Accounting 3 - 4 Cambridge

Cambridge VCE
Accounting Fourth Edition
Units
Anthony Simmons
Richard Hardy
ISBN 978-1-108-46989-0 © Simmons et al. 2019
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iii
Contents
About the authors vii
Author acknowledgements vii
Foreword viii
Features of this resource viii
Unit 3
Financial Accounting for a trading business 1
Chapter 1
The role of Accounting 2
1.1 The purpose of Accounting * 3
1.2 Users of financial information 6
1.3 The Accounting process * 8
1.4 Accounting assumptions 10
1.5 Qualitative characteristics 14
1.6 Elements of Accounting reports 18
Chapter 2
The Accounting equation 26
2.1 Assets, liabilities and owner’s equity 27
2.2 The Balance Sheet 29
2.3 Classification in the Balance Sheet 30
2.4 Double-entry Accounting 32
Chapter 3
The General Ledger 37
3.1 Ledger accounts and the General Ledger 38
3.2 Double-entry recording in ledger accounts 40
3.3 Recording revenues and expenses 43
3.4 Specific transactions 45
3.5 The Trial Balance 52
3.6 Balancing 54
Chapter 4
Cash transactions: documents, the GST and the General Journal 63
4.1 Source documents and the Goods and Services Tax 64
4.2 GST 66
4.3 The General Journal 68
4.4 Cash receipts 69
4.5 Cash sales and the GST 72
4.6 Cash payments 76
4.7 Cash payments and the GST 79
4.8 The GST Clearing account 82
Chapter 5
Accounts Payable: documents, the GST and the General Journal 95
5.1 Credit purchases and the GST * 96
5.2 Payments to Accounts Payable 101

iv C A M B R I D G E VC E AC C O U N T I N G U N I T S 3 & 4
5.3 Purchase returns * 103

5.4 Discount revenue 107
5.5 Statement of Account 111
5.6 Accounts Payable Turnover * 113
Chapter 6
Accounts Receivable: documents, the GST and the
General Journal 126
6.1 Credit sales and the GST * 127
6.2 Receipts from Accounts Receivable 132
6.3 Sales returns * 134
6.4 Discount expense 139
6.5 Statement of Account 142
6.6 The GST Clearing account 143
6.7 Accounts Receivable Turnover * 144
Chapter 7
Other transactions: documents, the GST and the General Journal 157
7.1 Memos and the General Journal 158
7.2 Non-cash contributions by the owner * 159
7.3 Non-cash drawings by the owner 162
7.4 Establishing a double-entry system (for an existing business) 164
7.5 Correcting entries 166
7.6 Other business documents 168
Chapter 8
Recording and reporting for inventory 179
8.1 Trading firms and inventory 180
8.2 Inventory cards 183
8.3 Recording in inventory cards 184
8.4 Valuing inventory: changing cost prices 189
8.5 Valuing inventory at the time of sale: Identified Cost 191
8.6 Inventory losses and gains: Identified Cost 195
8.7 Valuing inventory at the time of sale: FIFO 200
8.8 Inventory losses and gains: FIFO 204
8.9 Identified Cost versus FIFO 207
8.10 Reporting for inventory 208
8.11 Benefits of the perpetual system 210
Chapter 9
Valuing and managing inventory 224
9.1 The ‘cost’ of inventory 225
9.2 Product costs 226
9.3 Period costs and other expenses 231
9.4 Reporting product and period costs 234
9.5 The Lower of ‘Cost’ and ‘Net Realisable Value’ (NRV) rule * 237
9.6 Inventory write-down 239
9.7 Reporting an Inventory write-down 242
9.8 Inventory Turnover (ITO) * 243

C ontents v
Chapter 10
Reporting for profit 257
10.1 Determining profit or loss 258
10.2 Closing the ledger 259
10.3 Transferring Drawings 266
10.4 The Income Statement 267
10.5 Uses of the Income Statement * 270
10.6 Financial indicators 273
10.7 Communicating information: graphical representations 276
Chapter 11
Reporting for cash 294
11.1 Reporting for cash 295
11.2 The Cash Flow Statement 298
11.3 Uses of the Cash Flow Statement * 303
11.4 Financial indicators 306
11.5 Cash versus profit 307
Unit 4
Recording, reporting, budgeting and decision-making 321
Chapter 12
Balance day adjustments: prepaid and accrued expenses 322
12.1 The need for balance day adjustments 323
12.2 Prepaid expenses 325
12.3 Accrued expenses 329
12.4 The Post-adjustment Trial Balance * 334
Chapter 13
Accounting for non-current assets 1 345
13.1 Non-current assets 346
13.2 Calculating depreciation expense: straight-line method 348
13.3 Calculation issues: straight-line method 351
13.4 Recording depreciation 353
13.5 Reporting depreciation * 356
13.6 Purchasing non-current assets 359
Chapter 14
Accounting for non-current assets 2 373
14.1 Methods of depreciation 374
14.2 Calculating depreciation expense: reducing balance method 375
14.3 Comparing depreciation methods * 378
14.4 Disposal of a non-current asset 381
14.5 Profit or loss on disposal of a non-current asset 386
14.6 Trade-in of a non-current asset 387
14.7 Reporting profit or loss on disposal of a non-current asset 390
Chapter 15
Bad and doubtful debts 400
15.1 Credit sales and Accounts Receivable * 401
15.2 Balance day adjustment: Bad debts expense (Allowance for doubtful debts) 402
15.3 Subsequent periods 406
vi C A M B R I D G E VC E AC C O U N T I N G U N I T S 3 & 4
Chapter 16
Balance day adjustments: Revenues 418
16.1 The need for balance day adjustments 419
16.2 Unearned revenues 420
16.3 Unearned sales revenue: sales of inventory involving a deposit 424
16.4 Accrued revenue 427
Chapter 17
Budgeting438
17.1 Budgeting 439
17.2 The budgeting process 441
17.3 The Budgeted Cash Flow Statement * 442
17.4 Calculating cash flows 447
17.5 The Budgeted Income Statement 450
17.6 The Budgeted Balance Sheet 453
17.7 Account reconstruction 456
17.8 Variance reports: cash and profit 460
Chapter 18
Evaluating performance: profitability 478
18.1 Analysis and interpretation of profitability 479
18.2 Tools for assessing profitability 481
18.3 Return on Owner’s Investment (ROI) 484
18.4 Debt Ratio 486
18.5 Return on Assets (ROA) 488
18.6 Earning revenue: Asset Turnover (ATO) 490
18.7 Controlling expenses 492
18.8 Net Profit Margin (NPM) 493
18.9 Gross Profit Margin (GPM) 495
18.10 Vertical analysis of the income statement 497
18.11 Non-financial information * 499
18.12 Strategies to improve profitability 501
Chapter 19
Evaluating liquidity 509
19.1 Assessing liquidity 510
19.2 Working Capital Ratio (WCR) 512
19.3 Quick Asset Ratio (QAR) 514
19.4 Cash Flow Cover (CFC) 516
19.5 The speed of liquidity 517
19.6 Inventory Turnover (ITO) * 518
19.7 Accounts Receivable Turnover (ARTO) * 520
19.8 Accounts Payable Turnover (APTO) * 522
* includes ethical considerations
Glossary 532
Selected answers 539
Acknowledgements541

vii
About the authors

Anthony Simmons
Anthony Simmons B.Comm, Dip.Ed, M.Ed (Ed. Management) is Head of MNab House
at Penleigh and Essendon Grammar School. Having spent over 20 years as a teacher of VCE
Accounting, he has made important contributions to the understanding of how students learn
the discipline and think about Accounting, and how that should influence the way in which the
subject is taught. Anthony continues to be involved in all aspects of teaching VCE Accounting,
from development of the Curriculum to assessment of student understanding. As evidenced
by his involvement in this textbook series, Comview, VCTA professional learning sessions with
teachers, student lectures and published articles, Anthony is a leading voice on how Accounting
is taught and learned.
Richard Hardy
Richard Hardy B.Ec (Accounting), G Dip.Ed, PG EdAdmin, M.Ed (Admin) is Dean of Academic
Administration at Clayfield College. He has taught Accounting for over 20 years and has been a
presenter at Comview and VCTA professional development sessions. Richard has also been a
VCE Accounting examination assessor and part of the examination writing panel. He continues to
instil his passion for Accounting in all of his students.
Author acknowledgements
Although we have been working on these editions of our textbooks for a year or two, we’ve been
developing our understanding – of both Accounting as well as students and how they learn – for
the best part of 50 years between us. And in that time we have had the guidance and support of
a whole host of people who, together, have helped these books come into being.
First, we would like to thank our families. Our names might be on the cover but every word herein
only exists because of your love, patience and support. You have not only shouldered the extra
responsibilities we left every time we sat down to write, but you have given us confidence in our
abilities to understand learning, and solve the many challenges that arose along the way. Your
names appear in various exercises as a small acknowledgement of your love and support, but to
you Kristine and Erin in particular – thank you.
We would also like to thank the school leaders and other teachers at Penleigh and Essendon
Grammar School (where we both began this venture), at Balcombe Grammar School and at
Clayfield College. These learning communities informed our understanding of how people learn,
and this has been a central focus of writing these texts. In particular, we would like to thank
Tony Larkin, Matthew Dodd and Kathy Bishop who, as Principals at these schools, provided the
leadership that meant we were able to learn from and within great learning communities.
In the world of VCE Accounting our colleagues have provided ideas, feedback and inspiration and
for this we thank them all, but especially (in chronological order) Seb Italia, Jacqui Birt, Keith King,
Neville Box, Greg Gould, Diana Russo, Sue Lenz, Erin McEwan, Darrell Cruse, Steve Davis, Vicki
Baron and Celia Mara. We are also indebted to our students for providing us with insights and
feedback (especially when we got it wrong), not to mention inspiration (and not a few names) for
the exercises.
Our very special thanks to all the staff at Cambridge University Press: Nick Alexander, Linda
Kowarzik, Thuong Du, Amy Robson and our editor Karen Jayne for managing us and the whole
project and its various components. Nick – without your gentle pressure applied relentlessly we’d
never have finished.
Finally, thank you for choosing this resource. We hope it helps you to understand Accounting as a
discipline, and that as a result of using it you are able to think a little bit more like an Accountant,
so that your decisions are just a little more informed, and help you in making your own sound
financial decisions.
Anthony and Richard
viii
Foreword
Cambridge Accounting for Units 3 and 4 Fourth Edition, written for the current study
design by Anthony Simmons and Richard Hardy, represents an excellent reflection
and interpretation of the course. Each chapter follows and collates all the relevant key
knowledge into one comprehensive chapter allowing students to gain a complete and
in-depth understanding of the relationships between the various key knowledge points.
Examples and scenarios provided in each chapter enable students and teachers to be
guided as to the process and provide detailed explanations of the whys with links to
accounting assumptions, qualitative characteristics and the ever-important new concept
of ethical considerations in decision-making.
Above all else, the main features of the original text remain. The layout with margin
definitions, study tips and review questions throughout each chapter guide students in
their learning and alert them to key information.
I am pleased to be able to recommend this as an excellent resource for VCE accounting

teachers and their students.
Vicki Baron
2018
Features of this resource

Chapter openers: Each chapter opens with a summary of what is to come (Where are
we headed?) as well as a list of Key terms for you to familiarise yourself with.
Glossary terms and definitions: All of the glossary terms in each chapter are defined
for you in the margin and in the glossary at the end of the book. The glossary is also
marked with page references for ease of use.
Use of colour: Colour has been used to make it easy for you to follow particular
transactions through the Accounting process. You can simply track what impact a
transaction had in the journals, the ledger and in various reports.
Review questions: Review questions are placed at the end of each section within
each chapter, giving you the opportunity to review and reinforce your understanding as
you work through the book.
Study tips: Study tips are included in the page margin to draw attention to particular
issues, provide a technique for understanding or remembering an element of the
course content.
Ethical considerations: Ethical considerations are highlighted in the page margin to
draw attention to this particular element of the course.
End of chapter sections: At the end of each chapter, you will find a chapter summary
(Where have we been?) and exam-style Exercises, each of which is linked with an icon
to the corresponding Workbook pro-forma.
Downloadable Exercise pro-formas: In the Interactive Textbook you will find
downloadable versions of all Review questions, as well as Exercise pro-formas in both
Excel and Word formats.
Financial
Accounting for a
trading business
Unit 3
In Unit 3 of the VCE Accounting course, we will cover the following
chapters:
Chapter 1 The role of Accounting 2
Chapter 2 The Accounting equation 26
Chapter 3 The General Ledger 37
Chapter 4 ash transactions: documents, the GST
C
and the General Journal 63
Chapter 5 ccounts Payable: documents, the GST
A
Chapter 6 ccounts Receivable: documents, the
A
GST and the General Journal 126
Chapter 7 ther transactions: documents, the GST
O
Chapter 8 Recording and reporting for inventory 179
Chapter 9 Valuing and managing inventory 224
Chapter 10 Reporting for profit 257
Chapter 11 Reporting for cash 294

Chapter 1
The role of Accounting
Where are we headed?

After completing this chapter, you should be able to: • identify and explain the stages in the Accounting
• explain the purpose of Accounting process
• explain the importance of non-financial information • define and apply the Accounting assumptions and
• explain how ethical considerations affect business Qualitative characteristics
decision-making • explain the relationships between the Accounting
• identify the users of Accounting information and assumptions and Qualitative characteristics
the financial information they may require • identify and define the Elements of financial
• distinguish between financial data and financial statements.
information
Key terms
After completing this chapter, you should be familiar • Qualitative characteristics
with the following terms: – Relevance
• purpose of Accounting – Faithful representation
• Accounting – Verifiability
• non-financial information – Comparability
• ethical considerations – Timeliness
• financial data – Understandability
• financial information • materiality
• transaction • Elements of financial statements
• Accounting process – assets
– source documents – liabilities
– recording – owner’s equity
– reporting – revenue
– advice – expense.
• Accounting Standard
• Conceptual Framework
• Accounting assumptions
– Accounting entity
– Going concern
– Period
– Accrual basis

C H A P T E R 1 T H E R O L E O F AC C O U N T I N G 3
1.1 The purpose of Accounting

Decisions, decisions, decisions – we make them every day. From deciding what to wear
in the morning to choosing what we will eat for dinner, decision-making is part of our
lives as people, citizens and consumers. The bases on which we make those decisions
vary as much as the decisions themselves, as we use logic, preference, instinct, emotion
and even a ‘toss of a coin’ to make up our minds and decide what we should do.
When we reflect on the best decisions we have made, we may find that sometimes
we have been very successful ‘going with our gut’ or ‘following our heart’. But when
we think about financial decisions, it is usually the case that our best decisions are made
when we have good data and information, analyse carefully, weigh our options logically,
and then pick the one that is most likely to succeed.
In financial decisions, we need a way – a ‘system’ – to generate and analyse purpose of Accounting
information so that we may make sound decisions. This is the purpose of Accounting: to provide financial information
and advice to assist decision-
to provide financial information and advice to assist decision-making.
making
With this purpose in mind, Accounting can be described by the processes it uses to
generate and communicate financial information. That is, Accounting involves: Accounting
• collecting and recording financial data the process of collecting
• reporting, analysing and interpreting financial information and recording financial
• advising users about possible courses of action to assist decision-making. data; reporting, analysing
and interpreting financial
information; and advising users
about possible courses of action
Accounting is best described as a process – a ‘way of doing things’ – that is to assist decision-making
designed to generate financial information to support decision-making.

4 U N I T 3 F I N A N C I A L AC C O U N T I N G F O R A T R A D I N G B U S I N E S S
At its core, Accounting is about decision-making. Just as history exists as a way of

understanding the present by making sense of the past, Accounting exists as a way of
improving decision-making by making sense of financial information. Accounting cannot
guarantee that decision makers will make the right decisions, but through the provision
of information and advice it should at least help them to make more informed decisions,
increasing the chances of better decisions being made.
Accounting for small business

Accounting is used by individuals, businesses (large and small), not-for-profit organisations
Study tip and governments, and in all cases serves the purpose of generating and communicating
financial information and advice so that better decisions can be made. In this course,
we will focus on how Accounting supports decision-making for small businesses,
There are other ways to
defined (for the purpose of this course) as sole traders, where there is one owner of the
define ‘small business’,
but this course business, who is also its manager.
concentrates on sole Many owner/operators begin in business precisely because they have expertise
traders only. related to the product they are selling and the market in which it is being sold. Indeed,
it is this expertise that helps them to make decisions about selecting product lines,
setting prices and approving advertising campaigns.
However, small business owners also need detailed information about a range of
other financial issues that may affect their chances of business success, including:
• keeping financial records
• preparing financial reports
• determining the firm’s tax obligations
• managing cash and ensuring the business can meet its short-term debts
• assessing the firm’s ability to earn profit and continue operating into the future.
Accounting plays a critical role in providing important financial information on issues
like these so that the owner can make informed decisions about how to respond.
Financial information
The quality of the information generated by an Accounting system will have a direct
effect on the quality of the decisions that are made: good financial information will
Study tip improve the chances of good decisions being made.
For this reason, the Accounting profession (in conjunction with governments and
professional bodies) has developed a framework for how Accounting information should
Much of this text is be generated and reported, which includes:
concerned with applying • a number of assumptions that underpin the preparation of financial reports
these theoretical (see Section 1.4)
components, and each is • the Qualitative characteristics of the information in the reports (see Section 1.5)
explained in detail in this
• the definitions of the Elements of the reports themselves (see Section 1.6).
chapter and throughout
Each feature of the Accounting system is designed to both reflect and support this
the text as it arises.
framework for how financial information should be generated and presented.
Other considerations
However, the ability to make good decisions rests not only on the financial information
generated by an Accounting system: decision makers must also take into account
any available non-financial information, and think about the social and environmental
consequences – the ethical considerations – of a decision.
Non-financial information
Most information used in Accounting is financial in nature. Important information like
sales revenue, monthly wages, cash in the bank and even Net Profit are all measured
in dollars and cents (or another currency) and reported in the financial statements. This
information is critical to decision-making, but even the best financial information cannot
provide a complete picture.
Non-financial information is a very broad term that includes any information that non-financial information
cannot be found in the financial statements, and is not expressed in dollars and cents, any information that cannot
or reliant on dollars and cents for its calculation. It could include business-specific be found in the financial
statements, and is not
information like the number of website hits in the last month, the number of customer
expressed in dollars and cents,
complaints about a particular product, or the average length of employment for staff; or reliant on dollars and cents
to more general information like a council decision to change parking conditions at a for its calculation
shopping centre, a looming legal case about the safety of particular products, changes
to workplace laws or even the weather reports that might affect sales of ice-creams at
a beach café!
Taken together with the financial information, this non-financial information helps to
present a more complete and accurate picture of the firm’s circumstances, allowing the
owner to make more informed and thus more effective decisions.
Ethical considerations Ethical

Even with complete information, decisions themselves need to be made within an ethical considerations
context, as they can have real and lasting effects on people and the environments in
which they live. Deciding to change wages and conditions can affect not just the profit
of the business concerned, but also the livelihood of its employees and, in a small town,
the viability of the entire community. Obtaining materials from a renewable source might
mean marginally higher short-term costs, but might provide long-term sustainability of
the resource itself.
Examples like these illustrate that financial decisions usually have non-financial
consequences. For this reason, Accounting is increasingly concerned not just with
the financial parameters of decision-making, but also with its ethical ramifications.
These ethical considerations include the social and environmental consequences of ethical considerations
a decision: the effects on people, communities and society, and the local and wider the social and environmental
environment. consequences of a financial
decision
Users of Accounting information need to think about how a decision will affect not
only the financial side of the business, but also the people and community with whom
it is connected, and its local and global environment. After all, the long-term success of
a business is inextricably linked to the health of the society and environment in which
it operates.
Study tip
There is no set list of

‘ethical considerations’ in
this course, but examples
will be presented as
issues arise.

Considering all these factors – financial information, non-financial

information and ethical considerations – Accounting should be seen as
both a technical and a social practice:
• technical in that it applies specific, technical knowledge and processes
to generate, communicate and analyse financial information
• social in that it involves understanding, liaising with and advising
people who are not only responsible for decision-making, but also
affected by the decisions that are made.
Review questions 1.1

1 Explain the purpose of Accounting.
2 Define ‘Accounting’.
3 List five financial issues about which small business owners would need
detailed information.
4 Define the term ‘non-financial information’. Identify two examples of non-
financial information and explain how each might affect business decision-
making.
5 Explain why non-financial information is important for decision-making.
Ethical
6 Define the term ‘ethical considerations’ as it relates to business decision-
considerations
making.
7 Explain the importance of ethical considerations in business decision-making.
1.2 Users of financial information

This course concentrates specifically on Accounting for sole traders; that is, trading
businesses that are owned by only one person, who is usually responsible for running
the firm. For this reason, we will concentrate on the information that the owner will
want to see.
However, it is important to note that a number of different parties may be interested
in the firm’s financial information. Including the owner, these parties are known as the
‘users’ of the Accounting information, and may include:
• Accounts Receivable (debtors) and other customers, who may wish to know about
the firm’s continuing ability to provide them with goods
• Accounts Payable (creditors) and other suppliers, who may wish to know about the
firm’s ability to repay what it owes them
• banks and other financial institutions, who will want to know about the firm’s
current levels of debt before providing it with any additional finance
• employees, who may wish to know about the firm’s long-term viability – and their
long-term employment prospects – or its ability to afford improvements in wages
and conditions
• prospective owners, who may wish to know about the firm’s financial structure and
earnings performance
• the Australian Tax Office (ATO), which will require financial information for taxation
purposes.

Considering the variety of users of financial information, and the different information
each may require, what information should the Accounting system provide? This
seemingly broad question has a surprisingly straight-forward answer: the Accounting
system should provide whatever information the user decides is necessary. This means
that it is the user – not the accountant or the Accounting system – who decides what
is necessary.
Financial data versus financial information

Given that Accounting is concerned with providing information, it is worth noting the financial data
difference between financial data and financial information. Financial data refers the raw facts and figures upon
to the raw facts and figures on which financial information will be based. For most which financial information is
based
businesses, this data is contained in their receipts, cheque butts, invoices and other
business documents. For instance, a file full of business documents may provide the
details (data) relating to the firm’s activities over the last week or month.
In their original form these documents would be of limited use as the data has financial information
financial data that has
not been processed in any way. Only when this information is sorted, classified and
been sorted, classified and
summarised into a more useable and understandable form does it become financial summarised into a more
information that can be used as the basis for business decisions. This sorting, useable and understandable
classifying and summarising is performed by the Accounting system. form

1 List six likely users of financial information.
2 Explain why banks and other financial institutions will be interested in the
financial information of a small business.
3 Explain the difference between ‘financial data’ and ‘financial information’.

1.3 The Accounting process

Earlier, Accounting was described as ‘a process’ – a way of doing things – to aid decision-
Accounting process
making. This process involves financial data first being collected; then processed into
the process used to generate
financial information from a useable form; and then communicated so that the business owner has meaningful
financial data leading to the information on which to base a decision. The accountant should then provide some
provision of advice to assist guidance as to appropriate courses of action. These four ‘phases’ or ‘stages’ are the
decision-making basis of what is known as the Accounting process.
Figure 1.1 The Accounting process
Source
Records Reports Advice
documents
Stage 1: source documents

This is sometimes known as the ‘input stage’, with the source documents providing the
data on which the Accounting information is based.
transaction The most basic unit of business activity is a transaction (an exchange of goods
an exchange of goods or or services with another party), and each transaction must be verified or ‘proven’
services with another party
by a source document. Source documents are therefore the documents (paper or
source documents electronic) that provide both the evidence that a transaction has occurred and the details
documents that provide both
of the transaction itself.
the evidence that a transaction
has occurred and the details of Common source documents include:
the transaction itself • receipts (including EFTPOS) and Bank Statements, which provide evidence of cash
received by the business
• cheque butts, EFTPOS receipts (issued by the seller) and bank statements, which
provide evidence of cash paid by the business
• invoices, which provide evidence of credit sales and purchases
• memos, which provide evidence of transactions within the firm itself.
These source documents are covered in more detail in Chapter 4.
A business will enter into many transactions every day, and every one of these
transactions must be detailed on a source document, with the documents collected,
sorted and stored. As far as the Accounting process is concerned, if it isn’t written
down, it didn’t happen.

Stage 2: recording
Once the source documents have been collected, the data each contains must be
written down or noted in a more useable form, or ‘recorded’. Recording thus involves recording
sorting, classifying and summarising the data contained in the source documents so sorting, classifying and
that it is more useable. This is sometimes known as the ‘processing’ stage, where data summarising the data contained
in the source documents so that
becomes information.
it is more useable
Common Accounting records include:
• journals, which record daily transactions
• ledgers, which record the effect of transactions on each of the items in the firm’s
Accounting reports
• inventory cards, which record all the movements of inventory (stock) in and out of
the business.
These Accounting records, and how they are used, will be discussed in detail
throughout this text.
Stage 3: reporting
The ‘output’ stage of the Accounting process involves taking the information generated
by the Accounting records (in Stage 2) and reporting that financial information to
the owner of the business in an understandable form. Reporting thus involves the reporting
preparation of financial statements that communicate financial information to the owner, the preparation of financial
so that advice can be provided and decisions can be made. statements that communicate
financial information to the
There are three general-purpose reports that all businesses should prepare:
owner
• Cash Flow Statement, which reports on the firm’s cash inflows and outflows, and
the change in its cash balance over a period
• Income Statement, which reports on the firm’s revenues, expenses and profit from
its trading activities over a period
• Balance Sheet, which reports on the firm’s assets and liabilities at a particular point
in time.
This text explores each of these reports developmentally, beginning with simple
versions and adding layers of complexity as the Accounting system becomes more
advice
sophisticated. the provision to the owners of a
range of options appropriate to
Stage 4: advice their aims/objectives, together
Armed with the information presented in the reports, the owner should be in a better with recommendations as to
position to make informed decisions and take action. However, the best course of the suitability of those aims/
objectives
action is sometimes unclear. Therefore, the accountant should be able to offer advice
by presenting owners with a range of options, an assessment of those options, and
some suggestions about an appropriate response. The advice should also consider Ethical
any available non-financial information, and take into account any relevant ethical considerations
considerations.
Essentially, the Accounting process involves collecting data from source documents;
sorting it, classifying it and writing it down; communicating the financial information to
the owner; and providing advice about that information to support decision-making. It
is the provision of advice that is the accountant’s key function, as it is this advice that
assists the owner in decision-making, but the advice itself rests on the information
generated by the first three stages of the Accounting process.


1 List the four stages in the Accounting process.
2 Explain the role of source documents in the Accounting process.
3 Identify the type of transaction evidenced by the following source documents:
• receipt
• cheque butt
• invoice
• memo.
4 Explain the difference between the ‘recording’ and ‘reporting’ stages of the
Accounting process.
5 State the purpose of each of the following Accounting reports:
• Cash Flow Statement
• Income Statement
• Balance Sheet.
1.4 Accounting assumptions

By and large, accountants approach their craft from a common perspective. For instance,
all would agree that a motor vehicle purchased by the business in 2018 for $24 000
should be regarded as an asset of that business.
Accounting Standard
a technical pronouncement
that sets out the required
Accounting for particular types
of transactions and events for
businesses reporting under
company law
Study tip
This shared understanding of ‘how Accounting should be done’ rests on a mixture of

Accounting Standards
generally agreed theoretical principles, specific definitions, rules and procedures (many
underpin many of the
techniques used in this reflected in Accounting Standards), and even particular laws.
text, but students are In recent times, the International Accounting Standards Board (IASB) has attempted
not required to know to ‘codify’ these agreed principles and ideas in its ‘Conceptual Framework for Financial
the relevant Accounting Reporting’. The Conceptual Framework, as it has become known, brings together the
Standard. broad concepts that underpin the preparation of financial reports including:
• a number of Accounting assumptions that underpin the preparation of financial
reports
Conceptual Framework
• the Qualitative characteristics of the information in the reports (see Section 1.5)
a statement of generally
accepted theoretical principles • the definitions of the Elements of the reports themselves (see Section 1.6).
that form the frame of reference Taken together, the Accounting assumptions, Qualitative characteristics and
for financial reporting definitions of the Elements of the reports help accountants to make decisions about

how to report – and therefore how to record – transactions and business events. In
effect, they become the ‘rule book’ for how the game of Accounting is ‘played’, or how
Accounting should be ‘done’.
When generating Accounting information, there are certain things that accountants
agree are ‘true’, and these Accounting assumptions provide the starting point for how Accounting assumptions
Accounting information is generated and reported. the generally accepted
The Accounting system covered in this course rests on the following four Accounting principles that influence the
way Accounting information is
assumptions:
generated
• the Accounting entity assumption
• the Going concern assumption
• the Period assumption
• the Accrual basis assumption.
Accounting entity assumption

The Accounting entity assumption states that the records of assets, liabilities and Accounting entity
business activities of the entity are kept completely separate from those of the owner of assumption
the entity as well as from those of other entities. This assumption is critical for defining the assumption that the
records of assets, liabilities and
‘who’: whose Accounting information is being considered, and whose performance is
business activities of the entity
being assessed. are kept completely separate
The idea that the business and owner are considered separate may seem odd, from those of the owner of the
especially when we consider that the owner of a sole proprietorship is frequently the entity as well as from those of
person behind the counter. Indeed, from a legal perspective the owner and the business other entities
are considered to be the same, with a sole trader legally responsible for the activities
and debts of the business.
However, from an Accounting perspective the business must be assumed to be
separate from the owner. If we are to assess the performance of the business, we
must include only information relevant to the business, and provide information on that
entity only. The owner may have a beach house or a four-wheel drive, but if these items
are not contributing directly to the firm’s performance, they must not be included as
business assets.
Transactions between the business and the owner

In practical terms, the Accounting entity assumption means that the business must
have its own Accounting records, as well as its own separate bank account, and that
business bank account should only be used for business purposes. If the owner uses
business funds for personal purposes, this must be recorded in the business’ records
as ‘Drawings’ – a reduction in the owner’s equity in the business. In the same way, if
the owner contributes personal assets to the business, then this should be recorded as
a ‘Capital contribution’ from one entity (that is, the owner) to another entity (that is, the
business), increasing the owner’s equity in the business.
Going concern assumption

The Going concern assumption states that financial reports are prepared on the Going concern assumption
assumption that the business will continue to operate in the future, and its records are the assumption that the
kept on that basis. It is sometimes referred to as the ‘Continuity’ assumption, suggesting business will continue to
operate in the future, and its
the life of the business will be continuous.
records are kept on that basis
This assumption is critical for businesses being able to record and report, and value,
transactions that have occurred but which will have an effect on the firm’s future
operations. For instance, assuming the business will operate in the future allows the
business to record and report the effect of credit transactions. Where a sale is made
on credit terms, the cash will not have been received from the customer. The Going

concern assumption allows us to record these Accounts Receivable (or ‘debtors’) as

assets because at some stage in the future the business is likely to receive the cash.
The same applies to amounts the business owes to its Accounts Payable (or ‘creditors’)
for its credit purchases, which will only be paid in the future.
Further, because Going concern assumes the entity does not need or intend to
liquidate (sell) all its assets immediately, those assets do not need to be valued at
their current market value (what they would realise if sold today). Instead, assets can
be valued at what they represent in terms of future contribution to the business (i.e.
purchase price less any Accumulated depreciation).
Period assumption
Period assumption The Period assumption states that reports are prepared for a particular period of time,
the assumption that reports such as a month or a year, in order to obtain comparability of results. This assumption
are prepared for a particular has the effect of helping to define the when of reporting, effectively ‘putting brackets’
period of time, such as a month
around the transactions that are included (and excluded) in the reports, based on when
or year, in order to obtain
comparability of results they occurred. A period can be as short as the owner requires, but in most cases, to
meet taxation requirements, is no longer than a year.
The adoption of this assumption is a direct consequence of the Going concern
assumption, which assumes the business will continue to operate into the future.
Assuming the business will continue indefinitely would mean we could never calculate
profit, as the firm’s operations would never be finished.
However, if we divide the life of the business into periods of time (such as a month
or a year), it allows for profit to be determined for that period. Further, in calculating that
profit figure, we use only the revenue earned for the period, less the expenses incurred
Study tip for the period. Revenues and expenses earned or incurred outside of the current period
are excluded from the current reports, and reported in the (previous or future) period
when they occurred or will occur.
See Section 1.6 for a
The Period assumption is also significant in distinguishing between assets (whose
discussion of the
benefit extends into future reporting periods) and expenses (whose benefit is totally
difference between assets
consumed within one reporting period ). Both will bring economic benefits to the
and expenses.
business, but for differing lengths of time (and across different periods).
Accrual basis assumption

Whereas the Period assumption helps us to define the period of time for which we are
Accrual basis assumption reporting, the Accrual basis assumption helps us to decide what needs to happen for
the assumption that revenues items to be included in the reports at that time.
are recognised when earned
Strictly speaking, Accrual Accounting means that the Elements of the reports (assets,
and expenses are recognised
liabilities, owner’s equity, revenues and expenses) are recognised and reported when
when incurred, so profit is
calculated as revenue earned they satisfy the definitions and recognition criteria for those elements. That is, items
in a particular period less should be reported if and when they meet all parts of the definition. As a result, it is
expenses incurred in that period important that accountants understand and can apply the definitions of these elements.
(Section 1.6 will explore these definitions in detail.)
In practice, the Accrual basis assumption is most directly applied to revenues and
expenses, so profit is calculated by subtracting expenses incurred for the period from
revenue earned for that period.
Under the Accrual basis the definition of revenue is satisfied at the point of sale,
because this is when the economic benefit from the sale (represented by cash or an
amount due to be received from Accounts Receivable) can be measured in a faithful
and verifiable manner (by reference to the source document). This means revenues are
recognised in the period in which they are earned.

Similarly, the definition of an expense is satisfied when the consumption of the

goods or services can be measured, because this is when the decrease in assets or
increase in liabilities occurs. This means expenses are recognised in the period in which
they are incurred.
Importantly, the Accrual basis does not require cash to be received or paid for
revenues and expenses to be recognised. Even where a business has made a credit
sale and is waiting to receive cash, or has not yet paid for some of its expenses, the
Accrual basis says these amounts should still be included in the calculation of profit as
the revenue has been earned (when the goods were sold) and the expense incurred
(when the item was consumed) during the current period.

1 Define the following Accounting assumptions:
• Accounting entity assumption
• Going concern assumption
• Period assumption
• Accrual basis assumption.
2 Explain one practical consequence of adopting the Accounting entity
assumption.
3 Explain how the Going concern assumption allows businesses to:
• report assets and liabilities
• value its assets.
4 State the length of a reporting period. (Beware: this is a trick question!)
5 Explain why the implementation of the Going concern assumption requires the
adoption of the Period assumption.
6 State how profit is calculated under the Accrual basis of Accounting.
7 Explain the relationship between the Going concern, Period and Accrual basis
assumptions.

1.5 Qualitative characteristics

Whereas the Accounting assumptions describe the generally agreed principles
Qualitative characteristics that underpin the preparation of financial reports, the Qualitative characteristics
the qualities of the information describe the qualities of the information in those reports. As a group, these Qualitative
in financial reports
characteristics describe what the information ‘should be like’ if it is to be used to support
financial decision-making.
In this course, the six Qualitative characteristics of the financial information in
Accounting reports are:
• Relevance
• Faithful representation
• Verifiability
• Comparability
• Timeliness
• Understandability.
Relevance
Relevance Relevance states that financial information must be capable of making a difference to
financial information must be the decisions made by users of the report. Relevant information must be related to an
capable of making a difference
economic decision, and either help users to form predictions about the outcomes of
to the decisions made by
events or confirm (or change) their previous evaluations, or both.
users by helping them to form
predictions and/or confirm The application of Relevance helps accountants to decide what information to provide
or change their previous in the financial reports; that is, users should be provided with all information that may
evaluations make a difference to their decision, but at the same time only with information that may
make a difference to their decision.
Relevance is supported by following the Accounting entity assumption. For example,
a Balance Sheet for a business would include the assets and liabilities of that business,
as this information is useful for making predictions about future business activities (such
as meeting short-term debts). By contrast, the business’ Balance Sheet would exclude
the personal assets of the owner, and assets of other businesses, as they are assumed
to be separate entities. These assets are not being used by our business (the business
for whom we are Accounting) to earn revenue, so this information is not helpful in
making decisions about our business.
Similarly, Relevance is supported by the Period and Accrual basis assumptions. That
is, an Income Statement should include only revenues earned and expenses incurred
in the current period as these will make a difference to decisions about this year’s
performance: wages incurred last year or sales revenue to be earned next year will not
confirm or change our assessment of this year’s profit.
In short, Relevance tells us which information should be included, as well as excluded,
when financial reports are prepared: if information is capable of making a difference to
decision-making, it is relevant and should be included in the reports; if not, it should be
excluded.
Materiality
materiality The Relevance of information is determined largely by whether the nature of the item
the size or significance makes it capable of making a difference to decision-making. For instance, revenues
of financial information,
and expenses are relevant to making decisions about earning profit and so should
determined by considering
whether omitting it or be included in an Income Statement; assets and liabilities are relevant to considering
misstating it from the reports financial position and so must be reported in a Balance Sheet.
could influence decisions that However, the materiality of the item can also be important. According to the
users make Framework, information is material – and thus relevant – if omitting it or misstating it could

influence decisions that users make. Conversely, items that are too small or insignificant
to make a difference to decision-making may be considered to be immaterial, meaning
they can be reported as part of the value of a larger item, or in some cases omitted from
the reports.
For instance, Relevance might allow us to report Total Assets as $1 400 000 rather
than $1 399 480 as this difference is not material: $520 will not change decisions based
on assets of almost $1.4 million. It might also allow us to report $1.95 spent on stationery
as part of ‘Office supplies’, or even omit it from the Balance Sheet altogether (as it is
such a small amount) and instead report it as an expense. In both cases, the inclusion (or
exclusion, for that matter) of the information will not influence the decisions that users Study tip
make: it is not material, and therefore not relevant.
At the same time, information that is small may still be material. For instance, a small
payout to a customer as compensation for a faulty product may still be material and thus The application of
relevant, and therefore should be disclosed in the financial reports. The same might be materiality gives us
permission to ‘break
true for errors identified in the recording of certain expenses or the detection of theft
the rules’ in certain
or fraud.
situations, as long as
Accountants must decide whether an item is relevant by first referring to its nature,
this doesn’t compromise
with an assessment of its materiality providing a secondary ‘threshold or cut-off point’ decision-making.
to determine whether the information should be included in the financial reports.
Faithful representation
Faithful representation states that financial information must be a faithful (or ‘truthful’) Faithful representation
representation of the real-world economic event it claims to represent: complete, free financial information should be
a faithful representation of the
from material error and neutral (without bias).
real-world economic event it
Let’s unpack each aspect separately: claims to represent: complete,
• Complete means information that presents ‘the whole picture’ including, as a free from material error and
minimum, a description and a numerical valuation for the item, and any other neutral (without bias)
details that are necessary for the user to understand what is going on.
• Free from material error means information that is accurate and can be checked
or verified to support its accuracy. (Note that ‘material’ – as previously defined –
relates to significance, and small errors which will not influence decision-making
should not be thought of as negating Faithful representation.)
• Neutral (without bias) means information that is not subjective or based on
guesses, and usually means using information that can be verified by reference to
a source document rather than estimates. Where estimates cannot be avoided,
neutrality requires that they should be determined without bias towards a particular
representation or result so that they are more reliable for use.

These three aspects are applied together to ensure that financial information provides
a Faithful representation of what has occurred. For example, a Faithful representation of
an asset like a vehicle would include its Historical cost (and not just its current Carrying
value), as this original purchase price is verifiable by the source document and thus
without error and also neutral. An asset like inventory might similarly be valued at its
purchase price rather than its selling price, as the selling price is an estimate and thus
neither free from error nor neutral (but biased).
Whereas Relevance helps the accountant to decide what to include, Faithful
representation emphasises the quality of the information that has been included. If users
are to rely on financial information to make decisions, they need to have confidence that
the information they are given represents accurately (faithfully) what actually occurred,
and this will be the case only if the information is complete, free from error and neutral.
Poor information – information that is incomplete, inaccurate or biased – will lead to poor
decisions and undermine the very purpose of Accounting.
Verifiability
Verifiability Verifiability states that financial information should allow different knowledgeable
financial information should and independent observers to reach a consensus (agree) that an event is faithfully
allow different knowledgeable
represented. This is maintained by retaining source documents used to record
and independent observers
to reach a consensus (agree)
transactions and checked through auditing and other checking mechanisms (such as
that an event is faithfully a Trial Balance to verify the General Ledger or a physical inventory count to verify the
represented balance of Inventory on hand).
Verifiability is thus a core way of ensuring that Faithful representation is upheld, and
the reason estimates are not used unless absolutely necessary and budgeted (predicted)
information is not included in financial reports.
Comparability
Comparability Comparability states that financial information should be able to be compared with
financial information should similar information about other entities and with similar information about the same
be able to be compared with entity for another period or another date.
similar information about
One of the most basic uses of Accounting reports is to allow owners to make
other entities and with similar
information about the same comparisons between different businesses, and/or over time, so that they can identify
entity for another period or and understand similarities and differences in the way each business has been operating.
another date This information can then inform their decision-making and help them to improve their
firm’s operations.
However, comparisons like this require the use of consistent Accounting methods
(between businesses or between periods), so that differences in results can be linked
to differences in performance (and not just differences in Accounting methods). The
amounts in the reports do not need to be the same, but the way they are calculated does.
Where Accounting procedures are different, this should be stated clearly (disclosed)
in the reports, so that the users can make more informed assessments of what the
reports are telling them.
Timeliness
Timeliness Timeliness states that financial information should be available to decision makers in
financial information should be time to be capable of influencing their decisions.
available to decision makers If business owners are to use financial information to inform their decision-making,
in time to be capable of
that information needs to be available at the time decisions are being made. It is of
influencing their decisions
little use to receive information about ballooning wages costs only after new staff have
been hired, or to discover that sales have increased only after that product line has been
discontinued. Timely information improves the Relevance of the reports as the owner

has all the information that is capable of making a difference to their decision-making.
Generally, the more current the information is, the more useful it is to decision-making,
so up-to-date information means better decisions.
Understandability
Understandability states that financial information should be understandable or Understandability
comprehensible to users with a reasonable knowledge of business and economic financial information
activities, and presented clearly and concisely. should be understandable
or comprehensible to users
The most basic function of Accounting reports is to communicate information to
with a reasonable knowledge
the user, and for a sole trader that user is the owner. Although it is fair to assume of business and economic
that owners have a reasonable knowledge of business and economic activities, most activities, and presented clearly
small business owners are not accountants, so it is not sensible to present reports in and concisely
a form that he or she cannot understand. In addition to classifying and categorising
the information, it may be more effective to present information in graphs, tables or
charts, or simply in language that is free from Accounting jargon so that the owner can
understand what is going on.

1 Define the following Qualitative characteristics:
• Relevance
• Faithful representation
• Verifiability
• Comparability
• Timeliness
• Understandability.
2 Explain how the Accounting entity and Period assumptions ensure Relevance
in the Accounting reports.
3 Explain how an accountant could ensure the Faithful representation of a non-
current asset like a vehicle.
4 Explain how Verifiability supports the Faithful representation of financial
information.
5 Explain how the recording system supports Comparability in Accounting
reports.
6 Explain how Timeliness improves the Relevance of financial information.
7 Suggest two ways of improving the Understandability of Accounting reports.

1.6 Elements of Accounting reports

We have discussed at length the qualities that Accounting reports should possess,
but what items should they include? The Framework identifies the Elements of the
Accounting reports as:
• assets
• liabilities
• owner’s equity
• revenues
• expenses.
Assets
The word ‘asset’ is used in a variety of settings, usually to describe ‘something of
value’ (such as ‘she’s a real asset to her team’). In Accounting, the term ‘asset’ still
has connotations of value, but it is defined in a very specific way and, as with most
Accounting terms, the specifics of the definition are very important in determining
whether an item can in fact be identified as an asset.
asset In Accounting, an asset is defined as a present economic resource controlled by an
a present economic resource entity as a result of past events, where an ‘economic resource’ is a right that has the
controlled by an entity as a
potential to produce economic benefits. Let’s explore this definition a little further.
result of past events
Present economic resource

Economic resources are simply items have the potential to produce economic or
financial benefits for a business, such as ‘Bank’ (the cash held there, not the building),
‘Accounts Receivable’ (debtors), ‘Inventory’ (stock), vehicles and premises.
Under this definition items need only to represent potential economic benefits to
be recognised as assets. The idea of potential economic benefit recognises that assets
represent some sort of future economic benefit – a benefit that is yet to be received.
This reflects the Going concern assumption. For example, cash in the bank can be spent
and inventory can be sold at some point in the future; the amount owed to the business
by its Accounts Receivable will be received as cash at some time in the next month or
so; and items such as premises and vehicles will usually be used for business activities
for a number of years into the future.
On the other hand, cash paid for this month’s wages is not an asset, as there is no
potential benefit. In order to gain a further benefit from employees, a further payment
must be made. Items such as this cannot be classified as assets because their benefit
does not extend beyond what has already been received.
The idea of potential economic benefit also means that businesses can recognise
assets even when the benefit may not eventuate. For instance, inventory may remain
unsold, and Accounts Receivable may not pay, but because they both represent potential
economic benefits both may be recognised as assets.
Controlled by the entity

Further, only those items that are controlled by the entity can be defined as assets. The
definition explains that what makes these items assets for a specific business is not
ownership, but instead:
• the ability to determine how and when the item is used (such as how and when
the cash in the bank account will be spent, when Accounts Receivable are
expected to pay or how the vehicles will be used) and/or
• the right to access the benefits (such as the cash from inventory or Accounts
Receivable, or the use of a vehicle or premises).

Although a business will own many of its assets, ownership itself is not a necessary
condition for an item to be classified as a business asset: the definition actually makes Study tip
no reference to ‘ownership’ at all. Control is much broader than ownership, so the firm’s
assets will include, but not be restricted to, what it owns.
For an item to be
In addition, the item must fall under the control of the entity – the business. The
recognised as an asset,
owner’s home cannot be classified as a business asset because it is not under business it must meet each part
control. Following the Accounting entity assumption, the owner’s home is under the of the definition: an item
control of the owner, who is considered to be a separate Accounting entity from the that fails to meet any
business. of these requirements
cannot be considered to
be an asset.
Past event
This element of the definition helps to distinguish between items that are already assets,
and items that may be assets in the future, but should not be recognised as assets yet.
For instance, vehicles currently under business control become assets as a result of a
past event, namely their purchase. By contrast, an inventory that has been ordered but
not yet delivered, invoiced or paid for cannot be recognised as an asset as there is no
past event to transfer control from the supplier to the acquiring business.
Liabilities
Many people use the term ‘liability’ to refer to a debt or perhaps even a risk, but this is
more of a popular appropriation (a ‘borrowing’) of the term rather than a definition.
In Accounting, a liability is a present obligation of an entity to transfer an economic liability
resource as a result of past events. This may seem like a lot of jargon, but broken into a present obligation of an
its components it is easier to understand. entity to transfer an economic
resource as a result of past
events
Present obligation
If the business has a legal responsibility (or obligation) to settle a debt, then this debt is
likely to be a liability. In the case of a bank overdraft or mortgage, the contract with the
lender means the business is obliged to repay the amount owing. Similarly, a business
that has taken cash from a customer as a deposit is legally obliged to supply the goods.
Contrast these items with the amount that the business expects to pay next year
for advertising. This cannot be reported as a liability, as at present there is no obligation
to pay. The obligation will only occur once the firm has signed the contract, or the
advertising itself has been provided.

However, a present obligation does have consequences for the future. If the obligation
is still ‘present’, it means it must have not yet been ‘met’ or ‘settled’, meaning the
business is still obliged to take action (to settle the debt). The Going concern assumption
allows businesses to report as liabilities these amounts which are due to be settled at
some time in the future.
Transfer an economic resource

In many cases, the economic resource to be transferred will be cash, and the transfer will
occur when the business pays its debts. This would certainly be the case for amounts
owed to Accounts Payable (creditors) and banks for loans.
However, this is not always the case, as there may be an alternative economic
resource that must be transferred. A business that has received cash in advance for
goods yet to be supplied is obliged to transfer the goods. In this case, the resource is the
goods rather than cash that must be transferred to meet its obligation and settle its debt.
Past event
As with assets, this aspect of the definition helps to distinguish between items that are
already liabilities, and items that should not be recognised as liabilities yet. An entity
has a present obligation as a result of a past event only if it has already received the
economic benefits, or conducted the activities, that establish its obligation.
Owner’s equity
owner’s equity Owner’s equity is the residual interest in the assets of the entity after the deduction
the residual interest in the of its liabilities. In effect, owner’s equity is what is left over for the owner once a firm
assets of an entity after the has met all its liabilities. Because the owner and the firm are considered to be separate
deduction of its liabilities
entities, it can also be described as the amount the business ‘owes the owner’.
Given that owner’s equity is derived by deducting liabilities from assets, it is fair
to say that owner’s equity is a function of, and depends on, liabilities and assets. It is
thus the element that makes the Accounting equation balance (but more about this in
Chapter 2).
Revenues and expenses

Whereas assets, liabilities and owner’s equity represent balances – amounts at a
particular point in time – revenues and expenses represent flows: the amounts by which
those balances have increased or decreased during a period.
Revenues
revenue Revenues are increases in assets or decreases in liabilities that result in increases in
increases in assets or owner’s equity, other than those relating to contributions from the owner.
decreases in liabilities that Applying the Accounting entity assumption, inflows from capital contributions are
result in increases in owner’s
excluded because they occur not due to the activities of the business, but rather the
equity, other than those relating
to contributions from the owner actions of the owner. This means revenue represents the increases in owner’s equity
that occur through business activities.
In most cases revenue will represent what the business has gained from the goods
it has sold or the work it has done. But there are other forms of revenue, and although
revenue may take the form of cash, this is not a requirement. Credit sales would be
revenue in the form of an increase in an asset other than cash (namely, Accounts
Receivable), whereas Discount revenue would take the form of a decrease in a liability
(Accounts Payable). The key is that a revenue must increase owner’s equity, but not as
a consequence of the owner making a contribution.

Expenses
Expenses are decreases in assets or increases in liabilities that result in decreases in expense
owner’s equity, other than those relating to distributions to the owner. decreases in assets or
As with revenues, the application of the Accounting entity assumption means increases in liabilities that
result in decreases in owner’s
distributions to the owner (drawings) are excluded because they don’t contribute to the
equity, other than those relating
firm’s ability to carry out its trading activities and do not affect its ability to earn revenue to distributions to the owner
or profit.
Expenses then represent the decreases in owner’s equity that occur through
business activities or, put simply, what a business has ‘consumed’ (or ‘used up’) to Study tip
earn its revenue. Even though many expenses are measured by what is paid in cash,
this is not a requirement. Inventory loss due to theft would be an expense in the form
Compare the definitions
of a decrease in assets (Inventory), whereas wages expense could take the form of an
of revenues and
increase in liabilities (accrued wages) if it were yet to be paid. The key here is that an expenses: ‘opposites’
expense must decrease owner’s equity, but not as a consequence of the owner making can be used to remember
a withdrawal from the business. these definitions.
The Accrual basis assumption

Under the Accrual basis assumption, items are recognised when they meet the
definitions (as previously explained), and while the assumption applies to all the
Study tip
Elements of the reports – assets, liabilities, owner’s equity, revenues and expenses – it
is in relation to revenues and expenses that its effects are most notable.
Understanding the
In the case of revenues, the definition is satisfied when the increase in assets (or difference between profit
decrease in liabilities) and increase in owner’s equity occurs, so it is at this point that and cash is important
the revenue is recognised as earned. The same principle applies to expenses, which to decision-making, and
are recognised as incurred when the decrease in assets (or increase in liabilities) and so is a recurring theme
decrease in owner’s equity occurs. As a result, applying the Accrual basis assumption within this text. You
to revenues and expenses means that profit is calculated as revenues earned less may not understand it in
expenses incurred for the current period. full until the end of the
Note that in neither definition is the receipt or payment of cash required, so profit course!
under the Accrual basis assumption cannot be said to be a measure of cash received
and paid. Indeed, in most cases a firm’s profit (measured by comparing its revenue
earned and expenses incurred) will be different to its cash performance (measured
by comparing cash received and paid). Both profit and cash still require attention and
management, and sometimes strategies will affect both, but they are different measures
of performance and must be seen and managed with this in mind.

1 Define the following items, and list three examples of each (except owner’s
equity):
• asset
• liability
• owner’s equity
• revenue
• expense.
2 State one reason why wages paid is not considered to be an asset.
3 State one reason why the amount expected to be paid for advertising for next
year is not considered to be a liability.
4 Explain why a capital contribution is not considered to be revenue.
5 Explain why drawings is not considered to be an expense.
6 Explain how the Accrual basis assumption affects the recognition and reporting
of revenues and expenses.
Where have we been?

• The purpose of Accounting is to provide financial information to assist decision-making.
• The Accounting process involves collecting source documents, recording financial data and then
reporting financial information, and subsequently advising the owner on an appropriate course of action.
• Accounting assumptions are the generally accepted rules governing the way Accounting information is
generated, and include:
– Accounting entity assumption
– Going concern assumption
– Period assumption
– Accrual basis assumption.
• Qualitative characteristics are the qualities we would like our financial reports to possess, and include:
– Relevance
– Faithful representation
– Verifiability
– Comparability
– Timeliness
– Understandability.
• The three general-purpose Accounting reports are the Cash Flow Statement, the Income Statement and
the Balance Sheet.
• The Elements of the Accounting reports are assets, liabilities, owner’s equity, revenue and expenses.
Exercises
Exercise 1.1 W B page 3

Accounting assumptions
In each of the following situations, identify the appropriate Accounting assumption and explain how it should
be applied.
a Rhonda recorded the payment of her daughter’s orthodontist’s fees as a business expense.
b Falcon Cosmetics has decided to report in its Balance Sheet the amounts it still owes for goods
purchased last month.
c Because some sales contracts cover a long period of time, Roberts Records only prepares financial
reports every two years.
d Mason Manufacturing sold goods on credit but decided to wait until the cash was received before
recording the sales as revenue.
e Richmond Spare Parts values its assets at what they would realise if they were all sold on the day the
reports are prepared.
f Casee is the owner of CG Industries and paid for petrol for her business car using her own cash.
g Galvin Plastics received cash as a deposit on a sale of goods but did not report it as revenue.


Qualitative characteristics
In each of the following situations, identify the appropriate Qualitative characteristic and explain how it should
be applied.
a Alice took $350 from the cash register of her business to purchase new shoes for her son.
b Henry’s Hats was informed by a real estate agent that its business premises is currently worth $780 000,
but they decided to report it in the Balance Sheet at its original purchase price.
c Charlie Cool sells sunglasses, and in 2024 reported every month. In 2025 it provided sales updates every
6 months.
d Benelle Beauty products estimated its expenditure on electricity to be $5 200 and reported this figure in
its financial statements.
e In August 2025, Frank Howard received information that inventory losses for January 2025 were $35 000.
f Lucas Christopher is an accountant who presents Accounting information using only technical language
to increase its specificity and accuracy.
g Jean’s Jeans has reported its inventory at its likely selling price.
h Tom’s BBQs has included in its revenue for 2024 the value of sales made on credit during the year but
not due to be received until 2025.

Accounting assumptions and Qualitative characteristics
During December 2025, Bon Wilhelm paid for a family holiday using a business cheque. This transaction was
treated as a business expense, with Bon arguing, ‘It’s my business; it’s my money.’
Required
a Referring to one Accounting assumption, explain why this transaction should have been recorded as
Drawings.
b Explain how Wilhelm’s decision will undermine the Relevance of the financial reports.

In October 2025, Mark Larkin, the owner of Larkin Lighting, decided that the firm’s inventory should be valued
at its selling price rather than its cost price because, according to Mark, ‘That’s what it is actually worth.’
Required
a Referring to Verifiability, explain why the inventory must be valued at its cost price.
b Explain how valuing inventory at its selling price will undermine the ability of the reports to provide a
Faithful representation of the firm’s position.

In an attempt to satisfy Comparability, Coolick Refrigerators always reports the same figure for its Depreciation
of equipment expense.
Required
a Explain how the use of consistent Accounting methods supports Comparability.
b Referring to Comparability, explain why Coolick Refrigerators is incorrect in always reporting the same
figure for Depreciation of equipment expense.


The owner of Frosty Fridges believes its market value is shown in the Balance Sheet as the difference between
its total assets and total liabilities.
Required
a Referring to one Accounting assumption, explain why the market value of Frosty Fridges’ assets will not
be shown in its Balance Sheet.
b Referring to Relevance and Faithful representation, explain why the market value of Frosty Fridges will
not be shown in its Balance Sheet.

The Accounting department of Plastic Cups Emporium recently issued a report to a meeting of the employees
of the firm, complete with various financial statements and financial ratios. Although the employees had a
reasonable understanding of the firm’s business operations, none had specific knowledge of Accounting.
Required
a Referring to one Qualitative characteristic, explain why the Accounting
reports will not fulfil their intended function. Ethical
b Explain one reason why the Accounting department has an ethical considerations
responsibility to provide appropriate financial reports to the employees of
Plastic Cups Emporium.
c Explain one technique the Accounting department could employ to improve the appropriateness of its
financial reports.

Erica Carr’s business has been sued for false advertising, and her solicitor has indicated that she is likely to
lose the forthcoming court case and be liable to pay damages. Erica has decided to not disclose the damages
in the Income Statement.
Required
a Referring to one Qualitative characteristic, explain why Erica may wish to disclose the damages in the
reports.
b Suggest one reason why Erica may choose to not report the damages in the Income Statement.
Identify one Qualitative characteristic to support your answer. Justify your response.
c Explain how a lack of Timeliness in the availability of information might affect
the Relevance of the reports for this business. Ethical
d Discuss why this situation might present an ethical dilemma for Erica and her considerations
accountant.

W B page 13
Exercise 1.9
Accounting assumptions, Qualitative characteristics and Elements of the reports
In October 2024, Rad Magazines successfully completed a marketing campaign where readers pay in advance
for magazines to be delivered in 2025. The owner wants to record all the cash received as revenue for 2024.
Required
a Referring to one Accounting assumption, explain why the cash received should not be recorded as
revenue for 2024.
b Identify the Qualitative characteristic that will be undermined if the cash received is reported as revenue
for 2024. Justify your answer.
c Referring to the definitions of the Elements of the reports, explain why the cash received must not be
reported as revenue in 2024.

Elements of the reports
Using the definitions of the Elements of the reports, explain how each item below should be reported:
a Vehicle b Cash sales
c Loan – principal d Interest on loan
e Owner’s capital f Amounts owing from credit sales
g Wages incurred h Wages owing

Elements of the reports
Hard Utes specialises in the sale of utility vehicles. On 31 August 2025, the firm purchased a new vehicle
worth $35 000 using a loan from HQ Finance.
Required
a Explain the difference between an asset and an expense.
b Explain how the Going concern assumption affects whether the vehicle is reported as an asset or
expense in the reports of Hard Utes.
c Explain one circumstance in which the cost of the new vehicle would be reported as a current asset in
the reports of Hard Utes.
d Explain one circumstance in which the cost of the new vehicle would be reported as a non-current asset
in the reports of Hard Utes.
e Explain one circumstance in which the cost of the vehicle would be reported as an expense in the
reports of Hard Utes.

Goodwill
Over the last couple of years, Elaine has built up a loyal clientele for her fashion boutique, Fine Fashions.
These customers buy from Elaine on a regular basis because they trust her judgement and expertise, and she
knows this ‘goodwill’ is worth something.
Elaine also knows she could make a higher profit without losing her loyal customer base by maintaining the
same selling prices but switching to cheaper, imported clothing made by suppliers who treat their employees
poorly and do not pay them fairly.
Required
a Discuss whether Elaine should recognise this ‘goodwill’ as an asset. In your Ethical
answer refer to at least two Qualitative characteristics. considerations
b Discuss what action, if any, Elaine should take in relation to the products she sells.

