BUSN1001 Business Reporting and Analysis

Tutorial discussion questions – Week 6

Chapter 6: Statement of profit or loss and statement of

changes in equity
6.16. Consider each of the following transactions and examine whether they satisfy the
income definition criteria using the accrual method of accounting:
a. Received cash for services to be provided in the next reporting period
b. Borrowed money from a bank
c. Credit sale of goods
d. Received cash for goods sold
e. Owner contributed $20 000 to fund a new product line
f. Received a grant from a government body to assist with an export program.

To satisfy the income definition criteria there must be:

 an increase in economic benefits during the reporting period via an increase in assets or
reduction in liabilities;
 resulting in an increase in equity;
 which must not be related to contributions from equity participants (i.e. owners).

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

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

b. Borrowed money from a bank

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

c. Credit sale of goods

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

d. Received cash for goods sold

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

e. Owner contributed $20 000 to fund a new product line

This does not satisfy the income definition, because although there is an increase in economic
benefits through an increase in assets (cash) that increases equity, the $20 000 relates to
contributions from equity participants (i.e. owner).

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

6.17. Consider each of the following transactions and examine whether they satisfy the
expense definition criteria under the accrual method of accounting:
a. Paid wages owing from the previous reporting period
b. Owner withdrew money for a holiday
c. Money owed to Telstra for phone charges this reporting period
d. A property asset is impaired
e. Paid a supplier for goods that had been purchased on credit
f. Purchased a computer system to computerise the accounting records.

To satisfy the expense definition there must be:

 a decrease in economic benefits during the reporting period via a decrease in assets or an
increase of liabilities;
 resulting in a decrease in equity;
 which must not be related to distributions to equity participants (i.e. owners).

a. Paid wages owing from the previous reporting period

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

b. Owner withdrew money for a holiday

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

c. Money owed to Telstra for phone charges this reporting period

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

d. A property asset is impaired

An asset is impaired when the asset’s carrying amount exceeds its recoverable amount. In
that case, AASB 136 Impairment of Assets prescribes that the asset’s carrying amount shall
be reduced to its recoverable amount. This reduction, known as impairment loss, satisfies the
expense definition. Impairment loss results in a decrease in economic benefits in the form of
decrease in asset (e.g. carrying amount of property) which decreases equity, and the loss does
not relate to distribution to equity participants.

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e. Paid a supplier for goods that had been purchased on credit
This does not satisfy the expense definition. Although there has been a decrease in economic
benefits via the reduction of cash at bank, there is no decrease in equity. The decrease in
assets is offset by the reduction of a liability (accounts payable).

f. Purchased a computer system to computerise the accounting records

This does not satisfy the expense definition because the decrease in cash is offset by the
increase in another asset class, namely property, plant, and equipment. Overall, equity
remains the same.

6.25.
a. Compare the adjustments necessary on the accounts (income or expense only) of Julie
Durkin to reflect (1) a cash-based and (2) an accrual-based accounting system (assume
the accounting period is for 12 months ending on 31 December 2015):

i. Accrued wages and salaries of $800 are due to be paid on 1 January 2016.
ii. Julie depreciates her business computer purchased on 1 January 2014 over three
years at $600 per annum.
iii. Insurance premium of $12 000 for one year was paid on 1 December 2015.
iv. A client paid Julie $5000 on 1 September 2015 for work not yet done.
v. A client owes $2000 for work started and completed in October 2015.
vi. Julie has tendered for work totalling $2400 on 4 December 2015. She hadn’t heard
whether or not she had been successful by 31 December 2015.
vii. Julie paid her quarterly electricity bill of $400 on 30 September 2015.

b. Discuss why the profit for the period is different depending on whether a cash- or
accrual-based accounting system is used. Justify the preference to use accrual-based
accounting.

a. Compare the adjustments necessary on the accounts (income or expense only) of Julie
Durkin to reflect (1) a cash-based and (2) an accrual-based accounting system (assume
the accounting period is for 12 months ending on 31 December 2015):

i. Accrued wages and salaries of $800 are due to be paid on 1 January 2015.
Cash accounting: The $800 is recognised as expense for the period ending 31 December 2015
as cash is paid during that period.
Accrual accounting: The $800 is not recognised as expense for the period ending 31
December 2015, as it has been recognised in the period ending 31 December 2014 when the
wages and salaries were incurred.

ii. Julie depreciates her business computer purchased on 1 January 2014 over three
years at $600 per annum.
Cash accounting: The $600 is not recognised as expense for the period ending 2015, as
depreciation expense is a non-cash item.
Accrual accounting: The $600 is recognised as expense for the period ending 2015, as
depreciation expense has been incurred when the economic benefits from the computer were
consumed.

