SIM MODULE BOOK

PRINCIPLES OF ACCOUNTING &

BUSINESS FINANCE

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Module Book
PRINCIPLES OF ACCOUNTING & BUSINESS FINANCE

Module Book Developer : Lin Hui Yee

Production : SIM Global Education

Module Book  SIM Global Education 2018

All rights reserved.

No part of this material may be reproduced in any form or by any means without permission
in writing from SIM Global Education

First Version @ July 2018

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Table of Content

Introduction 4

Session 1: Introduction to Principles of Accounting and the 12

Accounting Equation

Session 2: Double Entry Bookkeeping 26

Session 3: Recording Business Transactions – Ledger Accounts 40

and Trial Balance

Session 4: Bank Reconciliation 57

Session 5: Introduction to Managerial Accounting and 73

Analysis of Cost Behaviour

Session 6: Cost Assignments 85

Session 7: Pricing System 97

Session 8: Budgeting 108

Session 9: Introduction to Business Finance 118

Session 10: Capital Budgeting 126

Session 11: Time Value of Money 135

Session 12: Overview of Financial Markets 146

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Module Book
PRINCIPLES OF ACCOUNTING & BUSINESS FINANCE
Content

This module will provide students with an overview of the financial accounting, management
accounting and business finance concepts. Main topics include the accounting equation,
recording of business transactions, the preparation of financial statements, cost terminology,
cost behaviour and time value of money. Other topics include bank reconciliation, budgeting
and capital investment decision which equip students with basic accounting and financial
management skills. This module will help students establish a basic foundation for the
Accounting and Finance modules in advance diploma studies.

Module Aims

The aims of this module are to:

1. Provide students with a fundamental understanding of the nature and purpose of

accounting and finance.
2. Assist students to acquire knowledge and applications of accounting concepts and
skills within the general framework of the Principles of Accounting and Business
Finance.

Learning Outcomes

On completion of this module, the student should be able to:

1. Show a detailed knowledge and understanding of:

i) Basic accounting terms such as assets, liabilities, capital, revenues and expenses.
ii) The accounting equation and effects of transactions on the equation.
iii) The double entry principle.
iv) The main components of the Profit and Loss Account and the Statement of Financial
Position.
v) Bank reconciliation statement.
vi) The objectives of management accounting.
vii) The elements and classification of costs and various cost behaviours.
viii) Assignment of predetermined overhead rate.
ix) Pricing of raw materials.
x) The behavioural aspects of budgeting.
xi) Key activities of the financial manager.
xii) Alternative approaches to be used in making investment and financing decisions.
xiii) The nature of corporations.

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2. Demonstrate module specific skills with respect to:

i) Preparing a simple Profit and Loss Account and Statement of Financial Position of a
service firm.
ii) Preparation of bank reconciliation statements.
iii) The use of budgeting as a planning and control tool.
iv) Evaluating investment decisions.

3. Show cognitive skills with respect to:

i) Ability to distinguish cash and accruals basis of accounting.

ii) The use of budgets as a managerial control tool.
iii) Applying quantitative methods to analyze data, interpret data and make sound
decision-making.

4. Demonstrate transferable skills in:

i) Information retrieval and numerical analysis.

ii) Logical reasoning & decision making.
iii) Effective communication.
iv) Accounting in context.
v) Working with others.

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Delivery of Module and Lesson Plan

S/N Topic Learning Outcomes Recommended

At the completion of this session, Text, Readings
students will be able to: and/or
Activities

1. Introduction to 1. Define the nature and purpose Module book

Principles of of accounting. Session 1
Accounting and the
Accounting 2. Describe the types of business
Equation organization.

3. Identify the external and

internal users.

4. Define assets, liabilities and

capital.

5. State the accounting equation.

6. Identify and define each

element of the equation.

7. Prepare a simple Statement of

Financial Position based on the
accounting equation concept.

8. Describe and illustrate how

business transactions result in
changes in the elements of the
equation.

9. Rewrite the accounting equation

with different emphasis.

2. Double Entry 1. State the double entry principle. Module book

Bookkeeping Session 2
2. Understand the double entry
concept and the accounting
rules that govern the asset,
liability and equity account.

3. Define revenue and expense.

4. Understand the accounting rules

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 that govern the revenue and
expense account.

5. Describe and illustrate

journalizing transactions using
the double-entry accounting
system.

3. Recording Business 1. Describe the characteristics of Module book

Transactions – ledger accounts. Session 3
Ledger Accounts and
Trial Balance 2. Describe and illustrate the
posting of transactions to
accounts.

3. Determine the balances of

accounts to prepare a trial
balance.

4. Prepare a trial balance.

5. Understand the differences

between cash and accrual basis.

6. Prepare a simple Profit & Loss

Statement and a Statement of
Financial Position for service
firm.

4. Bank Reconciliation 1. State the features of good Module book

internal control over cash. Session 4

2. Explain the need to prepare a

bank reconciliation statement.

3. Describe the procedure of

preparing a bank reconciliation.

4. Reconcile the cash book balance

with the bank statement balance
and prepare a bank
reconciliation statement.

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5. Introduction to 1. Explain the meaning of Module book
Managerial managerial accounting. Session 5
Accounting and
Analysis of Cost 2. Explain the differences between
Behaviour management accounting and
financial accounting.

3. Explain the meaning of cost and

how costs are assigned to
products and services.

4. Define the various costs of

manufacturing products.

5. Explain the meaning of cost

behavior.

6. Define and describe fixed,

variable and mixed costs.

6. Cost Assignments 1. Understand how costs are Module book

assigned to cost objects. Session 6

2. Compute the predetermined

overhead rate and use the rate to
assign overhead to units.

7. Pricing System 1. Describe the materials recording Module book

procedure. Session 7

2. Explain the First in, First out

(FIFO) method of pricing
materials issued from inventory.

3. Explain the Last in, First out

(LIFO) method of pricing
materials issued from inventory.

4. Explain the Weighted Average

(WAC) method of pricing
materials issued from inventory.

8. Budgeting 1. Define budgeting and discuss its Module book

role in planning, control, and Session 8
decision-making.

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 2. Explain the interlinking of the
various budgets within a
business.

3. Indicate the uses of budgeting

and construct a simple cash
budget.

9. Introduction to 1. Define business finance. Module book

Business Finance Session 9
2. Identify and describe the key
activities of the financial
manager within the firm.

3. Explain why wealth

maximization rather than profit
maximization is the firm’s goal.

4. Discuss the relationship

between risk and return.

10. Capital Budgeting 1. Explain the importance and Module book

nature of capital budgeting. Session 10

2. Calculate, interpret, and

evaluate the Accounting Rate of
Returns (ARR).

3. Calculate, interpret, and

evaluate the Payback Period.

11. Time Value of 1. Discuss the concept of time Module book

Money value of money and the use of Session 11
computational tools.

2. Calculate, interpret and evaluate

the Net Present Value (NPV).

12. Overview of 1. Explain the nature of Module book

Financial Markets corporations. Session 12

2. Overview of financial markets

and institutions.

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 3. Understand the process of
raising capital for both new and
established firms.

Teaching and Learning Methods

Delivery comprises lectures to highlight concepts and principles as well as tutorial style
interaction where participants will have opportunities to apply the principles via
illustrations and exercises. Participants will be expected to learn independently by
carrying out reading and directed study beyond that available within taught classes.

Indicative Readings

Prescribed Textbook SIM PABF Module Book

Supplementary reading Wood, F & Sangster, A (2015). Frank Wood’s Business

Accounting 1. Harlow, Essex: Financial Times/Prentice Hall.
ISBN-13: 978-1292084664.

Mowen M.M., D.R. Hansen and D.L. Heitger (2016).

Managerial Accounting: The Cornerstone of Business
Decisions (7th Ed.) South-Western Cengage earning.
ISBN-13: 978-1337115773.

Gitman, L. J. (2014). Principles of Managerial Finance (14th

Ed.) Pearson Education.
ISBN-13: 978-0133507690

Assessment/coursework

All assessments must comply with the SIM Rules and Regulations. To satisfy
module requirements, students must:
1) Satisfactorily complete and present on due dates their completed assignment. A
penalty of 20% of the total marks will be imposed for late submission. A
submission later than 1 calendar day past deadline will receive a zero mark.
2) Complete all assessments and coursework in a satisfactory manner.
3) Reference all their work and observe SIM’s policy on plagiarism. Students found
guilty of plagiarism will be dealt with severely.
4) Adopt either the Harvard or APA (American Psychological Association)
Referencing Styles.

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Specific for this module are the following requirements:

Weighting between components A and B - A: 60% B: 40%

Element Description % of Assessment

Component A (Controlled Conditions)

Examination (120 minutes) 60%

Component B (CA: Continuous Assessment)

CA1
CA2 40%
CA3
Total (Component A+B) 100%

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 PRINCIPLES OF ACCOUNTING & BUSINESS FINANCE

SESSION 1

INTRODUCTION TO PRINCIPLES OF ACCOUNTING AND THE ACCOUNTING

EQUATION

At the end of the lecture, students should be able to:

1. Define the nature and purpose of accounting.

2. Describe the types of business organizations.
3. Identify the external and internal users.
4. Define assets, liabilities and capital.
5. State the accounting equation.
6. Identify and define each element of the equation.
7. Prepare a simple Statement of Financial Position based on the accounting equation
concept.
8. Describe and illustrate how business transactions result in changes in the elements of
the equation.
9. Rewrite the accounting equation with different emphasis.

1.1 Nature and Purpose of Accounting

Accounting can be defined as the process of identifying, measuring, recording and

communicating economic information about the business entity to the users of the
information to assist them in making decisions.

Recording refers to the keeping of accurate records of business transactions/financial

activities. The data recorded is summarized and financial information is reported to
management and other interested parties in the form of financial reports. The reports could
show the profit made for a certain period of time or the enterprise’s financial position.

Identification

Measurement

Recording

Communication

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Activity 1.1

What is the difference between book keeping and accounting?

1.2 Users of Financial Information

The financial reports provide a wealth of financial information that helps various users to
make informed decisions. The users who are interested in financial information include the
following:

 Owners
They are interested in assessing the returns of their investment such as dividend and their
potential capital gain.

 Managers
They are concerned with the company’s performance as their performance is measured
based on how well they have made use of the company’s resources to earn profits for the
business.

 Creditors and Lenders

They have an interest in how well the business performs in terms of its ability to meet
payments for goods and services acquired on credit terms. Lenders such as banks are
concerned with a business’s ability to meet loan and interest payments.

 Employees
They want to be assured of steady employment and if the business is profitable, they
hope to benefit from an employee profit sharing scheme.

 Governments
They are interested in the financial data to assess taxes.

 Prospective Investors
They are interested to invest in a business that is financially stable and solvent.

Activity 1.2

Classify the users mentioned in the above paragraphs under external and internal users of
accounting information. Explain the rationale of your classification.

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1.3 Types of Business Organisation

Businesses range enormously in size but they all have something in common which is to sell
goods and services for the purpose of making profits. Most types of businesses can be
classified in the following three forms.

 Sole Trader/Proprietorship
The business is owned by one individual who is entitled to all the profits made by the
business and also suffers all the losses made by the business.

 Partnership
The business is owned by two or more individuals with a common view to profit. The
partners agree on how the firm should be run and share profits and losses according to
their agreement.

 Limited Company
The business is organized under the country’s laws and the owners are known as
shareholders. The shareholders’ investment in the business is measured in shares and
their liability is limited up to the amount of capital invested. This is unlike the sole
proprietorship and partnership where the owners face unlimited liability as they may
have to make up for the business losses from their personal resources.

Activity 1.3

List the main types of businesses. Identify the different features among them.

1.4 Definition of Assets, Liabilities and Equity

Assets may be defined at this stage as items of value owned by a business. A business’s
assets comprise of items such as cash, motor vehicles, land, buildings, inventories/stock,
debts owing to it (known as accounts receivable or debtors), and so on.

Liabilities are amounts owed by the business. They include amounts owed as a result of the
purchase of goods or services (known as accounts payable or creditors), a bank overdraft or
other loans of money to the business.

Owner’s Equity may be defined as the interests of the owner or owners in the business. It
can arise because the owner has injected cash in the business (known as capital) or it can be
created by the business making profits. On the other hand, when the owner withdraws cash
from the business for personal use (known as drawings), it will cause owner’s equity to
decrease.

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Activity 1.4

Classify the following items into their correct category as asset, liability or owner’s equity.

(a) Office equipment

(b) Loan from DBS Bank
(c) Motor vehicles
(d) Bank balance
(e) Mortgage on factory
(f) Account receivables
(g) Inventory of goods held for resale
(h) Accounts payable
(i) Bank overdraft
(j) Capital
(k) Business’s website

1.5 The Accounting Equation

When an entity comes into being it is possible to note two aspects – the source of funds
provided to start the business, and the assets which represent those funds.

Assets of the business = Funds provided

Where the funds are all provided by the owner we can record this as:

Assets of the business = Funds provided by the owners

Usually, people other than the owners will also provide some of the funds. Hence, we can
expand the equation to:

Assets of the = Funds provided by + Funds provided by

business the owners outsiders

Assets = Owner’s Equity + Liabilities

So, the accounting equation is:

ASSETS = OWNER’S EQUITY + LIABILITIES

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Activity 1.5

Complete the following table:

Assets Liabilities Owner’s Equity

$ $ $
(a) 55,000 ? 36,400
(b) ? 21,200 18,500
(c) 40,000 15,400 ?
(d) 121,000 ? 62,000
(e) 198,000 ? 110,000

1.6 The Balance Sheet or Statement of Financial Position

The balance sheet or statement of financial position is a statement of assets, liabilities and
equity, suitably arranged and classified to reflect the financial position of an accounting entity
at a particular point in time.

Statement of Financial Position of Adam Trading

Assets $ $
Van 50,000
Premises 9,500
Equipment 1,500
Inventories 1,000
Cash in hand 3,000
Total assets 65,000

Liabilities
Payable/ Creditor 20,000
Loan 5,000 25,000

Owner’s Equity
Adam’s capital 40,000
Total liabilities and equity 65,000

Activity 1.6

Joyce has the following items in her statement of financial position on 30 April 2017:

Capital $22,200; Accounts payable $7,400; Fixtures $11,100; Inventories $4,300; Motor van
$8,600; Accounts receivable $4,100; Cash at bank $1,600; Cash in hand $2,900; Loan
$3,000.

Draw up Joyce’s statement of financial position as at 30 April 2017.

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 1.7 Effect of Transactions on the Accounting Equation

As the business engages in transactions, its assets, liabilities and equity change continually.
However, the relationship in the accounting equation will always hold true. The equality is
always maintained as the assets controlled by the business had to be financed by one or more
sources, such as the owner or lenders.

Illustration 1.1

(a) If the owner decides to invest $1,000 to start a business, then owner’s equity will be
increased by $1,000. At the same time $1,000 in cash will have been added to the
assets, so that the equation would now read:

Assets = Liabilities + Owner’s Equity

Cash + $1,000 Capital + $1,000

A ($1,000) = L(0) + OE ($1,000)

(b) If $600 is used to buy some furniture, one asset (cash) will be replaced by another asset
(furniture).

Assets = Liabilities + Owner’s Equity

Cash - $600
Furniture +$600

A ($1,000 - $600 + $600) = L(0) + OE ($1,000)

A ($1,000) = L(0) + OE ($1,000)

(c) If the furniture had been bought on credit, instead of cash being replaced, there will now
be a liability (payable).

Assets = Liabilities + Owner’s Equity

Furniture +$600 Payable +$600 Capital + $1,000

A ($1,000 + $600) = L($600) + OE ($1,000)

A ($1,600) = L($600) + OE ($1,000)

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(d) If the owner takes out $100 from the business’s cash to pay for his personal expenses,
this will reduce his interests in the business. Hence owner’s equity will be reduced by
$100. At the same time, asset (cash) will also reduce by $100.

Assets = Liabilities + Owner’s Equity

Cash -$100 Drawings -$100

A ($1,600 - $100) = L($600) + OE ($1,000 - $100)

A ($1,500) = L($600) + OE ($900)

Activity 1.7

Show how the accounting equation is affected with the following transactions:

Transactions Assets = Owner’s + Liabilities

Equity
a) Eve started a small
trading business with
$10,000, deposited
into a bank

10,000 = 10,000 + 0
b) Purchase a
computer by cheque
$1,500

10,000 = 10,000 + 0
c) She bought a piece
of furniture for
$1,500 on credit.

11,500 = 10,000 + 1,500

d) Make payment to
payable $1,000 by
cheque

10,500 = 10,000 + 500

e) Business borrowed
$3,000 from the bank

13,500 = 10,000 + 3,500

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 f) Eve withdrew
$600 from business
bank for personal use

12,900 = 9,400 + 3,500

Review Questions

Question 1

Which of the following statements is correct?

A. Accounting is defined as an information system that provides reports to external

users only.
B. Financial statements do not provide relevant information to credit suppliers.
C. All the information required by all users are met by the financial statements.
D. Financial statements comprise of an Income Statement and a Balance Sheet to
meet the needs of a number of user groups.

Question 2

Potential investors are interested in financial information because they need to

A. assess the business’s ability to meet loan and interest payments.

B. decide whether to buy shares in the company.
C. be assured of steady employment.
D. assess taxes.

Question 3

Which of the following statements about the accounting equation is correct?

A. Assets – Liabilities = Owner’s equity

B. Assets + Liabilities = Owner’s equity
C. Assets + Owner’s equity = Liabilities
D. Liabilities – Owner’s equity = Assets

Question 4

Jamie withdrew $9,000 from her business. What is the effect of the transaction on the
business’s accounting equation?

A. Increase in asset and owner’s equity

B. Decrease in an asset and decrease in another asset
C. Increase in assets and liabilities
D. Decrease in assets and owner’s equity

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Question 5

Leslie paid $12,900 to trade payables with a personal cheque. What is the effect of the
transaction on the business’s accounting equation?

A. Increase in asset and owner’s equity

B. Decrease in an asset and decrease liabilities
C. Increase in assets and liabilities
D. Decrease in liabilities and increase in owner’s equity

Question 6

Susan contributed $10,000 into her business. What is the effect of the transaction on the
business’s accounting equation?

A. Increase in asset and owner’s equity

B. Increase in an asset and decrease in another asset
C. Increase in assets and liabilities
D. Increase in liabilities and owner’s equity

Question 7

Dorcas took a loan from DBS and deposited the money in her business bank account. What
is the effect of the transaction on the business’s accounting equation?

A. Increase in bank and increase in loan

B. Decrease in bank and accounts payable
C. Increase in bank and accounts payable
D. Decrease in bank and loan

Question 8

Complete the following table:

Assets Liabilities Capital

$ $ $
(i) 89,200 43,000 ?
(ii) 47,000 ? 21,350
(iii) ? 21,789 67,000

A. (i) Capital $132,200; (ii) Liability $68,350; (iii) Assets $88,789

B. (i) Capital $ 46,200; (ii) Liability $25,650; (iii) Assets $88,789
C. (i) Capital $ 46,200; (ii) Liability $68,350; (iii) Assets $88,789
D. (i) Capital $132,200; (ii) Liability $25,650; (iii) Assets $45,211

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Question 9

Write down the effects on the accounting equation when

(i) a sole proprietor brought in a printer of $1,050 into the business
(ii) and bought another printer that cost $1,980 on credit
(iii) subsequently returned the newly bought printer to the supplier as it was
defective

Question 10

During the month of April 2017, Ronald Teo entered into the following transactions:
(i) Gave a cheque of $11,280 to a creditor.
(ii) Withdrew $3,000 from his business’s bank account and put it as cash in the till.
(iii) Bought a cabinet for $890 on credit.
(iv) Repaid a loan of $25,000 to the bank.