Chapter 2
The Accounting equation

After completing this chapter, you should be able to: • explain the relationship between the Accounting
• define and identify assets, liabilities and owner’s equation and the Balance Sheet
equity • define and identify current and non-current items
• explain the relationship between the Elements of • prepare a fully classified Balance Sheet
the Accounting equation • apply the rules of double-entry Accounting
• calculate owner’s equity using the Accounting • analyse how transactions affect the Accounting
equation equation and the Balance Sheet.
Key terms
After completing this chapter, you should be familiar • current asset
with the following terms: • non-current asset
• equities • current liability
• Accounting equation • non-current liability
• Balance Sheet • double-entry Accounting.
• classification

C H A P T E R 2 T H E AC C O U N T I N G E Q U AT I O N 27
2.1 Assets, liabilities and owner’s equity

The most obvious place to start an assessment of any business is with its current situation
or, if you like, its current financial position. At its most basic, this assessment will consider
the economic resources it controls – its assets – and the obligations it has – its liabilities.
By preparing a Balance Sheet, which details these assets and liabilities, an owner can
assess the owner’s equity – the net worth of the owner’s investment in the business.
Let’s start by refreshing our understanding of how assets, liabilities and owner’s
equity are defined in Accounting terms.
Assets
As was explained in Chapter 1, assets are defined as present economic resources
controlled by an entity as a result of past events.
A common list of assets for a trading business might include the following items:
• Bank – cash kept in the business’ bank account
• Accounts Receivable (also known as ‘debtors’) – the amounts owed to the
business as a result of sales made on credit
• Inventory (also known as ‘stock’) – goods purchased and held for resale to
customers
• Fixtures and fittings – items used in the business premises, such as shelving or
window coverings
• Vehicles – cars, trucks and vans used for business purposes
• Premises – the building(s) from which the business activity is conducted.
Liabilities
Liabilities are present obligations of an entity to transfer an economic resource as a
result of past events.
A common list of liabilities might include:
• Bank overdraft – an amount owed to the bank when a business spends more than
is currently in its bank account
• Accounts Payable (also known as ‘creditors’) – the amounts owed by the business
for goods it has bought on credit
• Loan – an amount that is borrowed from a bank or other financial institution that
must be repaid at some time in the future
• Mortgage – a specific type of loan that is secured against property.
Thinking of assets as ‘what the firm owns’ and liabilities as ‘what the firm owes’ is
fine as a starting point, but such simplistic definitions will not suffice in more complex
Accounting situations (including the exam!). The more sophisticated definitions (as listed
above and described in detail in Chapter 1) must be applied to determine accurately and
conclusively whether an item is an asset or a liability.
Owner’s equity
Owner’s equity is the residual interest in the assets of the entity after the deduction
of its liabilities. Because the value of the firm’s assets must exceed its liabilities, there
will be an amount ‘left over’. Applying the Accounting entity assumption, which states
the business is separate from the owner and other businesses, this left-over amount is
then ‘owed’ to the owner, so owner’s equity is sometimes referred to as the ‘amount
owed to the owner’.
What liabilities and owner’s equity have in common is that they are both equities equities
or claims on the assets of the business. That is, liabilities are what the business owes claims on the assets of a
to external parties, while owner’s equity is what the business owes to the owner. Both business, consisting of both
liabilities and owner’s equity
types of claim must be funded from the business’s assets.
The Accounting equation

The relationship between assets, liabilities and owner’s equity is described by the
Accounting equation Accounting equation.
the rule that states that assets
must always equal liabilities
plus owner’s equity Accounting equation
Assets = Liabilities + Owner’s equity
The Accounting equation is as important to Accounting as Einstein’s theories are to

physics, and it is subject to one immutable law: it must always balance. That is, assets
must always equal liabilities plus owner’s equity. It is not possible for the equation to
be out of balance.
For instance, if a firm has assets of $820 000 and liabilities worth $685 000, its
owner’s equity must be the residual (that is, what is left over): $135 000. It is not
possible for owner’s equity to equal an amount greater than this, because there would
be insufficient assets to fund the claim.
On the other hand, it is not possible for owner’s equity to equal an amount less than
this. Of the assets of $820 000, if liabilities claimed $685 000, and the owner claimed
only $120 000, that would leave an amount of $15 000 that has not been claimed by
liabilities, nor by the owner (and no-one is suggesting it should just be given away!). It is
not possible for an amount to remain unclaimed, proving that the Accounting equation
must always balance.
Indeed, it is the fact that owner’s equity is defined as the ‘residual’ – the amount left
over – which means that the Accounting equation will always balance.

1 Define the term asset.
2 List three assets that would be found in the Balance Sheet of a typical trading
firm.
3 Define the term liability.
4 List three liabilities that would be found in the Balance Sheet of a typical trading
firm.
5 Define the term owner’s equity.
6 Referring to one Accounting assumption, explain how a business can ‘owe its
owner’.
7 Define the term equities.
8 State the Accounting equation and explain what makes it always balance.

2.2 The Balance Sheet
Source
documents
Information about a firm’s Accounting equation is communicated to the owner by the Balance Sheet
preparation of an Accounting report called a Balance Sheet, which details the firm’s an Accounting report that
assets, liabilities and owner’s equity at a particular point in time, and thus allows the details the business’s assets,
liabilities and owner’s equity at
owner to assess the firm’s current financial position.
a particular point in time
Indeed, the layout of a Balance Sheet is a direct reflection of the firm’s Accounting
equation, as is shown in Figure 2.1:
Figure 2.1 The Accounting equation and the Balance Sheet
Accounting equation
Assets = Liabilities + Owner’s equity
Balance Sheet
Assets Liabilities
plus Owner’s equity
TOTAL ASSETS TOTAL EQUITIES
A simple Balance Sheet for a trading firm may look like the one shown in Figure 2.2:
Figure 2.2 Balance Sheet

MORGAN’S MERCHANDISE
Balance Sheet as at 30 June 2025
$ $ $ $
Assets Liabilities
Bank 50 000 Accounts Payable 60 000
Inventory 340 000 Loan – MHB Bank 360 000 420 000
Accounts Receivable 120 000 Owner’s equity
Vehicles 90 000 Capital – Morgan 180 000
Total Assets 600 000 Total Equities 600 000
As with every Accounting report, the title of the Balance Sheet states who it has been
prepared for (the business, Morgan’s Merchandise), what kind of report it is (Balance Sheet)
and when it was prepared (30 June 2025). Because businesses engage in a number of
transactions every day, and every transaction changes the Balance Sheet, the Balance Sheet
is only ever accurate on the day it is prepared. Thus, the title says ‘as at’ a particular date.
Reflecting the Accounting equation, the Balance Sheet lists each asset on the left-
hand side and each liability and owner’s equity on the right-hand side. This listing of each
asset and liability upholds Relevance, as the nature and amount of each item is capable
of making a difference to decision-making. For example, the owner can identify which
assets make up the Total Assets figure, and how they can be used to generate both cash
and profit. Each of the amounts should also be Verifiable (and checkable by reference to
a source document) to ensure that the Balance Sheet provides a Faithful representation
of the firm’s financial position that is accurate, free from error and neutral (without bias).

Further, because the Accounting equation balances, so too must the Balance Sheet. In
this case, the Total Assets (all economic resources controlled by the business) of $600 000
equals the Total Equities (all claims on those resources, i.e. liabilities plus owner’s equity).
Note also how the term ‘Owner’s equity’ is used as a heading. The actual item
representing the owner’s claim is known as ‘Capital’, with the name of the owner listed
next to it. Any profits earned by the business – and thus increasing what is ‘owed’ to the
owner – would also be listed under the heading of ‘Owner’s equity’.

1 Explain the purpose of preparing a Balance Sheet.
2 Explain the relationship between the Accounting equation and the Balance
Sheet.
3 State the three pieces of information that must be present in the title of every
Accounting report.
4 Explain why the Balance Sheet is titled ‘as at’ a particular date.
5 Explain how the Balance Sheet provides information that is:
• Relevant to the firm’s financial position
• a Faithful representation of the firm’s financial position.
classification
grouping together items 2.3 Classification in the Balance Sheet
that have some common
characteristic
Given that Accounting exists to provide financial information to assist decision-making,
current asset accountants are always seeking ways to improve the usefulness of the information they
a present economic resource provide. One simple but very effective way of improving the usefulness of the Balance
controlled by an entity as a
Sheet is by classifying the information it contains. Classification involves grouping
result of past events that is
reasonably expected to be together items that have some common characteristic. In relation to the Balance Sheet,
converted to cash, sold or the assets and liabilities have already been grouped together, but within these groupings
consumed within the next the items can be classified according to whether they are current or non-current.
12 months
non-current asset Current and non-current assets
a present economic resource All assets are defined as ‘present economic resources’, but an assessment of when
controlled by an entity as each resource will bring economic benefits determines how they should be classified.
a result of past events that
Assets, like cash and other items, that are held primarily for sale or trading or are
is not held for resale and is
reasonably expected to be reasonably expected to be converted to cash, sold or consumed within 12 months
used for more than the next (that is, are expected to provide an economic benefit only in the next 12 months) are
12 months classified as current assets. Common current assets include the cash in the firm’s
Bank account, the Inventory it is holding for resale, and the amounts owed to it as
current liability
a present obligation of an Accounts Receivable.
entity to transfer an economic Any assets that are expected to provide an economic benefit for more than 12
resource as a result of past months (such as business Premises, Vehicles or Shop fittings) should be classified as
events that is reasonably non-current assets.
expected to be settled within
12 months
Current and non-current liabilities
non-current liability The same ‘12-month’ test applies to liabilities. Current liabilities are obligations that
a present obligation of an
are reasonably expected to be settled within the next 12 months, such as amounts
entity to transfer an economic
resource as a result of past owing to Accounts Payable and Loans due in the next year. By contrast, non-current
events that is not required to be liabilities are those obligations that must be met some time in more than 12 months.
settled within 12 months Longer-term loans, such as Mortgages, are the most common non-current liabilities.

Bank overdrafts
A Bank overdraft is classified as a current liability, not so much because it will be met
in the next 12 months as because it can be. That is, although it is unlikely to occur, it is
possible that an overdraft could be called in (for repayment) on very short notice, making
it a current liability.
Loans
When classifying loans, some of the amount owing may be current and some non-
current. For example, with a loan such as a Mortgage, the lender (usually a bank) would
expect the borrower (the business) to make gradual repayments off the principal rather
than repay one large amount at the end of the loan. In this case, the amount that is due
for repayment in the next 12 months would be classified as a current liability, with the
remainder (which does not have to be repaid until after 12 months) classified as a non-
current liability. As a result, the amount owing on a long-term loan may need to be split
between current and non-current liabilities.
Classified Balance Sheet

If we take the Balance Sheet shown earlier in this chapter and classify its contents, the
result would appear as is shown in Figure 2.3:
Figure 2.3 Classified Balance Sheet

MORGAN’S MERCHANDISE
$ $ $ $
Current Assets Current Liabilities
Inventory 340 000 Loan – MHB Bank 24 000 84 000
Accounts Receivable 120 000 510 000 Non-current Liabilities
Non-current Assets Loan – MHB Bank 336 000
Vehicles 90 000 Owner’s equity
Capital – Morgan 180 000
Study tip
In this classified version of the Balance Sheet, assets and liabilities have been further
classified as current or non-current. Note that different columns have been used for
reporting the amounts, with the left-hand column (on each side of the report) used Check the dates and
for listing individual amounts, and the right-hand column showing the total of each other information about
classification. This is a simple mechanism for improving the layout of the report and when a loan has to be
repaid; this is the key to
making it more user-friendly and Understandable.
identifying whether it is
Also, the $360 000 owing on the Loan – MHB Bank has been split between current
current or non-current (or
and non-current liabilities: $24 000 must be repaid in the next 12 months, with the
both).
remaining $336 000 due for repayment some time after that.
Uses of the classified Balance Sheet

With current and non-current items identified, the Balance Sheet is now more
Understandable and is more helpful for decision-making. For example, by identifying
the total amount of current liabilities, the report highlights the debts that must be repaid
in the next 12 months. The owner could then go further by comparing the firm’s current
liabilities against its current assets to assess the firm’s ability to meet those short-term
debts. With this information, the owner would be better equipped to make decisions

about future cash needs or borrowings. (This is, in effect, an assessment of the firm’s
liquidity by calculating its Working Capital Ratio but we will leave this until Chapter 19).

1 Distinguish between current assets and non-current assets.
2 List three current assets and three non-current assets.
3 Distinguish between current liabilities and non-current liabilities.
4 List three current liabilities.
5 Explain how a mortgage should be classified in the Balance Sheet.
6 Referring to one Qualitative characteristic, explain one benefit of classifying
the Balance Sheet.
2.4 Double-entry Accounting

Although the Balance Sheet states a firm’s financial position at a particular point in
time, this position is not static: it will change after every transaction. For example, if
the business buys Inventory on credit, its assets (Inventory) will increase, but so will
its liabilities (Accounts Payable); if it pays cash for new carpet, its Bank balance will
decrease, but its Shop fittings will increase.
Specifically, when a business exchanges goods and/or services with another entity,
at least two items will change in its Accounting equation and, therefore, its Balance
Sheet. This is true of every transaction that a firm could have. This means the Accounting
equation and the Balance Sheet will need to be rewritten after every transaction. At
double-entry Accounting
the same time, the Accounting equation must always balance, so even after each
a system that records at least
two effects on the Accounting transaction has been recorded, the Accounting equation – and therefore the Balance
equation as a result of each Sheet – must still balance.
transaction These two rules form the basis of what is known as double-entry Accounting.
Rules of double-entry Accounting

1 Every transaction will affect at least two items in the Accounting
equation.
2 The Accounting equation must always balance.
Example Imelda’s Shoe Shop has presented the following transactions:

1 Imelda contributed $20 000 to establish a business bank account and
commence operations as ‘Imelda’s Shoe Shop’.
2 Purchased inventory on credit from Milano Leather Products for $45 000.
3 Paid $12 000 to purchase new shop fittings.
1 Imelda contributed $20 000 to establish a business bank account and

commence operations as ‘Imelda’s Shoe Shop’.
As a result of this transaction, the business now has $20 000 in its Bank account:
an increase in its assets of $20 000. In addition, because that cash came from the
owner (who is assumed to be a separate Accounting entity), the Owner’s equity has
increased by $20 000.

The Accounting equation for Imelda’s Shoe Shop after this transaction is shown in
Figure 2.4:
Figure 2.4 Accounting equation 1

$ $ $ $
Assets Liabilities
Bank 20 000 nil
Owner’s equity
Capital – Imelda 20 000
Note how the transaction has changed two items – Bank (asset) and Capital (owner’s
equity) – both of which have increased by $20 000. As a result, the Accounting equation
still balances.
2 Purchased inventory on credit from Milano Leather Products for $45 000.
This time it is not Bank that increases, but a different asset: Inventory. On the other
side of the Accounting equation, a liability is created, called Accounts Payable,
representing the amount owed to Milano Leather Products.
The Accounting equation for Imelda’s Shoe Shop after transaction 2 is shown in
Figure 2.5:

$ $ $ $
Assets Liabilities
Inventory 45 000 Owner’s equity
Capital – Imelda 20 000
While there is no change to Bank, the new asset – Inventory – increases the
assets to $65 000. On the other side, Accounts Payable increases the equities to the
same amount and, once again, the Accounting equation balances.
3 Paid $12 000 to purchase new shop fittings.
This transaction creates a third asset – Shop fittings – but in the process decreases
Bank by the same amount. Thus, the amounts of the individual assets change
without changing the total assets figure.
The Accounting equation for Imelda’s Shoe Shop after transaction 3 is shown in
Figure 2.6:

$ $ $ $
Assets Liabilities
Inventory 45 000 Owner’s equity
Shop fittings 12 000 Capital – Imelda 20 000
In this example, there is no change on the equities side of the equation, proving
that although two items must change, they can both be on the same side of the
Accounting equation, provided that the result still balances.

1 Explain why the Accounting equation must be redrawn after every transaction.
2 State the two rules of double-entry Accounting.
Where have we been?

• Assets are present economic resources controlled by the entity as a result of past events.
• Liabilities are present obligations of the entity to transfer an economic resource as a result of past events.
• Owner’s equity is the residual interest in the assets of the entity after the deduction of its liabilities.
• The Accounting equation is ‘Assets = Liabilities + Owner’s equity’, and it must always balance.
• The Balance Sheet is an Accounting report that details the business’s assets, liabilities and owner’s
equity at a particular point in time and is a reflection of the firm’s Accounting equation.
• Assets are classified as current if they are reasonably expected to be converted to cash, sold or
consumed within the next 12 months. Assets that are not held for resale and are reasonably expected to
be used for more than the next 12 months are classified as non-current.
• Liabilities are classified as current if it is reasonably expected they will be settled within 12 months.
Liabilities that are not required to be settled within 12 months are classified as non-current.
• Double-entry accounting means each and every transaction will have at least two effects on the
Accounting equation, and after these effects have been recorded the Accounting equation must balance.
Exercises
Please note: asterisks indicate that an answer for that question is available in the selected answers section at the end of
this book.

Classifying items
Classify each of the following items as assets or liabilities, and as current or non-current:
• Accounts Payable • Bank overdraft
• Cash on hand • Capital
• Accounts Receivable • Equipment
• Mortgage (for both this year and the remainder) • Premises
• Inventory • Vehicles
• Wages owing to employees • Rent paid in advance
• GST payable.

Balance Sheet
Mark Florence is the owner of Ponte Jewellers and has provided the following list of the firm’s assets and
liabilities as at 31 May 2025:
Inventory $62 000
Accounts Payable 3 400
Loan – NAB (repayable 2025) 30 000
Shop fittings 12 000
Bank 5 900
Accounts Receivable 8 600
Office equipment 4 100
Required
a Explain what is meant by the term ‘equities’.
b Calculate Capital as at 31 May 2025.
* c Prepare a classified Balance Sheet for Ponte Jewellers as at 31 May 2025.
d Referring to your answer to part ‘c’, explain your classification of Accounts Payable.
e Explain how including ‘Bank’ in the Balance Sheet upholds Relevance.


Balance Sheet
Greg Miller owns Greg’s Gardening Supplies and has provided the following information as at
31 January 2025:
$ $
Term deposit (matures 2025) 8 000 Bank 700
Accounts Receivable 2 490 Accounts Payable 1 400
Wages owing 600 Motor vehicle 22 000
Inventory 50 000 Loan – ANZ (repayable $2000 p.a.) 36 000
Required
a Calculate Capital as at 31 January 2025.
* b Prepare a classified Balance Sheet for Greg’s Gardening Supplies as at 31 January 2025.
c Referring to your answer to part ‘b’, explain your treatment of Inventory.
d The motor vehicle is three years old, and the owner has estimated its value at $15 200, rather than
$22 000 as listed in the Balance Sheet. Explain how the motor vehicle should be valued, referring to at
least two Qualitative characteristics in your answer.

Balance Sheet
Laura Destio owns Mallacoota Wines and has provided the following information as at 30 June 2025:
Item $ Item $
Bank overdraft 2 500 Shelving 43 000
Stock 12 000 Mortgage 60 000
Creditors 5 000 Accounts Receivable 10 500
Premises 100 000 GST payable 1 700
Note: The mortgage is repayable in quarterly instalments of $1500.
Required
* a Prepare a classified Balance Sheet for Mallacoota Wines as at 30 June 2025.
b Explain why a Balance Sheet is titled ‘as at’.
c Referring to your answer to part ‘a’, explain your treatment of:
• Accounts Receivable
• Bank overdraft.
d State two external users who might be interested in this Balance Sheet.

Transactions and the Accounting equation
State the effect on the Accounting equation of each of the following transactions:
a A loan for $5 000 was received from ANZ Bank
b Office furniture worth $19 000 was purchased with cash
c $450 was paid to Accounts Payable
d The owner contributed to the business a vehicle worth $25 000
e $1 000 was paid off the loan principal
f Inventory worth $3 000 was purchased on credit from HP Enterprises
g $800 was received from an Account Receivable


Transactions and the Balance Sheet
As at 31 March 2025, the assets and liabilities of Pete’s Paint Emporium were as follows:
$ $
Assets Liabilities
Bank 2 300 Wages owing 2 000
Delivery van 25 000 Capital – Pete ?
Fixtures and fittings 18 000
Inventory 24 000
In the first week of April 2025, the following transactions occurred:
Apr. 1 Paid $3 000 to Accounts Payable

2 Borrowed $28 000 cash from the NAB, which was used to purchase another van. The loan is to be
repaid in monthly instalments of $1 000, commencing in May 2025
3 Received $2 400 from Accounts Receivable
4 Pete withdrew $1 500 worth of paint for his own purposes
5 Paid the wages owing
6 Pete contributed to the business his personal computer. Pete had paid $4 600 but on this date its
value was $4 000
Required
a Calculate Capital as at 31 March 2025.
b Explain why the computer contributed on 6 April 2025 must not be valued at $4 600. In your answer
refer to one Accounting assumption and one Qualitative characteristic.
c Prepare a table to show the effect of each transaction on the Balance Sheet of Pete’s Paint Emporium.
* d Prepare a classified Balance Sheet for Pete’s Paint Emporium as at 6 April 2025.

Transactions and the Balance Sheet
As at 30 September 2025, the assets and liabilities of Sam Booker Liquor were as follows:
$ $
Assets Liabilities
Accounts Receivable 3 000 Bank overdraft 2 500
Fixtures and fittings 15 000 Accounts Payable 7 000
Fridges 40 000 Loan – ANZ (repay. $6000 p.a.) 36 000
Inventory 25 000 Capital – Sam ?
In the first week of October 2025, the following transactions occurred:
Oct. 1 Paid $2 000 to an Account Payable

2 Sam contributed $5 000 of his own money to the business
3 Paid $3 000 off the loan principal
4 Purchased Inventory on credit for $10 000
5 Sam took home for personal use a fridge worth $2 500
6 Paid $1 200 rent in advance for the next 6 months
Required
a Prepare a table to show the effect of each transaction on the Balance Sheet of Sam Booker Liquor.
*b Prepare a classified Balance Sheet for Sam Booker Liquor as at 6 October 2025.
c Referring to your answer to part ‘b’, explain your treatment of rent paid in advance.

Chapter 3
The General Ledger

After completing this chapter, you should be able to: – cash and credit sales of inventory
• explain the role of the General Ledger – receipts from Accounts Receivable
• apply the rules of double-entry Accounting to the – payments to Accounts Payable
General Ledger – drawings by the owner
• record transactions in the General Ledger • identify the effect of transactions on the
• explain the role of a cross-reference Accounting equation using an Analysing Chart
• record in the General Ledger: • foot ledger accounts
– opening balances • prepare a Trial Balance
– cash and credit purchases of inventory • balance ledger accounts.
Key terms
After completing this chapter, you should be familiar • cross-reference
with the following terms: • Analysing Chart
• ledger account • Cost of Sales
• General Ledger • Trial Balance
• debit side • footing
• credit side • balancing.

3.1 Ledger accounts and the General Ledger
Source
documents
Chapter 2 introduced the concept of double-entry Accounting – the principle that

for every business transaction, there will be at least two effects on the Accounting
equation, and that after each transaction, the Accounting equation must still balance.
This was illustrated by any number of transactions, each of which required a redrawing
of the Accounting equation to reflect how its components had changed.
Having done some exercises in Chapter 2, it may by now have occurred to you that
rewriting the Accounting equation after every transaction would not be practical for
a real, functioning small business. (In addition, the accountant or bookkeeper would
probably find it very repetitive and boring!)
This is particularly the case when we consider that although every transaction will
change at least two items in the Accounting equation, there may well be a large number
of items that do not change. For instance, a credit purchase of inventory will increase
Inventory (asset) and Accounts Payable (liability), but will have no effect whatsoever on
Bank, Accounts Receivable, Loans or even Capital. There may be many items that do
not need to be changed, but they would still need to be rewritten in an updated version
of the Accounting equation.
The challenge then is to develop an Accounting system that is capable of recording
changes in the Accounting equation without requiring it to be rewritten every time. The
response to this challenge is to record transactions in ledger accounts.
Ledger accounts and the General Ledger

ledger account As part of the Accounting process, a ledger account is an Accounting record (like a
an Accounting record showing scrollable page) where the effects of transactions are written down, with each ledger
all the transactions that affect a account recording all of the transactions that affect a particular item in the financial
particular item
reports. For instance, the Bank ledger account will record all movements of cash in and
out of the firm’s bank account; the Inventory ledger account will record all movements
of Inventory (stock) in and out of the business; each Accounts Payable ledger account
will record all increases and decreases in what the firm owes to that supplier.
There must be a separate ledger account for each item in the reports; that is, a
separate ledger account for Bank, and a separate ledger account for each of Inventory,
Accounts Receivable, Accounts Payable, Loans, Capital, etc. If the business has 400
items in its reports, it will need 400 ledger accounts. Collectively, this group of ledger
General Ledger accounts is known as the General Ledger, and when taken together the accounts
the collective name for in the General Ledger sort, classify and summarise financial data to transform it into
the main group of ledger information that can then be used in Accounting reports.
accounts
At the same time, each individual ledger account only records the increases or
decreases in that particular item. That is, the Bank ledger account will only record
changes to Bank, and the Accounts Payable ledger account will only record changes to
amounts owed to suppliers.
Each transaction changes at least two items in the Accounting equation, so at least
two ledger accounts will need to be changed, but by recording each transaction only in
the ledger accounts of the items that are affected, changes to the Accounting equation
can be recorded without having to rewrite every item in that Accounting equation.
C hapter 3 T he G eneral L edger 39
The ‘T-form’ ledger account

The most basic form of ledger account is a ‘T-form’ account, created by dividing the
page into two columns. The left-hand column is labelled the debit column (or debit debit side
side) and the right-hand column is labelled the credit column (or credit side). Figure 3.1 the left-hand side of a ledger
shows the format of a T-form account: account
credit side
Figure 3.1 T-form account the right-hand side of a ledger
account
Name of item/account
Debit column/side Credit column/side
(Dr) (Cr)
The word ‘debit’ in this context simply means the left side of a ledger account, and
‘credit’ means the right side of a ledger account; neither one should be thought of as
good or bad. One of these columns will be used to record increases in the value of the
item; the other will be used to record decreases.
The ‘3-column’ or ‘running balance’ ledger account

General Ledger accounts can also be prepared as ‘3-column’ or ‘running balance’ ledger
accounts. These accounts retain separate columns for debit and credit entries (indeed,
there is still a ’T’ between the debit and credit entries), but it is only the amount that is
recorded on the debit or credit side. Further, they include an additional column showing
the updated (running) balance after each transaction. Figure 3.2 shows the format of a
3-column ledger account:
Figure 3.2 3-column ledger account
Name of item/account
Debit Credit
Date Details (Dr) (Cr) Balance
A 3-column ledger account is particularly suited to spreadsheets (like Excel or

Numbers) where a formula can be used to calculate the balance automatically.

1 Explain the role of a ledger account.
2 In reference to ledger accounts, define the following terms:
• General Ledger
• debit side
• credit side.
3 Explain how T-form and 3-column ledger accounts are:
• similar
• different.

3.2 Double-entry recording in ledger accounts

There are set rules for recording transactions in ledger accounts, rules that apply the
concepts of double-entry recording and preserve the Accounting equation.
Just as every transaction will affect at least two items in the Accounting equation,
every transaction will affect at least two ledger accounts. In order to ensure that the
Accounting equation remains in balance, the transaction must be recorded in one of
those ledger accounts on the debit side and in the other account on the credit side. The
rules for double-entry recording in ledger accounts are:
Double-entry rules
1 Every transaction must be recorded in at least two ledger accounts.
2 Every transaction must be recorded on the debit side of at least one
ledger account and on the credit side of at least one other account.
Given that every transaction must be recorded on the debit side of one ledger
account and the credit side of another, the most obvious question is: when are
transactions recorded on the debit side, and when are they recorded on the credit side?
Unfortunately, there is no one answer as it depends on what type of item is in question.
Fortunately, just as a T-form account looks like a Balance Sheet, the rules for recording
in a ledger account follow a similar pattern.
Assets
Asset items appear on the left of the Balance Sheet, so increases to assets are recorded
on the left – the debit side – of the asset account. By the law of opposites, decreases in
assets must be recorded on the credit side of the asset account.
Bank (Asset)
Increases are recorded on the Decreases are recorded on the
debit side credit side
Liabilities and owner’s equity

Liabilities and owner’s equity items appear on the right of the Balance Sheet, so
increases in liabilities or owner’s equity are recorded on the right – the credit side – of
those ledger accounts. By the law of opposites, decreases in liabilities and owner’s
equity must be recorded on the debit side of these accounts.
Accounts Payable (Liability)

Decreases are recorded on the Increases are recorded on the
Capital (Owner’s equity)

Decreases are recorded on the Increases are recorded on the
Recording ledger entries

Let’s examine a transaction to see how it would be recorded in the General Ledger
accounts.

Jan. 1 Bill Brighton deposited $40 000 of his own funds in a business bank Example
account to commence business operations as Bright Books.
What ledger entries are required to record this transaction?

First, the deposit by the owner means that the firm’s Bank is increasing. Because
Bank is an asset, which will appear on the left side of the Balance Sheet, the $40 000
increase must be recorded on the left side – the debit side – of the Bank ledger account.
This would be described as ‘debiting the Bank account’.
Bank (A)
Date Cross-reference Amount $ Date Cross-reference Amount $
Jan. 1 40 000
At the same time, the fact that the cash has come from the owner means that Capital
is increasing. As an owner’s equity item, Capital would appear on the right side of the
Balance Sheet, so the increase must be recorded on the right side – the credit side – of
the Capital ledger account. This would be described as ‘crediting the Capital account’.
Capital (Oe)
Jan. 1 40 000
One transaction has produced an effect on two different accounts, with one entry on
the debit side (in the Bank account) and one entry on the credit side (in the Capital account).
The cross-reference
Note how each entry in this example shows both the date of the transaction and its
amount. It has probably not escaped your attention that there is a gaping hole in each
of the ledger accounts shown – a hole that seems to require an additional piece of
information. (If it had initially escaped your attention, it should be obvious now that it
has been pointed out!)
This space between the date and the amount of each transaction is used to record
what is known as the cross-reference. Because each transaction affects two ledger cross-reference
accounts at the same time, these accounts are linked. The cross-reference specifies the name of the other account
the link between these two accounts by identifying the other account affected. In the affected by a transaction, so
that both accounts affected by
Bank account, for example, the cross-reference would be ‘Capital’, while in the Capital
a particular transaction can be
account the cross-reference would be ‘Bank’. identified
The two accounts – with their cross-references now entered – would show:
Bank (A)
Jan. 1 Capital 40 000
Capital (Oe)
Jan. 1 Bank 40 000
In reading these ledger accounts, it is the side on which the amount is placed
that determines whether the account has been debited or credited. A common
misconception is to confuse the cross-reference with the account. In this example,
the $40 000 appears on the left side of the Bank account, so it is this account that
has been debited. The cross-reference ‘Capital’ appears only to show the name of the
other account affected by that particular transaction.
Example Jan. 2 Purchased $12 000 worth of inventory on credit from KH Books

(continued) Jan. 3 Borrowed $20 000 from Sunbank
Jan. 4 Paid $15 000 for a van to use for business deliveries
Continuing with the ledger accounts used on the previous page, the transactions
would be recorded as follows:
Jan. 2 Purchased $12 000 worth of inventory on credit from KH Books
Study tip
This transaction will increase Inventory (asset) and because it is an asset (left-hand
side of the Balance Sheet), this increase must be recorded on the debit side of the
Although it is likely that Inventory account.
there will be more than At the same time, because this is a credit purchase it will increase the amount owed
one line of inventory, all to Accounts Payable (liability – right-hand side of the Balance Sheet), so the increase
transactions affecting must be recorded on the credit side of the Accounts Payable account.
Inventory will be Jan. 3 Borrowed $20 000 from Sunbank
recorded in the same This transaction increases Bank (asset) via a debit to that account, and also increases
General Ledger account. Loan – Sunbank (liability) via a corresponding credit to that account.
Jan. 4 Paid $15 000 for a van to use for business deliveries
Although Bank is an asset and would normally appear on the left side of the Balance
Sheet, this transaction actually involves a decrease to Bank. This decrease must
Study tip
therefore be recorded on the credit side of the Bank account. The increase to assets
(in the form of the new van) would be recorded on the debit side of the Van account as
In this example, one usual.
ledger account has been As a result of these transactions, the accounts in the General Ledger would then
used for all Accounts appear as shown in Figure 3.3:
Payable but later in this
text individual accounts Figure 3.3 General Ledger accounts
will be used for each
Account Payable (and General Ledger
Bank (A)
Account Receivable).
Jan. 1 Capital 40 000 Jan. 4 Van 15 000
3 Loan – Sunbank 20 000
Capital (Oe)
Jan. 1 Bank 40 000
Inventory (A)
Jan. 2 Accounts Payable 12 000
Accounts Payable (L)

Jan. 2 Inventory 12 000
Loan – Sunbank (L)

Jan. 3 Bank 20 000
Van (A)
Jan. 4 Bank 15 000

Every transaction has been recorded in at least two accounts, with a debit entry
in one account and a credit entry in another account, and after every transaction the
General Ledger has been left in balance.

1 State the two rules of recording in ledger accounts.
2 Identify on which side of a ledger account a transaction would be recorded in
order to:
• increase an asset account
• decrease an asset account
• increase a liability or owner’s equity account
• decrease a liability or owner’s equity account.
3.3 Recording revenues and expenses

The ledger rules for recording revenues and expenses can be determined by referring to
their relationship to owner’s equity.
Revenues
Revenues represent an increase in owner’s equity (it is, in fact, part of the definition),
so the rules for recording revenue are the same as those for recording an increase in
owner’s equity: increases are recorded on the credit side of the ledger account and, by
the law of opposites, decreases are recorded on the debit side.
Sales (Revenue)
Decreases are recorded on the Increases are recorded on the Study tip
Expenses Revenues and expenses

Expenses represent a decrease in owner’s equity (again, as dictated by the definition), are recorded on opposite
sides of the ledger:
so the rules for recording expenses are the same as those for recording a decrease in
revenues on the credit
owner’s equity: an increase in expenses (which means a decrease to owner’s equity)
side; expenses on the
is recorded on the debit side of the expense account, with decreases in expenses
debit side.
recorded on the credit side.
Wages (Expense)
Increases are recorded on the Decreases are recorded on the
Revenues and expenses Example

Jan. 5 Received $600 commission from a publisher (continued)
Jan. 3 Paid wages $1 200
These revenue and expense transactions would be recorded in the General Ledger
as is shown in Figure 3.4:

Figure 3.4 General Ledger: recording revenues and expenses
General Ledger
Bank (A)
Jan. 1 Capital 40 000 Jan. 4 Van 15 000
3 Loan – Sunbank 20 000 6 Wages 1 200
5 Commission revenue 600
Commission revenue (R)

Jan. 5 Bank 600
Wages (E)
Jan. 6 Bank 1 200
Figure 3.5 summarises how to record an increase or decrease in each type of ledger
account:
Figure 3.5 Summary of ledger entries
Type of account Debit side Credit side

Asset Increase Decrease
Liability Decrease Increase
Owner’s equity Decrease Increase
Revenue Decrease Increase
Expense Increase Decrease
Analysing Charts
Until these recording rules become second nature (which they will and, in fact, must), it
may be worthwhile to follow the four simple steps outlined below to record transactions
in the General Ledger:
1 Identify the items (accounts) affected. (Remember there will be at least two.)
2 Identify what type of accounts they are – A / L / Oe / R / E.
3 Identify whether they are increasing or decreasing.
4 Use the Balance Sheet (or the table above) to identify whether the account should
be debited or credited.
Analysing Chart This procedure can be followed by completing what is known as an Analysing Chart.
a tool used to identify the steps The Analysing Chart for the six transactions described earlier is shown in Figure 3.6:
for recording transactions in the
General Ledger Figure 3.6 Analysing Chart
Increase/
Date Accounts affected Type of account Decrease Debit $ Credit $
Jan. 1 Bank Asset Increase 40 000
Capital Owner’s equity Increase 40 000
Jan. 2 Inventory Asset Increase 12 000
Accounts Payable Liability Increase 12 000
Jan. 3 Bank Asset Increase 20 000
Loan – Sunbank Liability Increase 20 000
Jan. 4 Van Asset Increase 15 000
Bank Asset Decrease 15 000
Jan. 5 Bank Asset Increase 600
Commission revenue Revenue Increase 600
Jan. 6 Wages Expense Increase 1 200
Bank Asset Decrease 1 200
By convention, the debit entry is shown first, and the second entry is indented
slightly to emphasise that it is the credit entry.
The Analysing Chart is not an Accounting record; it is simply a tool to use until the ledger
entries become automatic (like training wheels when you learn to ride a bike). When you
feel that you know the ledger rules (and can balance on your own two wheels) you can stop
using the Analysing Chart and record the transactions straight into the ledger accounts.

1 Referring to their relationship to owner’s equity, explain why:
• revenue accounts increase on the credit side
• expense accounts increase on the debit side.
2 Draw a table to summarise the rules for recording in ledger accounts.
3 Explain the role of an Analysing Chart.
3.4 Specific transactions

The principles of recording in ledger accounts can be applied to any transaction using
the approach just described, but let’s consider some specific transactions.
Cash sales (of inventory)

Most of the entries that have been dealt with to date have had only two effects on the
ledger accounts: one debit entry and one credit entry. The sale of inventory – whether
for cash or on credit – is more complicated because it requires two double entries.
Figure 3.7 represents the flows of cash and goods from a sale of inventory:
Figure 3.7 Sale of inventory
Inventory
Business (the supplier) Customer
Cash
The simple mechanics of a cash sale involves the business (the supplier) receiving
cash in exchange for providing goods (inventory) to the customer.
However, the cash received and the inventory sold will be valued differently: the
cash will be for the selling price, whereas the inventory sold will be valued at its cost
price. (In fact, it is the difference between these two amounts that creates a Gross
Profit from the sale. For example, goods purchased for $320 may be sold for $590
earning $270 Gross Profit).
In the General Ledger, because there are two prices to record, there are two double
entries to record.
Selling price
A cash sale results in a receipt of cash so this increase in assets must be recorded as a
debit to the Bank account at the selling price charged to the customer.
The value of this increase in assets as a result of the sale is also recorded as revenue,
as it occurs from the ordinary activities of the business and leads to an increase in
owner’s equity. This revenue that has been earned is called Sales revenue, and it is
recorded via a credit to this (revenue) account.
Cost price
At the same time, the sale results in a decrease in the Inventory (stock) held by the
business, and this is recorded by way of a credit entry to this account. However, goods
are valued in the Inventory account at their original purchase price, so this reduction in
assets will be recorded at cost price.
The value of the decrease in Inventory as a result of the sale is also recorded as an
expense, as it arises as a result of ordinary business activities, and it leads to a decrease
Cost of Sales in owner’s equity. This expense that has been incurred is called Cost of Sales and is
the value of inventory that has recorded via a debit to this (expense) account.
been sold in a particular period, In essence then, a cash sale leads to a decrease in one asset (Inventory) valued at
valued at its cost price
cost price, in return for an increase in another asset (Bank) valued at selling price, with
the difference between the Sales revenue and Cost of Sales expense representing the
Gross Profit earned from the sale.
Example July 7 Sold inventory for $590 cash (cost price $320)
(continued)
Figure 3.8 shows how this sale affects the ledger accounts:
Figure 3.8 Analysing Chart: Cash sale
Increase/
July 7 Bank Asset Increase 590
Sales Revenue Increase 590
Cost of Sales Expense Increase 320
Inventory Asset Decrease 320
The cash sale would be recorded in the General Ledger as shown in Figure 3.9:
Figure 3.9 General Ledger: Cash sale

General Ledger
Bank (A)
July 1 Balance 1 000
7 Sales 590
Sales (R)
July 7 Bank 590
Inventory (A)
July 1 Balance 4 000 July 7 Cost of Sales 320
Cost of Sales (E)

July 7 Inventory 320
Effect on the Accounting equation

A cash sale thus has the following effect on the Accounting equation:
Increase/Decrease/No effect Amount $

Assets Increase (Increase Bank $590, decrease Inventory $320) 270
Liabilities No effect
Owner’s equity Increase (Sales $590 less Cost of Sales $320 = Profit $270) 270
Credit sales
A credit sale involves the same provision of inventory as a cash sale, but it differs in that
the cash is received from the customer at a later date.
As with a cash sale, a credit sale generates revenue because it creates an increase in
assets that leads to an increase in owner’s equity. The only difference is that for a cash sale,
the increase in assets is in the form of cash (Bank), whereas for a credit sale, the asset is
in the form of an amount owed by Accounts Receivable (sometimes known as ‘Debtors’).
July 12 Sold goods on credit for $720 (cost price $480) Example
(continued)
Figure 3.10 shows how this sale affects in the ledger accounts:
Figure 3.10 Analysing Chart: Credit sale
Increase/
July 12 Accounts Receivable Asset Increase 720
Sales Revenue Increase 720
Cost of Sales Expense Increase 480
Inventory Asset Decrease 480
Despite no cash being received, credit sales should still be recognised as revenue –
in the Period when the sale is made – because it is at this point that the increase in
assets (the amount owed by the Accounts Receivable) occurs and, as a consequence,
the revenue is earned. Failing to include credit sales as revenue would breach the Accrual
basis assumption, and it would omit from the Income Statement an important and
Relevant piece of information, capable of making a difference to decision-making.

A credit sale thus has the following effect on the Accounting equation:

Assets Increase (Increase Accounts Receivable $720, decrease Inventory $480) 240
Owner’s equity Increase (Sales $720 less Cost of Sales $480 = Profit $270) 240
In terms of profit, a credit sale and a cash sale are identical: the only difference is in
the nature of the asset (Accounts Receivable instead of Bank) that increases as a result
of the sale.
Cash received from Accounts Receivable

Following a credit sale, the business will at some point in the future receive the cash
from the Accounts Receivable customer. The most common error in recording this kind
of transaction is to treat it as additional revenue, rather than as simply the swapping of
one asset (Accounts Receivable) for another (Bank).
Indeed, the fact that assets do not increase overall means that cash received from
Accounts Receivable cannot be recorded as revenue: it does not fit the definition. In
addition, recording this cash as revenue would be double-counting the revenue that was
already recorded – as a credit sale – when it was earned; that is, at the point of sale,
when the goods were provided to the customer.
Example
July 24 $500 was received from a credit customer. (continued)
Figure 3.11 shows how this receipt from an Accounts Receivable customer would
be entered in the ledger accounts:
Figure 3.11 Analysing Chart: Receipt from Accounts Receivable
Increase/
July 24 Bank Asset Increase 500
Accounts Receivable Asset Decrease 500

A receipt of cash from an Accounts Receivable customer thus has the following effect
on the Accounting equation:

Assets No overall effect (Increase Bank, decrease Accounts Receivable) Nil
Liabilities No effect Nil
Owner’s equity No effect Nil
Overall, there is no change to total assets or, for that matter, liabilities or owner’s
equity. (Indeed, because there is no revenue earned there can be no profit from this
transaction). All that changes are the individual assets, with Bank increasing and
Accounts Receivable decreasing by the same amount.
The credit sale and the receipt of cash from the Accounts Receivable customer
would be posted to the General Ledger as shown in Figure 3.12:
Figure 3.12 General Ledger: Credit sale and receipt from Accounts Receivable
General Ledger
Bank (A)
7 Sales 590
24 Accounts Receivable 500
Accounts Receivable (A)

July 1 Balance 3 000 July 24 Bank 500
12 Sales 720
Sales (R)
July 7 Bank 590
Inventory (A)
12 Cost of Sales 480
Cost of Sales (E)

12 Inventory 480

Drawings
Drawings represents the value of the assets the owner has withdrawn from the
business. Although it is classified as an owner’s equity account, because it only records
decreases in owner’s equity it is in fact a negative owner’s equity account. This account
must therefore be debited when drawings occur. The account to be credited depends
on the asset the owner has withdrawn: if cash has been withdrawn, the Bank account
would be credited to record the decrease; if inventory has been withdrawn, then the
Inventory account would be credited.
July 28 Owner withdrew $650 in cash Example

July 31 Owner took home inventory worth $1 200 (continued)
Figure 3.13 shows how these drawings would be entered in the ledger accounts:
Figure 3.13 Analysing Chart: Drawings
Increase/
July 28 Drawings – Owner’s equity Increase 650
Bank Asset Decrease 650
July 31 Drawings – Owner’s equity Increase 1 200
Inventory Asset Decrease 1 200
These entries would be posted to the General Ledger as shown in Figure 3.14:
Figure 3.14 General Ledger: Drawings
General Ledger
Bank (A)
July 1 Balance 1 000 July 28 Drawings 650
7 Sales 590
Inventory (A)
31 Drawings 1 200
Drawings (–Oe)
July 28 Bank 650
31 Inventory 1 200

Drawings – of cash or some other asset – thus has the following effect on the Accounting
equation:

Assets Decrease (Decrease Bank $650, Inventory $1 200) 1 850
Owner’s equity Decrease (Increase Drawings $1 850) 1 850
Total Drawings – in this case $1 850 ($650 cash and $1 200 inventory) – is then
reported in the Balance Sheet under the heading ‘Owner’s equity’, but as a deduction
from Capital, as is shown in Figure 3.15:
Figure 3.15 Balance Sheet: Owner’s equity
MICKELHAM FRAMES
Balance Sheet (extract) as at 30 June 2025
$ $
Owner’s equity
Capital 23 000
Plus Net Profit 500
23 500
Less Drawings 1 850 21 650
Opening balances
When ledger accounts are started for a business that has already been trading for some
time, there will be pre-existing balances for items in its reports and these balances
must be entered in the ledger accounts before any new transactions can be recorded.
The normal rules for recording in ledger accounts still apply, such as increases in assets
on the debit side, and increases in liabilities and owner’s equity on the credit side.
However, the balances in each account will be the product of a number of different
transactions, and thus will not be traceable to one single account. This means that the
cross-reference can be stated as simply ‘Balance’.
Example The assets and equities of Mickelham Frames as at 1 July 2025 were as follows:
Bank $1 000 Accounts Payable $2 000

Inventory 4 000 Capital – Malloy 23 000
Shelving 17 000
Even when entering opening balances, a proper double entry must still be recorded,
with total debits equalling total credits. Figure 3.16 shows the Analysing Chart to enter
these opening balances:
Figure 3.16 Analysing Chart: Opening balances
Increase/
July 1 Bank Asset Increase 1 000
Inventory Asset Increase 4 000
Accounts Receivable Asset Increase 3 000
Shelving Asset Increase 17 000
Accounts Payable Liability Increase 2 000
Capital Owner’s equity Increase 23 000

Figure 3.17 shows how these opening balances would be entered in the ledger
accounts:
Figure 3.17 General Ledger: Opening balances

General Ledger
Bank (A)
Inventory (A)

Shelving (A)
July 1 Balance 17 000 Study tip
If the capital figure is
not given, it can always
Capital (Oe) be calculated using the
Date Cross-reference Amount $ Date Cross-reference Amount $ Accounting equation:
July 1 Balance 23 000 OE = A – L.

1 Show the debit and credit entries necessary to record:
• a cash sale (of inventory)
• a credit sale
• a receipt from Accounts Receivable
• cash drawings.
2 Explain why cash received from Accounts Receivable does not increase profit.

3.5 The Trial Balance

Once all transactions have been recorded in the General Ledger, it must be checked to
see that the Accounting equation still balances; that is, that the total debits equal the
Trial Balance total credits. This check is carried out by preparing a Trial Balance, which is a list of all
a list of all the accounts in the ledger accounts and their balances, with the balance being the ‘net amount’ left in
the General Ledger, and their an account.
balances, to determine if total
debits equal total credits
Footing ledger accounts
footing Before the Trial Balance can be prepared, each ledger account must be ‘footed’. Footing
an informal process used to is the process of informally calculating the balance of an account, and involves the
determine the balance of a following steps:
ledger account
1 Adding up all the amounts on the debit side, and then pencilling the total below the
last debit amount.
2 Adding up all the amounts on the credit side, and then pencilling the total below
the last credit amount.
3 Deducting the smaller total from the larger total.
4 Pencilling this figure – the balance – on the side of the larger total, and then
drawing a circle around it.
This balance should not be written in the same column as the other amounts,
because this risks inadvertently (and incorrectly) counting it as an additional entry. The
balance should be written in the cross-reference section to make it clear that it is not
an entry, but the balance of the account. Figure 3.18 shows how a Bank account would
be footed:
Figure 3.18 Footing an account
General Ledger
Bank (A)
March 1 Balance 12 500 March 3 Wages 4 000
15 Sales 6 000 12 Rent 9 000
22 Accounts Receivable 3 400 25 Drawings 6 250
2 650
21 900 19 250
The balance of the Bank account is thus $2 650 (on the debit side, meaning it is an
asset).

The Trial Balance

Once all the accounts have been footed, the balances are listed in two columns: one for
debit balances and one for credit balances. The columns are then totalled and – if the
ledger recording is correct – the totals should be the same. Figure 3.19 shows the Trial
Balance for Clack’s Shoe Shop as at 31 March 2025:
Figure 3.19 Trial Balance

CLACK’S SHOE SHOP (PROP. G. CLACK)
Trial Balance as at 31 March 2025
Account Debit $ Credit $
Advertising 400
Bank 2 650
Buying expenses 200
Capital – Clack 19 350
Cost of Sales 5 600
Drawings 2 500
Inventory 22 000
Interest revenue 100
Loan – KH Bank 40 000
Rent 1 500
Sales 13 000
Wages 2 100
Study tip
Totals 78 950 78 950
Errors revealed If the Trial Balance does

If the Trial Balance does not balance, the ledger entries have not been recorded not balance, look for a
correctly, perhaps because: transaction involving
• two entries have been recorded on the same side of the General Ledger (for the amount identified as
example, two debits or two credits, instead of one debit and one credit) the difference, half the
• only one entry has been recorded (for example, one debit entry without a difference or twice the
corresponding credit entry, or vice versa) difference, and check this
• different amounts have been recorded on each side (for example, $450 on the entry first.
debit side, but $4 500 on the credit side).
In this case, the entry that has caused the difference between the two totals must
be found and corrected.
Errors not revealed

In spite of its benefits, the usefulness of a Trial Balance as a diagnostic tool in detecting
errors is limited: it will only detect errors if total debits do not equal total credits. One or
more of the following errors may be present in the ledger accounts even when the Trial
Balance balances:
• A transaction has been omitted altogether.
• The debit and credit entries have been reversed. (For example, instead of recording
a payment to an Account Payable by debiting Accounts Payable and crediting
Bank, the entry is erroneously recorded as a debit to Bank and a credit to Accounts
Payable.)

• The transaction has been recorded in the wrong ledger accounts. (For example,
instead of recording the payment of wages as a debit to the Wages account, the
transaction is incorrectly debited to Rent.)
• An incorrect amount is recorded on both sides of the ledger.
None of these (incorrect) entries would be detected or revealed by a Trial Balance
because each of them still has a matching debit and credit entry. That is, even though
the entry would be wrong, there would still be an amount recorded on the debit side
and an equal amount recorded on the credit side. The Trial Balance is a useful tool, but
it will not detect all the errors that may exist in the ledger.

1 State the purpose of a Trial Balance.
2 Referring to ledger accounts, state what is meant by the term ‘footing’.
3 List the steps involved in footing a ledger account.
4 State three errors that will be detected by the preparation of a Trial Balance.
5 State four errors that will not be detected by the preparation of a Trial Balance.
3.6 Balancing
Footing is an informal process that can be done to any account at any time to determine
balancing its balance. But balancing asset, liability and owner’s equity accounts must occur at
ruling off an asset, liability the end of the period, with these accounts formally ‘ruled off’ so that their balances
or owner’s equity account to can be reported in the Balance Sheet and also carried forward to the next period. This
determine its balance at the
helps to ensure Relevance in the Balance Sheet, as only the accurate and up-to-date
end of the current period and
transferring that balance to the figures (from the end of the period) which might make a difference to decision-making
next period are reported.
Balancing ledger accounts

Balancing an account involves the following steps:
1 Totalling the amounts on each side, and then writing the larger of these two totals
on both sides.
In the example on the next page, the transactions on the debit side add up to
$21 900, and the transactions on the credit side add up to only $19 250, so $21 900
is written on both sides. This figure should be ‘ruled off’ with a double line to
indicate that in the current Period there are no more transactions that affect the
account.
This is not the balance of the account: it is the total. At this point, the amounts
on only one side – in this case the debit side – will add up to this total of $21 900.
2 Calculating the balance by deducting the total of the smaller side from the total of
the account.
In the example, this is $21 900 (total) – 19 250 (smaller side) = $2 650 (balance).
3 Entering this balance as a proper ledger entry, with a matching debit and credit:
– above the total on the smaller side
– below the total on the larger side.
This entry ‘carries forward’ the balance from the end of one period to the start of the
next. This is why in the example the date is given as March 31 above the total but as
April 1 below.

Figure 3.20 shows the ‘Bank’ account after it has been balanced:
Figure 3.20 Balancing an account

General Ledger
Bank (A)
Date Cross-reference Amount $ Date Cross-reference Amount $ Study tip
March 1 Balance 12 500 March 3 Wages 4 000
15 Sales 6 000 12 Rent 9 000
22 Accounts Receivable 3 400 25 Drawings 6 250 Compare this ‘balanced’
31 Balance 2 650 account with the ‘footed’
account in Figure 3.18.
21 900 21 900
The balance of the
April 1 Balance 2 650
account is the same, but
this account has been
In this example, the balance of $2 650 must be recorded on the credit side above the more formally completed.
total so that the credit side adds up to $21 900. It must then be transferred to the debit
side, but below the total, as the opening balance for the next period (beginning April 1).
Balancing versus footing

Both footing and balancing involve calculating the balance of an account, but there are
three main differences:
1. Balancing is done only at the end of the period.
2. Only asset, liability and owner’s equity accounts are balanced. (Revenue and expense
accounts are closed. This will be covered in detail in Chapter 9.)
3. Balancing is a more formal process, involving a proper double entry; that is, a debit
and matching credit entry.

1 List the steps involved in balancing a ledger account.
2 Explain why the entries required to balance a ledger account are shown with
different dates.
3 List three differences between footing and balancing a ledger account.
Where have we been?

• A ledger account is an Accounting record showing all the transactions that affect a particular item.
• The General Ledger is the collective name for the main group of ledger accounts.
• The left-hand side of a ledger account is the debit side; the right-hand side is the credit side.
• Every transaction must be recorded in at least two ledger accounts. Every transaction must have a debit
entry and a credit entry.
• To record an increase in assets or expenses, record the transaction on the debit side.
• To record an increase in liabilities, owner’s equity or revenues, record the transaction on the credit side.
• The cross-reference specifies the link between two accounts by identifying the other account affected.
• Footing is an informal process to calculate the balance of an account.
• Errors a Trial Balance will reveal: two entries recorded on the same side; only one entry recorded; or a
different amount recorded on each side.
• Errors a Trial Balance will not reveal: a transaction omitted altogether; debit and credit entries reversed; a
transaction recorded in the wrong ledger accounts; or an incorrect amount recorded on both sides of the
ledger.
• Balancing involves ruling off an asset, liability or owner’s equity account to determine its balance at the end
of the current period and transferring that balance to the next period.

Exercises
this book.

Recording in the General Ledger
Jane Green is an ex grounds-keeper who has just gone into business for herself selling lawn seed, operating
under the name Reap and Sow. Her transactions for the first week of May 2025 are shown below:
May 1 Contributed $40 000 cash to commence business

2 Rented a small office, paying $500 rent for May 2025
3 Purchased inventory worth $8 000 on credit from Lush Lawnseed
4 Paid $3 000 for office furniture
5 Paid $150 for advertising in the local paper
6 Jane contributed to the business her personal computer (fair value $1 200)
Required
a Prepare an Analysing Chart to show the double entry required to record each entry
in the General Ledger of Reap and Sow.
b Record the transactions for the first six days of May 2025 in the General Ledger of Reap and Sow.
c Referring to the definitions, explain why the transaction on 3 May 2025 creates a liability for Reap and
Sow.
d Referring to one Accounting assumption, explain why the transaction on 6 May 2025 must be recorded
in the accounts of Reap and Sow.

Recording in the General Ledger
Phil Meecup just commenced business as Quick Perk, a company that sells coffee machines. The following
transactions occurred during the first week of November 2025:
Nov. 1 Phil contributed $25 000 cash to commence business

2 Purchased premises for $140 000 using a mortgage from the Bank of RLM
3 Purchased inventory worth $50 000 on credit from NewCaffe Supplies
4 Paid wages to office manager $1 900
5 Phil withdrew $1 000 cash for personal use
6 Paid $4 000 for advertising that will not begin until December 2025
7 Paid NewCaffe Supplies $1 500
Required
a Prepare an Analysing Chart to show the double entry required to record each entry in the General Ledger
of Quick Perk.
b Record the transactions for the first week of November 2025 in the General Ledger of Quick Perk.
c Explain how the Going concern assumption affects the recording of the transaction on 2 November
2025.
d Referring to the definitions, explain why the advertising should be recognised as a current asset as at
7 November 2025.


Cash sales in the General Ledger
Melita Anogra just opened Melita Mows, a shop specialising in the sale of mowers. The firm’s transactions
for the first week of January 2025 showed the following:
Jan. 1 Contributed capital to commence business – $15 000 cash and one vehicle $22 000 (fair value)
2 Paid rent of $600 for January 2025
3 Purchased mowers on credit for $45 000 from Havanna Mowers
4 Sold one mower for $700 cash (cost price $500)
5 Paid wages of assistant $150
6 Sold two mowers for $700 cash each (cost price $500)
7 Paid $2 500 to Havanna Mowers
Required
a Explain why the vehicle contributed on 1 January 2025 must be valued at its fair value.
b Prepare an Analysing Chart to show the double entry required to record each
entry in the General Ledger of Melita Mows.
c Record the transactions for the first week of January 2025 in the General Ledger of
Melita Mows.
d State the effect on the Accounting equation of the transaction on 4 January 2025.
e Explain how valuing inventory at its cost price ensures Faithful representation in the Balance Sheet.
f Calculate Gross Profit for Melita Mows for the first week of January 2025.

Cash and credit sales in the General Ledger
Kim Swood just opened her own spare parts shop called Monaro Motors. Transactions for August 2025
showed the following:
Aug. 1 Capital contribution of $10 000 inventory (fair value) and $30 000 cash
2 Purchased premises worth $150 000 paying a $10 000 cash deposit with the balance funded by a
mortgage from QV Bank
3 Cash sale of parts for $400 (cost price $200)
4 Paid $2 500 cash to Wilson Fittings for shelving
5 Purchased inventory on credit from HolFord Parts for $2 600
6 Sold parts on credit to Lemon Rentals for $900 (cost price $450)
7 Paid wages of apprentice $600
8 Kim Swood took home inventory worth $1 500
9 Received $500 cash from Lemon Rentals
Required
a Prepare an Analysing Chart to show the double entry required to record each transaction in the General
Ledger of Monaro Motors.
b Record the transactions for August 2025 in the General Ledger of Monaro Motors.
c Explain how the Accrual basis assumption affects the reporting of the transaction on 6 August 2025.
d State the purpose of preparing a Trial Balance.
* e Foot the accounts and prepare a Trial Balance as at 9 August 2025.


Opening balances in the General Ledger
Finoula O’Riley owns a small shop called Hot Doggies that sells dog-grooming products. Finoula has been
operating for three years, but on 1 June 2025 decided to adopt a double-entry recording system. Her opening
account balances on 1 June 2025 were Bank $1 500, Inventory $5 000, Accounts Receivable $8 000, Shelving
$16 000, Loan – CF Bank $6 000 and Capital – O’Riley $24 500.
Transactions for June 2025 showed the following:
June 1 Received $2 000 cash from Accounts Receivable (Lynx) for inventory sold in May 2025
2 Finoula contributed her laptop to the business (fair value $2 500)
3 Inventory was sold on credit to Allendale Kennels for $1 000 (cost price $650)
4 Paid wages $900
5 Purchased inventory worth $1 900 on credit from Laminar Products
6 Cash sales of $120 (cost price $80)
7 Received $500 from Allendale Kennels
8 Purchased extra shelving for $3 200 cash
9 Cash sales of $230 (cost price $150)
10 Paid $700 off the loan – CF Bank
11 Inventory was sold on credit to Joanie’s Dog Wash for $500 (cost price $380)
12 Paid wages $900
Required
a Record the opening balances in the General Ledger of Hot Doggies as at 1 June 2025.
b Record the transactions for June 2025 in the General Ledger of Hot Doggies.
c Referring to the definitions of the Elements of the reports, explain why the cash received from Lynx on
1 June 2025 should not be reported as revenue for June 2025.
d Explain the effect on the Accounting equation of Hot Doggies if the transaction on 6 June 2025 had not
been recorded.
* e Foot the accounts and prepare a Trial Balance for Hot Doggies as at 12 June 2025.
f State one error that would cause the Trial Balance to not balance.


Opening balances in the General Ledger
Paul McMartin is the owner/operator of Bright Camping, a business that sells camping gear. On 1 October
2025, Paul decided to adopt a double-entry recording system. The firm’s balances on that date were as
follows: Inventory $70 000, Accounts Receivable $34 000, Shop fittings $17 000, Premises $100 000, Loan –
Highland Bank $90 000, Accounts Payable $51 000 and Bank overdraft $1 000.
The transactions for October 2025 were as follows:
Oct. 1 Credit sale to Sleepy Hollow Caravan Park for $10 000 (cost price $5 000)
2 Purchased new shop fittings for $5 000 – 10% paid in cash with the remainder financed by a
short-term loan from Punkah Credit Co.
3 Received $8 000 cash from Accounts Receivable (Milawa Adventures)
4 Cash sales of $2 000 (cost price $1 000)
5 Paul paid $130 for the firm’s advertising using a personal cheque
6 Purchased camping gear on credit from Hardy Camp Gear for $12 000
7 Paid wages of $700
8 Received $4 000 cash from Sleepy Hollow
9 Sold inventory on credit to High Peak Adventures for $3 500 (cost price $1 750)
10 Paid $7 000 to Accounts Payable (Jillaroo’s Choice)
Required
a Record the opening balances in the General Ledger of Bright Camping.
b Record the transactions for October 2025 in the General Ledger of Bright Camping.
c Explain the importance of a cross-reference when recording transactions in ledger accounts.
d Referring to the definitions of the Elements of the reports, explain why the transaction on 7 October
2025 should be reported as an expense.
* e Foot the accounts and prepare a Trial Balance for Bright Camping as at 10 October 2025.
f State two errors in the General Ledger that will not be detected by a Trial Balance.


