TOPIC 3: WORKED EXAMPLES: CONTINUED

HORSE COMPANY REVISITED

x We have already looked at HORSE Company and successfully completed the example.

x However, to understand some additional accounting issues lets make a few changes: In
particular, lets assume that after the month-end the following information emerged:

A: ACCRUED EXPENSE

New Information I
Lets assume that just after the month end the Gas bill for July arrived. For simplicity lets assume
that this bill was for 100 and was all for gas usage in July.

Impact

HORSE companys accounts should reflect the economic reality. Although the expense has not been
recorded yet, it should be part of Julys profit calculation. Also the additional bill is a liability (i.e.,
we owe the Gas company). In the SOFP, this bill, which is a CURRENT LIABILITY, is referred to
as an ACCRUED EXPENSE.

The entry which we need to make: (1) record the expense (2) record the amount owing

ADJUSTING ENTRY 1:

Gas Expense: +100

Accrued Expenses: +100

B: PREPAID EXPENSE

New Information II
In Transaction (vii), we paid Rent of 300. Lets assume that in fact, 20% of this Rent payment is for
the month of July. The remainder of the payment covers the months from August to November
inclusive.

Impact

The true rent expense for July is not 300 but is in fact 60. This means that we have (i) overstated
Rent by 240 and (ii) we have a rent prepayment of 240. In the SOFP, this prepayment, which is a
CURRENT ASSET, is referred to as a PREPAID EXPENSE.

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ADJUSTING ENTRY 2:

Rent Expense: -240:

Prepaid Expenses: +240

III: DEPRECIATION

New Information III

Lets assume that it appears that the building will have a 25 year life and will be worth nothing at the
end of the life (i.e., residual value is nil).

Impact:

In accounting, we usually make a charge to reflect the usage of the asset in each period. For
simplicity, lets assume that all of the cost of the Property is for buildings (aside: land is not usually
depreciated so for simplicity we will assume the total cost represents buildings).

The annual depreciation charge is:

[Cost Residual Value]/Useful Life

[3,000 0]/25 years = 120 per annum.

In this case, the monthly depreciation charge is:

1/12 of 120 = 10

Impact

We need to charge Depreciation expense for July of 10. One might expect that the corresponding
entry would be to reduce the Asset cost by 10. In fact, the convention in accounting is to record the
Depreciation Charge in a separate account (called a contra account) known as Accumulated
Depreciation. Accumulated Depreciation records all of the depreciation charge on the asset over time.
In the SOFP, Property will be shown as follows:

Property at Cost XXXX

Accumulated Depreciation on Property XXXX Net Book Value of
Property XXXX

ADJUSTING ENTRY 3:

Depreciation Expense: +10.

Accumulated Depreciation on Property: +10

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 x At first look you may think: does this not break the Extended Accounting Equation? The
answer is: No! Following standard accounting practice, rather than recording Property as
10, we show the 10 in a separate Accumulated Depreciation account. The net effect, when
you think about it, is the same!

x Note that the SOFP does not set out to measure market value. So, the Net Book Value of the
Property could differ significantly from its Market Value.

EXAMPLE: 3.2: HORSE COMPANY WITH ADJUSTMENTS

x Show the impact of ADJUSTING ENTRIES I to III on the EXTENDED ACCOUNTING

EQUATION in the space below

Assets Expenses Liabilities Equity Revenue

I.

II.

III.

x Draw up a a REVISED list showing the balances on each of the individual assets,
expenses, equity, liabilities and revenue accounts AFTER ADJUSTMENTS.

x Draw up a REVISED classified Income Statement for the month ended July 20X2
and a Statement of Financial Position at 31 July 20X1 AFTER ADJUSTMENTS.

Example 3.5: TIGER Company:

After the last 12 months of transactions, the following balances are drawn from the books of TIGER
Company on 31/12/20X9 after all adjustments have been made. All figures in .

x Complete the table below

Asset, Income Statement

Liability, (IS) or
Equity, Statement of
Revenue Financial
Item Expense Position (SOFP)?
Accrued expenses 2300
Accumulated Depreciation on Van 8000
Cash 50000
Cost of Goods Sold 23000
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Delivery Van at Cost 25000
Depreciation Expense 6000
Dividends 21000
Electricity Expense 4000
Inventories 28000
Retained Earnings at 1/1/20X9 94900
Prepaid Expenses 400
Rates Expense 2000
Rent Expense 3000
Share Capital 60000
Sales Revenue 240000
Accounts Payable 19000
Accounts Receivable 17000
Van Running Expenses 17000
Wages Expense 38000

x Draw up a classified Income Statement for the year ended December 20X9 and a
Statement of Financial Position at 31 December 20X9.