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iii. Insurance premium of $12 000 for one year was paid on 1 December 2015.
Cash accounting: The $12 000 is recognised as expense for the period ending 2015, as the
insurance premium is paid during that period.
Accrual accounting: Only $1000 is recognised as expense for the period ending 2015, as the
benefits from only one month of the insurance are consumed in that period. $11000 is
recorded as an asset, prepaid insurance.

iv. A client paid Julie $5000 on 1 September 2015 for work not yet done.
Cash accounting: The $5000 is recognised as income for the period ending 2015, as cash is
received in that period.
Accrual accounting: The $5000 is not recognised as income for the period ending 2015, as
work has not been done for the client in that period and hence income has not been earned.
Instead, the $5000 is recorded as a liability.

v. A client owes $2000 for work started and completed in October 2015.
Cash accounting: The $2000 is not recognised as income for the period ending 2015, as cash
has not been received.
Accrual accounting: The $2000 is recognised as income for the period ending 2015, as work
is completed in that period and hence income has been earned.

vi. Julie has tendered for work totalling $2400 on 4 December 2015. She hadn’t heard
whether or not she had been successful by 31 December 2015.
Cash accounting: No income is recognised for the period ending 2015, as no cash has been
received.
Accrual accounting: No income is recognised for the period ending 2015, as no work has
been done and hence income is not yet earned.

vii. Julie paid her quarterly electricity bill of $400 on 30 September 2015.
Cash accounting: The $400 is recognised as expense for the period ending 2015, as the
electricity bill is paid in that period.
Accrual accounting: $400 is recognised as expense for the period ending 2015, as the
quarterly electricity expense was incurred in that period.

b. Discuss why the profit for the period is different depending on whether a cash- or
accrual-based accounting system is used. Justify the preference to use accrual-based
accounting.

Cash-based accounting recognises income and expenses differently from accrual-based

accounting. Under cash-based accounting, income and expenses are recognised when cash
exchanges. That is, income is recognised in the period when it is received, and expenses are
recognised in the period they paid. Subsequently, profit for the period under cash-based
accounting is calculated as cash receipts from income items less cash payments for expense
items.
Accrual-based accounting, on the other hand, recognises income and expenses when earnings
of income and incurrence of expenses occur. That is, income is recognised in the period when
it is earned (regardless of whether cash has been received) and expenses are recognised in the
period when they are incurred (regardless of whether cash has been paid). Subsequently,
profit for the period under accrual-based accounting is calculated as income earned less
expenses incurred, which is different from profit under cash-based accounting.

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Most entities now use accrual-based accounting, as accrual-based accounting provides more
relevant information about business performance. In fact, many entities are required to use
accrual accounting. Under accrual-based accounting, profit for the period is based on what is
actually earned and incurred, rather than based on timing of cash flows. There are times when
earnings of income or incurrence of expenses occur in different periods from when cash is
received or paid. In this case, information recorded using cash-based accounting may be
distorted and is not representative of the business performance, which makes it less useful for
decision-making.

6.29. A list of account balances for Mr Zheng’s business (Futronics) at the end of the 30
June 2017 reporting period is shown below. Produce the statement of profit or loss for
the reporting period, and the equity balance at the end of the year.

FUTRONICS PTY LTD

Statement of profit or loss
for the 12-month period ended 30 June 2017

Service Revenue 178 000

Rent Revenue 14 000
Total Income 192 000

Expenses
Salaries Expense 114 300
Supplies Expense 17 500
Rent Expense 29 500
Insurance Expense 2 100
Depreciation Expense 20 650
Total Expenses 184 050
Profit $7 950

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 FUTRONICS PTY LTD
Statement of Changes in Shareholders’ Equity
for the 12-month period ended 30 June 2017

Share capital at the beginning of period ..................................... 75 000

