 _______ 3,500 10% debentures Secured long-term loan Total liabilities Shareholders equity 9% cumulative preference shares of RM100 each Ordinary shares of RM10 each Capital reserves Reserves & surplus 1,000 2,000 _______ 6,000
1,000 _______
2,000
10,000 Total liabilities and 10,000 _______ _______ shareholders equity ______________________________________________________________________
Table 2.1 Statement of financial position of Syarikat Ramsons
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Understanding financial statements
Current assets
Current assets are assets which will normally be converted into cash within a year or within the operating cycle. The operating cycle is the duration in time taken by a unit of cash to circulate through the business operations. For example, in a simple trading operation, we use cash to buy merchandise and we sell it to recover cash. The operating cycle in such a situation will consist of the period for which cash, merchandise inventory and receivable are held. The cycle starts with cash and ends with the collection of cash. The items comprising current assets are listed in the order of their relative liquidity and hence, cash is listed first.
Cash
Cash is usually taken to include currency (legal tender), cheques or any other document that circulates as cash. Cash is usually classified as a current asset when it is available for a firms day-to-day operations. It includes cash kept in the safe and also deposit accounts with banks. If cash is specifically ear-marked for any purpose and not available for transactions, it is better classified as other assets.
Temporary investments
Whenever firms have short-term excess cash, it may be readily invested in marketable securities. These securities may include shares, debentures and government securities. These assets are readily marketable and could be sold whenever cash is required. They are classified as current assets only when these investments are held with the objective of realisation within a year. These securities are usually recorded at cost at which they are acquired. Since they are only held for short duration, their cash value should be reflected. These securities are often valued at lower of cost or market price. Apparently, the valuation rule lower of cost or market price may look contradictory. Why should one not value the securities at a higher price than cost? This distinction is made, based on the generally accepted accounting principles. We do not anticipate gains but only losses. Gains are recognised in accounting only when outside transaction takes place. This is the essence of conservatism in accounting. When the firm values its securities at cost or market price, whichever is lower, we say that the firm is conservative. That is, whenever presented with two alternatives, the firm chooses the one which shows the lower valuation of assets or higher valuation of liabilities.
Accounts receivable
Accounts receivable are amounts owed to the company by debtors. This is the reason why we also use the term sundry debtors to denote the amounts owed to the firm. This represents amounts usually arising from normal commercial transactions. In other words, accounts receivable or sundry debtors represent unpaid customer accounts. In the statement of financial position illustration, these represent amounts owed to the firm by customers on the statement of financial position date. These are also known as trade receivables, since they arise from normal trading transactions. Trade receivables arise directly from credit sales and as such, provide important information for management and outsiders. In most situations, these accounts are unsecured and have only the personal security of the customer.
It is normal that some of these accounts default and become uncollectable. These collection losses are called bad debts. It is not possible for the management to know exactly which accounts and what amount will not be collected. However, based on past experience, it is possible for the management to estimate the loss on the receivable or sundry debtors as a whole. Such estimates reduce the gross value of accounts receivable to their estimated realisable value. For instance: Accounts receivable Less: Estimated collection loss at 10% Net realisable value of accounts receivable RM750,000 75,000 ________ RM675,000 ________
The estimated collection loss is variously referred to as provision for doubtful debts, provision for bad debts or provision for collection losses. It is a common practice to refer to this as a provision instead of reserve. It is a usual practice for debts to be evidenced by formal written promises to pay or acceptance of an order to pay. These formal documentary debts represent promissory notes receivable or bills receivable. These instruments used in trade are negotiable instruments and hence enable the trader to assign any of his/her receivables to another party or a bank for realising immediate liquidity. It is also usual for accounts receivables to be pledged or assigned mostly to banks against short-term credits in the form of cash credits or overdrafts.
Inventory
In a trading firm, inventory is the merchandise held for sale to customers in the ordinary course of business. In the case of manufacturing firms, inventory would mainly consist of materials required to manufacture the products, namely, raw materials, materials remaining with the factory at various stages of completion i.e., work in process and goods ready for sale or finished goods. Apart from these, there may be inventory of stores and supplies. Thus we have raw material inventory, work in process inventory, finished goods inventory and stores and supplies inventory.
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Understanding financial statements
It is common to refer to inventory as stock-in-trade and thus we could come across stock of raw materials, stock of work in process and stock of finished goods. Inventory is usually valued on the basis of lower of cost or market price. Market price is taken to mean the cost of replacement either by purchase or by reproduction of the material in question. As a general principle, inventory is valued at cost. It implies that all normal costs incurred to make the goods available at the place where it can be sold or used are treated as costs of inventory.
In trading firms, inventory costs include freight-in, transit insurance costs, import or entry levies and also the invoice cost. Warehouse costs, handling costs, insurance costs in storage and interest costs are not included as costs. They are treated as expenses of a period of the firm. In the case of manufacturing units, valuation of inventory costs is more complex and involved. As a general rule, all costs of materials, labour and plant facilities used for manufacturing the goods are included in the valuation of inventory. In valuing inventory at lower of cost or market price, care should be taken to see that the valuation does not exceed the realisable value or selling price in the ordinary course of business.
Prepaid expenses
In many situations, as a custom, some of the items of expenses are usually paid in advance such as rent, taxes, subscriptions and insurance. The rationale of including these prepayments as current assets is that if these prepayments were not made they would require the use of cash during the period.
Fixed assets
Fixed assets are tangible, relatively long lived items owned by the business. The benefits of these assets are that they are available not only in the accounting period in which the cost is incurred but over several accounting periods. Current assets provide benefits to the organisation by their exchange into cash. In the case of fixed assets, value addition arises by facilitating the process of production or trade. In other words, benefits from fixed assets are indirect rather than direct.
All man-made things have limited life. In accounting, we are concerned with the useful life of assets. Useful life is the period for which a fixed asset could be economically used. This implies that the benefits from the fixed assets will flow to the organisation throughout its useful life. Another aspect of this is that the cost incurred in the period of purchase of the asset will be providing benefits throughout the useful life of the asset. Valuation of fixed assets is usually made on the basis of original cost. However, since the assets have limited life, the cost will be expiring with the expiration of the
life. Thus, valuation of the assets is reduced in proportionate to the expired life of the assets. Such expired cost is referred to as depreciation in accounting. We shall discuss this idea in detail in the subsequent unit. The conceptual basis could be clarified with an example. Suppose a trader buys a machine at a cost of RM1,000,000. Assume that the machine will have to be discarded as junk at the end of five years. At the time of purchase: Machine at cost At the end of first year it will be represented as: Machine at cost Less: Depreciation to date Net value At the end of second year it will be: Machine at cost Less: Depreciation to date Net value RM1,000,000 RM1,000,000 RM200,000 _____________ RM800,000 _____________ RM1,000,000 RM400,000 _____________ RM600,000 _____________
The process of providing depreciation for each year will continue. At the end of five years, the valuation of the asset will be zero. The value of the assets at cost is usually referred to as gross fixed assets and the amount of depreciation to date as accumulated depreciation. Net value of the asset is usually referred to as net fixed assets. Please note that we reckoned the amount of depreciation by equally distributing the cost of asset over its useful life. This is the simplest method of determining the annual depreciation of the assets. Thus, we can say that the annual depreciation over the useful life of the asset shall not exceed its net cost. We say net cost because the actual cost of the asset to be depreciated is its purchase cost less any salvage value at the end of its useful life. Hence, depreciable cost of the asset is the net cost which is equal to the original cost minus the salvage value. The relationship between cost and depreciation could be visualised as follows: Year 1 Depreciation RM200,000 Year 2 Depreciation Year 3 Depreciation Year 4 Depreciation Year 5 Depreciation RM200,000
Depreciation represents the cost of earning revenue in an accounting period on account of use of fixed assets. Fixed assets are valued on the basis of cost, making the asset available and ready for use. Thus, cost includes the price as well as charges for delivery, assembly and construction. Fixed assets normally include assets such as land, building, plant, machinery and motor vehicles. All these items, with the exception of land, are depreciated. Land is not subject to depreciation and hence shown separately from other fixed assets.
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Understanding financial statements
Current liabilities
We have studied that liabilities are claims of outsiders against the business. In other words, these are amounts owed by the business to people who have lent money or provided goods or services on credit. If these liabilities are due within an accounting period or the operating cycle of the business, they are classified as current liabilities. Most of such liabilities are incurred in the acquisition of materials or services forming part of the current assets. As was the case with current assets, current liabilities are also listed in the order of their relative liquidity.
Accounts payable
Accounts payable or sundry creditors are usually unsecured debts owed by the firm. These are also referred to as payables on open accounts. They are not evidenced by any formal written acceptance or promise to pay. They represent credit purchase of goods or services for which payment has not been made as on the date of the statement.
Accrued liabilities
Accrued liabilities represent expenses or obligations incurred, in the previous accounting period but the payment for the same will be made in the next period. In many cases where payments are made periodically, such as wages, rent and similar items, the last months payment may appear as accrued liabilities (especially if the practice is to pay the same on the first working day of a month). This obligation shown on the statement of financial position indicates that the firm owed the said amount on the statement of financial position date.
Contingent liabilities
Contingent liabilities should be distinguished from estimated liabilities. Estimated liabilities are known liabilities where the amount is uncertain. Contingent liabilities on the other hand, are not liabilities, as of now. They become liabilities only on the happening of a certain event. In other words, both the amount and the liability (or obligation) are uncertain until the specified event occurs in the future. These may include items like a claim against the company contested in a court. Only if the court gives an unfavourable verdict, it becomes a liability. They are not listed as liabilities in the body of the statement of financial position. However, in order to give a fair view of all known facts about the affairs of the firm, contingent liabilities are disclosed as footnotes to the statement of financial position. They are not mentioned in the statement of financial position as the firm is not liable as on that date; they are mentioned as notes to the financial statements because all those who are concerned may know that there is a possibility that the events might occur.
Long-term liabilities
Long-term liabilities are usually for more than one year. They cover almost all the liabilities not included in the current liabilities and provisions. These liabilities may be unsecured or secured. Security for long-term loans, are usually the fixed assets owned by the firm, assigned to the lender by a pledge or mortgage. All details such as interest rate, repayment commitment and nature of security are disclosed in the statement of financial position. Usually, such long-term liabilities include debentures and bonds, borrowings from financial institutions and banks.
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Understanding financial statements
Activity 2.5
Fill in the blanks: 1. As a convention, items appearing on the statement of financial position are listed in the order of their relative ________________ .
2. Statement of financial position could be presented either in: a)________________ form, or b)_______________________.
4. Temporary investments are valued in the statement of financial position by applying the principle of _______________________ .
6. Expired cost with respect to a fixed asset is referred to as _____________ __________ expense.
Activity 2.6
1. We judge an item as a current asset if it is converted into cash during the _______________________ .
3. Items classified as current assets are usually listed in the order of their relative _________________________________________ .
