Chapter 4

Question 1

What is the accounting equation for the stock approach? (aka increment in wealth method)

Answer 1

Profit = (Ae-Ab) - (Le-Lb) - New contributions + Owner’s Distributions +/- Other changes in owners equity

Question 2

When might the stock approach be used?

Answer 2

a. The check on the accuracy of the transaction approach (‘R-E’)
b. By regulatory bodies (e.g. IRD) to determine the profit & loss when records are unavailable
c. By insurance assessors or other parties when records have been destroyed (e.g. by fire/eq)

Question 3

What four categories are used for expenses, for trading entities & service entities?

Answer 3

TRADING:

1. Cost of sales
2. Selling and Distribution
3. Admin and General
4. Financial

SERVICE:
Everything above except number 1.

Question 4

What is Gross Profit?

Answer 4

The difference between sales and cost of sales (i.e. without taking into account any other expenses or income associated with the business).

Question 5

What is Net Profit?

Answer 5

Wealth generated which is attributable to to the owners after all other expenses have been deducted.

Question 6

(4.5). The 3rd format for Income Statements is regulatory reports. This involves a fully classified income statement. Why might entities be reluctant to provide this?

Answer 6

They will not wish to give competitors that level of detail (e.g. Gross profit margin, selling expenses). Also, may entities are involved in a diverse range of activities, providing the detail around this may be complex, costly, and potentially confusing.

Question 7

What are the three formats of Income Statements?

Answer 7

1. Simple Reports (e.g. list of income and expenses, “trading and profit and loss account). Mostly used by smaller orgs
2. Classified Reports (larger orgs, catagorises expenses into 4 categories - Cost of sales/selling and distribution/ admin and general/ Financial
3. Regulatory Report (required for statutory standards, involves a lot more detail, orgs can be reluctant to provide, expenses classified to either nature or function)

Question 8

What is the ‘Realisation Convention’?

Answer 8

The convention which states that revenue will only be recognised when it is realised - usually when the transaction is substantially complete, can be objectively measured, and it is reasonably certain that the money will be received.

Question 9

When is the normal point of recognition when goods are sold on credit?

Answer 9

When the goods are passed onto the customer and accepted by them (at this point there is a legally enforceable contract between the parties).

NB: A sale on credit is usually recognised before the cash is ultimately received. Therefore, the total sales figure shown in the income statement may include sales for which the cash has yet to be received.

For bigger projects (e.g. long-term construction) its normal for this to be proportioned over the project.

Question 10

In respect of Revenue Recognition, what conditions have to be satisfied?

Answer 10

a. entity has transferred to the buyer the significant risks & reward of ownership
b. entity retains neither continuing managerial involvement to the degree usually associated with ownership, nor control over goods
c. the amount of revenue can be measured reliably
d. costs incurred (or to be incurred) can be measured reliably

Question 11

What is the difference between accrual- and cash- based transaction recognition?

Answer 11

Accrual - the expense is recognised when it is incurred.

Cash - the expense is recognised when the cash payment is made.

Question 12

What is materiality?

Answer 12

Information is material if its omission or misstatement would influence the decision of financial statement.

(e.g. at end of an accounting period, a bill of $5 for stationary is owning. As the time and effort involved in recording this as an accrual would have little effect on the measurement of profit/decisions, it can be ignored).

Question 13

What are the four factors to consider when calculating depreciation?

Answer 13

1. Cost (or other value) of the asset
   (nb. includes delivery, installation, modification costs, legal transfer costs)
2. Useful life of the asset
   (an item has both a physical life, and an ecoomic life. E.g. a computer might have a 8yr phys life, but only 3 yr econ life)
3. Estimated residual value of the asset
   (value when disposing, eg. equipment could still be valuable to others, and you might receive $ for this)
4. Depreciation method
   a. Straight-line depreciation
   b. Accelerated depreciation
   c. Units of production-based depreciation

Question 14

A. What is a Contra Asset Account?

B. Why does this provide more relevant info to financial report users?

Answer 14

A. An account that goes together with another account but represents a reduction in that account.

Eg.
Equipment Account: $x
Accumulated Depreciation - Equipment: $(x)

B. It reveals how much of the associated asset account has been used up (or expected to be used up). Without this, there would simply be the book value of the asset and valuable info would be lost.