SOLUTION: EXAMPLE 3.4: HORSE COMPANY: WITH ADJUSTMENTS:

RECAP: The new information provided may be summarised as follows:

x A gas bill for the month of July arrived in August (i.e., after the month end). This bill was for
100 and all of the amount was for gas usage in July.
x 20% of the rent paid in July was actually for July. The remaining 80% is a prepayment.
Hence, 20% of 300 = 60 is the Rent Expense for July and 240 represents Prepaid Rent
at the end of July.
x The building bought in July will have a useful life of 25 years and will have a zero Residual
Value. Hence, the deprecation charge is calculated as follows. Annual depreciation is
calculated (using the Straight Line method) as {[Cost-Residual Value]/Useful Life} =
{[3,000-0]/25} = 120 per annum. For ONE month, this represents a depreciation charge of
120/12 = 10. So the depreciation charge for July is 10.

HORSE COMPANY: ADJUSTING ENTRIES FOR JULY

Assets Expenses Liabilities Equity Revenue

AI Gas Expense +100 Accrued

Expenses
+100
A II Prepaid Expenses Rent Expense
+240 -240

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A III Property decrease Depreciation
via Expense
Accumulated +10
Depreciation
+10

FINANCIAL STATEMENTS OF HORSE COMPANY: AFTER ADJUSTMENTS

HORSE
COMPANY

INCOME STATEMENT FOR MONTH ENDED 31 JULY 20X1

Sales Revenue 6,000

Cost of Goods Sold (COGS)
Gross Profit
Expenses
Electricity -200
Rent* -60
Gas Expense -100
Depreciation Expense -10
Profit Before Interest and Taxes 3,130
Interest
Profit Before Tax
Tax 0

Net Profit 3,130

*Rent Expense = 300-240 = 60.

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 HORSE COMPANY
STATEMENT OF FINANCIAL POSITION AS AT 31 JULY 20X1

ASSETS
Non-Current Assets
Property at Cost 3,000
Less: Accumulated Depreciation 10
Net Book Value 2990

Current Assets
Inventory 2,500
Accounts Receivable 3,000
Prepaid Expenses 240
Cash 9,500
15,240

18,230
TOTAL ASSETS

LIABILITIES & EQUITY

LIABILITIES
Non-Current Liabilities 0
Current Liabilities
Accounts Payable 5,000
Accrued Expenses 100

5,100

5,100
Total Liabilities

EQUITY
Share Capital 10,000
Share Premium 0

Contributed Capital 10,000 Retained Earnings 3,130

13,130
TOTAL EQUITY
LIABILITIES + EQUITY 18,230

In practice, we do not usually draw up the Financial Statements until all of the adjusting entries have
been processed.

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SOLUTION EXAMPLE 3.5: TIGER COMPANY:
Asset, Income Statement
Liability, (IS) or Statement
Equity, of Financial
Revenue Position (SOFP)?
Item Expense
Accrued expenses 2300 Liability SOFP
Accumulated Depreciation on Van 8000 (Contra) Asset SOFP
Cash 50000 Asset SOFP
Cost of goods sold 23000 Expense IS
Delivery Van at Cost 25000 Asset SOFP
Depreciation Expense 6000 Expense IS
Dividends 21000 Equity SOFP
Electricity Expense 4000 Expense IS
Inventories 28000 Asset SOFP
Retained Earnings at 1/1/20X9 94900 Equity SOFP
Prepaid Expenses 400 Asset SOFP
Rates Expense 2000 Expense IS
Rent Expense 3000 Expense IS
Share Capital 60000 Equity SOFP
Sales Revenue 240000 Revenue IS
Accounts Payable 19000 Liability SOFP
Accounts Receivable 17000 Asset SOFP
Van Running Expenses 17000 Expense IS
Wages Expense 38000 Expense IS

TIGER Company
Income Statement for Year Ended 31
December 20X9

Revenue 240000
Cost of Sales
Gross Profit
Other Expenses
Rent 3000
Rates 2000
Wages 38000
Electricity 4000
Van Running Expenses 17000
Depreciation 6000
Profit for Year