Show how the accounting equation is affected with the above transactions.

Question 11

The following items are from Jason’s statement of financial position on 31 May 2016:

Trade payable $21,100; Office equipment $20,200; Furniture and fittings $4,800; Inventory
$19,600; Capital $25,650; Trade receivable $24,900; Bank overdraft $10,300; Cash in hand
$550; Bank Loan $13,000.

Draw up Jason’s statement of financial position as at 31 May 2016.

Question 12

Laura Tang provided the following information as at 30 June 2014:

$
Plant and Machinery 152,000
Cash 12,000
Motor vehicle 78,500
Premises 280,000
Trade receivable 45,080
Trade payable 92,340
Inventory 54,000
Office equipment 26,000
Bank loan 150,000
Bank overdraft 12,600
Mortgage Loan 120,000

Required:
Based on the information above, prepare a statement of financial position as at 30 June 2014
and compute the missing Capital amount.

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Homework Questions (with answers)

Question 1

Which of the following statements is correct?

A. Financial statements provide forecast information to users.

B. Financial statements do not provide useful information to lenders.
C. All the information required by the owner are met by the financial statements.
D. Financial statements are intended to meet the needs of a number of user groups.

Question 2

Lenders are interested in financial information because they need to

A. assess the business’s ability to meet loan and interest payments.

B. decide whether to buy shares in the company.
C. be assured of steady employment.
D. assess taxes.

Question 3

Which of the following item is not an asset?

A. Motor vehicle
B. Loan from a bank
C. Tables and chairs
D. Money in the bank

Question 4

Jeremiah paid $2,060 to a supplier for amount previously owed with a personal cheque. What
is the effect of the transaction on the business’s accounting equation?

A. Decrease in accounts payable and loan

B. Decrease in cash and accounts payable
C. Increase in cash and accounts payable
D. Decrease in accounts payable and increase in capital

MCQ Answers : D, A, B, D

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Question 5

Identify three groups of users and explain why they need financial information.

Answer (Any three groups of users)

 Owners
They are interested in assessing the returns of their investment such as dividend and their
potential capital gain.

 Managers
They are concerned with the company’s performance as their performance is measured
based on how well they have made use of the company’s resources to earn profits for the
business.

 Creditors and lenders

They have an interest in how well the business performs in terms of its ability to meet
payments for goods and services acquired on credit terms. Lenders such as banks are
concerned with a business’s ability to meet loan and interest payments.

 Employees
They want to be assured of steady employment and if the business is profitable, they
hope to benefit from an employee profit sharing scheme.

 Governments
They are interested in the financial data to assess taxes.

 Prospective Investors
They are interested to invest in a business that is financially stable and solvent.

Question 6

Complete the following table:

Assets Liabilities Capital

$ $ $
(a) ? 43,000 73,900
(b) 98,400 ? 47,500
(c) 63,000 34,400 ?

Answer: Assets Liabilities Capital

$ $ $
(a) 116,900 43,000 73,900
(b) 98,400 50,900 47,500
(c) 63,000 34,400 28,600

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Question 7

During the month of June 2016, Janelle entered into the following transactions:

(v) Received a cheque of $9,700 from a debtor.

(vi) Deposited $20,000 of her own money into the business’s bank account.
(vii) Bought a computer for $1,000 by paying cash.
(viii) Took up a loan of $35,000 from the bank.

Show how the accounting equation is affected with the above transactions.

Answer:
(i) Asset (Bank) + $9,700; Asset (Debtor) - $9,700.
(ii) Asset (Bank) + $20,000; Equity (Capital) + $20,000.
(iii) Asset (Equipment) + $1,000; Asset (Cash) - $1,000.
(iv) Asset (Bank) + $35,000; Liability (Bank Loan) + $35,000.

Question 8

Thomas has the following items in his statement of financial position on 31 January 2017:

Accounts payable $17,100; Furniture and fittings $20,800; IT equipment $19,800; Capital
$28,600; Accounts receivable $24,700; Bank overdraft $11,300; Cash in hand $3,700; Bank
loan $12,000.

Draw up Thomas’s statement of financial position as at 31 January 2017.

Answer:

Statement of Financial Position of Thomas as at 31 January 2017

Assets $ $
Furniture and fittings 20,800
IT equipment 19,800
Accounts receivable 24,700
Cash in hand 3,700
Total assets 69,000

Liabilities
Accounts payable 17,100
Bank overdraft 11,300
Bank loan 12,000 40,400

Owner’s Equity
Thomas’s capital 28,600
Total liabilities and equity 69,000

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Question 9

Joy Factory provided the following information as at 30 June 2016:

$
Machinery 148,000
Cash 12,000
Delivery trucks 72,500
Buildings 212,000
Trade receivables 47,000
Trade payables 41,300
Inventory 24,000
Equipment 37,000
Long-term loan 62,300
Bank overdraft 48,600
Mortgage 174,000

Required:
Based on the information above, compute the missing capital amount and prepare a statement
of financial position as at 30 June 2016.

Answer:
Statement of Financial Position of Joy Factory as at 30 June 2016

Assets $ $
Machinery 148,000
Cash 12,000
Delivery trucks 72,500
Buildings 212,000
Trade receivables 47,000
Inventory 24,000
Equipment 37,000
Total assets 552,500

Liabilities
Trade payables 41,300
Long-term loan 62,300
Bank overdraft 48,600
Mortgage 174,000 326,200

Owner’s Equity
Capital (552,500 – 326,200) 226,300
Total liabilities and equity 552,500

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 PRINCIPLES OF ACCOUNTING & BUSINESS FINANCE

SESSION 2

DOUBLE ENTRY BOOKKEEPING

At the end of the lecture, students should be able to:

1. State the double entry principle.

2. Understand the double entry concept and the accounting rules that govern the asset,
liability and equity account.
3. Define revenue and expense.
4. Understand the accounting rules that govern the revenue and expense account.
5. Describe and illustrate journalizing transactions using the double-entry accounting
system.

2.1 Dual Aspect Rule

The dual aspect rule states that every business event will always have a twofold effect. The
recognition of the twofold effect of all transactions gave rise to the double-entry bookkeeping
system.

2.2 Double Entry

It is a debit entry to at least one account and a credit entry to at least one account. The total
debits and total credits of each double entry must be equal.

Rules of Double Entry

– Every transaction affects at least 2 accounts.

– At least one account is debited and one account is credited.

– Total Debits == Total Credits

Accounts to Debit and Credit

Every account is deemed to have a nature, either debit or credit. Whether an account is to be
debited or credited depends on the nature of the account. Increases to the account are
recorded on the same side as the nature of the account. Decreases are recorded on the
opposite side to the nature of the account.

26
Hence, the accounting rules that govern asset, liability and equity accounts are as follows:-

Categories Nature Increase Decrease

Assets Debit Dr Cr

Liabilities Credit Cr Dr

Equity Credit Cr Dr

Steps to record a transaction

(i) Identify the two items(accounts) that are affected by the transaction.
( ii ) Determine if they are being increased or decreased.
( iii ) Decide whether each account should be debited or credited based on the nature.
( iv ) Check that total debit amount is equal to total credit amount.

Activity 2.1

Transaction Accounts Category Increase OR Dr OR

Affected Decrease Cr
1 Owner contributed
cash to the entity

2 Bought motor vehicle

on credit from Auto Ltd

3 Bought furniture paying

by cash

4 Business borrowed cash

from the bank

5 Paid amount owing to

Auto Ltd

6 Personal drawings of
cash by owner

27
 Transaction Accounts Category Increase OR Dr OR
Affected Decrease Cr
7 Paid off bank loan in
cash

8 A debtor (accounts
receivable) paid his
account by cash

2.3 Definition of revenue, expenses and profit

Revenue may be defined as the income that a business earns from its normal business
activities, usually from the sale of goods and services* to customers. An increase in revenue
results in an inflow of resources; hence, it will cause owner’s equity to increase. *For this
course, we will only focus on sale of services.

Expenses are amounts incurred by a business when it accepts goods or consumes services
provided by another entity. An increase in expense results in an outflow of resources; hence,
it will cause owner’s equity to decrease.

Profit is the difference between revenue and expenses. When a business makes profit from
its transactions, the profit becomes part of the owner’s equity.

2.4 Accounting Rules for Revenue and Expenses account

When the business makes profit, profit goes to the owner. Since equity is credit in nature,
profit which increases capital is also credit in nature.

Profit = Revenue – Expenses

Revenue increases profit which is credit in nature, hence revenue accounts are credit in nature
while expenses which decrease profit will then be debit in nature.

A summary on the accounting rules that govern revenue and expense accounts are as
follows:-

Categories Nature Increase Decrease

Expenses Debit Dr Cr

Revenue Credit Cr Dr

28
Activity 2.2

Transaction Accounts Category Increase OR Dr OR

Affected Decrease Cr
1 Paid wages to staff in
cash

2 Billed client-Peter for

services rendered

3 Received commission
by cash

4 Paid rent in cash

5 Collected cash from

Peter for amount owed

Activity 2.3

For each of the following transactions which relates to the business of Max:
i) Identify the accounts that are affected.
ii) Classify the account as an asset(A), liability(L), owner’s equity(OE), revenue(R) or
expense(E).
iii) Indicate whether each account will be increased or decreased.
iv) Decide whether the account should be debited or credited based on the nature.

Transaction Accounts Category Increase OR Dr OR

Affected Decrease Cr
1 Bought shelves to be
used in the office on
credit from Roma

2 Max brought in more

cash as capital

3 Received interest
income by cheque

29
 Transaction Accounts Category Increase OR Dr OR
Affected Decrease Cr
4 Paid cheque to Roma
for amount owed

5 Paid rent expense by

cheque

6 Bank in office cash

7 Paid wages and salaries

by cheque

8 Max issued a business

cheque to pay off a
personal loan

9 Billed a client Jill for

service rendered

10 Took up a bank loan

and received cheque
for it

11 Received cash from Jill

for amount owing

12 Paid off bank loan in

cheque

13 Max transferred a sum

of money from his
personal bank account
to the business’s bank
account

14 Transfer from the

business bank account
to cash in hand

30
Review Questions

Question 1

Susan received $10,000 of commission income. What is the effect of the transaction on the
business’s accounting equation?

A. Increase in cash and capital

B. Increase in cash and income
C. Decrease in cash and increase in expense
D. Decrease in cash and income

Question 2

John paid his worker $9,000 of wages. What is the effect of the transaction on the business’s
accounting equation?

A. Increase in expense and capital

B. Increase in cash and income
C. Decrease in cash and increase in expense
D. Decrease in cash and income

Question 3

A debit entry is recorded when

A. asset increases and liability decreases

B. asset increases and equity increases
C. equity increase and liability increases
D. expense decreases and revenue decreases

Question 4

A credit entry is recorded when

A. asset decreases and liability decreases

B. asset increases and capital increases
C. expense decrease and liability increases
D. drawings increase and revenue decreases

Question 5

Daryl bought a pick up that cost $45,000 paying by cheque. What is the effect of the
transaction on the business’s accounting equation?

A. Increase in expense and capital

B. Increase in vehicle and decrease in bank
C. Increase in vehicle and increase in other payable
D. Increase in cash and increase in income

31
Question 6

When motor vehicles are bought on credit, the accounting entries are

Debit Credit
A. Motor vehicles Other payable
B. Other payable Motor vehicles
C. Motor vehicles Cash
D. Cash Motor vehicles

Question 7

Toby received $7,000 from a trade debtor. What is the correct double entry to record this
transaction?

A. Dr Cash account Cr Capital account

B. Dr Cash account Cr Income account
C. Dr Expense account Cr Cash account
D. Dr Cash account Cr Trade debtor account

Question 8

Daisy paid $11,000 for advertising her product. What is the correct double entry?

A. Dr Expense account Cr Drawings account

B. Dr Cash account Cr Expense account
C. Dr Expense account Cr Cash account
D. Dr Cash account Cr Income account

Question 9

Consider the following transactions of Jill’s facial and spa firm, indicate the effects upon
assets, liabilities, owner’s equity, revenue and expense, i.e. whether the element will increase
or decrease, and write down the double entries to record the transactions.

Transaction Accounts Category  OR Double Entries

Affected 
1 Jill contributed $25,000
cash and beauty
equipment that costs
$70,000 to begin her
business.

2 Bought a computer
from Lee’s, $3,100 on
account.

32
 Transaction Accounts Category  OR Double Entries
Affected 
3 Paid $2,500 for rental
of shop space by cash.

4 Withdrew $890 in cash

to pay home utilities.

5 Took up a loan of
$10,000 from Citibank,
receiving a cheque for
it.

6 Banked in office cash

$1,000.

7 Paid amount owing to

Lee’s with a cheque

8 Received cash $2,500

for service rendered to
a client

9 Billed a client Jane

$3,200 for service
rendered. Client agreed
to pay the following
week.

10 Paid interest for the

Citibank loan in cash
$100.

11 Client Jane paid up the

amount owing in
cheque.

33
 Transaction Accounts Category  OR Double Entries
Affected 
12 Bought a cabinet $900
from Norman, paying
half in cash, the
remainder to be paid by
the end of the month.

Question 10

Complete the following table:

Debit Credit
a) Owner brought in her car for business
use

b) Bought a cabinet paying by cheque

c) Bought a truck from MX Ltd on

account

d) Returned the truck bought on credit

from MX Ltd.

e) Received commission income in cash

f) Issued a cheque to pay rent expense

g) Bought furniture on credit from

Harvey

h) Billed client Martha for service

rendered

i) Paid the amount owing to Harvey by

cheque

j) Owner issued a business cheque to

pay for his son’s tuition fee

k) Owner brought in more cash into the

business

34
 Debit Credit
l) Received a cheque from Martha for
the amount owing

m) Paid staff wages in cash

Homework Questions (with solutions)

Question 1

Peter withdrew $3,000 from the business’s bank account to pay for his personal income tax.
What is the effect of the transaction on the business’s accounting equation?

A. Decrease in bank and increase in expense

B. Decrease in bank and increase in drawings
C. Decrease in bank and increase in cash
D. Increase in bank and increase in drawings

Question 2

Stephen bought an equipment that cost $12,000 on credit. What is the effect of the transaction
on the business’s accounting equation?

A. Increase in expense and capital

B. Increase in equipment and decrease in cash
C. Increase in equipment and increase in other payable
D. Increase in cash and increase in sales

Question 3

Which of the following requires a debit entry?

1. Expense increases and liability increases

2. Asset increases and drawings increase
3. Revenue decreases and liability increases
4. Expense increases and revenue decreases

A. 1 and 2
B. 2 and 4
C. 2 and 3
D. 3 and 4

35
Question 4

When a lap top is bought on credit, the accounting entries are

Debit Credit
A. Office equipment Cash
B. Payable Office equipment
C. Cash Office equipment
D. Office equipment Payable

MCQ answers: B, C, B, D

Question 5

Explain the dual aspect rule and provide an example to illustrate the rule.

Answer:
The dual aspect rule states that every business event will always have a twofold effect. The
recognition of the twofold effect of all transactions gave rise to the double-entry bookkeeping
system.

For example, when the owner makes cash investment into the business, there is an increase in
asset called cash, followed by an increase in capital.

Question 6

Explain why an increase in revenue causes owner’s equity to increase while an increase in
expense has an opposite effect on owner’s equity.

Answer:
Revenue or turnover may be defined as the income that a business earns from its normal
business activities, usually from the sale of goods and services to customers. An increase in
revenue results in an inflow of resources; hence, it will cause owner’s equity to increase.

Expenses are amounts incurred by a business when it accepts goods or consumes services
provided by another entity. An increase in expense results in an outflow of resources; hence,
it will cause owner’s equity to decrease

36
Question 7

Complete the following table:

Debit Credit
a) Invested cash in business

b) Bought motor van by cheque

c) Returned furniture to Courts Ltd.

d) Machinery bought on credit from Saw Ltd.

e) Paid creditor Saw Ltd. By cheque

f) A debtor, Lynn, paid us in cash.

Answer:
Debit Credit

a) Invested cash in business Cash Capital

b) Bought motor van by cheque Motor vehicle Bank
c) Returned furniture to Courts Ltd. Payable-Courts Furniture
d) Machinery bought on credit from Saw Ltd. Machinery Payable-Saw
Ltd
e) Paid payable Saw Ltd. By cheque Payable-Saw Bank
Ltd
f) A receivable, Lynn, paid us in cash. Cash Accounts
receivable-Lynn

Question 8

Write down the double entries when a business

(i) bought some furniture for $14,000 on credit
(ii) subsequently returned some damaged furniture that cost $3,000
(iii) repaid the furniture supplier for the balance owed

Answer:
(i) Dr Furniture $14,000 Cr Payable $14,000
(ii) Dr Payable $3,000 Cr Furniture $3,000
(iii) Dr Payable $11,000 Cr Cash $11,000

37
Question 9

Complete the following table:

Transactions Dr $ Cr $
(a) We pay creditor $120 by cheque

(b) The owner takes out $1000 cash for his

personal use

(c) The owner puts a further $5,000 cash into

the business

(d) Bought fixtures $200 paying by cheque

(e) John lends the firm $200 in cash

(f) Paid staff salaries $700

(g) Received $1500 from client for service

rendered

(h) Paid John the amount owing by cash

(i) Billed client $5600 for taxation services

rendered

(j) Received $2800 cheque from a receivable

Answer:

Transactions Dr $ Cr $
(a) We pay creditor $120 by cheque Creditor 120 Bank 120

(b) The owner takes out $1000 cash for his Drawings Cash 1000
personal use 1000

(c) The owner puts a further $5,000 cash into Cash 5000 Capital 5000
the business

(d) Bought fixtures $200 paying by cheque Fixtures 200 Bank 200

38
(e) John lends the firm $200 in cash Cash 200 Loan 200

(f) Paid staff salaries $700 Salaries 700 Cash 700

(g) Received $1500 from client for accounting Cash 1500 Accounting
service rendered revenue 1500

(h) Paid John the amount owing by cash Loan 200 Cash 200

(i) Billed client $5600 for taxation services Debtor 5600 Taxation
rendered revenue 5600

(j) Received $2800 cheque from a receivable Bank 2800 Receivable

2800

39
 PRINCIPLES OF ACCOUNTING & BUSINESS FINANCE

SESSION 3

RECORDING BUSINESS TRANSACTIONS – LEDGER ACCOUNTS AND THE

TRIAL BALANCE

At the end of the lecture, students should be able to:

1. Describe the characteristics of ledger accounts.

2. Describe and illustrate the posting of transactions to accounts.
3. Determine the balances of accounts to prepare a trial balance.
4. Prepare a trial balance.
5. Understand the differences between cash and accrual basis.
6. Prepare a simple Profit & Loss Statement and a Statement of Financial Position for
service firm.

3.1 Ledger Accounts

We have learnt that every business transaction has an effect on the elements of the accounting
equation. It is necessary to have a mechanism to record the changes in each of these
individual items. In the double entry bookkeeping system, transactions are recorded in
accounts. Accounts are kept for each asset item, liability item, capital and drawings item and
each item of revenue and expenses.

An account is therefore a record, built up over time, of all the economic transactions that
have occurred. These accounts are collected and kept together in a ledger called the nominal
or general ledger.