Question 15

What is the reducing-balance method of depreciation?

a. . Explain method
b. Effect on profit
c. When might it be used?

Answer 15

a. Calculated on the reducing net book value, so a reducing depreciation amount across the life of the asset.
b. A bigger cost against profits in the first years of an asset’s life, less later on.

c. Suitable for assets that have increasing repairs and maintenance costs, as the reducing depreciation is offset by the increasing repair costs.
(The intention is to have a balanced cost of holding the asset against each year of its life.)

Question 16

How does a business choose which depreciation method to use for a particular asset?

Answer 16

Depends on the one that best matches the depreciation expense to the income it helped generate.

Where benefits are likely to remain fairly constant over time (e.g. buildings), the straight-line approach might be appropriate.

Where assets lose their efficiency over time & the benefits therefore decline as a result (e.g. certain types of machinery), reducing-balance might be more appropriate.

Where depreciation relates more to units than time, the units of output method might be more appropriate.

Question 17

What are the three methods for inventory cost allocation?

Answer 17

FIFO - First in first out
LIFO - Last in, first out
Avg Weighted cost

Question 18

(4.23) Why is LIFO not an approved method in NZ?

Answer 18

• it’s contrary to the actual physical flow of inventory where the earliest inventory will usually be the first out
• when inventory levels increase over time, the inventory on hand valuation can become out of date
• the use of LIFO can be used for managers to manipulate the financial position and performance eg. a large inventory purchase at the end of a period at a high price will decrease profit, at a low price will increase profit.

Question 19

What is Net Realisable Value (NRV)?

Answer 19

The estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale.

Question 20

(4.24) When might net realisable value be lower than the cost of inventory held?

Answer 20

• When the goods have deteriorated, or become obsolete
• there has been a fall in the market price, e.g. due to competition
• the goods are being used as a loss leader
• bad purchasing decision have been made
• demand for the product has dropped

Question 21

(4.25) Inventory valuation provides an example of the judgement required to derive the figures for inclusion in the financial statements.

What are the main areas where judgement is required in inventory?

Answer 21

• The choice of cost method (FIFO or avg)
• Deciding which costs should be included in the cost of inventory (particularly for work-in-progress and the finished goods of a manufacturing business)
• Deriving the net realisable value figures for inventory held

Question 22

(4.26) When preparing the financial statements, how would financial performance and position be affected by NOT taking into account the fact that a debt was bad?

Answer 22

Overstated assets (debtors/trade receivables) on the balance sheet and,
Overstated profit in the income statement,

As the sale (which has been recognised) will not result in any future benefits flowing into the entity.

Question 23

How would writing off a bad debt be recognised?

Answer 23

• Reducing Trade Receivables (debtors)

- Increasing expenses (by creating an expense known as ‘bad debts written off’) by the amount of the bad debt

Question 24

How would you record a doubtful debt?

Answer 24

• INCOME STATEMENT: An expense labelled “doubtful debts expense’ in the income statement
• BALANCE SHEET: A deduction from the debtors/trade receivables account labelled ‘allowance for doubtful debts’. (example of a contra asset account)

Question 25

What is an impairment test?

Answer 25

An impairment test is applied to many of the assets held by business entitles. It relates to the valuation of assets, and it is the amount by which the asset’s recoverable amount (the higher of its fair value less costs to sell and its value in use) exceeds it’s carrying amount

Question 26

Straight Line method of depreciation.

a. Explain method
b. Effect on profit
c. When might this be used?

Answer 26

a. Calculated on cost price, so a constant depreciation amount across the life of the asset.
b. Constant (steady) impact on profits.
c. Suitable for assets that have constant (steady) repairs and maintenance costs.

NOTE: Deduct the residual value off the book value before dividing by the years, e.g.
$10,000(value) - $1500(residual/onselling value) / 4(#of estimated life years)