5. Asset losses expected from non-collection of receivables are called _____ __________________.
Capital
We have seen earlier in this unit that the fundamental accounting equality states: Assets = Liabilities + Owners equity. From the example of statement of financial position, we can easily establish this. See Ramsons statement of financial position: Total assets Total liabilities Owners equity RM10,000,000 RM6,000,000 RM4,000,000
We also know that the owners equity consists of the contributed capital and the retained earnings of the firm. If Ramsons were an individual proprietorship business, the owners equity will be reflected directly as: Capital RM4,000,000
If Ramsons were a partnership firm with four partners W, X, Y and Z, having equal shares, the capital would be represented as: Capital Partner W Partner X Partner Y Partner Z Total RM1,000,000 RM1,000,000 RM1,000,000 RM1,000,000 ______________ RM4,000,000 ______________
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Understanding financial statements
In our example, the statement of financial position was titled Syarikat Ramsons. We did not provide the detailed statement of financial position incorporating all the legal requirements in order to avoid confusion. According to the company law, the capital has to be disclosed in greater detail. This requirement could be related to the corporate legislations need for ensuring maintenance of capital or keeping the firms assets intact. This is ensured by insisting that the distribution by way of dividends to shareholders is made only out of accumulated earnings. According to the legal requirements, the owners equity section of a companys statement of financial position is divided into two parts: (1) The share capital representing contributed capital, and (2) Reserves and surplus representing retained earnings. The contributed capital is the amount paid by shareholders. Share capital is the joint stock predetermined by the company at the time of registration. It may consist of either ordinary share capital or preference share capital (having preferential right to fixed dividend and repayment of capital at the time of liquidation), or both. This share capital stock is divided into units or shares. Thus, if the company decides to have a share capital, it could be either ordinary shares alone or ordinary and preference shares. A company has an authorised share capital of RM200,000, divided into 15,000 ordinary shares of RM10 each and 500 10% cumulative preference shares of RM100 each. This will be represented as: Authorised capital: 15,000 ordinary shares of RM10 each 500 10% cumulative preference shares of RM100 each Total RM150,000 RM50,000 ___________ RM200,000 ___________
The company need not raise the entire amount of the predetermined or authorised capital. That portion of the authorised capital which has been issued for subscription is referred to as issued capital. Suppose the company offered to the public 7500 ordinary shares and 500 preference shares for cash which were fully subscribed and paid up. The share capital of the company in summary will be: Authorised capital: 15,000 ordinary shares of RM10 each 500 10% cumulative preference shares of RM100 each RM150,000 50,000 ___________ RM200,000 ___________
Issued capital 7,500 ordinary shares of RM10 each 500 10% cumulative preference shares of RM100 each RM75,000 50,000 ___________ RM125,000 ___________
Subscribed, called up and paid up 7,500 ordinary shares of RM10 each 500 10% cumulative preference shares of RM100 each RM75,000 50,000 ___________ RM125,000 ___________
In the above example, even though the company was authorised to issue 15,000 ordinary shares, it needed only part of the capital and hence choose to issue only one half of the total authorised ordinary shares. The implication of authorised capital is that it is the maximum amount of capital a company may raise without altering the Memorandum of Association.
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Understanding financial statements
it has no retained earnings. If it earns say, RM10,000 profit in the first year and decides to distribute RM5,000 as dividends, the reserves and surplus at the end of the year will be RM5,000. During its second year of operation, if the firm makes a loss of RM3,000, then the retained earnings at the end of the year will be RM2,000. Retained earnings (or reserves and surplus) are in the nature of earned capital for the firm. We have seen earlier that the dividends are limited to retained earnings. This implies that, at no point in time, the original capital of the firm is depleted. In other words, the capital originally contributed is maintained intact. The Companies Act 1965 allows companies to distribute dividends from revenue reserves i.e. reserves accumulated from earnings over the years.
Activity 2.7
Fill in the blanks with the correct word(s). 1. Statement of financial position is a statement of ___________________ .
5. Amounts owed by a business on account of purchase of inventory are usually called ______________________ or ______________________ .
6. Amounts receivable by a firm against credit sales are usually called _____ _____________ or _________________.
7. As a general rule, all assets are valued at their _________________ to the business.
8. Owners equity could be understood as comprising two parts: ________ ____________________ and _________________________ .
10. All valuations in a statement of financial position are based on the assumption about the entity as a _____________________________ .
Summary
Statement of financial position as we have seen is one of the most important financial statements. It is a periodic summary of the position of the business. It is the statement of assets, liabilities and owners capital as of a particular point in time. This statement in itself does not reveal anything about the details of operations of the business. However, a comparison of two statement of financial positions could reveal the changes in the business position. A realistic understanding of the operations of the business would require two other statements Statement of comprehensive income and Statement of cash flow. We shall discuss them in subsequent sections.
Self-assessment exercises
l. Explain the following terms giving examples: Accounts receivable Inventory Current liabilities Reserves and surplus Contingent liabilities
2. By definition, a statement of financial position balances. Can you think of any advantages that flow from accountants adherence to this convention?
3. Fixed assets are physical assets that provide operating capacity for a number of accounting periods. Explain with the help of a suitable example. Are all fixed assets depreciable assets?
4. Peninsular Transport Company began trucking operations on January 1, 2003. The companys bank account showed a balance of RM90,000 on December 31, 2003, which was in agreement with the bank statement received on the same date. The company had RM6,000 cash in the office and RM4,000 worth of cheques received from customers. On December 31, receivables outstanding amounted to RM300,000. The company also had RM30,000 worth of promissory notes signed by their customers. Employees had drawn festival advance, which was
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Understanding financial statements
outstanding in the amount of RM6,000. Peninsular owed RM360,000 to Southern Service Station as at December 31, 2003. During the year, Peninsular purchased stationery and office supplies costing RM11,000 from Rahmat & Sons. The use of stationery and supplies during the year was estimated at RM8,000. Peninsular purchased eight trucks during the year, each costing RM400,000. They owed RM2,000,000 to Southern Sales and Finance at the end of the year on account of trucks bought. The obligation was supported by hire purchase agreement for payment at the rate of RM50,000 per month. Depreciation was RM80,000 per truck for the year. Spare parts and tyres inventory amounted to RM13,000. The company had rented a garage on a 30 year lease, office space and parking space at RM100,000 a year within the city limits. Because of the real estate boom, Peninsular could easily sublet the premises for RM150,000 a year. On January 1, 2003 when Peninsular started operations, they had paid the first two years rent in advance. On December 31, 2003, Peninsular purchased an air-conditioned car for office use costing RM100,000. Insurance and registration costs amounted to RM8,000. The company had a big storage tank of diesel needed for its trucks. The tank was filled on 4 occasions with 50,000 litres each. On December 31, the meter reading indicated that 180,000 litres had been used during the year. The average cost of diesel was RM3.00 per litre. Peninsular paid employees salary on the last day of each month. Bonus for employees for the year 2003 amounting to RM212,000 will be paid together with their first salary in 2004. The owners of Peninsular originally invested RM600,000. Net income for 2003 was RM208,000. Drawings by the owners during the year amounted to RM100,000. Prepare the statement of financial position as at December 31, 2003 for Peninsular Transport Company in the blank proforma provided in Table 2.2.
Peninsular Transport Company Statement of financial position as at 31st December, 2003 ______________________________________________________________________ Assets Liabilities and Capital ______________________________________________________________________ Current assets Cash Cash at bank Promissory notes Accounts receivable Advances to employees Office supplies inventory Prepaid insurance and license Prepaid rent Inventory of diesel Spare parts inventory _________ _________ _________ _________ _________ _________ _________ _________ _________ _________ Current liabilities Hire purchase payment due in one year Accounts payable Bonus payable Long term liabilities Hire purchase payable Capital Owners capital Net income for the year Less: Owners drawings _________ _________ _________ _________
_________
Trucks ______ Less: Accumulated depreciation ______ _________ Motor car _________ Total assets _________ Total liabilities and capital _________ ______________________________________________________________________
Table 2.2 Statement of financial position of Peninsular Transport Company
5. The following balances was extracted from the books of account of Syarikat Kaya Raya on 30 th June, 2008 after the statement of comprehensive incomefor that year had been prepared and all the relevant adjustments had been made. Balance as at 30th June 2008 RM ______________________________________________________________________ Freehold land and building at cost Bank overdraft Cash in hand Inventory Creditors 10% debentures Dividends proposed 8% Preference shares Ordinary shares Accrued expenses 32,000 27,200 1,680 74,400 18,560 34,000 1,600 6,000 2,400
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Understanding financial statements
20,000 General reserves (at 1st July 2007: RM8,000) Share capital: 200 8% Preference shares of RM100 each 20,000 6,000 Ordinary shares of RM10 each 60,000 Investments at cost 14,800 Motor vehicles at cost 37,200 th Provision for depreciation on 30 June 2008 9,600 Plant and machinery at cost 84,960 Provision for depreciation on 30th June 2008 24,160 Retained income (At 1st July 2007, RM28,000) 32,800 Share premium 14,240 Accounts receivable 25,520 ______________________________________________________________________ The authorised share capital consists of 400 8% preference shares of 100 each and 1,200 ordinary shares of RM10 each. Prepare the statement of financial position of Syarikat Kaya Raya as at 30th June, 2008. Also ascertain the net income for the year.
Further readings
Haron, H. (ed.) (2006) Accounting and Finance: Concepts, Principles and Techniques of Decision Making, Malaysia: Pearson Prentice-Hall (Chapters 1 4). Horngren, C T, Harrison, W T and Bamber, L S (2005), Accounting, 6th edn, Upper Saddle River, New Jersey: Pearson Education International (Chapters 1 4). Warren, C S, Reeve, J M and Fess, P E (2007) Accounting, 21st edn, Ohio: Thompson (Chapters 1 4). Wild, J J, Larson, K D, and Chiapetta, B (2007) Fundamental Accounting Principles, 18th edn, New York: McGraw-Hill Higher Education (Chapters 1 4).
Keywords
Asset: Anything tangible or intangible, which is of monetary value to a business entity. Liability: Any amount owed by one person (the debtor) to another (the creditor). In a statement of financial position, all the claims against the assets of the entity, other than those of the owners are liabilities. Current assets: All the assets held by a firm, with the objective of converting them to cash within the operating cycle or within one year, whichever is longer. Current assets include items such as cash, receivables, inventory and prepayments.
Current liabilities: All those claims against the assets of the firm, to be settled out of cash or other current assets within one year or within the operating cycle, whichever is longer. Usually include items such as accounts payable, tax or other claims payable, and accrued expenses. Intangible assets: Any long-term assets useful to the business and having no physical characteristics. Include items such as goodwill, patents, franchises, formation expenses and copyrights. Contingent liability: A liability which has not been recognised as such by the entity. It becomes a liability only on the happening of a certain future event. An example could be the liability which may arise out of a pending law suit.
Fixed asset: Tangible long-lived asset. Usually having a life of more than one year. Includes items such as land building, plant, machinery, motor vehicles, furniture and fixtures. Owners equity: It is the owners claim against the assets of a business entity. It could be expressed as total assets of an entity, less claims of outsiders or liabilities, and includes both contributed capital and retained earnings.
Activity 2.1
1. a) By a decrease in another asset. b) By an increase in liability. c) By an increase in owners equity.
3. Liability.
4. Assets.
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Understanding financial statements
Activity 2.2
1. F 2. T 3. F 4. T 5. F 6. F
Activity 2.3
1. Assets = Liabilities + Owners equity 2. RM25,000 3. RM25,000 = RM100,000 RM75,000 4. RM70,000 = RM100,000 RM30,000
Activity 2.4
1. a) Accounting period b) Fiscal year c) Financial year
Activity 2.5
1. liquidity.
5. sundry debtors.
6. depreciation.
7. amortisation.
8. accounts payable.
Activity 2.6
1. operating cycle.
2. cash.
3. liquidity.
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Understanding financial statements
5. bad debts.
Activity 2.7
1. assets, liabilities and capital.
2. Owners equity.
3. Liabilities.
4. Profits.
1. Accounts receivable are amounts owed to the company by debtors, for example, trade receivables and unpaid customer accounts. In a trading firm, inventory is the merchandise held for sale to customers in the ordinary course of business. In a manufacturing firm, inventory mainly consists of raw materials, work in progress and finished goods. Current liabilities are claims of outsiders against the business which are due within an accounting period or the operating cycle of the business. For example, accounts payable, notes payable and short-term loan. Reserves and surplus is also known as retained earnings which arise from profitable operations. It refers to a surplus not distributed by the firm as dividends and it is to be retained within the business. A contingent liability is a liability which has not been recognised as such by the entity. It becomes a liability only on the happening of a certain future event. For example, liability from a pending lawsuit.
2. One of the advantages that flow from accountants adherence to the convention of accounting equation is to ensure consistency and comparability of the statement of financial positions prepared by different firms.
3. Fixed assets are tangible, relatively long lived items owned by the business. The benefit of these assets is that they are available not only in the accounting period in which the cost is incurred but over several accounting periods. Benefits from fixed assets are indirect rather than direct. For example, a company purchases a delivery van for the use of the business to deliver goods to customer. The delivery van is recorded as a fixed asset as it will be used for at least several years and brings indirect benefit to the business. However, not all fixed assets are depreciable assets. One example is land. Land is not subject to depreciation and is shown separately in the statement of financial position.