The Account, which in its simplest form, is a page, sheet or card for each item. The left-hand
side of an account is known as Debit (Dr) and the right-hand side of the account is known as
Credit (Cr).

Format:

Dr. Name of Account Cr.

Date Particulars $ Date Particulars $

When we say “Debit Account A”, it means we are recording on the left side of Account A.
When we say “Credit Account A”, it means we are recording on the right side of Account A.

40
3.2 Posting of Transactions to ledger accounts

The recording of transactions into ledger accounts can be illustrated using the following
examples.

Illustration 3.1

On 1 Jan 2017, owner contributed $10,000 cash into the business’s bank account.

Double entries: Dr Bank $10,000 Cr Capital $10,000

Bank

2017 $
1 Jan Capital 10,000

Capital

2017 $
1 Jan Bank 10,000

Activity 3.1

Write up the ledger accounts to record the following transactions of Ezra. All monies
received and paid are recorded in the bank account.

June 1 Started business with $10,500 cheque from the owner.

2 Received a $1,500 cheque for services rendered.

4 Bought office equipment on credit from Homes $1,000.

7 Bought a computer paying by cheque $1,200.

12 Billed a client Matt $2,000 for services rendered.

18 Paid the amount owing to Homes $1,000 by cheque.

25 Received the amount due from client Matt $1,500.

29 Paid office rental $1,000.

41
 Bank

Capital

Service Revenue

Office Equipment

Payable - Homes

Receivable - Matt

Rent Expense

42
3.3 The Account Balances

The balance on an account is the amount by which the total value of debit entries and the total
value of credit entries in the account are different.

 When the total debits exceed the total credits, the account has a debit balance.

Bank

$ $
July 1 Capital 15,000 July 5 Office furniture 3,000
July 15 Receivable 4,000

Debit balance $16,000

Furniture

$
April 5 Payable 32,000

Debit balance $32,000

 When the total credits exceed the total debits, the account has a credit balance.

Payable - Wong

$ $
May 16 Bank 18,000 May 2 Office furniture 28,000

Credit balance $10,000

Loan

$
Jan 16 Bank 10,000

Credit balance $10,000

43
 When the total debits equal to the total credits, the account has no balance.

Payable - Toyo

$ $
Sep 17 Bank 35,000 Sep 9 Motor van 55,000
Sep 30 Bank 20,000

No balance

Activity 3.2

State whether the following accounts have a debit or credit balance and calculate the amount
of the balances.

Bank A/C
2017 $ 2017 $
Jan 1 Capital 10,000 Jan 5 Advertising 2,000
15 Receivable 3,900 6 Repairs 4,300
25 Wages 1,000

Payable A/C
2017 $ 2017 $
Jan 22 Bank 2,000 Jan 10 Furniture 5,000

3.4 Trial Balance

A trial balance is a list of all the accounts in the ledger with their current balances. It is a
check on the arithmetical accuracy of the work (i.e. to check that for every debit entry made,
an equal credit entry has been made) but not by any means an accurate check of the
accounting entries.

44
However, if the trial balance figures do not agree it is obvious an error has been made. The
trial balance is thus a form of control over the recording process.

The trial balance also forms as a first step for preparing a set of financial statements, the
statement of profit or loss and a statement of financial position. The statement of financial
position, introduced in session 1, shows the assets, liabilities and owner’s equity at a
particular point in time. The statement of profit or loss will be covered on the next page.

Format of a trial balance

Trial Balance as at 31 December 2016

Dr $ Cr $
Expenses X
Assets X
Drawings X
Revenue X
Liabilities X
Capital X

X X

Activity 3.3

Prepare a trial balance from the following balances that were extracted from the ledgers of
Ezra on 30 June 2016.

$ $
Bank 10,300 Office Equipment 2,200
Capital 10,500 Receivable – Matt 500
Service Revenue 3,500 Rent Expense 1,000

Trial Balance as at 30 June 2016

Dr ($) Cr ($)
Bank
Capital
Service Revenue
Office Equipment
Receivable – Matt
Rent Expense

45
3.5 Cash Basis & Accrual Basis

Cash Basis of Accounting states that revenue is recognized when cash is received and
expense is recognized when cash is paid.

Accrual Basis of Accounting, on the other hand, recognizes revenue only when it is earned
in an accounting period and expenses only when incurred. This is to ensure that there is
proper matching of revenue and expenses to determine profit.

Hence,

Profit = Revenue earned – Expenses incurred

Profit represents an increase in owners’ equity while loss reflects a drop in owners’ equity.

3.6 Statement of Profit or Loss of a Service Business

A service business is one that sells services directly to consumers or other businesses. Some
examples of service business include accounting, banking, consultation, cleaning, education,
insurance and transportation services.

Sometimes called the income statement, the statement of profit or loss is a summary of the
revenue and expenses of a business for a period of time, usually one year. The last line in the
statement indicates the net profit or loss of the business, hence the reference to the “bottom
line”.

Example of a Statement of Profit or Loss of a Service Business

Statement of Profit or Loss

For the year ended 31 December 2016
$ $
Revenue
Accounting fee 260,000
Taxation fee 40,000 300,000

Less: Operating Expenses

Advertising 10,000
Motor van expenses 3,000
Salaries 10,000
Office Expenses 5,000
Rent 12,000
Utilities 5,000 (45,000)
Net Profit 255,000

46
Activity 3.4

The following balances were extracted from the Trial Balance of Sarah’s Tuition Services on
30 June 2016:

Dr $ Cr $
Advertising 310
Interest paid 85
Light and power 92
Postage and stationery 124
Rent received 224
Salaries 5,620
Tuition fee 15,074

Required:
Prepare a Statement of Profit or Loss for the year ended 30 June 2016.

Statement of Profit or Loss for the year ended 30 June 2016

$ $
Revenue

Less: Operating Expenses

Net Profit

47
Activity 3.5

Below is the trial balance of Shawn as at 30 June 2017:

Dr Cr
$ $
Insurance 1,650
Motor expenses 2,960
Salaries and wages 5,850
Service revenue 25,600
Commission received 1,830
Sundry expenses 1,806
Motor vans 4,500
Payables 3,240
Receivables 7,810
Fixtures 4,960
Buildings 27,000
Cash at bank 2,134
Drawings 2,000
Capital 30,000
60,670 60,670

Required:
Prepare a Statement of Profit or Loss for the year ended 30 June 2017 and a Statement of
Financial Position as at that date.

Statement of Profit or Loss for the year ended 30 June 2017

$ $
Revenue

Less: Operating Expenses

Net Profit

48
 Statement of Financial Position as at 30 June 2017
$ $
Assets

Liabilities

Owner’s Equity

49
Review Questions

Question 1

What items are shown on the statement of financial position?

A. Assets and expenses

B. Drawings and expenses
C. Revenue and liabilities
D. Capital, Assets and liabilities

Question 2

What items are shown on the statement of profit or loss?

A. Assets and liabilities

B. Drawings and expenses
C. Revenue and expenses
D. Capital and drawings

Question 3

At 30 December 2016 Sharmila’s trial balance included the following balances:

Debit Credit
$ $
Beauty treatment revenue 45,000
Wages and salaries 15,500
Postage 340
Rent 6,000
Commission revenue 12,700
Advertising 1,900
Other expenses 2,500

What is Sharmila’s net profit?

A. $18,760
B. $26,240
C. $31,460
D. $57,700

50
Question 4

The following Trial Balance has a number of errors. Prepare a corrected trial balance.

Trial Balance as at 31 May 2017

Dr. Cr.
$ $
Capital 51,000
Cash at bank 16,800
Loan from UOB 50,000
Premises 116,000
Consultation Revenue 54,000
Sundry debtors 12,000
Sundry creditors 23,000
Repairs & Maintenance 7,000
Wages and salaries 22,000
Utilities 3,500
Drawings 700
Total 178,000 178,000

Answer:
Trial Balance as at 31 May 2017

Dr. Cr.
$ $
Capital
Cash at bank
Loan from UOB
Premises
Consultation Revenue
Sundry debtors
Sundry creditors
Repairs & Maintenance
Wages and salaries
Utilities
Drawings
Total

51
Question 5
Below is the information of Lily Woo, a sole proprietor for the year ended 31 July 2017:

$
Capital 61,000
Motor van 33,400
Cash at bank 11,700
Furniture and fixtures 18,290
Service revenue 13,850
Transportation expenses 1,250
Interest expense 400
Salaries & wages 7,000
Commission received 6,000
Utilities 4,000
Rental expense 9,300
Receivables 9,710
Payables 2,200
Loan 15,000
Drawings 3,000

Required:
Prepare a Statement of Profit or Loss for the year ended 31 July 2017 and a Statement of
Financial Position as at that date.

Homework Questions (with solutions)

Question 1

Explain how revenue and expenses are recorded under

(i) cash accounting
(ii) accrual accounting.

Answer:

Cash Basis of Accounting states that revenue is recognized when cash is received and
expense is recognized when cash is paid.

Accrual Basis of Accounting, on the other hand, recognizes revenue only when it is earned
in an accounting period and expenses only when incurred.

52
Question 2

Write up the ledger accounts to record the following transactions in the records of Felicia.
Determine the balance of the accounts at the end of the month and extract a trial balance. All
monies received and paid are recorded in the bank account.

July 1 Started business with $15,000 in the bank.

5 Bought office furniture by cheque $1,200.
6 Received a cheque $850 for commission revenue.
10 Bought a motor van $1,400 on credit from Mac Ltd.
11 Billed a client Tim $2,600 for transportation services rendered.
12 Received a cheque $330 for transporting goods for a client.
15 Sold some of the office furniture – not suitable or the business – for $150
cash.
17 Paid rent $580.
22 Paid the amount owing to Mac Ltd $1,400 by cheque.
31 Bought more furniture by cheque $650.

Answer:

Cash at Bank

1 Jul Capital 15,000 5 Jul Office furniture 1,200

6 Jul Commission revenue 850 17 Jul Rent 580
12 Jul Transportation revenue 330 22 Jul Payable – Mac Ltd 1,400
15 Jul Office furniture 150 31 Jul Office furniture 650

Debit balance $12,500

Capital

1 Jul Cash at bank 15,000

Credit balance $15,000

Office Furniture

5 Jul Cash at bank 1,200 15 Jul Cash at bank 150 31 Jul

Cash at bank 650

Debit balance $1,700

53
 Commission Revenue

1 Jul Cash at Bank 850

Credit balance $850

Motor Van

10 Jul Payable – Mac Ltd 1,400

Debit balance $1,400

Payable – Mac Ltd

22 Jul Cash at bank 1,400 10 Jul Motor van 1,400

No balance

Receivable – Tim

11 Jul Transportation revenue 2,600

Debit balance $2,600

Transportation Revenue

11 Jul Receivable - Tim 2,600

12 Jul Cash at bank 330

Credit balance $2,930

Rent

17 Jul Cash at bank 580

Debit balance $580

54
 Trial Balance as at 31 July

Dr ($) Cr ($)
Cash at Bank 12,500
Capital 15,000
Office Furniture 1,700
Commission Revenue 850
Motor van 1,400
Receivable – Tim 2,600
Transportation Revenue 2,930
Rent 580
18,780 18,780

Question 3
Beatrice
Trial Balance as at 30 April 2017
DR CR
$ $
Bank 235
Capital 1,500
Equipment 1,240
Accounts payable 730
Utilities 135
Commission revenue 1,827
Accounts receivable 845
Wages and salaries 967
Drawings 635
3,547 4,567

List the above balances under the correct debit and credit columns in order to balance the trial
balance.

Answer:
Beatrice
Trial Balance as at 30 April 2017
DR CR
$ $
Bank 235
Capital 1,500
Equipment 1,240
Accounts payable 730
Utilities 135
Commission revenue 1,827
Accounts receivable 845
Wages and salaries 967
Drawings 635
4,057 4,057

55
Question 4
Below is the information of Lawrence, a sole trader for the year ended 31 July 2016:
$
Capital 20,000
Receivables 7,072
Cash at bank 12,900
Payables 3,300
Office equipment 22,700
Service revenue 37,000
Transportation 480
Salaries & Wages 12,000
Interest received 3,220
Heating and lighting 1,768
Rental expense 6,600

Required:
Prepare a Statement of Profit or Loss for the year ended 31 July 2016 and a Statement of
Financial Position as at that date.

Answer:
Statement of Profit or Loss for the year ended 31 July 2016
$ $
Revenue
Service revenue 37,000
Interest received 3,220 40,220

Less: Operating Expenses

Transportation 480
Salaries & wages 12,000
Heating and lighting 1,768
Rental expenses 6,600 20,848
Net Profit 19,372

Statement of Financial Position as at 31 July 2016

$ $
Assets
Receivables 7,072
Cash at bank 12,900
Office equipment 22,700
42,672
Liabilities
Payables 3,300

Owner’s Equity
Capital 20,000
Add: Net profits 19,372 39,372
42,672

56
 PRINCIPLES OF ACCOUNTING & BUSINESS FINANCE

SESSION 4

BANK RECONCILIATION

At the end of the lecture, students should be able to:

1. State the features of good internal control over cash.

2. Explain the need to prepare a bank reconciliation statement.
3. Describe the procedure of preparing a bank reconciliation.
4. Reconcile the cash book balance with the bank statement balance and prepare a bank
reconciliation statement.

4.1 Internal Control over Cash

As cash is a tempting target for fraud and can easily be misappropriated, there is a need for
firms to put in place good control practices over cash. Some of the control practices include:

 Ensuring that no one person has access to both the physical assets and the related
accounting records so that the separate parties can check on each other independently.

 Periodic reconciling of the bank accounts with the bank statements by someone
independent of the cash recording. These bank reconciliations should be reviewed by
the owner(s) along with the review of the bank statements.

Activity 4.1

State one more feature of good internal control over cash.

4.2 Relationship between Business and Bank

If a business deposits $1,000 into the bank, the business now has $1,000 asset in the form of a
bank account. It is reflected as a debit balance in the business’s books.

From the bank’s point of view, the $1,000 kept with them represents the amount owing to the
business. Hence, the $1,000 will be reflected as a credit balance in bank’s records.

4.3 Bank Reconciliation Statement

Firms will normally open a current account with the bank. All deposits or withdrawals of
cash made at the bank are recorded in the cash book. With cheques and bank transfers, there
are timing differences between recording the receipt or payment in the cash book and the
actual transfer of money into or out of the bank account.

57
Therefore, at any given date, the cash book balance of the firm may differ from the bank
statement balance.

Bank Statement

At month-end, the bank will send the firm a bank statement, which gives details of money
drawn out and deposits made by the firm. It is used to check that the cash book details are
correct.

Bank Reconciliation Statement

The details in the bank statement are checked against the details in the cash book to make
sure that they are in agreement with each other. When the balance in the bank statement and
the balance in the cash book are different, a bank reconciliation is needed to check the
differences in the balances and make sure that the differences can be explained.

Bank reconciliation is an important control practice as it provides a check on the accuracy of

the cash book. Errors in the cash book would be identified and corrected. The cash book
would also be updated with items found in the bank statement but not previously entered on
the cash book such as, bank charges, interest on deposits etc.

4.4 Preparation of Bank Reconciliation Statement

Procedures of preparing a bank reconciliation

Step 1

Look for individual transactions in the cash book that can be matched with the same
transactions in the bank statement. When transactions are matched, it is a common practice
to mark it in both the cash book and the bank statement with a tick.

Step 2

The difference in the two ending balances must be explained by those transactions in the
bank statement and cash book that are not ticked.

Transactions not ticked in bank statement

- Items in the bank statement not entered on the firm’s cash book (Unrecorded items)

(i) Withdrawals from the firm’s bank account for items such as bank charges, standing
orders and dishonoured cheques.

(ii) Deposits into the firm’s bank account for items such as credit transfer from the firm’s
customers, dividends on investment and interest on deposits.

For these transactions, pass a double entry to record them in the cash book. Once done, tick
them off in the bank statement to show that they have been dealt with.

58
Step 3

After updating the cash book, there will be a new balance on the cash book, though it would
likely to be still different from the bank statement balance. This is due to items in the cash
book that have not been ticked because they are not in the bank statement.

Transactions not ticked in cash book

- Items in the firm’s cash book not recorded in the bank statement (Timing Differences)

(i) Unpresented cheques

These are cheques paid out by the firm recorded in the cash book at the date drawn out
but not yet presented to the bank for payment.

(ii) Uncredited deposits

These are cheques received by the firm recorded in the cash book but still passing
through the bank clearing system. They will not be recorded by the bank until money is
received from the drawer’s bank.

For these transactions, include them in the bank reconciliation statement to explain the
difference between the updated cash book balance and bank statement balance.

Summary of the Steps

Step 1 & 2
Unrecorded items
Update cash book cash book updated balance

Step 3

Prepare the bank reconciliation statement

XYZ Ltd
Bank Reconciliation Statement
as at 31 Dec 2016

Balance per bank statement XX

Less: Unpresented cheques

- Cheque no 123 (XX)
- Cheque no 125 (XX)

Add: Uncredited deposits XX

Updated balance per cash book XX

NOTE: Bank overdraft will be denoted by a ( ) to indicate its negative balance.

59
Follow up actions in the following month

Step 1
Check that previous month’s reconciling items are updated by the bank.

Step 2
Reconciling items not updated will remain in bank reconciliation statement till they are
finally updated by the bank.

Activity 4.2

The following shows the cash book and bank statement of a certain firm:

Dr. Cash Book (Bank Entries only) Cr.

2017 $ 2017 $
Mar 1 Balance 2,840 Mar 7 Toni Ltd 370
2 Johnny 400 11 Tanlin 200
10 Sales 550 20 Jamie 150
15 Sales 600 26 Sansan 187
31 Dawn 191 27 Felicia 212

Debit balance $3,462

Bank Statement Dr. Cr. Balance

2017 $ $ $
Mar 1 Balance 2,840
4 Deposit: Johnny 400 3,240
9 Cheque: Toni Ltd 370 2,870
10 Deposit 550 3,420
14 Cheque: Tanlin 200 3,220
15 Deposit 600 3,820
22 Cheque: Jamie 150 3,670
27 Lee Ltd (Dividend) 90 3,760
28 Bank charges 50 3,710

Required:
(i) Update the cash book.

(ii) Prepare a statement to reconcile the difference between the updated cash book balance
and the bank statement balance on 31 March 2017.

(iii) Which cash balance do we reflect in the statement of financial position – the adjusted
balance of the cash book or the closing balance in the bank statement?

60
(iv) The following are the cash book and bank statement for the following month. What
must you do with the previous month’s reconciling items?

Dr. Cash Book (Bank Entries only) Cr.

2017 $ 2017 $
Apr 1 Balance 3,502 Apr 5 Yeo 710
9 Commission 800 16 May 40
14 Sales 750 20 Jean 520
28 Matt 360
30 Tom 900

Bank Statement Dr. Cr. Balance

2017 $ $ $
Apr 1 Balance 3,710
2 Deposit: Dawn 191 3,901
6 Cheque: Felicia 212 3,689
10 Deposit 800 4,489
10 Cheque: Sansan 187 4,302
11 Cheque: Yeo 710 3,592
17 Deposit 750 4,342
19 Interest 60 4,402
30 Deposit 360 4,762
30 Bank charges 50 4,712

61
Activity 4.3

Lee’s cash cook (bank columns only) for the month of August 2016 was as follows:

Dr Cheque Cr
No.
2016 $ 2016 $
Aug 1 Balance 600 Aug 5 Beano 110 410
9 Cash 420 24 Tan Ltd 111 290
31 Lee Pte Ltd 720 30 Drawings 112 250

Debit balance $790

He received the following statement from his bank at the beginning of September 2016:

2016 Details Payments Receipts Balance

$ $ $
Aug 1 Bal 700
7 Cheque 110 410 290
9 Cheque 109 100 190
9 Cash 420 610
15 Banker’s Order – Insurance 140 470
30 Cheque 112 250 220
31 Deposit Interest 80 300

You are required to:

(i) Update the cash book.

