1 Solutions to Required Exercises

Discussion Questions:
3.4
By definition, an economic event cannot be classified as an accounting
transaction unless it can be shown to affect two or more individual accounts
within the balance sheet equation

Example
ie A = L + OE

3.6
(a) Current refers to a period of time, normally the longer of 12 months or the
operating cycle of the business (from acquisition of materials to sale of
products).
(b) Student specific (possibly Receivables; Investments; Inventories;
Intangibles; Property Plant and Equipment)
(c) Normally current assets (cash; debtors inventory) are more liquid (readily
converted to cash in the normal course of business) than non-current
assets (intangibles; investments; property, plant & equipment).

3.10
(a) Carrying amount, book value or written down value.
(b) Depreciation represents the cost (or other value) of the economic benefits
(service potential) of a tangible asset used up (consumed) during the
period. The consumption may relate to physical wear and tear (use or
time), technological obsolescence and commercial obsolescence (changes
in demand or regulations).
(c) Accumulated depreciation is a contraasset (negative asset) account. It
represents a deduction from the associated asset account.

3.14
While the definition of liabilities in terms of what the business owes external
parties is a very useful description of most liabilities, it is deficient in the sense
that the terms need to be clearly defined.

Liabilities do arise from contractual or legal obligations, but they can also be
recognised on the basis of moral obligations (equitable liabilities e.g. extra
warranty) or observed past practices (constructive obligations e.g. staff
bonuses).

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Also, essential to the definition of liabilities is that they give rise to a present
obligation to provide goods or services to a known external party, and the
obligation arose from a past (not future) transaction or event.

3.15
The accounting equation must always be in balance by definition. That is the
assets must always equals the claims against those assets (internal claims-
owners equity; external claims-liabilities). All transactions result in balanced
changes to this relationship (A=OE + L).

3.17
An important assumption of accounting is that the accounting entity; (unit of
account) is separate from the owners. However, many accounting entities are
not separate from the owner/s from a legal perspective (eg sole proprietorship;
partnership). In the case of a company, it is both a separate accounting entity
and a separate legal entity.

3.20
Some people object to the idea of humans being treated as assets for inclusion
on the balance sheet. It can be seen as demeaning for humans to be listed
alongside inventory, plant and machinery and other assets. However, others
argue that humans are often the most valuable resource of a business and the
placing of a value to this resource will help bring to the attention of managers
the importance of nurturing and developing this 'asset'. There is a saying in
management that 'the things that count are the things that get counted.' As the
value of the 'human assets' is not stated in the financial statements, there is a
danger that managers will treat these 'assets' less favourably than other assets
which are on the balance sheet.

Humans are likely to meet the first criterion of an asset listed in the chapter i.e. a
probable future economic benefit exists. There would be little point in employing
people if this were not the case. The second criterion concerning exclusive right
of control is more problematic. Clearly a business cannot control humans in the
same way as most other assets. However, a business can have the exclusive
right to the employment services that a person provides. This distinction
between control over the services provided, rather than control over the person,
makes it possible to argue that the second criterion can be met.

Humans normally sign a contract of employment with the business and so the
third criterion is normally met. The difficulty, however, is with the fourth criterion
i.e. whether the value of humans (or their services) can be measured with any
degree of reliability. To date, none of the measurement methods proposed enjoy
widespread acceptance.

3.22
The confusion arises because the owner seems unaware of the business entity
convention in accounting. This convention requires a separation of the business
from the owner(s) of the business, for accounting purposes. The business is
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regarded as a separate entity and the balance sheet is prepared from the
perspective of the business rather than that of the owner. As a result, funds
invested in the business by the owner will be regarded as a claim which the
owner has on the business. In a statement of financial performance (balance
sheet) prepared using the horizontal format, this claim will be shown alongside
other claims on the business from outsiders.

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Application Exercise:
3.1
No Account Ye No-Reason
. s
1 Accounts payable Yes
2 Provision for depreciation It is a contra asset. There is no present
obligation to an external party.
3 Debentures issued Yes
4 Loan guarantee It is a contingent liability, only to be
shown in the notes where the possibility
of a future obligation is not remote and it
is material in amount.
5 Unused bank overdraft There is no transaction. There is no
present obligation to an external party.
6 Provision for major There is no transaction. There is no
maintenance present obligation to an external party.
7 Provision for warranty Yes The only concern being with the
recognition rules in terms of the
probability of claims, and the amount of
the claims.
8 Rent revenue received in Yes
advance

3.2
Matching technique with accounting principles. Note particularly that the
techniques may be linked to more then one principle and the determination is
subjective. You may come to different conclusions.