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4. Solutions: Peninsular Transport Company Statement of financial position as at 31st December, 2003 ______________________________________________________________________ Assets Liabilities and Capital ______________________________________________________________________ Current assets Cash 10,000 Current liabilities Hire purchase payment due in one year Accounts payable Bonus payable Long term liabilities Hire purchase payable Capital Owners capital Net income for the year 208,000 Less: Owners drawings 100,000 Plant and equipment Trucks 3,200,000 Less: Accumulated depreciation 640,000 2,560,000 Motor car 100,000 __________ Total assets 3,280,000 Total liabilities __________ and capital 600,000 1,400,000
Cash at bank 90,000 Promissory notes 30,000 Accounts receivable 300,000 Advances to employees 6,000 Office supplies inventory 3,000 Prepaid insurance and license 8,000 Prepaid rent 100,000 Inventory of diesel 60,000 Spare parts inventory 13,000
108,000
5. Solutions: Syarikat Kya Raya Statement of Financial Position as at 30th June, 2008 ______________________________________________________________________ Assets Liabilities and Capital ______________________________________________________________________ Current assets Cash in hand Iventory Accounts receivable Total Current Assets 1,680 74,400 25,520 __________ 101,600 Current liabilities Accrued Expenses 2,400 Bank Overdraft 27,200 Creditors 18,560 Proposed Dividneds Preference 1,600 Ordinary 6,000 __________ 55,760 __________ Property, Plant & Equipment Plant & Machinery at cost 84,960 Less: accumulated depreciation 24,160 depreciation __________ Motor Vehicle at cost 37,200 Less: accumulated depreciation 9,600 depreciation __________ Freehold Land & Building at cost Other Assets Investment at cost 14,800 __________ 236,800 __________ Net Income for the year = RM32,800 RM28,000 = Rm4,800 __________ 236,800 __________ Long term liabilities 10% Debentures 60,800 Capital Share Capital 27,600 Ordinary Preference Share Premium Retained Earnings General Reserve 34,000
32,200
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Understanding financial statements
Introduction
The statement of financial position, as we have studied in the previous section, is intended for reporting the value of assets, liabilities and owners equity at a particular point in time. It does not disclose anything about the details of operation of the business. It tells about the net change in owners equity brought about by operations during the period between the previous statement of financial position and present one. Was it a good year or a bad year? What was the volume of operations? What was the margin available on sales? How was sales Ringgit distributed among different expenses and profit? All these questions cannot be answered without the help of an additional financial statement addressed exclusively to summarise revenues and expenses of the particular period. This statement is so named since it summarises all the revenues or incomes and all the expenses for earning that revenue, showing the net difference, that is net income or profit or loss for the period.
5.1 Statement of comprehensive income and statement of financial position: The linkage
When you sell an item costing RM70 for RM100, assuming no other costs, you earn a profit of RM30. What we have done is nothing but measurement of the net income. This is achieved by comparing the revenue from sales against the cost of materials incurred for earning that revenue. The net difference of this comparison, in simple terms, represents the net income or profit.
The importance of profit and its measurement in accounting leads to the significance of statement of comprehensive income. However, it will be interesting to see how this document is related to the statement of financial position. In the previous unit, we have seen that the earning of revenue increases owners equity. Please recall the statement of financial position equation that we had seen in the previous unit. It stated: Assets = Liabilities + Owners equity....(1) We know that owners equity at any point in time is represented by the following relationship: Owners Equity = Assets Liabilities.(2) This implies that, except in the case of the first statement of financial position, owners equity need not be equal to the contributed capital. We also know that the owners equity changed with the sale transactions. How did this happen? It happened as follows: l. The amount of sales revenue realised, increased the owners equity. 2. The amount of goods parted with, decreased the owners equity. Thus, resultant increase in owners equity was equal to the net increase in assets. That means, it is equal to the profit. We explained owners equity in the previous unit as: Contributed capital + Retained earnings Assuming no withdrawals, retained earnings is nothing but all the revenue minus expenses. Thus, we could write our relationship as follows: Retained earnings = Revenue Expenses..(3) Now, substituting the right hand side of equality (1) in our earlier statement of financial position equation, we have: Assets = Liabilities + Contributed capital + Revenue Expenses..(4) It is the last two terms in equality (4) above which is referred to as statement of comprehensive income or profit and loss account or income summary. Thus, we find that statement of comprehensive income is an integral part of any statement of financial position in that it is an expansion of one of the terms of the statement of financial position. In order to appreciate and understand statement of comprehensive income, we should clearly understand the conceptual basis of the same.
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Understanding financial statements
Realisation
Realisation is technically understood as the process of converting non-cash resources and rights into money. It is understood to mean sale of assets for cash or claims to cash. As an accounting principle, it is used to identify precisely the amount of revenue to be recognised and the amount of expense to be matched to such revenue for the purpose of income measurement. Realisation, thus, usually pertains to the recognition of revenue from sale or provision of goods or services to customers. When should we recognise revenue? This is the question that realisation principle tries to answer. There can be several arguments for and against recognising revenue at the time when the inventory is acquired, when the goods are made ready for sale, when the order is received, when the goods are delivered, or when the sale proceeds are collected. In order to avoid such confusion in accounting, revenue is generally recognised when goods are delivered or services are rendered. This is done despite the fact that delivery is only one of a series of events related to sale. The rationale is that delivery validates a claim against the customer. Realisation being the point of recognition of revenue, also enables us in recognising the expiration of costs incurred in making available such goods or services. Thus, the realisation principle facilitates the process of income measurement by identifying revenues and the expiration of costs with respect to such revenues. By implication, if costs are incurred in producing the goods, such costs are not considered as expenses unless sales are made. There are two major exceptions to the notion that an exchange is needed to justify the realisation of revenue. First, in the case of long-run construction contracts, revenue is often recognised on the basis of a proportionate or partial completion method. Thus in this case, revenue is recognised without satisfying the test of completion and delivery. Second, in the case of long run instalment sales contracts, depending on the uncertainties involved, revenue is regarded as realised only in proportion to the actual cash collections. In this case, even though delivery is complete at the time of contract, recognition of revenue is deferred and is related to actual cash collections.
Accrual
It is generally accepted in accounting that the basis of reporting income is accrual. Resources and obligations change in time periods other than those in which money is received or paid. Economic activity of an enterprise in a short period is complete if the cycle of productive resources to money is completed. In reality, continuous production, use of credit, and long lived assets produce several overlapping cycles. This makes the process of evaluation of income very complex. Accrual principle tries to evaluate every transaction in terms of its impact on the owners equity. In simple terms, it implies that recognised revenues result in increases in the owners equity while expired costs or recognised expenses result in decrease in the owners equity. The essence of the accrual concept is that net income arises from events that change the owners equity in a specified period and that these are not necessarily the same as the change in the cash position of the business. Thus, realisation and accrual together, lay down the ground rules for measurement of income.
Activity 2.8
Fill in the blanks below. 1. Statement of comprehensive income is a summary of __________ and ___________for an accounting period.
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Understanding financial statements
Accounting period
Once we accept the concept of going concern, it is inconceivable to approach the problem of profit measurement without a clear understanding of the idea of accounting period. The most accurate way to measure the results of an entitys operations will be to measure them at the time of liquidation. Considering the whole life of the business, net income is nothing but the excess of amount the owners get over what they have put into it (investment). But it is inconceivable and impractical to imagine that one has to wait until the winding up of the business for ascertaining the profit. Accountants choose some convenient segment of time, such as a calendar year, to collect, summarise and report all information on material changes in the owners equity during that period. There is no sanctity about an accounting period being a year. It has evolved as a convention out of convenience over the years. There is some historical evidence to suggest that accounting periods used to be a couple of years or the entire lifetime of a venture and so on, in the past. Even now, there are firms which follow the system of certain number of weeks as an accounting period. However, generally as a convention, most enterprises try to have a uniform length of accounting period for period to period comparison of results. The crux of the matter is that the realisation and accrual principle, as we have seen earlier, will have to be applied in the context of the accounting period. It is the revenue which is realised during that accounting period which is treated as accruing to the owners equity. Thus, accounting period enables us to have a practical system of valuation and measurement. Accounting periods are bounded by statement of financial positions at the beginning and at the end of the period. Operations during the period are summarised by statement of comprehensive incomes. This process can be illustrated in the following form: time: t0 Statement of comprehensive income or income summary for the first accounting period. Opening statement of financial position at the beginning of the enterprise t1 Statement of comprehensive income or income summary for the second accounting period. Statement of financial position as at the end of second accounting period t2 t3
Here accounting periods could be seen as links in the chain which makes up the life of the enterprise.
Matching
In reality, we match revenues and expenses during the accounting periods. Matching is the entire process of periodic earnings measurement, often described as a process of matching expenses with revenues. In a narrow sense, this means deducting from the revenues of a period the cost of goods sold or other expenses that can be identified with such revenues of that period on the basis of cause and effect.
Revenue
In a broad sense, revenue is the total amount realised from the sale of goods or provision of services together with earnings from interest, dividend, rents and other items of income. Revenue is recognised when the enterprise has a right to income. In practice, we make a segregation of an enterprises income as obtained from its main operations and from activities incidental to the main operations. The former is referred to as operating income and the latter as other income or non-operating income. Realised revenue as we have seen earlier, need not be realised in cash. If the right to receive that income is created or the time to which the income relates has expired, we treat the income as accrued. For example, a credit sale to be collected during the next accounting period is an income of this period. Similarly, interest to be received on a specified date is treated as accrued and hence earned for the period covered by the current accounting period.
Measurement of expenses
Expenses are costs incurred in connection with the earnings of revenue. As such, the point of reference for recognition of expense becomes the recognition of revenue. Costs incurred do not become expenses until the goods or services in question are exchanged. Expense is sacrifice made and resource consumed in relation to the revenues earned during an accounting period. Thus, cost is not synonymous with expense. Only costs that have expired during an accounting period are treated as expenses. Consider the following example: Chong purchases merchandise worth RM1,000 during the period and sells one half of this during the same period for RM750. Here, we have: Cost Revenue : RM1,000 : RM750 The purchase price of the merchandise. The sale proceeds realised in exchange of one half of the merchandise. The cost of the merchandise parted with or given over to the customer in exchange of the revenue i.e., cost with respect to the revenue earned and hence the expired cost.
Expense
: RM500
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Understanding financial statements
Inventory
: RM500
The unexpired cost. An asset i.e., merchandise inventory (as a convention, valued at cost).
Generally, unexpired costs represent assets. All assets which have limited life expire as expenses with respect to the revenue earned during their useful life. Expense means a decrease in owners equity that arises from the operation of a business during a specified accounting period. Thus, cost means any sacrifice, whether or not the sacrifice affects the owners equity during a given accounting period. Expense is the expired cost, directly or indirectly related to a given fiscal period of the flow of goods or services to the market and of related operations. Recognition of cost expiration is based on a complete or partial decline in the usefulness of assets, or on the appearance of a liability without a corresponding increase in assets. Expenses of a given period are: 1. Expenses of this year. These are costs incurred during the accounting period which become expired costs during the same period. Example: Cost of material bought and sold during the same accounting period. 2. Costs incurred in a previous accounting period that become expenses or expired costs during this year. Example: Inventory purchased during the previous period but sold during this period. The amount of inventory which represented unexpired costs and hence an asset at the close of the previous accounting period becomes expired cost and hence expense during the period in which it is sold. 3. Expenses of this year, the monetary outlay for which will be made during a subsequent period. These are also expired costs of the current period, but the costs are incurred by contracting a liability. Expenses are recognised under the following circumstances: 1. Expenses are given recognition in the period in which there is a direct identification or association with the revenue of the period. This implies that recognition of expense is directly related to the realisation of revenue. 2. An indirect association with the revenue of the period. Example: Rent, salaries, insurance, depreciation and such other costs which are not usually inventoried. 3. Measurable expiration of assets though not associated with the production of revenue for the current period. Example: Loss from flood, fire and similar events.
