Chapter 2: Financial statements for decision making

3. Entities are expected to perform in the spheres of profit, people and the planet. List
some key performance indicators applicable to each sphere.

The sphere of profit relates to financial performance and business strategies of the entities.
Examples of key performance indicators under the profit sphere include:
 profit margin
 profit after tax
 return on assets
 return on equity
 asset turnover
 EPS growth
 sales growth.

The sphere of people relates to the entities’ employees and involvement in the community.
Examples of key performance indicators under the people sphere include:
 employee turnover rate
 employee absenteeism
 number of work place accidents
 percentage of female employees
 donations to charities
 programs run by the entities for the community.

The sphere of planet relates to the impact of the entities’ operations on the environment.
Examples of key performance indicators the planet sphere includes:
 carbon gas emissions
 water and electricity usage
 recycling program
 waste management.

6. Discuss whether an asset needs to be legally owned to be recorded as an asset on the

balance sheet.
Assets are defined in the Conceptual Framework as ‘resources controlled by the entity as a result
of past events and from which future economic benefits are expected to flow to the entity’ (para.
49(a)). That is, to be recorded as assets, the entity must have the ability to benefit from the use of
the assets and deny access of others to the benefits (i.e. control).

Although, in most cases, legal ownership will give the entity control over an asset, certain types
of lease arrangements can result in the entity controlling the asset. For example, finance leases
transfer the risks and benefits of ownership to the lessee, which means the leased asset is now
controlled by the lessee. Subsequently, the leased asset should be recorded as an asset on the
lessee’s balance sheet, even though the lessee does not legally own the asset just yet.

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Furthermore, following the qualitative characteristics of faithful representation in the Conceptual
Framework, it is important that the economic substance rather than the legal form of the
transaction is reported. In a finance lease, legal title to the leased asset still remains with the
lessor until the end of the relevant lease term when the lessee has made all lease payments.
However, the lessee has use of and earns economic benefits from the leased asset for this time
period (i.e. economic substance), and hence the leased asset should be recorded as an asset in the
lessee’s balance sheet during the period of the lease term.

In summary, an asset does not need to be legally owned by the entity to be recorded as an asset
on the balance sheet. As long as the entity controls the asset, then the asset must be reported on
the entity’s balance sheet.

10. Discuss the significance of the following assumptions in the preparation of an

entity’s financial statements:
(a) Entity assumption
(b) Accrual basis assumption
(c) Going concern assumption
(d) Period assumption

(a) Entity assumption:

If the transactions of an entity are to be recorded, classified and summarised into financial
statements, the accountant must be able to identify clearly the boundaries of the entity being
accounted for. Under the accounting entity assumption, the entity is considered a separate
entity distinguishable from its owner and from all other entities. It is assumed that each entity
controls its assets and incurs its liabilities. The records of assets, liabilities and business activities
of the entity are kept completely separate from those of the owner of the entity as well as from
those of other entities.

The accounting entity assumption is important since it leads to the derivation of the accounting
equation.

(b) The accrual basis assumption:

Under the accrual basis of accounting, the effects of transactions and events are recognised in
accounting records when they occur, and not when the cash is received or paid. Hence, financial
statements report not only on cash transactions but also on obligations to pay cash in the future
and on resources that represent receivables of cash in future. It is argued in the Conceptual
Framework that accounting on an accrual basis provides significantly better information about
the transactions and other events for the purpose of decision making by users of financial
statements than does the cash basis.

(c) The going concern assumption:

According to the Conceptual Framework, financial statements are prepared on the assumption
that the existing entity is expected to continue operating into the future. It is assumed that the

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assets of the entity will not be sold off and that the entity will continue its activities; hence,
liquidation values (prices in a forced sale) of the entity’s assets are not generally reported in
financial statements, as this assumes that an entity is to be wound up.

When management plans the sale or liquidation of the entity, the going concern assumption is
then set aside and the financial statements are prepared on the basis of estimated sales or
liquidation values. The significance of the going concern assumption is in the valuation placed
on the assets of an entity in the entity’s financial statements. The statements should identify
clearly the basis upon which asset values are determined — going concern? Or liquidation?

(d) The period assumption:

For financial reporting purposes, it is assumed that the total life of an entity can be divided into
equal time intervals. Hence, the financial performance of the entity can be determined for a given
time period, and the financial position of the entity can be determined on the last day of that
reporting period.

As a result of this assumption, profit determination involves a process of recognising the income
for a period and deducting the expenses incurred for that same period. Together, the period
assumption and accrual basis assumption lead to the requirement for making end-of-period
adjustments on the last day of the reporting period. These adjustments will be considered in
chapter 4.

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Exercise 2.10

Explaining accounting transactions

The following schedule shows the effect of several transactions on the accounting equation
of Preya Palit and the balance of each item in the equation after each transaction. Write a
sentence to explain the nature of each transaction. (LO5)

(1) Preya Palit invested $20 000 into the business.

