SHAREHOLDERS’ EQUITY

Shareholders’ equity is the excess of assets over liabilities. It is a residual claim of the shareholders on the assetsof the organisation. Shareholders’ equity consists of two main elements: share capital and retained profits.

v Share capital is the amount that owners have directly invested in the company.

v Retained profits represent the total cumulative amounts of profits that the company has retained in thebusiness rather than distributed as dividends.

The relationship between assets, liabilities and shareholders’ equity can be expressed in the followingaccounting equation:

Assets = Liabilities + Shareholders' equity

This equation shows that the resources of an enterprise are funded from two types of sources: debt orequity. The effects of transactions on this equation are discussed in Chapter 2. At this point you should notethat the equation balances at every point in time.

Comparative balance sheetsNote that the balance sheet in Exhibit 1.1 shows numbers for 2011 and 2012. The changes from 2011 to2012 provide the reader with information about what is happening to various account balances; for example,cash at bank has increased from $1400 to $2000. The statement does not tell us the reasons for the change,but it is possible to obtain information on the change in this account in the statement of cash flows providedin Exhibit 1.3 (to be discussed later). While some of the reasons for the changes in other balances are toocomplicated for this introductory chapter, you will be able to understand the changes after you havecompleted the next two chapters (we will return to Exhibit 1.1 in Chapter 2). For now, consider somepreliminary ideas:

v What would be a likely explanation for the increase in accounts receivable? Most likely credit sales (thiswould increase accounts receivable) are greater than cash received from customers related to credit sales(this would decrease accounts receivable).

v What does the no change in share capital mean? This normally indicates that there have been no sharesissued during the year. The long-term loans have increased from $25 000 to $30 000.

HOW’S YOUR UNDERSTANDING?• If the balances of total assets and shareholders’ equity are $100000 and $40000 respectively,

what is the balance of total liabilities?• If the balances of total liabilities and shareholders’ equity are $200000 and $300000 respectively,

what is the balance of total assets?• Given the following balances – assets $300000; liabilities $200000; share capital $60000 – what

is the balance of retained profits?

(Your answers should be: $40000; $500000; $40000)

14 v FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH

In a company, the board of directors is the senior level of management, operating the company on behalf ofthe owners. When the board declares a dividend, the amount is deducted from retained profits at that time. Atthat point, the company has a liability to the owners, which it pays off later by sending the owners the promisedcash. This involves two principles of financial accounting:

1 Transactions with owners, of which the main example is dividends, are taken out of retained profits. Theyare not an expense, and therefore are not deducted in calculating profit for the period.

2 Owners can be creditors too, if they are owed dividends or have lent the company money in addition tothe shares they bought.

2.8 Connecting balance sheetsand income statementsThe balance sheet shows all assets, liabilities and shareholders’ equity accounts at a point in time. Usually thebalance sheet is comparative, showing the accounts at both the beginning of the income statement’s period(that is, the end of the previous period) and at the end of the income statement’s period, and thereforeshowing both the beginning retained profits and the ending retained profits.

Assets at beginning = Liabilities + equity (including retained profits) at beginning

Assets at end = Liabilities + equity (including retained profits) at end

Change in assets = Change in liabilities + change in equity (including retained profits)

Suppose a corporation had assets of $1200 at the beginning of a year and $1450 at the end, and liabilitiesof $750 at the beginning and $900 at the end. We can deduce that its equity was $450 at the beginning and

HOW’S YOUR UNDERSTANDING?Here is an exercise you should be able to complete, based on what you have read. The following

transactions occurred during 2012:

a Issues shares to investors for 100 000 cash.

b Borrowed $61 000 from the bank.

c Purchased equipment for cash $17 000.

d Purchased $723 000 of additional inventory on credit.

e Sold $1 141 900 of products to customers on credit; cost of the goods was $700 000.

f Incurred $218 200 in selling expenses, paying 80% in cash and owing the rest.

g Paid cash dividends of $16 000

h Earned $4000 interest on investments, receiving 75 per cent in cash.

i Incurred $2900 in interest expense to be paid at the beginning of next year.

1 What was revenue for the year?

2 What are expenses for the year?

3 How much will retained profits increase by?

(Your answer should be:

1 1 141 000 + 4000 = 1 145 000

2 700 000 + 218 200 + 2900 = 921 100

3 1 145 000 – 921 100 = 223 900)

Chapter 2 Measuring and evaluating financial position and financial performance v 65

3.1 Transaction analysisThe purpose of this section is to extend your knowledge of how various transactions affect the accountingequation. In this section we concentrate on transactions that affect the balance sheet. In section 3.2, theaccounting equation is expanded to show the effect on the income statement. Transaction analysis is a usefulway of understanding how any transaction or event affects a company’s financial statements.