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Understanding financial statements
For the sake of simplicity, we ignore withdrawals. However, if we consider withdrawals, it will imply assets being less to that extent and equality being provided with one more negative term of withdrawals or drawings. Thus, the equality will be: A = L + C + R (E + D) Where D = Dividends or drawings By transposing this equality, it is possible for us to write it without negative symbols. Thus we have: A+E+D=L+C+R ...(6) ...(5)
This equality is the basic accounting equality. The quantities on the left hand side (LHS) are normally referred to as debit or Dr. in short and quantities on the right hand side (RHS) as credit or Cr. in short. We have also seen that because of the basic statement of financial position equality, this accounting equality will always hold true. The terms on the RHS and LHS are represented by one or more separate accounts where information is accumulated using the same framework. LHS terms, namely, A, E and D have debit balances. In other words, normally these accounts have debit side entries more than or equal in value to entries on the credit side. Hence, for those accounts, Debits Credits > 0. When it is equal to zero, there is no balance in the account. Similarly, the accounts relating to the terms on the RHS of the equality, that is L, C, and R, normally have credit balances. Hence, these accounts imply: Credits Debits > = 0. The process of accumulating information is also simple. In the accounts representing LHS terms, all increases of those items are debited in the respective accounts and decreases are credited and the net difference shows the actual position at any point in time. Similarly, in the case of accounts representing RHS, increases with respect to an item are credited in a particular account, and decreases are debited to that account. Net difference shows the balance of that item as of a point in time. From this, it is also clear that the terms debit and credit in accounting have no more practical significance than left and right of an account. An account thus could be represented as a capital letter T denoting the nature of information accumulated in that. Thus, we have cash account or receivables account or payables account or inventory account and so on. Example: Cash account _____________________________________ Dr. Cr.
In this case, LHS will represent all cash receipts or increase and RHS will represent all cash payment or decreases. Let us illustrate the ideas we have discussed with the help of a simple example: January 1 Started business with RM1,000. January 1 Bought merchandise worth RM800 and stored it. January 8 Received order for half the merchandise from A. January 10 Delivered the merchandise, customer invoiced RM500. January 15 Received order for the other half of merchandise. January 17 Delivered merchandise and cash received cash of RM500. January 31 Customer (A) pays.
Accounts of the above transactions ______________________________________________________________________ RM Debit Cash A/c RM Credit ______________________________________________________________________ Capital Sales Receivable (A) 1,000 500 500 _________ 2,000 _________ Merchandise inventory Balance 800 1,200 _________ 2,000 _________
Balance 1,200 ______________________________________________________________________ ______________________________________________________________________ RM Debit Capital A/c RM Credit ______________________________________________________________________ Balance 1,000 _________ 1,000 _________ Cash 1,000 _________ 1,000 _________
Balance 1,000 ______________________________________________________________________ ______________________________________________________________________ RM Debit Merchandise inventory A/c RM Credit ______________________________________________________________________ Cash 800 _________ 800 _________ Cost of goods sold Cost of goods sold 400 400 _________ 800 _________
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Understanding financial statements
______________________________________________________________________ ______________________________________________________________________ RM Debit Sales A/c RM Credit ______________________________________________________________________ Income summary 1,000 _________ Receivables (A) Cash 500 500 _________
1,000 1,000 _________ _________ ______________________________________________________________________ ______________________________________________________________________ RM Debit Receivables (A) A/c RM Credit ______________________________________________________________________ Sales 500 _________ Cash 500 _________
500 500 _________ _________ ______________________________________________________________________ ______________________________________________________________________ RM Debit Cost of goods sold A/c RM Credit ______________________________________________________________________ Merchandise inventory Merchandise inventory 400 400 _________ Income summary 800 _________
800 800 _________ _________ ______________________________________________________________________ ______________________________________________________________________ RM Debit Income Summary RM Credit ______________________________________________________________________ Cost of goods sold Retained earnings 800 200 _________ Sales 1,000 _________
1,000 1,000 _________ _________ ______________________________________________________________________ ______________________________________________________________________ RM Debit Retained earnings RM Credit ______________________________________________________________________ Balance 200 _________ 200 _________ Income summary 200 _________ 200 _________
______________________________________________________________________ RM Debit Balance A/c RM Credit ______________________________________________________________________ Cash 1,200 _________ Capital Retained earnings 1,000 200 _________
1,200 1,200 _________ _________ ______________________________________________________________________ In the above example, what we have attempted is to complete the accounting process based on a very simple situation. The process of recording and summarising that we resorted to, could be explained as follows: Starts business with RM1,000. This transaction affects two accounts: Cash increase entry on the debit side of the account. Capital increase entry on the credit side of the account. Purchases merchandise and stores them. Merchandise inventory increase entry on the debit side of the account. Cash account decrease entry on the credit side of the account. Receipt of order for half the merchandise. Receipt of order does not warrant any record. We consider realisation of revenue only when goods are delivered. 1. Delivered goods and customer is invoiced. Since cash is not collected simultaneously, it represents a credit transaction. It results in an increase in claims against A. Accounts receivable is debited. Revenue is earned, sales account is credited. 2. We should also consider the cost of sales. We part with merchandise inventory worth RM400. It is an expired cost, hence a reduction in owners equity is an expense. Debit cost of sales account with increase in expense or expiration of cost. We credit the merchandise inventory account to show the reduction in inventory. Cash received from sales. Debit cash and credit increase in revenue/sales. We also recognise expense by debiting cost of sales account and crediting merchandise inventory account. Receivables collected. Cash increase is recorded by a debit in cash account and a credit to receivables (A) account. The credit to receivables account shows the liquidation of our claim (asset). In practice, this amounts to repayment of the debt by A.
UNIT 2 49
Understanding financial statements
1,000 1,000 _________ _________ ______________________________________________________________________ The statement of financial position records arising from this transaction will be: Statement of financial position ______________________________________________________________________ Assets RM Liabilities & capital RM
Accounts receivable 1,000 Retained earnings 500 ______________________________________________________________________ Now assuming that one of the accounts is going bad, the collection loss will amount to RM250. If we do not take this into account, the implications are: We have overstated receivables (asset in the statement of financial position), sales (revenue in the profit and loss account) and profit (retained earnings in the statement of financial position). It is possible for us to estimate these losses on account of bad debts and reduce the revenues and thereby profits to that extent. It is achieved by recognising this amount as our increase in expense (bad debts expense), thereby reducing profit. Thus, we will prepare income summary and statement of financial position as follows:
Income Summary ______________________________________________________________________ Debit RM RM Credit ______________________________________________________________________ Cost of sales Bad debt expense Profit 500 250 250 _________ Sales 1,000 _________
1,000 1,000 _________ _________ ______________________________________________________________________ Statement of financial position ______________________________________________________________________ Assets RM Liabilities & capital RM ______________________________________________________________________ Accounts receivable Less: Estimated collection loss 1,000 Retained earnings 250
250 750 ______ ______________________________________________________________________ Usually the possible collection losses are estimated and provided for by charging them as expenses of the period. Such estimate is reduced from the value of the asset receivables to show the realisable value of the asset.
UNIT 2 51
Understanding financial statements
We can approach this problem diagramatically. Assume that the following scale shows the amount of revenue earned. RM10,000
We take it that the revenue is earned in equal amounts during the five years of the life of the asset. Assuming no other costs and no salvage value, the cost of the asset becomes expense over a five-year period. Now the question is, how should we apportion this cost over the life of the asset? If we make the simple assumption that the cost expires in equal proportion, we have the simplest solution. This we could represent as follows: RM5,000
Now, having made the assumption of spreading the cost equally, we have come to the conclusion that one-fifth of the cost of the asset expires annually. That portion of the cost of the asset which is reckoned to expire during an accounting period is what is termed as depreciation expense. This also clarifies that, normally, the total amount of depreciation of an asset shall not be more than the depreciable cost of the asset. It is this expense which is matched against the revenues of a period for determining profit. From the above example we can easily determine that the profit per annum is RM1,000, that is, RM5,000 over the useful life of the asset. Thus, to recapitulate, depreciation expense is the cost of a fixed asset written off against the revenues of different periods during which the asset is used.
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Understanding financial statements
1,000 900 800 Depreciation (Ringgit) 700 600 500 400 300 200 100 0 1 2 3 4 5 6 7 Useful life (Years) 8 9 10 Annual depreciation
If we draw a graph showing the annual depreciation, it will be a straight line parallel to the base line. Hence, the name is straight line method (Figure 2.1). The accumulated depreciation will be increasing annually at a uniform rate, becoming equal to the depreciable cost of the asset at the end of useful life (Figure 2.2). As shown in Figure 2.2, it is a straight line sloping upward to the right from the origin whereas the written down value steadily declines to become zero at the end of the useful life of the asset. Hence, a downward sloping straight line is reaching the origin at the end of its useful life (Figure 2.3).
1,000
500
Annual depreciation
1,000 900 Written down value (Ringgit) 800 700 600 500 400 300 200 100 0 5 Useful life (Years) 10 Written down value
UNIT 2 55
Understanding financial statements
Annual depreciation under written down value method is the highest during the first year and keeps on reducing over the subsequent years. This is shown by a rapidly declining curve (Figure 2.4). However, the rate of decline reduces as the number of years approaches the end of the life of the asset. Accumulated depreciation, similarly, increases at a rapid rate during the initial years and the rate of increase declines in later years (Figure 2.5). The written down value of the asset is a declining curve (Figure 2.6). The unallocated portion of the cost is usually charged as depreciation in the last year of the life of the asset. RM 200 180 Annual depreciation (Ringgit) 160 140 120 100 80 60 40 20 0 0 1 2 3 4 5 Years 6 7 8 9 10 Annual depreciation
RM 1,000 900 Accumulated depreciation (Ringgit) 800 700 600 500 400 300 200 100 0 0 1 2 3 4 5 Years 6 7 8 9 10 Accumulated depreciation
RM 1,000 900 800 Written down value (Ringgit) 700 600 500 400 300 200 100 0 0 1 2 3 4 5 Years 6 7 8 9 10 Written down value
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Understanding financial statements
(1) Year
Includes the unallocated depreciation charge, since there is no salvage value for the assets. Under this method, there will always be a terminal unabsorbed depreciation. Figures are rounded off.
UNIT 2 59
Understanding financial statements
follows: Tools Malaysia Statement of comprehensive income For the year ending December 2007 (RM in millions) ______________________________________________________________________ Debit Credit ______________________________________________________________________ Sales Other income (Schedule 1) (Schedule 2) 255 5 _________ 260 130 _________ 130 (Schedule 4) (Schedule 5) (Schedule 6) 49 11 28
Cost of goods sold Gross profit Operating expenses: Personnel Depreciation Other expenses Operating profit Less: Interest expense Net profit before taxes Less: Provision for taxes Net profit after tax
(Schedule 3)
(Schedule 7)
18 _________ ______________________________________________________________________ The condensed statement of comprehensive income will be accompanied by schedules or notes to the financial statements, providing details of various items forming the total. Sales: Net sales shown in the statement of comprehensive income is after deducting RM5 million from gross sales. Schedule 1 also provides the detailed breakdown of sales by different divisions of the company and also by domestic market and export sales. Schedule 1 Sales (RM in millions) ______________________________________________________________________ Gross sales Less: Sales returns and allowances Sales discount 260 1.75 3.25 _________ 5 _________ 255 _________ Net sales (inland)
Machine tools group Watch group Tractor group Lamp group Dairy machinery group
83 87 60 13 2 _________ 245
Export: Machine tools group Watch group Others Total net sales
6 2 2 _________
10 _________
255 _________ ______________________________________________________________________ Sales returns and allowances: Sales records are prepared as and when goods are shipped to customers. Goods which are not according to specifications, damaged or defective may be returned by the customers and refund or credit sought. Such refunds or allowances are separately accumulated for the purpose of control by management. At the time of preparation of the statement of comprehensive income, such allowances are set off against the gross sales and net sales are taken as the operating revenue earned. Many companies may not disclose this information in published accounts. Sales discount is a reduction from invoice price, granted for prompt payment of the invoice within a specified time limit. This is also called cash discount. In our example, Tools Malaysia allowed RM3.25 million in discounts to customers. It is a usual practice to state the discount offered to customers on the invoice. Discounts or terms of payments are usually presented in short forms or symbols. They may be Net amount or No cash discount (N) net amount due at end of the month (N/EOM); Net amount due in 30 days of invoice, no cash discounts (N/30); 5 per cent discount if payment is made in 10 days, net amount to be paid in 30 days (5/10, N/30). An invoice of 5/10, N/30 simply means that 5 per cent discount will be allowed if payment is made within ten days. It also implies that by not paying in 10 days, you could avail the normal credit of 30 days. Suppose you have RM1,000 invoice with 5/10, N/30. You are losing 5 percent for 20 days credit. In other words, it costs you 360/20 5% = 90% per annum in equivalent interest. This knowledge will definitely help you in planning your short-term finances more effectively. Trade discounts are used as adjustments in price and used when bulk sales are made by wholesaler to retailers. Trade discounts are deducted from list prices to give the actual transaction price agreed between buyer and seller. Other income: The revenue earned by an enterprise is usually bifurcated into two parts, operating income and non-operating income. Operating income usually refers
UNIT 2 61
Understanding financial statements
to income derived from the main-line operations of the business. Other income usually arises from activities incidental to the business. Schedule 2 lists the details of non-operating incomes of Tools Malaysia. Schedule 2 Other income RM in millions ______________________________________________________________________ Interest Banks Interest Staff and office Export incentives Sales agency commission Profit on sales of assets Dividend on trade investment Other miscellaneous income Total 0.50 1.20 1.80 0.50 0.30 0.20 0.50 _________
Activity 2.9
Relate items in Column A to all items in Column B. A 1. 2. 3. 4. Gross sales. Sales returns and allowances. Depreciation. Discounts. B 1. 2. 3. 4. 5. 6. Non-cash expense of the period. Total invoice value of goods sold during the period. Reduction from invoice price. 2/5, N/30. Given effect when goods are returned by customers. Adjustments to recorded sales.