(2) Purchased office equipment for cash $7000.
(3) Preya Palit invested a further $2000 into the business, OR sold services for cash.
(4) Performed services and billed clients for $6000.
(5) Office supplies of $3000 were bought on credit.
(6) $4000 was received from clients for amounts owed (accounts receivable).
(7) Preya Palit withdrew $8000 from the business, or expense paid in cash.
(8) $2000 worth of office supplies were used.
(9) Paid accounts payable $3000 owed to them.

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Problem 2.21

Correction of financial statements

A new business graduate with one subject of accounting prepared the financial statements
below for Helen’s Dancing School at the end of the first year of operations.

Additional analysis revealed the following:

1. Dancing fees of $7500 (owed by customers) were unrecorded at 30 June.
2. Additional equipment of $10 500 purchased with a bank loan at the end of the month
had not been recorded.
3. Supplies on hand at 30 June costing $10 600 were included in expenses.
4. Wages of $2500 were payable at 30 June.

Required
(a) Prepare a corrected income statement for the year ended 30 June 2019.
(b) Prepare a corrected balance sheet in narrative form as at 30 June 2019.
(c) Prepare a statement of changes in equity for the year ended 30 June 2019.
(d) Discuss the accounting assumptions that the graduate has breached.

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(LO3, LO4 and LO5)

(a)

HELEN’S DANCING SCHOOL

Income Statement
for the year ended 30 June 2019
INCOME
Dancing fees $122 500
EXPENSES
Studio rent expense $18 000
Wages expense 45 500
Supplies expense 5 600
Electricity expense 6 750
Depreciation expense
— vehicle 3 200
— equipment 4 300
7 500
83 350
PROFIT $39 150

(b)

HELEN’S DANCING SCHOOL

Balance Sheet
as at 30 June 2019
ASSETS
Cash at bank $12 600
Accounts receivable 7500
Supplies on hand 10600
Equipment 28 300
Vehicle 20 700
TOTAL ASSETS 79700
LIABILITIES
Accounts payable 13 000
Wages payable 2500
Bank loan 10 500
TOTAL LIABILITIES 26000
NET ASSETS 53700
EQUITY

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 H. Horner, Capital 53700
TOTAL EQUITY

c)

HELEN’S DANCING SCHOOL

Statement of Changes in Equity
for the year ended 30 June 2019
H. Horner, Capital – 1 July 2018* 25750
Add: Profit for the year 39 150
64900
Less: Drawings during the year 11 200
H. Horner, Capital – 30 June 2019 53700

*Beginning balance of capital is found by working backwards, namely,

$53700 + $11 200 – $39 150. This assumes that the owner did not make a capital contribution
during the year.

(d) The graduate mainly has breached the accrual basis assumption, which states that financial
statements of an entity are assumed to be prepared using accrual basis. Under the accrual basis,
income (expenses) is (are) recognised in the period when increases (decreases) in economic
benefits occur, rather than when cash is received or paid.

The accrual basis assumption was breached as the graduate initially:

 Did not record $7500 dancing fees owed by customers as income for the year ended 30 June
2019. The dancing lesson was provided during that period, and therefore under the accrual
basis the $7500 dancing fees were earned in that period even though the customers have not
yet paid; the amount owing should be recorded as an asset on the balance sheet.
 Did not record the $2500 wages owed by the dancing school to its employees as expenses for
the year ended 30 June 2019. The employees have providences to their services to the
dancing school during the period, and therefore under the accrual basis the $2500 wages
payable was incurred in that period even though the employees have not yet been paid.
 Included $10 600 unused supplies as expenses in the year ended 30 June 2019. Under the
accrual basis, expenses are to be recognised when decreases in economic benefits have
occurred (i.e. when supplies are used), and therefore unused supplies should not be
recognised as expenses. Instead, they should be recorded as assets on the balance sheet.

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Chapter 3: Recording transactions
1. Indicate whether each of the following events is an internal transaction, an external
transaction, or a non-transaction event. Explain your answer in each case:
(a) Receipt of money from a customer in payment of services to be provided early in the
next accounting period.
(b) Equipment is used to provide a service for a customer
(c) The human resources department provided services to the customer service
department.
(d) A building owned by the business increased in value
(e) Received payment from a customer on account for services provided in the previous
accounting period.
(f) A prospective employee is interviewed and hired for a job
(g) Stationery supplies are used by an employee.

(a) External, because an event has happened between the entity and an outside party. Even
though no service has yet been provided the receipt of money means that the entity now has a
liability to either provide the service in the future or return the money. This needs to be
recorded immediately.

(b) External and Internal. Even though the equipment has been used in the performance of a
service to an outside party (external), the usage and wearing out of the equipment is usually
recorded as an internal adjustment by way of depreciation on the equipment.

(c) Internal, as there needs to be a record kept within the entity of the provision of services
between departments so that the cost of running each department may be accurately
determined.

(d) Non-transaction event. However, if it is the practice of an entity to revalue such assets to
show the higher value of the building, it would be recorded as an internal transaction, as there
is no outside party involved.

(e) External, as there is an external party directly involved. Even though the provision of
services would have been recorded in the previous period along with accounts receivable, the
receipt of cash affects the cash at bank and reduces accounts receivable in the current period.