Identifying transactions
Mira Van Sanden is a photographer who owns and operates a shop in Melbourne called Perfect Photographs. The
firm’s General Ledger for December 2025 showed the following:
General Ledger
Bank (A)
Dec. 1 Balance 1 000 Dec. 3 Office equipment 100
2 Sales 900 Dec. 6 Repairs 150
Inventory (A)
Dec. 1 Balance 5 000 Dec. 2 Cost of Sales 600
8 Accounts Payable 800 5 Cost of Sales 400

Dec. 1 Balance 1 700 Dec. 7 Bank 300
5 Sales 600
Office equipment (A)

Dec. 1 Balance 4 000 Dec. 4 Drawings 250
3 Bank 100

Dec. 1 Balance 1 100
8 Inventory 800
Capital (Oe)
Dec. 1 Balance 9 600
Sales (R)
Dec. 2 Bank 900
Drawings (–Oe)
Dec. 4 Office equipment 250
Cost of Sales (E)

Dec. 2 Inventory 600
5 Inventory 400
Repairs (E)
Dec. 6 Bank 150

Required
a Using the General Ledger, describe each transaction (in date order).
b Calculate the rate of mark-up that is applied to sales of inventory.
* c Prepare a Trial Balance for Perfect Photographs as at 8 December 2025.
On 9 December 2025, Mira paid $200 for Office equipment. The transaction was posted into the General
Ledger as follows:
Ledger account Debit $ Credit $

Office equipment 200
Bank 200
d State whether the Trial Balance would identify this error. Justify your answer.
e Explain the effect on the Accounting equation of Perfect Photographs if this error was not corrected.
f Show the debit and credit entries necessary to correct this error.


Transactions to reports
Turning Points is a firm that sells exercise machinery. Its owner, Tracey Nicole, has decided to adopt a double-
entry recording system. At 1 July 2025, the firm’s assets and liabilities were as follows:
Accounts Payable $7 500 Mortgage – JH Finance $85 000

Accounts Receivable 2 000 Office equipment 10 900
Bank 1 200 Premises 190 000
Inventory 52 000
The firm’s transactions for July 2025 showed the following:
July. 1 Cash sale to R. Donnegan (cost price $400) $800

3 Paid for electricity 450
6 Credit sales to Lowdown Gym (cost price $2 700) 5 400
7 Purchased exercise machinery on credit from Havilland Machines 4 000
9 Paid wages 500
11 Credit sales to St Martin’s Hospital (cost price $3 500) 7 000
14 Received cash from Walkers’ World for goods sold in June 2025 1 600
17 Paid cash to Havilland Machines 1 000
19 Made monthly payment on mortgage (including $200 interest) 700
20 Tracey took home an exercise machine for her son 600
23 Paid wages 500
25 Cash sale to J. Notts (cost price $290) 580
27 Received cash from Lowdown Gym 5 400
31 Paid in advance for six months’ advertising, which will begin in August 2025 6 000
Required
a Calculate Tracey’s capital as at 1 July 2025.
b Record the opening balances in the General Ledger of Turning Points.
c Record the transactions for July 2025 in the General Ledger of Turning Points.
* d Balance the accounts (where appropriate) and prepare a Trial Balance as at 31 July 2025.
e Referring to one Accounting assumption, explain why the transaction on 14 July 2025 is not considered
to be revenue for July 2025.
f State the effect on the Accounting equation of Turning Points if the transaction on 19 July 2025 was not
recorded.
* g Prepare an Income Statement for Turning Points for July 2025.
* h Prepare a classified Balance Sheet for Turning Points as at 31 July 2025.
i Referring to one Qualitative characteristic, explain why the advertising must be reported in the Balance
Sheet as at 31 July 2025.

Chapter 4
Cash transactions: documents, the GST
and the General Journal

After completing this chapter, you should be able to: • explain how cash transactions affect the financial
• explain the role of source documents in the reports
Accounting process, including their relationship to • apply Accounting skills to cash transactions
the Qualitative characteristics including:
• explain the effect of the Goods and Services – cash receipts such as capital contributions and
Tax (GST) on the Accounting system of a small cash sales
business – cash payments such as purchases of inventory,
• identify the characteristics of a tax invoice payments for expenses and drawings
• calculate GST on transactions and the GST • explain the effect of transactions on the Accounting
balance equation
• explain the role of the GST Clearing account • explain the circumstances in which a GST refund
• explain the role of the General Journal and GST settlement will occur
• identify cash transactions from source documents • record GST refunds and settlements in the General
• record cash transactions in the General Journal and Journal and General Ledger
General Ledger • report GST Clearing in the Balance Sheet
• explain the effect on the Accounting equation of • discuss ethical considerations in business decision-
cash transactions making.
Key terms
After completing this chapter, you should be familiar • General Journal
with the following terms: • narration
• Goods and Services Tax (GST) • cash receipt
• tax invoice • Bank Statement
• GST Clearing • EFT receipt
• GST settlement • credit card receipt
• GST refund • cheque butt.

4.1 Source documents and the Goods and Services Tax
Source
documents
Source documents
With the aim of assisting decision-making, the Accounting process must begin with the
raw financial data about the firm’s transactions. The exercises in Chapter 3 (involving
recording transactions in the General Ledger) were generally presented as a list, with
the date and details of the transaction spelt out clearly. This is not a luxury afforded to
bookkeepers in real businesses. In a functioning business, the information would be
contained on the source documents, and part of the job of the bookkeeper would be to
sort the documents and decipher the information they contain.
Source documents come in a variety of shapes and sizes, but they have in common
one essential quality: they provide the evidence, or proof, that a transaction has occurred.
Source documents are thus the first stage in the Accounting process and provide the
facts and details on which all subsequent Accounting information – and decision-making –
will be based.
Because source documents provide evidence of the details of every transaction,
they are integral in ensuring that the data in the Accounting records is Verifiable (that is,
supported by evidence and can be checked). In turn, this ensures that the Accounting
reports provide a Faithful representation of the firm’s transactions: complete, neutral
(without bias) and free from material error.
The Goods and Services Tax

Already important in providing the financial data on which financial information is based,
Goods and Services Tax the introduction in July 2000 of the Goods and Services Tax (GST) – which applies
(GST) to most goods (except fresh food) and services – provided an added incentive for the
a 10% tax levied by the federal careful use of source documents.
government on most purchases
Under the GST, the federal government charges consumers a tax of 10% of the price
of goods (excluding fresh food)
and services of whatever they have purchased. However, responsibility for charging the customer –
and ultimately collecting the GST from that customer – rests with each business that
sells the goods/services. These businesses must therefore charge the customer the
selling price plus an amount for GST, and at a later date transfer to the Australian Tax
Office (ATO) any overall GST owing.
With this legal responsibility as a tax collector in mind, most businesses are even
more interested in source documents to ensure that they pay to the ATO only what
they owe.

C hapter 4 C A S H T R A N S AC T I O N S 65
Source documents and the GST

The source document used to verify a transaction involving the GST is a tax invoice. In tax invoice
order to be called a tax invoice, and be used to substantiate a GST transaction, a source a source document that
document must include particular details, including: contains specific information
required by the ATO to
• the words ‘Tax Invoice’ stated clearly
substantiate GST amounts
• the name of the seller
• the Australian Business Number (ABN) of the seller
• the date of the transaction
• a description of the good/service provided
• the price of the transaction, including the GST
• the amount of the GST.
Sales of more than $1 000 must also show the name and address or ABN of the
buyer.
All tax invoices are source documents, but not all source documents are tax invoices:
only those that contain the information listed above can be called tax invoices and be
used to substantiate GST transactions.
Figure 4.1 shows how a tax invoice might show the information listed above:
Figure 4.1 Tax invoice
Snaps Photographic Equipment

22 Grace St, Essendon VIC 3041
ABN: 11 049 411 049
TAX INVOICE
Sold to: G. Love 12 March 2025
34 Napier St, Essendon, 3041 Terms: Cash only
ABN: 22 654 885 001 Rec. 06
Item Quantity Unit Price Total
Brixol Camera stand (BR101) 2 90 180.00
GST (10%) 18.00
Total $198.00
Amount paid 198.00
Balance owing nil
Study tip
This tax invoice is a cash receipt issued by Snaps Photographic Equipment for a cash
sale to G. Love, which included $18 GST. The business named at
Without all these important details, a source document cannot be classified as a the top of the source
document is always the
tax invoice and therefore cannot be used to substantiate GST transactions, and the
seller – the business
business may end up owing the ATO more GST than is required.
providing the goods and/
As a result, the GST source documents – already important in providing details and
or service.
evidence of transactions – have become more significant.

1 Referring to the Qualitative characteristics, explain the role of source
documents in the Accounting process.
2 Define the term ‘Goods and Services Tax (GST)’.
3 List the information that must be shown on a source document to substantiate
GST.
4 Explain the importance of source documents for a small business when
Accounting for the GST.

4.2 GST
At the end of the period, each business must calculate how much GST overall it owes to
the ATO, or whether it is owed a refund by the ATO. This means the Accounting system
must be capable of identifying, calculating, recording and reporting the effects of GST.
Calculating GST
Although a tax invoice must specify the amount of the GST, it is still useful to understand
the relationship between:
• the selling price of the good/service (excluding GST)
• the GST itself
• the total price of the transaction (including GST).
In its simplest form, GST is calculated as 10% of the selling price, and added to the
selling price to determine the total price, as shown in Figure 4.2:
Study tip
Figure 4.2 Calculating GST and total price (including GST)
GST Total price
Use this method when a Selling price + (selling price × 10%) = (including GST)
question says ‘plus’ GST. $350 + $35 = $385
At other times, it may be necessary to work backwards from the total price, to
determine either the GST (1/11 of the total price) or the selling price (10/11 of the total
price). Figure 4.3 shows this relationship:
Study tip
Figure 4.3 Calculating GST or selling price from total price

Use this method when a Total price Selling price GST
question says ‘including’ (including GST) = (10/11 of total price) + (1/11 of total price)
GST. $385 = $350 + $35
GST balance
When a business charges its customers GST, it does so on behalf of the government.
As a result, any GST on sales creates a liability as the GST is owed to the ATO.
However, if the business has been charged any GST by its own suppliers, it is allowed
to deduct this GST on purchases from its GST liability. That is, because the GST charged
on its purchases will be forwarded to the ATO by the firm’s suppliers, it is treated as if
the business had paid the GST straight to the ATO.
Example Victoria’s Kennel sells clothing for dogs and during March 2025 the following
transactions occurred:
• Purchased goods for sale from MP Products worth $400 plus $40 GST
• Sold goods to A. Pittance worth $750 plus $75 GST

The GST ‘flows’ for this business are shown in Figure 4.4:
Figure 4.4 GST flows
Customer:
A. Pittance
$75
GST on sales
$75 on GST on sales

less $40 GST on
Victoria’s Kennel
purchases =
$35 GST owed to ATO
$40
GST on purchases Receives $75 GST
ATO $35 from Victoria’s Kennel
plus $40 from MP Products
Supplier:
MP Products $40 owed to ATO
In this case, despite charging $75 GST on sales to its customer (A. Pittance),
Victoria’s Kennel would only owe $35 GST to the ATO as the $40 GST on its purchases
will be transferred to the ATO by the supplier, MP Products, (ensuring the ATO will still
ultimately receive the full $75 GST on sales).
The overall amount owed to the ATO for GST is thus determined as:
Overall GST owing = GST on sales less GST on purchases
Reporting GST
Source
documents
All transactions involving GST are recorded in a new ledger account called GST Clearing GST Clearing
(covered in detail throughout this chapter), but the overall GST may be reported as either a ledger account that records
a current liability or a current asset depending on its balance. all GST transactions
GST liability
Because selling prices are usually higher than cost prices, in most cases the GST on
sales will be greater than the GST on purchases. This means that, overall, the business
will owe GST to the ATO.
As a result, its Balance Sheet will report GST as a current liability: a present obligation
GST settlement
of the entity (as the GST owing to the ATO must be paid) to transfer an economic a cash payment to the ATO to
resource (cash) as a result of a past event (or in this case events) involving GST. This settle a GST liability from a
GST liability must be paid at some time in the future by making a GST settlement. previous period
GST asset
If the business makes a bulk order of inventory which it has not yet sold, or purchases
an expensive non-current asset, then its GST on purchases could be greater than its
GST on sales, meaning the ATO actually owes GST to the business.
In this case, the business will have a current asset in relation to GST: a present
GST refund
a cash receipt from the ATO economic resource (cash to be received from the ATO) controlled by the entity (as the
to settle a GST asset from a business has a right to claim the cash) as a result of a past event. This GST owed to
previous period the business by the ATO will be received at some time in the future as a GST refund.

1 Show how the GST will affect the calculation of:
• total price when given selling price
• selling price/GST when given total price.
2 Explain why GST on sales creates a GST liability.
3 Explain why GST on purchases leads to a reduction in any GST liability.
4 Explain why most small businesses will end up with a GST liability at the end
of the period.
5 Define the term ‘GST settlement’.
6 State two ways a small business could end up being owed a GST refund by
the ATO.
7 Define the term ‘GST refund’.
4.3 The General Journal
Source
documents
If we return to the Accounting process, there is a clear need to connect the important
General Journal financial data contained on source documents with the recording that takes place in the
an Accounting record used General Ledger, so that the reports which are generated provide financial information
to analyse and record each that is both Relevant and a Faithful representation of the firm’s financial situation and
transaction, and to identify its performance. The General Journal provides this connection.
source document before posting The General Journal records each transaction before it is posted to the General
to the General Ledger
Ledger, allowing for the identification of the source document that verifies the
transaction, and an analysis of how the transaction affects the General Ledger.
Study tip
Format of the General Journal
All transactions must be recorded in the General Journal before they are posted to
Some businesses the General Ledger, and because the General Journal is used to record a variety of
use special journals transactions, it must have a fairly simple format. As a result, it has columns for Date
to summarise similar and Details; and a Debit column and a Credit column to record amounts, as is shown in
transactions before Figure 4.5:
posting to the General
Ledger, but Units 3 and
Figure 4.5 The General Journal
4 of the VCE Accounting
course – and many types General Journal
of Accounting software Date Details Debit $ Credit $
– use only a General
Journal.

The most obvious and immediate thing to notice is how closely the General Journal
resembles the analysing charts we used when learning the ledger recording process
(in Chapter 2). Basically, transactions are recorded in date order (as they occur), with
the Details column used to record the name of each ledger account affected by the
transaction. The amount is then recorded in the debit or credit column as is necessary.
By convention, the debit entries are recorded first, followed by the credit entries, with
the name/s of the account/s to be credited indented slightly.
The key thing to remember about the debit and credit columns in the General
Journal is that, for each transaction, the debit entries must equal the credit entries. If
the transaction does not balance in the General Journal, it cannot balance when it is
posted to the General Ledger.
Narrations narration
Because the General Journal records a wide variety of transactions, it is necessary to a brief description of a
transaction recorded in the
give a brief description of the transaction immediately after recording the debit and
General Journal, including a
credit entries. This description is known as a narration, which should ‘tell the story’ of
reference to the relevant source
what has happened, and also note the source document involved. document
Let’s now consider some specific transactions, the source documents used to verify
their details, and how they would be recorded in the General Journal and General Ledger.

1 Explain the role of the General Journal in an Accounting system.
2 Explain how the rules of double-entry Accounting apply to the General Journal.
3 In relation to the General Journal, explain the purpose of a narration.
4.4 Cash receipts cash receipt

a source document used to
When a business receives cash, it must be able to verify how much cash has been verify cash received
received, from whom, and for what purpose, and this will mean it needs to generate a
cash receipt. Study tip
When cash is received, the business will issue a cash receipt to the customer or
entity who has contributed the cash, and the business will keep a copy of the receipt
In Accounting, the
for its own records.
word ‘receipt’ is used
Depending on the type of transaction, the receipt could take the form of: interchangeably to refer
• a written or electronic cash receipt (or cash register roll) to both an inflow of cash
• an EFT (Electronic Funds Transfer) receipt and the document used to
• a credit card receipt verify that inflow of cash.
or it could be simply noted on:
• a Bank Statement. Bank Statement
Some businesses will not issue an individualised receipt to every customer, preferring a report generated by a bank
instead to issue only a cash register receipt, and rely on the summary generated by the listing all cash deposits into and
register to verify the cash received in a single day’s trading. withdrawals from a particular
account
On 1 January 2025, Darryn Bull opened a business bank account in the name of Example
‘ST.J Clothing’, depositing $50 000 of his own money to get the business started
(Rec. 001).

Source documents
Study tip
When interpreting a Source

source document, always documents
start by identifying the
business for whom you
are Accounting.
In this example, there is no GST to account for (as there has been no sale or purchase),
so a handwritten receipt for this cash contribution by the owner might appear as is
shown in Figure 4.6:
Figure 4.6 Cash receipt: handwritten
ST.J Clothing
102 Kareela Rd Frankston 3199
ABN: 25 014 332 980
Rec. 001 1 January 2025
Received from D. Bull
The amount of Fifty thousand dollars
Being for Capital contribution by owner
Amount $ 50 000.00
Study tip
As with all documents, the name of the seller – ST.J Clothing – appears at the top of
Because they are issued
document. When combined with the other information, such as the document number
by the business, the
‘receipt numbers’ of cash (Rec. 001), and also by the description which identifies that cash has been ‘Received
receipts like this will run from’ someone (D. Bull), we can identify that this is cash received by ST.J Clothing. The
in sequence. reason for the receipt of cash is noted as ‘Being for’ a Capital contribution, allowing an
identification of what kind of transaction has occurred, and therefore in what accounts
this transaction will be recorded in the General Ledger.
EFT receipt Alternatively, a cash transfer this large might be made using EFT (Electronic Funds
a source document used to
Transfer), meaning the cash is transferred electronically – using phone or internet
verify a cash transfer received
via Electronic Funds Transfer banking – with the EFT receipt appearing as shown in Figure 4.7:
Figure 4.7 Cash receipt: EFT
Bank of Karingal
Your local bank
Funds transfer report:

ST.J Clothing (A/c: 332 001 454)
From D and M Bull
Study tip
Bank name JPC Bank (Aus.)
Date of deposit 1 / 1 / 25
Because they are issued Amount $50 000
by the bank, it is unlikely Payee reference 001
that EFT receipt numbers
will run in sequence.
In this case, the document is issued by the Bank of Karingal and ST.J Clothing is
identified as the account holder who has received cash as a deposit from the account of
‘D and M Bull’ (and we know that D. Bull is the owner).

Recording: General Journal
Source
documents
If a cash receipt is the source document it means cash has been received, and in terms
of the General Ledger this means the Bank account must be debited to recognise this
increase. The other entry must therefore be a credit entry, depending on the type of
cash receipt. In this case, because of the Entity assumption, the Capital account must
be credited to show the increase in the owner’s equity.
This would be recorded in the General Journal as is shown in Figure 4.8:
Figure 4.8 General Journal: Cash capital contribution

General Journal
Date Details Debit $ Credit $
Jan. 1 Bank 50 000
Capital 50 000
Cash contribution by the owner to commence business
operations (Rec. 001)
As noted above, the General Journal shows the accounts that must be debited
(Bank) and credited (Capital), with the debit entry recorded first, and the name of the
account to be credited indented slightly. The narration listed underneath provides a brief
description of the transaction, and also notes the source document (Rec. 001) so that
the transaction can be traced and therefore verified if required.
Recording: General Ledger
Source
documents
Following its recording in the General Journal, the transaction would be posted to the
General Ledger as is shown in Figure 4.9:
Figure 4.9 General Ledger: Cash capital contribution

General Ledger
Bank (A)
Jan. 1 Capital 50 000
Capital (Oe)
Jan. 1 Bank 50 000
Other receipts of cash

Some form of cash receipt should be issued every time cash is received, and other
transactions resulting in an inflow of cash and increase in Bank might include:
• cash received from a loan

• cash received from Accounts Receivable

• interest received
• cash sales with GST.
Of these, the first three cash flows are not subject to GST, so the receipts listed
above are likely to be sufficient. However, where a cash sale occurs and GST is involved,
more information is required.

1 State the source document used to verify cash received and list three different
types of this document.
2 Show the General Journal entries to record a contribution of cash by the owner.
3 List three different transactions for which a cash receipt may be issued.
4.5 Cash sales and the GST

While receipts like those listed above are sufficient for verifying the amount of cash
received, they are insufficient to substantiate GST as they do not meet the requirements
of a tax invoice. The receipt for a cash sale of inventory must therefore include more
information if it is to be used to verify the amount of GST received from customers and
thus owed to the ATO.
Example On 7 April 2025, Snaps Photographic Equipment sold a Menolta camera to

J. Mortlock for $400 plus $40 GST (Rec. 17). The camera had a cost price of $250.
Source documents
Source
documents
At the time a cash sale is made, the business will receive the cash for the inventory plus
the GST on the sale, and this must be documented on the tax invoice / cash receipt such
as the examples shown in Figures 4.10 and 4.11:
Figure 4.10 Cash receipt (handwritten): Cash sale with GST

ABN: 11 049 411 049
TAX INVOICE
Date: 7/4/2025 Receipt: 17
Received from: J. Mortlock
The sum of: Four hundred dollars plus forty dollars GST
Being for: Cash sale – Menolta camera
Amount: $440.00
Signed: J. Buckley

Figure 4.11 Cash receipt (electronically generated): Cash sale with GST
Study tip
As with all documents,

22 Grace St, Essendon VIC 3041 the name of the seller is
ABN: 11 049 411 049 listed at the top.
TAX INVOICE
Receipt: 17
Date: 7/4/2025
Received from: J. Mortlock
For: Cash sale of 1 Menolta camera
Total Amount: $440.00
GST: $40.00 (inclusive)
Both documents meet the requirements of a tax invoice as noted in Section 4.1, and
include:
• the words ‘Tax invoice’
• the date of the transaction (7/4/2025)
• the receipt number (17)
• the name and ABN of the seller (Snaps Photographic Equipment, 11 049 411 049)
• a description of what has been sold (one Menolta camera)
• the selling price inclusive of the GST ($440). This is the total cash received.
• the amount of the GST ($40). This means the selling price of the camera is $400.
Note how the Sales revenue figure is identified differently in each document.
Whereas Figure 4.10 separately identifies the sales revenue of $400, in Figure 4.11 this
amount is not identified, and must be calculated by deducting the GST ($40) from the
total amount received ($440).
(The $250 cost price of the sale is not shown on the cash receipt because Snaps
Photographic Equipment does not want to disclose its mark-up to the buyer: doing so
would undermine the buyer’s satisfaction with the selling price, leading to a demand for
a lower selling price, or a desire to look for a cheaper supplier.)
Credit card sales

Although called a ‘credit’ card sale, such a transaction is for all intents and purposes
the equivalent of a cash sale and treated as such, because the receipt of cash from the
credit card company is all but assured (even if it is delayed by a day or so).
Had the sale been made by credit card, the credit card receipt might appear as is credit card receipt
shown in Figure 4.12: a source document issued for
sales made on credit card
Figure 4.12 Credit card receipt: Cash sale with GST

ABN: 11 049 411 049
7 April 2025 15:26
Account: xxxx xxx xxx 4546 CR
Menolta Camera 400.00
GST (10%) 40.00
Total 440.00
Rec. 17
Thank you for your business!

If the credit card receipt did not include the required GST information, an additional
cash receipt (such as those shown in Figure 4.10 and 4.11) would still be required as a
tax invoice.
Other systems like Paypal, Google Wallet, Intuit, Square, SecurePay … (there are
many!) may differ in terms of specific logistics – and service fees – but the same basic
accounting requirements remain: if cash has been received, some type of receipt must
be generated; and if GST is involved, a document meeting the demands of a tax invoice
is required.
Source
documents
All of the preceding documents identify the $440 total cash that Snaps Photographic
Equipment has received from the customer, and this is the amount that will be debited
to the firm’s Bank account. (If the cash had been received electronically, this is the
amount that would appear on the EFT receipt or in the Bank Statement.)
However, this total cash received includes $40 GST on the sale, an amount which is
collected on behalf of, and therefore owed to, the ATO. This amount must therefore be
credited to the GST Clearing account to recognise that Snaps Photographic Equipment
now has a liability – a present obligation to transfer (to the ATO) an economic resource
(cash) as a result of the GST that it has collected from sales.
Consequently, of the $440 cash received by Snaps Photographic Equipment
only $400 can be credited to the Sales revenue account as revenue earned by Snaps
Photographic Equipment.
Finally, as is the case for any sale, Cost of Sales must be debited to recognise the
expense incurred when the inventory is sold, and Inventory must be credited to record
the decrease in this asset, both using the cost price of $250.
Figure 4.13 shows how this cash sale with GST would be recorded in the General
Journal:
Figure 4.13 General Journal: Cash sale with GST

General Journal
April 7 Bank 440
Cash sales 400
GST Clearing 40
Cost of Sales 250
Inventory 250
Cash sale of one Menolta camera (Rec. 17)
Note that the narration is brief, but still describes the transaction (a cash sale), what
has been sold and how many (one Menolta camera), and the source document (Rec. 17)
so that the transaction can be verified.
Also note that this entry shows that GST does not affect profit, as the cost price
of the sale ($250) is not affected by the GST, and neither is the Sales revenue earned
($400): Gross Profit on this sale would still be $150, with or without the GST.

Source
documents
The cash sale with GST would be recorded in the General Ledger as shown in Figure 4.14:
Figure 4.14 General Ledger: Cash sale with GST

General Ledger
Bank (A)
7 Sales/GST Clearing 440
Sales (R)
April 7 Bank 400
GST Clearing (A or L)
April 7 Bank 40
Inventory (A)
April 1 Balance 15 000 April 7 Cost of Sales 250
Cost of Sales (E)

April 7 Inventory 250
The cross-reference in the Bank account refers to both Sales and GST Clearing
because the $440 cash received includes both $400 Sales and $40 GST. However, in
the Sales and GST Clearing accounts the only cross-reference is Bank: both accounts
are connected to Bank (for the cash received), but not to each other.
Study tip
A cash sale with GST thus has the following effect on the Accounting equation:
In the VCE Accounting
Increase/Decrease/No effect Amount $ Study Design,
Assets Increase (Increase Bank $440, decrease Inventory $250) 190 transactions that are
Liabilities Increase (GST Clearing) 40 subject to GST will be
Owner’s equity Increase (Sales $400 less Cost of Sales $250 = Profit) 150
identified.


1 Explain why a Bank Statement or EFT receipt may be insufficient to
substantiate GST.
2 Explain why a receipt for a cash sale must also be a tax invoice.
3 Show the General Journal entries to record a cash sale with GST.
4 Explain why the GST received on a cash sale increases the GST liability.
5 Explain the effect of ‘GST on sales’ on:
• Revenue earned
• Cost of Sales
• Gross Profit.
6 Show the effect on the Accounting equation of a cash sale with GST.
4.6 Cash payments

Similar to cash received, when a business pays cash, it must be able to verify how
much cash has been paid, to whom, and for what purpose, and this will mean it needs
to generate a source document.
For many years, businesses used only cheques to make cash payments as they were
secure, traceable and verifiable, and even today some suppliers still require payment
cheque butt by cheque. In such cases, a cheque butt is retained by the business as evidence of
a source document used to the cash it has paid. Today, business owners can make payments in numerous ways,
verify a cash payment made by including online (via EFT), by business credit card, or even by withdrawing cash via ATM
cheque
(Automatic Teller Machine). As a result, it is necessary to be able to account for cash
payments made by cheque, but also payments made by other means.
Depending on the type of transaction, the payment could be verified by:
• a cheque butt
• an EFT or ATM document
• a Bank Statement.
Example During March 2025, HD Fitness Gear made the following cash payments:
March 6 Paid $350 cash to an employee (Sam Oliver) for weekly wages (Ch. 245)
March 8 The owner (Hannah Dow) withdrew $100 from the business bank
account for her personal use (ATM Ref. 613)
Source documents
Source
documents
There is no GST to account for in either of these transactions, but the payments have
been made using different methods, so their source documents will differ.

The cheque butt to verify the cash payment of Wages on 6 March 2025 might appear
as is shown in Figure 4.15:
Figure 4.15 Cash payment: Cheque butt
RDO Banking Co.

Your local bank
Date 6 March 2025

Study tip
To S. Oliver
For Weekly Wages
Cheque numbers as
Bal c/fwd $ shown on the cheque
butt will run in sequence
Deposits $ because they are
allocated to the business;
Amount $ 350 this is less likely for other
documents issued by the
Balance $
bank.
CH. 245
The ATM document to verify the cash Drawings by the owner on 8 March 2025
might appear as is shown in Figure 4.16:
Figure 4.16 Cash payment: ATM document
RDO Banking Co.

Your local bank
DATE TIME ATM ID
8/03/2025 11:14am 54012
CARD: …. …. …. 841
REF. NO.: 613
WITHDRAW FROM: CHEQUE
AMOUNT: $100.00
BALANCE $4 650
PLEASE RETAIN OR DISPOSE OF
THOUGHTFULLY
Source
documents
Because these transactions are both payments, both will result in a credit to the Bank
account and this is true of all cash payments. The other General Ledger entries must
therefore be debit entries.

In these examples, the Wages account must be debited on 6 March 2025 to

recognise the expense, and the Drawings must be debited on 8 March to recognise the
decrease in owner’s equity. Figure 4.17 shows the General Journal entries to record
these two transactions:
Figure 4.17 General Journal: Cash payments

General Journal
March 6 Wages 350
Bank 350
Cash payment of wages to S. Oliver (Ch. 245)
March 8 Drawings 100
Bank 100
Cash drawings by owner – H. Dow (ATM Ref. 613)
Source
documents
Following its recording in the General Journal, the transactions would be posted to the
General Ledger as is shown in Figure 4.18:
Figure 4.18 General Ledger: Cash payments

General Ledger
Bank (A)
Mar. 1 Balance 5 100 Mar. 6 Wages 350
8 Drawings 100
Wages (E)
Mar. 6 Bank 350
Drawings (−Oe)
Mar. 8 Bank 100
Other cash payments

Some form of cash document should be collected every time cash is paid, and where no
Study tip GST is applied the documents above will be sufficient as they identify the date, amount
and purpose of each cash payment. In addition to payments for Wages and Drawings,
other cash payments for which these documents may be sufficient include:
As with cash receipts,
• cash paid for loan repayments
cash payments that are
• cash paid to Accounts Payable
subject to GST will be
• interest expense paid.
identified in the VCE
Accounting course. However, cash payments involving the GST – for inventory and most expenses –
require more information to be provided, meaning additional documentation is required.


1 List three different source documents that could be used to verify cash paid.
2 Show the General Journal entries to record a cash payment for:
• Wages
• Drawings.
3 List three different transactions for which cash may be paid without GST.
4.7 Cash payments and the GST

When a business pays cash for inventory or an expense which is subject to GST, it must
pay for whatever it is purchasing plus the GST on the purchase. The GST paid does not
change the value of what is purchased (the inventory or the expense), but it will increase
the amount of cash paid out of the Bank account. It will also decrease the GST liability
owed to the ATO as the ATO is due to receive this amount from the supplier at some
point in the future.
On 14 September 2025, Nina’s Stationery made a cash payment of $1 320 to TLA Example
Suppliers for $1 200 worth of inventory (40 boxes of gold paper) plus $120 GST
(Ch. 1105).
Source documents
Source
documents
The cheque butt that provides evidence of this payment is shown in Figure 4.19:
Figure 4.19 Cheque butt: Cash payment with GST
Bentleigh Bank
Date 14/9/2025
To TLA Suppliers
For $1 200 Inventory
plus $120 GST
Bal c/fwd $
Deposits $
Amount $ 1 320
Balance $
CH. 1105

Although the cheque butt provides all the information needed to record the transaction,
to satisfy the ATO Nina’s Stationery would also need to keep the tax invoice issued by
TLA Suppliers. This would also be the case if the payment had been made by EFT or
some other means. Figure 4.20 shows how this tax invoice might appear:
Figure 4.20 Tax invoice: Cash purchase of inventory with GST
TLA Suppliers
32 Dinah Parade, Keilor East VIC 3033
ABN: 63 552 412 100
Sold to: Nina’s Stationery Tax invoice (Rec. 135)
ABN: 22 654 885 001 14 September 2025
Items Quantity Unit Price Total
Gold paper (box of 5 reams) 40 30 1 200.00
Plus GST (10%) 120.00
Total $1 320.00
Amount paid $1 320.00
Balance owing nil
The seller in this case is TLA Suppliers, hence this is the name that appears at the
top of the document: Nina’s Stationery appears in the middle as the business who the
goods were ’Sold to’. The document identifies itself as both a Tax invoice and a receipt
(Rec.135) for TLA Suppliers, and the payment details in the bottom right-hand corner
confirm that Nina’s Stationery has made the payment as the ‘Amount paid’ is $1 320,
leaving the ‘Balance owing’ as nil. The ‘Items’ also confirm what has been purchased
(gold paper), which, in a business such as Nina’s Stationery, is Inventory – goods that it
has purchased to sell.
Source
documents
With GST involved, a total of $1 320 is paid and this must be credited to the Bank
account.
At the same time, Inventory must be debited $1 200 to recognise the asset that
Nina’s Stationery has acquired. The GST does not affect the value of the Inventory itself:
as an asset, it remains an economic resource controlled by Nina’s Stationery as a result
of (this) past event, and the potential of the inventory to produce economic benefits
(through its sale) is unchanged.
Instead, GST Clearing must be debited $120 to recognise that as a consequence
of paying GST to its supplier (TLA Suppliers), the GST liability of Nina’s Stationery
will decrease. That is, because the $120 GST must be forwarded to the ATO by TLA
Suppliers, it is no longer owed to the ATO by Nina’s Stationery.

As a result, the debits and credits to record a cash payment with GST would be as
Figure 4.21 General Journal: Cash payment with GST

General Journal
Sept. 14 Inventory 1 200
GST Clearing 120
Bank 1 320
Cash purchase of inventory (gold paper – 40 boxes) from
TLA Suppliers (Ch. 1105)
In terms of a narration, some transactions involving Inventory will require that the
type and number of the inventory items involved are identified and this detail has been
provided in this example. However, there will be transactions where it is impractical to
itemise each and every line and quantity of inventory. In cases such as these, the actual
source document can be used to provide this extra level of detail.
Source
documents
Following its recording in the General Journal, the transactions would be posted to the
General Ledger as shown in Figure 4.22:
Figure 4.22 General Ledger: Cash payment with GST

General Ledger
Bank (A)
Sept. 1 Balance 5 100 Sept. 14 Inventory / GST Clearing 1 320
Inventory (A)
Sept. 1 Balance 30 000
14 Bank 1 200
Sept. 14 Bank 120 Sept. 1 Balance 2 000
Once again, the cross-reference in the Bank account refers to both Inventory and
GST Clearing as both amounts have been paid, but the cross-reference in the Inventory
and GST Clearing accounts is simply Bank.


This cash payment for Inventory with GST has the following effect on the Accounting
equation:

Study tip Assets Decrease (Decrease Bank $1 320, increase Inventory $1 200) 120
Liabilities Decrease (GST Clearing) 120
As with cash receipts, Owner’s equity No effect

transactions that are
subject to GST will Review questions 4.7
be identified, but the
1 Explain why a cheque butt or EFT document may be insufficient to
amount may not be.
substantiate GST for a cash payment.
2 Show the General Journal entries to record a cash purchase of inventory with
GST.
3 Explain how the GST on a cash purchase of inventory affects the value of
Inventory.
4 Explain why the GST paid on a cash purchase of inventory decreases the GST
liability.
5 Show the effect on the Accounting equation of a cash purchase of inventory
with GST.
4.8 The GST Clearing account

At the end of the current period, the GST Clearing account must be balanced, and
reported as either a current asset or a current liability, depending on whether it has a
debit balance or a credit balance. After the end of its Business Activity Statement (BAS)
period, when it must complete and submit its BAS, each business must then pay any
GST owing to the ATO as a GST settlement, or will receive a GST refund from the ATO
for excess GST.
GST Clearing: current liability

Because selling prices are usually higher than cost prices, in most cases GST on sales
will be higher than GST on purchases. This will mean the GST Clearing account will
often have a credit balance, so the business will have a GST liability.
Example Casee’s Cosmetics started trading on 1 June 2025, and after recording the
transactions for June and balancing the ledger, its GST Clearing account showed
the following:
June 8 Bank 11 June 2 Bank 42
12 Bank 25 5 Bank 39
16 Bank 80 15 Bank 80
23 Bank 12 28 Bank 120
29 Bank 32
30 Balance 121
281 281
July 1 Balance 121

The credit entries in this account would be the result of cash sales involving GST,
while the debit entries would be the result of cash payments for inventory and expenses
that involved GST.
The credit balance of $121 indicates that as at 30 June 2025 this account is a current
liability: GST on sales ($281) is greater than GST on purchases ($160), so the business
owes $121 to the ATO.
GST Clearing would thus be reported in the Balance Sheet of Casee’s Cosmetics as
at 30 June 2025 with its other current liabilities, such as Bank overdraft and Accounts
Payable, as a present obligation (to the ATO) to transfer economic resources (cash) that
is reasonably expected to be settled sometime within the next 12 months (when the
business pays the GST owing).
GST settlement
Assuming 30 June 2025 is the end of its BAS period, during July 2025 Casee’s Cosmetics
would be required to make a payment of $121 to the ATO to ‘settle’ this GST liability.
This payment is known as a GST settlement, which reduces the GST liability by paying
to the ATO the amount owing from last period.
Assuming Casee’s Cosmetics paid its GST settlement on 3 July 2025 (Ch. 241), it
would be recorded in the General Journal as is shown in Figure 4.23:
Figure 4.23 General Journal: GST settlement

General Journal
July 3 GST Clearing 121
Bank 121
GST settlement paid to ATO for balance owing as at
30 June 2025 (Ch. 241)
The GST Clearing account of Casee’s Cosmetics would now appear as shown in
Figure 4.24:
Figure 4.24 GST Clearing account: GST settlement

GST Clearing (L)
June 8 Bank 11 June 2 Bank 42
16 Bank 80 15 Bank 80
23 Bank 12 28 Bank 120
29 Bank 32
30 Balance 121
281 281
July 3 Bank 121 July 1 Balance 121
Note that although the GST settlement is paid, it is paid to the ATO, to settle the
GST liability accrued in previous periods. This differs from the GST paid to suppliers,
for purchases and expenses, on payments made in the current period. As a result,
it must be reported separately in the Cash Flow Statement (as will be explained in
Chapter 11).

GST Clearing: current asset

If the GST on sales had been less than the GST on purchases, the GST Clearing account
would have had a debit balance. This could be the result of purchasing more inventory
than has been sold or purchasing non-current assets during the period.
Example During March 2025, Mack ‘n’ Roe Tennis Gear made a bulk purchase of inventory
and paid for a number of non-current assets. At the end of March 2025, its GST
Clearing account showed the following:
March 4 Bank 120 March 1 Balance 130
16 Bank 41 19 Bank 40
22 Bank 29 23 Bank 26
28 Bank 36 31 Balance 345
576 576
April 1 Balance 345
In this case, the debit balance of $345 indicates that as at 31 March 2025 this account
is a current asset: GST on purchases ($576) is greater than the opening balance ($130)
plus GST on sales ($101), so the business is owed $345 by the ATO.
GST Clearing would thus be reported in the Balance Sheet of Mack ‘n’ Roe Tennis
Gear as at 31 March 2025 with its other current assets, such as Bank, Inventory
and Accounts Receivable, as a present economic resource controlled by Mack ‘n’
Roe Tennis Gear, which has the potential to produce economic benefits because it
is expected to be converted to cash in the next 12 months (when it receives a GST
refund from the ATO).
GST refund
Again, assuming 31 March 2025 is the end of its BAS period, during April 2025 Mack
‘n’ Roe Tennis Gear would receive $345 cash from the ATO as a refund because it has
paid more GST than it has received. This cash receipt is known as a GST refund, which
reduces the GST owed to the business by the ATO.
Assuming Mack ‘n’ Roe Tennis Gear received the GST refund on 9 April 2025 (EFT.
Ref. 44128), it would be recorded in the General Journal as shown in Figure 4.25:
Figure 4.25 General Journal: GST refund

General Journal
April 9 Bank 345
GST Clearing 345
GST refund from the ATO for balance owing as at 31 March
2025 (EFT Ref. 44128)

The GST Clearing account of Mack ‘n’ Roe Tennis Gear would now appear as shown
in Figure 4.26:
Figure 4.26 GST Clearing account: GST refund

March 4 Bank 120 March 1 Balance 130
16 Bank 41 19 Bank 40
22 Bank 29 23 Bank 26
28 Bank 36 31 Balance 345
576 576
April 1 Balance 345 April 9 Bank 345
As in the case with a GST settlement, a GST refund would be reported separately
to other GST received as it is received from the ATO, to offset the GST asset from last
period.
GST cash flows

The payment of a GST settlement or receipt of a GST refund means that there are four
potential cash flows related to GST:
• GST paid to suppliers for cash purchases and expenses
• GST received on cash sales
• GST settlement
• GST refund.

1 Explain the circumstances that would lead the GST Clearing account to have a
credit balance.
2 Explain how a credit balance in the GST Clearing account would be reported in
the Balance Sheet.
3 Define the term ‘GST settlement’.
4 Show the General Journal entries to record a GST settlement.
5 Explain the circumstances that would lead the GST Clearing account to have a
debit balance.
6 Explain how a debit balance in the GST Clearing account would be reported in
the Balance Sheet.
7 Define the term ‘GST refund’.
8 Show the General Journal entries to record a GST settlement.
9 Identify the two transactions relating to GST that involve a cash inflow.
10 Identify the two transactions relating to GST that involve a cash outflow.

Where have we been?

• Source documents provide both the evidence that a transaction has occurred and the details of the
transaction itself.
• By ensuring that transactions are Verifiable, source documents ensure that data is supported by evidence
and can be checked to ensure the reports provide a Faithful representation of what has occurred, and are
complete, free from material error and neutral (without bias).
• The Goods and Services Tax (GST) is a 10% tax levied by the federal government on most goods and
services excluding fresh food.
• GST on sales is owed to the government, but GST on purchases reduces that liability.
• A source document must meet the requirements of a tax invoice in order to substantiate GST transactions.
• When cash is received, the source document will be a cash receipt of some form, such as a handwritten
or electronic receipt, an EFT receipt, a credit card receipt or a Bank Statement. Cash sales must also be
verified by a tax invoice.
• When cash is paid, the source document may be a cheque butt, EFT document or Bank Statement. Cash
payments involving GST must also be verified by a tax invoice.
• All GST transactions are summarised in the GST Clearing account, which can be a current asset or current liability.
• If GST on sales is greater than GST on purchases, the business will have a GST liability and will be
required to make a GST settlement.
• If GST on purchases is greater than GST on sales, the business will have a GST asset and is due a GST refund.
• As selling prices are generally higher than cost prices, most firms will end up with a GST liability.
Exercises
this book.

Calculating GST
Dodd’s Nursery sells plants and has provided the following information relating to its sales for March 2025:
Selling price Total price

(excluding GST) GST (10%) (including GST)
March 1 $400 $40
5 $60 $660
13 $390 $429
19 $720
23 $120
28 $1 012
Required
a Explain the role of a tax invoice.
b State three pieces of information that must be present on a source document if it is be used as a tax invoice.
c Calculate the missing figures to complete the table above.
d Calculate the total GST received by Dodd’s Nursery in March 2025.
e Explain why small businesses who make sales involving the GST have a liability to the ATO.
During March 2025, Dodd’s Nursery paid $140 GST on its purchases.
f Explain why Dodd’s Nursery is allowed to deduct the GST on its purchases from the GST on its sales
when calculating the GST that it owes to the ATO.
g Calculate the total GST owed to the ATO by Dodd’s Nursery as at 31 March 2025.

CHAPTER 4 C A S H T R A N S AC T I O N S 87

Cash receipt
On 1 May 2025, Lenny O’Connell opened a business selling calculators, cash registers and other business
machinery by making a deposit into the firm’s bank account, as shown on the document below:
Bank of Casseo
Your money, our responsibility
Deposit record:
Cal Q Later (A/c: 322 001 545)
From L. O’Connell
Bank name Bank of Collingwood
Date of deposit 1 / 5 / 2025
Amount $30 000
Payee reference 001
Required
a Referring to the Qualitative characteristics, explain the role of source documents in the Accounting process.
b Identify the source document above.
c Describe the transaction verified by this document.
d Record this document in the General Journal of Cal Q Later.
e Show how this transaction would appear in the General Ledger of Cal Q Later.
f Referring to one Accounting assumption, explain why a small business should have a bank account
separate from its owner.

88 UNIT 3 F I N A N C I A L AC C O U N T I N G F O R A T R A D I N G B U S I N E S S

Cash sale
The following document was found in the office of Hats Off to Hats! The owner, Harry, applies 100% mark-up
to all inventory, meaning the selling price is determined by adding 100% of the cost price to that cost price.
866 Mickleham Road

Hats Off to Hats! Tullamarine VIC 3043
ABN: 45 983 453 101
Date: 2 November 2025

Receipt no: 60 (tax invoice)
Received from: Cash sales
The sum of: Two hundred and twenty dollars
Being for: 2 top hats @ $100 each
Amount: $ 200.00
Plus GST: $ 20.00
Total: $ 220.00
Signed. Paula Ekland
Required
a Identify the source document above.
b Describe the transaction verified by this document.
c Record this document in the General Journal of Hats Off to Hats!
d Show how this transaction would appear in the General Ledger of Hats Off to Hats!
e Explain why this transaction creates a GST liability for Hats Off to Hats!
f Explain the effect of this transaction on the Accounting equation of Hats Off to Hats!
g Referring to one Qualitative characteristic, explain the importance of recording transactions as they
occur.


Cash transactions
Leon’s Bike Shop sells bikes and cycling gear. As at 1 December 2025, it had $2 400 Cash in the bank,
Inventory worth $20 000 and Leon’s Capital was $22 400. The business has provided the following information
relating to its operations for December 2025:
Document A
Leon’s Bike Shop Tax invoice (Rec. 43)

Lygon St, East Brunswick 1 December 2025
ABN: 66 320 157 880
Sold to: Cash sales
Items Quantity Unit Price Total
Gargantuan Road Bike (GG1000) 2 2 400 4 800
GST (10%) 480
Payment made by EFT – thank you 5 280
Each bike had a cost price of $1 800.
Document B
Leon’s Bike Shop

Lygon St, East Brunswick
2 December 2025
11.04am
Account: xxxx xxx xxx 4546 CR
Cycling clothing 319.00
Price includes GST of $29.00
Credit card ref. 021 003
The cycling clothing had a cost price of $200.
Additional information:
Dec. 3 Received $40 000 cash as a loan from TN Finance (EFT Ref. 165).
4 Cash sale of one bike for $3 740 including GST. The bike had a cost price of $2 600 (Rec. 44).
5 $20 interest was credited directly into the firm’s bank account (Bank Statement).
Required
a Identify two features of Document A that indicate that Leon’s Bike Shop has received cash.
b Explain why Document B would not be recognised by the ATO as a tax invoice.
c Calculate the sales revenue earned from the transaction in Document B.
d Explain how a narration supports the Qualitative characteristic of Verifiability.
e Record these transactions in the General Journal of Leon’s Bike Shop. (Narrations are not required.)
f Show how the General Ledger of Leon’s Bike Shop would appear after these transactions had been
recorded.
g Calculate the Gross Profit earned by Leon’s Bike Shop for 1–5 December 2025.
h Referring to your answer to part ‘e’, explain how GST Clearing would be reported in the Balance Sheet
of Leon’s Bike Shop as at 5 December 2025.


Cash payment
The following source document was discovered by the manager of Sally’s Shoe Shop:
Bank of Neighbours Bay

ABN: 21 552 421 998
Date 2/5/2025
To Bay Gazette
For $950 advertising
plus $95 GST
Bal c/fwd $
Deposits $
Amount $ 1 045
Balance $
CH. 663
Required
a State whether source documents take place at the input, processing or output stage of the Accounting process.
b Identify the source document above, and then describe the transaction it verifies.
c State two advantages of paying by cheque.
d Record this transaction in the General Journal of Sally’s Shoe Shop.
e Explain the effect of this transaction on the Accounting equation of Sally’s Shoe Shop.
f Referring to the document above, explain why Sally’s Shoe Shop would need additional documentation
to ensure its information was Verifiable.

Cash payments
Stipe, Buck and Mills sells furniture, and as at 1 January 2025 it had $4 200 cash in the bank, Inventory on hand
worth $30 000, a GST liability of $300 and Owner’s equity of $33 900. The business has provided the following
source documents for January 2025:
Document A Document B
Bank of Georgia
Bank of Georgia
REMEMBER LIFE!
REMEMBER LIFE!
Date 4/1/2025
DATE TIME ATM ID
To Pageant Furniture 10/01/2025 6.02pm 662001
For $1 400 worth of
CARD: ********** 264
inventory (plus GST)
REF. NO.: 819
Bal c/fwd $
WITHDRAW FROM: CHEQUE
Deposits $
Amount $ 1 540
AMOUNT: $400.00
BALANCE ********
Balance $
PLEASE RETAIN OR DISPOSE OF
CH. 104 THOUGHTFULLY

Document C
Fables Energy
Electricity and Service
Collins St., Melbourne 3000
ABN: 54 218 975 220
Service address: Stipe, Buck and Mills Tax invoice No. 32014
14 Reconstruction Rd, East Malvern, 3145 15 January 2025
ABN: 32 001 546 887
Service period: 1 January – 15 January 2025
Service charge (monthly) $ 95
Usage (620 kWh @ 25c per kWh) 155
Total (includes GST of $25) 275
Amount paid (EFT – 564 009) 275
Balance owing nil
Jan. 20 Paid $600 wages to B. Berry (EFT Ref. 632).
26 Paid BGO Insurance $352 including GST (Ch. 105).
31 Bank fees of $10 were paid directly from the business bank account (Bank Statement).
Required
a Calculate the GST paid on the transaction in Document A.
b Document B relates to cash withdrawn by the owner. Explain why there is no GST to account for on this
transaction.
c Explain how the transaction in Document C would affect the GST liability of Stipe, Buck and Mills.
d Explain the role of the General Journal in an Accounting system. Identify at least one Qualitative
characteristic that supports your answer.
e Record these transactions in the General Journal of Stipe, Buck and Mills. (Narrations are not required.)
f Show how the General Ledger of Stipe, Buck and Mills would appear after these transactions had been
recorded.


GST Clearing account
E&I Pianos has provided its GST Clearing account showing its transactions for August 2025:
GST Clearing
Aug. 2 Bank 35 Aug. 5 Bank 240
8 Bank 12 11 Bank 320
16 Bank 500 23 Bank 250
22 Bank 21
28 Bank 19
Required
a State what type of transaction caused the three credit entries in the GST Clearing account of E&I Pianos.
b Referring to the dates of the debit entries in the GST Clearing account of E&I Pianos, suggest which
transaction is most likely to relate to a purchase of inventory. Justify your answer.
c Balance the GST Clearing account as at 31 August 2025.
d Referring to your answer to part ‘c’, explain how the GST Clearing account would be reported in the
Balance Sheet of E&I Pianos as at 31 August 2025.
On 4 September 2025, E&I Pianos made a payment to the ATO for the balance owing as at 31 August 2025
(Ch. 658).
e Record this transaction in the General Journal of E&I Pianos.

Mind Games has provided its GST Clearing account showing its transactions for March 2025:
GST Clearing
March 1 Balance 240 March 5 Bank 63
14 Bank 12
22 Bank 21
28 Bank 19
Required
a Explain what circumstances may have caused the GST Clearing account of Mind Games to have a debit
balance as at 1 March 2025.
b Calculate the sales revenue of Mind Games for March 2025.
c Balance the GST Clearing account of Mind Games as at 31 March 2025.
d Referring to your answer to part ‘c’, explain how the GST Clearing account would be reported in the
Balance Sheet of Mind Games as at 31 March 2025.
On 6 April 2025, Mind Games received a GST refund from the ATO (EFT Ref. 22101).
e Record this transaction in the General Journal of Mind Games.


Cash transactions
Peta Anthony sells uniforms to other businesses. As at 1 February 2025, it had a Bank overdraft of $1 900,
Inventory on hand worth $23 000, and a GST liability to the ATO of $520.
The firm’s transactions for February 2025 were:
Feb. 2 Borrowed $15 000 from QPR Bank to purchase new shop fittings (EFT Ref. 3015).
5 Paid $3 500 plus GST for new shop fittings (Ch. 613).
9 Paid $420 wages (EFT Ref. 3024).
12 Cash purchase of inventory for $800 plus $80 GST (Ch. 614).
15 Sold inventory for $2 300 plus $130 GST. The clothing had a cost price of $1 150 (Rec. 44).
17 Peta withdrew $300 for her own purposes (ATM Ref. 876).
21 Paid rent for the month of $902 including GST (EFT Ref. 3029).
26 Purchased inventory for $792 including GST (Ch. 615).
29 Clothing which had been purchased in January 2025 for $1 000 plus GST was sold for $2 200
including GST (Cr. Card Rec. 12145).
• The Loan – QPR Bank will be repaid in monthly instalments of $500.
• Peta only buys inventory from suppliers who comply with the industry Code of conduct for employee
conditions. She is aware of other suppliers who do not comply and charge less for their inventory, but
she is concerned that purchasing from them would not be good for her business.
Required
a Calculate the Owner’s capital as at 1 February 2025.
b Record the transactions for February 2025 in the General Journal of Peta Anthony. (Narrations are not
required.)
c Show how the General Ledger of Peta Anthony would appear after all transactions for February 2025
had been recorded.
* d Prepare a Trial Balance for Peta Anthony as at 29 February 2025.
* e Prepare an Income Statement for Peta Anthony for February 2025.
f Discuss whether Peta’s decision regarding the suppliers and the industry Code of Conduct is good for
her business.
* g Prepare a Balance Sheet for Peta Anthony as at 29 February 2025.
h Explain how Peta Anthony ensures that its Balance Sheet provides a Faithful representation of the value
of its non-current assets.


Cash transactions
Parkerman Suppliers sells all types of business stationery and as at 30 June 2025 had the following balances:
Bank $4 700 DR
Inventory $25 000 DR
GST Clearing $1 700 CR
The firm’s transactions for July 2025 were:
July 3 Owner withdrew $500 cash (EFT Ref. 512).

7 GST settlement paid to ATO for balance owing as at 30 June 2025 (Ch. 9001).
12 Cash sale $1 600 plus GST (Rec. 320). The inventory had a cost price of $800.
14 Paid $650 for inventory plus $65 GST (EFT Ref. 516).
19 Paid electricity bill of $693 including GST (Ch. 9002).
21 Sale of inventory for $1 650 including GST (Cr. Card Rec. 7878). The mark-up on this inventory
was 50%.
27 Peta withdrew $300 for her own purposes (ATM Ref. 876).
30 Paid $572 including GST for inventory (EFT Ref. 539).
The owner has argued that because GST applies to all cash sales and purchases of inventory, the GST balance
will simply be 10% of the Bank balance so it is unnecessary to report GST Clearing in the Balance Sheet.
Required
a Explain why the transaction on 3 July 2025 must be recorded as Drawings. Identify one Accounting
assumption which supports your answer.
b Record the transactions on 7 July 2025, 12 July 2025 and 19 July 2025 in the General Journal of
Parkerman Suppliers.
c Explain the effect of the transaction on 21 July 2025 on the Accounting equation of Parkerman Suppliers.
d Show how the Bank, GST Clearing and Inventory accounts would appear in the General Ledger of
Parkerman Suppliers as at 31 July 2025 after accounts have been balanced.
e Explain how the Inventory account will be classified in the Balance Sheet of Parkerman Suppliers as at
31 July 2025.
f Discuss the accuracy of the owner’s statement. In your answer refer to at least two Qualitative
characteristics.

Chapter 5
Accounts Payable: documents, the GST
and the General Journal

After completing this chapter, you should be able to: • apply credit terms and calculate settlement
• explain the features of a credit transaction discounts
• apply Accounting assumptions and Qualitative • discuss ethical considerations in business
characteristics decision-making
• identify transactions with Accounts Payable from • identify the effect of GST on transactions with
source documents Accounts Payable
• record transactions with Accounts Payable in the • interpret and explain the role of a Statement of
General Journal and General Ledger Account
• explain the effect on the Accounting equation of • calculate and analyse Accounts Payable Turnover
transactions with Accounts Payable • discuss strategies to manage Accounts Payable.
• explain how transactions with Accounts Payable
affect the financial reports
• apply Accounting skills to transactions with
Accounts Payable including:
– credit purchases of inventory (including GST)
– payments to Accounts Payable, including
discounts
– purchase returns to Accounts Payable
Key terms
After completing this chapter, you should be familiar • purchase return
with the following terms: • credit note
• credit transaction • settlement discount
• credit purchase • discount revenue
• Account Payable • Statement of Account
• purchase invoice • Accounts Payable Turnover (APTO)
• credit terms • liquidity.

5.1 Credit purchases and the GST

Chapter 4 considered how to identify and record cash transactions, including those that
involved the GST. Each transaction involved some type of exchange, but because they
were all cash transactions, the cash and the goods were both exchanged on the same day.
credit transaction This chapter considers credit transactions, specifically those relating to the purchase
a transaction that involves an of inventory, where the cash and the inventory are still exchanged, but on different days.
exchange of goods or services
on one date, followed by the
Figure 5.1 Credit transaction
exchange of cash at a later date
Inventory
Supplier Customer
Cash
credit purchase A credit purchase means that the business buys and obtains the inventory on the
a transaction that involves day of the purchase, but the cash is not paid to the supplier until a later date. The
buying inventory on credit, with supplier from whom the inventory is obtained, and to whom the cash is still owed, is
the exchange of the inventory
called an Account Payable.
on one date, followed by the
exchange of cash at a later date This means that for every credit purchase two different transactions will occur,
possibly with many days between them, which are:
Account Payable • the credit purchase of the inventory
a supplier from whom goods • the payment to the Account Payable.
(usually inventory) or services
have been purchased on credit, Qualitative characteristics and Accounting assumptions
and the amount still owing for
Recognising credit purchases is only possible because of the application of two Accounting
those purchases (also called a
‘creditor’) assumptions: the Going concern assumption and the Accrual basis assumption.
Applying the Going concern assumption allows the business to record a credit
purchase, and the amount that still needs to be paid, because it assumes that the life
of the business is continuous. As the business will continue to operate into the future,
it will still be operating when the payment to the Account Payable is due to be made.
This works in combination with the Accrual basis assumption, which states that the
Elements of the reports are recognised when they satisfy the definitions and recognition
criteria, regardless of whether cash has been exchanged or not. In the case of a credit
purchase, these Elements of the reports are:
• inventory that can be sold, which meets the definition of an asset – a present
economic resource controlled by the entity as a result of a past event
• an amount that is owed to the Account Payable, which meets the definition of
a liability – a present obligation to transfer economic an economic resource as a
result of a past event.
Applying both the Going concern and Accrual basis assumptions to record a credit
purchase also ensures Relevance in the reports, because all information capable of
making a difference to decision-making (specifically, the amount of inventory on hand
and the amount owed to the Account Payable) is included in the financial statements.
Example On 6 August 2025, Hardware Plus purchased inventory from Marcon Tools for
$2 250 plus $225 GST (Inv. A16).

C hapter 5 AC C O U N T S PAYA B L E 97
Source document
Source
documents
When a business makes a credit purchase of inventory, it must be able to identify the
value of the inventory it has purchased plus the GST on the purchase, as both amounts
will be owed to the Account Payable. This information can be found on the purchase purchase invoice
invoice issued by the supplier / Account Payable, which may appear as shown in a source document used to
Figure 5.2: verify a credit purchase of
inventory or other items
Figure 5.2 Purchase invoice
Marcon Tools 6 August 2025

TAX INVOICE A16
ABN 98 756 458 751 Original
33 Gaffney St Terms: 5/7, n/60
Coburg VIC 3058
Charge to: Hardware Plus
Johnson St, Collingwood VIC 3066 Study tip
ABN: 44 110 787 854
Qty Item Unit price Total cost
$ $ Because purchase
invoices are issued by the
10 AED electric drill (AED 400) 180.00 1 800.00
supplier, who will have
5 Ryboshi Socket Set (RSS1) 90.00 450.00
other customers, invoice
GST (10%) 225.00 numbers on purchase
Total 2 475.00 invoices will not run in
Amount paid Nil sequence.
Balance owing 2 475.00
Study tip
Given that all documents that are used to substantiate GST are called ‘tax invoices’,
and these exact words must actually appear on the document, how can a purchase
invoice be distinguished from any other GST document? In the accounts of
First, we must look for the name of the business at the top of the document, and Hardware Plus, this
then consider the name of the business for whom we are Accounting. Like all source transaction is a credit
documents, the name of the seller appears at the top, so the name of the business purchase, but in the
making the credit purchase appears lower down as the business that is ‘Charged to’. In accounts of Marcon Tools
this example, Marcon Tools appears at the top as the seller, meaning the purchase has this document would
been made by Hardware Plus. If we are Accounting for Hardware Plus, this document be identified as a Sales
represents a purchase. invoice and recorded as a
Second, a purchase invoice will indicate in some way that payment has not yet credit sale.
been made. In this example, the Amount paid is nil. This on its own may indicate a
credit purchase, but this document also identifies a Balance owing of $2 475 (the same credit terms
information that details how
amount as the Total) to the supplier (the Account Payable – Marcon Tools)
many days a business has to
Third, a purchase invoice will probably note some type of credit terms to indicate pay for a credit transaction,
how long the customer has to pay, and if a settlement discount applies, the terms of and any applicable settlement
that discount. In Figure 5.2, the terms of the sale (5/7, n/60) indicate that Hardware Plus discount
has 60 days to settle the net amount of the debt by making a payment to Marcon Tools,
but if payment is made within 7 days, a 5% discount will be applied to the total amount
owing. (Discounts are explained in detail in Section 5.4 later in the chapter.)
Source
documents
As a result of this credit purchase, Hardware Plus must debit Inventory $2 250 to
recognise the increase in this asset.
In addition, the supplier is obliged to charge GST, calculated as 10% of the price of
the inventory. This GST will eventually be forwarded to the ATO by Marcon Tools, so
Hardware Plus can debit its GST Clearing account $225 to recognise this as a reduction
in its GST liability.
Taken together, and in light of the transaction being on credit (no cash has been
paid), Hardware Plus will owe its supplier (Marcon Tools) $2 250 for the inventory it has
purchased, plus $225 for the GST on that purchase, which will require a credit of $2 475
to the current liability Account Payable – Marcon Tools. This amount owed represents
a present obligation (to Marcon Tools) to transfer an economic resource (by paying
cash or, indeed, returning the inventory) as a result of a past event, with this obligation
expected to be settled within the next 12 months.
This would be recorded in the General Journal as shown in Figure 5.3:
Figure 5.3 General Journal: Credit purchase with GST
General Journal
Aug. 6 Inventory 2 250
GST Clearing 225
Account Payable – Marcon Tools 2 475
Credit purchase of inventory from Marcon Tools (Inv. A16)
A credit purchase thus results in two debits and one credit, but together they
balance, keeping the Accounting equation and Balance Sheet also in balance. As always,
the narration includes the source document (Inv. A16) to support Verifiability and thus
Faithful representation.
Note that although the GST increases the amount owed to the Account Payable, it
does not affect the valuation of inventory as it does not affect the value of the economic
resource represented by that inventory. Any economic benefit from the inventory is
realised when the inventory is sold, whereas any GST benefit (in the form of a reduction
in the GST liability) is realised when the GST settlement or refund occurs.