UNIT 2 63
Understanding financial statements
Units January 11 January 14 January 16 January 21 January 30 Total Sales Sales Sales Sales Sales 1,000 500 1,000 2,000 1,500 _________
6,000 _________ ______________________________________________________________________ If we value the cost of sales on the basis of FIFO, we have the following situation: ______________________________________________________________________ Date Quantity Quantity Rate Amount Total sold break-up amount ______________________________________________________________________ January 11 500 3 1,500 500 4 2,000 3,500 ______________________________________________________________________ January 14 500 500 4 2,000 2,000 ______________________________________________________________________ January 16 1,000 1,000 5 5,000 5,000 ______________________________________________________________________ January 21 1,000 5 5,000 1,000 6 6,000 11,000 ______________________________________________________________________ January 30 1,500 1,500 4 6,000 6,000 ______________________________________________________________________ Total sales 6,000 27,500 ______________________________________________________________________ Inventory 1,500 4 6,000 2,000 7 14,000 20,000 ______________________________________________________________________ Total 9,500 47,500 ______________________________________________________________________
Table 2.5 Cost of goods sold and inventory under FIFO
1,000
2,000
3,500
Thus, cost of goods sold and inventory under FIFO are: Cost of goods sold Inventory Total 27,500 20,000 _________ 47,500 _________
If we follow LIFO, the picture will be as follows (Table 2.6): ______________________________________________________________________ Date Quantity Quantity Rate Amount Total sold amount ______________________________________________________________________ January 11 1,000 1,000 5 5,000 5,000 ______________________________________________________________________ January 14 500 500 5 2,500 2,500 ______________________________________________________________________ January 16 1,000 1,000 6 6,000 6,000 ______________________________________________________________________ January 21 2,000 2,000 4 8,000 8,000 ______________________________________________________________________ January 30 1,500 1,500 7 10,500 10,500 ______________________________________________________________________ Total sales 6,000 32,000 ______________________________________________________________________ Inventory 3,500 500 1,000 500 1,000 500 3 4 5 4 7 1,500 4,000 2,500 4,000 3,500
_________ Total
15,500 _________
Thus, cost of goods sold and inventory under LIFO are: RM Cost of goods sold Inventory Total 32,000 15,500 _________ 47,500 _________
From the example above, we find that the FIFO cost of goods sold, which is based on prices of inventory procured earliest prior to sales, would amount to RM27,500. And the closing inventory of 3,500 units will be valued at RM20,000, which is based on the most current purchase prices. The LIFO cost of goods sold, which is based on the most recent prices of the inventory purchased, is RM32,000. Closing inventory, based on the prices of earlier purchase, is valued at RM15,500. In both cases, inventory plus cost of goods sold amount to the same, that is, RM47,500 since it is based on actual historical cost only.
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Understanding financial statements
Here again, over the entire life of the entity there will be no difference, irrespective of the method used in valuing the cost of goods sold. There will also be no difference if the entire inventory is sold. The differences again reflect one of the effects of accounting periods on income measurement. However, you need to note that Financial Reporting Standards in Malaysia, FRS102, prohibits the LIFO method of inventory measurement.
Operating expenses
All those expenses which are necessary to run the business enterprise but which are not directly associated with the companys output or production or trading are usually termed as operating expenses. Usually these expenses include all items of cost concerned with providing administrative and general support to business operations. It is the usual practice to segregate these costs as falling under two broad groups: Selling and distribution and general administrative expenses. The latter also covers personnel expenses including staff and workmens compensation and other benefits. In case of Tools Malaysia, details of the expenses on account of personnel are given in Schedule 4. Schedule 4 Personnel expenses (RM in millions) ______________________________________________________________________ Salaries, wages and bonus House rent allowance Gratuity Contribution to EPF Contribution to SOCSO Workmen and staff welfare expenses 37.81 2.19 0.75 2.75 0.50 5.00 _________
Depreciation
Depreciation, as explained earlier, is the expiration of costs of fixed assets. It is a usual practice to classify the depreciation expense for different groups of assets. In case of Tools Malaysia, Schedule 5 gives the breakdown of depreciation for different groups of assets.
Schedule 5 Depreciation (RM in millions) ______________________________________________________________________ Fixed assets Tools and instruments Patterns, jigs and fixtures 9.84 0.02 1.14 _________
Other expenses
Other expenses shows the detailed breakdown of most of the major items of operating expenses other than personnel, depreciation and financing costs. In the case of Tools Malaysia, the details are provided in Schedule 6. Schedule 6 Other expenses (RM in millions) ______________________________________________________________________ Power and fuel Rent Rates and taxes Insurance Water and electricity Repairs to buildings Repairs to machinery Printing and stationery Advertisement and publicity Training Audit fees Royalties Sole selling and other agents commission Directors fees Provision for bad debts and advances Loss on assets sold or discarded Provision for warranty repairs Miscellaneous expenses 3.10 0.50 0.40 0.50 0.60 0.20 0.80 0.90 2.40 0.10 0.05 0.85 4.70 2.00 0.20 1.30 1.00 8.40 _________
UNIT 2 67
Understanding financial statements
Interest expense
Interest expense arises out of managements decision to finance part of the expenses from borrowed funds. The level of interest expense represents the amount of risk the company is carrying in terms of fixed commitments, irrespective of the volume of operations and profit. Schedule 7 shows the different items of interest commitments of Tools Malaysia. Schedule 7 Interest (RM in millions) ______________________________________________________________________ Debentures Fixed deposits Loans from government Term loans from banks/financial institutions Cash packaging credit from banks Others Total 0.58 1.50 5.00 0.42 3.50 1.00 _________
Income taxes
The profit before tax determines the level of taxation. As per the tax laws, the amount of tax payable is not determined on the basis of reported net profit. In most cases, the accounting profit arrived at has to be reclassified and recomputed for determining the tax liability. Furthermore, the tax liability, though certain, is determined only after the tax assessment is completed. This is the reason why tax liability is always provided as a provision, implying that this liability is based on an estimate. When the amount is actually determined later on, it is set off against this provision.
Activity 2.10
Classify each item listed in Column A under appropriate classification in item B, assuming that the information relates to a small manufacturing firm. A 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. Raw material consumed. Interest received. Dividends received. Wages paid to workers. Carriage on goods sold. Carriage on goods purchased. Salary of clerical staff. Rent for office. Power and fuel. Selling agents commission. Advertising. Auditors fees. Sales tax. Municipal rates on office premises. Profit on sale of machinery. Bonus paid to workers. Sales discount. Purchase returns and allowances. Dividends paid. Interest expense on loans. B i) Operating revenue ii) Non-operating revenue. iii) Cost of goods sold. iv) Selling and distribution expenses. v) Administrative expenses. vi) None of the above.
UNIT 2 69
Understanding financial statements
Summary
In this section, we have developed and examined the statement of comprehensive income, also known as the profit and loss account. This account or statement shows the net profit or earnings generated by the company. Thus, this measures the managements ability to generate income from assets. The statement of comprehensive income summarises the revenues and expenses of an accounting period. As a result of this summary, it shows the net profit or net loss experienced by the company during the period. The reader of this account is provided with the past cost structure and profitability. The net profit after payment of dividends shows the amount retained and hence links the statement of financial position with the statement of comprehensive income.
Self-assessment exercises
1. Following is the summarised statement of comprehensive income of Shyam Enterprise for five consecutive periods. Complete the same by supplying the missing information. 1 Sales Cost of goods sold Gross profit Administrative expenses Selling and distribution expenses Operating profit Other incomes Net profit before tax Corporate income tax Profit after tax 200 150 150 300 300 500 800 100 1,000 500 800 700 1,000 300 2 3 3,000 2,500 1,500 400 4 5 5,000 3,000
150
500
1,000
2. The following are the balances taken on 31st December, 2007 from the books of account of Western Plastics. RM ______________________________________________________________________ Preference share capital Ordinary share capital Investments at cost (a) quoted (b) unquoted Freehold land and buildings at cost Plant and machinery at cost Share premium account 9% Debentures (secured on property) Provision for depreciation to 31st Dec. 2006 Freehold land and buildings Plant and machinery General reserve Bank overdraft Creditors Sales turnover Cost of goods sold Audit fee Debtors Retained earnings Income from quoted investments Income from unquoted investments Administration expenses Legal expenses Bank interest Establishment expenses Directors emoluments Debenture interest Preference dividend Ordinary dividend Interim Merchandise inventory 31st Dec. 2007 100,000 90,000 32,000 75,500 81,000 198,500 50,000 40,000 7,600 33,800 16,500 13,080 18,830 410,760 298,460 6,000 30,720 27,400 1,560 4,220 6,200 340 1,100 4,230 6,520 3,600 5,000 4,500 60,080 _________ 813,750 In addition, the following information is available: a) The authorised share capital is: 20,000 10% preference shares of RM10 each, 24,000 ordinary shares or RM10 each. b) All the issued ordinary shares are fully paid.
_________ 813,750
UNIT 2 71
Understanding financial statements
c) Depreciation to be provided for 2007 as follows: Property Plant, etc. 2% on cost 10% on cost
d) Provide for the preference dividend due. e) A final dividend of 10% on the ordinary shares is proposed. Ignore the taxation. With the help of the above information: i) Prepare a statement of comprehensive income for the year ended 31st December, 2007 and a statement of financial position as at that date. ii) Comment on the salient features of the financial statements you have prepared so far as they provide meaningful information for users needs. iii) Identify the main information objectives of shareholders and assess the extent to which these objectives are satisfied by the financial statements you have prepared.
Further readings
Haron, H (ed.) (2006) Accounting and Finance: Concepts, Principles and Techniques of Decision Making, Malaysia: Pearson Prentice-Hall (Chapters 1 4). Horngren, C T, Harrison, W T and Bamber, L S (2005) Accounting, 6th edn, Upper Saddle River, New Jersey: Pearson Education International (Chapters 1 4). Warren, C S, Reeve, J M and Fess, P E (2007) Accounting, 21st edn, Ohio: Thompson (Chapters 1 4). Wild, J J, Larson, K D, and Chiapetta, B (2007) Fundamental Accounting Principles, 18th edn, New York: McGraw-Hill Higher Education (Chapters 1 4).