(f) Non-transaction event, which is not recorded until an employee has begun work and has
provided services to the entity

(g) Internal, as there is merely an adjustment inside the entity to reflect a change in value due to
supplies being used. No external party is involved.

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Exercises

Exercise 3.8

Recording transactions in general journal and analysis

The following accounts appear in the ledger of the Henrietta’s Huge Hair Hairdressers:
Cash at Bank; Accounts Receivable; Hairdressing Equipment; Accounts Payable;
Henrietta Bouffant, Drawings; Hairdressing Revenue; Salaries Expense; and Advertising
Expense.

Required
(a) Prepare the general journal entries to record the transactions that occurred during
December (ignore GST).
(b) Explain why you have made each of the journal entries to account for the transactions.

(LO4)

(a)

HENRIETTA’S HUGE HAIR HAIRDRESSERS

(ignore GST)
Dec. 1 Hairdressing Equipment 65 000
Cash at Bank 5 000
Accounts Payable 60 000
Purchased hair drying equipment for cash and on credit.

3 H. Bouffant, Drawings 1 200

Cash at Bank 1 200
Cash withdrawn by owner.

8 Salaries Expense 6 800

Cash at Bank 6 800
Salaries paid.

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14 Advertising Expense 800
Cash at Bank 800
Cash paid for radio commercials.

19 Cash at Bank 540

Accounts Receivable 540
Cash received from credit customers

23 Accounts Payable 3 700

Cash at Bank 3 700
Cash paid to suppliers.

30 Cash at Bank 46 080

Accounts Receivable 11 520
Hairdressing Revenue 57 600
Memberships fees earned.

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(b)

December 1 The Hairdressing Equipment account is increased to record the purchase

by debiting the account. At the same time, Cash at Bank is decreased by
crediting the account for the amount of the deposit paid, and a liability,
Accounts Payable is increased by crediting the account for the amount
of $60 000 payable in 60 days.

3 This transaction is a withdrawal of assets from the business by the

owner and is not an expense related to the earning of income. A debit is
made to the Drawings account to reflect the decrease in the owner’s
investment in the business, and the decrease in the Cash at Bank account
is recorded by a credit.

8 Salaries are an expense of the business to reflect the cost of services

received by the business from its employees. The business pays its
employees for the services they have rendered to the business by
crediting the Cash at Bank account and debiting the Salaries Expense
account.

1 Advertising costs are an expense of the business to reflect the cost of

4 advertising services received as supplied by the newspaper. The
business pays the newspaper for the services rendered to the business by
crediting the Cash at Bank account and debiting the Advertising
Expense account.

1 The receipt of cash from credit customers is recorded by a debit to the

9 Cash at Bank account; and Accounts Receivable is credited to reduce the
amount owing to the business by these customers. Services have
previously been supplied to the customers by the business, and this
transaction reflects the receipt of cash from these customers.

2 The supplies had been purchased on a previous occasion; hence, an

3 Accounts Payable liability account would have been credited at that
time. Now, the payment of the Accounts Payable is recorded by
reducing the liability account (debit) and reducing the Cash at Bank
account (credit) for the amount of $3700.

3 This is an income transaction reflecting the amount of hairdressing

0 revenue earned (received or receivable) for the month of December.
Hence, a revenue account, called Hairdressing Revenue, is credited and
Cash at Bank is debited for the amount received from customers who
paid in cash. For credit customers, an asset, Accounts Receivable, is
debited to record the amount owing by these customers for services
received by them from the business in December.

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Problem 3.18

Preparing the general journal

GST version

The Arid Sands Golf Club was opened for business on 1 July by Todd Simpson. The
following selected events and transactions occurred during the first month of operations.

Required
Prepare general journal entries for the month of July, using appropriate account titles.
Assume that a GST of 10% needs to be added for all appropriate transactions. (LO4)

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July 1 Cash at Bank 2 500 000
Todd Simpson, Capital 2 500 000
Cash contributed by owner.

3 Land 1 000 000
Building 650 000
Equipment 150 000
GST Receivable 180 000
Cash at Bank 1 980 000
Jeffrey’s Golf World acquired for cash.

6 Advertising Expense 36 000

GST Receivable 3 600
Cash at Bank 39 600
Cash paid for advertising.

10 Prepaid Insurance 36 000

GST Receivable 3 600
Cash at Bank 39 600
Cash paid for 1 year insurance policy.

18 Golfing Equipment 60 000

GST Receivable 6 000
Accounts Payable 66 000
Purchase of golfing equipment from Rory
Golfing.

19 Cash at Bank 24 200

Golf Fees Income 22 000
GST Payable 2 200
Cash received for golf fees.

25 Cash at Bank 88 000

Unearned Golf Services 80 000
GST Payable 8 000
Cash received on sale of 200 coupon books for
$90 each.

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27 Todd Simpson, Drawings 10 000
Cash at Bank 10 000
Cash withdrawn by owner.

29 Wages Expense 12 600

Cash at Bank 12 600
Cash paid for wages

30 Accounts Payable 66000

Cash at Bank 66 000
Cash to Rory Golfing.

31 Cash at Bank 13 200

Golf Fees Income 12 000
GST Payable 1 200
Cash received for golf fees.

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