(ii) Prepare a statement, to reconcile the difference between your updated cash book
balance and the balance in the bank statement on 31 August 2016.

62
Review Questions

Question 1

What are unpresented cheques?

A. Cheques recorded and sent to suppliers but not yet presented for payment
B. Cheques received and recorded but not credited by the bank .
C. Cheques received and recorded but dishonoured by the bank
D. Cheques recorded and sent to suppliers and presented for payment

Question 2

Listed below are some possible reasons for the differences between the cash book balance
and the bank statement balance when preparing a bank reconciliation.

1. Bank charges
2. Dividend income
3. Unpresented cheques
4. Uncredited receipts
5. Dishonoured cheques

Which of these items will be shown in bank reconciliation statement?

A. 1, 2 and 3
B. 3,4 and 5
C. 3 and 4 only
D. All of the items

Question 3

For Question 2, what are the items to be credited to the cash book?

A. 1, 2 and 5
B. 3 and 4
C. 3, 4 and 5
D. 1 and 5

Question 4

What is a bank statement?

A. Statement by the bank showing deposits made by the firm

B. Statement by the bank showing money drawn out by the firm
C. Statement by the firm showing money drawn out and deposits made by the firm
D. Statement by the bank showing money drawn out and deposits made by the firm

63
Question 5

Uncredited deposits refer to

A. cheques received by the firm that had been recorded in the cash book but had not
passed through the bank clearing system at month end.
B. cheques paid out by the firm that had been recorded in the cash book but not yet
presented to the bank for payment at month end.
C. cheques that were not cleared by the bank due to insufficient funds in the payers’ bank
accounts
D. cancelled cheques

Question 6

Felicia’s cash book (bank columns only) for the month of July 2016 was as follows:

Dr. Cr.
2016 $ 2016 $
Jul 1 Balance 800 Jul 2 Edwin 120
4 Cash 300 10 Thomas 825
16 Suyin 220 23 Morgan 360
24 Cash 70 26 Petty Cash 50
25 Don 80
31 Susan 100

Debit balance $215

The following bank statement was received in early August 2016:

Bank Statement Dr. Cr. Balance

2016 $ $ $
Jul 1 Balance 800
4 Cash 300 1,100
8 Edwin 120 980
10 Banker’s Order – Fire Insurance 105 875
16 Cheque 220 1,095
17 Thomas 825 270
24 Cash 70 340
25 Cheque 80 420
26 Petty Cash 50 370
28 Dishonoured Cheque – Don 80 290
31 Interest on Deposit a/c 80 370

Required:
(i) Adjust the cash book.

(ii) Prepare a statement to reconcile the difference between the amended cash book balance
and the bank statement balance on 31 July 2016.

64
Question 7

Laura’s cash book (bank columns only) for the month of June 2017 was as follows:

Dr. Cheque No Cr.

2017 $ 2017 $
June 1 Balance 1,200 June 1 Dawn 991 680
5 Cash 660 15 Terence 992 415
16 Jix 1,390 24 Amy 995 4,760
25 Cash 2,070 27 Petty Cash 999 90
26 Sanuti 480
30 Cash 200

Debit balance $55

The following bank statement was received in early July 2017:

Bank Statement Dr. Cr. Balance

2017 $ $ $
June Bal 860
1 Error corrected – contra 31 May 230 1,090
1 Cheque No: 989 110 1,200
7 Cash 660 1,860
9 Dawn 680 1,180
10 Banker’s Order – Fire Insurance 919 261
18 Cheque 1,390 1,651
18 Terence 415 1,236
27 Cash 2,070 3,306
29 Cheque 480 3,786
29 Petty Cash 90 3,696
30 Unpaid Cheque – Sanuti 480 3,216
30 Interest on Structural Deposit a/c 114 3,330

Required:

(i) Bring the cash book up to date.

(ii) Prepare a statement to reconcile the difference between your amended cash book
balance and the balance in the bank statement on 30 June 2017.

(iii) State the amount for the bank balance which would appear in Laura’s Statement of
Financial Position for 30 June 2017.

65
Question 8

Daryl’s cash book on 30 April 2017 showed a debit balance at the bank of $6,320 while the
bank statement of the same date had a debit balance of $849.

Subsequently the following discoveries were made:

a) Amounts received in the last few days of April 2017 totaling $5,478 and recorded in
the cash book have not been included in the bank statements until 3 May 2017.

b) The bank had made a standing order payment on 24 April 2017 to AIA for office
insurance of $1,125. It has been recorded in the bank statement but is not recorded in
the cash book.

c) Cheque number 1113 for $510.30 in favour of Eugene has been correctly recorded in
the bank statement, but included in the cash book as $105.30.

d) Bank commission of $57 and interest on overdraft of $102 had been charged by the
bank.

e) Cheques paid according to the cash book during April 2017 and totaling $225 were
not presented for payment to the bank till May 2017.

f) The bank statement shows that a cheque for $427 received from Colin was returned
by the bank due to insufficient funds.

g) The bank had received by direct credit transfer (bank Giro) a payment of $200 due to
Daryl from debtor Pamela.

Required:

(i) Bring the cash book up to date.

(ii) Prepare a statement to reconcile the difference between your amended cash book balance
and the balance in the bank statement on 30 April 2017.

66
Homework Questions (with solutions)

Question 1

Bank reconciliations must be performed by someone who is

A. responsible for cash receiving and recording

B. from the bank
C. not involved in cash recording
D. the owner

Question 2

Listed below are some possible reasons for the differences between the cash book balance
and the bank statement balance when preparing a bank reconciliation.

1. Bank charges
2. Dividend income
3. Unpresented cheques
4. Uncredited receipts
5. Dishonoured cheques

Which of these items require an entry in the cash book?

A. 1, 2 and 5
B. 3 and 4
C. 3, 4 and 5
D. All of the items

Question 3

Listed below are some possible reasons for the differences between Joyce’s cash book
balance and the bank statement balance as at 31 March 2017.

1. Cheques recorded and sent to suppliers before 31 March 2017 but not yet presented for
payment.
2. Interest income
3. Cheques received and recorded before 31 March 2017 but not credited by the bank until
3 April 2017.
4. Standing order
5. Cheques received and recorded before 31 March 2017 but dishonoured by the bank

Which of the following options correctly classify the items into those that require a correction
of the cash book and those that would appear in the bank reconciliation?

Cash book entry Bank reconciliation

A. 1, 3, 5 2, 4
B. 2, 4 1, 3, 5
C. 2, 5 1, 3, 4
D. 2, 4, 5 1, 3

67
Question 4

What are the details that can be found on the bank statement?

A. money received by the firm only

B. money that the firm owes
C. money drawn out by the firm only
D. money drawn out and deposits made by the firm

MCQ Answers: C,A,D,D

Question 5

What is the purpose of preparing bank reconciliation statement?

Answer:

Bank reconciliation is an important control practice as it provides a check on the accuracy of

the cash book. Errors in the cash book would be identified and corrected. The cash book
would also be updated with items found in the bank statement but not previously entered on
the cash book such as, bank charges, interest on deposits etc.

Question 6
Ray’s cash book for the month of May 2016 was as follows:

Dr Cheque No. Cr
2016 $ 2016 $
May 1 Balance 900 May 19 Ruth Chan 1001 130
4 Cash 200 15 Terri 1002 206
11 A. Hill 94 22 Carol Koh 1003 315
17 Zakaria 71 25 Petty Cash 1004 25
23 Cash 100
30 B. John 90

Debit balance $779

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The following bank statement was received at the beginning of June 2016:

Details/Cheque Number Payments Receipts Balance

2016 $ $ $
May 1 Balance 1,010
4 Cash 200 1,210
11 Cheque 94 1,304
12 1001 130 1,174
13 995 110 1,064
17 Cheque 71 1,135
17 Bankers’ Order – Fire Insurance 98 1,037
21 Dishonoured cheque – Zakaria 71 966
23 Cash 100 1,066
25 1003 315 751
25 1004 25 726
29 Interest 42 768

Required:

(i) Correct the cash book.

(ii) Prepare a statement to reconcile the difference between the amended cash book
balance and the bank statement balance on 31 May 2016.

Answer:
(i)
Bank A/C
$ $
Balance 779 Fire insurance 98
Interest income 42 Zakaria (dishonoured chq) 71

Debit balance $652

(ii) Bank Reconciliation Statement as at 31 May 2016

$
Balance per bank statement 768

Less: Unpresented cheques

Cheque no. 1002 (206)

Add: Uncredited deposits

B. John 90

Updated balance per cash book 652

69
Question 7

This is the bank account of a firm as shown in its cash book for the month of January.

Dr. Cash Book Cr.

2017 $ 2017 Cheque No. $
Jan 1 Balance 910 Jan 3 Wages 2000 60
6 Sales 505 7 Purchases 2001 312
7 Rent received 40 10 Amanda 2002 141
18 York 80 15 Foo 2003 114
29 Sales 407 30 Rates 2004 20
30 Otter 110

Debit balance $1,405

On 3 February 2017, the firm received the following bank statement:

Bank Statement Dr. Cr. Balance

2017 $ $ $
Jan 1 Balance 745
Deposit 265 1,010
2 Cheque No. 1999 100 910
4 Cheque No. 2000 60 850
9 Deposit 505 1,355
Deposit 40 1,395
10 Credit transfer: Denise 200 1,595
12 Cheque No. 2001 312 1,283
15 Cheque No. 2003 114 1,169
20 Deposit: York 80 1,249
31 Service charge 30 1,219

Required:

(i) Update the cash book.

(ii) Prepare a statement to reconcile the difference between the amended cash book balance
and the bank statement balance on 31 January 2017.

70
Answer:
(i)
Bank A/C
$ $
Balance 1,405 Service charge 30
Denise 200

Debit balance $1,575

(ii) Bank Reconciliation Statement as at 31 January 2017

$
Balance per bank statement 1,219

Less: Unpresented cheques

Cheque no. 2002 (141)
Cheque no. 2004 (20)

Add: Uncredited deposits

Sales 407
Otter 110

Updated balance per cash book 1,575

Question 8

Kim Song’s cash book at 30 September 2016 showed a debit balance at the bank of $512 but
the bank statement of the same date had a credit balance of $131.

After comparing the cash book with the bank statement, the following differences were
noted:

(a) An amount of $71 paid into the bank had not yet appeared on the statement.

(b) Bank interest $30 in respect of an earlier overdraft had been charged by the bank.

(c) Cheques issued for $280 had not been presented for payment.

(d) A cheque for $400 which had been paid into the bank had been returned unpaid because
of lack of funds. No action has been taken by Kim Song to deal with this item.

(e) Funds of $560 paid into the bank had been entered in the Cash Book as $500.

71
(f) The bank had made a banker’s order payment for insurance of $240 which had not been
recorded by Kim Song.

(g) The bank had received by direct credit transfer (bank Giro) a payment of $20 due to Kim
Song from Joshua.

Required:

(i) Correct the cash book.

(ii) Prepare a statement to reconcile the difference between the amended cash book balance
and the bank statement balance 30 September 2016.

(iii) State the amount for the bank balance which would appear in Kim Song’s Balance
Sheet for 30 Sep 2016.

Answer:

(i)
Bank A/C
$ $
Balance 512 Interest charge 30
Funds 60 Dishonoured chq 400
Joshua 20 Insurance 240

Credit balance $78

(ii) Bank Reconciliation Statement as at 30 Sep 2016

$
Balance per bank statement 131

Less: Unpresented cheques (280)

Add: Uncredited deposits 71

Updated balance per cash book (78)

(iii)The amount for the bank balance which would appear in Kim Song’s Balance Sheet for
30 Sep 2016 is a bank overdraft of $78

72
 PRINCIPLES OF ACCOUNTING & BUSINESS FINANCE

SESSION 5

INTRODUCTION TO MANAGERIAL ACCOUNTING AND ANALYSIS OF COST

BEHAVIOUR

At the end of the lecture, students should be able to:

1. Explain the meaning of managerial accounting.

2. Explain the differences between managerial accounting and financial accounting.
3. Explain the meaning of cost and how costs are assigned to products and services.
4. Define the various costs of manufacturing products.
5. Explain the meaning of cost behaviour.
6. Define and describe fixed, variable and mixed costs.

5.1 The Meaning of Managerial Accounting

Management accounting is the provision of accounting information for a company’s internal

users. It is concerned with providing information to internal managers to help them in
planning, controlling and decision-making within an organisation.

Planning

Planning involves coming out with action plans to achieve a particular end. It is often
forward looking and includes long-term and short-term planning.

Planning requires:
- setting objectives/goals for the organisation
- establishing the resources required
- identifying methods to use the resources to achieve the objectives

Example: preparation of annual budgets.

Controlling

Controlling ensures the plan developed from the planning stage is being carried out
accordingly, taking corrective actions as and when required. Control is usually achieved by
comparing actual performance with expected performance.

Example: comparing actual and budgeted results.

Decision-making

Decision-making is the process of choosing among competing alternatives. It is required in

both the planning and controlling phase as a manager cannot successfully plan or control the
organisation’s actions without making decisions regarding competing alternatives.

Example: Producing product A or product B.

73
5.2 Differences between Managerial Accounting and Financial Accounting

The data used to prepare financial accounts and management accounts are the same though
the difference lies in the way the data is analysed.

Managerial Accounting Financial Accounting

 No legal requirement  Legal requirement for limited

companies

 Focus on internal management  Focus mainly on external users

needs i.e. prepared for management needs e.g. shareholders

 Past and projected data (budgets)  Past data

 Information used for planning,  Information is used for reporting of

controlling and decisions-making financial information over a
over relevant periods predefined period

 May be approximate  Accurate

 There are no mandatory rules  Has to comply with Accounting

Standards (FRS)

5.3 The Meaning of Cost

One of the most important tasks of managerial accounting is to determine the cost of products
and services or any other items deemed necessary to managers.

Cost can be defined as the amount paid for the goods supplied or the service provided. Cost is
important as it helps an organisation to determine the selling price, after a profit element is
added.

Selling Price = Cost + Profit

5.4 Assigning Costs to Products and Services

There is a number of ways to assign costs to products and services; some are accurate but
require more work while others can be quick and easy but less accurate. The method chosen
will thus depend on the management’s need for accuracy.

To assign costs, one needs to know the nature of costs.

74
 Direct Costs

Direct costs are costs that can be accurately and easily traced to a cost object. A cost object is
something for which the organisation wants to know the cost. It can be a product, a
department, a project, service etc. Direct costs are also known as prime costs.

Direct materials – materials that form an integral part of the finished product. Example:
cloth in shirts, wood in furniture.

Direct labour – labour directly involved in making the product. Example: wages of workers
on an assembly line.

Indirect Costs

Indirect costs are costs that cannot be easily and accurately traced to a cost object. They
normally benefit multiple cost objects and it is not practical to accurately trace them to
individual products, departments etc. Indirect costs are also known as production
overheads.

Indirect materials – materials used that do not form part of the final products. Example:
lubricants used for machine that produce the final product.

Indirect labour – labour not directly involved in production but essential to the
manufacturing process. Example: salary of supervisors.

Other indirect costs – factory insurance, factory rent, factory utilities etc

It is important to note that all costs in the factory are either direct materials, direct labour or
production overhead. No product cost can be omitted; no matter how remotely related it is to
the actual manufacturing process.

Total Product Costs

Direct Materials
Partially
Finished Completed Sold

Direct Labour Work in Finished Cost of

Process Goods Goods Sold

Production
Overheads

75
Period Costs

Besides production cost, there are other costs of running a business, referred to as period
costs. Thus, period costs are all costs that are not production costs, e.g. advertising, research
and development, CEO’s salary and salesman commission.

Total Cost = Production Cost + Period Cost

Activity 5.1

A company manufactures and sells t-shirts.

Classify the following items into their correct category as direct materials, direct labour,
production overheads and period costs.

(a) Paper for office printer

(b) Buttons for t-shirts
(c) Lubricant for sewing machines
(d) Interest on loan
(e) Market research undertaken before launching a new product
(f) Cost of advertising products on newspaper
(g) Wages of workers in the cutting department
(h) Factory rental

5.5 Cost Behaviour

Cost behaviour refers to the way a cost changes as volume of output rises. Costs can be
variable, fixed or mixed. Understanding how costs change as output rises helps managers in
planning, controlling and decision making.

Specifically, a distinction between fixed and variable cost might be used:

(a) To help managers make decisions about increasing or decreasing output.

(b) To estimate future costs for the purpose of forecasting and budgeting.

Fixed Costs

Fixed costs are costs that do not vary with the level of output within the relevant range.

An example of fixed cost is the rent of a factory, which remains the same regardless of how
much is produced inside it.

76
 Cost $

Total Fixed Cost

Level of Output

In reality, there must be a level of output so large that the business will need to rent more than
1 factory and in this instance, rent will no longer be a fixed cost. However, as long as we are
looking at a reasonable range of output, rent can be considered a fixed cost. This reasonable
range of output is known as the relevant range.

If a cost is fixed within a relevant range, then the cost per unit must fall as the level of output
rises.

Cost $

Fixed cost per unit

Level of Output

Committed Fixed Costs

They are fixed costs that cannot be easily changed. Such costs will continue to be incurred
even when production level drops to zero. Often, committed fixed costs are those that
involve a long term contract, e.g. leasing of warehouse space, purchase of plant and
equipment, insurance and salaries of important personnel.

Discretionary Fixed Costs

They are fixed costs that can be changed or avoided easily by management decisions. Usually
such costs will be increased in better times and reduced during difficult period, e.g.
advertising, research and development costs.

Activity 5.2

Suggest some examples of fixed costs for a hairdressing business.

77
Variable Costs

Variable costs are costs that vary directly with the level of output. This means that the higher
the output, the higher the level of total variable cost. An example will be the direct material
like the cost of a screen installed in each computer.

Cost $

Total Variable Cost

Level of Output
However, variable cost per unit is a constant amount.

Cost $

Variable Cost per unit

Level of Output
Activity 5.3

Suggest some examples of variable costs for a hairdressing business.

Step Costs

Step costs are costs which are fixed for a range of output and then jump to a higher level and
are fixed again for another range. Example of a step cost is the factory supervisor’s salary.
For production up to a certain level, just one supervisor is sufficient. However, beyond this
level and up to the next level of production, two supervisors will be required and so on.

Cost $

Level of Output

78
Mixed Costs

Mixed costs are costs that have both a fixed and variable component. For example,
salesman’s salaries normally include a base salary and commission that increases with
volume of sales.

Cost $

Variable cost

Fixed cost

Units sold

79
Review Questions

Question 1

Which of the following statements is NOT correct?

A. Management accounting focus mainly on internal users needs

B. Management accounting can assist in providing estimates for the future
C. Management accounting must comply with accounting standards
D. Management accounting can assist with budgeting

Question 2

The board of directors is looking into the most profitable product to manufacture. The
management accountant has prepared a report that compares the profitability of Product Mint
and Product Spice. This report will primarily help management in:

A. Planning
B. Controlling
C. Decision-making
D. Implementing

Question 3

Which of the following best describes the control process?