Retained earnings at the beginning of period ............................. 16 000
Plus profit for reporting period ................................................... 7 950
Retained earnings at the end of period ....................................... 23 950
Shareholders’ Equity at the end of period ............................. $98 950

6.36 Adjusting income, expense, asset and/or liability accounts

Generate the adjustments needed for income, expense, asset and/or liability accounts for
Games Pty Ltd to reflect the following transactions in the entity’s financial statement
for the 12-month reporting period ended 31 December 2015 using the accrual system:
a. The fortnightly salaries and wages bill of $6900 for December 2015 is due to be paid
on 1 January 2016.
b. The entity has $30 000 of office furniture and equipment with a $10 000 residual
value that it depreciates over five years on a straight-line basis.
c. A client owes $5000 for services rendered in December 2015.
d. Games Pty Ltd utility services bill (water, telephone, electricity) for the quarter
ended December 2015 has not yet been received. Based on previous bills, the quarterly
expense is expected to be $1200.
e. Games Pty Ltd has a two-year subscription to a trade magazine at a cost of $2400.
The subscription was paid on 1 March 2015.
f. A customer had commissioned work and paid $5000. As at 31 December 2015, the
work had not been performed.
g. Games Pty Ltd expects to lose a court case over a breach of contract. If it loses, the
damages awarded could be in the range of $20 000 to $80 000.
h. Games Pty Ltd tendered for work totalling $40 000 in November 2015. It has been
advised that its tender is one of three being considered.
i. One of Games Pty Ltd’s clients was placed into liquidation in December 2015. This
client owes Games Pty Ltd $6200.
j. Games Pty Ltd has a property with a carrying value of $120 000. An assessment has
determined that its recoverable amount is $90 000.

a. The fortnightly salaries and wages bill of $6900 for December 2015 is due to be
paid on 1 January 2016.

The entity has incurred the salaries and wages for the two weeks up to 31 December 2015,
but they have not paid the salaries and wages. The recognition of expenses for the purpose of
accrual accounting does not require cash payments to have been made. Therefore the wages
expense of $6900 should be recognised in the statement of profit or loss for the 12 month
period ending 31 December 2015. The corresponding double entry is to record a liability
wages payable of $6900 that will be recognised in the balance sheet as at 31 December 2015.
When the salaries and wages are paid on 1 January 2016, there will be no impact on profit.
The liability will be eliminated and the cash at bank account reduced by the equivalent
amount.

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b. The entity has $30 000 of office furniture and equipment with $10 000 residual
value that it depreciates over five years on a straight-line basis.

Based on this information, the depreciation expense will be $4000 per year ([$30 000 - $10
000] / 5). On 31 December 2015, a depreciation expense of $4000 should be recognised in
the statement of profit or loss and $4000 should be added to the accumulated depreciation
account for office furniture and equipment (which is a contra-asset account). The asset
section of the balance sheet as at 31 December 2015 will show the office furniture and
equipment at its carrying amount (i.e. the cost price less the accumulated depreciation).

c. A client owes $5000 for services rendered in December 2015.

Since the income has been earned, it should be recognised in the statement of profit or loss
for the 12 months ended 31 December 2015. Therefore $5000 will added to the service
revenue account. The corresponding accounting entry is to recognise an asset (an account
receivable) being the money that the client owes the entity as at 31 December 2015. When
the client pays the money in 2016, the account receivable will be reduced and the entity’s
cash at bank will increase. There is no profit impact associated with the payment of the cash.

d. Games Pty Ltd utility services bill (water, telephone, electricity) for the quarter
ended December 2015 has not yet been received. Based on previous bills the
quarterly expense is expected to be $1200.

The utility expense has been incurred, and therefore a utility expense of $1200 should be
recognised in the statement of profit or loss for the 12 month period ended 31 December
2015. Since it is unpaid, accounts payable (a liability account) will increase by $1200
representing the future sacrifice of economic benefits that the entity is required to make.
When the account is paid, the liability account is reduced and an asset account (cash at bank)
is also reduced.

e. Games Pty Ltd has a two-year subscription to a trade magazine at a cost of

$2400. The subscription was paid for on 1 March 2015.