No Asset measurement Accounting principle Answer

.
1 Inventories at the lower of A Historical cost A, B, C, F
cost or market
2 Equipment at residual cost B Prudence A, B, C, D,
F
3 Debtors at estimated C Accounting period B, C, E, F
amount collectible
4 Land at fair value D Going concern C, E
5 Prepayments at unexpired E Full disclosure A, C, F
cost
6 Patent at unamortised cost F Matching A, B, C, D,
F
7 Goodwill at recoverable B, C, E, F
amount
8 Leased assets at net E
present value

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3.3
Equation Effects Examples
(a) A= L Borrowing
Credit purchase of assets
(b) A= OE Owners contributions
Revenues
c) A= A Cash purchase of assets
Debtors pay

(d) A= L Repay loan

Pay creditors
(e) A= OE Cash expenses
Allocation expenses (eg depreciation)
Asset drawings
(f) L= OE Accrued expenses
Drawings from overdraft
(g) L= OE Owners pay business debts
Sales to creditors
Credit purchase returns

3.4
(a) (b) (c) (d)
Current Assets 13,900 18,300 13,200 9,100
Non Current Assets 51,600 71,600 110,700 69,600
Current Liabilities (14,200) (11,900) (9,600) (17,500)
Non Current Liabilities (17,900) (39,600) (41,500) (51,200)
Opening Capital (20,700) (29,200) (47,100) (26,700)
Profit or Loss (19,600) (17,900) (37,400) 9,500
Drawings 6,900 8,700 11,700 7,200

3.7
Account Classification
Cash at Bank Current
Patent Non Current : Intangibles
Equipment Non Current : P.P. & E.
Pre-payment Current
Land Non Current : P.P. & E.
Goodwill Non Current : Intangibles
Accounts Receivable Current
Shares in Telstra Non Current : Investments
Accumulated Depreciation - Equipment Non Current : P.P. & E.
Inventories Current
Leasehold Improvements Non Current : P.P. & E.
Preliminary Expense Non Current : Other
Interest Payable Not Applicable Current Liability
Government Bonds Non Current : Investments

3.9
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Beginning Transactions Ending

Assets 1 2 3 4 5 6 7
Cash 3,000 4,000 2,000 (7,000) 10,000 (6,000) (2,000) 4,000
Accounts
Receivable 5,000 (4,000) 6,000 7,000
Inventory 7,000 5,000 (6,000)
6,000
Freehold
Premises 60,000
60,000
Furniture &
Fittings 18,000 6,000 24,000
93,000 101,000
Liabilities
Trade
Creditors 3,000 5,000 (7,000) 1,000
Bank Loan 30,000 (2,000) 28,000
33,000
Capital 60,000 2,000 (10,000) 72,000
93,000 101,000

3.12

Joe Conday
Balance sheet as at 1 March 2009
$ $
Bank 20,000 Capital 20,000

Balance sheet as at 2 March 2009

$ $
Bank 14,000 Capital 20,000
Fixtures and fittings 6,000 Creditors 8,000
Inventory 8,000 _____
28,000 28,000

Balance sheet as at 3 March 2009

$ $
Bank 19,000 Capital 20,000
Fixtures and fittings 6,000 Creditors 8,000
Inventory 8,000 Loan 5,000
33,000 33,000

Balance sheet as at 4 March 2009

$ $
Bank 11,800 Capital 19,800
Fixtures and fittings 6,000 Creditors 8,000
nventory 8,000 Loan 5,000
Motor car 7,000 _____
32,800 32,800

Balance sheet as at 5 March 2009

$ $
Bank 9,300 Capital 19,300
Fixtures and fittings 6,000 Creditors 8,000

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Inventory 8,000 Loan 5,000

Motor car 9,000 _____
32,300 32,300

Balance sheet as at 6 March 2009

$ $
Bank 10,300 Capital 21,300
Fixtures and fittings 6,000 Creditors 8,000
Inventory 8,000 Loan 4,000
Motor car 9,000 _____
33,300 33,300

Balance sheet as at 6 March 2009

$ $
Current assets
Bank 10,300
Inventory 8,000
18,300
Non-current assets
Motor car 9,000
Fixtures and fittings 6,000
15,000
33,300
Current liabilities
Creditors 8,000
Non-current liabilities
Loan 4,000
Capital (Owners equity) 21,300
33,300

Case Study 3.2

3.2.1 Undertake a web search.
However, the key accounting issues revealed in nearly every recent corporate
crash being:
a) Revenues have been overstated. They have been recognised before they
have been realised (in advance of receiving the cash or having an
unavoidable claim to a certain amount of cash).
b) Expenses have been understated. Expenditure has been deferred as an
asset in situations where there are going to be no future economic
benefits related to that expenditure. This has been particularly evident in
relation to intangible items (research and expenditure; advertising;
goodwill; other identifiable intangibles; set-up costs). It also relates to
management errors in under estimating the economic benefits of tangible
assets used up during the period (eg inventory obsolescence;
depreciation; amortisation; impairment).
c) The expense understatement also relates to inadequate provisions for
transactions arising during those periods (eg employee benefits;
restoration of the environment; warranty claims; taxation).
d) Assets have been overstated for reasons already identified above
(receivables that will not be collected; intangibles that will generate no