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TIGER Company
Statement of Financial Position (Balance Sheet) as at 31
December 20X9
Non Current
Assets
Delivery Van at Cost 25000
Accumulated Depreciation on Van
Van at Net Book Value

Current Assets
Inventories 28000
Trade Receivables 17000
Prepaid Expenses 400
Cash
Total Current Assets

Total Assets 112,400

Current
Liabilities
Trade payables 19000
Accrued Expenses 2300
21,300
Total Liabilities

Owners Equity
Opening Share Capital 60000
Retained Earnings
Opening Retained Earnings -94900
Plus Net Income for Year 147,000
Less Dividends -21000 31100
91,100
Total Equity

112,400
Total Liabilities Plus
Equity

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 MISCELLANEOUS ADDITIONAL POINTS MADE IN LECTURES

Format of the Statement of Retained Earnings

Retained Earnings at start of period XXXX
Plus: Net Income XXXX
Less: Dividends XXXX
Retained Earnings at end of period XXXX

For our purposes, we can show this as a separate statement or in the Equity Section of the SOFP.

Corporate Failure: Terminology

Examinership: Legal protection while trying to sort out difficulties Liquidation:
Business wound up and assets sold.

Order of Payment in Liquidation:

Liquidator Secured Creditors Unsecured Creditors Shareholders.

CLARIFICATION OF TERMINOLGY

Trading Cycle (or Operating Cycle)

Buy goods on Credit: Accounts Payable

Buy goods for Cash

Hold Inventory

Sell goods on Credit Accounts Receivable

Sell goods for Cash

Accounts Receivable pay Cash Use this Cash to pay Accounts Payable

Historic Cost
US GAAP: Focus largely on Historical Cost
IFRS: Mainly Historical Cost but many exceptions. In the future, likely to move more towards Fair
value

Prudence Also known as Conservatism. Future losses are recognised immediately. Future gains
are never anticipated.

Form 20F:
A statement reconciling profit under an individual countrys accounting rules with the profit number
that would be reported under US GAAP. Form 20F is no longer required for firms reporting under
IFRS.
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Internally generated brands
Internally generated brands are not included in the SOFP. However, if there is a market transaction
where company A bought the brands of company B then the value of the purchased brands would be
shown on As SOFP.

Purchased Goodwill & Impairment

Suppose Company A buys Company B for $100 million. Assume also that the Net Assets (i.e.,
Assets-Liabilities) on As SOFP are $40million. The difference of $60 million is termed purchased
goodwill and is recorded on As SOFP as a Non-Current Asset. Each year (or sometimes, more
frequently) A will have to undertake Impairment Testing to see if the $60million of Goodwill is still
worth $60million.

x If the Goodwill is still worth $60 million then it remains on the SOFP at $60million x
If the Goodwill is worth less than $60 million say $40million then there is an
impairment loss (or charge) of $20 million.
x If the Goodwill is worth more than $60 million say $70 million the increase is not recorded
and the Goodwill figure remains at $60 million on As SOFP.

Depreciation of Tangible Assets

Using straight line deprecation, we calculate the depreciation charge as [Cost-Residual Value]/Useful
life. Say cost = $10K, expected residual value = 0 and useful life = 5 years. The depreciation
expense will be $2k per annum.

Example:
Suppose Property at Cost = 100 and Depreciation Expense = 10 each year. The extracts from the
financial statements for the following three years are as follows:

Extract From The Income Statement For:

Year 1 Year 2 Year 3

Depreciation Expense 10 10 10

Extract From The SOFP at the end of:

Year 1 Year 2 Year 3

Property at Cost 100 100 100
Accumulated
Depreciation
Net Book Value

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Amortization of Intangible Assets
The cost of purchased intangible assets (e.g., patents, copyrights etc.) is expensed over the useful life
of those assets. This is termed Amortization and is equivalent to Depreciation for Tangible Assets.

Depletion
For natural resources (e.g.. oil wells,, gold mines etc.) Depletion refers to the extraction of the
resource over time. For example, suppose an oil well is held at cost in the SOFP at $100million. The
well is estimated to have 20m barrels of oil in total. If 5m barrels are extracted in a given period, the
depletion charge will be (5/20) $100 million = $25 million.

Terminology:
EBIT = Earnings Before Interest and Tax
EBITDA = Earnings Before Interest, Tax, Depreciation and Amortization

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