Keywords
Revenue: Assets received from the sale of goods or services to customers. Also includes income generated from assets and investments, usually classified as non-operating revenue. Revenues increase owners equity. Expense: Any reduction in owners equity (total assets minus total liabilities) not resulting from distribution to owners. Represents expiration of costs, use or loss of an asset without being replaced by another asset. Realisation: Recognition of the revenue in accounting based on the assumption that increases in owners equity arises at the point of delivery or provision of goods or services. Accrual: Income measured on the realisation of revenue independent of the timing of cash receipt and payment. Profit: Revenue minus expenses for a given accounting period. Negative profit (income) is known as loss. Profit and loss account: The final summary of all revenues, gains, expenses and losses during an accounting period. Shows the net profit or loss for the period. Depreciation: The amortisation representing allocation of cost expiration of tangible fixed assets over their useful life. Cost: The amount paid or to be paid for acquisition of goods or services. Matching: Income measurement based on comparison of expenses and revenues of a period.
Activity 2.8
1. revenue and expenses
2. revenue
3. expenses to revenues
UNIT 2 73
Understanding financial statements
5. accrues
6. decrease
7. revenue, accounting
Activity 2.9
1. A1-B2
2. A2-B5, B6
3. A3-B1
4. A4-B3, B4
Activity 2.10
1. (iii) 11.(iv)
2. (ii)
12.(v)
3. (ii)
13.(vi)
4. (iii)
14.(v)
5. (iv)
15.(ii)
6. (iii)
16.(iii)
7. (v)
17.(iv)
8. (v)
18.(iii)
9. (iii)
19.(vi)
10.(iv)
20.(v)
1. 1 Sales Cost of goods sold Gross profit Administrative expenses Selling and distribution expenses Operating profit Other incomes Net profit before tax Corporate income tax Profit after tax 1,000 500 500 100 150 250 150 400 200 200 2 1,500 800 700 300 200 200 100 300 150 150 3 3,000 2,000 1,000 300 300 400 200 600 300 300 4 4,000 2,500 1,500 400 500 600 400 1,000 500 500 5 5,000 3,000 2,000 400 600 1,000 500 1,500 700 800
UNIT 2 75
Understanding financial statements
Introduction
Depending on the users purpose, the term funds may be used differently. Literally, it means a supply that can be drawn upon. In this sense it is used to mean cash, total current assets or working capital. We use it here in the sense of working capital, meaning total current assets less current liabilities. Funds flow is used to refer to changes in or movement of current assets and current liabilities. This movement is of vital importance in understanding and managing the operations of a business. We have seen in the unit dealing with statement of financial position that every material transaction changes the position statement (or statement of financial position). In other words, this implies a dynamic situation involving continuous movement of resources into the business, within the business and out of the business. The complexity of these flows increases with the increasing size and volume of business. Directly or indirectly, all these flows take place in business through the medium of funds. Funds in the form of cash and cash equivalents, in the right quantity are necessary for the smooth functioning of any business. The continuous movement of cash within the business and out of the business could be understood by studying the statement of cash flow.
UNIT 2 77
Understanding financial statements
Ramsons: Schedule of cash payments ______________________________________________________________________ Month Explanation Amount RM Total RM ______________________________________________________________________ January Operating expenses Withdrawals January purchases Operating expenses Withdrawals February purchases Operating expenses Withdrawals 26,000 4,000 112,500 26,000 4,000 112,500 26,000 4,000 30,000
February
142,500
March
142,500
April
March purchases 112,500 Operating expenses 26,000 Withdrawals 4,000 142,500 ______________________________________________________________________ Ramsons: Schedule of cash receipts ______________________________________________________________________ Month Explanation Amount RM Total RM ______________________________________________________________________ January Cash sales Credit sales of the month first instalment Cash sales Credit sales of the month first instalment January sales second instalment Cash sales Credit sales of the month first instalment January sales third instalment February sales second instalment 50,000 25,000 50,000 25,000 25,000 50,000 25,000 25,000 25,000 75,000
February
100,000
March
125,000
April
Cash sales 50,000 Credit sales of the month first instalment 25,000 January sales fourth instalment 25,000 February sales third instalment 25,000 March sales second instalment 25,000 150,000 ______________________________________________________________________
Opening statement of financial position of Ramsons will be as follows: Ramsons: Statement of financial position as at January 1, 2008 ______________________________________________________________________ Assets Fixed assets Inventory Cash RM 600,000 337,500 30,000 _________ Liabilities and capital Capital RM 967,500 _________
967,500 967,500 _________ _________ ______________________________________________________________________ We have assumed that the entire asset requirements are financed by the owners capital. Working capital of Ramsons on January 1, 2008 is as follows: ______________________________________________________________________ Current assets: Inventory Cash Total current assets Less: Current liabilities Working capital 337,500 30,000 _________ 367,500 Nil _________
367,500 _________ ______________________________________________________________________ Ramsons: Schedule of cash balances ______________________________________________________________________ January Opening balance Cash receipts Total cash available Less: Cash payments Cash balance 30,000 75,000 _________ 105,000 30,000 _________ February 75,000 100,000 _________ 175,000 142,500 _________ March 32,500 125,000 _________ 157,500 142,500 _________ April 15,000 150,000 _________ 165,000 142,500 _________
UNIT 2 79
Understanding financial statements
Ramsons: Statement of comprehensive income for the month ending ______________________________________________________________________ 29th February 31st March 30th April 31st January ______________________________________________________________________ Sales 150,000 150,000 150,000 150,000 Less: Cost of sales 112,500 112,500 112,500 112,500 Other expenses 26,000 26,000 26,000 26,000 Depreciation 5,000 143,500 5,000 143,500 5,000 143,500 5,000 143,500 ______ ______ ______ ______ ______ ______ ______ ______ Net profit 6,500 6,500 6,500 6,500 ______ ______ ______ ______ ______________________________________________________________________ Ramsons: Statement of financial position as at the end of ______________________________________________________________________ Assets 31st March 30th April 31st January 29th February 2008 2008 2008 2008 ______________________________________________________________________ Fixed assets Less: Depreciation Net fixed assets Inventory Receivables Cash Total current assets Total assets 600,000 5,000 _________ 595,000 _________ 337,500 75,000 75,000 _________ 487,500 _________ 1,082,500 _________ 600,000 10,000 _________ 590,000 _________ 337,500 125,000 32,500 _________ 495,000 _________ 1,085,000 _________ 600,000 600,000 15,000 20,000 _________ _________ 585,000 580,000 _________ _________ 337,500 337,500 150,000 150,000 15,000 22,500 _________ _________ 502,500 510,000 _________ _________ 1,087,500 1,090,000 _________ _________
Liabilities and capital Capital Add: Retained earnings Owners equity Accounts payable 967,500 2,500 _________ 970,000 112,500 _________ 967,500 5,000 _________ 972,500 112,500 _________ 967,500 967,500
7,500 10,000 _________ _________ 975,000 977,500 112,500 112,500 _________ _________
Ramsons: Schedule of working capital ______________________________________________________________________ 31st March 30th April 31st January 29th February 2008 2008 2008 2008 ______________________________________________________________________ Current assets Less: Current liabilities 487,500 112,500 _________ 375,000 _________ Funds from operations Net profit Add: Depreciation Total funds generated from operations 6,500 5,000 _________ 6,500 5,000 _________ 6,500 6,500 5,000 5,000 _________ _________ 495,000 112,500 _________ 382,500 _________ 502,500 510,000 112,500 112,500 _________ _________ 390,000 397,500 _________ _________
Cash
It is difficult to perceive cash kept in the vault as an investment. Rather, you would be thinking that if we invest cash, then how can cash itself be an investment? But you will realise that a certain minimum amount of cash is necessary for any business. Take a simple case: If you are a retailer, will you send away a customer who does not have exact change? However, you can entertain him only if you keep the change. That is your investment in cash. Similarly, you will have to pay your employees and suppliers at a specific time. In order to do that, you need cash. Thus, investment in cash is that amount which is required to be kept on hand to meet day-to-day requirements of cash. This amount is determined after taking into account the regularity and amounts of inflows of cash, the amount and frequency of outflows, and also the uncertainties related to these. Obviously, as your business grows, the need for cash will also grow.
UNIT 2 81
Understanding financial statements
Receivables
In most situations, it will be necessary to grant credit to customers. This may be necessary either because of competition or because of the custom of trade. However, when we grant credit to customers, it implies that we have to finance the cost of materials for the duration of such credit. In other words, you are financing your customers business to the extent of the credit granted. Whenever the business is expanding, the volume of receivables will also expand. Please note that the need for financing receivable is not to the full extent of the accounts receivables (sales). You are actually financing only to the extent of the cost of goods sold out of the receivables (sales) in question.
Similarly, we know from the information available that every month, one-third of the sales are made on cash and two-thirds are on credit which is to be collected in four instalments. This means, cash collection during the month will be cash sales plus one-fourth of credit sales of the period and one-fourth of three previous months credit sales. Similarly, in the first month, we will be really making one half of the sales for cash and the other half on credit. In our example, Total sales Cash sales Credit sales First instalment in cash Total cash collection RM150,000 RM50,000 RM100,000 RM25,000 _________ RM75,000 _________
Credit period of the sales will be as follows: First month sales on credit less first instalment of RM75,000. This means, RM75,000 credit for one month RM50,000 credit for one month RM25,000 credit for one month This is equivalent to RM75,000 sales made for two months credit. In terms of working capital requirement, we require one months financing of the cost of sales with respect to RM150,000 sales. That is RM112,500 is needed for financing this amount. Thus, we could summarise Ramsons need for funds for financing current asset to start operations, as follows: RM 3 months inventory One months expenses as cash 337,500 30,000 _________ 367,500 _________ During the first month, Ramsons will sell one-third of the inventory generating RM75,000 in cash and the other half of RM75,000 to be collected in three instalments. Thus, we need some additional funds to finance our granting credit to the customers. Similarly, we would need to replenish the inventory and make payments for expenses. We shall examine these with the help of the statement of financial position and profit and loss account of Ramsons for the first four months.
UNIT 2 83
Understanding financial statements
Activity 2.11
1. Please explain what these internal and external sources are: ________________________________________________________________ _________________________________________________________________ __________________________________________________________________ ___________________________________________________________________ ___________________________________________________________________ ___________________________________________________________________
Internal sources
When we are looking for sources of funds, it is natural to start searching at home. What do we have? While examining the need for working capital, we could also make an assessment as to whether the existing working capital is sufficient or not. Thus, the first internal source is any excess working capital that we might be having. If we have any non-current assets which do not have any use, they could be disposed off, thereby generating additional working capital. Please note that this is not a regular and continuing source of funds. We have seen earlier that every profitable sale brings with it funds in excess of what was expended on the goods sold. In other words, profits generated by the business contribute towards additional working capital. But you may also notice that whenever we measure profits, we match the revenue against all expenses relating to the revenue, whether it involves the use of funds in the current period or not. Thus, the profits measured do not reflect the actual amount of funds available. In order to assess the actual funds generated from current operations, we should add back to the profits all those items of expenses not involving the use of funds during the current period. One major example of such an item is depreciation.
Thus, we could summarise the important possible sources of funds as: 1. Funds generated from operations. That is, profit plus depreciation and other amortisations. 2. Sale of non-current assets. 3. Any surplus working capital.
Cost of goods sold Gross profit Profit expenses: Personnel Depreciation and amortisation Other expenses Operating profits Less: Interest expense Net profit before income taxes Less provisions for taxes
UNIT 2 85
Understanding financial statements
55 20 _________
35 _________ ______________________________________________________________________ * Other income includes RM1 million profit on the sale of furniture. Thus the funds provided from the operations are in fact the revenues earned from operations (as also non-operating incomes) less all immediate costs of goods sold requiring the use of funds. In other words, it is net income or profit after taxes, plus all the non-cash expenses, such as depreciation and amortisation. The funds flow statement would show funds from the operations of Tools Malaysia as follows: ______________________________________________________________________ (RM in million) Operations Net income Add: Depreciation and amortisation 55 11.90 _________ 66.90 1.00 _________
External sources
External sources of funds are resources raised from outside the organisation to augment funds availability for any of the uses to be discussed later. Normally, there are only two ways of doing this: 1. By contributing or raising additional capital. 2. By increased long-term borrowing.
Please note that short-term creditors are not included as a source of funds since we have already defined funds as current assets less current liabilities. Thus, working capital represents long-term investment in current assets and hence short-term borrowing will not increase working capital.