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future benefits; inventory that is obsolete; property, plant and equipment

with values that cannot be recovered).
e) Liabilities that have been understated through omission, misstatements,
or reliance on the legal form, rather that the underlying substance of the
financial arrangement. Liabilities in relation to stakeholder claims are
understated (eg employee benefits; restoration of the environment;
warranty claims). Liabilities related to executory costs are not shown (eg
operating leases; construction contracts; purchase contracts; employment
contracts).
f) Liabilities in relation to future contingencies are excluded, and those
contingencies are no longer remote or immaterial (eg legal suits;
guarantees). Liabilities have been labelled as owners equity (eg
preference shares that are secured and redeemable).
g) The parties responsible for oversight have failed. This includes the
management, directors, and the auditors.

3.2.2
(a) Insider trading is using private information gained in your employment
position, and which is not available publicly to other investors or stakeholders, to
make a financial gain in the market.
(b) The corporations law is concerned not just that such behaviour is immoral,
but that it will severely impact on market confidence. The regulations under
corporations law, and its enforcement, is aimed at providing equity for all
stakeholders related to the operations of companies, and maintaining the
confidence of the general public in the equities market.

3.2.3
(a) A balance sheet is a statement of financial position at a point in time
identifying the monetary balances in the assets and the claims against those
assets (inside-owners equity; and outside-liabilities).
(b) The balance sheet equation: A = L + OE or OE = A L.
The next three questions use the term incorrect and different interpretations
could be made of this term. Does it mean that they were inconsistent with the
economic reality, but consistent with the regulations, or does it mean they were
inconsistent with the regulations, or inconsistent with particular critics
interpretations of those regulations.
In answering parts (c) , (d), and (e) you may have considered the following:
1. Element definition-conflict may have arisen in terms of what represents an
asset, liability, and owners equity. The definitions are subject to different
interpretations.
2. Element recognition-conflict may have arisen in terms of the recognition
criterion (probability and reliability of measurement) which are subjective in
nature.
3. Transaction measurement- accounting uses a range of different measures for
assets and liabilities including historical cost, residual historical cost, fair value,
market value, recoverable amount, value in use, value in exchange, net
realisable value, deprival value, net present value. The assessment of what each
terms means is not always clear, and objective determination of the stated
figures may be even more difficult.
4. Estimation- many of the accounting measures used require management or
expert estimation of future variables. This estimation process by its very nature
will lead to differences in outcomes (examples of estimates include asset lives;
residual values; pattern of use; expected collection; future claims; changes in

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wage level; interest rates; exchange rates; regulations; technological changes;

economic growth etc).
5. Accounting method choice- within existing regulations management is given
considerable choice.(eg to capitalise or expense certain outlays; to use
accelerated or straight line depreciation; to use FIFO or weighted average
inventory; to use the direct or indirect approach for bad debts; to revalue assets
or use the cost method etc).
6. Disclosure methods-information can be revealed directly in the accounts, or in
the notes to the accounts, or by other disclosures (directors statement; news
release)
7. Intentional or unintentional material errors or omissions in terms of accounts
and account balances.

3.2.4 Off-balance sheet financing refers to obligations of the entity that are not
included in the balance sheet as a liability. This arises from intentional or
unintentional error, or in relation to what has been known as executory
contracts. Executory contracts being those contracts that are either equally
performed or unperformed at a given point in time. Common examples might be
building contracts; future sales contracts; employment contracts; or lease
agreements. Given that there has not been performance by the other party
(builder; customer; employee; lessor) there is no need to recognise either the
asset or the liability. However, in these cases there is often a legal contractual
obligation in place that the entity cannot avoid, and yet no record of this appears
on the balance sheet.
3.2.5 The collapse of Enron brought down the giant accounting firm of Arthur
Andersen in at least two ways:
o Firstly, because there were massive claims against Arthur Andersen
and its partners the liquidation of the business was really the only
option.
o Secondly, the business would have been unlikely to have survived
as clients would have left in mass for other accounting service
providers.

3.2.6 It is not necessarily legally or morally wrong for the CEO to provide advice
to others to acquire shares in a company while at the same time selling shares in
that company. The CEO may have a particular need for cash at that time, or may
wish to diversify risk, or be aware of better alternative investments.
However, it is not just a matter of doing what is right, but being seen to be doing
what is right. It would, therefore, seem inappropriate ethically for a CEO to be
provide positive advice to others to invest in the company while he himself is
selling off his/her shares in that same company.

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