Recall that the basic accounting equation is:

Assets  =  Liabilities  +  Shareholders0 equity

After each transaction, the total assets must always equal the total liabilities and shareholders’ equity. Thisequality remains regardless of the type of transaction.

To illustrate, consider the following transactions for LRM Ltd for March 2012:

1 Shareholders invest $200000 cash in the business. The effect of this transaction is to increase cash (an asset)and increase share capital (a shareholders’ equity account).

2 Land and building is purchased for $30000, which is financed by a loan from the seller repayable in five years. Forthis transaction, land and buildings (an asset) is increased. This is financed through a loan, so loan (a liabilityaccount) is also increased. Note that this transaction does not affect shareholders’ equity. The shareholdersdo not have any more or less equity in the company, as assets and liabilities increased by the same amount.Note that after these first two transactions the accounting equation is still in balance, as will be the case afterevery transaction.

3 Inventory worth $50000 is bought on credit. Inventory is purchased for $50000, with an agreement to pay thesuppliers at a later date (usually 30 days after the date of sale). Again, both an asset and a liability areincreased. In this case they are inventory (asset) and accounts payable (liability).

4 Equipment worth $90000 is purchased by paying $20000 cash and signing an agreement to pay the remainderin 90 days. This involves the purchase of equipment (increase in an asset), which is financed by both payingout cash (an asset) and incurring a liability, which in this case is notes payable. Notes payable differs fromaccounts payable because the liability is evidenced by a promissory note or bill of exchange. Notes payableincreased by $70000.

5 Damaged inventory which was purchased on credit at a cost of $5000 was returned to the supplier. This reversespart of transaction 3. The damaged inventory is returned to the supplier, thus decreasing inventory (anasset). As less money is now owed to the suppliers, accounts payable (a liability) is also reduced.

6 Paid $30000 on accounts payable. This results in the liability, namely accounts payable, being reduced by thepayment that reduces an asset, namely cash.

7 Purchased $10000 inventory using cash. All of the above six transactions have affected both sides of theequation. However, this transaction affects only the asset side. It results in one asset (inventory) increasingand another asset (cash) decreasing. Again, after all transactions have been recorded, the accountingequation balances.

A summary of the effect of each of these transactions is shown in Exhibit 3.1. Based on the totals ofthe accounting equation in Exhibit 3.1, a balance sheet is produced in Exhibit 3.2. As this is a new organisationand none of the transactions affected revenues or expenses, there is a zero balance for retained profits. Notethat at this stage neither interest on the loan nor depreciation on the buildings and office equipment has beenincluded.

96 v FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH

b Shareholders’ equity increases and liabilities decrease.c Assets increase and liabilities decrease.

3 Why does an increase in revenues result in an increase in shareholders’ equity? What other part ofthe accounting equation is likely to be affected?

4 Why does an increase in expenses result in a decrease in shareholders’ equity? What other part ofthe accounting equation is likely to be affected?

5 Which accounts normally have a debit balance and which normally have a credit balance?6 Choose five transactions and show both the resource effect and the source effect.7 Explain how the balance sheet and the income statement articulate.8 List some of the larger expenses you would expect to see in the income statement for the following

organisations:a Woolworthsb Commonwealth Bankc Red Cross Charityd Australian Navy

PROBLEMS

PROBLEM 3.1Complete transaction analysis and prepare financial statements

The following transactions occurred for the month of November 2012 for Hoad Ltd:1 The company was incorporated, with shareholders investing $200 000 in cash.2 Purchased inventory for cash, $20 000.3 Paid $4000 for a month’s rent on the premises.4 Purchased inventory on credit, $30 000.5 Received an advertising bill for newspaper advertisement to promote the new company. The $1000

bill will be paid in May.6 Inventory with a cost of $40 000 was sold on credit for $90 000.7 Paid $25 000 of accounts payable.8 Received $30 000 from accounts receivable.9 Paid wages of $15 000.10 Paid sales commission at the rate of 1 per cent on sales made during the month.11 Purchased a new computer for $6000, paid $3000 in cash and $3000 to be paid in 15 months

time.12 Owed employees $2000 in wages at the end of the month.

Required:

1 Show the effect of each of the above transactions on the accounting equation.2 Prepare an income statement and a balance sheet at 30 November 2012.3 Prepare journal entries for each transaction and determine the balances for each account.4 For each transaction (a) to (l), what is the effect on net profit and total assets? Write increase,

decrease or no effect for each transaction.