Source
documents
After posting the General Journal, the General Ledger would appear as shown in
Figure 5.4:
Figure 5.4 General Ledger: Credit purchase with GST
General Ledger
Inventory (A)
Aug. 1 Balance 45 000
6 Account Payable – 2 250
Marcon Tools
6 Account Payable – 225 Aug. 1 Balance 3 000
Marcon Tools
Account Payable – Marcon Tools (L)

Aug. 6 Inventory/GST Clearing 2 475
The $2 475 credited to the Account Payable includes $2 250 worth of inventory plus
$225 GST, so both Inventory and GST Clearing are noted in the cross-reference in the
Account Payable account, but the cross-reference in the Inventory and GST Clearing
accounts is simply Account Payable. Debiting the GST Clearing account reduces the
liability to the ATO (in this case, by $225, or from $3 000 to $2 775).

A credit purchase of inventory will thus have the following effect on the Accounting Study tip
equation:
Increase/Decrease/No effect Amount $ Although invoices

Assets Increase (Inventory) 2 250 would be issued for
Liabilities Increase (Increase Account Payable $2 475; decrease GST Clearing $225) 2 250 credit purchases of
many items – inventory
Owner’s equity No effect
and other assets – this
Note that there is no revenue earned or expense incurred from a credit purchase, so course only covers credit
purchases of inventory.
there is no effect on profit.
Ethical considerations
Ethical
When purchasing inventory, a business needs to strike a balance between price (low)
c onsiderations
and quality (high). Purchasing inventory at low prices will mean an ability to sell at a
lower price, achieving higher sales volume and/or a better mark-up, but if this comes
at the expense of quality it could mean customers are dissatisfied and return items or,
worse still, shop elsewhere.

Further, businesses have an ethical and often legal obligation to provide goods
that are safe (within legal, industry and consumer standards) and, to varying degrees,
‘socially responsible’. Increasingly, this need for ethical purchasing relates not only to
the final product, but also to how those products are produced.
Ethical purchasing is not easily defined, and even subject to rapid change, but a
business that does not factor ethical considerations into its decision-making is likely
to encounter difficulties. Businesses who source inventory from suppliers who exploit
their employees or cause damage to the environment must consider that this may have
negative consequences for their operations, as consumers are unwilling to purchase
items produced in these ways. Business owners also need to act within their own
ethical parameters, lest they be conflicted about purchasing (and selling) items that may
damage the society and environment in which they and others live.
This does not mean businesses cannot sell cheap products – low prices are a key
business strategy – but it does mean businesses must be honest and ethical, and also
provide products that do what they purport to do, meet their intended purpose, and
comply with legislative and other standards. Indeed, there may be a market advantage
in purchasing items from socially and environmentally responsible suppliers, with
consumers more willing to purchase these items (and sometimes at a higher price)
and from businesses that are regarded as being honest and ethical, and socially and
environmentally responsible.

1 Define the following terms:
• credit transaction
• credit purchase
• Account Payable.
2 Explain how the Accounting assumptions support the recognition of Accounts
Payable.
3 Explain how the recording of credit purchases ensures Relevance in the
Balance Sheet.
4 Identify the source document used to verify a credit purchase.
5 Explain how the source document used to verify a credit purchase can be
distinguished from other tax invoices.
6 Show the General Journal entries to record a credit purchase.
7 Explain why an Account Payable is reported as a liability.
8 Explain how GST on a credit purchase will affect:
• the value of the inventory purchased
• GST owed to the ATO.
9 State the effect of a credit purchase on the Accounting equation.
Ethical 10 Explain how a credit purchase is reported in the Income Statement.
c onsiderations 11 Explain how ethical purchasing decisions can improve business performance.

5.2 Payments to Accounts Payable

Having purchased inventory on credit, the business will at some point in the future have
to make a payment to ‘settle’ the amount owing to the Account Payable.
On 15 August 2025, Hardware Plus paid Marcon Tools $1 500 (Ch. 253). Example
Source document
Source
documents
A payment to an Account Payable could be made in any number of ways, but cheque
and EFT transfer are likely to be the most common. Assuming the payment was made
by cheque, the cheque butt may appear as shown in Figure 5.5:
Figure 5.5 Cheque butt: Payment to Account Payable
FinCo Bank
Date 15/8/2025
To Marcon Tools
For Payment to
Account Payable
Bal c/fwd $
Deposits $
Amount $ 1 500
Balance $
Ch. 253
There is no GST to account for when a payment is made to an Account Payable as it

was already recognised at the time the credit purchase was recorded (in this case, on
6 August 2025).
Source
documents

As a cash transaction, a payment to an Account Payable reduces the Bank so this account
is credited. At the same time, the amount owing to the Account Payable also reduces,
so this liability account is debited. Figure 5.6 shows how this would be recorded in the
General Journal:
Figure 5.6 General Journal: Cash payment to Account Payable

General Journal

Aug. 15 Account Payable – Marcon Tools 1 500
Bank 1 500
Cash payment to Account Payable – Marcon Tools (Ch. 253)

After posting the General Journal, the General Ledger would appear as shown in Figure 5.7:
Figure 5.7 General Ledger: Cash payment to Account Payable

General Ledger
Bank (A)
Aug. 1 Balance 20 000 Aug. 15 Account Payable – 1 500
Marcon Tools

Aug. 15 Bank 1 500 Aug. 6 Inventory/GST Clearing 2 475
In this example, the entire amount owed to Marcon Tools ($2 475) has not been paid,
so $975 is still owing, and would be reported as a current liability in the Balance Sheet
of Hardware Plus.

A payment to settle an Account Payable will thus have the following effect on the
Accounting equation:
Increase / Decrease / No effect Amount $

Assets Decrease (Bank) 1 500
Liabilities Decrease (Account Payable – Marcon Tools) 1 500

1 Identify the source documents that might be used to verify a payment to an
Account Payable.
2 Explain why there is no GST to account for when a payment is made to an
Account Payable.
3 Show the General Journal entries to record a payment to an Account Payable.
4 State the effect of a payment to an Account Payable on the Accounting equation.
5 Explain how a payment to an Account Payable is reported in the Income
Statement.

5.3 Purchase returns

The main objective of a trading firm is to earn a profit by purchasing inventory then purchase return
reselling it at a higher price. However, given the sheer number of transactions a trading the return to a supplier (Account
firm will have with its suppliers, it is only logical to expect that not every item of inventory Payable) of inventory bought
on credit
purchased will prove to be suitable. This means that in the normal course of business
operations, the business can expect to make a certain number of purchase returns
Study tip
where it returns inventory to its suppliers (Accounts Payable).
Reasons for returns of inventory Although returns may

There are probably as many reasons for returning inventory as there are for purchasing be made for cash, this
it, but some of the more common reasons are because: course concentrates
• the inventory is faulty or damaged only on purchase returns
• the inventory is the wrong size/colour/shape/model to suppliers (Accounts
• too many items of inventory were purchased Payable) of inventory
• the business has simply changed its mind about what inventory it intends to sell. bought on credit.
On 28 August 2025, Hardware Plus returned 2 AED electric drills to Marcon Tools Example
because they were faulty (Cr. Note 85).
Source document
Source
documents
As with all transactions, the process of recording and reporting a purchase return
must begin with a source document. Information that cannot be verified by a source
document will undermine the ability of the reports to provide a Faithful representation
of firm’s financial position and performance.
credit note As this course deals only with purchase returns to a supplier (Account Payable) of
a source document that verifies inventory previously purchased on credit, the only document to provide the evidence of
the return of inventory a purchase return will be a credit note, such as the one shown in Figure 5.8:
Figure 5.8 Credit note: Purchase return
Marcon Tools
ABN 98 756 458 751 28 August 2025
33 Gaffney St TAX INVOICE A16
Coburg VIC 3058 Credit Note 85
Returned by: Hardware Plus
Johnson St, Collingwood VIC 3066
ABN: 44 110 787 854
Qty Item Unit price $ Total cost $
2 AED electric drill (AED 400) 180.00 360.00
GST (10%) 36.00
Total 396.00
Reason Faulty goods
Every credit note must identify the name of the business or person returning the
Study tip inventory; the type and quantity of inventory returned; and the reason for the return.
However, closer inspection is required to determine if the document verifies a purchase
return or in fact a sales return. (Sales returns will be covered in Chapter 6).
A credit note is not ’store Just like an invoice, a credit note is always prepared by the seller or business who
cash’, but rather evidence originally supplied the inventory, and is now accepting it back as a return, with the name
that the balance owed
of the business returning the inventory appearing in the middle. In this case, the items
has been reduced as a
have been ‘Returned by’ Hardware Plus, so it is a purchase return in the accounts of
result of a return.
Hardware Plus.
Source
documents
A purchase return occurs when a business returns inventory to a supplier (Account

Payable) for inventory previously purchased on credit, so in terms of debit and credits it
is the exact reverse of a credit purchase.
Returning the inventory to the supplier reduces the amount that is owed to that
supplier, so this is recorded as a debit to Account Payable – Marcon Tools. However,
the original amount owing to the Account Payable consisted of two amounts: the cost
price of the inventory ($360), plus the GST on that purchase ($36), so returning the
inventory decreases the Account Payable by the sum of these two figures ($396).
Second, because the inventory level decreases, the Inventory decreases via a credit
to this account, but this is only for the value of the inventory returned ($360), with the
remaining $36 recorded as a separate credit to GST Clearing, increasing the liability to
the ATO (or possibly reducing the asset). That is, whereas GST on the credit purchase
reduced the GST liability – because the supplier will forward the GST to the ATO – this
entry is ‘reinstating’ that GST liability because it will no longer be paid to the supplier.
Figure 5.9 General Journal: Purchase return

General Journal
Aug. 28 Account Payable – Marcon Tools 396
Inventory 360
Study tip
GST Clearing 36
Purchase return to Marcon Tools of 2 AED electric drills –
faulty (Cr. Note 85) GST on a purchase return
‘undoes’ the decrease in
In the case of a return, the narration must identify not only the source document the GST liability caused
(Cr. note 85) but also the type and quantity of inventory being returned and the reason by a credit purchase.
for the return.
Source
documents
Figure 5.10:
Figure 5.10 General Ledger: Purchase return

General Ledger Study tip
Inventory (A)
Aug. 1 Balance 45 000 Aug. 28 Account Payable – 360
Resist the temptation to
use the cross-reference
6 Account Payable – 2 250 Marcon Tools
‘Purchase Returns’ in
Marcon Tools the Account Payable
GST Clearing (A or L) account: it describes the
transaction but there is
no such ledger account.
6 Account Payable – 225 Aug. 1 Balance 3 000
Marcon Tools 28 Account Payable – 36
Marcon Tools

Aug. 15 Bank 1 500 Aug. 6 Inventory/GST Clearing 2 475
28 Inventory/GST Clearing 396
The two cross-references in the Account Payable account reflect the fact that the
$396 decrease is a result of no longer owing Marcon Tools for the inventory ($360), nor
for the GST on that inventory ($36).
Each account also has identical cross-references on the debit and credit sides (but
with differing amounts), reflecting the fact that a credit purchase and a purchase return
are exactly the opposite in terms of General Journal and General Ledger entries.

Effect on the Accounting Equation

Because a purchase return is the opposite of a credit purchase, its effect on the
Accounting Equation is also the opposite. Whereas a credit purchase will increase
Inventory and Accounts Payable and decrease the GST liability, a purchase return has
the following effect on the Accounting Equation:

Assets Decrease (Inventory) 360
Liabilities Decrease (decrease Account Payable $396; increase GST Clearing $36) 360
If the GST Clearing account has a debit balance, and is therefore an asset, then
a purchase return will decrease that asset. This will change the overall effect on the
Accounting Equation: asset and liabilities will still decrease, but by the total on the credit
note, including the GST.
Because a purchase return does not affect any revenue or expense items, and does
not involve a cash flow, it will not be reported in either the Cash Flow Statement or
the Income Statement. In fact, it will not be reported anywhere. A purchase return will
change the balances of Inventory, Accounts Payable and GST Clearing in the Balance
Sheet, but will not be reported as a separate item.
The question of whether to return inventory is sometimes easy to answer, with
Ethical businesses well within their rights to return items that are damaged or faulty or not
c onsiderations what was ordered.
However, there may be occasions when this question is harder to answer, such
as when it is not clear whether the damage occurred before or after the inventory
was delivered. Returning inventory that was delivered in good condition, and damaged
only after it was received, may reduce losses in the short term, but over time could
jeopardise relationships with suppliers. The same applies to returns where the business
simply changes its mind, as suppliers are not obliged to accept returns in these cases.

1 Define the term ‘purchase return’.
2 State four reasons why inventory may be returned to a supplier.
3 Identify the source document used to verify a purchase return.
4 List five pieces of data that must be noted on the source document used to
verify a purchase return.
5 Show the General Journal entries to record a purchase return.
6 State one reason why the term ‘purchase return’ is not used as a cross-
reference in the Accounts Payable account.
7 Explain the effect of a purchase return on GST liability to the ATO.
8 State the effect of a purchase return on the Accounting equation.

5.4 Discount revenue

settlement discount
For a business that sells on credit terms, the issue of how to make sure customers pay a reduction in the amount paid
either early or on time can be a vexed question. One of the more common options is to by a credit customer in return
offer a settlement discount, which rewards customers who pay early by reducing the for early repayment
amount that they are required to pay. discount revenue
For a business that purchases on credit, the discount is offered by the supplier, a revenue in the form of a
reducing the amount paid (to the Account Payable) in return for that payment being decrease in liabilities (Accounts
made early. The discount itself is the amount that will not have to be paid but will still be Payable) and an increase in
deducted from the amount owing to the Account Payable, and it is known as discount owner’s equity, earned when
Accounts Payable are paid early
revenue as it decreases liabilities (Accounts Payable) and increases owner’s equity
and a settlement discount is
(without requiring a decrease in Bank or any other asset). given by the supplier
Linen and McCartney purchases sheets, towels and other manchester on credit Example
from CC Cotton under terms of 5/7, n/30.
During March 2025, the following transactions occurred:
March 3 Purchased inventory on credit from CC Cotton for $1 400 plus GST (Inv. 43)
8 Paid CC Cotton in full settlement of account (EFT Trans. 4002)
Source document
Source
documents
The source document for a payment to an Account Payable will be the same with or
without a discount, and it will most likely be a cheque butt or an EFT receipt. In this
example, the payment is verified by an EFT receipt, and notes that it is in full settlement
of account, confirming both that it is a payment to an Account Payable, and also that it
will reduce to zero the balance owed to that supplier.
However, to determine whether a discount applies, and if so the amount of the
discount, it is necessary to check the payment document against the purchase invoice,
the terms noted on the invoice, and the date of both the purchase and the payment.
Calculating the discount

Study tip
As noted earlier, the terms of a settlement discount must be stated on the invoice.
The discount rate and the number of days allowed to pay will vary between firms,
depending on how quickly they need their cash and the relationships they develop In credit terms, the
with their customers, but the format for expressing the credit terms is generally fairly second and fourth
consistent. numbers refer to the
In this example, Linen and McCartney has 30 days to pay the net amount (balance number of days.
owing) on the invoice, but because the payment is made on 8 March 2025 – within
the 7 day discount period from the purchase date of 3 March 2025 – it is entitled to a
discount of 5%.

The discount revenue earned on 8 March 2025 would be calculated as shown in

Figure 5.11:
Figure 5.11 Calculation: Discount revenue
Study tip Discount revenue = Discount rate × Amount owing

= 5% × $1 540
= $77
GST can be adjusted so
that businesses do not
have to absorb the GST By paying early, Linen and McCartney earns a discount of 5% on the full balance of
they do not collect, but
$1 540 (including the GST) that it owes to CC Cotton. This discount of $77 means it is
this is beyond the scope
only required to pay $1 463, but the balance it owes to CC Cotton is reduced by the total
of this course.
amount of $1 540 ($1 463 plus $77).
Source
documents
On 8 March 2025, only $1 463 has been paid so this amount is recorded as a credit
to the Bank account. At the same time, Linen and McCartney has earned a discount
of $77 so this amount must be credited to Discount revenue. However, the amount
owed to the Account Payable will decrease by both amounts (the $1 463 paid plus the
$77 discount) so it is this total of $1 540 that must be recorded as a debit to Account
Payable – CC Cotton.
Figure 5.12 General Journal: Cash payment to Account Payable with discount
General Journal
Mar. 8 Account Payable – CC Cotton 1 540
Bank 1 463
Discount revenue 77
Cash paid to CC Cotton to settle debt, with 5% discount
for early payment (EFT Trans. 4002)

Source
documents
Figure 5.13:
Figure 5.13 General Ledger: Cash payment to Account Payable with discount
General Ledger
Account Payable – CC Cotton (L)
Mar. 8 Bank/Discount revenue 1 540 Mar. 3 Inventory/GST Clearing 1 540
Bank (A)
Mar. 1 Balance 12 000 Mar. 8 Account Payable –
CC Cotton 1 463
Discount revenue (R)

Mar. 8 Account Payable – 77
CC Cotton
Note that as a result of this payment, the balance of the Account Payable – CC
Cotton has been reduced by $1 540: even though only $1 463 has been paid, the $77
Discount revenue is also deducted from the balance owing (leaving the balance at zero).
The cross-reference in Account Payable – CC Cotton acknowledges this by identifying
both Bank and Discount revenue as the other accounts affected.
On the other hand, the cross-reference in the Discount revenue account refers only
to Account Payable – CC Cotton: there is no connection between the Bank and Discount
revenue accounts as, by definition, the discount is the amount that has not been paid.

A payment to settle an Account Payable where Discount revenue is involved will thus
have the following effect on the Accounting equation:

Liabilities Decrease (Account Payable) 1 540
Owner’s equity Increase (Discount revenue increases Net Profit) 77

Benefits and costs

While paying Accounts Payable early may generate Discount revenue, it is not without
its costs and may not be suitable in all business circumstances. As is the case with
many decisions, the owner must weigh the potential benefits of paying early against
any potential costs.
Benefits
Study tip • Less cash is paid to Accounts Payable, meaning some cash is retained to make
other payments such as wages or other expenses.
• Net profit is increased, as the discount earned is revenue.
A settlement discount
does not reduce Cost of
Sales expense as this is Costs
incurred at the point of • Cash is paid to Accounts Payable faster, meaning there may be less time to
sale: it increases revenue generate cash from sales.
and profit when the cash • Cash is unavailable to make other payments, such as wages or other expenses.
is paid.

• settlement discount
• discount revenue.
2 Explain why a discount received for an early payment to an Account Payable is
classified as revenue.
3 Explain what is meant by the notation ‘5/7, n/30’.
4 Show the General Journal entries to record a payment to an Account Payable
with discount revenue.
5 Explain why the cross-reference in the Accounts Payable account includes two
other ledger accounts when a discount revenue is earned.
6 Explain the effect of a payment to an Account Payable with discount revenue
on the Accounting equation.
7 List the benefits of early payments to Accounts Payable.
8 List the costs of early payments to Accounts Payable.

5.5 Statement of Account

A firm making credit purchases will record (in the Accounts Payable accounts in its Statement of Account
General Ledger) the transactions it has with each of its suppliers. At the same time, a summary of the transactions
those suppliers will also keep their own records and then, every month or so, send a business has had with a
particular Account Payable (or
a Statement of Account as a summary of these transactions over that period. This
Account Receivable) over a
allows each customer to check its own records, and also reminds those customers certain period of time (usually
about any debts outstanding, thereby encouraging payment. a month)
A Statement of Account is not evidence of a single transaction with a particular
Account Payable, but rather a summary of transactions that have already occurred.
These transactions should have already been recorded (when they occurred) and
should have been verified by the individual source documents (such as purchase
invoices, credit notes, and cheque butts and EFT receipts) related to each transaction.
Figure 5.14 shows a Statement of Account received by Snaps Photographic
Equipment from one of its suppliers and Accounts Payable (Pentacks) for April
2025:
Figure 5.14 Statement of Account
PENTACKS
41 Kookaburra St, Frankston VIC 3199
ABN: 22 098 822 098 For period:
STATEMENT OF ACCOUNT April 2025
Account of: 22 Grace St, Essendon VIC 3041
ABN: 55 20 141 989
Date Details Sales Payments Balance Study tip
April 1 Balance 550
8 Payment received: thank you (Ch. 245) 495 nil
Discount allowed 55 Although the column
16 Inv. N3V09 792 792 headings are different,
this Statement of
19 Goods returned (Cr. Note 5167) 154 638
Account works the same
25 Inv. N3V42 572 1 210
as a 3-column ledger
Balance owing: 30 April 2025 $ 1 210 account.
This Statement of Account would have been produced by Pentacks (the seller)
to summarise its various transactions with its customer (Snaps Photographic
Equipment).
However, from the perspective of Snaps Photographic Equipment this Statement of
Account would be a summary of their transactions with their supplier (Pentacks). Snaps
should then compare each transaction in this Statement of Account against the source
document that was issued at the time, and against the transactions recorded in its own
General Ledger, to ensure that its records are accurate and complete. Any differences
should be communicated to the supplier or, alternatively, corrected in the records of the
business.

Assuming all the transactions matched and were recorded accurately, Figure 5.15
shows how Account Payable – Pentacks would appear in the General Ledger of Snaps
Photographic Equipment:
Figure 5.15 General Ledger: Account Payable

General Ledger
Account Payable – Pentacks (L)
April 8 Bank/Discount revenue 550 April 1 Balance 550
19 Inventory/GST Clearing 154 16 Inventory/GST Clearing 792
30 Balance 1 210 25 Inventory/GST Clearing 572
1 914 1 914
May 1 Balance 1 210
The details as recorded in the Statement of Account are not the same as those used
in the account because cross-references must refer to General Ledger account names,
but the transactions are the same, and result in the same balance of $1 210 owed to the
Account Payable – Pentacks.
The Statement of Account is therefore not a source document that must be recorded,
but it does allow for the checking of each transaction and the final balance owed to
the Accounts Payable. This supports the Verifiability of the firm’s records, and thereby
ensures that the reports are complete and accurate and provide a Faithful representation
of the balance owed to each Account Payable.

1 Explain what is shown in a Statement of Account.
2 Explain how a Statement of Account can be used to ensure reports provide a
Faithful representation of a firm’s financial events.
3 Explain what action should be taken if discrepancies are detected between a
Statement of Account and the firm’s General Ledger.
4 State how many Statements of Account a business will receive in a month.
Justify your answer.

5.6 Accounts Payable Turnover
Source
documents
Purchasing inventory on credit brings a number of benefits so it is important that

Accounts Payable are paid ‘on time’ to ensure that ongoing access to credit facilities
is maintained. While this needs to be assessed on an individual basis (by reviewing
payments to each individual Account Payable), it is also important that the business has
some sense of how its payment practices are working overall. This overall assessment
is facilitated by calculating the Accounts Payable Turnover (APTO) which measures Accounts Payable Turnover
the average number of days taken to pay Accounts Payable, thereby indicating the (APTO)
effectiveness of the firm in managing payments to its Accounts Payable. the average number of days it
takes for a business to pay its
The Accounts Payable Turnover is calculated as shown in Figure 5.16:
Accounts Payable
Figure 5.16 Formula: Accounts Payable Turnover
Average Accounts Payable

Accounts Payable Turnover (APTO) = × 365
Net Credit Purchases (plus GST)
= Average number of days
The formula uses the average balance of Accounts Payable (derived by adding the
starting and ending balances, and then dividing by 2) to accommodate for any changes in
that balance over the period, and then multiplies by 365 so that the answer is expressed
in terms of days. It also uses ‘Net’ Credit Purchases (plus GST) to account for any
returns of inventory, as these will reduce the amount that must be paid.
Markwell Mirrors has provided the following information relating to its Accounts Example
Payable for 2025:
Credit purchases plus GST $275 000

Purchase returns plus GST $17 600
Accounts Payable as at 1 January 2025 $44 000
Accounts Payable as at 31 December 2025 $46 000
Accounts Payable Turnover for 2024 69 days
Credit terms offered by suppliers 60 days

Calculating Accounts Payable Turnover

The Accounts Payable Turnover for Markwell Mirrors for 2025 would be calculated as
Figure 5.17 Calculation: Accounts Payable Turnover
(44 000 + 46 000)/2
= × 365
Accounts Payable Turnover (APTO) 275 000 – 17 600
45 000
= × 365
257 400
= 64* days (63.8 rounded up to the
nearest day)
This APTO indicates that in 2025 Accounts Payable were paid on average every 64 days.
Analysing Accounts Payable Turnover

Study tip
When assessing any aspect of business performance, it can be useful to compare its
results against some type of ‘benchmark’ or ‘standard’. In the case of Accounts Payable
Changes in APTO should Turnover, these benchmarks allow the owner to assess whether the business is paying
be described as faster its Accounts Payable faster or slower than:
or slower: than previous • last year (performance in previous periods)
periods; than budgeted; • expected (budgeted performance) or
than similar businesses; • its competitors (performance of similar businesses, sometimes reflected in an
or than credit terms. industry average).
In this example, Markwell Mirrors’ Accounts Payable Turnover of 64 days in 2025
is actually 5 days faster than the 69 days taken in 2024, indicating an improvement in
its management of Accounts Payable. If a figure for budgeted APTO was available, this
could also be used to assess management of payments to Accounts Payable.
However, a more significant benchmark specifically for assessing Accounts Payable
Turnover is the credit terms offered by suppliers, which sets the maximum number
of days for the business to pay. In this example, Markwell Mirrors’ Accounts Payable
Turnover indicates it is paying on average every 64 days, which is 4 days slower than
the credit terms of 60 days offered by its suppliers. This is unsatisfactory, and may lead
to negative consequences for the business, including:
• strained relationships with suppliers
• a reduction in the firm’s credit rating (making it difficult to establish lines of credit in
the future)
• a loss of credit facilities (requiring a change of supplier or reliance on cash
purchases only).
Of course, the Accounts Payable Turnover is an average, and it is likely that payments
to individual Accounts Payable are being made faster and slower than this average.
Therefore, it is also necessary to review the timing of payments to each individual
Account Payable.
liquidity
Managing Accounts Payable
the ability of a business to meet Using the credit provided by Accounts Payable, businesses are more able to manage
its short-term debts as they when they pay for their inventory, and this gives them an important resource for
fall due managing their liquidity – their ability to meet their short-term debts as they fall due.

The benefits of purchasing on credit

To begin with, the ability to make credit purchases means that a business can obtain
inventory, which it can then sell to generate profit and cash, even if it has little (or
no) cash on hand. Secondly, the payment terms allow the business time to sell the
inventory, and collect the cash from the customer, before payment (to the Accounts
Payable) is required, ensuring the business is able to meet this debt as it falls due. This
also means the business does not have to use its existing cash on hand, so this cash
can be used to meet other payments as they fall due.
On the other hand, a business that is unable to purchase on credit from its existing
supplier/s may be forced to use cash to purchase inventory, reducing its cash on hand
and leaving it with no time to make sales and collect cash before making payments. As
an alternative, it could look for other suppliers who are willing to offer credit, but this
may mean changes to inventory available for sale, with a loss of sales a possibility if
customers do not like the new inventory lines.
Strategies for managing Accounts Payable

Having access to credit therefore makes it critical that Accounts Payable are managed
effectively, and this can be done by following some broad principles:
• Develop a strong relationship with each supplier Ethical
This can be of great benefit in terms of accessing better prices, better credit terms, c onsiderations
or better quality inventory. Relationships between businesses are often relationships
between the people who operate them, and if these personal interactions are ethical
and strong, it increases the chances that so too will be their business and financial
interactions.
• Pay within, but as close as possible to, the credit terms
Paying on time ensures that Accounts Payable will continue to provide ongoing
access to credit facilities and the benefits that this brings. However, the business
should wait until the end of the credit terms firstly to give itself time to generate the
cash, and secondly so that it can retain cash to meet other payments as they fall due.
By contrast, a business that continually pays late may incur a reduction in its credit
rating (limiting its access to future credit, or favourable credit terms), or even the loss
of credit facilities altogether (see above).
• Pay early to earn discount revenue (if available, and affordable)
Paying early reduces the total amount of cash paid, and also increases profit through
the discount revenue that it generates. However, it does require that there is
enough cash available to pay the Accounts Payable and still meet other payment
requirements.
• Check each Statement of Account against the Accounts Payable ledger
account
The Statement of Account provided by each supplier can be used to ensure the
Verifiability of the information recorded in the firm’s Accounts Payable accounts in
its General Ledger. Checking that each account is accurate and complete means
not only that the firm’s reports will provide a Faithful representation of the balances
owed to the Accounts Payable, but also reduces the possibility of over or under
payment.
• Appoint an Accounts Payable Officer / Clerk
An Accounts Payable Officer / Clerk has responsibility for record keeping (including
checking the Statements of Account), liaising with each Account Payable, and
ensuring that accounts are paid on time (and with appropriate discounts). This
would of course bring a financial cost but might be beneficial overall in ensuring that
Accounts Payable were managed effectively.

• Consider non-financial information

Information which is not included in the reports, or determined by dollars and cents,
can be critical to managing Accounts Payable, and could include:
– the supplier’s attitude to their own credit terms (and how likely they are to ‘chase’
late payments)
– the personal relationship with the supplier (which may permit a ‘more relaxed’
approach to paying on time, or even prompt a faster payment as a means of
support)
– the strength of customer demand for the products provided by a particular
supplier and whether alternative suppliers exist, with suppliers who provide
inventory that is: in high demand (for reasons of fashion or quality); essential to
the sale of other items (like particular brands of footwear in a particular sport or
popular games for gaming consoles); or unavailable from other suppliers given
‘special’ attention.
• Communicate in a timely fashion
At times there may be discrepancies with particular Accounts Payable (about records,
transactions or business agreements), and at other times it may be difficult to pay
within the credit terms. At these times, in particular, communication that is clear
and timely may help a supplier understand the firm’s perspective, and this can be
important to maintaining the ongoing relationship with that supplier.
Ethical In all of these dealings, acting in an ethical manner – particularly by acting with
considerations integrity and being honest (and open, within the bounds of commercial confidentiality) –
remains essential, as it does in all business decision-making.

1 State what is measured by Accounts Payable Turnover (APTO).
2 Show the formula to calculate Accounts Payable Turnover.
3 List three benchmarks that can be used to assess Accounts Payable Turnover.
4 Describe the importance of ‘credit terms’ when assessing Accounts Payable
Turnover.
5 Define the term liquidity and explain how purchasing inventory on credit can
help a business to manage its liquidity.
6 State three negative consequences of exceeding the credit terms offered by
suppliers.
7 List five strategies for managing Accounts Payable effectively.
Ethical 8 Explain how ethical considerations and personal relationships can be useful in
considerations the effective management of Accounts Payable.

Where have we been?

• Credit transactions involve the exchange of goods at one point in time and the exchange of cash at a
later date.
• Credit purchases are verified by a purchase invoice; payments to Accounts Payable are verified by a
cheque butt or EFT receipt; purchase returns are verified by a credit note from the supplier.
• GST on credit purchases decreases any GST liability to the ATO; GST on purchase returns increases any
GST liability to the ATO.
• A settlement discount is offered by suppliers for early payment, reducing the cash paid and generating
discount revenue.
• Financial and ethical considerations are important when purchasing inventory.
• A Statement of Account summarises all transactions with a particular Account Payable.
• Accounts Payable Turnover measures the average number of days taken to pay Accounts Payable.
• Strategies to manage Accounts Payable include developing a strong relationship with each supplier; paying
within, but as close as possible to, the credit terms; paying early to earn discount revenue (if available and
affordable); checking each Statement of Account against the Accounts Payable ledger account; appointing an
Accounts Payable Officer / Clerk; considering non-financial information; and communicating in a timely fashion.
Exercises

Credit purchase
The following document was handed to the manager of Porcelain Magic, a shop that sells tea sets and
porcelain statues:
Fine Tea China

322–335 Swindle St, Melbourne VIC 3000
ABN: 24 664 237 190
Invoice: S.90 Tax invoice

Terms: 5/7, n/30
Charge to: Porcelain Magic
245 Bulla Rd, Keilor VIC 3043
ABN: 82 100 346 275
Date Details Qty Unit Price $ Total $
4 May 2025 Fine China Tea Sets 10 120 1 200
GST (10%) 120
Total owing $1 320
Required
a Identify the source document above, and describe the transaction it verifies.
b Record this transaction in the General Journal of Porcelain Magic.
c Show how the General Ledger of Porcelain Magic would appear after this transaction was recorded.
d Explain why GST on credit purchases does not affect the valuation of inventory.
e State the effect of this transaction on the Accounting equation of Porcelain Magic.
f Explain how ethical purchasing could affect the operations of Porcelain Magic.
Ethical
considerations


Credit purchase
Phil’s Pianos has provided the following list of transactions for August 2025:
Aug. 5 Purchased 3 grand pianos on credit from Yamaha. Each grand piano cost $4 000 plus GST (Inv.
Yh3764).
8 Bought 3 upright pianos from Yamaha for $1 100 including GST each (Inv. Yh4801).
15 Sold 2 grand pianos for $6 000 plus GST each (Rec. 301). These pianos had been purchased on
5 August 2025.
24 Purchased a special model piano from Yamaha for $2 200 including GST (EFT Trans. 430).
28 Received delivery of 4 grand pianos from Yamaha, at a total cost of $17 160 including GST (Inv.
Yh5132).
As at 1 August 2025, Phil’s Pianos had a bank balance of $3 800, inventory worth $76 000, a GST balance of
$1 500 CR and it owed $1 000 to Account Payable – Yamaha.
Required
a Record the transactions for August 2025 in the General Journal of Phil’s Pianos.
b Explain why these invoices provided to Phil’s Pianos do not run in sequence.
c Referring to your answer to part ‘a’, explain how the transaction on 5 August 2025 affects the
Accounting equation of Phil’s Pianos.
d Referring to your answer to part ‘a’, explain how the Going concern assumption affects the recording of
the transaction on 8 August 2025.
e Calculate the Gross Profit earned on the transaction on 15 August 2025.
f Referring to your answer to part ‘a’, explain your treatment of the transaction on 24 August 2025.
g Show how the General Ledger of Phil’s Pianos would appear after all the transactions for August 2025
were recorded.


Credit purchases and payments to Accounts Payable
Glow Warm is a lighting store and as at 1 November 2025 its General Ledger showed that it had $1 000 cash
in Bank, Inventory worth $80 000, a GST Clearing balance of $1 700 CR and owed $1 320 to Account Payable –
Shock Electrics.
The business has provided the following information relating to its operations for November 2025:
Document A
Edison Bank
Funds transfer
Date of payment 2 / 11 / 2025
From Glow Warm
A/c: 632 552 401
To Shock Electrics
BSB: 6321
A/c: 2034 10 552
For Payment to Account Payable
Amount $800
Reference 563 099
Nov. 13 Glow Warm purchased inventory worth $5 940 including GST from Shock Electrics (Inv. 553).
26 Glow Warm received notification from Shock Electrics that it was investigating concerns about
the quality of the products it had delivered during September 2025.
Required
a Identify two features of Document A that indicate it is a payment to an Account Payable.
b Explain why Document A does not identify any GST.
c Record the relevant transactions in the General Journal of Glow Warm.
d Show how the General Ledger of Glow Warm would appear after all the information was recorded.
e Explain how the transaction on 13 November 2025 would affect:
• Inventory
• Account Payable – Shock Electrics
• GST Clearing.
f Referring to the information on 26 November 2025, explain the importance of Timeliness in business
decision-making.
g Discuss possible actions Glow Warm could take in response to the information received on
26 November 2025.


Purchase return
Mentone Music Shop sells musical instruments and as at 1 February 2025 had inventory on hand worth
$43 000, a GST liability of $960 and owed $23 000 to an Account Payable – Musical Mayhem. It has not yet
recorded the following document:
MUSICAL MAYHEM
ABN: 61 363 217 404
TAX INVOICE
Credit Note 480
72 City View Rd (Original)
Balwyn VIC 3930 8 February 2025
Mentone Music Shop (ABN: 12 945 362 733)
Returned by:
91 Balcombe Rd, Mentone VIC 3194
Item no. Description Qty Unit Cost $
205 Saxophone – Tenor 2 500 1 000
GST 10% 100
Total 1 100
Reason: Goods damaged in transit
The owner of Musical Mayhem, Erin Carew, thinks that the damage may have been caused by the staff
of Mentone Music Shop but agreed to this transaction due to her working relationship with the owner of
Mentone Music Shop, David Grenville, with whom she has traded for years.
Required
b Record this transaction in the General Journal of Mentone Music Shop.
c Show how the General Ledger of Mentone Music Shop would appear after this transaction was
recorded.
d Explain the effect of this transaction on the GST liability of Mentone Music Shop.
e Explain why Mentone Music Shop must be sure to conduct itself ethically in Ethical
its dealings with Musical Mayhem. considerations

Purchases, payments and returns
Benny Electricals purchases its inventory from Freezing Fridges and its transactions for April 2025 were as follows:
April 6 Purchased 4 fridges from Freezing Fridges at $400 plus GST each (Inv. 45).
11 Paid $8 000 to Freezing Fridges.
18 Sold 3 of the fridges purchased on 6 April 2025 at a selling price of $1 100 including GST each
(Rec. 74).
26 Purchased 5 fridges from Freezing Fridges at a total cost of $2 310 including GST (Inv. 51).
29 Benny determined that there was too much inventory on hand so returned one of the fridges
purchased on 26 April 2025 (Cr. Note 38).
As at 1 April 2025, Benny Electricals owed Freezing Fridges $8 000 and had a GST balance of $350 CR.
Required
a Suggest what type of source document would be able to verify the transaction on 11 April 2025.
b Record the transactions in the General Journal of Benny Electricals. Narrations are not required.
c Complete the following accounts in the General Ledger of Benny Electricals after all the information for
April 2025 had been recorded:
• Account Payable – Freezing Fridges
• GST Clearing.
d Explain the effect on the Accounting equation of the transaction on 29 April 2025.
e Explain how Account Payable – Freezing Fridges would be reported in the Balance Sheet of Benny
Electricals as at 30 April 2025.

Discount revenue
Piia’s Party House sells balloons and other party supplies. As at 1 February 2025, it had $1 000 in the bank, a
GST liability of $390 and also owed $1 870 to J&M Papermill for inventory purchased on 31 January 2025. The
following document has not yet been recorded:
Bank of Finland
Date 5/2/2025
To J&M Papermill
For Payment to
Account Payable
Bal c/fwd $
Deposits $
Amount $ 1 683
Balance $
Ch. 100 325
• Inventory is purchased from J&M Papermills on terms of 10/7, n/60.
• The owner of Piia’s Party House is certain a discount will apply to the transaction on 5 February 2025.
• On 15 February 2025, Piia’s Party House bought more inventory from J&M Papermills for $2 750
including GST (Inv. JB201).
Required
a Explain why J&M Papermills would offer a settlement discount to its customers.
b Explain why the owner of Piia’s Party House is correct about the discount applying to the transaction on
5 February 2025.
c Calculate the discount revenue earned on 5 February 2025.
d Record the transaction on 5 February 2025 in the General Journal of Piia’s Party House.
e Show how the General Ledger of Piia’s Party House would appear after recording the transactions for
February 2025.
f Explain why the discount earned on 5 February 2025 would be reported as revenue in the Income
Statement of Piia’s Party House.
g Given that the GST and discount rate are both 10%, explain why the amount of the discount revenue earned
on 5 February 2025 is not the same as the amount of the GST on the purchase made on 31 January 2025.


Accounts Payable: Cash and credit transactions
Diana Adams is the owner of Diana’s Jewellery, which had the following balances in its ledger accounts as at
1 June 2025:
Bank $22 900
Inventory 74 500
Display cabinets 35 000
Account Payable – Carter Diamonds 15 950
GST Clearing 1 700 CR
Diana has provided the following list of transactions for June 2025:
June 1 Paid GST owing to ATO $1 700.

3 Paid Carter Diamonds balance outstanding as at 1 June 2025, less discount.
5 Cash sale of jewellery for $12 000 plus GST. This jewellery had a cost price of $8 000.
8 Paid wages $1 200.
12 Purchased inventory on credit from Carter Diamonds for $8 000 plus GST.
Cash purchase of additional display cabinets for $6 050 including GST.
14 Paid cash to Stone Works for inventory worth $4 500 plus GST.
17 Returned some jewellery to Carter Diamonds worth $1 500 plus GST.
20 Paid Carter Diamonds in full settlement of amount owing.
23 Cash sale of jewellery for $9 900 including GST. This jewellery had a cost price of $6 000.
26 Cash drawings $1 000.
29 Credit purchase of jewellery from Carter Diamonds for $11 000 including GST.
30 Paid electricity bill of $230 plus GST.
• As at 1 June 2025, there were no other assets or liabilities.
• Diana’s Jewellery has lost all of the source documents relating to the transactions for June 2025.
• Carter Diamonds offers credit terms of 8/10, n/45.
Required
a Referring to the Qualitative characteristics, explain how the loss of the source documents will affect the
Accounting information of Diana’s Jewellery.
b Record the transactions on 3, 12, 17 and 23 June 2025 in the General Journal of Diana’s Jewellery.
Narrations are not required.
c State the effect of the transaction on 3 June 2015 on the Accounting equation of Diana’s Jewellery.
d Show how the General Ledger of Diana’s Jewellery would appear after recording the transactions for
June 2025.
e Balance the Bank, Inventory and GST Clearing accounts.
f Explain how the GST Clearing account would be reported in the Balance Sheet of Diana’s Jewellery as
at 30 June 2025.


Accounts Payable
Thommo’s Toys presented the following summary of its transactions for October 2025:
Inventory – balance 1 October 2025 $42 000
Accounts Payable – balance 1 October 2025 34 000
GST Clearing – balance 1 October 2025 800 CR
Credit purchases of inventory 50 000 plus GST
Cash purchases of inventory 3 300 including GST
Cash paid to Accounts Payable 59 400
Discount revenue 600
Cash sales 90 000 plus GST (cost price $60 000)
GST paid on expenses 2 500
Purchase returns 1 100 including GST
All inventory is purchased on credit from Wilson Industries.
Required
a State the type of source document that would verify the purchase returns.
b State two reasons why inventory may be returned to a supplier.
c Show how the Inventory, Account Payable – Wilson Industries and GST Clearing accounts would appear
in the General Ledger of Thommo’s Toys after recording the transactions for October 2025. Transaction
dates are not required.
d Calculate the percentage discount given to Thommo’s Toys by Wilson Industries.
e Explain why inventory should be purchased on credit whenever possible.
f Discuss the benefits and costs of Thommo’s Toys paying its Accounts Payable early.

Exercise 5.9 W page 101

B
Statement of Account
The owner of Celtic Sensations has received the following source document in the mail:
Look of the Irish

ABN: 34 221 768 999
110 Main Rd
Greensborough VIC 3085 5 July 2025
STATEMENT OF ACCOUNT ACC: 8613
Celtic Sensations ABN: 16 422 031 164
Customer: 45 Burke Rd, Camberwell VIC 3350
Date Particulars Debit Credit Balance
June 1 Balance b/fwd 3 300
3 Thank you – payment Chq. 143 3 102 nil
Discount allowed 198
12 Inv. MH 365 1 320 1 320
19 Credit Note 43 220 1 100
24 Thank you – payment Chq. 167 500 600
29 Inv. MH 372 1 650 2 250
Days outstanding Current 30 – 60 60+
Amount outstanding nil 2 250 nil
Please pay any outstanding amounts immediately to ensure continuance of supply
Required
a Calculate the percentage discount given on 3 June 2025.
b Record the transactions on 3 and 12 June in the General Journal of Celtic Sensations.
c Explain how the transaction on 19 June 2025 would affect the Accounting equation of Celtic Sensations.
d Complete the account of Account Payable – Look of the Irish in the General Ledger of Celtic Sensations.
e Explain how Look of the Irish would be reported in the Balance Sheet of Celtic Sensations.
f Explain how Celtic Sensations would be reported in the Balance Sheet of Look of the Irish.
g Explain how this document supports the Qualitative characteristics of financial information.

Accounts Payable Turnover
Pringle Pumps has provided the following information for 2025:
Credit purchases including GST $91 300

Returns to Accounts Payable including GST $7 150
Accounts Payable as at 1 January 2025 $12 000
Accounts Payable as at 31 December 2025 $8 000
Accounts Payable Turnover (2024) 38 days
Required
a State what is measured by Accounts Payable Turnover.
b Calculate Accounts Payable Turnover for Pringle Pumps for 2025.
c State two reasons why the owner of Pringle Pumps should be concerned about Accounts Payable
Turnover in 2025.
d Explain how exceeding the credit terms offered by suppliers can negatively affect operations and
liquidity.
e Explain two actions the owner of Pringle Pumps could take to ensure the continuation of credit facilities
in 2026.


Sam’s Moulds has provided the following information for 2025:
Sam's Moulds
70
60
50
40
30
20
10
0
2023 2024 2025
APTO ( days)
• The suppliers of Sam’s Moulds offer credit terms of n/60.
• Sam, the owner of Sam’s Moulds, will sometimes delay payments to Accounts Payable until well after
the due date.
Required
a Describe the trend in the Accounts Payable Turnover of Sam’s Moulds from 2023 to 2025.
b Explain two possible reasons for the change in the Accounts Payable Turnover of Sam’s Moulds from
2023 to 2024.
c Explain one action the suppliers may have taken which explains the change in the Accounts Payable
Turnover of Sam’s Moulds from 2024 to 2025.
d Explain why the owner of Sam’s Moulds may be concerned about Accounts Payable Turnover for 2025.
e Discuss the benefits and costs of the owner’s payment strategy.
f Discuss whether Sam’s Moulds is managing its Accounts Payable in a Ethical
financially and ethically responsible manner.Ethical considerations c
onsiderations

Chapter 6
Accounts Receivable: documents, the GST
and the General Journal

After completing this chapter, you should be able to: • apply credit terms and calculate settlement
• apply Accounting assumptions and Qualitative discounts
characteristics • discuss ethical considerations in business
• identify transactions with Accounts Receivable decision-making
from source documents • identify the effect of GST on transactions with
• record transactions with Accounts Receivable in the Accounts Receivable
General Journal and General Ledger • calculate and analyse Accounts Receivable
• explain the effect on the Accounting equation of Turnover
transactions with Accounts Receivable • discuss strategies to manage Accounts
• explain how transactions with Accounts Receivable Receivable.
affect the financial reports
• apply Accounting skills to transactions with
Accounts Receivable including:
– credit sales of inventory (including GST)
– receipts from Accounts Receivable, including
discounts
– sales returns to Accounts Receivable
Key terms
After completing this chapter, you should be familiar • sales return
with the following terms: • discount expense
• Account Receivable • Accounts Receivable Turnover (ARTO)
• credit sale • Accounts Receivable Ageing Analysis.
• sales invoice

C hapter 6 AC C O U N T S R E C E I VA B L E 127
6.1 Credit sales and the GST

Whereas Chapter 5 considered how to identify and record transactions affecting
Accounts Payable, this chapter applies those skills to transactions affecting Accounts Account Receivable
Receivable, including credit sales (with GST), receipts from Accounts Receivable (with a customer to whom inventory
and without discounts) and sales returns (with GST). has been sold on credit, and the
amount still owing for those
sales (also called a ‘debtor’)
Credit sales
In all credit transactions, the exchange of cash happens sometime after the goods have credit sale
a transaction that involves
been exchanged. However, with a credit sale there is an additional factor to consider,
selling inventory on credit, with
because there are two different valuations of the inventory sold: the cost price paid by the provision of the inventory
the business at the time of purchase, and the selling price charged to the customer at the on one date, followed by the
time of sale. receipt of cash at a later date
Figure 6.1 Credit sale
Cost of Sales (cost price)
Customer
Business
(Account Receivable)
Sales revenue (selling price)
At the point of sale, a credit sale earns Sales revenue valued at the selling price
charged to the customer (who is also recognised as an Account Receivable). At the
same time, Cost of Sales expense is incurred to recognise the cost price of the inventory
that has been sold (and Inventory decreases). The difference in these two valuations
represents the Gross Profit earned from the sale.
The receipt of cash from the Account Receivable at some point in the future is simply
recognised as an increase in Bank and decrease in Accounts Receivable.
Qualitative characteristics and Accounting assumptions

As with credit purchases, it is only possible to recognise credit sales because of the
application of the Accrual basis and Going concern assumptions.
The Accrual basis assumption states that the Elements of the reports are recognised
when they satisfy the definitions and recognition criteria so that profit is calculated by
deducting expenses incurred from revenues earned in a particular Period. For credit
sales, revenue is recognised as earned, even though the cash has not been received,
because at the point of sale assets (Accounts Receivable) and owner’s equity increase.
Further, the amount yet to be received from the Account Receivable can be
recognised as an asset because the Going Concern assumption assumes the business
will still be operating in the future when the cash is due to be received.
Applying these assumptions and recognising the revenue earned from credit sales at
the point of sale also ensures Relevance in the reports because all information capable
of making a difference to decision-making (specifically, the Sales revenue earned and
the amount owed to the business by the Account Receivable) is included in the financial
statements.

Example On 8 July 2025, Vixen Sportswear sold inventory to SE Netball League for $600
plus $60 GST (Inv. 41). The inventory had a cost price of $400.
Source document
Source
documents
sales invoice When a business makes a credit sale, it must issue a sales invoice to the customer
a source document used to (Account Receivable) which satisfies the requirements of a tax invoice showing, among
verify a credit sale of inventory other details, the total amount owing and the GST on the sale. Figure 6.2 shows how
to an Account Receivable
such a sales invoice may appear:
Figure 6.2 Sales invoice
Vixen Sportswear
Plenty Rd, Bundoora 3083
ABN: 20 114 653 989
Study tip Charge to: SE Netball League 8 July 2025

ABN 98 764 885 101 TAX INVOICE 41
Deliver to: 43 Klauer St Duplicate
Seaford VIC 3199 Terms: 10/7, n/30
Because these
documents are issued by Qty Item Unit price $ Total cost $
the business for whom 10 Hoodies – Swifts Netball Club 60.00 600.00
we are Accounting, sales GST (10%) 60.00
invoice numbers will run Total 660.00
in sequence.
less Amount paid Nil
Balance owing 660.00
Study tip
As with all invoices, the name of the seller appears at the top of the document,
meaning this document records a sale by Vixen Sportswear. Note also that it is a
Remember to identify ‘duplicate’ as the original has been provided to the customer, the Account Receivable –
the Accounting entity SE Netball League (who is identified in the document as the business to ‘Charge to’ and
for whom you are ‘Deliver to’).
Accounting, as a credit The sales invoice also indicates the credit terms (10/7, n/30) and, by virtue of the
sale for one entity (e.g. fact that the ‘Amount paid’ is nil, that $660 remains owing by the Account Receivable.
Vixen Sportswear) is Note, however, that the sales invoice does not identify the $400 cost price of the
a credit purchase for inventory as the seller (Vixen Sportswear) does not want to disclose to its customers
another (e.g. SE Netball the mark-up it has applied for fear that the customers will feel empowered to negotiate
League).
vigorously for a lower selling price.

Source
documents
As a result of this credit sale, and the application of the Accrual basis assumption, Vixen
Sportswear must credit its Sales account by $600 to recognise the revenue that it has
earned on 8 July 2025.
In addition, Vixen Sportswear is obliged to charge its customers GST, calculated as
10% of the selling price. However, this GST is charged to the customer on behalf of the
ATO, and therefore owed to the ATO, so it must be recorded as a credit of $60 to the
GST Clearing account to recognise this increase in its GST liability.
Taken together, this means that Vixen Sportswear is owed $660 by its Account
Receivable: $600 for the inventory sold, plus $60 for the GST on that sale. This will
require a debit of $660 to the current asset Account Receivable – SE Netball League
representing the present economic resource (the cash due to be received from SE
Netball League) that it controls (because it can specify when the amount must be repaid
or that the inventory must be returned) as a result of past events, within the next 12
months.
Finally, the expense incurred from the sale is recorded by a debit to the Cost of Sales
account, and the reduction in Inventory recorded by a credit to this account, both at cost
price of $400. These entries are not affected at all by the GST.
All this would be recorded in the General Journal as shown in Figure 6.3:
Figure 6.3 General Journal: Credit sale with GST

General Journal
July 8 Account Receivable – SE Netball League 660
Sales 600
GST Clearing 60
Cost of Sales 400
Inventory 400
Credit sale of 10 hoodies to SE Netball League (Inv. 41)
A credit sale thus results in two separate, but balancing, sets of debits and credits:
one using the selling price and one using the cost price. As always, the narration includes
a description of the transaction as well as the source document (Inv. 41) to ensure the
information is Verifiable (can be checked against the source document) and provides
a Faithful representation of what has occurred: complete, free from material error and
neutral (without bias).

Source
documents
Figure 6.4:
Figure 6.4 General Ledger: Credit sale with GST

General Ledger
Account Receivable – SE Netball League (A)
July 8 Sales/GST Clearing 660
Sales (R)
July 8 Account Receivable – 600
SE Netball League
8 Account Receivable – 60
SE Netball League
Cost of Sales (E)

Inventory (A)
The $660 debited to the Account Receivable includes $600 worth of Sales plus
$60 GST, so both Sales and GST Clearing are noted in the cross-reference. However,
the Sales and GST Clearing accounts are not connected to each other, so the cross-
reference in these accounts is simply Account Receivable – SE Netball League.
Crediting the GST Clearing account increases the liability to the ATO (in this case, by
$60, or from $2 000 to $2 060).

A credit sale of inventory will thus have the following effect on the Accounting equation:

Assets Increase (Increase Accounts Receivable $660, decrease Inventory $400) 260
Liabilities Increase (GST Clearing) 60
Owner’s equity Increase (Sales revenue $600 less Cost of Sales $400) 200

This shows that although the GST on the sale increases the amount owed by the
Account Receivable, and increases the GST liability owed to the ATO, it does not
affect the revenue earned or expense incurred on the sale, and therefore has no effect
on profit.
Ethical
When selling inventory on credit, a business must give due consideration to:
c onsiderations
• the nature of the goods it is selling
• the customer’s capacity to pay.
Chapter 5 discussed in detail the need for businesses to consider the relationship
between the quality and price of what they purchase, and their legal and ethical
obligations to provide goods for sale that are safe and ‘socially and environmentally
responsible’ (both in terms of the product itself and how it is produced).
Further considerations apply when those goods are sold on credit. The customer’s
ability to repay is an important financial consideration, as debts which cannot be repaid
will cost the business both in terms of cash (that is not received) and profit (through bad
debts expenses).
However, it is also an important ethical consideration, especially where credit terms
are offered to customers who cannot really afford to make the subsequent repayments.
Sales made in these circumstances may generate a short-term benefit for the business,
but in the longer term can distort resource allocation, as these customers are forced to
make repayments (for goods they could not really afford, and perhaps did not need) at
the expense of other more important items like accommodation, school fees or even
healthy food.
And given that distorted resource allocation can undermine the very health of the
economy on which each business relies, perhaps businesses are wise to consider the
ethical and financial ramifications as complementary when making decisions about
selling on credit.

• credit sale
• Account Receivable.
2 Explain how the Accounting assumptions support the recognition of credit
sales.
3 Explain how the recording of credit sales ensures Relevance in the Balance Sheet.
4 Identify the source document used to verify a credit sale.
5 Explain why the cost price of inventory sold is not shown on the source
document used to verify a credit sale.
6 Show the General Journal entries to record a credit sale.
7 Explain why an Account Receivable is reported as an asset.
8 Explain how GST on a credit sale will affect:
• GST owed to the ATO
• the profit on the sale.
9 State the effect of a credit sale on the Accounting equation.
10 Explain how ethical decision-making regarding credit sales can improve Ethical
business performance. considerations

6.2 Receipts from Accounts Receivable

Having made a sale on credit, the business will at some point in the future receive cash
from the Account Receivable to settle the amount owing.
Example On 16 July 2025, Vixen Sportswear received $350 from SE Netball League
(Rec. 1040).
Source document
Source
documents
The most common ways for a business to receive cash from an Account Receivable
would be by cash received at the business premises or, increasingly, by EFT (a direct
credit or direct deposit into the firm’s bank account).
Assuming the cash was received by EFT deposit, the document may appear as
Figure 6.5 EFT receipt: Receipt from Account Receivable
Empire Bank
Vixen Sportswear (A/c: 003 003 045)
Funds transfer
Date of receipt 16/7/2025
SE Netball League
From A/c: 323 554 106
For Payment towards balance owing
Amount $350
Reference 1635
There is no GST to account for when cash is received from an Account Receivable as
it was already recognised at the point of sale (in this case, on 8 July 2025).
Source
documents
As a cash transaction, a receipt from an Account Receivable increases the Bank so

this account is debited. At the same time, the amount owed by Account Receivable
reduces, so this asset account is credited.

Figure 6.6 shows how this would be recorded in the General Journal:
Figure 6.6 General Journal: Cash receipt from Account Receivable

General Journal
July 16 Bank 350
Accounts Receivable – SE Netball League 350
Cash received from Account Receivable – SE Netball
League (EFT Rec. 1635)
Source
documents
Figure 6.7 General Ledger: Cash payment to Account Payable

General Ledger
Bank (A)
16 Account Receivable – 350
SE Netball League

July 8 Sales/GST Clearing 660 July 16 Bank 350
In this example, the entire amount owed by SE Netball League ($660) has not been
paid, so $310 is still owing, and would be reported as a current asset in the Balance
Sheet of Vixen Sportswear.

A cash receipt from an Account Receivable will thus have the following effect on the

Assets No effect (Increase Bank, decrease Account Receivable) Nil
Although the composition of assets will change (with Bank increasing and Accounts
Receivable decreasing), there is no overall change to any of the Elements of the
Accounting equation. As a result, there is no further increase in owner’s equity, so – by
definition as well as event – there is no revenue earned on this date.
This confirms that under the Accrual basis assumption, revenue is recognised as
earned when the credit sale occurs, and not when the cash is received.


1 Identify the source documents which might be used to verify cash received
from an Account Receivable.
2 Explain why there is no GST to account for when cash is received from an
Account Receivable.
3 Show the General Journal entries to record cash received from an Account
Receivable.
4 State the effect on the Accounting equation of cash received from an Account
Receivable.
5 Explain how cash received from an Account Receivable is reported in the
Income Statement.
6.3 Sales returns

sales return
the return by a customer Just as there may be a need to return inventory to a supplier (Account Payable) as a
(Account Receivable) of purchase return, there will from time to time be a need to accept inventory returned by
inventory sold on credit a customer (Account Receivable) as a sales return.
The reasons for sales returns mirror the reasons for purchase returns and include:
• the inventory is faulty or damaged
• the inventory is the wrong size / colour / shape / model
• too many items of inventory were purchased
• the customer has simply changed their mind.
Example On 23 July 2025, SE Netball League returned 3 hoodies because they had
purchased too many on 8 July 2025 (Cr. Note 101).
Source document
Source
documents
As this course deals only with sales returns by Accounts Receivable, the only document
to provide the evidence of a sales return will be a credit note, such as the one shown
in Figure 6.8:

Figure 6.8 Credit note: Sales return

Study tip
Vixen Sportswear
Plenty Rd, Bundoora 3083 Although returns may
ABN: 20 114 653 989 be made for cash, this
course concentrates
23 July 2025 only on sales returns by
SE Netball League TAX INVOICE: Credit Note 101 Accounts Receivable (of
Returned by: ABN 98 764 885 101 (Duplicate) inventory sold on credit).
Qty Item Unit price $ Total cost $
3 Hoodies – Swifts Netball Club 60.00 180.00
GST (10%) 18.00
Total 198.00
Reason: Customer bought too many on 8 July 2025
Please note: this amount of $198 will be credited to your account.
Note how similar a credit note is in appearance to an invoice and, just like an invoice,
the name of the seller is identified at the top of the document. In the case of a return, Study tip
the seller is also the business that is receiving the inventory as a return. In this example,
Vixen Sportswear is noted at the top, so it is receiving the inventory which has been
A credit note for a sales
returned by SE Netball League and would record this as a sales return. (In the accounts return is not ‘store cash’
of SE Netball League, this would be recorded as a purchase return.) but simply evidence of a
reduction in the balance
Recording: General Journal owed to the Account
Receivable.
Source
documents
Just as a purchase return is the reverse of a credit purchase, so too is a sales return the
reverse of a credit sale – with one twist!
The original credit sale was recorded as a credit to the Sales revenue account, so a
sales return requires the opposite. However, rather than simply debit the Sales revenue
account, a separate ledger account is used to record Sales returns. This account is a
negative revenue account and is debited $180 to record the reduction in revenue.
GST Clearing is also debited by $18 to reduce the GST liability owed to the ATO.
Because the inventory has been returned this is GST that Vixen Sportswear will never
receive, and therefore now does not owe to the ATO. Study tip
Reversing the sale also means that the debt owed by the Account Receivable is
reduced. This is achieved by crediting the Accounts Receivable – SE Netball League
account by $198, as the customer no longer owes the $180 charged for the sale or the In this course, sales
$18 of GST on that sale. returns will identify
Finally, as the goods are being returned to the business, Inventory must be debited the cost price of the
inventory returned (in this
to show the increase in this asset, with Cost of Sales credited by the same amount to
example by identifying
show the reduction in this expense. The inventory in this return comes from the sale on
the sale from which they
8 July 2025 which had a cost price of $400 for 10 items, or $40 each, so these 3 items
came).
have a cost price of $120 (3 hoodies × $40 per item).

