Chapter 5: Balance Sheet

Topic 3 Recommended Tutorial/Homework Solutions

Comprehension Questions
5.4

The Snags Software Company wants to increase its asset base by

recognising the databases that it has created as assets. Discuss whether this
is permissible under accounting standards.

Databases are regarded as intangible assets and accounting rules applicable from
1 January 2005 to reporting entities under AASB 138 Intangible Assets specify that
certain intangible assets that are internally generated (rather than being purchased)
cannot be recorded as assets on the balance sheet. Prior to 1 January 2005, Australian
entities had discretion to record internally generated intangibles as assets. This means
that The Snags Software Company would not be able to increase its asset base by
recognising the databases that it has created.
While it can be argued that such assets satisfy the asset definition criteria, regulators
concerns are that being able to reliably measure such assets, when they do not trade in
an active and liquid market, is problematic. If Snags had acquired the databases as
part of a business acquisition, it could legitimately record them as intangible assets
since they had been purchased.
Accounting for intangible assets is controversial and many Australian firms were
opposed to being disallowed the opportunity to recognise internally generated
intangible assets as assets on the balance sheet.
(Note: Show students an extract of a company report with derecognised identifiable
intangibles Coca-Cola would be a good example given that it had to derecognise
many millions of dollars of intangible assets).
Note: it is interesting to explore students views as to the appropriateness of having
different accounting treatments for internally generated versus acquired intangible
assets.
5.5

Trotter Pty Ltd operates a horse-riding business. The business has just been
notified that its annual insurance premium will increase from $5000 to $20
000. The owners decide not to renew their insurance but to self-insure. This
involves setting aside a portion of the profits each year to a provision for
insurance account. The provision for insurance is recognised as a liability
account on the balance sheet. Referring to the definition and recognition
criteria for recognising liability, discuss the appropriateness of Trotter Pty
Ltds accounting for self-insurance.

When deciding the appropriateness of recognising an asset or liability on the balance

sheet, it is necessary to refer to the definition and recognition criteria in the
Conceptual Framework. Referring to the Framework, a liability involves:
an outflow from the entity of resources embodying economic benefits

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Chapter 5: Balance Sheet

a present obligation to another entity

arising from a past transaction or event.

The decision of the owners of Trotter Pty Ltd not to renew their insurance but to selfinsure by setting aside a portion of the profits each year (i.e. reduce retained profits) to
a provision for insurance (i.e. increase liabilities) would not satisfy the liability
definition. As at reporting date there is no present obligation to another entity as a past
transaction (i.e. the insurable event) has not occurred. A present obligation usually,
although not necessarily, involves a legal obligation and means that the entity has no
option but to make the economic sacrifice. Reporting entities are expected to apply
the principles in the Framework and, assuming Trotter Pty Ltd is a reporting entity,
their current accounting treatment would be difficult to justify.

5.6

Knowing that you have some accounting experience, a friend has sought
your advice regarding a business that he intends purchasing. The balance
sheet for the business shows total assets of $80 000 and liabilities of $50 000.
The selling business has provided no notes to accompany the balance sheet.
On the basis of the information provided, your friend believes the business
is worth $30 000. Advise your friend as to the accuracy of his assessment
and what questions regarding the balance sheet he should ask the seller of
the business.

The carrying amount of the net assets of the entity is $30 000 (i.e. the $80 000 assets
less the $50 000 liabilities). However this does not mean that this is what the net
assets of the entity are worth. Considering the variety of measurement bases that can
be applied to an entitys assets and liabilities and the possibility that a business may
have valuable resources that are not captured on the balance sheet (i.e. strong
management), a balance sheet does not portray the worth of the entity. To illustrate,
consider an entity that acquired some land at a cost of $200 000 five years ago. The
entity can legitimately report the land on the balance sheet at its historical cost (i.e.
$200 000). This will not necessarily bear any resemblance to the current value of the
land. Assuming that real estate prices have increased, the land may currently be
valued at $500 000. Therefore carrying it at $200 000 on the balance sheet is not
reflecting its current value. As the balance sheet does not reflect the current value for
all assets and liabilities, valuing an entity based on the carrying amount of the net
assets may be inappropriate. Usually, it would be expected that the entity is worth
more than the net assets reported on the balance sheet.
This question highlights the importance of ascertaining things such as:
the measurement bases applied to the various asset and liability classes;
the depreciation method and assumptions used to calculate depreciation;
the amount of inventory on hand;
the age of the debtors;
the underlying profitability of the business;
the cash generating capability of the business;
an independent valuation of assets such as property, plant and equipment.