A. Making a choice between alternatives

B. Establishing a plan for a future period
C. Developing strategies to achieve objectives
D. Monitoring something to keep it on course

Question 4

Which of the following would be classified as direct expenses for a company producing
tables and chairs?

(i) The hire cost of maintenance tools and equipment

(ii) The cost of overtime worked by the carpenters to complete a specific customer order.
(iii) The wood used in making the tables and chairs
(iv) The carpenter’s wages

A. (i) and (iii)

B. (i), (ii) and (iv)
C. (ii), (iii) and (iv)
D. (iii) and (iv)

80
Question 5

Which of the following should be classified as indirect costs?

A. The repairs cost of equipment

B. The labour costs incurred in the production line
C. The hire of a machinery for a specific job
D. The material costs of a product

Question 6

A production worker is paid a salary of $900 per month, plus an amount of 50 cents for each
unit produced during the month. This labour cost is best described as

(a) A variable cost

(b) A fixed cost
(c) A mixed cost
(d) A step cost

Question 7

The following shows the unit cost of an expense at different production levels:

Level of Production (units) Unit Cost ($)

1 10,000
50 200
100 120
150 80

What is the correct behavioural classification for the expense?

A. Variable cost
B. Fixed cost
C. Mixed cost
D. Step cost

Question 8

A certain cost is classified as a fixed cost. If level of output increases by 10%, what will
happen to the cost per unit?

A. Remains the same

B. Increases
C. Reduces in proportion to the change in output level
D. Reduces but not in proportion to the change in output level

81
Question 9

Which chart shows the unit cost behaviour of factory rent?

Cost/unit Cost/unit
($) ($)

Qty Qty
A B

Cost/unit Cost/unit
($) ($)

Qty Qty
C D

Question 10

A company bakes and sells butter cookies.

Classify the following items into their correct category as direct materials, direct labour,
production overheads and period costs.

(a) Wages of storekeepers in the materials store

(b) Delivery charges for sending the cookies to supermarkets
(c) Wages of workers in mixing department
(d) Chief accountant’s salary
(e) Factory rental
(f) Advertising costs
(g) Butter and flour
(h) Cost of cookies tins
(i) Interest on bank overdraft

82
Question 11

State whether the following items are committed fixed costs, discretionary fixed costs,
variable costs, mixed costs or step costs:

(a) Cost of raw materials used

(b) Repairs and maintenance costs
(c) Factory rent
(d) Sales representative’s salary and commission
(e) Bottles in soft drink bottling factory
(f) Supervisor’s salary – 1 supervisor for every 20 workers
(g) Advertising costs
(h) Plant and machinery
(i) Research and development costs

Homework Questions (with solutions)

Question 1

Which of the following is a characteristic of managerial accounting?

A. There is no legal requirement.

B. There is an internal focus.
C. Subjective information may be used.
D. All of these.

Question 2

The process of choosing among competing alternatives is called

A. planning
B. controlling
C. decision-making
D. None of the above

Question 3

Setting objectives and identifying methods to achieve them is called

A. planning
B. controlling
C. decision-making
D. None of the above

83
Question 4

Which of the following does not form part of production costs of a product?

A. Administrative expenses
B. Production overheads
C. Raw materials
D. Direct labour

Question 5

Which of the following is most likely to be classified as a direct cost?

A. Supervisor costs
B. Factory rent
C. Material
D. Repairs and maintenance

Question 6

Which of the following statements relating to cost behaviour is incorrect?

A. Variable cost per unit is constant

B. Total variable costs is constant
C. Total fixed cost is constant
D. Fixed cost per unit falls with increased activity

Question 7

A telephone bill has been received with a line rental of $25 per month, and a charge per call
of 5cents. The telephone cost could be best described as:

A. A fixed cost
B. A variable cost
C. A step cost
D. A mixed cost

MCQ Answers: D, C, A, A, C, B, D

84
 PRINCIPLES OF ACCOUNTING & BUSINESS FINANCE

SESSION 6

COST ASSIGNMENTS

At the end of the lecture, students should be able to:

1. Understand how costs are assigned to cost objects.

2. Compute the predetermined overhead rate and use the rate to assign overhead to units.

6.1 Definition of Production Overheads

Unlike direct material and labour, overheads are indirect costs incurred which cannot be
easily and accurately traced directly to cost units. This includes:

 Indirect materials
 Indirect labour
 Other indirect expenses like factory rent, factory utilities.

It is necessary to include overheads in the cost of the product so that we can have the
complete production cost of the product. This can then be used as a basis to value inventories
and for decision making, one of which is to arrive at the selling price.

Hence, we need to allocate and apportion the overheads to the cost units.

Total Production Cost = Direct Material + Direct Labour + Production overheads

Directly traceable to Cannot be easily and

individual unit accurately traced to
individual unit

Allocate and apportion

to individual unit

85
6.2 Assigning Overheads to Cost Units

Allocation

Allocation is the process of charging a whole item of overhead cost to specific

production departments.
Example: costs of supervision in Production department A  Production department A
costs of supervision in Production department B  Production department B

Apportionment

Apportionment is a procedure whereby general overheads costs are shared between

production departments on a fair basis.
Example: factory rental can be apportioned to the different production departments on
the basis of floor space occupied by each department.

Some examples of typical bases used are:

Overheads Basis of Apportionment

Rent, rates, heating, cleaning, lighting, Floor space

Power Power usage %

Personnel, general administration Number of employees
Maintenance of machines Number of machines or machine hours
used in production

Adding up

For each production department:

Total Overhead Costs = Allocated Costs + Apportioned Costs

Absorption

An absorption rate is the rate at which overheads are added to the costs.

Calculate overhead absorption rate (OAR) for each production department.

Total Overhead Costs
OAR = --------------------------------------------------------------
Volume of Activity (direct labour hour, machine hour)

86
6.3 Absorption Rates based on Budgeted Figures

Many would believe that overhead absorption rates should be based on the actual overhead
costs and actual volume of activity.

In practice, this is not the case. Overhead absorption rates are based on budgeted figures.

Reasons:

(1) Using actual overhead costs cannot provide timely information when required. Most
actual overhead costs are not known till end of financial year and waiting for figures
to come in can cause delays in pricing the products and invoicing the customers.

(2) Actual overhead costs tend to fluctuate from year to year. Using actual costs to
calculate selling price will result in erratic pricing and affect competitiveness.

Hence,
Budgeted Overhead Costs
OAR = --------------------------------------------------------------
Budgeted Volume of Activity (direct labour hour, machine hour)

6.4 Assigning Overheads to Units

To assign overheads to the total costs of a product, we calculate absorbed overheads using the
OAR determined during the budgeting process.

Absorbed overhead = OAR x Actual activity level

87
Activity 6.1 – Overheads

SIM Manufacturing Ltd is preparing its production overhead budgets and determining the
apportionment of these overheads to products.

Production centres expenses and related information have been budgeted as follows:

Total Machine shop A Machine shop B Assembly

$ $ $ $

Indirect wages 33,450 8,586 9,190 15,674

Indirect materials 16,300 6,400 8,700 1,200

Rent and rates 16,700

Building insurance 2,400

Power 8,600

Other information:
Total Machine shop A Machine shop B Assembly
$ $ $ $
Floor area (sq m) 40,000 10,000 10,000 20,000

Power usage (%) 100 55 40 5

Required:

(a) Apportion the overheads to the production centres, showing clearly the basis of
apportionment.

(b) The Machine Shop A and Machine Shop B are machine intensive while the Assembly
centre is largely labour-based. Information on machine and labour hours for the
production centres is shown below:
Total Machine shop Machine shop Assembly
A B
Direct labour hours 35,000 8,000 6,200 20,800

Machine hours 25,200 7,200 18,000 -

Calculate production overhead absorption rates for each of the three production centers
(OAR)

88
(c) One of the products of SIM Manufacturing Ltd is Info. Cost information to produce
one unit of Info is as follows:

Direct Materials 3 kg at $5.20 per kg

Direct Labour 1.5 hours at $6.50 per hour

Time Spent in:

Machine Shop A 1.5 machine hours
Machine Shop B 2 machine hours
Assembly 4 labour hours

Find the cost per unit of Info.

Answers:

Production Centre
Basis Total Machine A Machine B Assembly
$ $ $ $
Allocated

Apportionment

Total (a)

Activity Base (b)

OAR = (a)/(b)

89
Review Questions

Question 1

Overhead apportionment is used to

A. charge whole items of costs to production centers.

B. charge cost units with an appropriate share of overheads.
C. spread common costs over production centers equally.
D. ensure budgeted overheads are not exceeded.

Question 2

Which of the following would be the most appropriate basis for apportioning machinery
maintenance costs to production departments within factory?

A. The number of machines in each production department

B. The floor area occupied by the machinery in each production department
C. The total cost of the machinery in each production department
D. The operating hours of the machinery in each production department

Question 3

A manufacturing company has two production centres, Cutting and Packing.

The budgeted overheads and operating hours for the two centres for the following year are:
Cutting $180,000 90,000 machine hours 5,000 labour hours
Packing $120,000 8,000 machine hours 12,000 labour hours

The overhead absorption rates for the departments should:

A. both be based on machine hours

B. both be based on labour hours
C. be based on machine hours for cutting centre and labour hours for packing centre
D. be based on labour hours for cutting centre and machine hours for packing centre

Question 4

What is the term associated with charging a specific item of overhead cost to one particular
department?

A. Absorption
B. Allocation
C. Apportionment
D. None of the above

90
Question 5

Labour hours are used to absorb overheads in a production department. Overheads allocated
and apportioned to the department are:

Allocated $24,710
Apportioned $11,890

180,000 units of products are produced at a rate of 60 per labour hour.

What is the overhead absorption rate per labour hour?

A. $3.96
B. $8.24
C. $12.20
D. $13.50

Question 6

The following information relates to the production of 1,000 units of Product Style.

Dept A Dept B

Direct materials consumed $5,000 $3,000

Direct labour rate per hour $4 $5
Direct labour hours 400 hrs 200 hrs
Machine hours 680 hrs 68 hrs

Budgeted overheads $160,000 $120,000

Budgeted direct labour hours 2,500 hrs 30,000 hrs
Budgeted machine hours 40,000 hrs 1,000 hrs

What is the total production cost to produce 1,000 units of Product Style?

A. $15,250
B. $13,333
C. $12,500
D. $14,120

91
Question 7

A manufacturing business has two production centres, assembly and finishing. The following
budgeted expenses are expected to be incurred next year.
$
Indirect materials - Assembly 13,500
- Finishing 8,000
Indirect labour - Assembly 14,000
- Finishing 9,000
Rent and rates 60,000
Heat and light 15,000
Power 18,000

You are also given the following information:

Assembly Finishing Total

Floor area (sq m) 1,000 500 1,500
Power usage (%) 65% 35% 100%

The assembly department is a largely machine based department whereas the finishing
department is largely labour based. The management of the business has decided that the
assembly department overheads should be absorbed on the basis of machine hours and that
the finishing department overheads should be absorbed on the basis of labour hours.

The budgeted machine hours in the assembly department is 100,000 whereas the budgeted
labour hours for the finishing department is 20,000.

Required

(a) Calculate the overhead absorption rate in each department.

(b) One of the products of the business is the Maximus. This product has direct material
costs of $14.30 per unit and direct labour costs of $16.50 per unit. Each unit of
Maximus spends 6 machine hours in the assembly department and 3 labour hours in the
finishing department.

What is the final unit cost of the Maximus?

92
Answers:

Production Centre
Basis Total Assembly Finishing
$ $ $
Allocated

Apportionment

Total (a)

Activity Base (b)

OAR = (a)/(b)

93
Homework Questions (with solutions)

Question 1

Overhead allocation is the process of:

A. the charging of direct labour to cost units.

B. the allotment of proportions of costs to production centres.
C. the charging of direct material to cost units.
D. the allotment of whole item of overhead to production centres.

Question 2

Which of the following would be the most appropriate basis for apportioning factory rental to
production departments within a manufacturing company?

A. The number of workers in each production department

B. The floor area occupied by each production department
C. The number of machinery in each production department
D. None of the above

Question 3

Glory Ltd has 2 production centres A and B. The budgeted rent for the coming year is
$48,000 and the floor area occupied by each of the centres is as follows

Production centre A 3,750 sqm

Production centre B 8,250 sqm

Calculate the amount of rent to be apportioned to each of the centres

Production Centre
A B

A. $16,000 $32,000
B. $10,000 $38,000
C. $15,000 $33,000
D. $15,500 $32,500

Question 4

The overhead absorption rate (OAR) equals

A. actual overhead divided by actual activity level for a period

B. estimated overhead divided by estimated activity level for a period
C. actual overhead minus estimated overhead
D. actual overhead multiplied by actual activity level for a period

94
Question 5

The following budgeted information is for MIS Co:

Assembly Finishing

Overheads $493,200 $216,000

Machine hours (MH) 10,960 1,200

Labour hours (LH) 548 6,750

Calculate the overhead absorption rate for each of the 2 production centres.

Assembly Finishing

A. $45/MH $32/LH
B. $45/MH $180/MH
C. $900/LH $32/LH
D. $900/LH $180/MH

MCQ Answers: D, B, C, B, A

Question 6

GM is a small manufacturing company with two production departments A and B. Budgeted

overhead costs for a period are listed below:

Production Department
A B Total
$ $ $
Costs allocated 24,970 22,100 47,070
Costs to be apportioned:
Factory manager’s salary 35,800
Building operating costs 62,000
144,870

Additional information:
Number of staff 12 8 20
Floor area (sqm) 260 140 400

The budgeted direct labour hours in production department A and B is 20,000 and 12,000
respectively.

Required:

(a) Calculate the total of the allocated and apportioned overheads of each production
centre.

(b) Calculate a direct labour hour overhead absorption rate for each production centre.

95
Answers:

Production Centre
Basis Total A B
$ $ $
Allocated costs 47,070 24,970 22,100

Apportionment

Factory manager’s 12/20 x 35,800 8/20 x 35,800

No of staff 35,800
salary = 21,480 = 14,320

Building operating 260/400 x 62,000 140/400 x 62,000

Floor area 62,000
costs = 40,300 = 21,700

Total (a) 144,870 86,750 58,120

Direct
Activity Base (b) 20,000 12,000
labour hour

86,750/20,000 58,120/12,000
OAR = (a)/(b)
= $4.34/DLH = $4.84/DLH

96
 PRINCIPLES OF ACCOUNTING & BUSINESS FINANCE

SESSION 7

PRICING SYSTEM

At the end of the lecture, students should be able to:

1. Describe the materials recording procedure.

2. Explain the First in, First out (FIFO) method of pricing materials issued from inventory.
3. Explain the Last in, First out (LIFO) method of pricing materials issued from inventory.
4. Explain the Weighted Average (WAC) method of pricing materials issued from
inventory.

7.1 Definition of Materials

Materials can be classified as either direct materials or indirect materials.

Direct materials – Raw materials and components that are part of the final product
that the organisation makes.
Example: the many components that make up a car are the
direct materials of the car.

Indirect materials – Other materials that cannot be directly attributed to a unit of

production.
Example: oil used for lubricating machine.

7.2 Material Recording Process

The stores department is responsible for the receipt, storage and issue of materials and
components. Receipts into store and issues from store must be promptly recorded so that the
inventory balance can be kept up to date.

On the other hand, the costing department is responsible for recording the cost of materials
received into stores and putting a value to the cost of materials issued from store.

For materials received into stores,

Value of material received = Purchase cost of material

For materials issued from stores, a cost or price has to be attached to them. This is because
the materials in the store have different prices. The company uses a number of different
suppliers and the price of raw materials will also change regularly. Therefore this may pose a
problem when determining the value of issues. Three common methods used for valuing
material issues are:

 First in first out (FIFO)

 Last in first out (LIFO)
 Weighted average cost (WAC)

97
7.3 First In, First Out (FIFO) Method

This method assumes that materials are issued from store in the order in which they are
received. Hence, materials issued are valued at the ‘older’ prices while the ending inventory
is reflected at the most recent prices.

Activity 7.1

Date Receipts Issue Balance

Jan 1 500 @ $4 500 @ $4 = $2,000
2 400 @ $4.50 500 @ $4 = $2,000
400 @ $4.50 = $1,800

900 $3,800
6 300

12 400

7.4 Last In, First Out (LIFO) Method

This method assumes that materials are issued from store in the reverse order in which they
are received. Hence, materials issued are valued at the most recent prices while the ending
inventory is based upon the earliest purchase made.

Activity 7.2

Date Receipts Issue Balance

Jan 1 500 @ $4 500 @ $4 = $2,000
2 400 @ $4.50 500 @ $4 = $2,000
400 @ $4.50 = $1,800

900 $3,800
6 300

12 400

98
7.5 Weighted Average Cost (WAC) Method

Using this method to price material issues, all quantities of an item of inventory are valued at
a weighted average cost. This weighted average cost will be used to value both the materials
issued and the ending inventory.

The business can choose either the continuous weighted average cost method or the periodic
weighted average cost method.

Continuous Weighted Average Cost Method

A new weighted average cost is calculated each time there is a new delivery into stores.

Weighted Average Price

Inventory value of items in store + Purchase cost of units received
=
Quantity already in stores + Quantity received

Activity 7.3

Date Receipts Issue Balance

Jan 1 600 @ $4 600 @ $4 = $2,400
2 400 @ $4.50 600 @ $4 = $2,400
400 @ $4.50 = $1,800

6 300

12 400

13 300 @ $4.80

99
Periodic Weighted Average Cost Method

The weighted average price is only calculated at the end of the period which is then used to
price all issues and the ending inventory.

Periodic Weighted Average Price

Cost of opening inventory + Cost of all receipts in the period
=
Units in opening inventory + Units received

Activity 7.4

Date Receipts Issue Balance

Jan 1 100 @ $4 = $400
2 800 @ $4.50
6 300
12 400
13 500 @ $4.80
26 300

100
7.5 Comparison of FIFO, LIFO and WAC Methods

In times of inflation when prices keep increasing:

First In, First Out Last in, First Out WAC

(FIFO) (LIFO)

Advantage: Advantage: Advantage:

Produces current value for Produces realistic Simple to operate
closing inventory production costs and
therefore realistic profit
figures.

Disadvantage: Disadvantage: Disadvantage:

Produces outdated Produces unrealistically Both inventory values
production costs and low closing inventory and production cost
therefore potentially values likely to differ from
overstates profit. current value.

101
Activity 7.5

You are given the following information about raw material item 123:

Date Receipt Qty Purchase Price Issue Qty Balance

2017 (Units) Per Unit ($) (Units)
Mar 1 100 @ $2
3 20
6 40 $2.20
14 60
20 25
24 50 $2.50

Required:
(a) Prepare the Stock Cards based on each of the following methods of valuation
- FIFO
- LIFO
- WAC (continuous)
- WAC (periodic)

Answers:

FIFO
Date Receipts Issue Balance
Mar 1 100 @ $2 = $200

3 20

6 40 @ $2.20

14 60

20 25

24 50 @ $2.50

102
LIFO
Date Receipts Issue Balance
Mar 1 100 @ $2 = $200

3 20

6 40 @ $2.20

14 60

20 25

24 50 @ $2.50

WAC (continuous)
Date Receipts Issue Balance
Mar 1 100 @ $2 = $200

3 20

6 40 @ $2.20

14 60

20 25

24 50 @ $2.50

103
WAC (periodic)
Date Receipts Issue Balance
Mar 1 100 @ $2 = $200
3 20
6 40 @ $2.20
14 60
20 25
24 50 @ $2.50

Review Questions

Question 1

Which of the following is the underlying principle of the Last in, First out (LIFO) method of
pricing material issues?