PROBLEM 3.2Net profit and total assets

During the year ended 30 June 2012, the following information was recorded in the company’s accounts:1 credit sales $400 0002 cash sales $120003 collections from customers $3000004 purchases of inventory on credit $1400005 payments of accounts payable $1000006 cost of goods sold $160000

Chapter 3 The double-entry system v 131

PROBLEM 3.24Retained profits

The accounts for Prentice Retail Ltd for last year included the following (in alphabetical order):

$

Dividends declared 87000 DR

Income tax expense 145210 DR

Miscellaneous revenue frominvestments

23570 CR

Operating expenses 1703470 DR

Retained profits, beginning of year 354290 CR

Revenue from sales 2111480 CR

Calculate net profit, and prepare a note to show the change in retained profits for the year.

PROBLEM 3.25Cash balance and accrual accounting profit

Using the following information for David Tours, calculate:1 the cash in bank as at the end of 20122 the 2012 accrual accounting profit.

$

Owing from customers as at the end of 2011 (collected in 2012) 1000

Owing from customers as at the end of 2012 (collected in 2013) 850

Cash collected from customers during 2012 for 2012 trips 68 990

Payable to suppliers as at the end of 2011 (paid in 2012) 1480

Cash paid to suppliers during 2012 for 2012 expenses 36 910

Payable to suppliers as at the end of 2012 (paid in 2012) 2650

Depreciation on equipment during 2012 3740

Cash in bank as at the end of 2011 12 430

PROBLEM 3.26Reconciliation of cash profit and accrual profit

Turku Services Company had a cash profit for its first year in business of $67450 and an accrual profit of$49 860. Show how the two amounts reconcile, using the following information:1 Uncollected revenue at the end of the year was $18730.2 Unpaid bills for expenses at the end of the year totalled $24880.3 Expenses for the next year, paid already, totalled $2300.4 Depreciation on the company’s equipment was $13740 for the year.

PROBLEM 3.27Calculate accrual profit and change in cash

‘I just don’t understand it!’ Barry had received his accountant’s calculation of his business profit, showingan accrual profit for his first year in business of $45290. ‘If I made so much money, why don’t I have it inthe bank? My bank account shows only $15040 on hand!’

Chapter 3 The double-entry system v 141

commissions earned and unbilled revenues. For example, assume a company deposited $300 000 with a bankfor one year at 10 per cent on 1 March 2012 (interest payable at the end of the period). At 30 June 2012,they would have earned $10 000 interest, although the total interest of $30 000 would not be received until28 February 2013.

Accrued interest (also called ‘interest receivable’), which is an asset, would be increased by $10 000, andinterest revenue would be increased by $10 000.

Assets 5 Liabilities 1 Equity

Interest revenueAccrued revenue

30 June +10 000 +10 000

Total +10 000 +10 000

Accrued revenue (or interest receivable) is a current asset that will appear in the balance sheet, and interestrevenue is a revenue account that will appear in the income statement for the year ending 30 June 2012.

The journal entry would be:

30 June DR Accrued revenue 10 000

$ $

CR Interest revenue 10 000

An interesting example of accrued revenue is provided in the 2011 Telstra accounts. Telstra bills itscustomers either monthly or quarterly. When it bills customers, it increases accounts receivable andincreases sales revenue. When the cash is received, cash is increased and accounts receivable is decreased.However, at 30 June there will be a lot of telephone calls that have been made but not yet billed. Forexample, if you receive a bill on 1 June (and you are billed quarterly), you will not receive another bill until1 September. As telephone calls have been made in June, Telstra has provided the service; therefore, it isentitled to recognise the revenue. Telstra’s financial statements (note 10) show accrued revenue of$864 million ($895 million in 2010) under current assets. That is, at the end of the year, it decreasedaccrued revenue and decreased sales revenue.

HOW’S YOUR UNDERSTANDING?Here are two questions you should be able to answer, based on what you have just read:

1 What effect would failure to make adjustments for accrued expenses have on the balance sheet and

the income statement?

2 A company has a $50000 balance in the company’s unearned service revenue account. Where

would this account appear in the balance sheet?

(Your answer should be:

1 Income statement: expenses would be understated and therefore profit overstated.

Balance sheet: liabilities would be understated and retained profits would be overstated (because

profit was overstated).