The subscription cost per month will be $100 ($2400 / 24 months). As at 31 December 2015,
only 10-months of the economic benefits of the subscription have been used. Therefore, the
subscription expense to be recognised in the statement of profit or loss for the 12 months
ended 31 December 2015 is $1000. The entry to record this adjustment will depend on how
the initial cash outflow of $2400 was recorded. If it was recorded as a prepaid asset, the
adjusting entry would be to reduce the prepaid asset account by the $1000. If the $2400 cash
payment was recorded as an expense, the adjusting entry is to reduce the expense account by
$1400 and record a prepaid asset of $1400. Regardless of how the cash payment is initially
recorded, the adjustments described result in an expense of $1000 recognised in the statement
of profit or loss for the 12 month period ended 31 December 2015 and a prepaid asset in the
balance sheet as at 31 December 2015 of $1400.

f. A customer had commissioned work and paid $5000. As at 31 December 2015 the
work had not been performed.

Since the work has not been performed as at 31 December 2015, the entity has a liability as at
31 December 2015 being unearned revenue of $5000. Assuming that the $5000 was

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recorded as income when received in cash, at the end of December 2015 the income has to
be reduced by $5000 because the $5000 income has not been earned and therefore should
not be recognised as income in the 2015 reporting period.

g. Games Pty Ltd expects to lose a court case over a breach of contract. If it loses, the
damages awarded could be in the range of $20 000 to $80 000.

The cost of the lawsuit (damages) from losing a court case is not an existing liability. Rather,
it is a contingent liability because it depends on a future event (outcome of the lawsuit)
arising out of a past transaction (the contract). The accounting rules require liabilities to be
recognised on the balance sheet if they are probable and capable of being reliably measured.
If they do not satisfy both conditions, they do not need to be recognised on the balance sheet,
but should be disclosed in the notes to the account if they are material. In the case of Games,
although it is probable that Games will lose the case, the amount of damages cannot be
reliably measured (a range of estimation is not a reliable measurement). Therefore, nothing
will be recognised either in the statement of profit or loss or balance sheet. However, since
the estimated damages are considered to be material, they have to be disclosed in the notes to
the account.

h. Games Pty Ltd tendered for work totalling $40 000 in November 2015. It has
been advised that their tender is one of three being considered.

The Conceptual Framework specifies that income can only be recognised in the statement of
profit or loss when it is probable that the income has occurred and it can be measured
reliably. The term ‘probable’ means more likely than less likely, implying that if the
probability of the revenue occurring is more than 50%, it should be recognised. In this case,
although the amount of the tender can be measured reliably ($40 000), the probability of
Games winning the tender is less than 50% (only 33.33%). Therefore, there is no income to
be recognised in the statement of profit or loss for the 12 months ended 31 December 2015.

i. One of Games Pty Ltd’s clients was placed into liquidation in December 2015.
This client owes Games Pty Ltd $6200.

As the client is in liquidation, the probability of Games recovering the monies owed is low.
Funds generated from liquidating a business are normally insufficient to satisfy the creditor’s
claims. Given that future economic benefits, in the form of the $6200 accounts receivable, is
no longer probable, it does not satisfy the asset recognition criteria and should be written off.
The effect of this is to reduce the net carrying amount of accounts receivable in the balance
sheet as at 31 December 2015 and to recognise a bad debt expense of $6200 in the statement
of profit or loss for the 12 months ended 31 December 2015.

j. Games Pty Ltd has a property with a carrying value of $120 000. An assessment
has determined that its recoverable amount is $90 000.

AASB 136 Impairment of Assets paragraph 8 states that an asset is impaired when its
carrying amount exceeds its recoverable amount. In the case Games, the entity has a property
with carrying amount that exceeds its recoverable amount ($120 000 and $90 000
respectively). When an asset is impaired, the AASB 136 prescribes that the asset’s carrying
amount shall be reduced to its recoverable amount (para. 59). The amount by which carrying
amount exceeds recoverable amount shall be recognised as impairment loss in the statement

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of profit or loss. Following that, Games needs to recognise an impairment loss of $30 000 in
the statement of profit or loss for the 12 months ended 31 December 2015, which will reduce
its profit for the period. The corresponding accounting entry is to recognise a decrease in the
value of property (asset) by $30 000 in the balance sheet as at 31 December 2015.

6.45. Depreciation expense is an allocation of the cost of an asset over the asset’s useful
life. Entities assess the useful life of their various assets. The notes to the accounts for
two airlines reveal the following variation in useful life estimates.