Figure 6.9 General Journal: Sales return

General Journal
July 23 Sales returns 180
GST Clearing 18
Study tip
Account Receivable – SE Netball League 198
Inventory 120
GST on a sales return Cost of Sales 120
reduces the GST liability Sales return by SE Netball League of 3 hoodies
caused by a credit sale. – customer bought too many on 8 July 2025 (Cr. Note 101)
In the case of a return, the narration must identify not only the source document
(Cr. Note 101) but also the type and quantity of inventory being returned and the reason
for the return.
Source
documents
Figure 6.10 General Ledger: Sales return

General Ledger
July 8 Sales/GST Clearing 660 July 16 Bank 350
23 Sales returns/GST Clearing 198
Sales (R)
SE Netball League
Sales returns (−R)

SE Netball League
July 23 Account Receivable – 18 July 1 Balance 2 000
SE Netball League 8 Account Receivable – 60
SE Netball League

Cost of Sales (E)

July 8 Inventory 400 July 23 Inventory 120
Inventory (A)
The two cross-references in the Account Receivable account reflect the fact that the
$198 decrease is a result of the both the Sales return ($180) and the GST on that return ($18).

Because a sales return is almost the opposite of a credit sale, its effect on the Accounting
equation is also the opposite:

Assets Decrease (Decrease Accounts Receivable $198, increase Inventory $120) 78
Owner’s equity Decrease (Sales returns $180 less decrease Cost of Sales $120) 60
A credit sale leads to an increase in profit, so a sales return leads to a decrease in

that profit.
If the GST Clearing account has a debit balance, and is therefore an asset, then a
sales return will increase that asset. This will change the overall effect on the Accounting
equation: assets and owner’s equity will both decrease by the amount of profit ‘lost’.
(This, of course, changes if Bank is an overdraft).
Reporting sales returns

Sales returns can be an important indicator of the quality and suitability of the inventory
that is being sold, but in order to investigate the cause/s the owner must first know the
level of sales returns in a given Period. Recording a sales return in its own separate ledger
account allows this information to be reported separately in the Income Statement, and
thus assessed and managed by the owner (see Chapter 10 for more information).
Of course, the owner should not rely solely on the Income Statement for information
about the suitability of inventory. Inventory movements should be assessed regularly by
consulting with staff and customers, and by examining the inventory cards (which are
covered in detail in Chapters 8 and 9).
Financial, legal and ethical considerations

Sales generate profit, but sales returns reduce that profit, so there is a strong incentive
Ethical
for a business to keep its sales returns to a minimum. The first and most effective way
c onsiderations
of doing this is to sell good quality products, which will perform their intended function,
and to provide accurate information to customers (via good signage, and well trained
and knowledgeable staff) so that they are satisfied with what they have purchased.
However, even with the best products and customer service there will still be
occasions when sales returns eventuate. Damaged or faulty inventory must be accepted
for return, provided the customer has the source document (such as the sales invoice)
as proof of purchase, and the business is satisfied the fault lies with the product rather
than with how it was used. Owners should obtain advice regarding their legal obligations
in this area, but in most cases where the product is not ‘fit for the purpose intended’ the
business has a legal obligation to accept the return.
Accepting returns from customers who have purchased the wrong items, or too many
items, or simply changed their minds is up to each business. For some businesses – and
some products – it may be inappropriate to accept returns (cut material and, perhaps,
underwear may fall into this category). However, businesses that do accept returns may
actually generate greater sales, with customers more willing to buy if they know they
can return the product if it turns out to be unsuitable.
The decision to accept sales returns in these cases depends on the business, the
product/s and the situation, with a consideration of the potential ‘Cost v Benefits’ often
being helpful:
• Option 1: accepting the return
Costs: reduction in profit, extra inventory management costs (e.g. repackaging),
inability to re-sell (at current price)
Benefits: higher goodwill (from current and future customers), higher future sales
• Option 2: not accepting the return
Costs: lower goodwill (from current and future customers), lower future sales, costs
of dealing with an ongoing complaint, possible legal consequences
Benefits: retention of profit, no extra inventory management costs
Sales returns and purchase returns

In cases where damaged or faulty inventory is returned by a customer, the business
may decide to return those items to its supplier by way of a purchase return. However,
as it may be possible to repair the inventory and prepare it for resale it should not be
assumed that all sales returns will result in a purchase return. A purchase return must
still be verified by its own credit note before it can be recorded in the accounts.

1 Define the term ‘sales return’.
2 State four reasons why inventory may be returned by a customer.
3 Identify the source document used to verify a sales return.
4 Explain how a credit note can be used to distinguish between a purchase
return and a sales return.
5 Show the General Journal entries to record a sales return.
6 Explain how the cost price of a sales return is determined.
7 Explain the effect of a sales return on GST liability to the ATO.
8 State the effect of a sales return on the Accounting equation.
9 Explain why a sales return is reported separately in the Income Statement.
10 Explain the circumstances in which a business:
• must accept a sales return
• might accept a sales return.

6.4 Discount expense

Businesses who pay their Accounts Payable early might be entitled to receive a
settlement discount, with this discount revenue reducing the total amount that they are
required to pay, and also increasing their profit.
By the same token, businesses who sell on credit may offer their own customers
a discount for paying early, but for the business offering the discount it would actually
be a discount expense, as it would decrease their assets (Accounts Receivable) and discount expense
owner’s equity by the amount not received from the Account Receivable (but still an expense in the form of a
decrease in assets (Accounts
deducted from their balance).
Receivable) and owner’s equity,
Note that this is not a ‘sales discount’ that reduces the selling price charged to the incurred when cash is received
customer at the time of sale, such as ‘All stock must go – 50% off marked prices!’ early from Accounts Receivable
Rather, it is a ‘settlement discount’ offered to encourage early payment from customers a settlement discount is
(Accounts Receivable) to whom sales have already been made. allowed
Harrison Starr Bicycles sells bikes and other cycling gear. During January 2025, Example
the following transactions occurred:
Jan. 2 Sold inventory on credit to R. George for $2 860 including GST (Inv. 621)
on terms of 5/10, n/30.
5 R. George returned some items worth $200 plus GST (Cr. Note 39)
11 Received cash from R. George for balance of account (Rec. 134)
Source document
Source
documents
The source document for a receipt from an Account Receivable will be the same with
or without a discount (i.e. a receipt – manual or EFT), but it must identify that it is in
fact from an Account Receivable. This transaction specifies that the receipt covers the
balance of account, meaning it settles any and all amounts owing.
Study tip
Calculating the discount
To determine the discount, if any, it is necessary to check the date of the receipt against
the date of and terms on any invoices. In this case, a discount is applied if the cash In credit terms, the
second and fourth
is received from the Account Receivable within 10 days, so the cash received on 11
numbers refer to the
January 2025 will entitle the customer to a 5% discount on whatever is still owing.
number of days.
As at 11 January 2025 – when the cash is received – the account of Account
Receivable – R. George would appear as shown in Figure 6.11:
Figure 6.11 General Ledger: Calculating discount

General Ledger
Account Receivable – R. George (A)
Jan. 2 Sales/GST Clearing 2 860 Jan. 5 Sales returns/GST Clearing 220
2 640

This $2 640 balance still owing will be the amount ’settled‘ on 11 January 2025,
Study tip and the amount on which the discount expense will be calculated as is shown in
Figure 6.12:
GST can be adjusted so

Figure 6.12 Calculation: Discount expense
that businesses do not
have to absorb the GST Discount expense = Discount rate × Amount owing
they do not collect, but = 5% × $2 640
this is beyond the scope = $132
of this course.
This discount of $132 is the amount that R. George will not have to pay (but will still
be deducted from its Accounts Receivable account) meaning $2 508 ($2 640 owing less
$132 discount) will be received in cash.
Source
documents
On 11 January 2025, $2 508 is received as cash so this amount is recorded as a debit

to the Bank account. At the same time, Harrison Starr Bicycles has incurred an expense
of $132 so this amount must be debited to Discount expense. However, the balance
of the Account Receivable will decrease by both amounts (the $2 508 received plus the
$132 discount) so it is this total of $2 640 that must be recorded as a credit to Account
Receivable – R. George.
Figure 6.13 General Journal: Cash receipt from Account Receivable with discount
General Journal
Jan. 11 Bank 2 508
Discount expense 132
Account Receivable – R. George 2 640
Cash received from R. George with 5% discount for early
payment (Rec. 134)
Source
documents

Figure 6.14:
Figure 6.14 General Ledger: Cash receipt from Account Receivable with discount
General Ledger
Jan. 2 Sales/GST Clearing 2 860 Jan. 5 Sales returns/GST Clearing 220
11 Bank/Discount revenue 2 640
Bank (A)
Jan. 1 Balance 6 000
11 Account Receivable – 2 508
R. George
Discount revenue (R)

Jan. 11 Account Receivable – 132
R. George
Note that as a result of this payment, the balance of the Account Receivable –
R. George has been reduced by $2 640 (to zero) due to the $2 508 that has been received
in cash, and $132 discount expense. The cross-reference in Account Receivable –
R. George acknowledges this by identifying both Bank and Discount expense as the
other accounts affected.
However, there is no connection between the Bank and Discount expense accounts
as, by definition, the discount is the amount that has not been received.

A cash receipt from an Account Receivable, where Discount expense is involved, will
thus have the following effect on the Accounting equation:

Assets Decrease (Increase Bank $2 508, decrease Accounts Receivable $2 640) 132
Owner’s equity Decrease (Discount expense decreases Net Profit) 132
Costs and benefits

Offering discounts to Accounts Receivable can be an effective way to generate faster Study tip
cash inflows, but it does also come with costs.
Benefits A settlement discount

• Cash is received faster from Accounts Receivable, making it available for use to make does not reduce revenue
other payments (and take advantage of any discounts offered by Accounts Payable). as this is earned at the
point of sale: it increases
• Sales may increase as customers may be more willing to buy from a business that
expenses and reduces
offers discounts.
profit when the cash is
• Bad debts may decrease as customers pay early rather than leave debts unpaid for
received.
long periods of time.

Costs
• Less cash is received from Accounts Receivable because the discount reduces the
amount the Account Receivable has to pay.
• Net Profit is decreased, as the discount incurred is an expense.

1 Define the term discount expense.
2 Explain why discounts given to Accounts Receivable are classified as
expenses.
3 Explain what is meant by the notation ‘5/7, n/30’.
4 Show the General Journal entries to record a receipt from an Account
Receivable with a discount.
5 Explain the effect of a receipt from an Account Receivable with a discount on
the Accounting equation.
6 List the benefits and costs of offering settlement discounts to Accounts Receivable.
6.5 Statement of Account

A Statement of Account provided by a supplier can be used to check the General Ledger
account for a particular Account Payable.
In the case of Accounts Receivable, the Statement of Account is prepared by the
business itself, based on the information contained in its own General Ledger, so there
should already be agreement. However, the process of sending a Statement can be a
prompt for payment of outstanding amounts, and also invites each Account Receivable
to check their own records and notify the business about any discrepancies, providing
its own form of Verifiability and Faithful representation.
Figures 6.15 shows the Statement of Account provided to R. George by Harrison
Starr Bicycles:
Figure 6.15 Statement of Account
Harrison Starr Bicycles

Penny Lane, Tyabb VIC 3193
ABN: 63 252 001 498
STATEMENT OF ACCOUNT
For period: March 2025
R. George
Account
9 Liverpool St, Ringwood VIC 3134
of:
ABN: 60 402 462 317
Date Details DR CR Balance
Mar. 1 Balance 200
3 Payment received: thank you (EFT Rec. 319) 200 nil
6 Goods as per invoice (Inv. 678) 1 485 1 485
10 Goods returned (Cr. Note 51) 385 1 100
Payment received: thank you (Rec. 156) 1 045
15 Discount allowed 55 nil
29 Goods as per invoice (Inv. 701) 1 320 1 320
Balance owing: 31 March 2025: $ 1 320

Assuming all the transactions matched and were recorded accurately, Figure 6.16
shows how Account Receivable – R. George would appear in the General Ledger of
Harrison Starr Bicycles:
Figure 6.16 General Ledger: Account Receivable

General Ledger
Mar. 1 Balance 200 Mar. 3 Bank 200
6 Sales/GST Clearing 1 485 10 Sales returns/GST Clearing 385
29 Sales/GST Clearing 1 320 15 Bank/Discount expense 1 100
31 Balance 1 320
3 005 3 005
Apr. 1 Balance 1 320
The details as recorded in the Statement of Account are not the same as those used
in the account because cross-references in the General Ledger must refer to account
names, whereas the Statement is more Understandable if it uses more straightforward
descriptions. However, the transactions are the same, and result in the same balance of
$1 320 owed by the Account Receivable – R. George.

1 Explain how a Statement of Account provided to an Account Receivable can
be used to ensure Faithful representation in the reports of the supplier.
2 Explain why the cross-references in an Account Receivable account may not
match the details provided in the Statement of Account.
6.6 The GST Clearing account

At this point it is probably worth revisiting what the GST Clearing account may look like,
including as it now does the effects of transactions that include:
• GST on cash sales
• GST on credit sales
• GST on sales returns
• GST on cash purchases
• GST on credit purchases
• GST on purchase returns
• GST settlements and refunds.
Shepherd Guitars provided the following information relating to its transactions for Example
February 2025:
Balance of GST Clearing account as at 1 February 2025 1 $1 200 CR
GST settlement 2
1 200
GST on cash sales 3
9 000
GST on credit sales 4 6 000
GST on cash purchases and payments 5
3 600
GST on credit purchases 6
8 500
GST on sales returns 7
600
GST on purchase returns 8 490

Ignoring individual transactions and their dates (which have not been provided), the
GST Clearing account of Shepherd Guitars for February 2025 would appear as shown
in Figure 6.17:
Figure 6.17 General Ledger: GST Clearing

General Ledger
Feb. Bank 2
1 200 Feb. 1 Balance 1
1 200
Bank 5 3 600 Bank 3 9 000
Accounts Payable 6
8 500 Accounts Receivable 4
6 000
Feb. 28 Balance 2 790
16 690 16 690
Mar. 1 Balance 2 790
This account shows an opening balance on the credit side and ends with a credit
balance, which is likely to be more common, as selling prices are higher than cost prices,
and GST on sales is likely to be higher than GST on purchases. However, it is possible
that a business could end (and start the next period) with a debit balance, particularly if
purchases are greater than sales or it purchases a non-current asset.

1 Identify three types of transactions that will increase a GST liability owed to
the ATO.
2 Identify four types of transactions that will decrease a GST liability owed to
the ATO.
3 Explain why it is more likely that a business will have a credit balance in its
GST Clearing account.
4 Explain how a business could end up with a debit balance in its GST Clearing
account.
6.7 Accounts Receivable Turnover
Source
documents
Offering credit to customers can be an important way of generating sales, but it is not
without risk that customers will either pay slowly or not all. Without immediate access
to cash a business may have difficulties meeting its own payments as they fall due, so
it needs to manage its Accounts Receivable diligently to ensure that offering credit to its
customers is, on balance, good for business and, in particular, that Accounts Receivable
Accounts Receivable
are paying on time.
Turnover (ARTO)
An overall assessment of the management of Accounts Receivable is facilitated by
the average number of days
it takes for a business to calculating the Accounts Receivable Turnover (ARTO), which measures the average
receive cash from its Accounts number of days that it takes to receive cash from Accounts Receivable, thereby indicating
Receivable the effectiveness of the firm in managing its Accounts Receivable.
The Accounts Receivable Turnover is calculated as shown in Figure 6.18:
Figure 6.18 Formula: Accounts Receivable Turnover
Average Accounts Receivable
Accounts Receivable Turnover (ARTO) = × 365
Net Credit Sales (plus GST)
Like its Accounts Payable equivalent, Accounts Receivable Turnover uses the
average balance of Accounts Receivable (derived by adding the starting and ending
balances and dividing by 2) to accommodate for any changes in that balance over the
period, and then multiplies by 365 so that the answer is expressed in terms of days. It
also uses ‘Net’ Credit Sales (plus GST) to account for any sales returns, as these will
reduce the amount that will be received.
Markwell Mirrors has provided the following information for 2025: Example
Credit sales plus GST $462 000

Sales returns plus GST $22 000
Accounts Receivable as at 1 January 2025 $32 000
Accounts Receivable as at 31 December 2025 $35 000
Credit terms offered to customers 30 days
Accounts Receivable Turnover for 2024 35 days
Accounts Payable Turnover for 2025 64 days
Calculating Accounts Receivable Turnover

The Accounts Receivable Turnover for Markwell Mirrors for 2025 would be calculated
as shown in Figure 6.19:
Figure 6.19 Calculation: Accounts Receivable Turnover Study tip
(32 000 + 35 000)/2
462 000 – 22 000 Changes in ARTO should
33 500 be described as faster
= × 365 or slower: than previous
440 000
periods; than budgeted;
=
28* days (27.8 rounded up to the
nearest day)
than similar businesses;
or than credit terms.
This ARTO indicates that in 2025 cash was received from Accounts Receivable, on
average, every 28 days.
Analysing Accounts Receivable Turnover

This Accounts Receivable Turnover should be assessed against ‘benchmarks’ or
‘standards’ including:
• last year (performance in previous periods)
• expected (budgeted performance)
• its competitors (performance of similar businesses, sometimes reflected in an
industry average).

This allows the owner to assess whether the business is paying its Accounts
Receivable faster or slower than previously expected or than its competitors. But
comparison against the credit terms offered to customers is critical to assess whether
Accounts Receivable are being managed effectively to pay ‘on time’.
In this example, Markwell Mirrors’ Accounts Receivable Turnover of 28 days in 2025
is actually 7 days faster than the 35 days taken in 2024, indicating an improvement
in its management of Accounts Payable. But perhaps more importantly, cash is now
being received from Accounts Receivable within the 30 days credit terms offered to
customers, indicating effective management of Accounts Receivable. This satisfactory
outcome may have been the result of using a number of strategies (outlined below).
By contrast, an Accounts Receivable Turnover that is slower than the credit terms places
a strain on the firm’s cash position, with a number of negative consequences possible:
• not enough cash available to meet payments, such Accounts Payable, wages and
other expenses
• an increased possibility of bad debts, as the longer a debt remains unpaid the more
likely it is that will never be paid.
Where Accounts Receivable Turnover is particularly slow and cash is not available to
meet short-term debts as they fall due, Accounts Payable Turnover can suffer, with all
the negative consequences this may cause, ranging from a loss of discounts to a loss of
credit facilities (see Chapter 5 for more information).
Having said that, the Accounts Receivable Turnover is an average, and it is likely that
Accounts Receivable some Accounts Receivable will be paying faster or slower than this figure. Therefore,
Ageing Analysis
it is also necessary to review the timing of receipts from each individual Account
a listing of the amount and
proportion of Accounts Receivable. To this end the business may prepare an Accounts Receivable Ageing
Receivable according to the Analysis (sometimes known as a Debtors Ageing Analysis), which calculates how
length of time they are owing much is owing from Accounts Receivable based on the ‘age’ of the debt.
Managing Accounts Receivable

Given the importance of receiving from Accounts Receivable on a timely basis, the
owner may consider implementing some, or all, of the following strategies to manage
its Accounts Receivable:
• Offer discounts for quick settlement
As noted above, this has costs and benefits, but it can encourage Accounts Receivable
to pay well within the credit terms. (Note that this is a strategy to encourage early
payment of debts that are not already late: discounts should not be offered on
overdue debts!)
• Send invoices promptly
Invoices should be sent with the goods so that the customer is immediately aware
of the amount owing and the repayment date. Until the invoice is received, Accounts
Receivable will not begin to even think about paying.
• Conduct extensive credit checks
Only offering credit to customers who have a proven record will increase the chances
that cash will be received on time.
• Send reminder notices
Notices should be sent immediately to remind Accounts Receivable that their
payment is overdue, progressing from friendly reminders to threatening legal action.
Reminders may take the form of a copy of the invoice, or a Statement of Account
that has the outstanding amount clearly shown as overdue.

• Threaten legal action

The threat of court action can sometimes prompt payment, but legal action can be a
long and costly process. (It also signals the end of the relationship with the Account
Receivable, but perhaps Accounts Receivable who pay this late are undeserving of
further credit sales!)
• Employ a debt collection agency
Debt collection agencies can employ practices ranging from annoying a late payer by
persistent telephone contact to embarrassment at their place of work.
• Deny access to credit facilities
Accounts Receivable who have not paid their current debts should be refused further
credit until the amount outstanding is received.
• Develop a strong relationship with each customer
This can be of great benefit in terms of encouraging Accounts Receivable to think of
timely payment as supportive of a close relationship with their supplier.
• Appoint an Accounts Receivable Officer / Clerk
An Accounts Receivable Officer / Clerk has responsibility for record keeping (including
checking the Statements of Accounts) and liaising with each Account Receivable to
ensure that they pay on time.
Information which is not included in the reports could include:
– the customer’s current business (or even personal) circumstances
– the significance (importance or length) of the relationship with the customer.
These factors might prompt the business to adopt a more ‘flexible’ approach than
that afforded to most customers, especially if the customer is experiencing short-term
hardship, or if the business has made significant sales to a particular customer over a
long period.
Acting in an ethical manner also remains essential, as it underpins the financial and
Ethical
personal relationships between the business and its customers, which can sustain both
considerations
through difficult periods. Having said that, a strong personal relationship should not be
asked to substitute for good financial and business relations.

1 State what is measured by Accounts Receivable Turnover (ARTO).
2 Show the formula to calculate Accounts Receivable Turnover.
3 List three benchmarks that can be used to assess Accounts Receivable
Turnover.
4 Describe the importance of ‘credit terms’ when assessing Accounts
Receivable Turnover.
5 Explain the importance of Accounts Receivable Turnover in managing
Accounts Payable Turnover.
6 List, in sequence, the strategies for effective management of Accounts
Receivable.
Ethical
7 Explain how ethical considerations and non-financial information can inform the
considerations
management of Accounts Receivable.

Where have we been?

• Credit sales are verified by a sales invoice; cash received from Accounts Receivable is verified by a
receipt; sales returns are verified by a credit note issued by the business.
• GST on credit sales increases any GST liability to the ATO; GST on sales returns decreases any GST
liability to the ATO.
• A settlement discount offered to customers for early payment reduces the cash received and incurs
discount expense.
• Financial and ethical considerations are important when selling inventory on credit and collecting cash
from Accounts Receivable.
• A Statement of Account summarises all transactions with a particular Account Receivable.
• Accounts Receivable Turnover measures the average number of days taken to collect cash from
Accounts Receivable.
• Strategies to manage Accounts Receivable include offering discounts for quick settlement; sending
invoices promptly; conducting extensive credit checks; sending reminder notices; threatening legal action;
employing a debt collection agency; denying access to credit facilities; developing a strong relationship with
each customer; appointing an Accounts Receivable Officer / Clerk; considering non-financial information.
Exercises

Credit sale
Alex, the owner of Deco Décor, found the following document under the cash register. It has not been recorded.
Deco Décor Invoice: 90

Block Arcade, Melbourne VIC 3000 DUPLICATE
Tax invoice
ABN: 98 564 872 575
6/7, n/30
Charge to: Country Inn, Ballarat VIC 3350
May 4 Single bed sheet sets 12 60 720
GST (10%) 72
Total $792
• As at 1 May 2025, Deco Décor had $13 000 in its Bank account, $50 000 of Inventory on hand, a GST
liability of $600 and was owed $400 by Account Receivable – Country Inn.
• All sales are marked up by 100%.
Required
b Explain what is meant by the terms ‘6/7, n/30’.
c Calculate the cost price of the inventory in this transaction.
d Record this transaction in the General Journal of Deco Décor.
e Show how the General Ledger of Deco Décor would appear after this transaction was recorded.
f State the effect of this transaction on the Accounting equation of Deco Décor.
g Explain why this transaction increases the GST liability of Deco Décor.


Credit sales
Polly Junior sells children’s furniture and has provided the following list of transactions for September 2025:
Sept. 3 Sold 2 bookcases on credit to Rydell PS for $240 plus $24 GST each (Inv. 75).
11 Sold 3 children’s beds to Camp Somerset for $660 including $60 GST per bed (Rec. 55).
16 Purchased 5 desks from Pine Products for a total of $900 plus GST (Inv. A310).
23 Sold 4 children’s beds to Rydell PS for a total invoice price of $2 640 (including GST).
29 Sold 1 desk to Rydell PS. The desk was purchased on 16 September 2025 (Inv. 77).
• As at 1 September 2025, Polly Junior had inventory worth $43 000, was owed $500 by Account
Receivable – Rydell PS, had a Bank overdraft of $2 000, a GST balance of $800 CR and owed $400 to
Account Payable – Pine Products.
• Polly Junior sells all inventory at a 50% mark-up.
Required
a State the invoice number for the transaction on 23 September 2025.
b Record the transactions for September 2025 in the General Journal of Polly Junior.
c Referring to your answer to part ‘b’, explain how the transaction on 3 September 2025 affects the
Accounting equation of Polly Junior.
d Referring to your answer to part ‘b’, explain your recording of the transaction on 11 September 2025.
e Show how the General Ledger of Polly Junior would appear after recording the transactions for
September 2025.
f Assuming these were the only transactions, explain how the GST Clearing account would be reported in
the Balance Sheet of Polly Junior as at 30 September 2025.

150 UNIT 3 F I N A N C I A L AC C O U N T I N G F O R A T R A D I N G B U S I N E S S

Credit sales and receipts from Accounts Receivable
Book Me Danno sells antique and rare books, and during October 2025 had the following transactions with
one of its customers – V. Deo:
Oct. 1 Balance owed by V. Deo: $270.

23 Sale of books to V. Deo for $572 including GST (Inv. 152). The books had been purchased by Book
Me Danno for $350 plus GST.
29 Received $300 cash from V. Deo (EFT Rec. 302).
The following document was also found under the cash register:
Document A
Book Me Danno Rec. #83

Antique and rare books
Puckle St, Moonee Ponds VIC 3039 ABN: 50 303 303 303
Received from: V. Deo Date: 15/10/25
The sum of: Two hundred and seventy dollars
Being for: Settlement of account
Signed: Alex Micard Amount: $270.00
• Book Me Danno offers credit terms of 7/10, n/30.
• As at 1 October 2025, the General Ledger of Book Me Danno showed Bank $3 000, Inventory $26 000,
Account Receivable – V. Deo $270, and GST Clearing $500 CR.
Required
a Identify two features of Document A that indicate Book Me Danno has received cash from an Account
Receivable.
b Explain why Document A does not identify any GST.
c Explain why V. Deo is not entitled to a discount on 15 October 2025.
d Record the transactions in the General Journal of Book Me Danno.
e Show how the General Ledger of Book Me Danno would appear after recording the transactions for
October 2025.
f Referring to one Accounting assumption, explain the effect of the transaction on 15 October 2025 on
the profit of Book Me Danno for October 2025.
g Explain how a failure to record Document A would affect the Faithful representation and Relevance of
the reports of Book Me Danno.


Sales returns
Pickwick Books is a bookshop in South Melbourne and has provided the following source document:
Pickwick
Books TAX INVOICE
ABN: 09 990 656 432 Credit note: 46
1102 Clarendon St Duplicate
South Melbourne VIC 3205 12 June 2025
Returned by: Grant Hugh
19 Cobbam Drive, Glen Waverley VIC 3150
Item Description Qty Unit Cost $
GD100 Children’s Bible 5 50 250.00
GST 25.00
Total 275.00
Reason: Items damaged in mail
• As at 1 June 2025, Pickwick Books had $32 000 worth of Inventory on hand, a GST liability of $450 and
was owed $990 by Account Receivable – Grant Hugh.
• Each children’s bible has a cost price of $30.
Required
b Record the transaction on 12 June 2025 in the General Journal of Pickwick Books.
c Show how the General Ledger of Pickwick Books would appear after recording the information above.
d State the effect of the transaction on 12 June 2025 on the Accounting equation of Pickwick Books.
e Explain what action/s Pickwick Books might take now that the books have
been returned. Ethical
f Referring to legal, financial and ethical considerations, discuss whether considerations
Pickwick Books should have accepted these books for return.


Sales, receipts and returns
Joseph Robert Fashions has provided the following information relating to its transactions for September 2025:
Sept. 2 Sold 3 suits to L. Christopher for $520 plus GST each (Inv. 205). The suits had been purchased for
$330 including GST each.
9 Received $1 000 cash from L. Christopher (EFT Rec. 4532).
15 Purchased inventory from Delmonte Suits for $13 200 including GST (Inv. 40A).
21 L. Christopher returned one of the suits he purchased on 2 September 2025 because it was too small.
29 Sold 2 jumpers to L. Christopher for a total invoice price of $176 including GST (Inv. 224). These
jumpers had been marked up by 100%.
As at 1 September 2025, had Inventory on hand worth $38 000, its GST Clearing account had a balance of
$300 DR and L. Christopher owed $1 100.
Required
a Identify the source document that would verify the transaction on 21 September 2025.
b Suggest one reason why the source documents for the transactions on 2 and 29 September 2025 do
not run in sequence.
c Record the transactions in the General Journal of Joseph Robert Fashions. Narrations are not required.
d Complete the following accounts in the General Ledger of Joseph Robert Fashions after all the
information for September 2025 had been recorded:
• Account Receivable – L. Christopher
• Inventory
• GST Clearing.
e Explain the effect of the transaction on 21 September 2025 on the assets of Joseph Robert Fashions.
f Explain two strategies Joseph Robert Fashions could use to reduce its sales returns.

Discount expense
Milner Costumes sells costumes and other fancy dress products. The following document has not yet been
recorded:
LFC Banking
Milner Costumes
Funds transfer
DATE OF RECEIPT 3 May 2025
FROM M. Salah
A/c: 380 011 011
FOR Settlement of account
AMOUNT $1 034
REFERENCE 36524
• As at 1 May 2025, Milner Costumes had a Bank overdraft of $600 and was owed $1 100 by M. Salah for
inventory sold on 24 April 2025.
• Milner Costumes offers credit terms of 6/10, n/30.
• The owner of Milner Costumes has claimed that discounts for early payment reduce revenue and has
suggested that they be discontinued.
Required
a Explain why M. Salah is entitled to a discount for the payment on 3 May 2025.
b Calculate the discount expense incurred on 3 May 2025.
c Record the transaction on 3 May 2025 in the General Journal of Milner Costumes.
d Explain why the discount incurred on 3 May 2025 would be reported as an expense in the Income
Statement of Milner Costumes.
e Show how the General Ledger of Milner Costumes would appear after recording the transactions for
May 2025.
f Referring to one Accounting assumption, explain why the owner’s claim about discounts is incorrect.
g Discuss whether Milner Costumes should offer discounts for early payment.

Accounts Receivable: cash and credit transactions
Sports Bonanza is owned by Joe Little and on 1 December 2025 the business had the following balances in
its ledger accounts:
Inventory $14 000
Account Receivable – Emerald CC 1 320
GST Clearing 700 DR
Bank 500 CR
Loan – FinCo 12 000
Capital ?
Joe has provided the following list of transactions for December 2025:
Dec. 1 Joe Little withdrew $500 cash for personal use ATM Rec. 43521
3 Received GST refund from ATO BS
5 Received amount outstanding from Emerald CC (after discount) EFT Rec. 2420
8 Purchased inventory from Apex Sports for $11 000 including GST Inv. AS2521
9 Sold clothing to St Carls PS for $1 300 plus GST (cost price $800) Inv. 904
12 Paid wages $780 EFT Trans. 3209
13 St Carls PS returned inventory worth $200 plus GST (cost price $120) Cr. Note 29
15 Purchased inventory from Sports Plus for $4 100 plus GST Ch. 1002
16 Sold inventory to Emerald CC for $825 including GST (cost price $450) Inv. 905
17 Paid Apex Sports in full settlement of account Ch. 1003
21 Received cash from St Carls PS in full settlement Rec. 35
24 Sold goods to Easting SC for $700 plus GST (cost price $400) EFT Rec. 2651
27 Paid $1 210 including GST for electricity Ch. 1004
31 Received $500 cash from Emerald CC EFT Rec. 2701
• Sports Bonanza offers to its customers credit terms of 10/25, n/30.
• Apex Sports offers credit terms of 7/10, n/60.

Required
a Explain one weakness in the credit terms Sports Bonanza offers to its customers.
b Record the transactions on 5, 9, 13, 17 and 21 December 2025 in the General Journal of Sports Bonanza.
c Explain why there is no discount applicable to the transaction on 31 December 2025.
d Show how the General Ledger of Sports Bonanza would appear after recording the transactions for
December 2025.
e Balance the Bank, Inventory and GST Clearing accounts.
f Explain how the Bank account would be reported in the Balance Sheet of Sports Bonanza as at
31 December 2025.
g Explain the effect of the transaction on 24 December 2015 on the equities of Sports Bonanza.
h Discuss whether the relationship between the credit terms offered by Sports Bonanza and the credit
terms offered by Apex Sports will have a positive effect on the liquidity of Sports Bonanza.

As at 1 July 2025, the GST Clearing account of Tony’s Towels had a balance of $1 620 CR. During July 2025,
the following summary of GST transactions was taken from the firm’s General Journal:
GST settlement $1 620 GST on cash payments $380

GST on cash sales 640 GST on sales returns 120
GST on credit sales 920 GST on purchase returns 95
GST on credit purchases 630
Required
a Explain why the GST settlement is recorded separately from other GST payments.
b Explain the effect of the GST settlement on the Accounting equation of Tony’s Towels.
c Show how the GST Clearing account would appear in the General Ledger of Tony’s Towels after all
information was recorded. Transaction dates are not required. Balance the account at 31 July 2025.
d Explain how the GST Clearing account would be reported in the Balance Sheet of Tony’s Towels as at
31 July 2025.
e Explain why it is more likely that a business will end up with a credit balance in its GST Clearing account.

Accounts Payable and Accounts Receivable
Drew Curtains presented the following summary of its transactions for November 2025:
Credit sales $44 000 including GST; cost price: $25 000

Cash sales 20 000 plus GST; cost price $12 500
Sales returns 1 320 including GST; cost price $750
Credit purchases 30 000 plus GST
Cash purchases 8 800 including GST
Purchase returns 750 plus GST
Expenses paid 1 500 plus GST
Cash received from Accounts Receivable 39 000 plus discount $540
Cash paid to Accounts Payable 28 500 plus discount $370

• Drew Curtains had the following balance in its General Ledger as at 1 November 2025:
Bank $5000
Inventory $13 000
Accounts Receivable $25 000
Accounts Payable $35 000
GST Clearing $950 CR
• A GST settlement was made during November 2025.
Required
a Show how the following accounts would appear in the General Ledger of Drew Curtains after recording
the information above:
• Bank • Accounts Payable
• Inventory • GST Clearing
• Accounts Receivable • Cost of Sales
Dates are not required.
b Explain one weakness in using only one General Ledger account for Accounts Receivable.
c Explain one circumstance in which it may be appropriate for Drew Curtains to use only one General
Ledger account for Accounts Payable.
d Explain one way that Drew Curtains could ensure that its Accounts Payable account provided a Faithful
representation of the balance.

Accounts Receivable Turnover
Ferrante Suits has provided the following information relating to its activities for 2025:
Cash sales including GST $220 000

Credit sales including GST $56 100
Sales returns including GST $1 870
Accounts Receivable as at 1 January 2025 $6 000
Accounts Receivable as at 31 December 2025 $8 000
Accounts Receivable Turnover for 2024 38 days
Required
a State what is measured by Accounts Receivable Turnover.
b Calculate Accounts Receivable Turnover for Ferrante Suits for 2025.
c Referring to your answer for part ‘b’, explain two reasons why the owner of Ferrante Suits should be
concerned about Accounts Receivable Turnover in 2025.
d Referring to your answer for part ‘b’, explain why the Accounts Payable of Ferrante Suits may be
concerned about its Accounts Receivable Turnover in 2025.
e Explain two strategies the owner of Ferrante Suits may implement in 2026 to ensure Accounts
Receivable pay on time.
f Explain why Ferrante Suits’ Accounts Receivable Turnover may not have a significant impact on its
ability to meet its short-term debts.


Galvin Plastics has provided the following information for 2025:
Galvin Plastics
80
70
60
50
40
30
20
10
0
2023 2024 2025
ARTO (days) APTO (days)
• All sales and purchases are made on credit. Galvin Plastics offers its customers 30 days to pay while its
suppliers offer Galvin Plastics 60 days.
• During 2025, the owner of Galvin Plastics stopped offering credit to customers who are more than
10 days late on their last payment. This included McGregor Mouldings, which had been a customer of
Galvin Plastics for more than 10 years and usually paid 3 or 4 days late.
Required
a Explain why the relationship between the credit terms offered by Galvin Plastics (to its customers) and
to Galvin Plastics (by its suppliers) should help its liquidity.
b Suggest two reasons why the Accounts Receivable Turnover of Galvin Plastics may have slowed in 2024.
c Explain how the change in the Accounts Receivable Turnover of Galvin Plastics for 2024 affected its
Accounts Payable Turnover for 2024.
d Explain two reasons why the owner of Galvin Plastics should be happy with the firm’s Accounts
Receivable Turnover for 2025.
e Explain why the owner of Galvin Plastics should be concerned about the firm’s Accounts Payable
Turnover for 2025 and suggest two actions it could take to manage the situation.
f Discuss the costs and benefits of Galvin Plastics’ decision to stop offering credit to customers who were
more than 10 days late with their last payment.

Chapter 7
Other transactions: documents, the
GST and the General Journal

After completing this chapter, you should be able to: • apply Accounting skills to transactions including:
• apply Accounting assumptions and Qualitative – establishment of a double-entry system
characteristics – contributions and withdrawals by the owner
• identify transactions from source documents – correction of errors
including memos • interpret and explain the role of business
• record transactions from memos in the General documents including order forms, shipping and
Journal and General Ledger order confirmations and delivery dockets
• explain the effect of transactions on the Accounting • reconcile the information on business documents
equation • discuss ethical considerations in business
• explain how transactions affect the financial reports decision-making.
Key terms
After completing this chapter, you should be familiar • correcting entry
with the following terms: • order form
• memo • order confirmation
• fair value • shipping confirmation
• commencing entry • delivery docket.

7.1 Memos and the General Journal

The transactions that we have recorded so far have all been related in some way to one
of three major General Ledger accounts:
• Bank (cash receipts and cash payments)
• Accounts Payable (credit purchases, purchase returns, payments with discounts)
• Accounts Receivable (credit sales, sales returns, receipts with discounts).
This is an appropriate place to start, as buying and selling (for cash and credit) and
the cash transactions that occur as a result form the bulk of the transactions that a small
business may have in any given period.
However, many other transactions are likely to occur that do not involve the receipt
or payment of cash, or buying or selling inventory, and the Accounting system must be
capable of verifying, recording and reporting these transactions before advice can be given.
This chapter concentrates on some of these more infrequent transactions, as well
as some other types of business documents that can be used to provide information to
support business decision-making.
Source document: Memo
Source
documents
Transactions which do not relate to a sale, purchase or return of inventory, or the

movement of cash, are verified by an internal source document called a memo (short
memo for memorandum).
an internal source document A memo is issued to help the business communicate with itself and this, along with
used to verify a transaction that the fact that it can be issued for any number of transactions, means that the format of a
does not involve cash and is not
memo is very basic. Put simply, it will show the date and description of the transaction, a
a sale, purchase or return of
inventory memo number, and the signature of the owner or another member of staff to authorise
the information to be recorded.
Figure 7.1 shows how a memo may appear:
Figure 7.1 Memo
Date: 11 April 2025

Memo: 16
To: Accounting department
Re: Please note that I took one pair of football boots (Puma Kings, white, size
10½) from inventory to give to my son.
Signature: R. Friminho
This memo describes a withdrawal of inventory by the owner (R. Friminho) of a pair
of football boots and would be recorded as ‘Drawings’. Note that this memo does not
identify an amount, leaving it to the Accounting department to determine a valuation
for the inventory that has been withdrawn. As an internal document, a memo is not
required to identify an amount (but many will).

C hapter 7 OT H E R T R A N S AC T I O N S 159
However, even though it is an internal document, Verifiability remains important, so

the document is identified by a number as Memo 16. This source document must then Study tip
be identified as part of the narration in the General Journal to allow the recording to be
checked for its accuracy, in turn ensuring the Faithful representation of the transaction
A memo does not contain
(complete, free from error and neutral) in the financial reports.
sufficient information to
be used as a tax invoice,
Transactions verified by memo but this does not matter
As noted earlier, memos are used for non-cash transactions that do not relate to the as a memo should not
sale, purchase or return of inventory, including: be used for transactions
• non-cash contributions by the owner where GST is charged
• non-cash drawings by the owner (like sales, purchases or
• establishment of a double-entry system (for an existing business) returns).
• correction of errors
• use of inventory for advertising purposes (covered in Chapter 8)
• inventory losses and gains (covered in Chapter 8)
• inventory write downs (covered in Chapter 9)
• balance day adjustments (covered in the chapters related to Unit 4).
Each of these transactions is covered in detail later in this text.

1 Explain the purpose of a memo.
2 Referring to Verifiability and Faithful representation, explain why the memo
number must be identified in the narration in the General Journal.
3 List the transactions which would be verified by a memo.
7.2 Non-cash contributions by the owner Study tip

In chronological terms, the first time a memo is likely to be used is when the business
begins, and the owner contributes non-cash assets. AASB 13 actually defines
Because the business is assumed to be a separate Accounting entity, transactions fair value as ‘the price
between the business and its owner must be recorded in the firm’s records as changes that would be received
to the owner’s capital. Chapter 4 showed how to record an initial cash contribution by to sell an asset or paid
the owner to commence business operations, using some form of cash receipt as the to transfer a liability in
source document, and this process can be used to record a cash contribution by the an orderly transaction
owner at any time (see Chapter 4 for a reminder.) between market
In the case of a contribution of a non-cash asset, such as a vehicle, the Accounting participants at the
entity assumption has a further effect in terms of the way the asset is valued. Consider measurement date’, but
in this course it is applied
an asset, such as a vehicle, purchased by the owner but then contributed to the business.
only to non-current
In the records of the business, this asset cannot be valued at the original price paid by
assets contributed by the
the owner because the owner is assumed to be a separate entity.
owner.
Rather, it must be valued at what it is worth to the business, at the time it is acquired
by the business. However, because there is no ‘sale’ from the owner to the business,
and there is no ‘sale’ document to verify its cost, the asset must be valued at its fair fair value
value – the price that would be received if the asset was sold at the time it was acquired the price of an asset
by the business. In effect, this means the fair value of an asset is an estimate of its contributed by the owner that
would be received if that asset
market value at the time it is contributed by the owner.
was sold at the time it was
The specific dollar amount of the fair value is indeed an estimate, and therefore not acquired by the business
Verifiable in the same way as other assets that have been purchased by the business.

This may in turn raise questions about the ability of fair value to provide a Faithful
Ethical representation of the asset’s value. However, an ethical approach by the owner which
considerations references current market valuations of other comparable assets (of a similar age and/or
in a similar condition) will help to ensure that the fair value chosen is as neutral (without
bias) as possible. After all, an incomplete or inaccurate valuation will undermine the
Relevance of the firm’s reports and weaken its decision-making.
Example On 1 July 2025, the owner contributed to the business her own vehicle, which
had been purchased in 2021 for $28 000 plus GST, but had a fair value of $23 000
(Memo 31).
Source document
Source
documents
The memo – prepared by the owner – to verify this transaction might appear as shown
in Figure 7.2:
Figure 7.2 Memo: Contribution of a non-cash asset
Date: 1 / 7 / 2025 Memo Number: 31

To: Accounting department
Re: Today I contributed to the business my car which I purchased in 2021
for $28 000 plus GST. Its current fair value is $23 000.
Signature: E. Bennett
Recording: General Journal and General Ledger
Source
documents
As the business has acquired a new asset, the Vehicle account increases via a debit
entry while the contribution is recorded as an increase to owner’s equity via a credit to
the Capital account. Both entries record the $23 000 representing the fair value of the
asset at the time of its acquisition by the business, which now becomes the historical
cost of the asset as far as the business is concerned. (The $28 000 paid by the owner
is not recorded in the firm’s records as it relates only to the owner who is a separate
Accounting entity: it is not Relevant to the business at all.)

This would be recorded in the General Journal as shown in Figure 7.3 and posted to
the General Ledger as shown in Figure 7.4:
Figure 7.3 General Journal: Contribution of a non-cash asset
General Journal
July 1 Vehicle 23 000
Capital – Bennett 23 000
Contribution of vehicle (valued at fair value) by owner (Memo 31)
Figure 7.4 General Ledger: Contribution of a non-cash asset

Vehicle (A)
July 1 Capital 23 000
Capital – Bennett (Oe)

Vehicle 23 000

A contribution of any asset, including those valued at fair value, will have the following
effect on the Accounting equation:

Assets Increase (Vehicle) 23 000
Liabilities No effect nil
Owner’s equity Increase (Capital) 23 000
Note that a capital contribution by the owner increases owner’s equity, but it does
not affect profit as the definition of revenue expressly excludes contributions from the
owner.

1 Referring to one Accounting assumption, explain why transactions with the
owner must be recorded in the accounts of the business.
2 Define the term fair value.
3 Explain why non-cash assets contributed by the owner must be valued at fair
value. In your answer refer to one Accounting assumption and one Qualitative
characteristic.
4 Explain why fair value is less Verifiable than valuations for assets actually
purchased by the business.
5 Explain how the owner can ensure that fair value provides a Faithful
representation of an asset’s value.
6 Show the General Journal entries necessary to record a capital contribution of
a vehicle.
7 Show the effect of a capital contribution on the Accounting equation.

7.3 Non-cash drawings by the owner

Where the owner of a business withdraws assets from the business, this must be
recorded as Drawings. Cash drawings will be verified by a cheque butt, EFT receipt or
ATM receipt, but drawings of non-cash assets will be verified by a memo.
Example On 16 May 2025, the owner took home an office chair worth $120 (Memo 46).
Source document
Source
documents
The memo – prepared by the owner – to verify this transaction might appear as shown
in Figure 7.5:
Figure 7.5 Memo: Drawings of a non-cash asset
Date: 16 May 2025 Memo Number: 46

Details: Please record the fact that I took home an office chair worth $120.
Authorised signature:
Vanessa Rayner
V. Rayner
In general terms, the more information recorded on the memo the better: if inventory
was involved, this would include the type of inventory (and perhaps inventory code) and
the quantity of items involved.
Source
documents
As noted in Chapter 3, Drawings represents the value of the assets the owner has
withdrawn from the business and because it is a negative owner’s equity account it
must be debited, in this case by $120. This reduces the amount that the business ‘owes
to the owner’. Using a separate account to record drawings means this figure can be
reported separately in the Balance Sheet (and compared against Net Profit to assess
its appropriateness). At the same time, Office furniture has been withdrawn so this
account is credited $120 to record this decrease in the asset.

This would be recorded in the General Journal as shown in Figure 7.6 and posted to
the General Ledger as shown in Figure 7.7:
Figure 7.6 General Journal: Drawings of a non-cash asset

Study tip
General Journal
May 16 Drawings 120 The provision of more
Office furniture 120 detailed information in
Drawings of an office chair by the owner (Memo 46) the memo allows more
detailed information
to be recorded in the
Figure 7.7 General Ledger: Drawings of a non-cash asset
narration.
Office furniture (A)
May 1 Balance 40 000 May 16 Drawings 120
Drawings (–Oe)
May 16 Office furniture 120

Drawings of any asset will have the following effect on the Accounting equation:

Assets Decrease (Office furniture) 120
Liabilities No effect nil
Owner’s equity Decrease (Capital) 120
Note that Drawings decreases owner’s equity, but it does not affect profit as the
definition of an expense expressly excludes distributions to the owner.

1 Show the General Journal entries necessary to record drawings of office
furniture.
2 Explain why Drawings is recorded in a separate General Ledger account.
3 Show the effect of Drawings on the Accounting equation.

7.4 E
stablishing a double-entry system (for an existing
business)
This course focuses on businesses that employ double-entry Accounting, utilising a
General Ledger to record their transactions. However, some businesses may operate
with a single-entry system (like the one explained in the Unit 1 and 2 version of this
commencing entry textbook series) utilising special journals to record their transactions.
a General Journal entry to When a business has been operating for some time already, and the owner decides
establish double-entry records
to switch from single-entry to double-entry Accounting records, its first General
by entering existing asset,
liability and owner’s equity Journal will be to open or establish ledger account balances for any existing asset,
balances in the General Ledger liability and owner’s equity items. This is known variously as an establishing, opening or
accounts commencing entry.
Source documents
Source
documents
Example On 1 January 2025, G. Petto, the owner of Toy Bonanza, prepared the following
memo to his accountant, Pino Cchio:
MEMO 49
1 January 2025
Dear Pino
Please set up a double-entry accounting system for us to use from here on. The
firm’s assets and liabilities as of today are:
Bank 1 400 GST Clearing 300 CR
Inventory 37 000 Account Payable – Hunter Toys 21 000
Account Receivable – F. Whistle 1 320 Loan GQC Finance 15 600
Account Receivable – G. Newton 572
Signed: G. Petto
Source
documents
Study tip
The five asset accounts – Bank, Account Receivable – F. Whistle, Account Receivable –
G. Newton, Inventory and Shop fittings – require a debit balance, while the liability
Use the Accounting accounts – GST Clearing, Account Payable – Hunter Toys and Loan GQC Finance –
equation (Assets =
require a credit balance. However, on their own, these five entries do not comprise
Liabilities + Owner’s
a complete entry, because the debit entries ($62 292) do not match the credit entries
equity) to calculate the
($36 900); a further credit (of $25 392) is required. This balancing amount becomes the
Capital figure.
owner’s Capital.
Figure 7.8 General Journal: Commencing entry
General Journal
Jan. 1 Bank 1 400
Inventory 37 000
Account Receivable – F. Whistle 1 320
Account Receivable – G. Newton 572
GST Clearing 300
Account Payable – Hunter Toys 21 000
Loan GQC Finance 15 600
Capital – G. Petto 25 392
Commencement of double-entry records (Memo 49)
As noted previously, the narration provides a brief description of the transaction,

which in this case is the ‘Commencement of double-entry records’. It also identifies the
source document that verifies the transaction: Memo 49.
This General Journal entry would be posted to the General Ledger accounts as
Figure 7.9 General Ledger: Commencing entry

General Ledger
Bank (A)
Inventory (A)
Account Receivable – F. Whistle (A)
Account Receivable – G. Newton (A)
Jan. 1 Balance 572
Shop fittings (A)
GST Clearing (L)
Jan. 1 Balance 300
Account Payable – Hunter Toys (L)
Loan GQC Finance (L)
Capital – G. Petto (Oe)

As these balances are the product of many entries, there is no single account which
can be named as the cross-reference so ‘Balance’ can be used instead.

1 Define the term commencing entry.
2 Explain why a commencing entry may be necessary.
3 In reference to a commencing entry, explain how the amount of the Capital
entry is determined.
4 Explain why the cross-references used in the General Ledger for a
commencing entry do not identify an account name.
7.5 Correcting entries

In an Accounting system designed and run by humans, it is only natural that mitsakes
mistakes will occur from time to time. Where these errors are detected, the need to
provide an audit trail, which allows the records to be checked and verified, means that
correcting entry entries cannot just be crossed out or rewritten. Instead, a correcting entry in the
a General Journal entry to General Journal will be required to correct the error and ensure the General Ledger
correct an error in the way a provides a true representation of what has occurred.
transaction is recorded in the
It is difficult to set rules for the correction of errors because such a wide variety
General Journal or General
Ledger of errors may need to be corrected. If a transaction has been omitted altogether, the
error could be corrected by simply making an additional entry in the General Journal.
However, in other situations it may be necessary to correct the use of the wrong ledger
account or the use of an incorrect amount (or both).
In most cases, the correcting entry will need to:
1 undo the incorrect entry by reversing it; that is, record a debit entry to undo an
incorrect credit, and vice versa
2 record the entry as it should have been recorded.
Most correcting entries are derived by combining these two steps as one entry.
Example On 31 July 2025, it was discovered that:

• Drawings of inventory worth $250 had been recorded as inventory used for
advertising (Memo 20).
• $440 paid for electricity plus GST was incorrectly recorded as Wages (Memo 21).

Study tip
‘See, Think, Solve’ may Source

be used as a thinking documents
routine to determine how
to correct an error.
In these examples, certain ledger accounts affected are identified in the information
provided (i.e. these accounts can be ‘Seen’), making it clear that corrections must be made
to the Drawings and Advertising accounts and also the Electricity and Wages accounts.

In the case of Memo 20, Advertising is credited to undo the incorrect debit to that
account when the error was made, and Drawings is debited, as this is the correct
entry that should have been recorded in the first place. There is no entry to change the
Inventory account, as the inventory was actually removed; the only difference being that
it was taken home by the owner rather than being used for advertising.
In the case of Memo 21, Wages is credited $440 to undo the error, and Electricity
($400) and GST Clearing ($40) both debited as this is how the entry should have been
recorded. There is no need to make a correction to the Bank account, as the credit entry
to record the payment (that we ‘Think’ must have occurred) is correct whether the
expense paid was Electricity or Wages.
Figure 7.10 General Journal: Correcting entries
General Journal
July 31 Drawings 250
Advertising 250
Correcting entry – drawings of inventory incorrectly
recorded as advertising (Memo 20)
July 31 Electricity 400
GST Clearing 40
Wages 440
Correcting entry – Electricity plus GST incorrectly
recorded as Wages (Memo 21)
These General Journal entries would then be posted to the General Ledger as is
Figure 7.11 General Ledger: Correcting entries
General Ledger
Drawings (–Oe)
July 31 Advertising 250
Advertising (E)
July Inventory 250 July 31 Drawings 250
Electricity (E)
July 31 Wages 400
GST Clearing
July 31 GST Clearing 40
Wages (E)
July Bank 440 July 31 Electricity 440
As a result of the correcting entries, the Electricity expense has increased as it should
have originally, and the Wages expense has decreased to what it would have been had
the entry not been incorrectly recorded. The same applies to Drawings (increased) and
the Advertising expense (decreased to pre-error level).

1 Explain why correcting entries are necessary.
2 List three types of errors that may need to be corrected via the General Journal.
3 List the two most common steps for correcting an error.
7.6 Other business documents

Including memos, we now have the following list of source documents to verify business
transactions, many of which will satisfy the requirements of a tax invoice, meaning they
can be used to substantiate GST:
Transaction Source document/s

Cash received receipt: manual / electronic, EFT ATM, credit card; Bank Statement
Cash paid cheque butt, EFT / ATM document, Bank Statement
Credit sale sales invoice
Credit purchase purchase invoice
Return of inventory credit note
Other * memo
* Including non-cash transactions with the owner, commencing entries, correcting entries
As noted in Chapter 4, a Statement of Account is not evidence of a single

transaction, but rather a summary of transactions with a particular Account Payable or
Account Receivable. These transactions should have been verified by individual source
documents (such as invoices, credit notes, receipts, cheque butts) and therefore should
already have been recorded.
The function of the Statement of Account then is not to facilitate recording per se,
but checking, providing an extra mechanism to support Verifiability and ensure that the
reports provide a Faithful representation of the firm’s transactions, and these Qualitative
characteristics are also supported by a number of other business documents including:
• order forms
• shipping and order confirmations
• delivery dockets.
Order forms
order form Sometimes called a purchase order, an order form is completed when a business
a document issued by a requests inventory or other supplies/assets from a supplier. Such requests are important
business requesting the supply for ensuring a business does not run out of inventory, in the process losing sales and
of inventory or other goods
profit. Some Accounting systems are able to automatically and electronically send order
forms to the firm’s suppliers when inventory reaches a certain level.
A business needs to keep copies of its order forms so that it is aware of how much
inventory has been ordered (and excess orders are not made), but the information they
contain does not need to be recorded in the General Journal or General Ledger as an
order form is simply a request for items. Goods requested may not be available or may
not be delivered for some time to come so no transaction (exchange) occurs when
inventory is ordered. It is only when the goods are exchanged, and the invoice is sent,
that a transaction occurs. It is the invoice, not the order form, that must be recorded.
Example On 3 May 2025, Snaps Photographic Equipment ordered 20 cameras (model #310)
from Menolta Cameras (Order 619).

Figure 7.12 shows how the order form might appear:
Figure 7.12 Order form

ABN: 11 049 411 049
ORDER FORM
Supplier: Menolta Cameras
55 High St, Armadale VIC 3143
3 May 2025
Please supply the following items:
Item Qty
Menolta camera – Model #310 20
Please inform re. delivery date
Order form number 619
Note how this order form does not specify an amount, as the business ordering
the inventory (Snaps Photographic Equipment) is not able to set the selling price, so it
cannot specify an amount on the order form. It is also unable to specify the GST or that
it is a tax invoice.
Some order forms may specify a price, based on prices advertised by the supplier,
but this price is not valid until the supplier agrees to the sale. The actual selling price will
only be specified on the purchase invoice that accompanies the goods when they are
delivered, and it is then that the transaction can be recorded.
Shipping and order confirmation

Having received the order form, the supplier may send an order confirmation to notify the order confirmation
business that it has received the order. At this point, it may also be able to confirm that it has a document issued by the
the inventory that was requested and the selling price for those items. Depending on the supplier confirming the receipt
of an order (for inventory)
supplier, there may then be further communication between the business and the supplier
to confirm the order and delivery details (including delivery costs where appropriate).
On 4 May 2025, Snaps Photographic Equipment received an order confirmation Example

from Menolta Cameras that it would be able to fill Order Form 619.
Figure 7.13 shows how the order confirmation might appear:
Figure 7.13 Order confirmation
Menolta Cameras 4 May 2025

To: Snaps Photographic Equipment

ABN: 11 049 411 049
Order confirmation Qty Unit price
We are pleased to confirm the availability of the items
as requested:
Order form 619: Menolta Camera (#310) 20 $700 plus GST
Please confirm delivery details by return email.

shipping confirmation Once the purchase is finalised and the goods have been dispatched, a shipping
a document issued by the confirmation may be sent by the supplier to confirm that the inventory is on its way to
supplier confirming that the business. Depending on the delivery system used by the supplier, the business may
inventory has been dispatched
receive updates or even be able to track its inventory on a virtual map.
and is being shipped to the
business
Example On 5 May 2025, Snaps Photographic Equipment received an email from Menolta
Cameras confirming that the items from Order form 619 had been shipped.
Figure 7.14 shows how the shipping confirmation might appear:
Figure 7.14 Shipping confirmation
Menolta Cameras 5 May 2025

Shipping confirmation
Your order from Menolta Cameras (#619) has been shipped (5/5/25, 3.06pm)
Your tracking number is 343 5454 0091.
Billing information: Shipping information:
Snaps Photographic Equipment Snaps Photographic Equipment
22 Grace St, Essendon VIC 3041 22 Grace St, Essendon VIC 3041
ABN: 11 049 411 049 Attn: Emma Larking
e.larking@accounts.spe.asm
The shipping confirmation specifies only that an order has been dispatched. In this
case it does not even itemise the goods, instead just providing a reference to the Order
number (619).
Even though the inventory has been shipped, at this point there is still no transaction
to record, as the business:
• cannot yet recognise the inventory as an asset as the items are not yet under its
control
• does not have the inventory, so it does not yet have a present obligation to the
supplier, so there is no liability to recognise.
Delivery docket (and invoice)

delivery docket When the goods arrive at the business, they should be accompanied by a delivery
a document issued by the docket which lists the items – type and quantity – that have actually been delivered.
supplier to accompany a
This delivery docket should be checked against the items themselves to ensure that
delivery, listing the type and
quantity of all items delivered what is listed has been received.
Example On 6 May 2025, Snaps Photographic Equipment received a delivery of 20 cameras

from Menolta Cameras, which was accompanied by delivery docket 329.