A. The first materials received will be the first to be issued to production.

B. The first materials issued will be priced at the cost of the most recently received
materials.
C. The first materials issued will be priced at the cost of the earliest goods still in stock.
D. The last materials received will be the last to be issued.

Question 2

If a company is using the first-in, first-out method for material issues at a time when material
prices are rising this will mean which of the following?

A. Production costs will be lower and profits will be higher than if the last-in, first-out
method had been used
B. Production costs will be higher and profits will be lower than if the last-in, first-out
method had been used
C. Production costs will be lower and profits will be lower than if the last-in, first-out
method had been used
D. Production costs will be higher and profits will be higher than if the last-in, first-out
method had been used

104
The following information relates to questions 3 to 5.

The inventory record for material x for the month of April showed:

Receipts Unit price ($) Issues

Opening inventory 500 2.50
3 April 1,000 2.75
12 April 1,600 2.80
15 April 1,200 2.85
22 April 2,100
27 April 1,500 2.90
30 April 1,800

Question 3

Using the FIFO method of pricing issues, the cost of issues during the month was:

A. $11,250
B. $10,760
C. $10,850
D. $11,300

Question 4

Using the LIFO method of pricing issues, what is the value of inventory at 30 April?

A. $4,100
B. $3,720
C. $5,120
D. $3,950

Question 5

Using the WAC(continuous) method of pricing, at what price would the issues on 30 April be
made? (Calculate to two decimal places.)

A. $3.00
B. $2.95
C. $2.90
D. $2.82

105
Question 6

Receipts and issues of a raw material for a period were:

Day Units $ per unit Total $

1 Balance 120 2.70 324
2 Issue 50
4 Issue 40
7 Receipt 100 3.10 310

What is the periodic weighted average price for the week?

A. $2.88
B. $2.90
C. $3.34
D. $4.88

Question 7

During times of inflation, which of the following statements is or are correct?

(1) Closing inventory value will be higher using last in, first out (LIFO) rather than
weighted average method.
(2) Profit will be lower using weighted average rather than first in, first out (FIFO)
method.

A. Only statement (1) is correct.

B. Only statement (2) is correct.
C. Both statements are correct.
D. Both statements are wrong.

Question 8

The inventory record of component GEM for the month of June 2016 showed:

Date Receipt Qty Purchase Price Issue Qty Balance

2016 (Units) Per Unit ($) (Units)
June 1 500 @ $14
5 300 $12
9 300
17 400
22 400 $11
29 300

Required:
Prepare the Stock Cards based on each of the following methods of valuation
(a) FIFO

106
(b) LIFO
(c) WAC (continuous)
(d) WAC (periodic)
(e) In a period of rising material prices, which method would result in a lower profit
figure? Explain. (calculations not required)

Homework Questions (with solutions)

Question 1

A company uses the first-in, first-out (FIFO) method to price issues of raw material to
production and to value its closing inventory.
Which of the following statements best describes the first-in, first-out method?

A. The last materials received will be the first issued to production

B. The first materials issued will be priced at the cost of the most recently received
materials
C. The last materials issued will be those that were most recently received
D. The first materials issued will be priced at the cost of the earliest goods still in
inventory

Question 2

If a manufacturing firm wants to ensure its production cost includes the most recent cost for
material, it would use:

A. First in, First out (FIFO)

B. Last in, First out (LIFO)
C. Weighted average cost (continuous)
D. Weighted average cost (periodic)

Question 3

Receipts and issues of a raw material for a period were:

Units $ per unit cumulative total $

Day 1 balance 160 3.70 592
Day 4 receipt 230 3.60 1,420
Day 5 issue 110
Day 6 issue 150

Using the LIFO inventory pricing method, what is the total cost of the issue on Day 6?

A. $540
B. $543
C. $545
D. $555

MCQ Answers: D, B, B

107
 PRINCIPLES OF ACCOUNTING & BUSINESS FINANCE

SESSION 8

BUDGETING

At the end of the lecture, students should be able to:

1. Define budgeting and discuss it role in planning, control, and decision-making.

2. Explain the interlinking of the various budgets within a business.
3. Indicate the uses of budgeting and construct a simple cash budget.

8.1 What are Budgets?

Budgets are financial plans for a future period of time and are a key component of both the
planning and control process.

Planning and control are closely linked. Planning is looking ahead to see what can be done to
achieve certain objectives. Control is looking backwards to see what has actually happened
and evaluate whether actual performance was as planned and, if not, the reasons for this.

Strategic Plan

Identify Long Term Objectives

Identify Short Term Objectives

Prepare Budgets

Collect Information on Actual Performance

Compare Actual with Planned Performance

Budgets convert long term plan into actionable plans for the immediate future. They help
managers to run the business. They also provide the means to monitor activities to see
whether they conform to the plan and to take corrective actions if necessary.

108
8.2 Advantages of Budgeting

Planning – Budgeting forces organisations to plan. Management are forced to look into the
future, foresee problems and develop future policies.

Decision Making – Budgets provide information to make better decision.

Improves Communication and Co-ordination – The process of budgeting involves all

departments and all levels of management. Final budgets need to be communicated to all
staff so employees can be aware of their particular role in achieving the organisation’s
objectives.

Improves Control - Compare actual results with planned results, taking corrective actions
when necessary.

8.3 How Budgets Link to One Another

There are different types of budgets, each relating to a specific aspect of a business’s
operations. The sales budget is normally the first to be prepared as the level of sales often
determines the production level and hence the different production and operating costs for the
coming period.

The following diagram shows how budgets are linked to one another:

Sales Budget

Production Budget

Direct Materials Budget Direct Labour Budget Overhead Budget

Cost of Goods Sold Budget Selling and Administrative

Costs Budget

Budgeted Statement of Profit or Loss

Cash Budget

Budgeted Statement of Financial Position

109
8.4 Cash Budgets

A cash budget is a detailed forecast of cash inflows and outflows for a future time period.

Knowing when cash inflows and outflows are likely to take place helps management to plan
when to borrow cash when needed and when to repay loans or invest cash during periods of
excess cash.

8.5 Constructing a simple Cash Budget

STEP 1

Draw up a cash receipt schedule from sales.

Activity 8.1

The actual and budgeted sales figures are as follows:

Actual Budgeted
Nov 2016 Dec 2016 Jan 2017 Feb 2017 Mar 2017
$ $ $ $ $
Credit sales 50,000 80,000 70,000 60,000 40,000

It is estimated that 50% of credit customers will pay in the month of sale, 30% will pay in the
second month and the remaining 20% in the third month.

Required:
Prepare a schedule of cash receipts from sales.

Schedule of Cash Receipts from Sales.

Descriptions Total $ Jan $ Feb $ Mar $

Nov 2016 50,000
sales
Dec 2016 80,000
sales
Jan 2017 70,000
sales
Feb 2017 60,000
sales
Mar 2017 40,000
sales
Total

STEP 2

Determine all other income to be received in each month.

110
STEP 3

Draw up a cash payment schedule on purchases.

Activity 8.2

The actual and budgeted purchases figures are as follows:

Actual Budgeted
Nov 2016 Dec 2016 Jan 2017 Feb 2017 Mar 2017
$ $ $ $ $
Credit 42,000 30,000 55,000 36,000 40,000
purchases

It is estimated that 80% of credit purchases are paid for in the month of purchase, and the
remaining 20% in the following month.

Required:
Prepare a schedule of cash payments on purchases.

Schedule of Cash payments on Purchases

Descriptions Total $ Jan $ Feb $ Mar $

Dec 2016 30,000
purchases
Jan 2017 55,000
purchases
Feb 2017 36,000
purchases
Mar 2017 40,000
purchases
Total

STEP 4

Determine all other cash disbursements. These would include payment for wages, rent, tax,
buying of non-current assets, repayment of loans etc.

STEP 5

Set out the cash budget month by month.

111
Activity 8.3

Using the information derived from activity 8.1 and 8.2, prepare the cash budget for the first
quarter of 2017 based on the following additional information:

1. Cash balance on 1 January 2017 is $4,000.

2. The company expects to receive commission income amounting to $5,800 in February

2017.

3. Shop rental is paid quarterly in advance on 1 January, 1 April, 1 July and 1 October.
The amount payable is $12,000 per quarter.

4. All other operating expenses are estimated to be $8,000 per month. These are settled in
the month the costs are incurred.

5. The company intends to purchase a new motor van costing $11,000 in Jan 2017 which
will be paid in February 2017.

6. The company is due to repay a loan of $5,000 in March 2017.

Cash Budget for Jan to Mar 2017

Jan $ Feb $ Mar $

Opening cash balance
Add : Receipts of cash
Sales
Commission income

Less : Payments of cash

Purchases
Shop rental
Other operating expenses
New motor van
Repayment of loan

Closing cash balance

112
Review Questions

Question 1

A budget

A. is only a control tool.

B. is necessary only for large firms.
C. is a short-term financial plan.
D. is a long-term financial plan.

Question 2

Which of the following is part of the control process?

A. Comparison of actual with planned activity

B. Investigating
C. Monitoring of actual activity
D. All of the above.

Question 3

Which of the following is not an advantage of budgeting?

A. It improves communication and coordination.

B. It forces managers to plan.
C. It guarantees an improvement in organisational efficiency.
D. It provides a standard for performance evaluation.

Question 4

A sole trader sells goods on credit and the following sales are expected:
$
April 20,000
May 30,000
June 25,000

The followings are the expected payments from credit sales:

60% in the month of sale
30% one month after sale
10% two months after sales

What is the expected cash received from credit sales in June?

A. $15,000
B. $26,000
C. $18,000
D. $23,500

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Question 5

A business sells goods on credit and the following sales are expected:
$
Jan 80,000
Feb 64,000
Mar 72,000
April 78,000

The followings are the expected payments from receivables:

50% in the month of sale
35% one month after sale
15% two months after sales

What is the expected cash received from credit sales in April?

A. $72,400
B. $73,200
C. $73,800
D. $74,000

Question 6

Which of the following are objectives of cash budgeting?

(1) To anticipate cash shortages and surpluses.

(2) To enable necessary funds to be made available.
(3) To monitor trade receivables.

A. 1,2 and 3
B. 2 and 3 only
C. 1 and 3 only
D. 1 and 2 only

Question 7

Pretty Ltd buys goods, repackage them and sells them to its customers. The following
forecast information relates to its sales and purchases for the first quarter in 2017.

Sales $ Purchases $
Jan 40,000 32,000
Feb 60,000 45,000
Mar 70,000 50,000

Additional information :

(i) Sales for November and December 2016 were $30,000 each month.
(ii) Purchases for November and December 2016 were $27,000 and $36,000 respectively.

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(iii) All sales are on credit and receivables are expected to pay :

40% in the month of sale

50% in the following month
10% two months after sale

(iv) It is estimated that 70% of credit purchases are paid for in the month of purchase, and
the remaining 30% in the following month.
(v) Repackaging costs are fixed at $5,000 per month and are paid in the month the costs
are incurred.
(vi) Pretty Ltd’s bank balance is $8,000 at 31 December 2016.

Required:

( a ) Prepare the schedule of cash receipts from sales.

( b ) Prepare a cash budget for each of the months January to March 2017 for Pretty Ltd,
showing clearly the bank balance at the beginning and end of each month.

Question 8

Infinity Ltd is a small retail shop. The following information (actual and budgeted) relates to
its sales and purchases for the first two quarters in 2017.

Actual Budgeted
January February March April May June
$ $ $ $ $ $
Credit sales 30,900 34,500 33,800 35,200 39,400 42,000
Credit purchases 11,700 17,500 16,100 15,000 19,800 12,600

Additional information:

(i) From past experience, Infinity Ltd expects that, of the credit sales, 60% will be
collected in cash during the month of sale, 30% in the second month and the remaining
10% in the third month.
(ii) Purchases are paid for one month after purchase.
(iii) Shop rental is paid quarterly in advance on 1 January, 1 April, 1 July and 1 October.
The amount payable is $26,000 per quarter.
(iv) All other operating expenses are fixed at $9,000 per month and are paid in the month
the costs are incurred.
(v) Infinity Ltd intends to pay back a bank loan of $20,000 in June 2017.
(vi) Beginning cash balance on 1 April 2017 is $7,200.

Required:

(a) Prepare the schedule of cash receipts from sales.

(b) Prepare a Cash Budget for each of the months April to June 2017, showing clearly the
cash balance at the beginning and end of each month.

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Homework Question (with solutions)

Haze Ltd is a small trading company selling air purifiers. As the accountant, you have been
preparing cash budgets on a quarterly basis. After examining the records, you find the
following:

1. Cash balance on 1 January 2017 is $2,700.

2. Actual and budgeted sales and purchases are as follows:

Actual Actual Budgeted Budgeted Budgeted

Nov 2016 Dec 2016 Jan 2017 Feb 2017 Mar 2017
Credit sales $14,600 $25,800 $32,000 $40,000 $30,000
Credit purchases $19,200 $16,200 $11,900 $10,500 $19,800

3. Credit sales are collected: 50% in the month of sale, 35% in the second month and
15% in the third month.

4. Credit purchases are paid for two months after purchase.

5. Shop rental is paid quarterly in advance on 1 January, 1 April, 1 July and 1 October.
The amount payable is $10,000 per quarter.

6. All other operating expenses are estimated to be $7,000 per month. These are settled in
the month the costs are incurred.

7. The company intends to purchase new display cabinets costing $17,000 in February
2017 which will be paid in March 2017.

Required:

(a) Prepare a cash receipts schedule for the period Jan to Mar 2017.

(b) Prepare a Cash Budget for each of the months Jan to Mar 2017, showing clearly the
cash balance at the beginning and end of each month.

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Answers:

Cash Receipts Schedule for Jan to Mar 2017

Descriptions Total $ Jan $ Feb $ Mar $

Nov 2016 14,600 (15%) 2,190
credit sales
Dec 2016 25,800 (35%) 9,030 (15%) 3,870
credit sales
Jan 2017 32,000 (50%) 16,000 (35%) 11,200 (15%) 4,800
credit sales
Feb 2017 40,000 (50%) 20,000 (35%) 14,000
credit sales
Mar 2017 30,000 (50%) 15,000
credit sales
Total 27,220 35,070 33,800

Cash Budget for Jan to Mar 2017

Jan $ Feb $ Mar $

Opening cash balance 2,700 (6,280) 5,590
Add : Receipts of cash
Sales 27,220 35,070 33,800

Less : Payments of cash

Purchases (19,200) (16,200) (11,900)
Shop rental (10,000)
Other operating expenses (7,000) (7,000) (7,000)
New display cabinets (17,000)

Closing cash balance (6,280) 5,590 3,490

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 PRINCIPLES OF ACCOUNTING AND BUSINESS FINANCE

SESSION 9

INTRODUCTION TO BUSINESS FINANCE

1. Define business finance.

2. Identify and describe the key activities of the financial manager within the firm.
3. Explain why wealth maximisation rather than profit maximisation is the firm’s goal.
4. Discuss the relationship between risk and return.

9.1 What is Business Finance?

Business finance, like accounting, exists to help users make decisions. Unlike accounting, it
is mainly concerned with the ways in which funds for a business are raised and invested to
create wealth, and how to go about paying investors back.

Hence, business finance is about making these decisions:

1. What to invest in i.e. the investment decision;

2. How to finance the investment i.e. the financing decision.
3. How to pay investors back i.e. the dividend decision.

A business can raise funds from investors (owners and lenders) and then use the funds to
invest in projects (like buying machinery, equipment, inventories) to create wealth. With the
wealth created, the business will pay the investors back in the form of dividends (owners) or
interests (lenders).

Companies Funds Investors

(Owners, Lenders)

Funds

Funds
Projects
(Cash dividends, Interests )

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9.2 Functions of a Financial Manager

A financial manager is a person who takes care of all the important financial functions of an
organization.

The main functions of a financial manager can include:

 Raising of Funds
In order to meet the many obligations of the business, the financial manager needs to plan
to ensure that funds are available at the right time.

Short Term – Funds needed to pay for purchases of inventory, amount owing to
payables etc.
Medium or Long Term – Funds needed to buy non-current assets, take on new
investment projects, open new branches etc.

The manager will need to choose from the various sources of finance, taking in
consideration the cost involved, maturity and risk.

 Allocation of Funds

Once the funds are raised, the financial manager will need to decide how to allocate the
funds in the best possible manner to increase the organisation’s wealth. The financial
manager is responsible for knowing how much the project is expected to cost and how
much revenue it is expected to earn so that the best projects get the necessary funding.
Hence, decisions like which projects should be selected, whether a new asset should be
bought would need to be made.

 Controlling

To ensure the various activities of the organisations are meeting its objectives and that
the assets are being used efficiently, the financial manager can compare data on actual
and planned performance.

 Profit Planning

Profit planning refers to proper usage of the profit generated by the business. The
financial manager has to decide how much of its profits should be distributed as
dividends and how much should be retained for investment to provide for future growth.

 Understanding Capital Markets

Shares of a listed company are traded on stock exchange and there is a continuous sale
and purchase of securities. Hence a clear understanding of capital market is an important
function of a financial manager. When securities are traded on stock market, a huge
amount of risk is involved. Therefore a financial manager has to understand and calculate
the risk involved in this trading of shares and debentures. He also needs to handle the risk
on foreign exchange and interest rate movements and investment of short term surpluses.

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9.3 Financial Objectives

Wealth Maximisation

A business is normally formed to enhance the wealth of its owners. In business finance, we
assume that the main objective of a financial manager is wealth maximisation i.e. to
maximise shareholders’ wealth.

The wealth of the shareholders in a company comes from:

 Dividends received
 Market value of the shares

The higher the dividends received and the share’s market value, the greater the shareholder’s
wealth.

For shares in a private company, it is not easy to measure their market value as they are not
traded on any stock market.

For shares trading on a stock market, the market value can be measured by the price at which
they are currently being traded. Hence, for such shares, the shareholders’ wealth would
increase when the share price goes up. This will happen when the company makes good
profits, which it either pays out as dividends or re-invest in the business to achieve future
growth. The company also needs to make sure the good profits are achieved without taking
any unnecessary risks which may worry the shareholders.

Profit Maximisation

There are many reasons why the objective of business finance is not profit maximisation.
Though profits do matter, they are not the best measure of a company’s achievements.

 Different accountants measure profit differently. There is a wide range of accounting

policies that may be applied. In fact, accounting profits can be manipulated to some
extent by the choice of accounting policies.

 There are many ways of increasing profit that may not be in the best interests of the
shareholders. For e.g. management may reduce expenses by cutting research and
development expenditure or buying cheaper quality materials. This could increase
profit in the short-run but may affect the long term competitiveness and performance
of the company. It is unlikely that such actions are in the best interests of the
shareholders.

 Profit does not take into account the level of risk the management is undertaking to
maximise profits. Shareholders would not be pleased if management invests in high
risk profitable projects as they are concerned with both risk and returns they expect to
receive.

 Profit on its own makes no mention of the volume of investment that has been taken
to earn the profit.

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  Profits reported every year are measures of short-term performance, whereas it is
widely believed that a company’s performance should be judged over a longer term.

9.4 Non-Financial Objectives

Other than wealth maximisation, there are other non-financial objectives that a business may
pursue. They are equally important for a company to survive and prosper in the long run.