The sources of funds, as usually presented in the fund flow statement, are enumerated below: Sources of funds ______________________________________________________________________ Operations: Net profit after taxes _________ Add: Depreciation _________ Other amortisations _________ Funds provided by operations _________ New issue of share capital _________ New issue of debentures/bonds _________ Additional long-term borrowing _________ Sale proceeds of fixed assets _________ Sale of long-term investment _________ ______________________________________________________________________
It should not be difficult to appreciate the necessity of having adequate fixed facilities with which to conduct the business. The amount we have invested in the shop, furniture and fixtures (refer to the example of Ramsons) has created the facilities for carrying on the business. It also limits the capacity. We cannot expand our business beyond a certain capacity which is limited by the facilities created by fixed assets. In the case of a manufacturing firm, it will be plant capacity; in the case of a transport undertaking, it may be tonnage of trucks, ships or wagons; in the case of airlines, it may be seating capacity, and so on. Any increase in such capacity would require additional investment. Thus, investment in fixed assets is required to expand capacity or to improve the current operation. Usually, addition to investments is judged on the basis of its ability to reduce the present costs or to increase the present output. Additional working capital is required to finance increased holding of inventory, increased credit to customers and increased cash holding requirements. Current creditors would finance part of this requirement for working capital. If Ramsons invests in another shop or in expansion of the existing shop, they will require additional funds for investment in fixed assets and also for increased level of current assets. You will notice that whenever additional investment is to be made
UNIT 2 87
Understanding financial statements
to non-current assets, we have to use the funds (working capital) available with us and separate arrangement is made for their financing. Likewise, when non-current assets are sold, they provide funds or result in sources of funds. We could summarise the usual applications of funds as follows: 1. Acquisition of new non-current assets (fixed assets). 2. Replacement of non-current debt (loans). 3. Payment of dividends. 4. Increase in the balance of working capital (Current assets Current liabilities). If the trading or business operations are unsuccessful, they may use funds rather than provide funds. The uses of funds, as they are usually presented in the fund flow statement, are enumerated below: Uses of funds ______________________________________________________________________ Dividends ____________ Non-operating losses not passed through statement of comprehensive income ____________ Redemption of redeemable preference share capital ____________ Repayment of debentures/bonds ____________ Repayment of long-term loans ____________ Purchase of fixed assets ____________ Purchase of long-term investment ____________ Increase in working capital ____________ ______________________________________________________________________
some of these increases. It is also possible that all the expenses may not move up proportionately. However, we will have to finance some of these increases. It is also possible that the increase in sales volume could be brought about by granting extended credits. In other words, by investing more funds, we increase the volume of sales. Fund requirements for the business may be seasonal. For example, in industries using agricultural raw materials, it may be more advantageous to procure raw materials during harvest season. In the case of consumer retailing, it may be necessary to hold large inventories during festive season. Most of the fund requirements are restricted to a limited period, and if we provide it on a permanent basis, we may have idle funds during most part of the year. Yet another important aspect which may condition fund requirement is the velocity of circulation of current assets. In other words, the length of the operating cycle will influence the need for funds. The shorter the duration of operating cycle, the faster is the conversion of money invested in current assets into cash and hence, lesser is the need for net working capital. Net working capital requirement is also influenced by the terms available from the suppliers. The credit terms extended by the suppliers will determine the amount of additional funds required. A firm which carries a months inventory and grants one months credit to customers, has to fund the inventory cost of two months. If it could avail two months credit from the suppliers, there is no need to hold inventory and funding receivables. In another situation, suppose the firm carries a balance of RM10,000 of accounts payable, payable in 30 days and an average accounts receivable balance of RM15,000, receivable in 45 days, the firm will have to keep a net working capital for the difference of receipts from customers and payments to creditors as follows: RM Fund required to meet payables due within 30 days Less: Funds received from customers. Received in 45 days, that is, RM15,000 30 45 Nil 10,000 10,000 _________
Assuming the time taken for collection of receivable is 90 days, the situation will be: RM Fund required to meet payables due within 30 days Less: Funds received from customers RM15,000 30 90 10,000 5,000
Fund required in the form of additional net working capital 5,000 ______________________________________________________________________
UNIT 2 89
Understanding financial statements
We could summarise the discussion in respect of the need for working capital by saying that the ability of the firm to circulate the cash raw material inventory work-in process finished goods inventory receivables cash is the most vital and important factor in determining the amount of working capital. However, the exact amount needed to be invested in all these will be determined by the period and quantum of holding each of these elements. This in turn is also influenced by the factors we have discussed in these sections.
232.00
180.00
81.00
73.00
12.50 2.00
6.30
Investments
Intangible assets Technical assistance fees Less: Amortisation 3.00 0.50 _________ 1.00 0.30 _________
Total
Liabilities and capital Current liabilities Acceptance Sundry creditors (Accounts payable) Advances against sales Other liabilities Interest accrued but not due on loans Provisions For taxation Proposed dividend For bonus Other provisions 25.55 2.25 3.40 3.80 _________ 20.45 2.25 2.35 2.95 _________ 4.74 27.16 26.60 8.86 2.64 _________ 3.02 18.75 20.28 7.95 2.00 _________
70.00
52.00
Total current liabilities & provisions Long term liabilities Bank loans 10.5% debentures Loans from financial institutions 40.00 25.50 24.50 _________
50.00 _________
50.00 _________
UNIT 2 91
Understanding financial statements
Issued, subscribed and paid-up 373,100 shares of RM100 each Reserves and surplus Total
As we have studied at the beginning of this unit, the net change in working capital can be computed easily by subtracting the net working capital at the end of the year from the net working capital at the beginning of the year. Tools Malaysia Change in working capital (RM in million) ______________________________________________________________________ December 31, 2006 December 31, 2007 ______________________________________________________________________ Current assets 180.00 232.00 Less: Current liabilities 80.00 105.00 Working capital 100.00 127.00 ______________________________________________________________________ Working capital on December 31, 2007 Working capital on December 31, 2006 127.00 100.00
Increase in working capital 27.00 ______________________________________________________________________ The RM27 million increase in the working capital of Tools Malaysia shows the composite changes in the operating assets. This does not tell us much in terms of the operations of the business. This change could be the net result of changes in all the accounts covered by current items. There may have been qualitative changes resulting from the depletion of liquid items of current assets and increase in nonliquid items such as inventory. In order to answer these questions, we try to analyse the changes in each of the working capital accounts.
The statement of changes in working capital (Table 2.7) shows that the increases in current assets amounted to RM52 million, a major part of the increase arising out of cash, receivable and inventory. Decrease in working capital came about mostly from the increased accounts payable, advances from customers and taxes payable. Total amount of decrease in working capital resulting from increase in current liabilities amounted to RM25 million, thus showing a net increase in working capital of RM27 million. Tools Malaysia Statement of changes in working capital for the year ending December 31, 2007 (RM in million) ______________________________________________________________________ Working capital ________________ Increase Decrease ______________________________________________________________________ Current assets Cash Accounts receivable Loans and advances Other current assets Inventory Total 19.05 10.87 8.18 32.25 20.28 11.97 42.58 33.82 8.76 17.20 15.93 1.27 120.92 99.10 21.82 _________ _________ _________ 232.00 180.00 52.00 _________ _________ _________ 8.18 11.97 8.76 1.27 21.82 Dec. 31 2007 Dec. 31 2006 Increase (Decrease)
Current liabilities & provisions Acceptances Accounts payable Advances against sales Other liabilities Interest accrued Taxes payable Proposed dividend Bonus payable Other provisions Total Working capital Increasing working capital
4.74 3.02 1.72 1.72 27.16 18.75 8.41 8.41 26.60 20.28 6.32 6.32 8.86 7.95 0.91 0.91 2.64 2.00 0.64 0.64 25.55 20.45 5.10 5.10 2.25 2.25 3.40 2.35 1.05 1.05 3.80 2.95 0.85 0.85 _________ _________ _________ _________ _________ 105.00 80.00 25.00 52.00 25.00 _________ _________ _________ _________ _________ 127.00 100.00 27.00 _________ _________ _________
UNIT 2 93
Understanding financial statements
Fixed assets
Figure 2.7 The cash cycle (Source: Adapted from Soloman, Ezra and John J. Pringle, An Introduction to Financial Management, Prentice Hall of India, 1978, p. 179.)
UNIT 2 95
Understanding financial statements
Cheque clears
Funds collected Cheque deposited Payment received Customer mails payment Goods sold
Payment
10 A B
15
2 C D
20 E Time (days)
30
2 2 2 F G H I
Goods produced are sold either on cash or credit. In the latter case, the pending bills are received at a later date. The firm thus receives cash immediately or later for the goods sold by it. The cycle continues repeating itself. The diagram in Figure 2.7 only gives a general idea about the channels of flow of cash in a business. The magnitude of the flow in terms of time is depicted in the diagram given in Figure 2.8. The following information is reflected in Figure 2.8. 1. Raw material for production is received 10 days after placement of order. 2. The material is converted into goods for sale in 37 days (15 + 2 + 20) from points B to E. 3. The payment for material purchased can be deferred to 17 days (15 + 2) after it is received i.e., the distance of time between points B to D, assuming that it takes 2 days for collection of payment of the cheque. 4. The amount of the bill for goods sold is received 32 days (30 + 2) after the sale of goods as depicted by the duration of time between points E to G. 5. The recovery of cash spent until point D is made after 56 days (20 + 30 + 2 + 2 + 2) as shown between points D to J.
Managing these inflows (collections) and outflows (disbursements) are discussed in detail in section 16 in Unit 5.
Activity 2.12
Meet an executive of Accounting and Finance department of a manufacturing organisation regarding the following: 1. What is the length of its cash cycle? Cash cycle is approximately __________________ days.
2. Draw the sequence of cash cycle, showing its successive events with the respective number of days. _____________________________________________________________ _____________________________________________________________ _____________________________________________________________ ____________________________________________________________
3. Find out if the organisation is satisfied with its length of cash cycle. What steps does it propose to take for reducing the cash cycle? _____________________________________________________________ ____________________________________________________________ ____________________________________________________________ _____________________________________________________________
UNIT 2 97
Understanding financial statements
Preparation of a statement of cash flow on cash basis is a straightforward exercise for students. Here, we would take up the statement of cash flow on profit basis for further examination. A framework of the steps to be followed for this purpose is appended below: Steps involved in preparation of a profit basis statement of cash flow: 1. From the first of the two statement of financial positions, take the closing cash balance, which will be the opening cash balance for the purpose of our statement of cash flow. 2. Take the net profit figure. If it is not directly given and you are provided with only profit and loss account balances in both the statement of financial positions, ascertain it (net profit) by preparing an Adjusted profit and loss account. For this purpose, all items of profit appropriations as well as non-cash expenses and income are to be added to and subtracted from the balance of P&L account, as the case may be. This gives the figure of Profit from operation. 3. Adjust increase or decrease in each item of current assets and current liabilities to the Profit from operation figure to arrive at the Cash from operation. 4. Revert back to the Opening cash balance. Add the Cash from operation to it. Also add cash flow from other sources like non-current assets & non-current liabilities, e.g., equity and debenture issue, raising term loan, sale of fixed assets. Deduct cash outflow to various uses, again involving non-current or fixed assets and non-current liabilities, e.g., redemption of preference shares/debentures, retirement of term loan, purchase of fixed assets, etc. 5. The balance arrived at (4) above should tally with the closing balance of cash in the second statement of financial position.
Increases and decreases in various items of assets and liabilities as mentioned under items 3 & 4 above can be optionally organised under operational, investment and financing activities for clarity sake.
We use the above approach and procedure in preparing a profit-basis statement of cash flow in Illustration 2.3. Illustration 2.3 Syarikat Mega Menang ______________________________________________________________________ Statement of financial positions as at31st March, 2007 31st March, 2008 RM RM ______________________________________________________________________ Assets: Freehold property Plant and machineries Less: Depreciation Goodwill Investment Debtors Stock Bills receivable Cash in hand and at bank Preliminary expenses 150,000 110,000 15,000 75,000 108,000 70,000 42,000 20,000 20,000 _________ 610,000 _________ 150,000 170,000 5,000 130,000 132,000 102,000 53,000 50,000 15,000 _________ 807,000 _________
______________________________________________________________________ 31st March, 2008 Statement of financial positions as at31st March, 2007 RM RM ______________________________________________________________________ Liabilities: Share capital (40,000 equity shares @ RM 10 per share) Share premium General reserve Dividend equalisation reserve Profit and loss a/c Sundry creditors Provision for taxation Bills payable
610,000 807,000 _________ _________ ______________________________________________________________________ Aditional information: 1. Shares were issued at a premium of RM1.50 per share.