2 Liabilities (probably current liabilities assuming that the service will be carried out within a year).)

218 v FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH

2 Prepare an accrual-basis income statement for Wizard Enterprises for the year ended 30 June2012.

PROBLEM 5.3Simple accrual expense questions

Before its opening, the Novelty Shop arranged for telephone service. The shop’s owner was told that thetelephone company bills the customer for each month’s service at the end of the month, and no depositor installation fee is required.1 Did the installation of the telephone increase the assets of the Novelty Shop? Did it result in an

expense at the time of installation?2 If the monthly service charge is $21, how will this affect the computation of profit for the first two weeks?3 What would be the effect on assets and profit if the service charge for the first month were paid in

advance at the beginning of the month?4 What would be the effect on assets and profit if an installation charge of $10 were paid at the

beginning of the month?

PROBLEM 5.4Revenue, expenses and cash

PQR provides one-day training programs on accounting. It charges $6000 per day.The following events occurred for PQR in the month of June 2012.

1 Received $24000 from accounts receivable for sales in previous months.2 Paid three months rent of $24000 covering 1 June 2011 to 30 August 2011.3 Received orders for 60 days training during the month. Delivered 50 of the days training during the

month and received payment for 30 of these days.4 Signed a contract to design a special program for lawyers at a price of $20000. Design will

commence in July. Received a $6000 deposit.5 Paid $500000 for new equipment on 1 June and $100000 to install it. The equipment has a life of

10 years.6 A contract was signed with a new CEO for $1000000 per year. The CEO will start on 1 July.7 Paid wages during the period of $60000 with accrued wages of $10000 owing at the end of the month.8 Declared and paid a dividend of $40000.9 Sold a piece of equipment which cost $160000 (accumulated depreciation $120000) for $32000.10 Wrote down the value of damaged inventory by $3600.11 Increased the allowance for doubtful debts by $6000.12 Borrowed $24000 on 1 June from the bank at 10 per cent per annum. Interest and principal

repayable in 10 months.

Required:

1 Determine total revenue for the month of June 2012.2 List all expenses for the month of June 2012 (including dollar amounts).3 Assume an opening balance in the cash account of $600000. What is the closing balance of this

account?

PROBLEM 5.5Revenue and expenses

ABCD started business on 1 July 2012 and had the following transactions on 1 July:1 Issued 400000 shares of $2 for $800000 cash.2 Bought equipment for $400000 paying cash. The equipment has a five-year life.3 Bought $90000 inventory on credit.4 Paid $10000 for a year’s rent on a building.5 Took out a two-year $400000 bank loan at an interest rate of 8 per cent per annum. The interest is

not payable until the end of the loan.Between 1 July and 31 December, the following transactions occurred:

248 v FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH

Practice problemsSolutions to practice problems can be found online at http://login.cengagebrain.com/. These problemsare intended to facilitate self-study and additional practice: don’t look at the solution for any of these

without giving the problem a serious try first, because once you have seen the solution it always lookseasier than it is.

PRACTICE PROBLEM ADepreciation, calculations, entries and effects

At the beginning of 2011, Garrison Ltd acquired machinery that cost $100000, had a useful life of10 years and zero scrap value. During 2011 and 2012, the company depreciated this machinery usingthe straight-line method. In 2010, it decided to change to the reducing balance method of depreciation ata rate of 20 per cent. Garrison is taxed at an income tax rate of 40 per cent.1 Calculate the depreciation expense Garrison has recognised for 2011 and 2012 and write a journal

entry to record either year’s amount.2 Calculate the depreciation expense Garrison would have recorded, had it been using the reducing

balance method for 2011 and 2012.3 Calculate the effects of changing from straight-line to reducing balance on the following:

a the balance sheet at the end of 2011b the income statement for 2012c the balance sheet at the end of 2012.

PRACTICE PROBLEM BDetermining cost of noncurrent assets

On 1 January 2012, Combo Ltd purchased a factory (and the land on which it stood), together with themachinery in it, for $700000 in total. The independently determined appraisal values were:

$

Land 320 000

Building 180 000

Machinery 200 000

In January, a portion of the building was demolished, at a cost of $1200, to allow for the extension ofthe building to house new machinery. $200 was received for materials salvaged from the demolition.However, in the course of the demolition, existing machinery was damaged, requiring expenditure of$400 on repairs. This amount was not recoverable from the demolition company. In February and Marchthe extensions were built. Construction costs were $40000, architect’s fees were $4000 and legal feeswere $500. In April, new machinery was purchased for $50000 (list price). Sales tax of 4 per cent waspaid, as were freight and installation costs of $750. In addition, $500 was spent on making changes toan existing machine to extend its useful life.