Figure 7.15 shows how the delivery docket might appear:
Figure 7.15 Delivery docket
Menolta Cameras Delivery docket: 329

6 May 2025
Delivery to: Details:

Snaps Photographic Equipment, Re order form 619
22 Grace St, Essendon VIC 3041 Attn: Emma Larking
Item Quantity
Product description
code Ordered Shipped Back order
310 Menolta Camera 20 20 nil
Invoice to accompany delivery. See invoice for terms.
We pride ourselves on our service. For queries please call Glenn Richards.
Following, or perhaps even accompanying, the delivery of the goods should be the
purchase invoice, and the delivery docket should also be checked against the invoice
to verify that the goods delivered matches the goods for which the business has been
charged.
It is only at this point – when the goods have been received – that the business has
control over a present economic resource and as such is able to record the inventory as
an asset. At the same time, it also has a present obligation to pay the supplier, and so
must record the Account Payable as a liability.
This is not an exhaustive list of business documents, but it illustrates the main
documents that will be used in the VCE Accounting course to verify transactions and
ensure that transactions are Verifiable (can be checked) and reports provide a Faithful
representation; complete, free from error and neutral (without bias). Other business
documents (including pay advice to employees, group certificates, tax remittances, and
statements of superannuation contributions) will be important in the normal course of
business activities, and each and every one of these documents must be collected,
checked, recorded (where necessary) and filed.

1 Explain the function of the following business documents:
• Statement of Account
• order form
• order confirmation
• shipping confirmation
• delivery docket.
2 Explain why a business does not need to record an order form in its General
Ledger.
3 Explain how a delivery docket can be used to ensure that the firm’s records
provide a Faithful representation of its transactions.
4 Referring to the definitions, explain why inventory is only recognised as an
asset once it has been delivered.

Where have we been?

• Memos are internal source documents used to verify transactions that do not involve cash and are not
sales, purchases or returns of inventory such as:
– non-cash contributions by the owner
– non-cash drawings by the owner
– commencing entries
– correcting entries.
• A narration describes each General Journal entry, including a reference to the source document.
• Other business documents include:
– order forms
– order confirmations
– shipping confirmations
– delivery dockets.
• These other documents do not need to be recorded but can assist in ensuring Verifiability and Faithful
representation.
Exercises
this book.

Non-cash contributions by the owner
On 1 April 2025, Max contributed second-hand shelving to his business, Max’s Smart Phones, with a fair value
of $12 500 (Memo 63). Max had originally paid $15 000 for the shelving. On 30 June 2025, the resale value of
the shelving was $8 500.
Required
a Referring to the definitions of the Elements of the reports, explain how the shelving should be classified
in the Balance Sheet of Max’s Smart Phones.
b Record the transaction on 1 April 2025 in the General Journal of Max’s Smart Phones.
c Referring to your answer to part ‘b’, explain your valuation of the shelving. Justify your answer by
referring to one Qualitative characteristic.
d Referring to your answer to part ‘b’, explain the effect of this transaction on the Accounting equation of
Max’s Smart Phones.
e Referring to one Accounting assumption, explain why the shelving should not be valued at its resale
value in the Balance Sheet as at 30 June 2025.

Non-cash contributions by the owner
The owner of Wendy’s Woollens sent the following memo to her bookkeeper:
Date: 12 August 2025 Memo Number: 182

To: Brenna (Accounting department)
Re: Hi Brenna
Just wanted to let you know that as of today I have given the business
exclusive use of my laptop. It has a fair value of $1 100 but I bought it
a year ago for $2 000 and I think it’ll make our reports look better if we
use $2 000 as our valuation. Signature: W. Pan

Required
a Explain the role of a memo in an Accounting system.
b Explain how the fair value of the laptop would have been determined.
c Referring to one Accounting assumption, explain why the laptop must be valued at $1 100 in the records
of Wendy’s Woollens.
d Record the transaction on 12 August 2025 in the General Journal of Wendy’s Woollens. A narration is
not required.
e Explain the effect on the Accounting equation of Wendy’s Woollens if the laptop was incorrectly valued
at $2 000.
f Referring to at least two Qualitative characteristics, discuss Wendy’s argument about the valuation of
the computer.

Non-cash drawings by the owner
Tom Matthias owns Tool Town, which on 1 September 2025 had $45 000 worth of Inventory on hand and
Tom’s capital was $23 000.Tom has provided the following memo:
TOOL Memo 73
TOWN DATE: 16 September 2025
FROM: Inventory Room

To: Accounting Department
$1 000 worth of inventory was given to my son as a birthday present.
Please update the records as necessary.
Thanks,
Tom
Required
b Referring to one Accounting assumption, explain why this transaction must be recorded in the records
of Tool Town.
c Record Memo 73 in the General Journal of Tool Town.
d Explain the effect of Memo 73 on the Accounting equation of Tool Town.
e Show how the Owner’s equity section of the Balance Sheet of
Tool Town would appear as at 30 September 2025.
f Explain why Tom has an ethical responsibility to declare these Ethical
drawings. considerations


Non-cash transactions with the owner
Sybil Hilesio is the owner of Soap and Suds and as at 1 July 2025 had $30 000 of capital in her business. Sybil
let her accountant know of two transactions that had taken place during July 2025:
July 2 Took office furniture home for personal use $100 (Memo 24)
10 Contributed to the store new shelving which she had purchased 2 years ago for $4 400 including
GST (Inv. A100) but would cost $2 750 including GST if purchased today (Memo 25)
Required
a Record the transactions in the General Journal of Soap and Suds.
b Referring to your answer to part ‘a’, explain your valuation of the shelving.
c Show how the Capital and Drawings accounts would appear in the General Ledger of Soap and Suds
after posting the General Journal.
d Explain whether the transaction on 2 July 2025 should be reported as an expense in the Income
Statement of Soap and Suds.
e Explain the effect on the Accounting equation of Soap and Suds as at 31 July 2015 if Memo 25 is not
recorded.

Commencing entry
The owner of Quality Pool Sweepers has decided to convert the firm’s records to a double-entry recording
system and provided Memo 54, which listed the following asset and liability balances as at
1 March 2025:
Account Payable – Pool Gear $48 000 GST owing to ATO $2 700

Account Receivable – Sunset Pools 8 250 Delivery vehicles (fair value) 69 000
Account Receivable – Mickel Homes 8 690 Inventory 124 000
Bank 3 400
Required
a Calculate the Owner’s equity of Quality Pool Sweepers as at 1 March 2025.
b Record Memo 54 in the General Journal of Quality Pool Sweepers.
c Referring to your answer to part ‘b’, explain your recording of GST owing to ATO.
d Explain why there is no receipt to verify the Bank figure of $3 400.
e Explain why commencing entries must be recorded in the General Journal.


Commencing entry
Claire’s Carpets sells quality flooring and has decided to convert its records to a double-entry recording system.
The following asset and liability balances were determined as at 1 May 2025:
Bank overdraft $2 500 GST refund due from ATO $1 450

Accounts Receivable: Inventory 117 000
– RACV 4 000 Accounts Payable:
– Borders 6 800 – NZ Pile 26 000
Mortgage 475 000 – Woolmark 31 000
Premises 500 000
• On 2 May 2025 Claire also decided to contribute to the business office equipment which was purchased
in 2023 for $5 000 but now has a fair value of $3 100.
• Claire has stated that the office equipment should be valued at $3 100 and the difference between the
two valuations ($1 900) should be reported as an expense of Claire’s Carpets.
• The mortgage is repaid in instalments of $500 per month.
Required
a Record the information above in the General Journal of Claire’s Carpets. Narrations are not required.
b Explain one part of Claire’s statement that is correct. Identify one Qualitative characteristic to support
your answer.
c Explain one part of Claire’s statement that is incorrect. Identify two Accounting assumptions to support
your answer.
* d Prepare a classified Balance Sheet for Claire’s Carpets as at 2 May 2025.

Contribution of assets and liabilities
On 1 July 2025, Danielle Mercer commenced business under the name of Danielle’s Antiques by contributing:
• $20 000 cash
• a van she had purchased in 2020 for $33 000 including GST which had a fair value of $13 000
• $18 000 worth of inventory. Danielle thinks this inventory can be sold for $46 000 plus GST.
A loan of $30 000 (due 31 March 2030) which had been used to purchase the van was also transferred into
the business’ name. As at 30 June 2025, $27 000 was still owing.
Required
a Record the information above in the General Journal of Danielle’s Antiques. A narration is not required.
b Explain why the cash and inventory contributed on 1 July 2025 will be verified by different source
documents.
c Explain why the purchase of the van does not lead to a GST refund from the ATO for Danielle’s
Antiques.
d Referring to your answer to part ‘a’, explain your valuation of the inventory. Justify your answer by
reference to at least one Accounting assumption.
e Discuss the use of ‘fair value’ to value the van.


Correcting entries
On 30 June 2025, Barry Powers discovered the following errors just prior to preparing the financial reports for
his business, Powers Tools:
• Telephone charges of $50 were incorrectly debited to Insurance (Memo 16).
• $90 recorded as Interest expense was actually interest on Powers’ home loan (Memo 17).
• A payment for Wages of $234 was incorrectly recorded as $432 (Memo 18).
• A receipt of $800 from an Account Receivable – B. Billiten had been incorrectly recorded as a payment to
an Account Payable – B. Bolton (Memo 19).
Required
a Show the General Journal entries that are necessary to correct each error.
b Explain why the entries to correct the error identified in Memo 16 would not affect the GST Clearing
account.
c Referring to your answer to part ‘a’, explain the effect on the Net Profit of Powers Tools for June 2025
of the entry to record Memo 17.
d Suggest one way the error identified in Memo 18 could have been detected.
e Explain the effect on the assets of Powers Tools if the error identified in Memo 19 had not been
corrected.
f Discuss whether Barry was required to declare the error identified in Memo 17.

Correcting entries
On 30 June 2025, the following errors were found in the General Ledger of Blue Lines:
i. Inventory that had been used for advertising (worth $500) had been incorrectly recorded as Drawings.
ii. $120 of Equipment plus GST was incorrectly debited to Cleaning expenses.
iii. A payment of $100 interest was incorrectly debited to Loan – HBM.
iv. A payment of Electricity of $505 was incorrectly recorded in the General Journal as a payment to an
Account Payable – N. Smythe for $550.
v. A sales return of $450 plus GST by B. Quick had been recorded as a purchase return by B. Quack. All
sales are marked up by 50%.
Required
a Show the General Journal entries that are necessary to correct each error. Narrations are not required.
b Explain the effect on Owner’s equity of the entries to correct error ‘i’.
c Explain the effect on the Net Profit of Blue Lines for June 2025 of the entries to correct error ‘ii’.
d Explain the effect on the Accounting equation of Blue Lines if error ‘iii’ not been corrected.
e Referring to error ‘iv’, explain the importance of a Statement of Account in ensuring Faithful
representation in the reports.
f Show the effect on the Accounting equation of Blue Lines of the entries to correct error ‘v’.


Order form
The Manager of Bev’s Photo Shop sent the following document to her supplier Komak:
Bev’s Photo Shop

Highpoint Centre, Purchase Order: 91
Maribrynong VIC 3168 29 April 2025
The Photographer’s Friend
Supplier KOMAK
Industrial Lane, Dandenong VIC 3162
Please supply the following:
Qty Photographic supplies
25 Film – Kodak 400
10 Paper – A45 (high gloss)
Please deliver within 7 days
Required
a Explain why order forms are not part of the Accounting process.
b Explain why there are no prices listed on this document.
c Referring to the definitions, explain why this document does not lead to the recognition of an asset in
the records of Bev’s Photo Shop.
d Name the document that will verify the purchase of the photographic supplies when they are delivered.


Delivery docket
Studio Suite sells indoor and outdoor furniture and received the following document:
Delivery docket: 1602
Fern-iture 13 September 2025
Garden furniture and ornaments
Delivery to: Details:

Studio Suite, Re order: 006
400 Nepean Hwy, Mt Martha 3934 Attn: K. Tod
Item Quantity
Product description
code Ordered Shipped Back order
CS32G Café set: 2 x chairs, 1 x table (green) 5 5 nil
CS32W Café set: 2 x chairs, 1 x table (white) 5 4 1
Items shipped by: J. Brown
Items in good condition when packaged. Confirmed J. Brown
Items in good condition when loaded. Confirmed J. Brown
Required
a Name the document above and describe its purpose.
b State two pieces of information that are not present on this document that would be necessary to record
the purchase of the items listed.
c In relation to ordering inventory, name two other documents that may have been exchanged before this
document was received.
d Identify how many Café sets (all colours) should have been received by Studio Suite on 13 September
2025. Justify your answer.
e Explain how this document can be used to ensure Verifiability in the records of Fern-iture.

Chapter 8
Recording and reporting for inventory

After completing this chapter, you should be able to: • explain the relationship between inventory cards
• define and identify inventory, and explain its and the General Journal
importance to a trading firm • explain the role of a physical inventory count
• explain the role of an inventory card and its • state the reasons for an inventory loss or
relationship to the Inventory account inventory gain
• explain and apply the Identified Cost and First In, • record transactions in the General Journal and
First Out (FIFO) methods of valuing inventory General Ledger including:
• record transactions in inventory cards, including: – inventory losses and gains
– purchases – inventory used for advertising
– purchase returns – drawings of inventory
– sales • distinguish between Cost of Sales and Cost of
– sales returns Goods Sold
– inventory used for advertising • prepare an Income Statement showing Gross Profit
– drawings of inventory and Adjusted Gross Profit
– inventory losses • explain the benefits of using a perpetual system to
– inventory gains account for inventory.
Key terms
After completing this chapter, you should be familiar • inventory count
with the following terms: • inventory loss
• trading firm • inventory gain
• inventory • First In, First Out (FIFO)
• inventory card • Net Sales
• cost price • Cost of Goods Sold (COGS)
• Identified Cost • perpetual system of inventory recording.

8.1 Trading firms and inventory

Throughout this text we have discussed the procedures to record and report the
trading firm transactions of a trading firm – a firm that buys inventory with the intention of reselling
a firm that purchases goods in it for a profit.
order to resell them at a profit
Inventory
But what exactly do we mean by inventory? How do we distinguish assets that are
considered to be inventory from those that are not?
Consider the example of a plant nursery. Among the assets under its control would
be various plants, pots, garden supplies and gardening tools, as well as other items,
such as shelving, a business vehicle and office equipment. Which of these should be
considered to be inventory?
Any goods that are held for resale – purchased by a trading firm with the intention
inventory of being resold at a later date for profit – should be considered inventory. This might
goods purchased by a trading include the plants, pots, garden supplies and even gardening tools.
firm and held for the purpose of However, if the garden supplies and gardening tools were held for use within the
resale at a profit
business (to tend the plants and maintain the appearance of the nursery), they would
not be considered to be inventory, but would instead be treated as non-current assets
(just like the shelving, vehicle and office equipment). This is not to say that these items
will never be sold, but if the intention behind their purchase was use, not resale, they
are not inventory.
This potential for resale – at a profit – at some time in the future means that inventory
represents a present economic resource, and because the inventory is also under the
control of the trading firm, fits perfectly with the definition of an asset. Given that the
firm’s intention would be to resell the inventory within the next 12 months, it means
that inventory is a current asset.
C hapter 8 R ecording and reporting for inventory 181
The importance of inventory

For a trading firm, inventory is of paramount importance. First, inventory is its main
source of revenue, and thus the key to its ability to earn profit. A trading firm that
cannot sell its inventory will not survive. Second, inventory is likely to be one of the
most significant assets the firm controls. Despite the, perhaps immense, value of
property and premises, it is still possible for inventory to be the largest single asset
listed in the firm’s Balance Sheet.
Unfortunately, inventory is not only one of the most important assets for a trading
firm, but also one of the most vulnerable. Inventory is susceptible to damage, spoilage,
theft and even changes in tastes and fashions, all of which can undermine its value.
Given its importance and vulnerability, it is vital that the Accounting system is able to
provide accurate information about inventory.
The Inventory account
Source
documents
In the General Ledger, all movements of inventory are summarised in the Inventory
account, with inventory coming ‘in’ recorded on the debit side, and inventory going ‘out’
recorded on the credit side.

Figure 8.1 shows the typical entries in the Inventory account for a trading firm:
Figure 8.1 Inventory account

General Ledger
Inventory (A)
Aug. 1 Balance 1
47 000 Aug. 6 Cost of Sales 5
21 000
8 Bank 2
16 000 19 Cost of Sales 6
43 000
15 Accounts Payable 3
44 000 21 Accounts Payable 7
1 500
28 Cost of Sales 4 800 25 Advertising 8 600
29 Drawings 9
700
Aug. 31 Balance 10
41 000
107 800 107 800
Sept. 1 Balance 10 41 000
In terms of transactions and events, these entries then represent:
On the debit side On the credit side

1. Inventory on hand at start of Period 5. Cash sales of inventory (recorded at cost price)
2. Cash purchases of inventory 6. Credit sales of inventory (recorded at cost price)
3. Credit purchases of inventory 7. Purchase returns
4. Sales returns (recorded at cost price) 8. Inventory used for advertising
9. Drawings of inventory by the owner
10. Inventory on hand at end (of current Period)
Total debits Total credits
10. Inventory on hand at start (of next Period)
With the exception of the Balances, an Inventory account is likely to have more than
one of each of these entries as it will purchase and sell inventory more than once each
Period. However, the cross-references would be the same, meaning the account would
contain a summary of all the transactions affecting the firm’s inventory.

1 Define the term ‘trading firm’.
2 Define the term ‘inventory’.
3 Explain how inventory should be classified in the Balance Sheet.
4 State two reasons why inventory is important to a trading firm.
5 State three reasons why inventory is considered to be a vulnerable asset.
6 Explain the role of the Inventory account.
7 Identify three transactions that would appear on the debit side of the Inventory
account.
8 Identify four transactions that would appear on the credit side of the Inventory
account.

8.2 Inventory cards

Although the Inventory account in the General Ledger provides an important summary
of all movements of inventory in and out of the firm, this account alone will not provide
sufficient information to manage inventory effectively. Most trading firms will carry a
number of different lines of inventory: different items, different colours and different
sizes. It is vital that the owner has detailed information relating to each line of inventory,
from basics (such as its description, location in the warehouse and supplier) to financial
information (such as the cost price of each unit, the number of units purchased and sold,
and the number of units on hand at any point during the period).
This information must also be recorded, and this must be done in far more detail
than the Inventory account can provide. For this reason, information relating to individual
lines of inventory, including details of individual transactions, are recorded in inventory inventory card
cards. A trading firm will only ever have one Inventory account in the General Ledger, a subsidiary Accounting record
but could have a huge number of inventory cards, with one inventory card for every that records each individual
transaction involving the
different line of inventory.
movement in and out of the
A typical inventory card is shown in Figure 8.2: business of a particular line of
inventory
Figure 8.2 Inventory card
Inventory Card
Inventory item: Plant pot – terracotta, 60 cm Location: Row 16, Bay C3
Inventory code: PTC60 Supplier: Potty 4 You
IN OUT BALANCE
Date Details Qty Cost Total Qty Cost Total Qty Cost Total
Top portion: details of item

The top portion of the inventory card shows the details relating to the inventory line,
including a description of the item (in this case, a Plant pot – terracotta, 60 cm). Its code
(PTC60) is also identified for easy reference within the firm. The location (Row 16, Bay
C3) can also be very important, particularly for inventory stored in a large warehouse
with many different storage bays. Lastly, the name of the supplier (Potty 4 You) is
identified to assist reordering.
If the firm sells plant pots in different sizes, each different-sized pot will need its own
inventory card. In addition, if the firm sells pots in different colours, each of these will
also require a different inventory card, with a different one for each size of each colour.
Bottom portion: transactions

The bottom portion of the inventory card is used to record the transactions and is divided
into four main sections: Date and Details; IN column; OUT column; and BALANCE column.
Date and details

The first section is used to record standard information relating to the date and details
of each inventory transaction. ‘Details’, in this case, refers to the source document
supporting Verifiability by allowing each transaction to be checked.
IN, OUT and BALANCE columns

These columns record exactly what they state:
• IN: all inventory coming in to the business, mainly through purchases (but also
through sales returns from customers)
• OUT: all inventory leaving the business, through sales, purchase returns to
suppliers, drawings or advertising.
• BALANCE: the inventory currently on hand and available for sale.
In each of these columns further information is provided, information that is not

available in the Inventory account. Whereas the Inventory account shows transactions
in dollar terms only, these columns in the inventory card also record:
cost price
the original purchase price • the Quantity, or number, of items of inventory
of each individual item of • the Cost (cost price or original purchase price) of each individual item
inventory • the Total value of each transaction (calculated as Total = Qty × Cost)

1 Explain the relationship between the Inventory account and the inventory
cards.
2 Identify four details that will be provided in the top portion of an inventory card
but not in the Inventory account.
3 Identify three details that are provided when transactions are recorded in an
inventory card but are not provided in the Inventory account.
4 State how many inventory cards a typical trading firm would require.
8.3 Recording in inventory cards

Where cost prices are constant, recording transactions in inventory cards means
identifying whether inventory is coming IN to the business or going OUT of the business,
and recording the Quantity, Cost and Total in the appropriate column before calculating
the new BALANCE.
Purchases
Whether on cash or credit, a purchase means that inventory is coming in to the business,
so must be recorded in the IN column of the inventory card.
However, the GST is not recorded in the inventory card as it does not affect the
economic resource (and potential to produce economic benefits) of the inventory.
(Instead, GST on a purchase will decrease any GST liability).
Example As at 1 August 2025, Pete’s Plants had on hand 4 terracotta pots (code PTC60)
that had a cost price of $60 each. On 5 August 2025, the business purchased
8 pots on credit from Potty 4 You for $60 plus $6 GST each (Inv. 364).
These pots are recorded in the IN column as Quantity 8, Cost $60, Total $480 (8 ×
$60). The effect is to increase the number of items on hand in the BALANCE column
to 12 pots (four on hand plus the 8 just purchased) at $60, for a Total balance of $720.
Figure 8.3 shows how this would be recorded in the inventory card:
Figure 8.3 Inventory card: Purchase

Inventory Card
IN OUT BALANCE
Aug. 1 Balance 4 60 240
5 Inv. 364 8 60 480 12 60 720

Note how the source document (Inv. 364) is recorded in the Details column to ensure
the Verifiability of the transaction, including the cost price of the inventory items that
were purchased (as charged by the supplier).
Purchase returns
A purchase return is simply the reverse of a purchase, so the inventory leaving the store

to be returned to the supplier is recorded in the OUT column.
On 7 August 2025, Pete’s Plants returned 2 pots (PTC60) to Potty 4 You as they Example
were damaged and received a credit of $60 plus $6 GST per pot (Cr. Note 51).
These pots are recorded in the OUT column as Quantity 2, Cost $60, Total $120 (2 x
$60). The effect is to decrease the number of items on hand in the BALANCE column to
10 pots (12 on hand less the 2 just returned) at $60, for a Total balance of $600.
Figure 8.4 shows how this would be recorded in the Inventory card:
Figure 8.4 Inventory card: Purchase return

Inventory Card
IN OUT BALANCE
Aug. 1 Balance 4 60 240 Study tip
5 Inv. 364 8 60 480 12 60 720
7 Cr. Note 51 2 60 120 10 60 600
The cost price of a
purchase or purchase
Once again, the source document (Cr. Note 51) issued by the supplier identifies the return will be shown on
cost price of the inventory, in this case relating to the items that were returned. the source document.
Sales
Whereas a purchase meant inventory was coming in, a sale (cash or credit) means
inventory is leaving the business and must be recorded in the OUT column.
On 12 August 2025, Pete’s Plants sold 3 pots (PTC60) for $100 plus $10 GST Example
each to Gift World (Rec. 23).
In this case, 3 pots must be recorded in the OUT column, but what price should be
recorded?
The price of the pots is given on the source document (Rec. 23) as $100, but no $100
Study tip
pots are listed in the inventory card. How can this be?
Remember that the price of $100 per pot on the source document (sales receipt
or invoice) will be the selling price, but the inventory card shows the cost price, which The cost price of a sale
is $60 each. The cost price of the inventory is not revealed to the customer as this will not be shown on the
protects the Gross Profit on the sale; customers who are aware of the mark-up have a source document: it must
tendency to haggle harder for price reductions. be determined from the
The cost price is determined only when the transaction is recorded in the inventory inventory card.
card, so this sale is recorded as Quantity 3, Cost $60 (not $100), Total $180 (3 × $60).
The effect is to decrease the number of items on hand in the BALANCE column to
seven pots (10 on hand less the 3 just sold) at $60, for a Total balance of $420.

Figure 8.5 Inventory card: Sale

Inventory Card
IN OUT BALANCE
5 Inv. 364 8 60 480 12 60 720
7 Cr. Note 51 2 60 120 10 60 600
12 Rec. 23 3 60 180 7 60 420
The selling price of the sale can be seen on the source document (Rec. 23) as $300
plus $30 GST (3 pots x $100 plus GST per pot) but it is the inventory card that is required
to calculate the cost price of the sale as $180 (3 × $60 per pot).
Figure 8.6 General Journal: Sale

General Journal
Aug. 12 Account Receivable: Gift World 330
Sales 300
GST Clearing 30
Cost of Sales 180
Inventory 180
Credit sale of 3 pots (PTC60) to Gift World (Inv. 23)
This makes the inventory cards a vital source of information when sales are recorded
in the General Journal, because it is the inventory card that will determine the cost price
of each sale:
• the selling price of each sale is detailed on the receipt/invoice
• the cost price of each sale is determined in the inventory card.
(This is not the case for purchases and purchase returns because the cost price of
the inventory must always be shown on the source document provided by the supplier.)
Sales returns
As the reverse of a sale, a sales return means that inventory is returning to the business
from a customer (an Account Receivable) and must be recorded in the IN column.
Example On 18 August 2025, Gift World returned one of the pots it purchased on 12
August 2025 because it was not needed, and Pete’s Plants issued a credit note
for $100 plus GST (Cr. Note 12).
As with a sale, the source document still does not identify the cost price, but it does
identify the sale from which the return has come, and this allows the cost price to be
determined by inspecting the inventory card on this date.
On 12 August 2025, when the sale was made, each pot was valued at $60, so the
1 unit returned to inventory on 18 August 2025 is recorded in the IN column at a cost
price of $60, increasing the BALANCE column to eight pots (7 on hand plus the 1 just
returned) at $60, for a Total balance of $480.
Figure 8.7 Inventory card: Sale

Inventory Card
IN OUT BALANCE
5 Inv. 364 8 60 480 12 60 720
7 Cr. Note 51 2 60 120 10 60 600
12 Rec. 23 3 60 180 7 60 420
18 Cr. Note 12 1 60 60 8 60 480
To record the Sales return in the General Journal, the source document (Cr. Note 12)
identifies the amounts to be debited to the Sales returns account ($100 selling price)
and credited to the GST Clearing ($10) and Account Receivable – Giftworld ($110)
accounts, but the amount to be recorded in the Inventory and Cost of Sales accounts
($60) comes from the inventory card.
Figure 8.8 General Journal: Sales return

General Journal
Aug. 18 Sales returns 100
GST Clearing 10
Account Receivable: Gift World 110
Inventory 60
Cost of Sales 60
Return of one pot (PTC60) from Gift World –
not needed (Cr. Note 12)
Advertising and Drawings

Drawings refers to what the owner withdraws from the business, and while it may be
cash it may also include other assets like inventory. Drawings of cash will be verified
by a document like a cheque butt or ATM receipt and recorded in the Bank account,
but Drawings of inventory will be recorded in the Inventory account and, as a result, the
appropriate inventory card.
A similar approach applies to inventory taken out of the store to be used for display
purposes or donated to a local community organisation (such as a school, church group
or charity), who then uses the inventory as a prize in a raffle or fundraising event. In
either case, the business donating the inventory can legitimately claim that the inventory
has been used for the purpose of advertising.
Where inventory is withdrawn by the owner or used for advertising purposes, this
must be recorded in the OUT column of the relevant inventory card.

Example On 22 August 2025, Pete donated two pots to the local school to be used in their
fundraising raffle (Memo 18). On 27 August 2025, Pete took home 1 pot for his
own house (Memo 19).
Both transactions would be recorded in the OUT column as is shown in Figure 8.9:
Figure 8.9 Inventory card: Advertising, Drawings

Inventory Card
IN OUT BALANCE
5 Inv. 364 8 60 480 12 60 720
7 Cr. Note 51 2 60 120 10 60 600
12 Rec. 23 3 60 180 7 60 420
18 Cr. Note 12 1 60 60 8 60 480
22 Memo 18 2 60 120 6 60 360
27 Memo 19 1 60 60 5 60 300
As is often the case for transactions of this type, the source documents (Memo 18
and Memo 19) do not identify a dollar figure, as they are designed for communication
within the business itself. Instead, the amounts of these transactions will be determined
by the inventory cards so that they can be recorded in the General Journal as is shown
in Figure 8.10:
Figure 8.10 General Journal: Advertising, Drawings

General Journal
Aug. 22 Advertising 120
Inventory 120
Two pots (PTC60) donated to local school fundraising as
advertising (Memo 18)
Aug. 27 Drawings 60
Inventory 60
One pot (PTC60) withdrawn by owner (Memo 19)
These entries will be added to any cash amounts paid for Advertising or taken as
Drawings when they are posted to the accounts in the General Ledger.
Summary
Used together, the inventory cards and Inventory account (in the General Ledger)
provide a rich source of information to assist decision-making, as:
• the inventory cards provide the specific information which is necessary for
managing each line of inventory
• the Inventory account provides the summary information which is used in the
Accounting reports.
Given that the inventory card records the cost price of each sale and sales return, the
inventory card can be used to calculate the Cost of Sales – for that line of inventory – for
the Period.

1 Explain why GST does not affect the valuation of an inventory purchase.
2 State the effect on the balance of inventory of a transaction recorded in the:
• IN column
• OUT column.
3 Identify two transactions recorded in the IN column of an inventory card.
4 Identify four transactions recorded in the OUT column of an inventory card.
5 Explain why the cost price is not shown on the source document that provides
the evidence of a sale.
6 Explain the role of inventory cards when sales and sales returns are recorded
in the General Journal.
7 Explain the role of inventory cards when purchases and purchase returns are
recorded in the General Journal.
8 State two reasons why a small business may use inventory for advertising
purposes.
9 Explain why inventory used for advertising purposes is classified as an expense.
10 Show the General Journal entries to record inventory used for advertising purposes.
8.4 Valuing inventory: changing cost prices

Frequently, the cost price charged by the supplier will change during the Period. That is,
the items on hand may have the same selling price and be identical in the eyes of the
customer but may have different cost prices.
Purchases
When inventory is purchased at different cost prices, both cost prices must be recorded
in the inventory card.
On 1 October 2025, Woolly Good had on hand 8 coats (WC1-L) which it had Example
purchased for $100 plus GST each. On 2 October 2025, it purchased another 20
for $120 plus GST each from AG Mills (Inv. XV35).
As this is a purchase and will increase the inventory on hand, this transaction must
be recorded in the IN column as Quantity 20, Cost $120, Total $2 400 (20 × $120).
There are now 28 coats on hand and the BALANCE column must reflect this, but we
cannot simply aggregate the inventory as 28 units at one particular unit cost. Even though
the coats are identical as far as the customers are concerned they were purchased in
different ‘batches’, and at different cost prices: 8 were purchased at $100, and 20 were
purchased at $120. Therefore, they must be listed separately in the Balance column of
the inventory card as is shown in Figure 8.11:
Figure 8.11 Inventory card: Purchase (changing cost prices)

Inventory Card
Inventory item: Woollen Coat (Large) Location: Aisle 3
Inventory code: WC1-L Supplier: AG Mills
IN OUT BALANCE
Oct. 1 Balance 8 100 800
2 Inv. XV35 20 120 2 400 8 100 800
20 120 2 400

In terms of the BALANCE, the 28 coats on hand as at 2 October 2025 consist of:
Study tip • 8 coats which were already on hand on 1 October 2025 (and remain on hand so
must be rewritten as part of the new balance on 2 October 2025) plus
• 20 new coats that have just been purchased.
Order is critical in an
inventory card: always
list the unit costs in the Purchase returns
BALANCE column in Given that the prices of purchases and purchase returns are set by the supplier, the cost
the order in which the
price of a purchase return will be identified by the supplier on the credit note, and this is
inventory entered the
the value that should be used in the inventory card. In this example, the purchase return
business.
could be valued at $100, or $120, or could even include some at each cost price – it
depends on the valuation used by the supplier.
Sales and other ‘OUT’ transactions

In the case of a sale (or for that matter, drawings of inventory or inventory used for
advertising purposes), the cost price is determined not from the source document but
from the inventory card. Where the inventory card identifies different cost prices for the
inventory on hand, a dilemma arises: which cost price is to be used when the inventory
is sold? Put another way, what is the cost (value) of the inventory that has left the
business in that transaction?
Example On 5 October 2025, Woolly Good sold 10 coats to V-Rail for $250 plus GST each
(Inv. 132).
As far as V-Rail is concerned it has purchased 10 identical coats for $250 each, and in
the records of Woolly Good the Sales revenue will be simply 10 × $250 = $2 500.
Further, the sale means that inventory is moving out of the business, so this
transaction must be recorded in the OUT column, but which coats have been sold:
those purchased for $100? Or those purchased for $120? What is the cost price of the
10 coats that have been sold?
Because of the different cost prices involved, the Accounting system must have
a mechanism for valuing the inventory at the time of the sale, and two alternatives
exist:
1 Identified Cost or
2 First In, First Out (FIFO).
Each is a valid way of determining the value (cost price) of inventory as it leaves
the business, but each will give a different valuation for both the Cost of Sales of
inventory sold, and the value of inventory on hand at the end of the Period. (This is
true unless all inventory is sold, in which case both methods will produce the same
valuations).
Regardless of which method is chosen, Comparability – the need to be able to
compare reports over time to identify similarities and differences – requires that method
to be used consistently from one period to the next. Otherwise, changes in the reports
may turn out to be the result of changes in the valuation methods, rather than changes
in performance.


1 Explain how the purchase of inventory at different cost prices is reflected in
the balance of an inventory card.
2 Explain how inventory is valued when a purchase return is made to a supplier.
3 Explain why it is necessary to use an inventory valuation method for sales
when cost prices are changing.
4 Name the two methods used to value inventory at the time of sale.
5 Referring to one Qualitative characteristic, explain why inventory valuation
methods should not be changed between Periods.
8.5 V
aluing inventory at the time of sale:
Identified Cost
At the time of sale, the inventory card is used to determine the cost price of each
item of inventory that has been sold. However, where inventory has been purchased at
different cost prices, which cost price is to be used? Which inventory has been sold?
One option to determine the cost price of inventory at the time of sale is to physically
mark or label each item of inventory in some way (such as a sticker with a colour or
Identified Cost
letter code, or a code on the packaging or price tag) at the time of purchase, and then
a method of valuing inventory
keep a record of the cost price that relates to that code. In this way, the business could by physically marking each
simply match the code on the item to the price in its records to identify the exact cost item in some way so that its
price of each individual item of inventory and use this Identified Cost when recording individual cost price can be
the cost price of sales. identified
On 5 October 2025, Woolly Good sold 10 coats to V-Rail for $250 plus GST each Example
(Inv. 132). Codes on the price tags indicated that 3 of the coats were from the
$100 batch, and 7 were from the $120 batch.
Because the cost price of each coat can be identified, each can be recorded separately
in the inventory card as is shown in Figure 8.12:
Figure 8.12 Inventory card: Sale (Identified Cost)

Inventory Card
IN OUT BALANCE
2 Inv. XV35 20 120 2 400 8 100 800
20 120 2 400
5 Inv. 132 3 100 300 5 100 500
7 120 840 13 120 1 560
Even though two different cost prices have been used, 10 coats have still been
recorded in the OUT column as being sold. The remaining BALANCE then lists that

18 coats are still on hand (28 less 10 sold) but continues to identify that 5 of these (8
on hand less 3 sold) were purchased at $100, and 13 (20 less 7 sold) were purchased
at $120.
The General Journal entry to record the sale would simply use the one figure – the
total Cost of Sales of $1 140 ($300 + $840) as is shown in Figure 8.13:
Figure 8.13 General Journal: Credit sale (Identified Cost)

General Journal
Oct. 5 Account Receivable – V-Rail 2 750
Sales 2 500
GST Clearing 250
Cost of Sales 1 140
Inventory 1 140
Credit sale of 10 coats (WC1-L) to V-Rail (Inv. 132)
Other OUT transactions: Advertising and Drawings

This method of identifying the cost price of inventory at the time of sale is also applied
to other transactions recorded in the OUT column, such as the use of inventory for
Advertising or the withdrawal of inventory as Drawings by the owner.
Example On 8 October 2025, Woolly Good donated to a charity raffle 4 coats, which had a
cost price of $120 (Memo 104).
On 10 October 2025, the owner of Woolly Good took home 2 coats, which had a
cost price of $100 (Memo 109).
Figure 8.14 Inventory card: Advertising, Drawings (Identified Cost)

Inventory Card
IN OUT BALANCE
2 Inv. XV35 20 120 2 400 8 100 800
20 120 2 400
5 Inv. 132 3 100 300 5 100 500
7 120 840 13 120 1 560
8 Memo 104 4 120 480 5 100 500
9 120 1 080
10 Memo 109 2 100 200 3 100 300
9 120 1 080

Figure 8.15 shows how these transactions would be recorded in the General Journal:
Figure 8.15 General Journal: Advertising, Drawings (Identified Cost)

General Journal
Oct. 8 Advertising 480
Inventory 480
Four coats (WC1-L) donated to a charity raffle as advertising (Memo 104)
10 Drawings 200
Inventory 200
Two coats (WC1-L) withdrawn by owner (Memo 109)
Purchase returns
Although also recorded in the OUT column, inventory returned to a supplier as a
purchase return does not need to be valued using Identified Cost because its cost price
is determined by that supplier and identified on the credit note they issue. (The items
returned may still bear the label or code of the business returning the inventory, but it is
the supplier who will determine the cost price to apply.)
Sales returns
from a customer (an Account Receivable), and it must be recorded in the IN column.
In this course, the cost price of the items returned will be identified on the source
document or inventory card.
On 19 October 2025, V-Rail returned 3 of the coats they had purchased on Example
5 October 2025 because they were too large and a credit of $250 plus GST per
coat was given (Cr. Note 17). Codes on the price tags indicated that 2 of the coats
had a cost price of $100 each and 1 had a cost price of $120.
The credit note still only identifies the selling price charged to the customer
($825 = $250 plus $25 GST per coat), but it also does identify the sale from which
the return has come, and the codes on the price tags allow the cost prices to be
identified.
Because the $100 coats were sold first, the 2 coats valued at this cost price are
listed first in the IN column as well as the BALANCE column, followed by the 1 coat

with a cost price of $120. Figure 8.16 shows how this would be recorded in the
inventory card:
Figure 8.16 Inventory card: Sales return (Identified Cost)

Inventory Card
IN OUT BALANCE
2 Inv. XV35 20 120 2 400 8 100 800
20 120 2 400
5 Inv. 132 3 100 300 5 100 500
7 120 840 13 120 1 560
8 Memo 104 4 120 480 5 100 500
9 120 1 080
10 Memo 109 2 100 200 3 100 300
9 120 1 080
19 Cr. Note 17 2 100 200 5 100 500
1 120 120 10 120 1 200
The cost price of this Sales return ($320), which increases Inventory, will also decrease
Cost of Sales, and will be recorded in the General Journal as shown in Figure 8.17:
Figure 8.17 General Journal: Sales return (Identified Cost)

General Journal
Oct. 19 Sales returns 750
GST Clearing 75
Account Receivable – V-Rail 825
Inventory 320
Cost of Sales 320
Sales return of 3 coats (WC1-L) by V-Rail – too large (Cr. Note 17)
Costs versus benefits

Because it requires each item of inventory to be marked or labelled, and also coded
against the specific purchase price of that item, Identified Cost is accurate and neutral
and thus provides a Faithful representation of the value of inventory.
However, not all inventory will be valued using Identified Cost, because:
• it is not always possible to mark or label individual items of inventory
Some types of inventory just cannot be labelled, particularly if they are sold by weight
or volume rather than as individual items. For instance, petrol at a service station may
be bought at different cost prices but these different batches mix in the same tank
and are therefore impossible to label.
• there are administration costs in labelling individual items and recording
codes and cost prices
The cost of labelling may include stationery (like inventory tags or stickers) and even
additional packaging so that the items can be labelled, but the more significant cost
will be the wages of staff employed to label each individual item and record each
code and cost price when the inventory is purchased.
It may also cost in terms of the time staff are not allocating to other tasks, and for
small items sold in high volumes this time could be significant. For example, a hardware
shop could label every nut and bolt, but this may not be a productive use of time.
Through scanning, computerised recording systems can alleviate the time taken to
locate the cost price at the time of the sale, but a business using Identified Cost would
still need to label the inventory and record the codes and cost prices at the time of
purchase.
Businesses must therefore make decisions on the costs of using Identified Cost
weighed against its benefits, and in some cases may decide it is just not worth the time
or the money.

1 Explain how the Identified Cost method values inventory at the time of sale.
2 Identify two transactions other than sales for which the Identified Cost method
may be used to value inventory.
3 Explain how inventory is valued when it is returned to a supplier as a purchase
return.
4 Explain how inventory is valued when a customer makes a sales return.
5 Explain how the Identified Cost method of valuing inventory ensures Faithful
6 List the costs of using the Identified Cost method of inventory valuation.
8.6 Inventory losses and gains: Identified Cost

Because the inventory cards are updated after every transaction, they provide a
continuous (or perpetual) record of inventory on hand. That is, at any stage, the number
of units shown in the BALANCE column should reflect the quantity of inventory on hand
in the shop, showroom or warehouse.
Inventory count
However, just because the inventory card says there should be a certain number of inventory count
items on hand does not mean this will be the case. To be sure, the number of units on a physical count of the
hand should be checked periodically by conducting an inventory count, which involves number of units of each line of
inventory on hand
a physical count of the number of units of each line of inventory on hand. This count can
then be compared against the balances in the inventory cards to check their accuracy
and can detect any inventory losses or gains, thereby ensuring that the reports provide
Study tip
a Faithful representation of the firm’s inventory on hand.
If the inventory count and

inventory cards differ,
assume the inventory
count is correct.

Although the inventory count can be done at any time, it is a time-consuming and
costly process. As a consequence, a full inventory count is likely to be done only
infrequently. At the very least, this would be at the end of the Period, just before the
reports are prepared.
Inventory losses
Whenever the number of units counted by the inventory count is less than the quantity
inventory loss shown in the balance of the inventory card, an inventory loss has occurred. This may
an expense incurred when the be for a variety of reasons, including:
inventory count shows a figure • theft
for inventory on hand that is
• damage/breakages
less than the balance shown in
the inventory card • undersupply from a supplier, where a supplier has delivered less inventory than has
been charged for
• oversupply to a customer, where inventory has been supplied to customers in
excess of what they have been charged for.
The fact that inventory losses can occur through undersupply from a supplier or
oversupply to a customer makes the process of checking the invoice against the delivery
docket even more important, as any errors detected at this point can be rectified before
a loss occurs.
Recording an Inventory loss

An inventory loss means that there is less inventory available for sale than is currently
shown in the inventory card and Inventory account, so the quantity missing (or lost)
must be recorded in the OUT column of the inventory card.
Example On 31 July 2025, the inventory card for Princess tennis racquets showed that the
business had on hand 5 racquets with a cost price of $60 each and 7 racquets
with a cost price of $65 each. An inventory count on the same day showed 4
racquets with a cost price of $60 each and 5 racquets with a cost price of $65
each (Memo 72).

Comparing the two sets of data reveals an inventory loss of 1 racquet with a cost
price of $60 each (5 according to the inventory card versus 4 according to the inventory
count) and 2 racquets with a cost price of $65 each (7 according to the inventory card
versus 5 according to the inventory count).
This inventory loss of 3 tennis racquets would be recorded in the OUT column of the
inventory card, as shown in Figure 8.18:
Figure 8.18 Inventory card: Inventory loss (Identified Cost)

Inventory Card
Inventory item: Tennis racquet – Princess 500 Location: Back wall of shop
Inventory code: P500 Supplier: Princess Racquets
IN OUT BALANCE
July 1 Balance 5 60 300
7 65 455
31 Memo 72 1 60 60 4 60 240
2 65 130 5 65 325
Following the recording of the Inventory loss ($190) the new BALANCE in the
inventory card – 4 racquets with a cost price of $60 each and 5 racquets with a cost
price of $65 each – is now the same as the inventory count, and totals $565.
Inventory loss is an expense as it is a decrease in assets (Inventory) that results in
a decrease in owner’s equity (but is not drawings). Therefore, in the General Journal
and General Ledger the Inventory loss account must be debited to record the expense
incurred, and the Inventory account must be credited to show the decrease in the asset.
Figure 8.19 General Journal: Inventory loss (Identified Cost)

General Journal
July 31 Inventory loss 190
Inventory 190
Inventory loss of 3 Princess tennis racquets (P500) revealed
by inventory count (Memo 72)
The narration here is quite detailed, identifying the specific inventory line involved
(in this case, also using the product code – P500) and the quantity of items lost (3). In
the case of recording inventory losses for a number of different lines of inventory, this
level of detail would be impossible to include. Consequently, it is the source document
(Memo 72) that is most important to include in the narration, as it would contain all the
necessary details recorded in the inventory cards.

Assuming the business used Identified Cost, the effect of an Inventory loss on the
Accounting equation would be:

Owner’s equity Decrease (Inventory loss expense decreases Net Profit) 190

An inventory loss decreases both assets (Inventory) and owner’s equity (through
Inventory loss expense decreasing Net Profit).
Inventory gains
When the number of units counted by the inventory count is more than the quantity
inventory gain shown in the balance of the inventory card, an inventory gain has occurred. This may
a revenue earned when the be due to:
inventory count shows a figure • oversupply from a supplier, where a supplier delivered inventory for which the
for inventory on hand that is
business has not been charged
more than the balance shown in
the inventory card • undersupply to a customer, where a customer has been charged for inventory that
has not been delivered (and the customer has not realised).
Although these are ‘gains’, continually undersupplying customers may in the long
run lead to a loss of sales, so it is better that inventory gains are instead detected by
checking the delivery dockets and invoices as the inventory leaves (or arrives in) the
business.
Recording an inventory gain

An inventory gain means that there is more inventory available for sale than is currently
shown in the inventory card and Inventory account, so the quantity gained must be
recorded in the IN column of the inventory card.
Example On 31 October 2025, the inventory count revealed 51 pairs of G10 gardening
gloves on hand: 23 pairs at $10 each and 28 pairs at $12 each (Memo 31). The
inventory card on the same date showed 47 pairs on hand: 20 pairs at $10 each
and 27 pairs at $12 each.
Comparing the two sets of data reveals an inventory gain of 3 pairs at $10 each (20
according to the inventory card versus 23 according to the inventory count) and 1 pair
at $12 (27 according to the inventory card versus 28 according to the inventory count).
This inventory gain of 4 pairs of gloves would be recorded in the IN column of the
Figure 8.20 Inventory card: Inventory gain (Identified Cost)

Inventory Card
Inventory item: Gardening Gloves Location: Row 21, Bay A5
Inventory code: G10 Supplier: Amsten Products
IN OUT BALANCE
15 Inv. 30A 30 12 360 22 10 220
30 12 360
23 Rec. 30 2 10 20 20 10 200
3 12 36 27 12 324
31 Memo 31 3 10 30 23 10 230
1 12 12 28 12 336
Following the recording of the inventory gain ($42) the new BALANCE in the inventory
card – 23 pairs at $10 each and 28 pairs at $12 each – is now the same as the inventory
count (51 pairs) and totals $566.

As an increase in assets (Inventory) that results in an increase in owner’s equity,

Inventory gain is a revenue item. Therefore, in the General Journal and General Ledger
the Inventory gain account must be credited to record the revenue earned, and the
Inventory account must be debited to show the increase in the asset. Figure 8.21 shows
how this would be recorded in the General Journal:
Study tip
Figure 8.21 General Journal: Inventory gain (Identified Cost)
General Journal Inventory gain is a good
Date Details Debit $ Credit $ reminder that revenue
Oct. 31 Inventory 42 does not need to be cash;
Inventory gain 42 in this case, the asset
Inventory gain of 4 pairs of gardening gloves (G10)
that has increased is
Inventory, with no effect
revealed by inventory count (Memo 31)
on cash.

Assuming the business used Identified Cost, the effect of an inventory gain on the
Accounting equation is the reverse of an Inventory loss, and would be:

Assets Increase (Inventory) 42
Owner’s equity Increase (Inventory gain revenue increases Net Profit) 42
An inventory gain increases both assets (Inventory) and owner’s equity (through
Inventory gain revenue increasing Net Profit).

1 Define the term ‘inventory count’.
2 Explain the role of an inventory count. Identify one Qualitative characteristic to
support your answer.
Inventory loss
3 Define the term inventory loss.
4 Explain why an inventory loss is classified as an expense.
5 Identify three reasons for an inventory loss.
6 Explain how the cost price of an inventory loss is determined if the business is
using Identified Cost
7 Show the General Journal entries necessary to record an inventory loss.
8 State the effect of an inventory loss on the Accounting equation.
Inventory gain
9 Define the term inventory gain.
10 Explain why an inventory gain is classified as a revenue.
11 Identify two reasons for an inventory gain.
12 Explain how the cost price of an inventory gain is determined if the business is
using Identified Cost.
13 Show the General Journal entries necessary to record an inventory gain.
14 State the effect of an inventory gain on the Accounting equation.

8.7 Valuing inventory at the time of sale: FIFO

Where inventory is not labelled or marked – because it is impossible or impractical,
or deemed by the owner to be not worth the time, effort and cost – the actual cost
price of each individual item cannot be identified, and the Identified Cost method
cannot be used. Therefore, when the inventory is sold, an assumption must be
First In, First Out (FIFO) made about its cost price, and under the First In, First Out (FIFO) assumption, it is
a method of valuing inventory assumed that the inventory that was purchased first will be sold first. This will mean
that assumes that, unless
that inventory leaving the business is valued at the earliest cost price listed in the
otherwise indicated, the first
inventory card.
items purchased are the first
sold, and therefore values This is in some ways fair enough, as the actual flow of goods will often reflect the
inventory sold using the earliest FIFO assumption, with goods purchased first being those taken first by customers.
cost price on hand However, there is no way of knowing for certain which items customers have taken;
some customers are even inclined to not take the older items, but instead fossick for
the newer items. (Milk and some packaged goods might fall into this category.) It is
therefore important to keep in mind that FIFO is only an assumption that is made in an
attempt to value inventory items for which no cost price has been identified.
Example On 5 October 2025, Woolly Good sold 10 coats to V-Rail for $250 plus GST each
(Invoice 132).
Whereas the Identified Cost method would identify which coats came from which
Study tip batch, under FIFO – which does not identify the cost price of each item – the only
information provided is that 10 coats were sold. In order to allocate a cost price to each
item sold it is necessary to apply FIFO to the inventory card, using the cost prices listed
To allow the Identified
in the BALANCE column.
Cost and FIFO methods
In this example, the BALANCE column shows that at the time of the sale there
to be compared, the
examples in this section were 28 coats on hand: 8 coats with a cost price of $100 (listed first because they were
mirror those used in purchased first) and 20 coats with a cost price of $120.
Section 8.5. Because they were purchased first, FIFO assumes that the 8 coats from the $100
batch are sold first. This means all of these $100 items are now assumed to be sold,
so the additional 2 coats (of the 10 sold) must be valued at $120 – the cost price of the
inventory purchased more recently.
Figure 8.22 Inventory card: Sale (FIFO)

Study tip Inventory Card
Compare Figure 8.22 to
IN OUT BALANCE
Figure 8.12 to see the
difference in Cost of Date Details Qty Cost Total Qty Cost Total Qty Cost Total
Sales between FIFO and Oct. 1 Balance 8 100 800
Identified Cost. 2 Inv. XV35 20 120 2 400 8 100 800
20 120 2 400
5 Inv. 132 8 100 800
2 120 240 18 120 2 160
Applying FIFO still results in a total of 10 coats recorded in the OUT column, but all
of the coats purchased in the first batch at $100 each are assumed to be sold before

any of the coats purchased in the next batch at $120 each, leaving only the $120 coats
as those assumed to be still on hand. Study tip
The debits and credits to record the sale in the General Journal are the same as
those used under Identified Cost, but the amount of the Cost of Sales ($800 + $240 =
Under FIFO, refer to
$1 040) is different, as is shown in Figure 8.23:
the BALANCE column
to determine which
Figure 8.23 General Journal: Credit sale (FIFO) cost price/s to use for
General Journal inventory sold.
Oct. 5 Account Receivable: V-Rail 2 750
Sales 2 500
GST Clearing 250
Cost of Sales 1 040
Inventory 1 040
Credit sale of 10 coats (WC1-L) to V-Rail (Inv. 132)
Because it uses the oldest cost prices on hand, FIFO will lead to a lower valuation for
Cost of Sales than Identified Cost when cost prices are rising.
Other OUT transactions: Advertising and Drawings

Where FIFO is used, it is also applied to other transactions recorded in the OUT column,
such as the use of inventory for Advertising, or the withdrawal of inventory as Drawings
by the owner, with the oldest inventory assumed to be taken first.
On 8 October 2025, Woolly Good donated to a charity raffle 4 coats (Memo 104). Example
On 10 October 2025, the owner of Woolly Good took home 2 coats (Memo 109).
There is no valuation attached to the coats: as with a sale, this must be determined
in the inventory card by referring to the BALANCE column.
Following the sale on 5 October 2025, the BALANCE of the inventory card now
only shows coats on hand worth $120 each, so this is the cost price used for both
transactions. Figure 8.24 shows how this would be recorded in the inventory card:
Figure 8.24 Inventory card: Advertising, Drawings (FIFO)

Inventory Card Study tip
Compare Figure 8.24 to
IN OUT BALANCE
Figure 8.14 to see the
difference in Advertising
Oct. 1 Balance 8 100 800 and Drawings using FIFO
2 Inv. XV35 20 120 2 400 8 100 800 and Identified Cost.
20 120 2 400
5 Inv. 132 8 100 800
2 120 240 18 120 2 160
8 Memo 104 4 120 480 14 120 1 680
10 Memo 109 2 120 240 12 120 1 440

Had the BALANCE column showed more than one cost price, FIFO would need to
be applied just as for a sale with the first items purchased assumed to be donated/taken
by the owner first.
The debits and credits to record these transactions in the General Journal would
be the same as those shown in Figure 8.15, but with different amounts as is shown in
Figure 8.25:
Figure 8.25 General Journal: Advertising, Drawings (FIFO)

General Journal
Oct. 8 Advertising 480
Inventory 480
Four coats (WC1-L) donated to a charity raffle as advertising (Memo 104)
10 Drawings 240
Inventory 240
Two coats (WC1-L) withdrawn by owner (Memo 109)
Purchase returns
Although also recorded in the OUT column, inventory returned to a supplier as a purchase
return does not need to be valued using FIFO, because just like Identified Cost, its cost
price is determined by that supplier and identified on the credit note they issue.
Sales returns
from a customer (an Account Receivable) and must be recorded in the IN column.
Example On 19 October 2025, V-Rail returned 3 of the coats they had purchased on
5 October 2025 because they were too large and a credit of $250 plus GST per
coat was given (Cr. Note 17).
FIFO does not identify the cost price of individual items of inventory, but in this
course the cost price of each item of inventory will be identified on the source document
or inventory card. In some cases, this may mean the specific price is given, and this cost
price should be used.
In other cases, it may be necessary to ‘reverse FIFO’ using the cost prices of the
original sale as identified in the inventory card in order to return the inventory card to
the position it would have been in if the sale had never taken place. If that sale involved
Study tip two different cost prices, then a reversal of FIFO assumes that the last items out are
the first items to be returned.
In this case, we know that the 3 coats being returned were sold on 5 October 2025,
In this course, where the so the cost prices from this sale should be used for the sales return. If 3 of these items
document or inventory had never been sold, then we would assume that the 2 coats with a cost price of $120
card will identify the
sold on this date would still be on hand, as would 1 of the coats valued at $100.
cost price of a sales
Because the $100 coats were sold first, the 1 coat valued at this cost price is listed
return, always use the
first in the IN column as well as the BALANCE column, and the 2 coats with a cost price
information provided.
of $120 are added to the existing balance.

Figure 8.26 Inventory card: Sales return (FIFO)

Inventory Card
Study tip
IN OUT BALANCE Compare Figure 8.26
Date Details Qty Cost Total Qty Cost Total Qty Cost Total to Figure 8.16 to see
Oct. 1 Balance 8 100 800 the difference in the
2 Inv. XV35 20 120 2 400 8 100 800 cost price of a Sales
20 120 2 400 return between FIFO and
Identified Cost.
5 Inv. 132 8 100 800
2 120 240 18 120 2 160
8 Memo 104 4 120 480 14 120 1 680
10 Memo 109 2 120 240 12 120 1 440
19 Cr. Note 17 1 100 100 1 100 100
2 120 240 14 120 1 680
The increase to Inventory and decrease to Cost of Sales ($340) will be recorded in
the General Journal as shown in Figure 8.27:
Figure 8.27 General Journal: Sales return (FIFO)

General Journal
Oct. 19 Sales returns 750
GST Clearing 75
Account Receivable – V-Rail 825
Inventory 340
Cost of Sales 340
Sales return of 3 coats (WC1-L) by V-Rail – too large (Cr. Note 17)
Costs versus benefits

The benefits of valuing inventory using FIFO stem from the fact that it has no requirement
to mark or label each individual item of inventory to identify its cost, meaning:
• it can be applied to all types of inventory
As noted in Section 8.5, there will be some occasions when it is not possible, practical
or cost effective to use Identified Cost but, in these cases, FIFO can still be used as it
does not require individual items of inventory to be marked or labelled.
• it costs less to administer than Identified Cost
FIFO does not require the same investment of time and labour (and therefore
money) to label every item of inventory, and then record each code and cost price in the
Accounting records. This means lower wages and other administrative costs, and also Study tip
that staff are able to attend to matters other than inventory costing.
As it still uses cost prices that are Verifiable by reference to the source document,
FIFO does still provide a Faithful representation of the value of inventory. Opposites often apply in
However, under FIFO there is no way of knowing if the cost prices allocated at the Accounting: many of the
costs of the Identified
time of the sale were in fact those which applied to those individual items of inventory
Cost method are the
at the time of their purchase. Indeed, the valuation of Cost of Sales under FIFO is biased
benefits of FIFO and
towards the inclusion of the inventory purchased first, and Inventory on hand biased
vice-versa.
towards the inclusion of the inventory purchased last.

1 Explain why a small business might choose to not use the Identified Cost
method to value its inventory.
2 Explain how the FIFO assumption values inventory at the time of sale.
3 Identify two transactions other than sales for which the FIFO assumption may
be used to value inventory.
4 Under FIFO, explain how inventory is valued when it is returned to a supplier
as a purchase return.
5 Under FIFO, explain how inventory is valued when it is returned by a customer
as a sales return.
6 Explain the benefits of using the FIFO assumption when compared to
Identified Cost.
7 Discuss the extent to which the FIFO assumption ensures Faithful
Study tip
8.8 Inventory losses and gains: FIFO
Regardless of which method is used to value inventory, an inventory count remains
To allow the Identified necessary to check that the number of items on hand as per the inventory cards matches
Cost and FIFO methods what is actually present in the store. However, where FIFO is used the inventory count
to be compared, the will simply note the total number of units on hand for each line of inventory.
examples in this section
mirror those used in Inventory losses
Section 8.6. Under FIFO, the inventory count must be compared against the inventory card to
determine not only the number missing, but also to allocate a cost price to these items.
Example On 31 July 2025, the inventory card for Princess tennis racquets showed that the
business had 12 racquets on hand: 5 racquets valued at $60 each and 7 racquets
valued at $65 each. On 31 July 2025, the inventory count showed 9 racquets on
hand (Memo 72).
Study tip
In this case, the inventory card shows that there are, in total, 12 racquets on hand
FIFO applies to an meaning 3 racquets (12 versus 9 counted) are missing and will be recorded as an
inventory loss just as Inventory loss. Because the cost price of each item of inventory is not identified, FIFO
it applies to sales: the
is applied to value these units at the first (oldest) price in the BALANCE column, which
oldest inventory still on
in this case is $60 per racquet.
hand should be assumed
This inventory loss of 3 racquets would be recorded in the OUT column of the
to be ‘lost’ first.
Figure 8.28 Inventory card: Inventory loss (FIFO)

Inventory Card
Study tip
Inventory item: Tennis racquet – Princess 500 Location: Back wall of shop
Inventory code: P500 Supplier: Princess Racquets
IN OUT BALANCE
Compare Figure 8.28
to Figure 8.18 to see
the difference in the July 1 Balance 5 60 300
valuation of an inventory 7 65 455
loss between FIFO and 31 Memo 72 3 60 180 2 60 120
Identified Cost. 7 65 455

Regardless of whether the business uses FIFO or Identified Cost, the total number
of units lost (3) and the total remaining on hand (2 + 7 = 9) is the same.
However, the application of FIFO when cost prices are rising leads to a lower
Inventory loss expense ($180), because it assumes that the older, cheaper items are
‘lost’. It also leads to a higher valuation of the Inventory on hand ($575), as it assumes
that the newer, more expensive items remain on hand.
In the General Journal and General Ledger, the same accounts are debited and
credited to record the Inventory loss, but compared to Identified Cost the amount is
different as is shown in Figure 8.29:
Figure 8.29 General Journal: Inventory loss (FIFO)

General Journal
July 31 Inventory loss 180
Inventory 180
Inventory loss of 3 Princess tennis racquets (P500) revealed
by inventory count (Memo 72)
As is the case with a sale, when there is more than one cost price in the inventory
card the amount of an Inventory loss will be different if using FIFO instead of Identified
Cost, and in times of rising prices FIFO will generate the lowest possible Inventory loss
figure, leaving the highest possible valuation of Inventory on hand.
Inventory gains
FIFO values inventory as it moves OUT of the business by using the earliest cost price
in the BALANCE column as this is the most logical flow of goods. However, because an
inventory gain represents a movement IN to the business FIFO does not apply; instead,
an inventory gain is valued by referring to the most recent transaction in the IN column.
On 31 October 2025, the inventory count revealed 51 pairs of gardening gloves on Example
hand (Memo 31). The inventory card on the same date showed 47 pairs on hand:
20 pairs at $10 each and 27 pairs at $12 each.
Where FIFO is used, the inventory count will simply note the total number of units on
hand (51 pairs) which, when compared against the inventory card (47 pairs) reveals an
inventory gain (of 4 pairs). However, there is nothing to identify the cost price of these
items: the gloves could be from the $10 batch or the $12 batch. What cost price is to
be used?
The most logical assumption to make is that the ‘extra’ items were delivered in the
last batch – the most recent (latest) transaction in the IN column. (It is fair to assume
that any inventory gained from earlier purchases would by now have been sold.) This is Study tip
also the valuation that gives the most Faithful representation of the value of inventory
on hand, as the most recent cost prices reflect what the business would be charged if it
FIFO values an inventory
was to purchase those items at the time of the inventory count and are likely to be more
gain using the most
accurate and less subject to bias.
recent (latest) price in the
In this case, the most recent transaction in the IN column is a purchase on 15 October
IN column.
2025, meaning the 4 pairs should be valued at $12 each.