Examples of non-financial objectives are:

 Employees’ welfare – providing good working conditions, fair wages and salaries etc.
Satisfied workers can result in higher productivity.

 Contribution to community – conserve the environment, reduce potential pollution,

commercial sponsorship of community programs etc.

 Customers’ satisfaction – providing quality products or services on time, dealing

honestly and fairly with customers, good after-sales services etc. Satisfied customers
mean customers loyalty.

 Suppliers’ satisfaction – paying promptly. Dissatisfied suppliers can withhold vital

supplies or give lower priority to orders received.

Faced with so many non-financial objectives, managers are likely to find that they cannot
simultaneously maximise their shareholders’ wealth whilst also keeping all the other parties
happy.

In this situation, the only practical approach is to try and work to satisfy the various
objectives rather than maximise any individual one. Adopting such a strategy means, for
example, that the company might earn a satisfactory return for its shareholders, whilst at the
same time paying reasonable wages to satisfy employees, and avoiding polluting the
environment, hence being a "good citizen."

9.5 Risks

All decision making involves the future and the only thing certain about the future is that we
can never be sure what will happen. As things will not turn out as planned, this risk should
be carefully considered when making financial decisions.

Hence, risk can be defined as the chance (probability) that the return on an investment will
turn out to be less than what is expected when the investment was made.

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Types of Risk

Risks can be broadly classified into unsystematic and systematic risks.

Unsystematic risk
Risk associated with a particular company or industry due to company or industry-specific
hazards. Such risk can potentially be eliminated by diversification i.e. by holding securities
in different companies. Diversification works as prices of different stocks do not move
exactly together. Also known as specific risk.

Systematic risk
Risk associated with investment losing its value because of economic developments, political
situations or other events that affect the entire market. This is risk inherent to the entire
market and cannot be avoided regardless of how much you diversify. Also known as market
risk.

9.5 Relationship between Risk and Return

It is commonly accepted that there is a direct relationship between risk and return. Generally,
the higher the potential return of an investment, the higher the risk. Low levels of risk or
uncertainty are associated with low potential returns. Hence, if the investor is willing to
accept the high possibility of losses, he can be rewarded with high profits.

Take for example, putting money in a saving account in a bank is quite low risk but the return
is also miserable with such low interest rates. On the other hand, high levels of uncertainty or
risk are associated with high potential returns. Think of lottery tickets, for example. They
involve a very high risk (of losing your money) and the possibility of an extremely high
reward.

This relationship between risk and return has important implications for the financial
manager. He or she will need to strike an appropriate balance between risk and return when
making investment decisions.

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Review Questions

Question 1

Which of the following statements concerning business finance is/are correct?

(1) It is concerned with investment decisions, financing decisions and dividend decisions
(2) It considers the management of risk

A. 1 only.
B. 2 only.
C. Both 1 and 2.
D. None.

Question 2

What was the main financial objective of a business organisation?

A. Producing environmentally friendly products

B. Profit maximisation
C. Delay payments to suppliers to improve cash flow
D. Wealth maximisation

Question 3

The financial manager usually oversees the following functions of a company except:

(1) Preparation of financial statements

(2) Investor relationships
(3) Raising new capital
(4) Advising on investment of non-current assets
(5) Deciding pay rates for staff

A. 1,3 and 4 only

B. 1,4 and 5 only
C. 1 and 5 only
D. 1 only

Question 4

Which of the following is not likely to fall within financial management?

A. Senior manager is appointed to the staff welfare committee

B. Decisions are made to set up an overseas branch
C. Funds are set aside to buy non-current assets
D. Dividend payment to shareholders is reduced to allocate more funds for research and
development

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Question 5

Which of the following statements concerning profit is incorrect?

A. Profit is a measure of short-term performance

B. Profit takes into consideration the level of risk
C. Profit can be increased at the expense of the shareholders
D. Profit can be manipulated by managers

Question 6

‘To finance the three investment projects, it was decided to cut down on dividend payment to
meet the financing requirement.’

Which decision is the above statement referring to?

A. Financing decision
B. Investment decision
C. Dividends decision
D. Executive decision

Question 7

Which of the following would you expect to be the responsibility of financial management?

A. Deciding pay rates for workers

B. Producing quarterly management reports
C. Producing annual accounts
D. Advising on investment in non-current assets

Question 8

Which of the following statements is/are correct?

(1) One of the problems with maximising accounting profit as a financial objective is that
it can be manipulated.
(2) Employee’s welfare is a financial objective.
(3) Contributing to society is the most important non-financial objective.

A. 1 only.
B. 1 and 2 only.
C. 1 and 3 only.
D. All.

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Question 9

Which of the following risks can be eliminated by diversification?

A. Market risk
B. Systematic risk
C. Unsystematic risk
D. None of the above

Question 10

‘It was just reported on the news that there was a sudden strike by the employees of the
company we have shares in.’

Which risk is the above statement referring to?

A. Systematic risk
B. Unsystematic risk
C. Can be either systematic or unsystematic risk
D. Not a risk

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 PRINCIPLES OF ACCOUNTING & BUSINESS FINANCE

SESSION 10

CAPITAL BUDGETING

At the end of the lecture, students should be able to:

1. Explain the importance and nature of capital budgeting.

2. Calculate, interpret, and evaluate the Accounting Rate of Returns (ARR).
3. Calculate, interpret, and evaluate the Payback Period.

10.1 Importance and Nature of Capital Budgeting

Capital budgeting is the process of making decisions regarding capital investment projects
that involve large sums of money and a long time frame.

Examples of capital investment decisions are purchase of non-current assets, open new
outlets, make new products, research development projects etc.

Capital investment decisions are necessary to ensure long term profitability of a business.
They can be classified into the following areas:

 Maintenance – purchase of new assets to replace worn-out or obsolete assets.

 Upgrading – expenditures or projects to achieve cost savings, improved quality,
improved productivity.
 Expansion – expenditures or projects to expand the business, launch new products,
open new branches.

To help them make a good and right decision, financial managers use different techniques to
compare the benefits and costs of various investment alternatives. For this course, you will
be learning the following techniques:

 Accounting Rate of Return (ARR)

 Payback Period
 Discounted Cash Flow method - Net Present Value (NPV)

We will discuss the first two methods, namely ARR and Payback methods, in this session.
The discounted cash flow method requires us to understand time value of money concepts
and will therefore be discussed in the next session.

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10.2 Accounting Rate of Return (ARR)

Accounting rate of return measures the return on a project in terms of its profit. It can be
defined as a ratio of average profit to average capital invested.

Average Profit
ARR = X 100%
Average Capital Invested

Total Profit
Average Profit =
Project Life

Initial Capital + Scrap Value

Average Capital Invested = 2

Steps to determine the ARR of a project

Step 1: Calculate the average profit

Step 2: Calculate the average capital invested

Step 3: Calculate the ARR = Average Profit X 100 %

Average capital invested

Step 4: Select project with the highest ARR

Advantages of Accounting Rate of Return

(1) Easy to calculate and understand.

(2) Accounting data are readily available.

Disadvantages of Accounting Rate of Return

(1) Ignores time value of money.

(2) Uses accounting profit instead of cash flows. Accounting profit is subjective and
subject to various accounting conventions. For example, the use of different accounting
policies may result in different amounts of profits reported.

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Activity 10.1

An investment requires an initial outlay of $100,000 and has a 4-year life with an ending
scrap value of $30,000. The yearly profits are $30,000, $50,000, $30,000 and $10,000.

Required:
Calculate the accounting rate of return.

10.3 Payback Period

Payback period is the number of years it takes to recover the initial investment.

The decision rule is to accept the project with the shortest payback. The shorter the period the
better.

Steps to calculate payback period

Step 1
To calculate the payback period of a project, set up the following table:

Year Description Cash inflow / (outflow) Cumulative cash flow

$ $
0 Initial investment (initial investment) (initial investment)
1 Cash inflow
2 Cash inflow

Step 2
Fill in the cash inflows for the project life until the balance in the cumulative column (column
4) changes from negative to positive.

Step 3
Determine the Payback Period as = A + a/b years.

A – Number of years before the first positive cumulative cash flow

a – Absolute value of last negative cumulative cash flow
b – Cash inflow in the year of first positive cumulative cash flow

Step 4
Select the project with the shortest payback.

Advantages of Payback Method

(1) Simple to use.

(2) Objective - Uses cash flow instead of accounting profit.

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(3) Favours projects with a quick return. This will produce faster growth for firms and
ensure more liquidity especially for smaller companies.

(4) Choosing projects with the fastest return will tend to minimise time related risk.

Disadvantages of Payback Method

(1) Ignores cash flows after the payback period.

(2) Ignores the time value of money.

Payback method is useful as an initial screening method, if used with other methods.

Activity 10.2

An investment requires an initial outlay of $100,000 and has the following expected annual
cash flow: $40,000, $50,000, $30,000 and $30,000.

Required:
Calculate the payback period.

Year Description Cash inflow / (outflow) Cumulative cash flow

$ $
0 Initial investment
1 Cash inflow
2 Cash inflow
3 Cash inflow
4 Cash inflow

Payback period =

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Review Questions

Question 1

Capital investments should always

A. be analysed using the ARR.

B. be analysed using the payback method.
C. earn back their original capital outlay.
D. earn back their original capital outlay plus a reasonable return.

Question 2

What is the payback period for an investment of $10,000 that produces a net annual cash
inflow of $2,500 for each of the 5 years?

A. 3 years.
B. 3.5 years.
C. 4 years.
D. 4.5 years.

Question 3

What is the payback period for an investment of $15,000 that produces a net annual cash
inflow of $4,000 for each of the 5 years?

A. 3.5 years.
B. 3.75 years.
C. 4 years.
D. 4.5 years.

Question 4

What is the payback period for an investment of $5,000 that produces a net cash inflow of
$1,000 in the first year, $2,000 in the second year and $3,000 in the third year?

A. 3 years.
B. 2.75 years.
C. 2.67 years.
D. 2.5 years.

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Question 5

Which of the following statements about payback period are correct?

(1) It uses profits instead of cash flows.

(2) It ignores the time value of money.
(3) It ignores cash flows after the payback period.
(4) It is easy to understand and calculate.

A. 1, 3 and 4 only.
B. 2 and 3 only.
C. 1 only.
D. 2, 3 and 4 only.

Question 6

What is the advantage that ARR has that is not possessed by the payback period?

A. It considers the profitability of a project beyond the payback period.

B. It considers the time value of money.
C. It uses accounting profits instead of cash flows.
D. It is simple to use.

Question 7

What is the ARR of an average investment of $2,000 that produces an average profit of
$420?

A. 18%.
B. 21%.
C. 23%.
D. 25%.

Question 8

A special project with an initial investment of $50,000 has the following expected cash flows
over its four-year life span.

Year Cash Inflow

1 $10,000
2 $20,000
3 $30,000
4 $10,000

Required:

Calculate the payback period for the special project. Clearly show your workings.

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Question 9

A firm is considering 2 projects each with an initial capital investment of $2,500 and a life of
5 years. The estimated net profit is as follows. Only one project can be selected.

Year Project A $ Project B $

1 250 500
2 250 450
3 250 200
4 250 200
5 250 300
Estimated scrap value YR 5 500 300

Required: Calculate the Accounting Rate of Return for the 2 projects and determine which of
the projects should be selected according to the ARR technique.

Question 10

A company is currently considering investing in 3 projects the cash flow of which is as

follows. Only one of the 3 projects should be selected.

Project A Project B Project C

$ $ $
Initial Investment 2,000 3,000 4,000
Year 1 800 500 600
Year 2 700 700 700
Year 3 500 800 500
Year 4 800 900 200
Year 5 900 1,000
Year 6 200 1,500
Year 7 300 2,000

Calculate the payback period for the 3 projects above & determine which one of the 3
projects should be selected.

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Homework Question (with solutions)

ABC Limited has been considering two projects, each of which will entail an investment of
$9,000,000. Due to cash constraints, only one of the projects can be undertaken. Details of
the net cash inflows after costs associated with the projects are as follows:

Year Project A Project B

$ $
1 2,500,000 1,000,000
2 2,200,000 3,700,000
3 2,400,000 2,300,000
4 2,600,000 3,000,000
5 2,800,000 3,000,000

Total 12,500,000 13,000,000

Required:

(a) Calculate the payback period for both projects.

(b) Based on your calculations in (a), which project should the company undertake?

(c) Calculate the Accounting rate of return for both projects.

(d) Based on your calculations in (b), which project should the company undertake?

Answers:

(a)

Project A
Year Description Cash inflow / (outflow) Cumulative cash flow
0 Initial investment (9,000,000) (9,000,000)
1 Cash inflow 2,500,000 (6,500,000)
2 Cash inflow 2,200,000 (4,300,000)
3 Cash inflow 2,400,000 (1,900,000)
4 Cash inflow 2,600,000 700,000
5 Cash inflow 2,800,000 3,500,000

Payback period = 3 years + (1,900,000/2,600,000) years = 3.73 years

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Project B
Year Description Cash inflow / (outflow) Cumulative cash flow
0 Initial investment (9,000,000) (9,000,000)
1 Cash inflow 1,000,000 (8,000,000)
2 Cash inflow 3,700,000 (4,300,000)
3 Cash inflow 2,300,000 (2,000,000)
4 Cash inflow 3,000,000 1,000,000
5 Cash inflow 3,000,000 4,000,000

Payback period = 3 years + (2,000,000/3,000,000) years = 3.67 years

(b) CHOOSE : Project B because it has a shorter payback period.

(c) Project A

Average profit = Total profit / Project life

= $12,500,000 / 5 years
= $2,500,000

Average capital = (Initial capital + Scrap value) / 2

= $9,000,000 / 2
= $4,500,000

ARR = Average profit / Average capital x 100%

= $2,500,000 / $4,500,000 x 100%
= 55.6%

Project B

Average profit = Total profit / Project life

= $13,000,000 / 5 years
= $2,600,000

Average capital = (Initial capital + Scrap value) / 2

= $9,000,000 / 2
= $4,500,000

ARR = Average profit / Average capital x 100%

= $2,600,000 / $4,500,000 x 100%
= 57.8%

(d) CHOOSE : Project B because it has a higher ARR.

134
 PRINCIPLES OF ACCOUNTING & BUSINESS FINANCE

SESSION 11

TIME VALUE OF MONEY

At the end of the lecture, students should be able to:

1. Discuss the concept of time value of money and the use of computational tools.
2. Calculate, interpret and evaluate the Net Present Value (NPV).

11.1 Time Value of Money

In order for a business to accept a capital investment project, it must make enough profits to
justify its costs. The returns must be high enough to compensate the business for the amount
invested and also for the length of time before the profits are made. For example, an
investment of $100,000 that earns a return of $8,000 in one week is definitely much more
profitable than one that earns a return of $8,000 in 5 years.

This is because money has a time value. Money received now can be invested to earn interest
or profits, so it is better to have $1 now than in one year’s time.

Hence….

A dollar received today is worth more than a dollar received in the future.

This is known as the time value of money.

Discounted cash flow (DCF) method is a capital investment appraisal technique that takes
into consideration the time value of money.

To understand DCF, you need to understand how interest is earned on investments.

11.2 Interest

Interest earned on an investment can be calculated as either simple interest or compound

interest.

Simple Interest

 Interest which is earned in equal amounts each month or year, as a given proportion of
total investment.
 Interest is not added to the investment amount.

Example: Interest payable on $1,000 at 10% per annum will be $100 every year.

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Compound Interest

 This is the much more common way of calculating interest.

 When interest is calculated, it is added to the initial investment so that the next interest
calculation will be based on the increased investment.

Example: An initial investment of $1,000 that earns a compound interest of 10% per annum.

In 1 year’s time, investment = $1,000 x 1.1 = $1,100

In 2 year’s time, investment = $1,100 x 1.1 or $1,000 x (1.1)2 = $1,210
In 3 year’s time, investment = $1,210 x 1.1 or $1,000 x (1.1)3 = $1,331 and so on.

In general,

Future value of y dollars after n years = y x (1 + r)n

Where r = compound interest rate per annum expressed as a decimal.

Activity 11.1

If you deposit $50,000 today in a bank account paying 10% compound interest, how much
will you have at the end of:

(a) 1 year

(b) 5 years

(c) 10 years

11.3 Discounting

Discounting is the reverse of compounding. It converts future amount of cash into present
value.

Future value of y dollars after n years = y x (1 + r)n

Present value

Future Value
Present Value = (1 + r)n

Where r = interest rate per annum expressed as a decimal.

We can also use the Present Value table to find the values.

136
Example:

The amount that we need to invest now so that we can have $10,000 in 4 years time,
assuming a compound interest rate of 10% is:

$10,000
Present Value = (1 + 0.1)4 or $10,000 x 0.683
= $6,830

The 0.683 is also known as a discount factor, and can be easily read from the Present Value
table.

Activity 11.2

You would like to invest in a fixed deposit today so that you can have $100,000 in 5 year’s
time to buy a car. If the market rate is 5% compounded annually, how much must you invest
today?

11.4 Net Present Value Method (NPV)

This is an investment appraisal method whereby all the cash outflows (negative values) and
cash inflows (positive values) are discounted to their present values. The sum of the present
value of all the cash flows from the investment is the net present value amount. The discount
rate used will be the cost of capital i.e. the cost of funds for the business. For the purpose of
this course, cost of capital will be given in the question.

Decision Criteria:
 If NPV is positive = Accept project.

 If NPV is negative = Reject project.

 If you are asked to select between a few projects, select the project with the highest
positive NPV.

Steps to calculate NPV

Step 1
To calculate the NPV of a project, set up the following table:

Time Cash Flow $ Calculation of PV of Cash Flow $ PV $

Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
NPV

137
Step 2
Include the initial investment in year 0 as a cash outflow and scrap value (if any) in the
final year as a cash inflow.

Step 3
Include all periodic cash inflow and cash outflow in the relevant years.

Step 4
Multiply the net cash flow by the discount factor to arrive at the discounted cash flow.
(Discount factor for Year 0 is always = 1)
Look up the Present values tables for the discount factor.

Step 5
Add up all discounted cash flow = NPV

Step 6
NPV Positive = Accept
NPV Negative = Reject

Timing of Cash Flows

 Year 0 is taken as time now. In other words, the time when the decision on the project is
undertaken

 To use the annual discount factor, the flows must be more or less 12 months apart. In
other words, do not be misled by calendar dates e.g. cash flows occurring at 31/12/2016 is
the same as 1/1/2017 as they are only one day apart.

 Generally cash flows which occur during a period will be taken to occur at the end of that
period. This applies to things like sales, purchases, expenses, etc.

Activity 11.3

The following information relates to a particular project:

Project initial investment $2,000

Scrap value at the end of the project life 100
Projected net cash inflow(cash revenue less cash expense)
Year 1 400
Year 2 600
Year 3 700
Year 4 600
Year 5 500

Required: Calculate the project’s NPV using a discount rate of 10%.

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 Time Cash Flow $ Calculation of PV of Cash Flow $ PV $
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
NPV

Activity 11.4

Senior management of Noah Ltd has to make a choice between two models of the machine;
model 1 is called Super and model 2 is called Deluxe. They are unsure as to which of the two
models they should buy. They have given you the following profiles of the two models. They
want you to use the Net Present Value method to recommend which of the two models is
better and to explain briefly why you have recommended one in place of the others under this
technique. You are told that funds are only available for one model.