Air New Zealand Ltd depreciates its aircraft fleet on a straight-line basis to an
estimated residual value over their economic lives as follows:

Source: Air New Zealand Ltd 2015, annual financial results, p. 15.

The Qantas Group depreciates its aircraft fleet as follows:

Source: Qantas Airways Ltd 2015, Annual report, p. 95.

Required
a. Comment on the effect of these differing depreciation rates on the profit of Air New
Zealand Ltd and the Qantas Group.
b. Can you suggest any reasons why the choice of useful lives would differ across the
entities?
c. Debate whether you believe entities should have discretion to choose the depreciation
method and useful lives applicable to various asset classes.
d. What do you think would affect the useful lives of assets such as aircraft?

a. Comment on the effect of these differing depreciation rates on the profit of Air New
Zealand Ltd and Qantas Group.

Even if the companies had an identical asset purchased on the same date for the same price,
different useful life estimations by the companies will result in different depreciation
expenses being recognised in the companies’ statement of profit or loss. The longer the
estimated useful life, the lower the annual depreciation expense per year. Assuming all else
equal, a lower depreciation expense results in higher profit. From the information given
regarding the estimated useful life of assets for Air New Zealand and Qantas, it appears that
Air New Zealand has a higher estimated useful life for its aircraft (airframe) and engines
compared to Qantas (i.e. 18 years compared to 2.5-20 years respectively). This implies that,
all other things equal and assuming aircraft and engines constitute a larger proportion of the
assets relative to aircraft spare parts, Air New Zealand’s profits will be higher compared to
Qantas. This is because Air New Zealand allocates less of the cost of its aircraft each year
compared to Qantas. However, Air New Zealand’s depreciation expense continues for more
years than Qantas. Obviously the depreciation expense is also a function of estimated residual
values and the method by which the companies are valuing the assets (i.e. fair value or cost).

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b. Can you suggest any reasons why the choice of useful lives would differ across the
entities?

In estimating the useful life of assets, the following information should be taken into account.

the condition of the asset: generally, if an entity acquires a new asset, the useful life of the
asset will be longer compared to when the firm acquires a second-hand asset.
the entity’s business repair and maintenance policy: each firm has their own policy for
repair and maintenance of assets. A firm with a good repair and maintenance policy may
estimate a longer useful life for its assets compared to a firm with a moderate repair and
maintenance policy.
current technological and industry trends: the useful life of assets is reduced if the
entity’s assets are susceptible to obsolescence due to technological advances and/or changes
in trends.
local conditions, e.g. weather: companies located in more extreme conditions (too hot or
too cold weather) are expected to have shorter useful life for their assets.

Since entities’ depreciation policies vary, it is important to identify the policies applied to
make valid comparisons of profits and asset bases.

c. Debate whether you believe entities should have discretion to choose the depreciation
method and useful lives applicable to various asset classes.

Each entity has different conditions, policies, and usage of assets in their business. This
implies that the estimated useful life of assets may differ across firms. Furthermore,
depending on their business, a particular method of depreciation may suit a firm more than
other methods, and the management is best positioned to determine how the cost of non-
current assets should be allocated over time based on the pattern of the consumption of future
economic benefits. Therefore, entities should have discretion in choosing a depreciation
method and an asset’s useful life. Mandating a certain method or estimated useful life to be
applicable by all entities will create an unfair disadvantage for some entities. Of course it can
be argued that the diversity in accounting for depreciation creates more opportunities for
earnings management and/or manipulation. However, strong corporate governance practices,
which are encoded, are expected to be able to minimise the negative effects of opportunistic
earnings management.

d. What do you think would affect the useful lives of assets such as aircraft?

the entity’s business repair and maintenance policy: a firm with a good repair and
maintenance policy may estimate a longer useful life for its assets compared to a firm with a
moderate repair and maintenance policy. In many countries regulations exist mandating
aircraft overhauls within a specified time period.
current technological and industry trends: the useful life of assets is reduced if the
entity’s assets are susceptible to obsolescence due to technological advances and/or changes
in trends. Developments in aviation engineering affect the useful life of aircraft.
hours flown and flight paths
local conditions, e.g. weather: companies located in more extreme conditions (too hot or
too cold weather) are expected to have shorter useful lives for their assets.

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