This inventory gain of 4 pairs would be recorded in the IN column of the inventory
card, as shown in Figure 8.30:
Figure 8.30 Inventory card: Inventory gain (FIFO)

Study tip Inventory Card
Inventory item: Gardening Gloves Location: Row 21, Bay A5
Inventory code: G10 Supplier: Amsten Products
Compare Figure 8.30
to Figure 8.20 to see IN OUT BALANCE
the difference in the Date Details Qty Cost Total Qty Cost Total Qty Cost Total
valuation of an inventory Oct. 1 Balance 22 10 220
gain between FIFO and 15 Inv. 30A 30 12 360 22 10 220
Identified Cost. 30 12 360
23 Rec. 30 5 10 50 17 10 170
30 12 360
31 Memo 31 4 12 48 17 10 170
34 12 408
Although not an application of FIFO itself (as inventory is coming IN rather than going
OUT), this approach has in common with FIFO that it assumes that the newer items
remain on hand.
As a result, when cost prices are rising it will lead to the highest possible Inventory
gain revenue ($48), and therefore the highest possible valuation of Inventory on hand
($578), as it assumes that the newer, more expensive items are gained and there are
now more of these items on hand.
Whether Identified Cost or FIFO is used, the debits and credits in the General Journal
and General Ledger are the same but the amounts are likely to be different as is shown
in Figure 8.31:
Figure 8.31 General Journal: Inventory gain (FIFO)

General Journal
Oct. 31 Inventory 48
Inventory gain 48
Inventory gain of 4 pairs of gardening gloves (G10)
revealed by inventory count (Memo 31)
In times of rising prices, where the most recent transaction is a purchase, FIFO
will generate the highest possible Inventory gain figure, leaving the highest possible
valuation of Inventory on hand.

1 Explain how the cost price of an inventory loss is determined if the business is
using FIFO.
2 Explain the effect of FIFO on the valuation of Inventory loss and Inventory on
hand when prices are rising.
3 Referring to one Qualitative characteristic, explain how the cost price of an
inventory gain is determined if the business is using FIFO.
4 Explain how the valuation of an Inventory loss is consistent with the valuation
of Inventory on hand under FIFO.
5 Explain the effect of FIFO on the valuation of Inventory gain and Inventory on
hand when prices are rising.

8.9 Identified Cost versus FIFO

The different inventory valuation methods described in this chapter – Identified Cost and
FIFO – result in exactly the same number of units sold and left on hand in the inventory
card, and the accounts to be debited and credited (in the General Journal and General
Ledger) are the same regardless of which method is used. However, because each
method determines the cost price of inventory differently, they will lead to different
valuations of both Cost of Sales and Inventory on hand.
Cost of Sales and other inventory expenses

Because FIFO assumes that first items purchased are the first items sold, in times of
rising cost prices it will assume that the older, cheaper items have been sold first. This
means that under FIFO, Cost of Sales be lower, and therefore Net Profit and Owner’s
equity will be higher than Identified Cost.
In fact, when cost prices are rising FIFO will lead to the lowest possible valuation
of any inventory expense, including Cost of Sales, Advertising and Inventory loss, and
therefore the highest possible valuation of Net Profit and Owner’s equity.
Inventory on hand
In turn, FIFO will assume that the newer, more expensive items of inventory remain on
hand, leading to a higher valuation of Inventory on hand than Identified Cost, and the
highest possible valuation of inventory on hand and overall assets.
This analysis is confirmed using the information provided from the examples in Example
this chapter, which have been brought together for comparison in Figure 8.32
below:
Figure 8.32 Identified Cost versus FIFO

Identified Cost (from Figure 8.12) FIFO (from Figure 8.22)
Cost of Sales Cost of Sales
(3 units x $100 per unit) 300 (8 units x $100 per unit) 800
(7 units x $120 per unit) 840 1 140 (2 units x $120 per unit) 240 1 040
Inventory on hand Inventory on hand
(5 units x $100 per unit) 500
(13 units x $120 per unit) 1 560 2 060 (18 units x $120 per unit) 2 160
In terms of Cost of Sales, FIFO ($1 040) provides a lower valuation than Identified
Cost ($1 140) because FIFO assumes that all of the older, $100 items are sold before
any of the $120 items. By contrast, Identified Cost can include in Cost of Sales any (or
all) of the newer, more expensive items if these are identified as being sold.
The same would apply to Advertising, Drawings and Inventory loss – all transactions
from the OUT column – with FIFO producing the lowest possible valuation for these Study tip
transactions.
For Inventory on hand, FIFO ($2 160) provides a higher valuation than Identified Cost
($2 060), because as a consequence of assuming the older items are sold, FIFO assumes If prices are rising,
that only the newer, $120 items remain on hand. Identified Cost on the other hand still Cost of Sales under the
Identified Cost method
identifies some of the items on hand as being from the older, cheaper $100 batch.
may be the same as FIFO,
If prices are falling, this situation would reverse, with FIFO generating a higher
but it will never be lower.
valuation of Cost of Sales, and lower Net Profit and Owner’s equity; and a lower

Inventory on hand. However, if all inventory was sold both methods would produce the
same valuations over the life of the business.
The decision to use one valuation method over the other should not be based on the
figures each generates, as both methods will produce information that is Relevant and
provides a Faithful representation of the inventory. Instead, a decision should be made
by weighing the benefits of each method against its costs in relation to the specific
inventory held by that particular business.

1 Explain how the use of FIFO instead of Identified Cost affects the accounts
which must be debited and credited to record inventory transactions.
2 Explain how the use of FIFO instead of Identified Cost affects the valuation of
Cost of Sales and Inventory on hand in times of rising prices.
3 Explain how the use of FIFO instead of Identified Cost affects the valuation of
Cost of Sales and Inventory on hand if all inventory is sold.
4 Explain how an inventory valuation method should be chosen.
8.10 Reporting for inventory
Source
documents
Once inventory transactions are entered in the inventory cards and recorded in the
General Journal and General Ledger, the records will contain all the information that is
necessary to prepare reports.
Balance Sheet
Relevance says that there is little point in identifying every line of inventory, and the
quantity and cost price of every line of inventory, in the Balance Sheet as this level of
detail will not make a difference to decision-making about the firm’s overall position.
As a result, only the balance of the Inventory account must be reported in the Balance
Sheet as a current asset: a present economic resource controlled by the business that is
expected to be sold in the next 12 months.
Income Statement
The main reason any business exists is to generate profits for its owner, and the
Income Statement details that profit by reporting revenues and expenses. So how does
inventory affect the report?
1 Sales revenue
Sales of inventory will be the main source of revenue for a trading firm, and this will
be recorded in the General Journal and shown as the balance of the Sales account in
the General Ledger. Given its importance, Sales revenue must be reported separately
to Other revenues, such as Discount revenue, which do not relate specifically to
inventory. (These are covered in more detail in Chapter 10).

2 Sales returns
Sales returns are recorded in their own separate ledger account, and reported
separately in the Income Statement, so that the owner has the information to make
decisions about the suitability of the inventory that is being sold (and returned). As a
negative revenue, Sales returns is reported as a deduction from Sales, leaving Net Net Sales
Sales. In Figure 8.33, this Net Sales figure is $30 000. overall Sales revenue after the
3 Cost of Goods Sold deduction of Sales returns
The inventory cards are necessary to calculate the cost price of each sale, and this
Cost of Sales information is recorded in the General Journal before it is posted to the
Cost of Sales account in the General Ledger. The Cost of Sales account records the
expense incurred when inventory is sold, or more specifically, the suppliers’ price for
the goods that were sold.
However, Cost of Sales may be only one of a number of expenses related to
inventory, as other costs may have been incurred before the inventory was ready for
sale. The term Cost of Goods Sold (COGS) is used to describe all costs incurred Cost of Goods Sold (COGS)
in getting goods into a condition and location ready for sale, with Cost of Sales all costs incurred in getting
simply one of the items that may be reported under this heading. Expenses such as inventory into a condition and
location ready for sale
Customs duty and freight in are also part of the total COGS, which must be deducted
from Sales revenue to determine Gross Profit.
4 Gross Profit
In mathematical terms, Gross Profit is the difference between Sales revenue and
Cost of Goods Sold. Because Gross Profit expresses the relationship between the
firm’s selling and cost prices, it is important that this figure is identified (with its own
heading) to allow the owner to assess the adequacy of the firm’s mark-up.
5 Adjusted Gross Profit
Any Inventory loss must be deducted from Gross Profit to show Adjusted Gross
Profit, while any Inventory gain would be added. Isolating the Inventory loss or gain
brings it to the attention of the owner so that strategies may be developed to address
any problems that are identified.
A standard Income Statement for a trading firm would be similar to the one shown
in Figure 8.33:
Figure 8.33 Income Statement showing Gross Profit and Adjusted Gross Profit
MARCONI ELECTRONIC PRODUCTS
Income Statement (extract) for August 2025
$ $
Revenue
Sales 1 31 500
Less Sales returns 2
1 500 30 000
Study tip
Less Cost of Goods Sold 3
Cost of Sales 17 000

Customs Duty 2 000 Discount revenue is not
Freight In/Delivery from Suppliers 1 000 20 000 reported here, as it is
Gross Profit 4 10 000 earned not by selling
Less Inventory loss 500
inventory but by paying
Accounts Payable early.
Adjusted Gross Profit 5 9 500
The same applies to
discount expense; it
This is obviously not a complete Income Statement, as it does not show any other ‘garden affects the amount paid,
variety’ expenses, such as Wages, Rent or Advertising, and it does not show Net Profit. (These not the amount incurred
will be covered in Chapter 10 when the Income Statement is addressed in detail.) for inventory.

However, this top section of the Income Statement, sometimes referred to as a

Trading Statement, details the effect of inventory transactions on profit, and this
information is vital to running a successful trading business.

1 Define the term ‘Cost of Goods Sold’.
2 State two reasons why Cost of Goods Sold may be greater than Cost of Sales.
3 Explain why it is important to identify Gross Profit in the Income Statement.
4 Explain why it is important to identify Adjusted Gross Profit in the Income
Statement.
8.11 Benefits of the perpetual system

The inventory recording system explained here consists of inventory cards, an Inventory
account in the General Ledger and a physical inventory count. These are the key
perpetual system of elements of what is known as the perpetual system of inventory recording, which
inventory recording involves recording individual inventory transactions in inventory cards as they occur,
recording inventory transactions then conducting a physical inventory count at the end of the Period to verify the balances
in inventory cards, then
of those inventory cards. In the process, any inventory losses or gains will be detected.
conducting a physical inventory
count at the end of the Period The key benefits of adopting a perpetual system for recording inventory transactions
to verify the balances of those include:
inventory cards, in the process • reordering of inventory is assisted
detecting any inventory losses Because inventory cards provide a continuous record of the number of units of
or gains inventory on hand, they can inform the owner when levels of inventory are low.
This Timely information can lead to better business decisions, such as reordering
inventory before it runs out and sales are lost.
• inventory losses and gains can be detected by comparing the balances of the
inventory cards against the physical inventory count
The inventory cards state what should be in inventory and the inventory count
states what actually is on hand: any discrepancy means an inventory loss or gain
has occurred. The perpetual system thus ensures that information is Verifiable and
provides a Faithful representation of the firm’s inventory.
• fast and slow-moving lines of inventory can be identified.
By examining the frequency of sales recorded in the OUT column of each inventory
Study tip card, the owner can identify which lines are selling well (or not so well). Inventory lines
can then be moved (within the shop), or the inventory mix (the kind and proportions
of inventory on hand) can be adjusted to include more of the high-selling lines (and
See Chapter 9 for a more less of the inventory that is not selling).
detailed explanation of
inventory management Having said that, the perpetual system is not without its costs, in time and money,
strategies. including:
• staffing
Every transaction must be recorded either manually or electronically, and the business
will need to pay a staff member to record or monitor what has been recorded. (This
cost would increase if the business decided to use Identified Cost and mark or label
each unit of inventory.)

• training
Staff must be trained in the systems – manual or electronic – used to record inventory
transactions, and the business may need to pay for this training.
• technology (set-up and maintenance).
At the very least this would include the cost of purchasing hardware like a computer,
but could also include specialised software, more specialised equipment like
scanners and IT support, all of which have associated costs.
As with most business decisions, the adoption of a perpetual system involves a
consideration of costs and benefits. Years ago, the nature of the inventory would have
been a more important consideration, with this system thought unsuited to cheap, fast
turnover items. However, the proliferation of IT solutions to recording inventory means
the perpetual system can be used for all types of inventory.

1 Explain the operation of the perpetual system of inventory recording.
2 Explain the benefits of the perpetual system of inventory recording.
3 Explain the costs of the perpetual system of inventory recording.
Where have we been?

• Inventory is defined as goods held by a trading firm for the purpose of resale.
• Inventory is of paramount importance to a trading firm, as it is its main source of revenue and one of its
most significant assets.
• The Inventory account summarises all inventory transactions; inventory cards detail individual transactions
affecting each line of inventory.
• Inventory cards are used to determine the cost price of sales (the Cost of Sales), as the source documents
will only show the selling price.
• Identified Cost labels each item of inventory with its cost price.
• First In, First Out (FIFO) assumes that inventory that is purchased first will be sold first.
• In times of rising prices, FIFO will lead to the lowest possible Cost of Sales, and highest possible profit and
Inventory on hand.
• A physical inventory count is conducted at the end of the Period to verify the balances in the inventory cards
and, in the process, detect any inventory losses or gains.
• The Income Statement reports for inventory by identifying both Gross Profit and adjusted Gross Profit.

Exercises
this book.

Inventory cards: constant cost prices
At the start of October 2025, Mark’s Mattresses had 60 SuperSoft mattresses (inventory code SSM) on hand,
each with a cost price $130 each.
During October 2025, the following transactions took place:
Oct. 2 Purchased 25 mattresses at $130 plus $13 GST each from SuperSoft (Inv. 4512)
5 Sold 20 mattresses for $200 plus $20 GST each to Bed World (Inv. 52)
7 Returned 2 mattresses to SuperSoft because they were damaged for a credit of $130 plus GST each
(Cr. Note 101)
11 Purchased 30 mattresses at $143 including GST each (EFT Rec. 2001)
14 Sold 40 mattresses for $220 each including GST (Rec. 64)
17 Purchased 20 mattresses paying a total of $2 860 including GST (Chq. 580)
20 Bed World changed its mind and returned one mattress it purchased on 5 October 2025 for a credit
of $220 including GST (Cr. Note 16)
22 Sold 10 bedside tables for $120 plus GST each (Rec. 68)
26 Donated two mattresses to the local school for use in its sick bay (Memo 43)
29 Sold 30 mattresses for a total of $6 600 including GST (Rec. 71)
31 Mark took home one mattress for use in his spare room (Memo 46)
Required
a Explain the impact of GST on the recording of transactions in the inventory cards.
b Record the transactions for October 2025 in the inventory card for SuperSoft mattresses.
c Referring to your answer to part ‘b’, explain your treatment of the transaction on 22 October 2025.
d Calculate the Cost of Sales of SuperSoft mattresses for October 2025.
e Referring to your answer to part ‘b’, explain why the balance is unlikely to be the amount reported in the
Balance Sheet for Mark’s Mattresses as at 31 October 2025.
f Record the following transactions in the General Journal of Mark’s Mattresses:
• 2 October 2025
• 5 October 2025
• 7 October 2025
• 20 October 2025
• 26 October 2025
g Referring to one Accounting assumption, explain why the transaction on 31 October 2025 results in a
decrease in owner’s equity.


Inventory cards: Identified Cost
Casey’s Cabinets uses Identified Cost to value its inventory and as at 1 May 2025 had on hand 40 glass-
fronted cabinets (inventory code GF900), which it had purchased for $240 plus GST each.
During May 2025, the following transactions took place:
May 2 Purchased 20 cabinets for $250 plus GST each from Fisher Furniture (Inv. C745).
4 Sold 35 cabinets at a selling price of $500 plus GST each to GQ Design (Inv. 76). 23 of the cabinets
were valued at $240 each and 12 were valued at $250 each.
7 Casey took from inventory 2 cabinets (with an Identified Cost of $250) to give to her niece
(Memo 34).
12 GQ Design returned 5 of the cabinets it purchased on 4 May 2025 because the colour was slightly
wrong and were granted a credit of $550 including GST per cabinet (Cr. Note 21). The cabinets were
identified as having a cost price of $240.
15 Returned to Fisher Furniture the 5 cabinets returned by GQ Design for a total credit of $1 320
(Cr. Note A56).
19 Purchased 30 cabinets at $286 including GST each from Fisher Furniture (Inv. C786).
24 Sold 20 cabinets for $550 including GST each (Rec. 98). Of these cabinets, 8 had a cost price of $240
and 12 had a cost price of $260.
28 Delivered 4 cabinets (with a cost price of $240 each) to be used in a display in a home-maker centre
(Memo 37).
31 Sold 15 cabinets to GQ Design at a total invoice price of $8 250 including GST (Inv. 89). All of these
cabinets were from the inventory purchased on 19 May 2025.
Required
a Record the transactions for May 2025 in the inventory card for GF900 glass-fronted cabinets.
b Record the following transactions in the General Journal of Casey's Cabinets:
• 4 May 2025
• 7 May 2025
• 12 May 2025
• 15 May 2025
• 24 May 2025
c Explain how inventory is valued under the Identified Cost method.
d Explain why it is ethical to include in the same sale any inventory that has Ethical
been purchased at different cost prices. considerations
e Calculate the Cost of Sales of GF900 glass-fronted cabinets for May 2025.
f Calculate the Gross Profit on GF900 glass-fronted cabinets for May 2025.
g Assuming GST Clearing has a credit balance, explain the effect on the Accounting equation of the
transaction on 31 May 2025.


Inventory loss: Identified Cost
Darren’s Desks supplies offices and homes with solid wood desks. Darren’s most popular brand is the
Executive 1000 and on 31 March 2025, the inventory card showed the following:
Inventory Card
Inventory item: Executive 1000 Location: Aisle 3
Inventory code: EX1000 Supplier: Partner Desks
IN OUT BALANCE
Mar. 31 Balance 4 290 1 160
15 300 4 500
10 320 3 200
An inventory count on 31 March 2025 showed that there were 27 Executive 1000 desks on hand: 3 at $290
each, 15 at $300 each and 9 at $320 each (Memo 95).
Required
a Referring to one Qualitative characteristic, explain the role of an inventory count.
b Apart from theft, state two possible reasons for the discrepancy between the inventory card for
Executive 1000 desks and the inventory count.
c Record Memo 95 in the inventory card for Executive 1000 desks.
d Record Memo 95 in the General Journal of Darren’s Desks.
e Referring to the definitions, explain why an inventory loss is reported as an expense.
f Explain the effect of Memo 95 on the Accounting equation of Darren’s Desks as at 31 March 2025.

Inventory gain: Identified Cost
Clinnick Music sells musical equipment and on 1 December 2025 the inventory card for Voss Headphones
Inventory Card
Inventory item: Voss Headphones
Location: Back wall
Inventory code: MVH Supplier: Voss Inc.
IN OUT BALANCE
Dec. 31 Balance 14 80 1 120
7 90 630
An inventory count on 31 December 2025 showed that there were 24 pairs of Voss Headphones on hand:
15 with a cost price of $80 each and 9 with a cost price of $90 each (Memo 115).
Required
a State two possible reasons for the discrepancy between the inventory card for Voss Headphones and
the inventory count.
b Record Memo 115 in the inventory card for Voss Headphones.
c Record Memo 115 in the General Journal of Clinnick Music.
d Referring to the definitions, explain why an inventory gain is reported as revenue.
e Explain the effect of Memo 115 on the Accounting equation of Clinnick Music as at 31 December 2025.
f Explain one benefit Clinnick Music would derive by changing to FIFO from the start of 2026.


Inventory cards: First In, First Out (FIFO)
Eclipse Trading uses FIFO to value its inventory and as at 1 January 2025 had on hand $5 000 worth of picture
frames (inventory code 45B). This was made up of 50 frames at $40 each (which had been purchased first)
and 60 frames at $50 each.
During January 2025, the following transactions occurred:
Jan. 3 Sold 35 frames to Painters Inc. for $100 plus GST each (Inv. 44).
5 Purchased 30 frames at $50 plus GST each (Chq. 243).
10 Sold 40 frames at $110 including GST each (EFT Rec. 68).
12 Purchased 40 frames from Zimmer Frames for $60 plus GST each (Inv. ZF390).
16 Took 12 frames from inventory to be used in a display at the local council chambers (Memo 14).
19 Painters Inc. returned 3 of the frames purchased on 3 January 2025 because they were the wrong
size for a total credit of $330 including GST (Cr. Note 55).
20 Sold 60 frames at $110 including GST each (Rec. 114).
22 Returned 6 frames to Zimmer Frames for a credit of $396 including GST (Cr. Note ZF82).
30 Purchased 25 frames from Zimmer Frames for a total price of $1 925 including GST (Inv. ZF402).
Required
a Record the transactions for January 2025 in the inventory card for 45B picture frames.
b Explain how inventory is valued under the FIFO method.
c Referring to your answer to part ‘a’, explain your valuation of the inventory in the transaction on
20 January 2025.
d Calculate the Cost of Sales of 45B picture frames for January 2025.
e Record the following transactions in the General Journal of Eclipse Trading:
• 10 January 2025
• 16 January 2025
• 19 January 2025
• 22 January 2025
• 30 January 2025
f Explain how the use of FIFO affects the valuation of Cost of Sales when prices are rising.


Inventory loss: FIFO
Essen Electrical specialises in the sale of dishwashers for small restaurants and its most popular item is the
FP 2000. Inventory is valued using FIFO, and on 30 June 2025 the inventory card of FP 2000 dishwashers
Inventory Card
Inventory item: FP 2000 dishwasher Location: Row 16, Bay 3
Inventory code: FP 2000 Supplier: FP Dishwashers
IN OUT BALANCE
June 30 Balance 6 600 3 600
12 620 7 440
An inventory count on 30 June 2025 showed that there were 17 dishwashers on hand (Memo 37).
Required
a Record Memo 37 in the inventory card for FP 2000 dishwashers.
b Referring to your answer to part ‘a’, explain how the FIFO method of inventory valuation is applied to an
inventory loss.
c Record Memo 37 in the General Journal of Essen Electrical.
d Explain the effect on the Balance Sheet of Essen Electrical as at 30 June 2025 if Memo 37 was not
recorded.
e The owner of Essen Electrical has suggested that the cause of the inventory loss is undersupply by the
supplier. Explain how this could have occurred, and suggest one action Essen Electrical could take to
prevent this in the future.

Inventory gain: FIFO
Bayside Knitting sells wool, needles and knitting materials. Inventory is valued using FIFO, and on 30 April
2025 the inventory card of mohair wool (blue) showed the following:
Inventory Card
Inventory item: Mohair wool, blue Location: Aisle 7
Inventory code: MBL Supplier: Aust. Wool Mills
IN OUT BALANCE
April 1 Balance 23 10 230
7 Chq. 1002 30 11 330 23 10 230
30 11 330
19 Rec. 56 8 10 80 15 10 150
30 11 330
An inventory count on 30 April 2025 showed that there were 47 balls of mohair wool (blue) on hand (Memo 43).
Required
a Explain one reason why Bayside Knitting may have decided to use FIFO to value its inventory.
b Record Memo 43 in the inventory card for mohair wool (blue).
c Referring your answer to part ‘b’, explain how the inventory loss or gain was valued. Identify one
Qualitative characteristic to support your answer.
d Record Memo 43 in the General Journal of Bayside Knitting.
e Referring to one Qualitative characteristic, explain why Bayside Knitting should not change the method
it uses to value its inventory.


Inventory cards: FIFO (v. Identified Cost)
Note: this exercise uses the same data as Exercise 8.2 but assumes the use of FIFO instead of Identified
Cost.
As at 1 May 2025, Casey’s Cabinets had 40 glass-fronted cabinets (inventory code GF900) on hand, which
it had purchased for $240 plus GST each.
During May 2025, the following transactions took place:
May 2 Purchased 20 cabinets for $250 plus GST each from Fisher Furniture (Inv. C745).
4 Sold 35 cabinets at a selling price of $500 plus GST each to GQ Design (Inv. 76).
7 Casey took from inventory 2 cabinets to give to her niece (Memo 34).
12 GQ Design returned 5 of the cabinets it purchased on 4 May 2025 because the colour was slightly
wrong and were granted a credit of $550 including GST per cabinet (Cr. Note 21).
15 Returned to Fisher Furniture the 5 cabinets returned by GQ Design for a total credit of $1 320
(Cr. Note A56).
19 Purchased 30 cabinets at $286 including GST each from Fisher Furniture (Inv. C786).
24 Sold 20 cabinets for $550 including GST each (Rec. 98).
28 Delivered 4 cabinets to be used in a display in a home-maker centre (Memo 37).
31 Sold 15 cabinets to GQ Design at a total invoice price of $8 250 including GST (Inv. 89).
Required
a Record the transactions for May 2025 in the inventory card for GF900 glass-fronted cabinets using FIFO.
b Referring to your answer to part ‘a’ of Exercise 8.8 and part ‘a’ of Exercise 8.2, identify how many
GF900 glass-fronted cabinets are on hand on 24 May 2025. Explain the reason for this situation.
c Calculate the Cost of Sales of GF900 glass-fronted cabinets for May 2025 using FIFO.
d Referring to your answer to part ‘c’ of Exercise 8.8 and part ‘e’ of Exercise 8.2, calculate the difference
in the Cost of Sales of GF900 glass-fronted cabinets for May 2025 using FIFO compared to Identified
Cost. Explain the reason for this difference.
e Referring to the information in Exercise 8.8 and Exercise 8.2, explain how the use of FIFO affects the
valuation of inventory on hand when prices are rising.
f Discuss whether Casey’s Cabinets should use Identified Cost or FIFO to value its inventory.


Reporting for inventory
Warren’s Woks has provided the following Trial Balance as at 30 September 2025:
WARREN’S WOKS
Trial Balance as at 30 September 2025
Account Payable – Best Suppliers 9200
Account Receivable – KP Kitchens 13 100
Account Payable – Best Suppliers 6 000
Bank 4 300
Capital – Warren 59 400
Customs duty 2 200
Drawings 3 000
GST Clearing 3 400
Interest 600
Inventory 19 500
Mortgage – BH Bank 90 000
Premises 120 000
Sales 81 200
Sales returns 1 200
Shelving 17 500
Wages 16 300
Totals 243 300 243 300
• A physical inventory count on 30 September 2025 showed inventory on hand worth $19 000.
• The principal of the Mortgage – BH Bank is repayable at $1 000 per month.
Required
a State whether interest is a revenue or expense item for Warren’s Woks for September 2025. Justify
your answer.
* b Prepare an Income Statement for Warren’s Woks for September 2025.
c Referring to your answer to part ‘b’, justify your treatment of Customs duty.
d Explain the importance of showing Gross Profit in the Income Statement of a trading firm.
* e Prepare a Balance Sheet for Warren’s Woks as at 30 September 2025.


Reporting for inventory
Pots ’n’ Pans has provided the following Trial Balance as at 30 June 2025:
POTS ’N’ PANS

Trial Balance as at 30 June 2025
Account Receivable – CS Cooking 2 500
Account Receivable – Hotel Tyabb 2 100
Account Payable – Pansteel Co. 6 300
Bank 1 500
Capital – Pamela 41 000
Cartage in 1 900
Delivery to customers 2 500
Drawings 5 000
GST Clearing 500
Inventory 19 300
Loan – QuickFin. 20 000
Rent expense 14 000
Sales 96 800
Sales returns 6 800
Wages 12 000
Totals $166 100 $166 100
• A physical inventory count on 30 June 2025 showed an Inventory gain of $700.
• The Loan – QuickFin is an interest-only loan due for repayment on 1 July 2030.
Required
* a Prepare an Income Statement for Pots ’n’ Pans for June 2025.
b Referring to your answer to part ‘a’, explain why the owner might be concerned about the quality of the
firm’s inventory.
c Referring to your answer to part ‘a’, evaluate the adequacy of the mark-up applied by Pots ‘n’ Pans.
* d Prepare a Balance Sheet for Pots ’n’ Pans as at 30 June 2025.
e Referring to your answer to part ‘d’, discuss whether the Drawings figure is too high.


Interpreting inventory cards
Michael Conlon owns The Good Oil, which imports olive oil from Sicily and sells it to retail stores throughout
Melbourne. All inventory is sold at a 50% mark-up.
The inventory card for Virgin Olive Oil for November 2025 is shown below:
Inventory Card
Inventory item: Virgin Olive Oil Location: Aisle 17
Inventory code: VO – 01 Supplier: Familia Oil Co.
IN OUT BALANCE
Nov. 1 Balance 50 30 1 500
3 Cr. Note 29 2 30 60 52 30 1 560
4 Cr. Note 12 2 30 60 50 30 1 500
9 Inv. L63 40 30 1 200 10 30 300
13 Inv. X70 50 40 2 000 10 30 300
50 40 2 000
16 Memo 63 4 30 120 6 30 180
50 40 2 000
22 Rec. 19 6 30 180
24 40 960 26 40 1 040
30 Memo 64 3 40 120 23 40 920
Required
a Identify whether The Good Oil uses Identified Cost or FIFO to value its Virgin Olive Oil. Justify your
answer by referring to at least one transaction from the inventory card above.
b Describe the transaction on 9 November 2025.
c Suggest how the transactions on 3 November 2025 and 4 November 2025 may be related. Justify your
answer.
d Suggest two possible reasons for the transaction on 16 November 2025.
e Record Receipt 19 in the General Journal of The Good Oil.
f The inventory manager sent Memo 64 after the inventory count was completed. Record Memo 64 in the
General Journal of The Good Oil.
g Calculate Cost of Sales for Virgin Olive Oil for November 2025.
h Referring to your answer to part ‘g’, state two reasons why this may not be the figure reported as Cost
of Goods Sold for November 2025.
i Calculate Adjusted Gross Profit for Virgin Olive Oil for November 2025.


Source documents and inventory cards
Hugh Glow owns Glare, a firm that sells light fittings and bedside lamps from a small shop in the city. Inventory
is valued using FIFO and physical inventory counts are carried out at the end of each quarter (every 3 months)
to update the records.
On 1 February 2025, the firm had on hand the following inventory of bedside lamps:
Quantity Cost Total

4 $20 $80
7 25 $175
The following transactions occurred during February 2025:
DOCUMENT A
Bright TAX INVOICE Invoice: 519

Lights ABN: 45 478 834 121 ORIGINAL
2a Buckley St,
Terms:
Collingwood VIC 3066
10/14, n/30
Charge to: Glare

Block Arcade
ABN: 65 980 706 511
Feb. 2 Bedside lamps 20 20 400
GST 40
Total $ 440
DOCUMENT B
E TAX INVOICE
AR
Invoice: 70
DUPLICATE
GL
ABN: 65 980 706 511

Block Arcade
Terms:
Melbourne VIC 3000
5/7, n/30
Charge to: The Hilton Country Inn

Block Arcade
ABN: 66 009 963 451
Feb. 12 Bedside lamps 10 60 600
GST 60
Total $ 660
Includes GST of $60

DOCUMENT C
E TAX INVOICE
AR
Order form # G35
DUPLICATE
GL ABN: 65 980 706 511
Block Arcade
Melbourne VIC 3000
Supplier: Bright Lights

2a Buckley St, Collingwood VIC 3066
Please supply the following:
Date Details Quantity
Feb. 23 Bedside lamps 30
Please deliver within 5 working days.
DOCUMENT D
E MEMO 73
AR
GL
28/2/25
Inventory count revealed that there were 18 bedside lamps on hand
Required
a Referring to one Qualitative characteristic, explain why Glare should conduct an inventory count more
often than every quarter.
b Record the relevant transactions in the inventory card for bedside lamps.
c Referring to your answer to part ‘b’, explain your treatment of Document C.
d Record the relevant transactions in the General Journal of Glare.
e Explain the effect of Document A on the Balance Sheet of Glare as at 12 February 2025.
f State the effect on the Accounting equation of Glare if Document D is not recorded.


Inventory and the General Ledger
Matthew Farewell owns Matt’s Mats, a store that specialises in selling welcome mats to carpet and general
stores. The business uses the perpetual inventory system and all inventory movements are recorded using
the FIFO method of cost assignment.
The inventory card for plain welcome mats showed the following transactions for April 2025:
Inventory Card
Inventory item: Plain welcome mat Location: Shelf 7
Inventory code: PWM Supplier: Coir Industries
IN OUT BALANCE
April 1 Balance 8 30 240
50 40 2 000
2 Cr. Note 36 2 30 60 10 30 300
50 40 2 000
9 Memo 71 3 30 90 7 30 210
50 40 2 000
17 Inv. 35 7 30 210
8 40 320 42 40 1 680
25 Inv. B003 60 45 2 700 42 40 1 680
60 45 2 700
30 Memo 72 3 45 135 42 40 1 680
63 45 2 835
• Plain welcome mats are purchased on credit from Coir Industries and sold at a 100% mark-up.
• On 1 April 2025, the Inventory account had a balance of $42 950.
• The only customer who buys plain welcome mats on credit is Account Receivable – Bullings and on
1 April 2025, the account showed a balance of $2 000.
• Memo 71 related to inventory withdrawn by the owner; Memo 72 related to the physical inventory count.
These were the only memos written in April 2025.
Required
a Explain the reason for the difference between the balance of the Inventory account and the balance
shown in this inventory card as at 1 April 2025.
b Identify the number of plain welcome mats detected by the physical inventory count on 30 April 2025.
c Referring to one Qualitative characteristic, explain why Memo 72 has valued the inventory items at $45
each.
d Record the following transactions in the General Journal of Matt’s Mats:
• Credit Note 36
• Memo 71
• Invoice B003
• Memo 72.
e Assuming there were no other transactions, show how the following accounts would appear in the
General Ledger of Matt’s Mats after recording the information provided:
• Inventory
• Account Receivable – Bullings.
f Explain the effect on the owner's equity of Matt’s Mats as at 30 April 2025 if Memo 71 had not been
recorded.

Chapter 9
Valuing and managing inventory

After completing this chapter, you should be able to: • define and apply the Lower of Cost and Net
• define and calculate the cost of inventory Realisable Value (NRV) rule
• explain the importance of Accounting assumptions • state possible reasons for an Inventory
and Qualitative characteristics in the valuation of write-down
inventory • record an Inventory write-down in the inventory
• define and identify product and period costs cards, General Journal and General Ledger
• record product and period costs in the inventory • report an Inventory write-down in the Income
cards, General Journal and General Ledger Statement
• report product and period costs in the Income • state the effect of an Inventory write-down on the
Statement and Balance Sheet Accounting equation
• explain the effect of period costing on the • calculate and analyse Inventory Turnover
Accounting equation and Accounting reports • discuss strategies to manage inventory.
Key terms
After completing this chapter, you should be familiar • period cost
with the following terms: • Net Realisable Value (NRV)
• cost of inventory • Lower of ‘Cost’ and ‘Net Realisable Value’ rule
• unit cost • Inventory write-down
• product cost • Inventory Turnover (ITO).

C hapter 9 Valuing and managing inventory 225
9.1 The ‘cost’ of inventory

How much is our inventory worth? It seems like a fairly obvious question for a business
owner to ask, and the owner would expect the accountant to be able to answer it
with absolute certainty. After all, inventory is often the most significant asset a trading
business will hold and, just as importantly, it is its main source of revenue. So how
should we value our inventory?
Applying the Accounting assumptions and Qualitative characteristics, the answer
seems easy enough. Under Going concern, it is assumed that the business will continue to
operate into the future and, by extension, is not intending to liquidate (sell) all of its inventory
immediately. This means that inventory does not need to be valued at what it would realise if
sold today. Indeed, the selling price of inventory does not provide a Faithful representation of
its value as there is no guarantee it can be sold at this estimated (and therefore biased) price.
Instead, inventory should be valued at its original purchase price, as this is Verifiable
by reference to a source document and does provide a Faithful representation of the
firm’s inventory because it is neutral and free from error and bias.
In essence then, inventory is valued by calculating its cost. In many cases, this will
simply be the price charged by the supplier. But in other cases, there may be other
costs associated with the purchase, and these must be accounted for in determining
the cost price of the inventory.
Sleepworld sell beds and bedroom furniture. On 18 October 2025, it purchased a Example
new item of inventory, a king-size waterbed, and incurred the following costs:
Waterbed – supplier’s price $800
Delivery to Sleepworld from supplier 100
GST on purchase and delivery 90
Total invoice price $990
The bed will have a selling price of $1 200 plus $120 GST.
What is the ‘cost’ of the bed?

Let’s start by eliminating the selling price as a possibility, because this figure is not the
purchase price, is not Verifiable, and will therefore not provide a Faithful representation
of the value of the firm’s inventory.
The GST charged by the supplier is not included as any GST on the purchase will be
debited to the GST Clearing account and will simply reduce the liability the business owes
to the ATO. It does not affect the economic resource represented by the inventory – the
economic benefits to be gained when the inventory is sold.
By contrast, the Supplier’s price of $800 is included as this is the key cost of purchasing
the bed. However, we must also consider that without the Delivery charges of $100 the
inventory would not be available to sell to customers; it is part of the purchase price and
must be included in the cost of inventory. In fact, any costs incurred in order to bring cost of inventory
the inventory into a condition and location ready for sale must be included in its cost all costs incurred in order to
price, and these may include: bring inventory into a condition
and location ready for sale
• the supplier’s price
• freight in (delivery to the firm from the supplier)
• modifications
• customs/import duties
• any other buying expenses.
Adding together the Supplier’s price and the Delivery charges, the cost price of the
bed is $900 or, put another way, the bed is worth $900.
The importance of an accurate calculation of cost price

Study tip
Calculating an accurate cost price for inventory is important not only in terms of valuing
inventory in the Balance Sheet, but also in terms of earning profit. Many businesses
Items such as determine their selling price by applying some sort of mark-up, which is itself based on
advertising, wages or the cost price. For example, if a firm applies a 100% mark-up, its selling price will be
freight out (the cost of twice its cost price. If the firm calculates the cost price of its inventory incorrectly, then
delivering inventory to it may set its selling prices too high, leading to a loss of sales volume, or too low, leading
customers) are excluded, to an insufficient mark-up.
as they are only incurred The use of the cost price in setting selling prices means that it is essential that
after the sale. the owner has accurate information relating to the cost price of each individual unit of
inventory. This is sometimes known as its unit cost.
unit cost
the cost price of each individual Review questions 9.1
item/unit of inventory
1 Referring to one Qualitative characteristic, explain why inventory should be
valued at its original purchase price.
2 Explain why valuing inventory at its selling price would breach Faithful
representation.
3 Explain why GST is excluded from the calculation of the cost of inventory.
4 Define the term ‘cost’ as it is used in reference to inventory.
5 State three costs, other than the supplier’s price, which may be included in the
cost price of inventory.
6 State two reasons why it is important to have an accurate calculation of the
cost price of inventory.
9.2 Product costs

We have already established that the cost of inventory includes all costs incurred in
product cost order to bring inventory into a condition and location ready for sale. But to calculate the
a cost incurred in order to bring
unit cost – the cost per item – it is also necessary that we are able to allocate those
inventory into a condition and
location ready for sale that can costs to each individual unit of inventory.
be allocated to individual units Including a particular expense in the calculation of the unit cost of an individual item
of inventory on a logical basis of inventory requires that the cost fits the definition of a product cost; that is, a cost
incurred in order to bring inventory into a condition and location ready for sale, which can
be allocated to individual units of inventory on a logical basis.
Study tip This is, in effect, a two-way test.
First, the cost must be incurred in order to bring the inventory into a condition
and location ready for sale. If this test is not met, the cost cannot be included in the
An absence of a logical unit cost of the inventory. This would include costs such as the supplier’s price, freight
basis to allocate costs in and modifications. Costs incurred only after the inventory is ready for sale (such as
would mean that a cost
advertising and wages) would be excluded.
cannot be treated as a
Second, once it has been established that the cost is incurred to get inventory ready
product cost and must be
for sale, we must determine if it can be allocated to individual units of inventory on
treated as a period cost
(see Section 9.3). a logical basis. This means the cost must be directly traceable to a particular line of
inventory, and a per item cost can be calculated on some logical basis.

On 15 April 2025, MacEvoy Golf Gear purchased 15 golf bags (code B1403) from Example
Bear Industries (Invoice 361). The purchase invoice showed the following:
Golf bags – supplier’s price (15 bags @ $190 each) $2 850
Cartage in 150
Total – before GST 3 000
GST (10%) 300
Total $3 300
The Supplier’s price is obviously a product cost: it is incurred to get the inventory
ready for sale and can easily be allocated to individual units of inventory on a logical
basis as it is already expressed as $190 per bag.
Cartage in is also incurred to get inventory ready for sale, but it applies to the whole
purchase. Can it be allocated?
Given that the cartage applies only to this purchase, and 15 bags were ordered, it is
logical to divide the total cost ($150) by the number of bags purchased (15), to calculate
the cost of cartage in per bag ($10). Thus, both the Supplier’s price and the Cartage
in can be treated as product costs, and included in the cost of each bag, or ‘product’
(hence the term ‘product’ cost), giving a unit cost of $200 per bag.
The unit cost (that is, the cost price of one golf bag) would thus be calculated as:
Supplier’s price $190
Cartage in ($150 / 15 bags) 10
Unit cost of one bag $200
Recording: Inventory cards
Source
documents
Because product costs are treated as part of the unit cost of each item of inventory,
they are recorded as part of the value of each item of inventory in the inventory card and
the Inventory Control account.
In the inventory card, the golf bags would be valued using a single product cost of
$200 per bag ($190 Supplier’s price plus $10 Cartage in) as shown in Figure 9.1:
Figure 9.1 Inventory card: Product costs

Inventory Card
Inventory item: Golf bags Location: Storeroom
Inventory code: B1403 Supplier: Bear Industries
IN OUT BALANCE
April 1 Balance 10 180 1 800
15 Inv. 361 15 200 3 000 10 180 1 800
15 200 3 000
The supplier’s price and cartage in are not identified separately; they are now just
part of the same cost price of $200 per bag.


Just as the product costs are recorded as part of the value of inventory in the inventory
card, so are they recorded together, as one figure, in the General Journal as shown in
Figure 9.2:
Figure 9.2 General Journal: Product costs

General Journal
April 15 Inventory 3 000
GST Clearing 300
Account Payable – Bear Industries 3 300
Credit purchase of 10 golf bags (B1403) from Bear Industries (Inv. 361)
The amount debited to the Inventory account ($3 000) includes both the total
Supplier’s price ($2 850) and the Cartage in ($150): there is no separate ledger account
for Cartage in, as this amount is included as part of the value of inventory recorded in
the Inventory account. As with all credit purchases, the entire amount charged ($3 300)
would be credited to the account of the Account Payable – Bear Industries.

Posting the General Journal to the General Ledger would mean the accounts would
appear as shown in Figure 9.3:
Figure 9.3 General Ledger: Product costs

General Ledger
Inventory (A)
Bear Industries
GST Clearing (L)

15 Account Payable – 300 April 1 Balance 2 500
Bear Industries
Account Payable – Bear Industries (L)

15 Inventory/GST Clearing 3 300
If the purchase had been made with cash, the effect on the inventory card, the
Inventory account and the GST Clearing account would be the same, but the transaction
would be credited to Bank instead of Account Payable – Bear Industries.

Product costs from other suppliers

The treatment of product costs is the same even when a different supplier provides the
service of delivering or modifying the inventory.
On 15 April 2025, MacEvoy Golf Gear purchased 15 golf bags (code B1403) from Example
Bear Industries (Invoice 51). The purchase invoice showed the following:
Golf bags – supplier’s price (15 bags @ $190 each) $2 850
GST (10%) 285
Total $3 135
This inventory was delivered by Green Square delivery company at a cost of $150
plus GST (Cheque 52).
The two purchases are made from different suppliers, but both are for the same
order of inventory, and so can still be treated as product costs. Therefore, the cost price
of each golf bag is still $200, the only difference being the need to recognise that two
transactions were involved in the purchase of the inventory. Figure 9.3 shows how this
would be recorded in the inventory card:
Figure 9.4 Inventory card: Product costs – more than one supplier
Inventory Card
IN OUT BALANCE
April 1 Balance 10 180 1 800
15 Inv. 361/Chq. 52 15 200 3 000 10 180 1 800
15 200 3 000
In this example, the extra product cost (the Cartage in) was incurred on the day
the inventory was purchased, and so can be recorded as part of the same line in the
inventory card, with the ‘Details’ column identifying both source documents: Invoice
361 and Cheque 52.
The General Journal would record this transaction as shown in Figure 9.5:
Figure 9.5 General Journal: Product costs – more than one supplier
General Journal
April 15 Inventory 2 850
GST Clearing 285
Account Payable – Bear Industries 3 135
Credit purchase of 10 golf bags (B1403) from Bear
Industries (Inv. 361)
April 15 Inventory 150
GST Clearing 15
Bank 165
Cartage in of 10 golf bags (B1403) by Green Circle (Chq. 52)

As a consequence of the different businesses supplying the bags and the cartage in,
the General Ledger would appear as shown in Figure 9.6:
Figure 9.6 General Ledger: Product costs – more than one supplier
General Ledger
Inventory (A)
Bear Industries
Bank 150
GST Clearing (L)

April 15 Account Payable – 285 April 1 Balance 2 500
Bear Industries
Bank 15
Account Payable – Bear Industries (L)

Bank (A)
April 1 Balance 9 800 April 15 Inventory/GST Clearing 165
Even though the inventory has been provided by two different suppliers and recorded
in two separate entries, a total of $3 000 is still debited to the Inventory account to show
the cost or value of the inventory purchased.
Product costs on different dates

Had the invoice for the purchase (from Bear Industries) and the payment for the
delivery (to Green Circle) occurred on different dates (such as April 15 and April 17),
the transactions would be recorded separately in the inventory card, but the value of
inventory would still end up as $200 per bag, as is shown in Figure 9.7:
Figure 9.7 Inventory card: Product costs – more than one supplier (different dates)
Inventory Card
IN OUT BALANCE
April
1 Balance 10 180 1 800
15 Inv. 361 15 190 2 850 10 180 1 800
15 190 2 850
17 Chq. 52 15 10 150 10 180 1 800
15 200 3 000

The transaction on 17 April does not increase the quantity of inventory on hand, just
its value (from $190 to $200 per unit).
(The General Journal and the General Ledger would simply appear as shown in
Figures 9.5 and 9.6, but with different dates.)

1 Define the term ‘product cost’.
2 Explain how product costs are recorded in the inventory cards.
3 Explain how product costs are recorded in the Inventory account in the General
Ledger.
4 Explain how the recording of product costs differs if more than one supplier is
involved.
9.3 Period costs and other expenses

In the example in Section 9.2 concerning the golf bags, there was a logical basis on which period cost
to allocate the Cartage in, so it could be expressed as cartage per unit and treated as a a cost incurred in order to
product cost. In other cases where there is no logical basis for allocation, this may not be bring inventory into a condition
and location ready for sale
possible. In cases such as this, the cost must be treated as a period cost: a cost incurred
that cannot be allocated to
in order to bring inventory into a condition and location ready for sale, which cannot be individual units of inventory on
allocated to individual units of inventory because there is no logical basis to do so. a logical basis
On 23 May 2025, MacEvoy Golf Gear purchased golf clothing from Nickwell Example
Clothing (Invoice 67). The purchase invoice showed the following:
Golf shirts – supplier’s price (20 shirts at $23 each) $460
Golf hats – supplier’s price (10 hats at $8 each) 80
Cartage in 50
Total – before GST 590
Study tip
GST (10%) 59
Total $649
Period and product costs
are both incurred to get
Although these costs are incurred to bring the inventory into a condition and location inventory ready for sale,
ready for sale, there is no logical basis to allocate the Cartage in of $50 because there so this characteristic
are two different lines of inventory ordered (golf shirts and golf hats). Both lines of will not distinguish
inventory would incur cartage, but we cannot assume that the Cartage in would be the between the two. It will
same per shirt as it is per hat, meaning we cannot divide the $50 cost between the 30 only distinguish between
costs related to inventory
items. As a result, we do not know the per item cost of the cartage.
and Other expenses (as
In a case like this, we have no choice but to treat the Cartage in as a period cost, and
explained later in this
value the inventory only at the price charged by the supplier, which is $23 per shirt and
section).
$8 per hat.

Recording: Inventory cards

Study tip
If a cost can be allocated Source

documents
on a per unit basis, it
should be treated as a
product cost; only when
this allocation is not
A period cost is unable to be treated as part of the unit cost of each item of inventory,
possible should the item
be treated as a period so it must be recorded and reported separately from the inventory. In terms of the
cost. inventory cards, the golf shirts would be valued only at their supplier’s price of $23 each,
and the golf hats at $8 each, as shown in Figure 9.8:
Figure 9.8 Inventory cards: Period costs
Inventory Card
Inventory item: Golf Shirt, 40 inch, Yellow Location: Storeroom
Inventory code: NCS40iY Supplier: Nickwell Clothing
IN OUT BALANCE
May 1 Balance 8 20 160
23 Inv. 67 20 23 460 8 20 160
20 23 460
Inventory Card
Inventory item: Golf Hats, Large Location: Storeroom
Inventory code: NCHL Supplier: Nickwell Clothing
IN OUT BALANCE
May 1 Balance 20 7 140
23 Inv. 67 10 8 80 20 7 140
10 8 80

Because the Cartage in is not recorded in the inventory cards as contributing to the
value of the inventory, it must be recorded in its own separate ledger account. In fact,
it is treated as a separate expense, incurred in the Period in which the inventory is
purchased (hence the name ‘period’ cost). Figure 9.9 shows how the purchase would
be recorded in the General Journal:
Figure 9.9 General Journal: Period cost

General Journal
May 23 Inventory 540
Cartage in 50
GST Clearing 59
Account Payable – Nickwell Clothing 649
Credit purchase of 20 golf shirts (NCS40iY) and 10 golf
hats (NCHL) from Nickwell Clothing (Inv. 67)

This shows that of the $649 charged by the Account Payable, $540 was for the
inventory, $50 was for the Cartage in expense and $59 was GST.

Because the Cartage in cannot be itemised it cannot be included in the inventory figure
and must be recorded as a separate expense. In the General Ledger there would be a
separate ledger account for Cartage in, as is shown in Figure 9.10:
Figure 9.10 General Ledger: Period cost

General Ledger
Inventory (A)
May 1 Balance 23 000
23 Account Payable – 540
Nickwell Clothing
Cartage in (E)
May 23 Account Payable – 50
Nickwell Clothing
GST Clearing (L)

May 23 Account Payable – 59 May 1 Balance 3 000
Nickwell Clothing
Account Payable – Nickwell Clothing (L)

May 1 Balance 2 750
23 Inventory/Cartage in/ 649
GST Clearing
Cost of Goods Sold and other expenses

Study tip
By definition, period costs cannot be allocated to individual items of inventory on a
logical basis, and so must be recorded in their own, separate account in the General
Journal. Indeed, the very fact that such an account exists in the General Ledger is proof Strictly speaking, any
enough that it has already been recorded as a period cost. cost that is not a product
Where such a cost is incurred to get inventory ready for sale, it will be reported under cost is a period cost
the ‘Cost of Goods Sold’ heading in the Income Statement. (in the sense that it is
However, costs that are not related to getting inventory ready for sale are simply incurred in the Period
classified as Other expenses, and for these expenses it does not matter whether there of purchase rather than
is a logical basis for allocation. The defining characteristic of Other expense is that rather when the product is sold).
than being incurred to bring inventory into a condition and location ready for sale, it is
incurred after the sale.

1 Define the term ‘period cost’.
2 Compared to product costs, explain one difference in the way period costs are
recorded in:
• the inventory card
• the General Ledger.
3 Explain how a period cost can be identified in the General Ledger.
4 Distinguish between an expense reported under Cost of Goods Sold and an
expense reported under Other expenses in the Income Statement.

9.4 Reporting product and period costs
Source
documents
As we have noted, treating costs as product costs means all the costs incurred to get
inventory ready for sale are allocated directly to the items of inventory themselves.
If the inventory is unsold, the product costs are included in the value of the asset,
Inventory, and when the inventory is sold, the product costs are included as part of the
Cost of Sales figure. In fact, product costs are recognised as being incurred, and their
benefit consumed, in the Period when inventory is sold.
Period costs, on the other hand, are recorded separately in the General Ledger, and
reported under the heading ‘Cost of Goods Sold’ in the Income Statement. Further,
the entire amount is recognised as being incurred in the Period when the inventory is
purchased, regardless of whether the inventory is sold or not.
Unless all the inventory is sold, period costing will lead to a higher Cost of Goods Sold in
the Period when inventory is purchased (resulting in a lower Gross Profit and Net Profit and
therefore a lower owner’s equity) and a lower value of inventory on hand (and therefore
lower assets). The exact amount by which these items will be different can be calculated
by multiplying the period cost by the fraction of items of inventory remaining unsold.
Example During October 2025, HiFi Central imported 10 sets of wireless headphones for
$120 plus GST each, incurring $350 plus GST in modification costs. 4 sets of
headphones were sold in October 2025 for $250 plus GST each.
Product costing
Assuming the modifications were (correctly) treated as product costs, the cost of one
set of headphones would be:
Supplier’s price $120
Plus Modifications ($350 / 10 sets) 35
Unit cost of one set of headphones $155
Figure 9.11 shows how the Income Statement (extract) would appear:
Figure 9.11 Income Statement: Product costs

HIFI CENTRAL
Income Statement (extract) for October 2025
$ $
Revenue
Sales (4 sets × $250) 1 000
Less Cost of Goods Sold
Cost of Sales (4 sets × $155) 620
Gross Profit 380
Product costing recognises the expense as being incurred only in the Period when
the inventory is sold, and because only 4 out of 10 sets have been sold, only 4/10 of the
$350 spent on modifications has been recognised as being incurred in October 2025.
This is included in the Cost of Sales figure of $620.
The remaining 6/10 of the modifications cost – yet to be incurred because the inventory
has not yet sold – is included in the value of Inventory on hand in the Balance Sheet at
the end of October 2025 as is shown in Figure 9.12:
Figure 9.12 Balance Sheet: Product costs
HIFI CENTRAL
Balance Sheet (extract) as at 31 October 2025
$
Current Assets
Inventory
(6 sets × $155) 930
Period costing
Assuming the same data, but using period costing, would produce very different reports.
Period costing would not allocate the modifications to each set of headphones, and hence
value them at only their supplier’s price of $120 each. However, it would recognise the
entire $350 spent on modifications as incurred in the Period when the inventory was
purchased. That is, the entire $350 would be reported as an expense for October 2025,
so the Income Statement (extract) would appear as is shown in Figure 9.13:
Figure 9.13 Income Statement: Period costs
HIFI CENTRAL Study tip
Income Statement (extract) for October 2025
$ $
Revenue If an item is listed in the
Sales (4 sets × $250) 1 000 Trial Balance, it means
Less Cost of Goods Sold it has its own ledger
Cost of Sales (4 sets × $120) 480 account, and therefore
Modifications 350 830 must have been recorded
Gross Profit 170 as a period cost.
Under period costing, the entire cost of the modifications ($350) has been recognised
as an expense, even though six remain unsold. Put another way, only 4/10 of the sets have
been sold, but 10/10 of the $350 has been recognised as being incurred as an expense.
The six remaining (unsold) sets will be valued only at their supplier’s price of $120
each, and thus would be shown in the Balance Sheet as shown in Figure 9.14:
Figure 9.14 Balance Sheet: Period costs
HIFI CENTRAL
Balance Sheet (extract) as at 31 October 2025
$
Current Assets
Inventory (6 sets × $120) 720
Figure 9.15 shows a comparison of product and period costing:

Figure 9.15 Product v Period costs
Product costing Period costing
Income Statement $ $ $
Sales 4 units @ $250 1 000 4 units @ $250 1 000
Cost of Goods Sold
Cost of Sales 4 units @ $155 * 620 4 units @ $120 480
Plus Period costs Modifications 350 830
Gross Profit 380 170
Balance Sheet
Inventory 6 units @ $155 * 930 6 units @ $120 720
* Includes part of $350 cost of modifications i.e. $35 per set

In this example, Cost of Goods Sold under period costing ($830) is higher than
product costing ($620) because it includes all of the modification costs. This means
Gross Profit is $210 lower ($210 = 6/10 unsold × $350).
At the same time, Inventory (and thus assets) under period costing ($720) is lower
than product costing ($930) by the same amount, because the six remaining headphone
sets will only be valued at their supplier’s price of $120.
Summary
If a cost is incurred to get inventory ready for sale and can be allocated to individual units
on a logical basis, then it is a product cost. Except where the cost is insignificant (see
below), treating a product cost as a period cost leads to the omission of information that
would be useful for decision-making, and thus breaches Relevance. Where there is no
logical basis on which to allocate the cost to individual units, period costing must be
used. In this situation, treating a period cost as a product cost would be misleading and
could result in poor decision-making.
Study tip Equally, period costing may be used if the cost concerned can be allocated but is
too small to affect decision-making; that is, it is immaterial. Here we are talking about
costs that would otherwise be, correctly, treated as product costs, but due to their
Period costing will lead
insignificance may be treated as period costs. The insignificance of such items means
to a higher COGS in the
period when inventory is that it should not really matter how they are treated, because, by definition, they will not
purchased, but a lower affect decision-making.
COGS in the following Period costing recognises the entire cost as an expense in the Period when the
period. However, if all inventory is purchased, whereas product costing includes the cost as an expense only
inventory is sold, both in the Period in which the inventory is sold. As a result, unless all inventory is sold, and
methods will produce the this is an important caveat, period costing will lead to a higher Cost of Goods Sold and
same figures. thus a lower profit and owner’s equity, and a lower Inventory and assets.

1 Compared to product costs, explain one difference in the way period costs are
reported in the Income Statement.
2 Explain the effect on profit if period costing is used instead of product costing.
3 Explain the effect on the Balance Sheet if period costing is used instead of
product costing.
4 State two circumstances in which it is appropriate to use period costing.
5 Referring to one Qualitative characteristic, explain why the correct inventory
valuation method should be applied.