Super Deluxe

Cost $500,000 $800,000

Net cash inflow $ $
Year
1 250,000 150,000
2 100,000 200,000
3 100,000 250,000
4 50,000 100,000
5 150,000 100,000
6 100,000 250,000
Scrap value 20,000 80,000

The cost of capital is 12%, which is what it costs to raise the required finance for the project.

Super
Time Cash Flow $ Calculation of PV of Cash Flow $ PV $
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
NPV

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Deluxe
Time Cash Flow $ Calculation of PV of Cash Flow $ PV $
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
NPV

Recommendation:

Review Questions

Question 1

What would be the total interest earned on an investment of $20,000 for four years at a
compound interest rate of 5% per annum?

A. $2,050
B. $3,153
C. $4,310
D. $5,526

Question 2

What is the value after three years of $1,000 invested now at a compound interest rate of 4%
per annum? (Round up to the nearest dollar)

A. $82
B. $125
C. $1,082
D. $1,125

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Question 3

What is the present value of $121,000 expected to be received one year from today at an
interest rate (discount rate) of 10% per year?

A. $133,100
B. $121,000
C. $110,000
D. $100,000

Question 4

According to the net present value rule, an investment in a project should be made if the:

A. Net present value is greater than the cost of investment

B. Net present value is greater than the present value of cash flows
C. Net present value is positive
D. Net present value is negative

Question 5

If the present value of $500 expected to be received one year from today is $400, what is the
discount rate?

A. 10%
B. 20%
C. 25%
D. 30%

Question 6

An initial investment of $400,000 will produce an end of year cash flow of $480,000. What
is the NPV of the project at a discount rate of 20%?

A. $0
B. $80,000
C. $124,000
D. $176,000

Question 7

John makes a deposit of $12,000 in a bank account. The deposit is to earn interest
compounded annually at the rate of 9 percent for 5 years. How much will John have on
deposit at the end of 5 years?

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Question 8

Tim is considering the purchase of an antique watch. He can buy the watch today and expects
the price to rise to $15,000 at the end of 10 years. He believes that he should earn an
investment yield of 10 percent annually on this investment. The asking price for the watch is
$7,000. Should he buy it?

Question 9

An investment allows us to receive $6,000, $8,000 and $14,000 at the end of Year 1, 2 and 3
respectively. Assuming a discount rate of 7%, how much would this investment be worth
today?

Question 10

You are employed as the assistant accountant in your company and you are currently working
on an appraisal of a project to purchase a new machine. The machine will cost $55,000 and
will have a useful life of three years at the end of which it expected to be sold for $5,500.
You have already estimated the cash flows from the project and the results of your estimates
can be summarised as follows.

Year 1 2 3
Cash inflow $ 18,000 $29,000 $31,000

Required:

Calculate the NPV of the project assuming a discount rate of 10%.

142
Question 11

Company M has to choose between 3 investments with details as follows:

Projected Cash Flow

Year Project A Project B Project C
0 ($100,000) ($120,000) ($150,000)
1 $60,000 $60,000 $0
2 $80,000 $60,000 $80,000
3 $40,000 $100,000 $120,000

The company uses a cost of capital of 10% to evaluate all its investments.

Required:

(a) Calculate the net present value of the three projects at the company’s cost of capital.

(b) On the basis of your calculations in (a), if Company M can only undertake one of the
projects, advise them as to which project should be accepted.

143
Homework Question (with solutions)

Question 1

Determine the end value of investing $50,000 for 7 years at a stated annual interest rate of 6
% compounded annually.

Question 2

Determine the present value of $1,400 earned at the end of each year for three years when the
discount rate is 11 % per annum.

Question 3

A project requires an initial investment of $30,000 and then will produce the following cash
flows for the next five years:

Year 1 2 3 4 5
Cash inflow $ 3,000 $9,000 $11,000 $10,000 $7,000

The company’s cost of capital is 12% per annum.

Required: Calculate the NPV of the project

Answers:

Question 1

Value of investment at the end of 7 years

= $50,000 x (1 + 0.06)7
= $75,181.51

Question 2

At the end of year 1, PV of $1,400 = $1,400 x 0.901= $1,261.4

At the end of year 2, PV of $1,400 = $1,400 x 0.812= $1,136.8
At the end of year 3, PV of $1,400 = $1,400 x 0.731= $1,023.4

Question 3

Time Cash Flow $ Calculation of PV of Cash Flow $ PV $

Year 0 (30,000) (30,000) x 1 (30,000)
Year 1 3,000 3,000 x 0.893 2,679
Year 2 9,000 9,000 x 0.797 7,173
Year 3 11,000 11,000 x 0.712 7,832
Year 4 10,000 10,000 x 0.636 6,360
Year 5 7,000 7,000 x 0.567 3,969
NPV (1,987)

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APPENDIX A

Present value table

Present value of 1, ie. (1 + r)-n

Discount rates (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239

11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065

145
 PRINCIPLES OF ACCOUNTING & BUSINESS FINANCE

SESSION 12

OVERVIEW OF FINANCIAL MARKETS

At the end of the lecture, students should be able to:

1. Explain the nature of corporations.

2. Overview of financial markets and institutions.
3. Understand the process of raising capital for both new and established firms.

12.1 Types of Business Ownership

A business enterprise is an organizational entity involved in the provision of goods or

services with the intention of earning a profit.

Business structure operating in today’s environment can generally take one of three forms:

 Sole Trader/Proprietorship
 Partnerships
 Limited Company

Sole Trader/Proprietorship
This refers to business that is owned by one individual who is entitled to all the profits and is
responsible for all the losses.

Partnerships
Refers to the ownership structure involving two or more persons carrying out a business in
common with a view of making profits

Limited Companies
A limited company is a business that is incorporated as a separate legal entity having its own
rights, privileges and liabilities distinct from those of its members. In other words, the
limited company is a legal entity separate and distinct from its owners. The owners of the
company are the shareholders.

The key characteristic of a company is the separation of ownership and control. The company
is owned by its shareholders but they are not responsible for the day to day running of the
business. To undertake this task they elect a board of directors. Sometimes, the shareholders
can be in the board of directors but this is not mandatory. This separation of ownership and
control has obvious advantages and disadvantages. The advantage is that ensures continuity.
The owners may change but the operation of the business continues. The disadvantage is that
conflicts may arise between the objectives of the owners (the shareholders) and the managers
of the business.

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Limited company can run as a private or public limited company. The main difference is
shares of a public limited company are traded in the stock exchange while private limited
company’s shares are not.

Sole Trader Partnership Limited Companies

No of owners 1 2 to 20 2 to 50 (Private
Limited)
Unlimited (Public
Limited)
Legal status Not a legal entity Not a legal entity Business is a separate
legal entity from the
shareholders
Taxation Owner pays income Partners pay income Business pays
tax tax company tax
Profits Owner entitles to all Partners share profits Shareholders receive
entitlement profits and suffers all according to terms in dividends
losses partnership
agreement
Liability Owners have Partners are jointly Shareholders are not
unlimited liability for and severally liable personally liable for
all the losses and for the losses and the debts of the
debts of the business debts of the company. Their loss
partnership is limited to their
initial share capital
investment.
Advantages Simple to organise Simple to organise Professional
management
Flexibility & More resources in
autonomy terms of capital, Company has greater
specialist knowledge, scope for raising
Owner is able to skills and ideas funds
introduce or
withdraw capital at Ease of transferring
any time ownership (shares)

Continuous life

Limited liability
Disadvantages Unlimited liability Unlimited liability More costly to set up
and maintain
Limited life Limited life
Subject to more
Limited resources Limited resources restrictions and rules
under company law
Introduction or
withdrawal of capital
requires agreement

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12.2 Sources of Funds for a Company

There are a number of ways that a public limited company can raise funds. In general they
can be loosely categorised into 2 distinct groups:
 Debt Funding
 Equity Funding

12.3 Debt Funding

Bank Loan
Bank loan is a long term loan taken from the bank usually with some underlying collateral.

Bonds
Bonds are a long-term debt instruments issued by a company. They are usually secured on
the issuing company’s assets. They are normally issued in denominations of $1,000 but can
also be in $100 or $10,000 etc. This is known as the par value of the bond which is also the
face value that is returned to the bondholder on maturity. Once issued, the bonds can be
traded in the bonds market and the prices can be higher or lower than the par value.

Interest is paid periodically, say half-yearly or yearly, as a percentage (known as interest or

coupon rate) of the par value of the bond. Thus a bondholder with a 5% interest rate and a
$1,000 par value will receive $50 (5% x $1,000) annually in interest until maturity. This is
regardless of what happens to the price of the bond. Interest must be paid whether the
company is making a profit or a loss and with priority over all shareholders.

When a company becomes insolvent, bonds have priority of claim before all the shares. If
interest on bond is not paid, the bondholders can force the company into bankruptcy. Thus
the bondholder’s claim on income is more likely to be honoured than that of common and
preferred shareholders, whose dividends are paid at the discretion of the company’s
management.

12.4 Equity Funding

Shares
The share capital of a company may be divided into different classes, as follows:
 Ordinary Shares
Ordinary shareholders are the true owners of the company unlike bondholders who are
viewed as creditors of the company. Being owners of the business, ordinary shareholders
have the right to residual income after bondholders and preference shareholders have
been paid. The income is in the form of dividends which are usually declared in this
manner: x cents per share. The dividend payout, when decided and declared by the
company’s board of directors, varies from year to year.

148
 Ordinary shareholders have a residual claim on assets in the case of liquidation i.e. after
all creditors and preference shareholders have been satisfied. However, when bankruptcy
does occur, the claims of ordinary shareholders are generally unsatisfied.

Being owners of the company, ordinary shareholders have voting rights and they are the
ones who elect the board of directors and auditor. They may vote in person or by proxy.

 Preference Shares
Preference shares or preferred stocks are often known as a hybrid security as they have
the features of both the ordinary shares and bonds. Like ordinary shares, they have no
fixed maturity date and dividends are paid only when company makes a profit. Like
bonds, they do not carry voting rights and dividends are fixed in amount – stated as a
% of their par value. Par value is the face value of the shares.

Preference shareholders are paid their dividends first before the ordinary shareholders.
They also have preferential claims to assets over the ordinary shareholders in the case of
bankruptcy.

Some preference shares carry a cumulative feature. Cumulative preference shares

require all past unpaid preference dividends be paid before any ordinary share dividends
are declared.

Debt Funding Equity Funding

Types Bank loans Bonds Preference shares Ordinary shares
Classification Non-Current Liability Equity
Voting Rights No No Yes
Returns Interests Fixed dividends Variable dividends
Conditions of Regardless of profit or loss Company making profit
Payout
Priority of First Second Third
Payments of
Returns
Priority First Second Third
during
liquidation

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12.5 Financial Markets and Institutions

In session nine, we learnt that in order to carry out any business, organization needs a set of
real assets like land, buildings, plant, equipment and so on. In order to finance the acquisition
of these assets they need to raise funds. There are many ways to do this, one of which is
through issuing either bonds or shares. Financial markets and institutions exist to help
organisations raise funds. They serve as channels to link up investors with excess funds and
those who are in need of them.

Financial Markets
Organisations Investors
(Need funds) (Excess funds)
Financial Institutions

FINANCIAL MARKETS

Financial markets are markets where financial instruments (like shares or bonds) are issued
and traded.

Types of Financial Markets

Capital markets
 Trading in long-term financial instruments (maturities of more than 1 year)
 Trade in shares (equity) and bonds (debts)
 Major borrowers are corporations and governments raising funds for long term needs
 Generally more risky and hence promise to pay a higher rate of returns to attract funds
 Example: New York Stock Exchange (NYSE), Singapore Stock Exchange (SGX)

Money markets
 Trading in short-term financial instruments (maturities of 1 year or less)
 Trade in securities issued by government and corporations like treasury bills, negotiable
certificates of deposits, commercial papers and bankers’ acceptances.
 Lenders will buy the securities at a discount and sell them at their face value on maturity,
earning the difference between them
 No physical marketplace; merely consists of a loose collection of banks and dealers
linked together by phones or internet

FINANCIAL INSTITUTIONS
In general, financial institutions are organisations that raise money from investors and
provide funds to those who need them. They serve the role of a middleman by collecting
surplus funds from depositors and lend them to users who can invest them to earn profits.

The product of this chain of lending, borrowing and investing activities is that everyone will
benefit. The investors get their profits from using the funds, the middleman gets his

150
commission and the lenders get their money back plus some interest for lending their money.
Overall, this will contribute to a country’s economic growth by creating more jobs from the
investment, resulting in higher income and a better living standard for everyone.

Types of Financial Institutions

Commercial Banks
 Lend money to businesses and individuals
 Provides a place for depositors to keep their money safely and withdraw when needed
 Provide services like cheques, credit cards and electronic transfers to individuals and
businesses

Investment Banks
 Offer advice and help to companies in raising funds. E.g. serve as underwriters for IPO
 Advise companies on takeovers, mergers and acquisitions
 Offer investment advice and manage investment portfolios for individuals and
institutional investors
 Run trading desks for foreign exchange, bonds

Insurance Companies
 Provide insurance policies
 Invest in shares and bonds
 Make long term loans to corporations

12.6 Central Bank

Central bank or monetary authority is an institution that manages a country’s currency,

money supply, interest rates and also serves as a bank regulator. Central bank also acts as a
“lender of last resort” to the banks during times of financial crisis. The primary objective of
the central bank is to promote sustainable non-inflationary economic growth while keeping
the economy at full employment. In Singapore, the central bank is the Monetary Authority of
Singapore (MAS).
Main functions of the central bank include:
 Managing monetary policy to achieve economic growth like full employment
– This can be done through controlling money supply, setting interest rates on loans and
bonds (interest rates can be raised to slow growth and avoid inflation or lowered to
promote growth, industrial activities and encourage spending)

 Supervising and regulating the activities of the commercial banks and other financial
institutions –The central bank conducts regular checks, issues warnings on banking
activities that are deemed to be unsafe, stipulates reserve requirements, implements
regulations to ensure compliance and investigates complaints on banking activities in the
financial system.

 The central bank is also usually responsible for the collection and replacement of
currency (coin and paper) from circulation. It also distributes new currency to meet the
public’s need for cash.

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12.7 Initial Public Offering

Most major businesses trade as companies (corporations). When companies are first
established they are usually small. They have a limited number of shareholders and are
closely controlled. They are usually private limited companies and are frequently owner
managed i.e. the board of directors are also major shareholders.

As the company grows, new shares are issued to finance the expansion. Share ownership
widens and the next step is to become a public limited company (PLC). This is when the
company seeks a listing for its shares on a stock exchange and becomes a quoted/listed
company. This is known as initial public offering of stock, or IPO.

12.8 Primary Markets and Secondary Markets

Any company that sells new stocks and bonds to the public for the first time does so in a
primary market. Hence, in the primary market, investors buy securities directly from the
company issuing them.

In the secondary market, investors trade securities among themselves, and the company
with the security being traded does not participate in the transaction. Hence, the secondary
market is where securities are traded after the IPO. For e.g. if a holder of SIA shares wants to
sell them, he has to do so in the secondary market. In Singapore, this will be the Singapore
Stock Exchange (SGX). Markets such as the New York Stock Exchange (NYSE), London
Stock Exchange or Nesdaq are all examples of secondary markets.

152
Review Questions

Question 1

In general, who are the owners of limited companies?

A. Board of directors
B. Managers
C. Shareholders
D. Shareholders and board of directors

Question 2

Limited liability is an important feature of:

A. Sole traders
B. Partnerships
C. Limited companies
D. All of the above

Question 3

The following are some of the actions shareholders can take if the corporation is not
performing well:

A. Replace the board of directors in an election.

B. Force the board of directors to change the management team.
C. Sell their shares of stock in the corporation.
D. Any of the above

Question 4

Which of the following is/are advantages of forming a limited liability company?

(1) It has continuous life.

(2) The ease of setting up the business.
(3) There is greater scope for raising funds.

A. 1 and 3
B. 1 and 2
C. 2 and 3
D. All 3

153
Question 5

Which of the following is/are features of preference shares?

(1) They carry voting rights.

(2) Their dividend varies from year to year.
(3) Their dividend is paid out in priority to an ordinary dividend.

A. 1 and 3
B. 2 and 3
C. 2 only
D. 3 only

Question 6

Which of the following statements always apply to a limited liability company?

(1) Change in ownership has no effect on business operations.

(2) Shares must be traded in stock exchange.
(3) Unlimited liability.
(4) Limited life.

A. 1, 2 and 3 only
B. 1, 2 and 4 only
C. 1 and 2 only
D. 1 only

Question 7

Which of the following financial instruments is/are traded on a money market?

A. Treasury bills
B. Shares
C. Bonds
D. All the above

Question 8

The organisation responsible for the conduct of monetary policy in Singapore is the

A. Singapore Treasury Board

B. Monetary Authority of Singapore
C. Currency Board
D. Inland Revenue Authority of Singapore

154
Question 9

Which of the following statements is/are true of financial institutions?

(1) They act as middlemen, borrowing funds from those who have saved and lending these
funds to others.
(2) They manage a country’s currency and money supply.
(3) They help promote a more efficient and dynamic economy.

A. All 3
B. 1 and 2 only
C. 1 and 3 only
D. 1 only

Question 10

Which of the following are long-term financial instruments?

A. A six-month loan
B. Negotiable certificates of deposit
C. Banker’s acceptances
D. SIA shares

Question 11

Which of the following are short-term financial instruments?

A. Government bonds
B. Treasury bills
C. Corporate bonds
D. Shares

Question 12

Which of the following statements about the characteristics of debt and equity is true?

A. Both can be long-term financial instruments.

B. Both can be short-term financial instruments.
C. Both will receive returns regardless of profits or loss.
D. Both receive fixed rate of returns.

155
Question 13

Securities are _____ for the person who buys them, but are _____ for the individual or firm
that issues them.

A. expenses; incomes
B. incomes; expenses
C. assets; liabilities
D. liabilities; assets

Question 14

A corporation acquires new funds when its securities are sold in

A. the primary market.

B. the secondary market.
C. both the primary and secondary market.
D. the Singapore Stock Exchange.

Question 15

Which of the following is/are financial institutions?

(1) Commercial banks

(2) Investment banks
(3) Insurance companies

A. All 3
B. 1 and 2 only
C. 2 and 3 only
D. 3 only

Question 16

Which of the following statements are correct?

(1) A certificate of deposit is traded in the money market.

(2) Financial markets can be classified into exchange and over-the-counter markets.
(3) Treasury bills are bought and sold on a discount basis.

A. 1,2 and 3
B. 1 and 2 only
C. 2 and 3 only
D. 1 and 3 only

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Homework Question (with solutions)

Question 1

Briefly explain the term limited liability.

Answers:

Limited liability means the shareholder’s liability is limited up to the amount of capital
invested i.e. the amount invested in the purchase of shares. They are not personally liable for
the debts of the company.

Question 2

Explain the advantages of a corporation as a form of business organization.

Answers:

Professional management
Company has greater scope for raising funds
Ease of transferring ownership (shares)
Continuous life
Limited liability

Question 3

What is the difference between the primary and the secondary market on the stock exchange?

Answers:

The primary market is the market where securities (debt and equity) are issued for the first
time. Organisations can raise new funds by issuing new shares or new bonds in the primary
market.

The secondary market is the market where securities which have been issued in the primary
market are traded, enabling existing investors to sell their investments, should they wish to do
so.
The marketability of securities is a very important feature of the capital markets, because
investors are more willing to buy stocks and shares if they know that they could sell them
easily. The secondary market does not raise new funds for companies.

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