Required:

1 If a balance sheet was to be prepared at the end of April 2012, what amounts would be shown forthe cost of land, buildings and machinery? Prepare separate schedules, listing individual componentsof the cost of land, buildings and machinery, to support your answer.

2 What is the effect on shareholders’ equity of the above transactions (if any), assuming all paymentswere made in cash? Briefly explain your answer.

478 v FINANCIAL ACCOUNTING: AN INTEGRATED APPROACH

Cash flows from financing activities:

Cash paid for dividends 40 000

Net cash flow used for financing activities (40 000)

Increase in cash 42 900

Cash at beginning of the year 27 500

Cash at end of the year 70 400

After reviewing the cash flow statement, John was puzzled and telephoned you to seek help. Johnraised the following questions and concerns:1 Issuing shares for the land is not listed in the statement. Wouldn’t this transaction affect both the

cash flows from investing and financing activities?2 Why does the bank need this statement anyway? They can calculate the increase in cash from the

balance sheets for the last two years.3 Would this cash flow statement enhance our chance of obtaining the loan from the bank?4 Why is depreciation and the decrease in accounts receivable deducted from net profit?5 What was the book value of the investments sold?6 Did the company borrow or issue shares during the year?7 What was the change in accumulated depreciation accounts during the year?8 Were credit sales or cash from customers high during the year?

PROBLEM 14.7Interpreting a statement of cash flows

Outline the five most important things you learn about Tabcorp Holdings Limited from the followingconsolidated statement of cash flows for the year ended 30 June 2011.

Note 2011 2010

$m $m

Cash flows from operating activities

Net cash receipts in the course of operations 4 439.3 4 280.2

Payments to suppliers, service providers and employees (2 357.2) (2 213.6)

Payment of government levies, betting taxes and GST (1 075.2) (1 038.0)

Interest revenue received 8.1 6.6

Finance costs paid (159.2) (155.0)

Income tax paid (197.7) (179.0)

Net cash flows from operating activities 21 658.1 701.2

Cash flows from investing activities

Payment for property, plant and equipment andintangibles

(595.6) (408.1)

Proceeds from sale of property, plant and equipmentand intangibles

2.1 2.7

Loans advanced to customers (47.6) (4.7)

Net cash flows used in investing activities (641.1) (410.1)

Chapter 14 The statement of cash flows v 633

Other income:

Dividends received 5

Other expenses:

Interest expense (25)

Loss on disposal of land (18)

(38)

Income before income tax 198

Income tax 88

Net profit 110

The following additional information during the year was obtained from an examination of the ledger:1 a parcel of land with an original cost of $60000 was sold2 all sales over the year are made on credit.

Required:

1 Prepare a statement of cash flows (direct method) for the year ending 30 June 2011.2 Prepare a reconciliation statement (indirect method) for the year ending 30 June 2011.

PROBLEM 14.24Ethics of cash flow manipulation

There is an interesting ethical issue behind the very reason that the statement of cash flows is thought bysome people to have advantages over the income statement. The reason is that people are oftenmistrustful of the income statement, because they feel its accrual accounting methods can be used tomanipulate net profit as a measure of performance, and they think that the cash flow figures are more‘real’. For example, a company might claim large revenues, not yet collected, that make its revenue higher(via the entry DR Accounts receivable, CR Revenue). However, if the cash has not been collected, theincrease in accounts receivable will be deducted from net profit on the statement of cash flows, and thelack of ‘real’ cash inflow will be apparent because cash from operations will be lower than would beexpected from the profit number. Therefore, it is thought the statement of cash flows ‘cash fromoperations’ figure is more believable than net profit and will even, if it is very different from net profit,unmask manipulations of the net profit.

The ethical issue is that it is possible to manipulate the cash flow figures too. For example, a companymight accelerate or delay receivables collections in order to change the cash flow figures – whether or notthe net profit is also being manipulated. There may be a difference from manipulating net profit, however,because changing cash flow figures requires real actions that affect customers or suppliers or employees.Therefore, there are real consequences, such as irritating customers or having to offer inducements forearly payment. Nevertheless, it can be done.

It seems that most people would feel that altering the accruals just to make net profit better (or worse,or smoother) is ethically questionable, even if it is understandable because of the way management isevaluated and rewarded. But is altering the cash flow ethically questionable? Is there an ethical problem ifmanagement decides to put pressure on customers to accelerate collections and improve the company’scash position? It sounds like good management, not like manipulation.

Suggest two or three ways, not included above, in which operating, investing or financing cash flowscould be altered from their normal levels. For each, discuss whether, or under what conditions, you wouldthink there is an ethical problem with such an alteration.

Chapter 14 The statement of cash flows v 645