UNIT 2 99
Understanding financial statements
2. During the year, taxation liability in respect of 2007 was RM20,000 and paid. 3. During the year, RM11,000 was provided for depreciation on plant and machinery. 4. An item of the plant with written down value of RM20,000 was sold at RM25,000. 5. During the year, a dividend @ 7.5% was paid. 6. Part of the investment costing RM30,000 was sold at RM35,000 and the profit was taken in statement of comprehensive income. Based on the above information, we first set ourselves to ascertain the cash inflow and outflow in respect of investment, plant and machineries and tax, which cannot be found out by a mere inspection of their balances in the two statement of financial positions. The task is accomplished by preparing the respective accounts and examining the effects of the additional information on each of these. This is followed by preparation of an Adjusted Statement of comprehensive income to find out the actual net profit earned during the period, in the light of the additional information now available. In the final stage, the Statement of cash flow is prepared (Table 2.9). Investment Account ______________________________________________________________________ To opening balance 75,000 To Statement of comprehensive income (profit on sale) 5,000 To bank (Purchases) 85,000 _________ By sale By closing balance 35,000 130,000 _________
165, 000 165, 000 _________ _________ ______________________________________________________________________ Plant & Machinery Account ______________________________________________________________________ To opening balance 110,000 To Statement of comprehensive 5,000 income (profit on sale) To bank 91,000 _________ By sale By Statement of comprehensive income Depreciation By closing balance 25,000
Provision for Taxation ______________________________________________________________________ To Bank By Closing balance 20,000 35,000 _________ By Opening balance By Statement of comprehensive income 20,000 35,000 _________
55,000 55,000 _________ _________ ______________________________________________________________________ Adjusted Statement of comprehensive income ______________________________________________________________________ To General Reserve To Dividend To Provision for tax To Depreciation 15,000 30,000 35,000 11,000 By Opening balance By Dividend equalisation reserve By Plant and machineries profit on sale By Investment profit on sale By profit for the year (balancing figure) 40,000 10,000 5,000 5,000 101,000
_________
161,000 161,000 _________ _________ ______________________________________________________________________ Statement of cash flow for the year ended 31.3.2008 ______________________________________________________________________ RM ______________________________________________________________________ Opening cash balance as at 1.4.2007 Add/(deduct): Cash flow from operating activities Net profit Add: Decrease in current assets Nil Increase in current liabilities: Sundry creditors 7,000 _________ Deduct: Increase in current assets Debtors Stock Bills receivables 101,000 20,000
7,000
67,000
UNIT 2 101
Understanding financial statements
25,000 _________
92,000
16,000
Add/(deduct): Cash flow from investment activities Add: Sale of plant & machineries Add: Sale of investment Deduct: Purchase of plant and machineries Deduct: Purchase of investments
60,000
85,000 _________
176,000
(116,000)
Add/(deduct): Cash flow from financing activities Add: Issue of share capital Share premium 100,000 60,000 _________ 160,000 Deduct: Payment of dividend 30,000 130,000 _________ 50,000 _________
In Malaysia, the content and format of the statement of cash flow are governed by FRS107. FRS107 permits two ways in which financial information may be presented in a statement of cash flow. A supplementary reading that illustrates these two approaches, the direct method and indirect method, as well as an example of statement of cash flow in accordance to FRS107 are available for download from WawasanLearn.
Activity 2.13
Mention the four major operating activities included in a statement of cash flow. ______________________________________________________________________ ______________________________________________________________________ ______________________________________________________________________ ______________________________________________________________________ ______________________________________________________________________ ______________________________________________________________________
Summary
In this section, we have developed the idea of flow of funds within the organisation. Starting with the funds requirement for an organisation, we have tried to trace the sources and the uses of funds. We have also studied the important sources of funds, namely, the operations, sale of fixed assets, long-term borrowings and issue of new capital. Similarly, important uses of funds were traced to acquisition of fixed assets, payment of dividends, repayment of loans and capital. The whole exercise reveals the areas in which funds are deployed and the source from which they are obtained. Finally, we learnt how to go about doing the funds flow analysis with the help of published accounting information. We have also learnt to distinguish between cash and fund and also statement of cash flow. The importance of cash and statement of cash flow was dwelt upon. Our discussion centered around statement of cash flow on cash basis and profit basis. We learnt how to go about doing the cash flow analysis with the help of accounting information and finally presenting the cash flows in the form of a statement of cash flow.
UNIT 2 103
Understanding financial statements
Self-assessment exercises
1. Jasmine Enterprise has a sales revenue of RM1,000. Depreciation for the period is RM200. Other operating expenses are RM900. Net loss for the period is RM100. a) What is the amount of funds generated from operations during the period by Jasmine Enterprise? b) Under what circumstances can the funds from operation be zero?
2. The following information and statement of financial position relate to Syarikat Rimbun: Syarikat Rimbun Statement of financial position as at 31st December ____________________________________________________________ Year 1 Year 2 Net change during the year
Increase Decrease ____________________________________________________________ Assets RM RM 15,000 25,000 35,000 85,000 (10,000) _________ 150,000 _________ RM RM 5,000 5,000 15,000
Cash 10,000 Receivables 20,000 Inventory 20,000 Plant and machinery cost 85,000 Less: Accumulated depreciation (15,000) _________ Total assets 120,000 _________
5,000
Liabilities & capital Sundry creditors Outstanding expenses Debentures payable Long-term loans Capital Retained earnings 8,000 7,000 10,000 5,000 50,000 40,000 _________ 120,000 _________ 10,000 10,000 5,000 25,000 50,000 50,000 _________ 150,000 _________ 2,000 3,000 5,000 20,000 10,000
______________________________________________________________________
Net profit for the period after charging RM5,000 on account of depreciation was RM20,000. A piece of equipment costing RM25,000 on which depreciation accumulated in the amount of RM10,000 was sold for RM10,000. Dividends paid during the year amounted to RM10,000. Prepare a sources and uses of funds statement in the following format: Syarikat Rimbun Sources and uses of funds (in RM) ____________________________________________________________ Uses of funds Sources of funds
Purchase of plant and Operations: machinery _________ Net income _________ Repayment of Add: Loss in sale of debentures _________ machinery _________ Payment of dividends _________ Add: Depreciation _________ Increase in working Sale of equipment _________ capital _________ Long-term loan _________ Total uses of funds _________ Total sources of funds _________ ____________________________________________________________ 3. The statement of financial position of Syarikat Bestwood as at 31st March 2007 and 31st March 2008 are as follows: ____________________________________________________________ 31st March 31st March 2007 2008 2007 2008 ____________________________________________________________ RM RM Freehold property at cost Equipment (see note) Stock in trade Debtors Bank RM RM
Issued share capital 60,000 80,000 Profit and loss account 54,000 46,000 Corporation tax due: 31st March 2007 12,000 st 31 March 2008 - 8,000 Creditors 24,000 26,000 _______ _______ 150,000 160,000 _______ _______
50,000 50,000 36,000 44,400 32,800 35,600 27,200 28,000 4,000 2,000
UNIT 2 105
Understanding financial statements
Note: Equipment movements during the year ended 31st March 2008 were: ____________________________________________________________ Cost Depreciation Net ____________________________________________________________ RM Balance at 31st March 2007 Additions during the year Depreciation provided during the year Disposal during year Balance at 31st March 2008 60,000 18,000 78,000 8,000 70,000 RM RM
The companys summarised profit calculation for the year ended 31st March 2008 revealed: RM Sales Gain on sale of equipment RM
200,000 800 _________ 200,800 173,200 7,600 _________ 180,800 20,000 8,000 _________ 12,000 _________
Net profit Corporation tax on profits of the year Retained profit of the year
During the year ended 31st March 2008, Syarikat Bestwood made a bonus issue of 1,000 ordinary shares of RM10 each by capitalisation from the profit and loss account. With the help of the above information, prepare a fund flow statement for Syarikat Bestwood, revealing the sources and applications of funds during the year ended 31st March 2008.
Further readings
Haron, H (ed.) (2006) Accounting and Finance: Concepts, Principles and Techniques of Decision Making, Malaysia: Pearson Prentice-Hall (Chapters 1 4). Horngren, C T, Harrison, W T and Bamber, L S (2005), Accounting, 6th edn, Upper Saddle River, New Jersey: Pearson Education International (Chapters 1 4). Warren, C S, Reeve, J M and Fess, P E (2007) Accounting, 21st edn, Ohio: Thompson (Chapters 1 4). Wild, J J, Larson, K D, and Chiapetta, B (2007) Fundamental Accounting Principles, 18th edn, New York: McGraw-Hill Higher Education (Chapters 1 4).
Keywords
Working capital: Current assets minus current liabilities. Funds from operations: The change in working capital resulting from operations. Difference between inflow of funds in the form of revenue and outflow of funds in the form of expenses. Sources of funds: The sources from which we obtain working capital for application elsewhere. Sources include operations, extraordinary profits, sale of fixed assets, new long-term borrowings, new issue of capital and the reduction of existing working capital. Use of funds: Also referred to as application of funds. It means the use of additional working capital and includes amounts lost in operations (Operating loss), acquisition of fixed assets, working capital used for retiring long-term loans, payment of dividends and amounts utilised to increase working capital. Cash from operations: It refers to Profit from operation duly adjusted against the increase or decrease in current assets and liabilities. Cash equivalents: These are highly liquid short term investments which could be readily converted to cash and which are subject to an insignificant risk of changes in value. Cash cycle: Represents the entire process of the flow of cash through a firms accounts.
UNIT 2 107
Understanding financial statements
Activity 2.11
Internal sources of funds commonly include funds generated from operations, sale of non-current assets and any surplus of the working capital. External sources of funds generally come from contributing or raising of additional capital or increasing the long-term borrowing.
Activity 2.13
The major operating activities included in a statement of cash flow are mainly cash inflows associated with sales, interest and dividends received and the cash outflows associated with operating expenses including payments to suppliers of goods and services, payment towards wages, interest and taxes, increase or decrease in current assets as well as increase or decrease from current liabilities.
1. a) Funds generated from operations = RM100. b) When operating cash expenses are equal to operating incomes or revenues.
2. Solution: Syarikat Rimbun Sources and uses of funds ____________________________________________________________ Use of funds RM Sources of funds RM RM
Operations: Net income 20,000 Add: Loss on sale of machinery 5,000 Add: Depreciation 5,000 Sale of equipment Long-term loan 30,000 10,000 20,000 ______
60,000 Total sources of funds 60,000 ______ ______ ______________________________________________________________________ ____________________________________________________________ Year 1 Year 2 __________________________ Current assets Less: Current liabilities Working capital 50,000 75,000
UNIT 2 109
Understanding financial statements
Summary of Unit 2
In this unit, you first looked at the statement of financial position which is a periodic summary of the position of the business. A statement of financial position is the statement of assets, liabilities and owners capital as of a particular point in time. Then, you developed and examined the statement of comprehensive income, also known as the profit and loss account. The statement of comprehensive income shows the net profit or earnings generated by the company and measures the managements ability to generate income from assets. The net profit after payment of dividends shows the amount retained and hence links the statement of financial position with the profit and loss account. In the last section of this unit, you have explored the idea of flow of funds within the organisation and have tried to trace the sources and uses of funds. You have also studied the important sources of funds, e.g., the operations, sale of fixed assets, long-term borrowings and issue of new capital; and the important uses of funds e.g., acquisition of fixed assets, payment of dividends, repayment of loans and capital. You have then explored discussion centered around statement of cash flow and how to go about doing the cash flow analysis with the help of accounting information. Finally, you learnt how to present the cash flow in the form of a statement of cash flow. Supplementary readings on topics in Unit 2 are available at WawasanLearn to provide you with futher information on the preparation of financial statements in relation to the relevant Financial Reporting Standards (FRS) in Malaysia. Please download the materials from WawasanLearn for your futher readings.