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Chapter 5: Balance Sheet

5.9

Frazier Ltd is always running short of cash, despite growing sales volumes
and its current assets exceeding its current liabilities. A review of its
operations by a consultant finds that a considerable portion of the
companys inventory is obsolete stock for which there is limited demand.
Further, many of the accounts receivable are overdue by more than 60
days. The accounts receivable and inventory are carried at their gross
amount and cost value respectively on the balance sheet. Explain how the
accounts receivable and inventory should be valued on the balance sheet. If
Frazier Ltd was to apply the correct measurement basis, determine the
effect on: 1.) profit and 2.) assets.

Accounts receivable should be measured at their cash equivalent. This is the cash that
the entity expects to recover. The carrying amount assigned to accounts receivable
should reflect the monies owed to the entity less an allowance for doubtful debts. The
allowance for doubtful debts represents the entitys estimate of the monies not
expected to be received. When estimating the amount to record as the allowance for
doubtful debts, entities consider the time for which the debt has been outstanding (e.g.
the collectability of debts related to invoices from 6 months ago may be remote if the
monies were due one month from the invoice date). Alternatively, based on past
experience, the entity may provide for a certain percentage of the current periods
sales to be treated as doubtful.
Inventory must be measured on the balance sheet at the lower of cost and net
realisable value. Net realisable value is the amount that the inventory could be sold for
in an orderly fashion less estimated selling costs. Thus it is necessary to compare the
cost price of inventory with the net realisable value with the lower valuation assigned
to the inventory for balance sheet purposes. For example, if inventory has a cost price
of $20 000 and it has a net realisable value of $30 000 the value assigned to the
inventory in the balance sheet would be $20 000 as the cost is lower than the net
realisable value. Conversely, if inventory has a cost price of $20 000 and it has a net
realisable value of $15 000 the value assigned to the inventory in the balance sheet
has to be $15 000 as the net realisable value is the lower value. In the latter case, this
would mean that the inventory, currently recorded at its cost price of $20 000, would
have to be written down by $5000 to $15 000. Given that an asset has been reduced,
to keep the balance sheet equation in balance, an expense of $5000 is recorded in the
income statement being the inventory write-down. Students will explore the concept
of income and expenses in Chapter 6.
If Frazier was to apply the correct measurement basis for its accounts receivable, the
entity firstly would need to estimate how much of its accounts receivable would be
uncollectable, since many of its accounts receivable are already overdue. The
estimated uncollectable accounts receivable is then debited as a bad debt expense and
is recognised in the income statement, which subsequently would reduce the entitys
profit in the current accounting period. At the same time, the estimated uncollectable
accounts receivable is also credited to an allowance for doubtful debts account, which
is a contra asset account that reduces the amount of accounts receivable. As a result,
applying the correct measurement basis for accounts receivable will reduce Fraziers
profit for the current period and its assets.

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Chapter 5: Balance Sheet

Similarly, if Frazier was to apply the correct measurement basis for its inventory, the
inventory must be valued at the lower of cost and net realisable value. As a
considerable portion of Fraziers inventory is already obsolete, the inventory must be
written down to net realisable value. The inventory write-down will reduce the
inventory value recognised in the balance sheet, and will be treated as an expense in
the income statement. As a result, Fraziers profit in the current period and its assets
will also decrease.
5.10

You are reviewing a balance sheet and notice that goodwill appears on the
statement. Relate this information to the entitys past investing decisions.
Discuss how goodwill is measured (1) at acquisition and (2) post
acquisition.

Goodwill is only permitted to be recognised as an asset in the balance sheet if it has

been acquired (i.e. purchased). Goodwill is the excess of the price paid for a business
over the fair value of the net assets acquired. Therefore, if an entity has goodwill
recorded on its balance sheet it means that the entity has purchased a business and
paid more for the business than the fair value of the net assets acquired.
As explained above, goodwill is recorded as the excess of cost over the fair value of
the net assets acquired at the acquisition date. After the acquisition, goodwill is not
amortised because it is considered to have an indefinite life. However, goodwill must
be tested for impairment at least annually. If the impairment test determines that
goodwill is impaired, the value of goodwill is then written down and an impairment
loss is recognised in the income statement.

Application and analysis exercises

5.15

Fraud
From the following account balances of Daisy Pty Ltd as at 30 September
2013, produce a balance sheet in both the T-format and the narrative
format:

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Chapter 5: Balance Sheet

Balance sheet in T-format

Daisy Pty Ltd
Balance Sheet
as at 30 September 2013
Current assets
Cash at bank

Current liabilities
$ 75 000 Tax payable

7 500

Accounts receivable (net)

37 500 Noncurrent liabilities

Inventory

30 000 Loan payable

$ 7 500

142 500 Total liabilities

$ 15 000

Non-current assets
Land
Fixtures and fittings

37 500 Equity
9 000 Share capital
46 500 Retained earnings

Total assets

$ 189 000 Total liabilities and equity

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$ 30 000
144 000
$ 189 000

Chapter 5: Balance Sheet

Balance sheet in narrative format

Daisy Pty Ltd
Balance Sheet
as at 30 September 2013
Current assets
Cash at bank

$ 75 000

Accounts receivable (net)

37 500

Inventory

30 000

Total current assets

$ 142 500

Non-current assets
Land

$ 37 500

Fixtures and fittings

9 000

Total non-current assets

$ 46 500

Total assets

$ 189 000

Current liabilities
Tax payable

$7 500

Noncurrent liabilities
Loan payable

7 500

Total liabilities

$ 15 000

Net assets

$ 174 000

Equity
Share capital

$ 30 000

Retained earnings

144 000

Total equity

$ 174 000

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Chapter 5: Balance Sheet

5.24 For each of the transactions identified, analyse how the asset, liability and/or equity accounts increase, decrease or remain
unchanged. (Hint: Remember the accounting equation.)
ASSETS (A) =
Equipment $45 000

LIABILITIES (L) +
Loan
$45 000

EQUITY (E)

a.

Obtained a loan to purchase

equipment for $45 000.

b.

The owners withdrew $3000 for

personal use.

Cash
$3000

c.

A trade receivable, who owes

$4000, made a part payment of
$2000.

Cash $2000
Accounts Receivable $2000

d.

Purchased inventory for $10 000,

paying $6000 cash and the balance
on credit.

Cash $6000
Inventory $10 000

e.

Revalued a building from its

acquisition cost less accumulated
depreciation of $100 000 to its fair
value of $150 000.

Building $50 000

Asset Revaluation
Reserve $50 000

f.

Inventory with a carrying amount

of $45 000 had a net realisable
value of $20 000.

Inventory $25 000

Equity by $25 000 as

Expense by $25 000
(inventory write-down)

Equity as Drawings
increases by $3000

Accounts Payable
$4000

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Chapter 5: Balance Sheet

5.25

A friend who owns a small entity trading as Jobs Galore knows that you
are studying accounting, and has asked if you would prepare the entitys
classified balance sheet as at 30 June. The friend has provided you with
the following list of assets and liabilities (the equity figure has not been
provided) to perform this task:

JOBS GALORE
Balance Sheet
as at 30 June
$
Assets
Current
Cash......................................................................................
Accounts receivable.............................................................
Prepaid rent...........................................................................
Total current assets...............................................................
Non-current assets
Motor vehicles......................................................................
Equipment............................................................................
Total non-current assets.......................................................

4 000
3 500
700
8 200
24 000
16 000
40 000

Total assets..........................................................................
Liabilities
Current
Accounts payable.................................................................
Accrued wages.....................................................................
Total current liabilities.........................................................

48 200

6 000
1 200
7 200

Non-current
Loan......................................................................................

18 000

Total liabilities.....................................................................
Net Assets.............................................................................
Equity..................................................................................

25 200
$23 000
$23 000

Synthesis and analysis problems

5.33

Preparing a balance sheet

Required
a.

What is the equity as at the end of the two financial years?

Equity = Total Assets Total Liabilities

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Chapter 5: Balance Sheet

Equity as at 30 June 2012

= ($6000 + $15 000 + $2500 + $6000 + $20 000 + $40 000) ($17 500 + $8000 +
$10 000 + $37 500)
= $16 500
Equity as at 30 June 2013
= ($15 000 + $14 000 + $5000 + $7000 + $20 000 + $40 000) ($26 000 + $5000 +
$10 000 + $35 000)
= $25 000
b. If Briony contributed an extra $15 000 capital during the financial year
ending 30 June 2013 and made no drawings, determine her profit (or loss)
for the year, assuming the above balances remain the same.
To calculate profit or loss for the 2013 financial year, it would be helpful to prepare an
extract of the statement of changes in equity for the period ending 30 June 2013 as
follows:
Beginning Capital, as at 1 July 2012
Add:
Additional Capital Contribution
Profit
Less:
Drawings
Ending Capital, as at 30 June 2013

$16 500 (from part (a))

15 000
???
0
$25 000 (from part (a))

Profit (loss) gained during the financial year ending 30 June 2013 is calculated as
owners equity as at 30 June 2013 less owners equity as at 30 June 2012 less
additional capital contribution, that is:
$25 000 - $16 500 - $15 000 = -$6500
This means that Briony incurred a loss of $6500 for the year ended 30 June 2013.

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Chapter 5: Balance Sheet

c.

If Briony had contributed an extra $20 000 and withdrew $15 000 during the
year ending 30 June 2013, determine her profit for the year, assuming the
above balances remain the same.

Again, it would be helpful to prepare an extract of statement of changes in equity in

order to calculate profit (loss) for the year 2013:
Beginning Capital, as at 1 July 2012
Add:
Additional Capital Contribution
Profit
Less:
Drawings
Ending Capital, as at 30 June 2013

$16 500 (from part (a))

20 000
???
(15 000)
$25 000 (from part (a))

If Briony contributed an extra $20 000 capital during the financial year ending 30
June 2013 and withdrew $15 000, her profit result for 2013 would be:
$25 000 - $20 000 (additional capital) - $16 500 + $15 000 (drawings) =
$3500

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Chapter 5: Balance Sheet

Analysis of business cases

5.52

Cabcharge Australia Limited (CAB), a company listed on the ASX,

supplies and services taxi metres. Nearly 18 000 taxis around Australia
have an EFTPOS terminal supplied by CAB. CAB also has a presence in
taxi ownership. It is affiliated with around 29 per cent of Australian taxis
through its owned networks and 441 taxi licences. The Australian
Competition and Consumer Commission (ACCC) alleged in June 2009
that CAB engaged in anti-competitive behaviour by refusing to deal with
rivals on commercial terms, that it underpriced its taxi meters to lock in
EFTPOS customers and that it struck a deal with a Townsville network
that included removing a rivals EFTPOS terminals. CAB charges a 10
per cent service fee every time a card is swiped through a CAB EFTPOS
terminal and CAB EFTPOS terminals are installed in 95 per cent of
Australian taxis. The ACCC alleged that CAB breached the law by
refusing to allow suppliers of rival EFTPOS terminals to process CAB
transactions, by supplying taxi meters and fee schedules free or below cost
and acquiring Townsville Taxiss charge account business and then
replacing rival terminals with its own. If it is found that CAB has
breached the relevant sections of the Trade Practices Act, the fines can be
up to $10 million per breach.

a.

Explain why taxi licences are recognised as assets on CABs balance sheet.

The Framework for the Preparation and Presentation of Financial Statements defines
assets as resources controlled by an entity as a result of past transactions and other
past events from which future economic benefits are expected to flow to the entity. In
addition, the Framework requires that for items to be recognised in the balance sheet
as assets, they need to satisfy the recognition criteria. Items can only be recognised as
assets if it is probable that any future economic benefit associated with the items will
flow to the entity, and the items have a cost or value that can be measured reliably.
Applying the definition and recognition criteria of assets as specified in the
Framework, taxi licences are regarded as assets since they satisfy the criteria as
follows:
future economic benefits: Taxi licences generate future economic benefits to CAB

because they give the company an exclusive right to provide taxi services to
customers, which other companies cannot do unless they register for the licences.
The future economic benefits generated would be in the form of revenue earned
from the taxi services provided.
control: The concept of control means the capacity of the entity to benefit from the

asset in the pursuit of its objectives and to deny or regulate the access of others to
the benefit. Taxi licence holders have the right to the future economic benefits
generated by the licence, and are legally able to regulate access to the benefits. For
example, CAB has control over the use of its taxis in deriving its revenue, and it
can prevent others from accessing the benefits. If other companies would like to
access the benefits of the taxi licences, they need to pay some considerations to

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Chapter 5: Balance Sheet

CAB. This also implies that CAB is able to file legal charges againts others who
are trying to access the benefits of the taxi licences without CABs permission.
past transactions: Taxi licences are a result of purchase transactions in the past.

CAB purchased the taxi licences from transport authorities, which then enables it
to have control over the licences.
probability of future economic benefits: It is probable (more likely than less likely)

that future economic benefits generated by taxi licences will flow to licence
holders as licences provide an exclusive rights for licence holders over the use of
the licences. In the case of CAB, the company has an exclusive right in providing
taxi services as a result of purchasing the taxi licences. It is probable that CAB will
receive future economic benefits generated by the taxi licences in the form of
revenue from the taxi services paid by the customers.
measurability: Before licence holders have the exclusive right over the use of the

licence, they need to purchase the licence and pay a sum of money to certain
licence registration institutions. Then they will have the right to control the use of
the licence over a period of time. CAB purchased its taxi licences from certain
transport authorities, and the money paid to purchase the licences represent the cost
of licences that can be measured reliably.
b.

Explain if the pending lawsuit should be recognised on CABs balance

sheet as a liability. If not, should it be disclosed?

Similar to the definition of assets, the Framework defines a liability as a present

obligation of an entity arising from the past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic
benefits. To be recognised in the balance sheet as a liability, it must be probable that
the outflow of resources embodying economic benefits will flow from the entity and
the item must have a cost or value that can be reliably measured.
In the case of CAB, the pending lawsuit filed by the ACCC is based on alleged
breaches of certain sections of the Trade Practices Act. If it is found that the breaches
do occur, CAB could be fined up to $10 million per breach. However, until a decision
is handed down, CAB is under no present obligation to sacrifice future economic
benefits. Further, at this stage the cost of the liability cannot be measured reliably as
the exact amount of fines that CAB may be required to pay is not yet known.
Therefore, the lawsuit should not be recognised in CABs balance sheet as a liability.
Instead, it should be disclosed as a contingent liability. It is a possible obligation
whose existence will be confirmed only by the occurrence of one or more uncertain
future events not wholly within the control of the entity. In this case, the uncertain
future event would be the courts decision regarding the lawsuit.
c.

What do you expect happened to CABs share price once it was

announced that the ACCC would be pursuing legal action? Justify your
expectations.

A companys share price generally represents how much the market values the
company, and it does not always equal its book value per share (i.e. shareholders
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Chapter 5: Balance Sheet

equity divided by total number of shares on issue). If a companys share price exceeds
its book value per share, it means that the market values some of the companys
assets which are not recognised in the companys balance sheet, such as brand name
or good management system.
The movements in a companys share price depend on the companys performance
and the markets (analysts, shareholders and potential investors) expectations on the
companys future performance. Generally if the company announces a bad news, or is
expected to announce a bad news, the companys share price will go down and vice
versa. In the case of CAB, it is expected that the companys share price will drop once
it was announced that the ACCC would be pursuing legal action. This is because the
market would consider this news as bad or negative. A pending lawsuit from the
ACCC implies that CAB faces potential fines of up to $10 million. CABs
shareholders and potential investors would not be satisfied with the news, as the
companys profits would be reduced if the court ordered CAB to pay the fines. In
addition, the ACCCs charges would also tarnish CABs reputation. If Cabcharge was
proven to be engaging in anti-competitive behaviour as the ACCC claimed, the
market would question the integrity of CABs management. Subsequently, the
companys share price would fall as the companys performance was not as what the
market expected and hence the market put less value on the company.
d. Investigate the outcome of the ACCCs allegations.
The lawsuit between the ACCC and CAB was heard in the Federal Court. CAB
admitted to all three allegations. In September 2010, the Federal Court ordered CAB
to pay a $15 million penalty, comprising $14 million in fines and $1 million towards
ACCC costs, for breaching the competition provisions in the Trade Practices Act.
The full article can be viewed at the following link:
http://www.abc.net.au/news/2010-09-24/cabcharge-to-pay-15m-penalty-in-accccase/2273320

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