9.5 T
he Lower of ‘Cost’ and ‘Net Realisable Value’
(NRV) rule
As we have noted, inventory is usually valued at its Cost – its original purchase price plus
any costs incurred to get it ready for sale – as this valuation upholds both Verifiability
(it can be checked against the purchase document) and Faithful representation (as the
valuation is complete, free from error and neutral or without bias).
However, there may be some situations when the Cost no longer provides a Faithful
representation of the value of inventory. For instance, inventory that is damaged may no
longer be worth its original purchase price.
While continuing to value this inventory at its Cost would uphold Verifiability, it would
actually breach Faithful representation as the original purchase price would not account
for the damage to the inventory, meaning it would no longer provide a valuation which
was complete or free from error. In fact, it would actually overstate the value of inventory
and assets as a whole and overstate profit by not recognising the loss (caused by the Ethical
damage) that is probable on the sale of the inventory. This lack of Faithful representation c onsiderations
might also be deemed to be unethical.
Net Realisable Value (NRV)

In cases such as this, where the Cost no longer provides a Faithful representation, it is
better to use an estimate based on the selling price to value the inventory. This estimate
is called Net Realisable Value (NRV) and is calculated by estimating the selling price Net Realisable Value (NRV)
of the inventory (its ‘realisable value’, or what it would be worth if it was sold today) and the estimated selling price
then deducting any direct selling expenses (costs that would be incurred in its selling, of inventory less any costs
involved in its selling, marketing
marketing or distribution).
or distribution
Net Realisable Value (NRV) = Estimated selling price less Direct selling expenses
Whereas the Cost of the inventory represents its value at the time it was purchased,
Net Realisable Value represents what the inventory would be worth if it was sold today,
less what it would cost to carry out the selling.
Lower of ‘Cost’ and ‘Net Realisable Value’ rule

If the Cost remains lower than the Net Realisable Value, as it will in most cases, it
indicates that the inventory is still expected to be sold at a profit, and therefore that the
cost price continues to provide a Faithful representation of the value of inventory.
However, if the Net Realisable Value should fall below the Cost, it indicates that the
inventory is not expected to be sold at a profit because something has happened to
either the inventory or the market (see below). This means the Cost no longer provides
a Faithful representation of the value of inventory, and the Net Realisable Value should Lower of ‘Cost’ and ‘Net
Realisable Value’ rule
be used instead.
inventory should be valued
In general terms then, inventory is valued at either its Cost (original purchase price) at either its Cost, or its Net
or its Net Realisable Value, using whichever valuation is lower. This is known as the Realisable Value, using
Lower of ‘Cost’ and ‘Net Realisable Value’ rule. whichever value is lower

Reasons why NRV may be lower than ‘Cost’

In most cases, Cost is lower than Net Realisable Value because the business wants
to sell its inventory at a profit. In these cases, the business will continue to value its
inventory at its Cost (upholding both Verifiability and Faithful representation).
However, there are a number of reasons why the Net Realisable Value may fall
below the Cost, including:
• damage or physical deterioration
Inventory that is damaged, or shop soiled, may have to be sold for less than its
original purchase price.
• a purposeful decrease in selling price
Some inventory may be sold for less than its cost price as a deliberate marketing ploy
to attract new customers or force a competitor out of the market.
• a decrease in demand
Inventory that is out of season or no longer in fashion may not be able to be sold for
what it was once worth. This applies particularly to clothes, sporting equipment and
fads.
• obsolescence.
Items that are technically obsolete, superseded by a new model or, in the case of
food items, out of date will be difficult to sell for more than their cost price.
If any of these situations occur, inventory must be revalued from its Cost to its Net
Realisable Value by making an Inventory write-down.

1 Referring to two Qualitative characteristics, explain why inventory is usually
valued at its cost price.
2 Explain the circumstances under which valuing inventory at its cost price may
undermine Faithful representation.
3 Explain the effect on the Accounting equation of not revaluing damaged inventory.
4 Define the term ‘Net Realisable Value’.
5 Referring to one Qualitative characteristic, explain why inventory should be
valued according to the Lower of ‘Cost’ and ‘Net Realisable Value’ rule.
6 Explain why Cost is usually lower than Net Realisable Value.
7 State four reasons why Net Realisable Value may fall below Cost.

9.6 Inventory write-down

Where NRV has fallen below Cost, it means that the cost price currently recorded in the
inventory card no longer provides a Faithful representation of the value of the inventory. Inventory write-down
the expense incurred when the
In such a case, applying the Lower of ‘Cost’ and ‘Net Realisable Value’ rule means the
Net Realisable Value (NRV) of
inventory must be revalued (to its NRV) by recording an Inventory write-down, which an item of inventory falls below
represents the expense incurred when the Net Realisable Value of an item falls below its Cost or original purchase
its Cost or original purchase price. price
As at 1 August 2025, Dave’s Discount Appliance Store had on hand 6 ‘Clarity’ Example
dishwashers that it had purchased for $500 plus GST each. These dishwashers
had a selling price of $650 plus GST each.
On 31 August 2025, the supplier released a new dishwasher model – the
‘Clarity Plus’. In response, Dave decided to reduce the selling price of the
remaining ‘Clarity’ dishwashers to $550 plus GST each, and spend $720 plus GST
on a special advertising campaign to promote the sale (Memo 31).
When the ‘Clarity’ dishwashers were purchased, each was valued at its Cost of
$500 as this amount was not only Verifiable, but also lower than its selling price (which Study tip
in this case is the same as its NRV) and thus provided a Faithful representation of each
dishwasher’s value. As a consequence, as at 1 August 2025 the dishwashers would be
GST, as it applies to
valued in the inventory card at $500 each.
either the selling price
or the cost price, is not a
Calculating the NRV factor to be considered in
Following the release of the new ‘Clarity Plus’, the Cost of the old ‘Clarity’ dishwashers the valuation of inventory
has not changed, but their NRV has as they can longer be sold for $650. Had this been as it affects GST
the only change, an Inventory write-down would not be required, as their Cost of $500 Clearing, not inventory or
would still be lower than their NRV of $550. profit. Cost is calculated
However, in this example the new estimated selling price of $550 is only likely to be with the GST excluded
‘realised’ after the business spends $720 on a campaign to advertise the 6 dishwashers and so is NRV.
still on hand.
These changed market conditions mean the NRV of the ‘Clarity’ dishwashers must
be recalculated as at 31 August 2025 as shown in Figure 9.16:
Figure 9.16 Calculation: Net Realisable Value
Net Realisable Value (NRV) = Estimated selling price less Direct selling expenses
=$
550 less $120 * (Advertising $720 / 6 dishwashers on hand)
= $430 per dishwasher
As a result of the release of the new model, the old models are now less in demand,
and have an NRV of only $430. This must be compared against their Cost to determine
if an Inventory write-down is necessary.

Calculating the Inventory write-down

Because the NRV of each dishwasher ($430) has fallen below its Cost ($500), the cost
price no longer provides a Faithful representation of the value of the inventory, so each
dishwasher must be written down (from its Cost, to its NRV) via an Inventory write-
down.
Study tip The amount of the Inventory write-down is calculated by comparing the Cost and
NRV as shown in Figure 9.17:
If the Inventory write-
down figure turns out to Figure 9.17 Calculation: Inventory write-down
be negative, the NRV is
greater than the Cost, so Inventory write-down = Cost less Net Realisable Value
an Inventory write-down
= $500 less $430
is not necessary!
= $70 per dishwasher
Given that there are six dishwashers still on hand, each of which must be written
down by $70, the total Inventory write-down will be $420 (6 × $70).
(This rule must be applied on an individual basis, because for most lines of inventory
their Cost is likely to remain lower than their NRV. These items will need to remain
valued at their cost price, which continues to provide a valuation that is both Verifiable
and a Faithful representation.)
Recording: Inventory write-down
Source
documents
At the time of purchase, inventory is recorded in the inventory card at its Cost. If the
inventory must be written down to its NRV, then both the inventory card and the
Inventory account in the General Ledger must be adjusted by an Inventory write-down.
Recording: Inventory card

The inventory card for dishwashers must record the write-down per item, as shown in
Figure 9.18:
Figure 9.18 Inventory card: Inventory write-down

Inventory Card
Inventory item: Dishwasher, Clarity Location: Row 5, Bay 2
Inventory code: CD3000 Supplier: F&P
IN OUT BALANCE
Aug. 1 Balance 6 500 3 000
31 Memo 31 6 70 420 6 430 2 580
Notice that even though this entry is recorded in the OUT column of the inventory
card, no units of inventory are actually leaving the business; inventory has been reduced
in value, not in quantity. Each dishwasher is written down by $70, leaving each one
valued at its NRV of $430 ($500 cost price less $70 Inventory write-down).


In the General Journal, Inventory write-down is debited to recognise the expense: the
reduction in assets (Inventory), which decreases owner’s equity. At the same time,
the asset Inventory is credited to recognise that the value of the asset has decreased.
Figure 9.19 General Journal: Inventory write-down Study tip

General Journal
Aug. 31 Inventory write-down 420 The amount used in the
Inventory 420
General Journal entry
is the amount of the
Write down of 6 dishwashers (Clarity) to NRV due to
Inventory write-down,
release of new model (Memo 31) not the new balance of
This General Journal entry would be posted to the General Ledger as shown in inventory on hand.
Figure 9.20:
Figure 9.20 General Ledger: Inventory write-down

General Ledger
Inventory * (A)
Aug. 1 Balance 140 000 Aug. 3 Cost of Sales 47 600
19 Account Payable – F&P 95 000 8 Drawings 500
22 Cost of Sales 1 000 10 Advertising 2 600
16 Cost of Sales 62 400
22 Account Payable – F&P 600
31 Inventory write-down 420
Inventory write-down (E)

Aug. 31 Inventory 420
* Other probable entries have been added to show a more complete Inventory account
The inventory card and the Inventory account in the General Ledger would now
show all inventory at the Lower of ‘Cost’ and ‘NRV’, ensuring that the reports provide a
Faithful representation of the value of inventory.
In the process, Relevance will also be upheld, as the information in the reports will
be more useful for decision-making.

In terms of the Accounting equation, the overall effect of an Inventory write-down is:

Owner’s equity Decrease (Inventory write-down expense decreases Profit) 420


1 Define the term ‘Inventory write-down’.
2 Referring to one Qualitative characteristic, explain why an Inventory write-
down may be necessary.
3 Show how the amount of an Inventory write-down is calculated.
4 Explain why the Lower of ‘Cost’ and ‘NRV’ rule should be applied to individual
inventory lines.
5 Show the General Journal entries necessary to record an Inventory
write-down.
6 Explain why an Inventory write-down is recorded in the OUT column of the
inventory card.
7 State the effect of an Inventory write-down on the Accounting equation.
9.7 Reporting an Inventory write-down
Source
documents
Because Inventory write-down is not a cost involved in getting the inventory into a
position or condition ready for sale, it should not be classified under Cost of Goods Sold:
it will not affect the mark-up on inventory which is reflected in Gross Profit.
However, it is related to inventory, and will affect the overall margin that the business
will earn from the sale of inventory. In this way, an Inventory write-down has the same
effect as an inventory loss or gain, so it is reported as a deduction from Gross Profit to
determine Adjusted Gross Profit.
Figure 9.21 shows how an Inventory write-down would appear in the Income
Statement:
Figure 9.21 Income Statement: Inventory write-down

Study tip DAVE’S DISCOUNT APPLIANCE STORE
Income Statement for August 2025
$ $
An Inventory write-down
Revenue
is reported in the same
place as an inventory Sales 165 000
loss or gain. Less Cost of Goods Sold
Customs duty 1 000 110 000
Gross Profit 55 000
Less Inventory write-down 420
Adjusted Gross Profit 55 420
In the Balance Sheet, the balance of the Inventory account would be reported as
would normally be the case, but its value would reflect the fact that all inventory was
valued at the Lower of ‘Cost’ and ‘Net Realisable Value’.


1 Explain why Inventory write-down is not reported as part of Cost of Goods
Sold in the Income Statement.
2 Explain how an Inventory write-down affects Adjusted Gross Profit.
9.8 Inventory Turnover (ITO)
Source
documents
As a firm’s main source of revenue, inventory is also its main source of cash inflows; but
before cash can be collected from cash sales or Accounts Receivable, the inventory must
Inventory Turnover (ITO)
first be sold. Inventory Turnover (ITO) calculates the average number of days taken to
the average number of days
sell inventory (or turn inventory into sales), and therefore assesses how effectively the it takes for a business to sell
firm has managed its inventory holdings. its inventory or convert its
Inventory Turnover is calculated as shown in Figure 9.22: inventory into sales
Figure 9.22 Formula: Inventory Turnover
Average Inventory
Inventory Turnover (ITO) = x 365
Cost of Goods Sold
Like Accounts Payable Turnover and Accounts Receivable Turnover, Inventory

Turnover uses the average balance of inventory (derived by adding the starting and
ending balances, and then dividing by 2) in an attempt to reflect the inventory on hand
carried throughout the period, while multiplying by 365 converts the turnover into days.
Fast Inventory Turnover, as measured by low days, means that, on average, inventory
is sold quickly. This will enhance the firm’s ability to earn profit and generate cash from
the sale of inventory.
Markwell Mirrors has provided the following information relating to its trading Example
activities for 2025:
Cost of Goods Sold $450 000

Inventory as at 1 January 2025 $56 000
Inventory as at 31 December 2025 $58 000
Inventory Turnover for 2024 41 days

Calculating Inventory Turnover

The Inventory Turnover for Markwell Mirrors for 2025 would be calculated as shown in
Figure 9.23:
Figure 9.23 Calculation: Inventory Turnover
(56 000 + 58 000)/2

Inventory Turnover (ITO) = x 365
450 000
57 000
= x 365
450 000
= 46* days (46.2 rounded down to the nearest day)
This ITO indicates that in 2025 inventory was sold on average every 46 days.
Analysing Inventory Turnover

This Inventory Turnover should be assessed against ‘benchmarks’ or ‘standards’
including:
• last year (performance in previous periods)
Study tip • expected (budgeted performance)
• its competitors (performance of similar businesses, sometimes reflected in an
industry average).
Changes in ITO should This allows the owner to assess whether the business is selling its inventory faster
be described as
or slower than previously, expected or its competitors.
faster or slower: than
In this example, Markwell Mirrors’ Inventory Turnover of 46 days in 2025 is actually
previous periods; than
4 days slower than the 41 days taken in 2024, indicating a worsening in its management
budgeted; or than similar
businesses. of inventory. This may have negative consequences for sales and profit, but also for
liquidity, with slower sales leading to slower cash inflows.
Fast Inventory Turnover

In general, fast Inventory Turnover is beneficial for profitability and liquidity because it
indicates higher sales, leading to higher profit and more cash on hand (provided collection
mechanisms are effective). It could also indicate effective inventory management
techniques that are leading to inventory moving quickly through the store, reducing the
chances of inventory losses and/or write-downs.
However, it is also possible that Inventory Turnover could be too fast as it may also
indicate that the selling price is too low, and this would be a loss of potential revenue
and profit. Alternatively, it may be because the firm is holding too little inventory. If
this is the case, costs such as delivery may be higher (because deliveries are more
frequent) and the business could lose the possibility of earning discounts for buying
in bulk.
Slow Inventory Turnover

Inventory Turnover that is too slow (that is, a high number of days) usually has negative
consequences for both cash and profit.
If slower Inventory Turnover is caused by a decrease in sales, its immediate effect
will be a negative effect on profit. However, it may also lead to worsening liquidity, as
cash is collected slower (as cash sales or cash received from Accounts Receivable) and
therefore less readily available to meet short-term debts as they fall due.
Even if slower Inventory Turnover is caused by an increase in inventory on hand
it still puts pressure on cash flows, as cash has already been spent, or is owed in

greater amounts (and in need of repayment) to Accounts Payable. Further, an increased

amount of inventory, which is not selling, becomes more susceptible to inventory loss
and Inventory write-down, causing expenses which decrease profit.
Other considerations
Any assessment of Inventory Turnover must consider the nature of the goods sold.
Goods that are perishable (such as fresh produce) or susceptible to changes in fashion
(like clothing) should have a fast Inventory Turnover so they are not subject to inventory
loss or Inventory write-down issues. Relatively cheap items should also be sold much
faster than more expensive items, such as luxury cars.
Further, because it only measures the average time taken to sell inventory, decisions
should not be made on an assessment of Inventory Turnover alone. It is important that
the owner also analyses the inventory cards, so that he or she has detailed information
about the speed at which specific lines of inventory are selling, so that appropriate
decisions can be made.
Finally, it must be remembered that Inventory Turnover is a historical measure: it
describes what has already happened and does not guarantee what will occur in the
future.
Inventory Turnover, Accounts Receivable Turnover and Accounts

Payable Turnover
As noted above, Inventory Turnover is a key consideration in an assessment of liquidity.
In the case of cash sales, the number of days taken to sell inventory will also be the
number of days taken to generate cash. However, for credit sales the business will
have to wait until the inventory is sold, and then wait again until cash is received from
Accounts Receivable. This in turn has consequences for the firm’s ability to make
payments to its Accounts Payable, with cash not available until inventory is sold, and
cash is collected.
Figure 9.24 shows the relationship between Inventory Turnover, Accounts
Receivable Turnover and Accounts Payable Turnover in what is sometimes called the
‘Cash cycle’:
Figure 9.24 Cash cycle
Sale of Inventory
Receipt from Account

Purchase of Inventory
Receivable
Payment to Account
Payable
The days between the purchase of inventory and sale of inventory is measured by
the Inventory Turnover; the days between the sale of inventory and the receipts from
the Accounts Receivable is measured by the Accounts Receivable Turnover; and the
days between the purchase of the inventory and the payments to the Accounts Payable
is measured by the Accounts Payable Turnover.

In most cases, a business will want its ITO and ARTO to be fast whereas it will want
its APTO to be as slow as possible (without exceeding credit terms). In terms of cash,
there may be a benefit in selling for cash and buying on credit, as it makes it more likely
that cash will be generated from sales before Accounts Payable must be paid. However,
there are significant advantages to selling on credit, and provided the business manages
its inventory, Accounts Receivable and Accounts Payable effectively, the cash cycle can
be managed to ensure debts are met on time.
Example Markwell Mirrors has provided the following summary of its financial indicators
for 2025:
Indicator 2025 Benchmark

Inventory Turnover 46 days 2024: 41 days
Accounts Receivable Turnover 28 days Credit terms offered to customers: 30 days
Accounts Payable Turnover 64 days Credit terms offered by suppliers: 60 days
In this example, it takes 46 days (ITO) to sell the inventory, and then a further 28 days
(ARTO) to receive cash from Accounts Receivable, meaning it takes 74 days (46 days
+ 28 days) to generate cash. This is perhaps the reason why it is taking 64 days (APTO)
to pay Accounts Payable. Given the fact that cash is received from Accounts Receivable
within the 30 day credit terms, it is the ITO that is most in need of attention to ensure
cash can be generated to meet Accounts Payable in time.
Managing Inventory
Given its importance to both profit and liquidity, the owner may consider implementing
some, or all, of the following strategies to manage its inventory:
• Maintain an appropriate inventory mix
What is ‘appropriate’ may change from season to season, or as tastes and
preferences change, so the owner must pay close attention to which inventory is
selling. Inventory lines that are selling well should be expanded, while those that are
not should be reduced or even discontinued.
‘Appropriate’ inventory must also meet community and legal standards, meaning
Ethical this decision has ethical and financial dimensions. In the longer term, inventory that
considerations is dangerous, outside the bounds of accepted community standards, or simply poor
quality and/or not ‘fit for the purpose intended’ will simply not sell.
• Promote the sale of complementary goods
Complementary goods are add-on sales that are generated to support the original
item sold. As part of its assessment of its inventory mix, the business should
consider what ‘extra sales’ it can generate from inventory that is related in some
way. For example, a business selling tents may also sell sleeping bags, inflatable
mattresses and gas lights to encourage more sales.
• Ensure inventory is up to date
Sales of some inventory lines will be heavily affected by changes in fashion or
technology. In order to maintain sales, inventory of these items must be the most
current version available: older and out-of-date versions should be discounted for
quick sale.
• Rotate inventory
The positioning of inventory in the store can have a significant impact on whether
it sells or simply sits on the shelf. Particularly for perishable items, older products

should be moved to the front, so they are taken first: this will minimise inventory
loss or write-down issues. At other times, moving an entire inventory line to another
location within the store may boost its sales.
• Determine an appropriate level of inventory on hand
Carrying too little inventory could mean a loss of sales so inventory levels should
be sufficient to meet demand. However, they should not be so high that additional
storage costs or inventory write-down issues (such as damage or technical
obsolescence) ensue. Setting a target level for inventory also assists in identifying
when to reorder.
• Market strategically and effectively (and ethically)
Strategies like advertising – in the right way, to the right customers – will hopefully
lead to increased sales and faster Inventory Turnover for all lines of inventory, or for
a particular line (which may then attract customers and entice them to buy other
items too).
Loyal customers are less sensitive to changes in price and less likely to switch to
a competitor. Some studies indicate that attracting new customers costs more than
five times as much as retaining existing customers, but increasing retention rates
and repeat sales can increase profits substantially.
Having said that, marketing must be ethical and provide an honest representation
of the goods, their qualities and their uses. Making promises that items of inventory Ethical
cannot fulfil is dishonest and, in certain cases, illegal, and will lead to sales returns c onsiderations
and could even result in legal sanctions.
• Appoint an Inventory Manager
An Inventory Manager has responsibility for record keeping including checking the
documents to ensure goods ordered and charged for are delivered, conducting a
physical count and ensuring inventory handling procedures are followed and are
effective.
Much of the information referred to above may be non-financial in nature, and based
on the owner’s assessment of customers, trends and the market such as consumer
preferences, community attitudes and even trends in the weather. (Umbrellas are more
likely to sell in winter than during the heat of summer). Taken together, financial and
non-financial information are crucial in determining what to sell, when, and in what
quantities.

1 State what is measured by Inventory Turnover (ITO).
2 Show the formula to calculate Inventory Turnover.
3 List three benchmarks that can be used to assess Inventory Turnover.
4 Explain why fast Inventory Turnover is beneficial for:
• profitability
• liquidity.
5 Explain the disadvantages of Inventory Turnover being:
• too fast
• too slow.
6 State two limitations of using Inventory Turnover to assess inventory
management.
7 Explain the role of inventory cards in an analysis of Inventory Turnover.
8 Explain the importance of Inventory Turnover and Accounts Receivable
Turnover in managing Accounts Payable Turnover.
9 List the strategies that businesses can use to manage their inventory.

Where have we been?

• Inventory should be valued at its original purchase price, as this is Verifiable by reference to a source
document and provides a Faithful representation of its value.
• The cost of inventory includes all costs incurred in order to bring the inventory into a condition and
location ready for sale.
• Product costs can be allocated to individual units of inventory on a logical basis; period costs cannot.
• Product costs are recorded as increases to the unit cost of inventory in the inventory cards; period costs
are recorded separately in the ledger.
• Product costs are recognised as being incurred only in the Period in which inventory is sold; period costs
are recognised as being incurred in the Period in which the inventory is purchased.
• Compared to product costing, period costing will lead to a higher Cost of Goods Sold and lower profit in
the Income Statement, and lower assets and owner’s equity in the Balance Sheet.
• To ensure Faithful representation, inventory must be valued at the Lower of Cost and Net Realisable
Value (NRV).
• NRV is the estimated selling price of the inventory less any costs involved in its selling, marketing or
distribution.
• Inventory write-down is calculated by deducting NRV from Cost.
• The overall effect of an Inventory write-down is to decrease both assets and owner’s equity.
• Inventory Turnover (ITO) calculates the average number of days taken to sell inventory.
• Fast ITO is beneficial for profit and liquidity, provided it is not too fast.
• Slow ITO can have negative consequences for profit and liquidity.
• ITO, ARTO and APTO are related in the cash cycle.
• There are many strategies that businesses can use to manage their inventory.
Exercises
this book.

Cost of inventory
On 1 March 2025, El Fresco Living had 25 barbecues on hand worth $85 each. On 4 March 2025, the business
purchased 40 barbecues at a cost of $80 plus GST each, with cartage in costing $10 plus GST per barbecue
(Cheque 102). The barbecues will have a selling price of $200 plus GST each.
Required
a Explain why the GST on the purchase is not included in the calculation of the cost price of inventory.
b Calculate the cost price of one of the barbecues purchased on 4 March 2025.
c Referring to your answer to part ‘b’, explain your treatment of ‘Cartage in’.
d Record Cheque 102 in the inventory card for barbecues.
e Record Cheque 102 in the General Journal of El Fresco Living.


Cost of inventory
As at 1 January 2025, Comfy Couches had eight couches on hand with a cost price of $1 590 each.
On 3 January 2025, the business purchased 10 couches from Wilson Products (Invoice 65), with the details
of the purchase provided as follows:
Supplier’s price $15 000

Anti-stain treatment $1 300
Sub-total $16 300
GST $1 630
Total invoice cost $17 930
Each couch has a selling price of $4 000 plus GST, with a special advertising campaign to sell the couches
costing $2 200 including GST.
Required
a Explain how valuing the couches at their selling price would breach both Verifiability and Faithful
representation.
b Calculate the cost price of one of the couches purchased on 3 January 2025.
c Referring to your answer to part ‘b’, explain your treatment of the advertising campaign.
d Record Invoice 65 in the inventory card for Couches.
e Record Invoice 65 in the General Journal of Comfy Couches.

Product versus period costing
Ben Scott owns an electrical shop called High Voltage, which is the sole distributor of a new combined
washer/dryer. The details of the new washer/dryer are:
Invoice price $900 per unit

Freight in 10% of invoice price
Modification costs $25 per unit
Insurance of inventory $400 per month
• Ben has decided to treat the Insurance of inventory as a period cost.
• On 6 November 2025, Ben purchased 40 washer/dryers from Young Bros. (Inv. 23) and paid $400 for
insurance for the month (Ch. 142).
• By 30 November 2025, 25 of the washer/dryers had been sold for $2 500 plus GST each.
Required
a Referring to one Qualitative characteristic, explain why it is important that the cost price of inventory is
calculated accurately.
b Explain why the modification costs should be treated as product costs.
c Calculate the unit cost of one washer/dryer.
d Record the purchase on 6 November 2025 in the inventory card for washer/dryers.
e Record the transaction on 6 November 2025 in the General Journal of High Voltage.
f Calculate Gross Profit on washer/dryers for November 2025.
g Explain whether Ben was correct in treating Insurance of inventory as a period cost.


Product versus period costs
As at 1 February 2025, FP Bicycles had four mountain bikes on hand that it had purchased for $155 plus GST
each.
On 12 February 2025, FP Bicycles purchased a further 10 mountain bikes from Wonder Cycles for a total
cost of $1 540 including GST (Invoice A13). On the same day, FP Bicycles paid a further $170 plus GST for sign
writing on the new bikes (Cheque 912). At the end of February 2025, eight mountain bikes remained on hand.
Required
a Calculate the cost of one of the mountain bikes purchased on 12 February 2025.
b Referring to your answer to part ‘a’, explain your treatment of the cost of sign writing.
c Record the purchase of inventory on 12 February 2025 in the inventory card for mountain bikes.
d Record the purchase of inventory on 12 February 2025 in the General Journal of FP Bicycles. Narration
not required.
e Calculate the value of mountain bikes on hand as at 28 February 2025.
f Calculate the value of mountain bikes on hand as at 28 February 2025 if the cost of the sign writing had
been treated as a period cost.
g State the effect on the valuation of inventory on hand as at 28 February 2025 if the cost of sign writing
had been treated as a period cost.

Static Sound and Vision commenced Operations on 1 April 2025 selling televisions and stereo systems. The
owner has provided the following document relating to the purchase of inventory on 1 April 2025:
Wired Electronics TAX INVOICE

ABN: 66 765 400 008 Invoice 201
89 Mill St,
Bendigo VIC 3550 Terms: 5/7, n/30
Charge to: Static Sound and Vision (ABN: 12 500 438 966)
Bell St, Coburg VIC 3058
Date Details Qty Unit price $ Total $
Apr. 1 60 inch television 12 650 7 800
Mini stereo system 5
300 1 500
Freight 300
Subtotal 9 600
GST 960
Total
$ 10 560
During April 2025, three televisions were sold for $1 320 including GST each, and two stereo systems
were sold for $550 including GST each. One television was written off as an inventory loss due after it was
dropped in the showroom.
Required
a Record Invoice 201 in the General Journal of Static Sound and Vision.
b Referring to your answer to part ‘a’, explain your treatment of Freight.
* c Prepare an Income Statement for Static Sound and Vision for April 2025 showing Gross Profit and
Adjusted Gross Profit. A full Income Statement is not required.
d Explain how treating expenses as period costs instead of product costs can
lead to a lower profit. Ethical
e Discuss whether it would have been ethical to sell the television that had been c
onsiderations
dropped.

Nordic Supplies purchases ski goggles in shipments of 100 units. They are sold under Nordic Supplies‘ own
brand name, and free delivery is offered to customers. The following details have been provided for a purchase
on 1 July 2025 (amounts do not include GST):
Supplier’s invoice price $9 000
Attachment of brand badges 80
Packaging and delivery to Nordic Supplies 1 600
Cost of delivery to customers 9 per unit
Account management fee 150 month
• During July 2025, 30 pairs of goggles were sold.
• The accountant has decided to treat the cost of attaching the brand badges as a period cost.
Required
a Discuss the accountant’s decision to treat the cost of attaching the brand badges as a period cost. In
your answer refer to at least one Qualitative characteristic.
b Calculate the cost price of each pair of goggles purchased on 1 July 2025.
c Referring to your answer to part ‘b’, explain your treatment of the Account management fee.
d Calculate Cost of Goods Sold for goggles for July 2025.
e Calculate Cost of Goods Sold for goggles for July 2025 if packaging and delivery had been treated as a
period cost.
f Explain the effect on the Accounting equation of Nordic Supplies if Packaging and delivery had been
treated as a period cost.


Lower of Cost and NRV
During 2005, Malcolm’s Memorabilia purchased commemorative plates of Australia’s first World Cup
qualification in 30 years. As at 1 May 2025, it still had 40 plates on hand, each with a cost price of $20. The
plates were originally sold for $30 plus GST, but on 31 May 2025 the owner estimated they could be sold for
only $5 plus GST each (Memo 39).
Required
a Calculate the value of plates on hand as shown in the inventory card at 1 May 2025.
b Referring to one Qualitative characteristic, explain why the plates should be valued at the Lower of Cost
and Net Realisable Value.
c Calculate the total Inventory write-down on the plates as at 31 May 2025.
d Record Memo 39 in the inventory card for plates.
e Record Memo 39 in the General Journal of Malcolm’s Memorabilia.
f Explain how the Inventory write-down will affect the Balance Sheet of Malcolm’s Memorabilia as at
31 May 2025.

Sukhveer Guneratne owns Sir Vaylance, a shop that sells security cameras. As at 1 September 2025, the
firm had 14 Viewmaster video cameras in inventory, valued at $450 each. On 21 September 2025, six video
cameras were sold for $800 plus GST each (Receipt 24). On 30 September 2025, the owner decided to lower
the selling price of the remaining cameras to $500 plus GST each (Memo 24). To encourage the sale of these
cameras to make way for new inventory she has offered her sales staff 15% commission on each sale.
Required
a Define the term Net Realisable Value (NRV).
b Calculate the total Net Realisable Value of the cameras as at 30 September 2025.
c Record Memo 24 in the inventory card for cameras.
d Record Memo 24 in the General Journal of Sir Vaylance.
* e Prepare an Income Statement for Sir Vaylance for September 2025, which shows Gross Profit and
Adjusted Gross Profit. A full Income Statement is not required.

Girlfriend Fashions has provided the following information after conducting a physical inventory count on
31 December 2025 (Memo 17):
Estimated Direct selling

Inventory Cost price selling price expenses
item Qty (per unit) (per unit) (per unit)
Jeans 200 $50 $75 $5
Shirts 50 $35 $40 $8
Hats 400 $20 $28 $3
Required
a Calculate the value of inventory on hand as at 31 December 2025 as would be shown in the inventory cards.
b Calculate the value of inventory on hand as at 31 December 2025 by applying the Lower of Cost and
NRV rule.
c State three reasons why the Net Realisable Value of the inventory might have fallen below its Cost.

d Referring to your answer to part ‘b’, explain why it would be unethical to

continue to value all inventory at its Cost.
Ethical
e Record the Inventory write-down in the appropriate inventory card of Girlfriend
considerations
Fashions.
f Record the Inventory write-down in the General Journal of Girlfriend Fashions. A narration is not required.
g State the effect on the Accounting equation of Girlfriend Fashions if the inventory is not written down
on 31 December 2025.

High Country Camping has produced the following information regarding its inventory of snow jackets as at
31 October 2025:
Snow jackets: Inventory on hand 50 @ $70 3 500

20 @ $72 1 440
The normal selling price of each jacket is $250 plus GST each, but as it is nearing the end of the ski season,
the owner estimates each jacket will only sell for $80 plus GST each (Memo 73). This will require extra selling
expenses costing $1 400 plus GST.
Required
a Referring to one Accounting assumption, explain why it would be incorrect to value the jackets at $250 each.
b Referring to one Qualitative characteristic, explain why the jackets should no longer be valued at their
cost price.
c Calculate the Inventory write-down on snow jackets as at 31 October 2025.
d Record Memo 73 in the inventory card for snow jackets.
e Record Memo 73 in the General Journal of High Country Camping.

Inventory Turnover
HP Pots sells cooking equipment and has provided the following information relating to its activities for 2025:

Inventory as at 1 January 2025 $68 000
Inventory as at 31 December 2025 $78 000
• Inventory is purchased on credit from SteelCo who offers terms of 10/7, n/60.
• All sales are marked up 100%. Approximately 10% of sales are made on credit.
• Inventory Turnover for 2024 was 72 days.
Required
a State what is measured by Inventory Turnover.
b Calculate Inventory Turnover for HP Pots for 2025.
c Referring to your answer for part ‘b’, explain two reasons why the owner of HP Pots should be
concerned about Inventory Turnover in 2025.
d Explain two reasons why the Inventory Turnover of HP Pots may have negative consequences for its profit.
e Explain two strategies HP Pots may implement in 2026 to improve its Inventory Turnover.
f Discuss whether HP Pots will have difficulties in paying its Accounts Payable on time in 2026.


Cash cycle
Sade Manio is the owner of Manio Man which sells men’s grooming products including hair wax, after shave,
beard trimmers and electric razors. The following information relating to the firm’s activities for 2025 has been
provided:
Manio Man
Inventory turnover
70
60
50
40
Days
30
20
10
0
Hair wax After shave Beard trimmers Electric razors
Product
Sade is concerned that the Inventory Turnover is not the same for each product line and is therefore intending
to decrease prices and increase advertising.
Required
a Identify which product has the fastest Inventory Turnover. Suggest one reason why this may be the case.
b Suggest one reason for the difference in Inventory Turnover between beard trimmers and electric razors.
c Explain why Sade should not be concerned that the Inventory Turnover is not the same for each product
line.
d Explain one strategy Sade could implement to improve the Inventory Turnover of after shave without
increasing sales.
e Identify one extra piece of information you would need before assessing the overall Inventory Turnover of
Manio Man for 2025. Justify your answer.
f Discuss how decreasing prices might affect both Inventory Turnover and profit in 2026.


On 1 August 2025, Suave Suits had 10 pure wool suits on hand, which it had purchased for $195 plus GST
each during July 2025. The following transactions occurred during August 2025:
TAX INVOICE
Invoice: 85
Woollen Mills Australia
Quality Clothing
Original
ABN: 45 111 981 342

Terms: 5/7, n/30
Charge to: Suave Suits (ABN: 44 505 612 349)
Geelong VIC 3220
Date Details Qty Unit price $ Total $
3/8/25 Pure wool suits 16 175 2 800
Tailoring costs 480
less Sales discount 80
Subtotal 3 200
plus GST 320
Total $ 3 520
On 9 August 2025, Suave Suits paid Woollen Mills Australia $3 168, receiving a $352 discount for early
payment. At the end of August 2025, four of the suits purchased on 3 August 2025 remained on hand.
Required
a Calculate the cost of one of the suits purchased on 3 August 2025.
b Referring to your answer to part ‘a’, explain why it is ethical to include the Ethical
tailoring costs as product costs. considerations
c Record Invoice 85 in the inventory card for wool suits.
d Referring to your answer to part ‘b’, explain your treatment of the discount for early payment.
e Record Invoice 85 in the General Journal of Suave Suits.
f Explain the effect on the Balance Sheet of Suave Suits as at 31 August 2025 if the tailoring costs had
been treated as period costs.
g Given that the discount and GST are both applied at a rate of 10%, explain why the dollar amount of the
discount is greater than the dollar amount of GST.


Recording and reporting for inventory
Zippy Scooters sells one type of scooter to selected retail stores. The scooters are manufactured by BX
Bikes in Wangaratta and delivered to the shop in Carlton in lots of five. Zippy Scooters uses FIFO to value its
inventory.
The following transactions took place during July 2025:
July 1 Inventory on hand: 16 scooters valued at $1 800 each.

5 Credit sale of 9 scooters for $3 000 plus GST each to J. Fangio (Inv. V23).
12 Purchase of 5 scooters at $1 400 each plus $2 000 freight (Inv. 42). Total GST on the purchase
amounted to $900. A local mechanic was paid $110 including GST per scooter to fit each one
with a sports kit (Chq. 188).
14 J. Fangio returned a scooter due to a faulty engine (Cr. Note 17) and received a credit for $3 000
plus GST.
16 Faulty scooter returned to the manufacturer; Zippy Scooters received a credit note for $1 980
including GST (Cr. Note 922).
26 Credit sale of 9 scooters for $3 300 including GST per bike (Inv. V24).
31 Inventory count revealed three scooters on hand, but one is scratched and damaged, and can
only be sold for $1 200 (Memo 36).
Required
a Calculate the cost price of each scooter purchased on 12 July 2025.
b Referring to your answer to part ‘a’, explain your treatment of the cost of the sports kit.
c Referring to one Qualitative characteristic explain why Memo 36 should be recognised in the financial
reports of Zippy Scooters.
d Record the transactions for July 2025 in the inventory card for scooters.
e Discuss whether the damaged scooter should be recorded in a separate inventory card.
f Record the transactions on 14, 16 and 31 July 2025 in the General Journal of Zippy Scooters.
g Show how the Inventory account would appear in the General Ledger of Zippy Scooters after recording
the information above. Balance the account.
* h Prepare an Income Statement for Zippy Scooters for July 2025, which shows Gross Profit and Adjusted
Gross Profit. (A full Income Statement is not required.)
i State the effect on the Balance Sheet of Zippy Scooters as at 31 July 2025 if the cost of the sports kit
had been treated as a period cost.
Zippy Scooters is considering using the Identified Cost method to value its inventory.
j Explain what actions Zippy Scooters would need to take to implement the Identified Cost method to
value its inventory.
k Explain why the adoption of the Identified Cost method would not have changed the recording of the
transaction on 5 July 2025.
l Identify one transaction from July 2025 that may have been recorded differently if the Identified Cost
method had been used instead of FIFO. Justify your answer.
m Discuss how the use of the Identified Cost method instead of FIFO might have affected the Net Profit of
Zippy Scooters for July 2025.

Chapter 10
Reporting for profit

After completing this chapter, you should be able to: • prepare an Income Statement for a trading firm
• define revenue, expenses and profit • explain and interpret the information presented in
• calculate profit an Income Statement
• explain the role of Accounting assumptions and • discuss strategies to generate revenue and control
Qualitative characteristics in the determination of profit expenses
• explain the reasons for closing the ledger • calculate and analyse the Gross Profit Margin and
• record closing entries in the General Journal and Net Profit Margin
General Ledger • construct and interpret graphical representations
• prepare the Profit and Loss Summary account of financial information.
• record the transfer of drawings to the Capital
account in the General Journal and General Ledger
Key terms
After completing this chapter, you should be familiar • profitability
with the following terms: • Net Profit Margin (NPM)
• closing the ledger • Gross Profit Margin (GPM)
• Profit and Loss Summary account • Vertical analysis of the Income Statement.
• Income Statement

10.1 Determining profit or loss

The most basic function of any small business is to earn a profit for the owner, and
the calculation of profit is simple enough: profit is what is left over after expenses are
deducted from revenues.
Net Profit = Revenue less Expenses
In this equation, revenues are defined as increases in assets or decreases in

liabilities that lead to an increase in owner’s equity (other than those relating to capital
contributions), and expenses are defined as decreases in assets or increases in liabilities
that lead to a decrease in owner’s equity (other than drawings by the owner).
Profit then represents a net increase in the owner’s equity in the business (and is
reported as such in the Balance Sheet).

The question of when to calculate profit depends on the needs of the owners. The
Going concern assumption states that the life of a business is continuous or never-
ending, so to follow this assumption alone means that profit could never be determined.
As a result, owners would not have information about the trading activities of their firm
until it was too late to do anything about it.
This is why the Period principle is so important: it allows the life of the business to
be divided into arbitrary periods so that profit can be determined.
The length of these Periods remains arbitrary, or subjective, as it is up to the
owners to decide how often they want profit to be determined (although taxation
requirements mean that it must be no longer than one year). Some owners will want
profit calculated every month, while others will be satisfied with seasonal or quarterly
profit reports. In some industries, such as fast food, hourly breakdowns of sales and
expenses may be useful.
Once the length of the Period is determined, the Accrual basis assumption is applied
to ensure that the calculation of profit includes only revenues and expenses that have
occurred during the current Period.
Under this assumption, revenues are recognised in the Period in which the
expected inflow of economic benefits can be measured, or when the revenue is
earned. Similarly, expenses are recognised when the consumption of goods and/
or services can be measured, or when the expense is incurred. This means profit
under the Accrual basis is determined by comparing revenue earned against expenses
incurred in that same Period.
Applying the Accrual basis assumption ensures that the reports support Relevance,
by including only information that is capable of making a difference to decision-
making. Including items other than revenues and expenses (such as drawings or
loan repayments), or even revenues or expenses that occurred outside the current
Period (such as last year’s wages), would mean the Income Statement would contain
information that would not be useful for decision-making. The information would thus
distort decision-making, and probably lead to negative consequences for the business
and its owner.

C hapter 10 R eporting for profit 259

• revenues
• expenses
• profit.
2 Explain how the Period assumption assists in the calculation of profit.
3 Explain how revenues and expenses are recognised under the Accrual basis
assumption.
4 Explain how profit is calculated under the Accrual basis assumption.
5 Explain how the Accrual basis assumption helps to ensure Relevance in the
Accounting reports.
10.2 Closing the ledger Study tip
The Profit and Loss

Source Summary account is like
documents a ‘funnel’ that collects all
revenues and expenses
so that profit can be
calculated, but it is a
Given that each revenue and expense item has its own ledger account, profit can be temporary Owner’s
calculated from the General Ledger by closing the ledger: transferring the balances equity account so is not
from all the revenue and expense accounts to a special account called the Profit and reported anywhere.
Loss Summary account, with a sole figure – the Net Profit or Loss for the current
period – produced at the end. In the process, the revenue and expense accounts will be closing the ledger
‘emptied’ or reset to zero in readiness for the next Period. transferring balances from
Thus, the two main aims of closing the ledger are: revenue and expense ledger
• to transfer revenues and expenses to the Profit and Loss Summary account in accounts to the Profit and Loss
order to calculate profit for the current Period Summary account so that profit
can be calculated
• to reset revenue and expense accounts to zero in preparation for the next Period.
It is only revenue and expense accounts that are closed, because only revenues and Profit and Loss Summary
account
expenses are used to determine profit, and revenues and expenses exist only during a
a General Ledger account that
particular Period. By contrast, assets and liabilities (and owner’s equity, for that matter) is used to summarise revenues
will exist into the future so they are not closed but balanced so that they carry forward and expenses so that profit can
into the next Period. be calculated

Example Pulse Music supplied the following Trial Balance as at 30 September 2025:
PULSE MUSIC SHOP

Trial Balance as at 30 September 2025

Account Payable – FNDR 36 000
Account Receivable – GQ College 9 600
Account Receivable – MC Co-op. 3 400
Advertising 1 300
Bank 3 800
Capital – B. Pressure 28 970
Cartage in 600
Drawings 2 000
Freight out 900
GST Clearing 1 500
Interest expense 120
Inventory 50 000
Inventory gain 200
Inventory write-down 350
Loan – Markos Bank 30 000
Rent expense 1 000
Sales returns 1 000
Sales revenue 35 000
Wages 5 400
Totals $132 170 $132 170
The owner has requested that the General Ledger be closed and reports
prepared (Memo 43).
Closing revenue accounts

In the General Ledger, the revenue accounts (Sales, Discount revenue and Inventory
gain) have a credit balance so to transfer amounts from these accounts (and set them
to zero) they must be debited. (Sales returns is a negative revenue account with a debit
balance but is also closed with the revenue accounts via a credit entry.)
Together, these amounts are then closed to the Profit and Loss Summary account
by a single credit entry to show net revenue earned for the Period.

Figure 10.1 General Journal: Closing revenue accounts

General Journal
Sept. 30 Sales 35 000
Inventory gain 200
Sales returns 1 000
Profit and Loss Summary 34 700
Closing revenue accounts to Profit and Loss Summary
Note how all the revenue accounts are closed in one General Journal entry, with
each individual revenue account debited, but one credit (for the net revenue figure) Study tip
credited to the Profit and Loss Summary account.
This entry would be posted to the General Ledger as is shown in Figure 10.2:
It may seem odd to debit
Figure 10.2 General Ledger: Closing revenue accounts a revenue account but
General Ledger remember that the aim
Sales * (R) is to reduce the revenue
Date Cross-reference Amount $ Date Cross-reference Amount $ accounts to zero.
Sept. 30 Profit and Loss Summary 35 000 Sept. 5 Account Receivable 15 000
– GQ College
17 Bank 8 000
28 Account Receivable 12 000
– MC Co-op.
35 000 35 000
Sales returns * (–R)

Sept. 8 Account Receivable 1 000 Sept. 30 Profit and Loss Summary 1 000
– GQ College
1 000 1 000
Inventory gain * (R)

Sept. 30 Profit and Loss Summary 200 Sept. 30 Inventory 200
200 200
Discount revenue * (R)

Sept. 30 Profit and Loss Summary 500 Sept. 23 Account Payable – 500
FNDR
500 500
Profit and Loss Summary (Oe)

Sept. 30 Revenues 34 700
* Other probable entries have been added to show more realistic accounts.

In the case of the Profit and Loss Summary account, the credit entry of $34 700 is
linked to the Sales, Sales returns, Discount revenue and Inventory gain accounts, but
rather than list each and every one of these account names, the cross-reference is
simply Revenues to indicate that there are a number of revenue accounts linked to this
total revenue figure.
As a result of the closing entry, all revenues have now been transferred into the
Profit and Loss Summary account so that profit can be calculated for September 2025,
and each revenue account has been reset to zero (it has a zero balance) in readiness
for the next Period (so the revenue accounts October 2025 will show only the revenue
earned in October 2025).
Closing expense accounts

The same principle applies when closing expense accounts: all expense accounts are
closed using one General Journal entry, with the total expenses figure posted to the
Profit and Loss Summary account.
Expense accounts (and in this case there are many) have a debit balance so to
transfer amounts from these accounts (and set them to zero) they must be credited,
with a single debit to the Profit and Loss Summary account to show the total expenses
incurred for the Period.
Figure 10.3 General Journal: Closing expense accounts

General Journal
Sept. 30 Profit and Loss Summary 31 370
Advertising 1 300
Cartage in 600
Freight out 900
Rent expense 1 000
Wages 5 400
Closing expense accounts to Profit and Loss Summary

This entry would be posted to the General Ledger as is shown in Figure 10.4:
Figure 10.4 General Ledger: Closing expense accounts

Advertising * (E)
Sept. 7 Bank 1 000 Sept. 30 Profit and Loss Summary 1 300
29 Inventory 300
1 300 1 300
Cartage in * (E)
Sept. 10 Bank 600 Sept. 30 Profit and Loss Summary 600
600 600
Cost of Sales * (E)

Sept. 5 Inventory 10 000 Sept. 8 Inventory 600
17 Inventory 4 600 30 Profit and Loss Summary 21 000
28 Inventory 7 000
21 600 21 600
Discount expense * (E)

Sept. 7 Account Receivable 500 Sept. 30 Profit and Loss Summary 700
– GQ College
29 Account Receivable 200
– MC Co-op.
700 700
Freight out * (E)

900 900
Interest expense * (E)

120 120
Inventory write-down * (E)

Sept. 26 Inventory 350 Sept. 30 Profit and Loss Summary 350
350 350

Rent expense * (E)

1 000 1 000
Wages * (E)
30 Bank 2 700
5 400 5 400

Sept. 30 Expenses 31 370 Sept. 30 Revenues 34 700
There is one single entry in the Profit and Loss Summary account but, as with
revenues, the debit entry of $31 370 is linked to a number of accounts so the cross-
reference in the Profit and Loss Summary must be just Expenses (in preference to
listing each expense account).
Study tip Transferring profit or loss

With all revenues and expenses now closed to the Profit and Loss Summary account,
the only step remaining is to calculate profit (by deducting expenses from revenues).
There will only ever In this example revenues ($34 700) are greater than expenses ($31 370), meaning
be three entries in the that a Net Profit of $3 330 has been earned. This profit represents an increase in owner’s
Profit and Loss Summary equity, and so leads to a credit to the Capital account. The Profit and Loss Summary
account: Revenues, account must then be debited to leave it with a zero balance ready for the next Period.
Expenses and the
(In the case of a loss, the Capital account would be debited to show the decrease in
transfer to the Capital
owner’s equity, with the Profit and Loss Summary account closed with a credit entry.)
account (for the profit or
loss).

Figure 10.5 shows the General Journal entries to transfer the profit from the Profit
and Loss Summary account: Study tip
Figure 10.5 General Journal: Transferring profit or loss

For the purposes of
General Journal
explanation, this closing
Date Details Debit $ Credit $ entry has been broken
Sept. 30 Profit and Loss Summary 3 330 into three separate
Capital 3 330 components but Figures
Transfer of Net Profit for September 2025 to Capital account (Memo 43)
10.1, 10.3 and 10.5
would in fact constitute
This would be posted to the General Ledger as shown in Figure 10.6. a single closing entry for
September 2025.
Figure 10.6 General Ledger: Transferring profit or loss
General Ledger
Sept. 30 Expenses 31 370 Sept. 30 Revenues 34 700
Capital 3 330
34 700 34 700
Study tip
Capital * (Oe)
Date Cross-reference Amount $ Date Cross-reference Amount $ Although the $3 330 is
Sept. 1 Balance 18 970 Net Profit this is not the
5 Bank 10 000 name of a ledger account
30 Profit and Loss Summary 3 330 so resist the temptation
to label it as ‘Profit’
* Other probable entries have been added to show more realistic accounts. in the Profit and Loss
Summary account.
As a result of the transfer of profit, the Profit and Loss Summary account now has a
zero balance too, ready for next period. Opening (when the revenues and expenses are
transferred in) and closing (when the profit or loss is transferred out) on the same day,
the account lasts for only as long as it takes to post these three entries. It is never listed
in an Accounting report, as its function is simply to facilitate the calculation of profit.

1 Explain the process of closing the ledger.
2 Referring to an appropriate Accounting assumption, explain two reasons for
closing the ledger.
3 Explain why asset and liability accounts are not closed.
4 Show the General Journal entries necessary to:
• close revenue accounts
• close expense accounts
• transfer profit or loss to the Capital account.
5 Prepare the ‘template’ of the Profit and Loss Summary account.
6 Referring to revenues and expenses, explain why the cross-references in the
Profit and Loss Summary account are not ledger account names.
7 Explain how the Profit and Loss Summary account would be classified in the
Balance Sheet. (Beware!)

10.3 Transferring Drawings

It is customary to record Drawings by the owner in a separate ledger account so that the
owner’s transactions for a particular Period can be identified. This allows Drawings to be
compared against Net Profit for the Period to determine whether it is at an appropriate
level. However, at the end of the Period, the balance of the Drawings account must be
transferred into the Capital account so that the Capital account can show the net effect
of all transactions with the owner.
Because Drawings has a debit balance, this transfer is achieved via a credit to the
Drawings account to set it to zero, and a debit to Capital to show the decrease in
owner’s equity. Figure 10.7 shows how this would be recorded in the General Journal:
Figure 10.7 General Journal: Transferring Drawings to Capital

General Journal
Sept. 30 Capital 2 000
Drawings 2 000
Transfer of Drawings for September 2025 to Capital account (Memo 43)
Figure 10.8 shows how the General Ledger accounts would appear after posting the
General Journal to the General Ledger:
Figure 10.8 General Ledger: Transferring Drawings to Capital

General Ledger
Drawings * (–Oe)
Sept. 16 Bank 1 800 Sept. 30 Capital 2 000
25 Inventory 200
2 000 2 000
Capital * (Oe)
Sept. 30 Drawings 2 000 Sept. 1 Balance 18 970
Balance 30 300 5 Bank 10 000
30 Profit and Loss Summary 3 330
32 300 32 300
Oct. 1 Balance 30 300
Although the Drawings account is transferred to the Capital account, it is not

closed through the Profit and Loss Summary account. Transactions with the owner are
expressly excluded from the definitions of revenues and expenses and must not be
counted in the calculation of profit. To include drawings in the calculation of profit would
be a direct breach of Relevance.


1 State one reason why transactions with the owner are recorded separately in
the Drawings account (rather than directly in the Capital account).
2 State one reason why the Drawings account is closed to the Capital account.
3 Referring to the definition of an expense, explain why the Drawings account is
not closed to the Profit and Loss Summary account.
4 Referring to one Qualitative characteristic, explain why Drawings are not
included in the calculation of profit.
5 Show the General Journal entries necessary to transfer Drawings to the Capital
account.
10.4 The Income Statement
Source
documents
Having closed the ledger, the profit figure will be known in the records, but it must still
be reported to the owner in an appropriate format. Knowing the Net Profit figure is all
well and good, but perhaps the most obvious question for the owner to ask about profit
is, ‘How was the profit generated?’ This question is answered by the preparation of an
Income Statement, which details the revenues earned and expenses incurred during Income Statement
the period and, in the process, shows both Gross Profit and Net Profit. an Accounting report that
The Net Profit reported in the Income Statement should be the same as the figure details the revenues earned and
expenses incurred during the
determined in the Profit and Loss Summary account, but the statement will show the
current Period
reasons why that profit (or loss) occurred, giving the owner far more information on
which to base his or her decisions. This fits with the basic function of all Accounting
reports: to communicate financial information that will assist the owner in making better
decisions.

Using the data provided in Section 10.2, and closed to the Profit and Loss Summary
account in Figures 10.1, 10.3 and 10.5, the Income Statement for Pulse Music would
Figure 10.9 Income Statement

PULSE MUSIC SHOP
Study tip Income Statement for September 2025
$ $
Presentation matters in Revenue 1
Accounting reports; items Sales revenue 35 000
must be reported under Sales returns 1 000 34 000
the correct headings less Cost of Goods Sold 2
for the statement to be

correct.
Cartage in 600 21 600
Gross Profit 3
12 400
add Inventory gain 200
less Inventory write-down 350 150
Adjusted Gross Profit 4
12 250
add Other revenues 5

12 750
less Other expenses 6
Advertising 1 300
Freight out 900
Rent expense 1 000
Wages 5 400 9 420
Net Profit 7 3 330
In common with all Accounting reports, the Income Statement begins by identifying
who the report was prepared for (Pulse Music); what type of report it is (an Income
Statement); and when the report covers (September 2025).
(Unlike a Balance Sheet which refers to as at, an Income Statement refers to for, as
the information it reports is not confined to a single day but covers a period of time; in
this case, the month of September 2025.)
The information within the report is classified under the following headings:
1 Revenue
This section lists only those revenues earned as a direct result of selling inventory,
namely, Sales revenue. Sales could be listed separately (as ‘Cash sales’ and ‘Credit
sales’) but in this business there is only a single ledger account called ‘Sales’, so only
one figure is reported in the Income Statement.
As noted in Chapter 6, reporting Sales returns separately allows the owner
to assess the quality of the firm’s inventory and customer service. As a negative
revenue, Sales returns is reported as a deduction from Sales, leaving Net Sales of
$34 000 – the overall Sales revenue earned after the deduction of Sales returns.
(In an Income Statement the heading ‘Revenue’ may not even be necessary,
particularly where there is only one figure for Sales.)

2 Cost of Goods Sold

As explained in Chapter 8, Cost of Goods Sold is a heading referring to all costs
incurred in getting goods into a condition and location ready for sale. Cost of Sales is
simply one of the items that may be reported under this heading with period costs,
like Cartage in, also included. (Any items listed separately under Cost of Goods
Sold are by definition period costs as they have not been recorded in the Inventory
account and expensed as part of Cost of Sales.)
Where Sales returns occur, the balance of the Cost of Sales account is changed
when the return is recorded, so the figure closed to the Profit and Loss Summary
account has already taken this into account.
3 Gross Profit
As the difference between Net sales ($34 000) and Cost of Goods Sold ($21 600),
Gross Profit reflects the profit earned directly from the sale of inventory.
Further, as both Sales and Cost of Sales are the result of the same sales volume
(or quantity of sales), the difference between them reflects the difference between
the firm’s selling and cost prices, so identifying this figure (with its own heading)
allows the owner to assess the adequacy of the firm’s mark-up.
4 Adjusted Gross Profit
Inventory losses and Inventory write-downs must be deducted from Gross Profit,
while Inventory gains must be added in order to determine Adjusted Gross Profit.
These items do not occur as a direct result of the sale of inventory but are related to
holding inventory and are therefore reported separately to allow the owner to make
decisions about managing inventory.
5 Other revenues
Any revenues other than Sales are reported after Adjusted Gross Profit in order to
protect Gross Profit as a measure of the mark-up.
Like Sales, Discount revenue will therefore increase profit; however, it is not
earned at the time of the sale: it actually occurs from paying Accounts Payable early,
so it is only earned when the payment is made. As a result, it must be reported
as Other revenues, after Gross Profit has been calculated. Interest revenues and
Commission revenue would also be reported here.
The figure derived by adding Other revenues to Adjusted Gross Profit ($12 750
in Figure 10.9) has no title, but it must be shown nonetheless. Leaving out this total
may result in failing to account for Other revenues when Net Profit is calculated.
6 Other expenses
Other expenses refers to all expenses not related to inventory, including day-to-day
expenses such as Advertising, Rent and Wages. If an expense is not reported in the
calculation of Adjusted Gross Profit, it is reported here.
Note that this is where Freight out (the cost of delivery to customers) is reported,
as this is incurred after the sale. Freight in (the cost of delivery from the supplier) is
incurred in the process of getting goods ready for sale, and so would be reported as
part of Cost of Goods Sold.
7 Net Profit
This is the ‘bottom line’ so frequently talked about in business circles: the overall
profit or loss earned by the business in the current Period. It is calculated by deducting
Other expenses from the previous total (in this case, $12 750 less $9 420) or by
deducting total expenses from total revenues. It is this Net Profit figure of $3 330
which represents the net increase (or decrease) in owner’s equity as a result of the
firm’s trading activities for the period.
If the closing entries have been recorded correctly, and the Income Statement
prepared correctly, this Net Profit figure should be identical to the figure calculated
in the Profit and Loss Summary account.

1 Explain why it is necessary to prepare an Income Statement even when the
profit figure is known.
2 Explain the relationship between the Profit and Loss Summary account and
the Income Statement.
3 Explain why the Income Statement is titled for the period rather than as at a
particular date.
4 State one reason for reporting Sales returns separately in the Income
Statement.
5 Explain the difference between Cost of Sales and Cost of Goods Sold.
6 Explain how to identify a period cost in the Income Statement.
7 Explain why Discount revenue is reported after Adjusted Gross Profit.
8 Identify two revenues other than Discount revenue that would be classified as
‘Other revenues’.
10.5 Uses of the Income Statement
Source
documents
The basic function of all Accounting reports is to communicate financial information that
will assist the owner in making better decisions. In the case of the Income Statement,
this information relates to the firm’s trading operations: the revenue it has earned, the
expenses it has incurred in the process, and the profit or loss that has resulted.
By reporting what has already happened as a result of the firm’s trading activities,
the Income Statement allows the owner to:
• assess the firm’s performance against its revenue and expense targets
This is so that areas of over and under performance can be identified, allowing
corrective action to be taken to improve profit in the next Period.
Comparisons of actual and budgeted (expected) revenues and expenses will
highlight where performance was better or worse than expected. Strategies can
then be implemented to generate more revenue and/or control expenses more
effectively (see the following pages).
• plan for future trading activities
This can be done by informing the formulation of the next set of revenue and expense
targets.
By providing a basis for the next set of budgeted revenues and expenses, the
Income Statement will aid in the setting of targets for the future. This may include
sales levels and advertising expenditure, or even inventory levels and staffing
requirements.
• calculate financial indicators to support analysis and interpretation
Financial indicators such as the Gross Profit Margin (GPM) and Net Profit Margin
(NPM) can be used not only to uncover what has happened, but to help explain why.
(This is covered in the following pages and in more detail in Chapter 18.)

Strategies to earn profit

Armed with the information provided by the Income Statement, the owner is better
equipped to make decisions to improve profit and profitability.
In basic terms, earning profit involves two simple yet complex activities:
• earning revenue
• controlling expenses.
These activities are simple in that they are easy to identify, but complex in that they
are often hard to achieve.
Earning revenue
To generate more revenue, the owner may:
• change selling prices
Selling prices could be decreased to generate a higher volume of sales or increased
to generate greater revenue per sale. Modelling of various scenarios can help the
owner make this decision in an informed manner.
• market strategically and effectively
Advertising could be increased, targeted more accurately at prospective customers,
or changed to emphasise different aspects of the business or the inventory it sells.
Marketing can also include how inventory is displayed for sale within the store.
At the same time, marketing must be ethical: it must represent honestly and Ethical
completely the details and the qualities of the products offered for sale. consideration
• implement strategies to manage inventory
Detailed in Chapter 9, this could include a whole range of strategies to improve
Inventory Turnover, such as:
– maintain an appropriate inventory mix
– promote the sale of complementary goods
– ensure inventory is up to date
– rotate inventory.
Provided selling prices do not drop, higher Inventory Turnover resulting in higher
sales volume will mean higher Sales revenue. (Some of these strategies could also
help to control expenses like inventory losses and Inventory write-downs.)
• move to a better location
If a relocation moves the business to an area which is more visible, closer to its
existing customers or close to a new potential market it may generate more sales
revenue.
However, changing location can be logistically difficult, as not only must the
assets of the business be moved but its customers must also be informed of the
move and, in the case of sales made from the shop floor, willing to travel to the new
location. (If sales are made online or over the phone this is less of a concern.)
• improve customer service.
Staff training could improve employees’ service and /or product knowledge and skills;
extra services (such as deliveries, wrapping, internet/phone access and product
advice) could be offered; and internal procedures (such as ordering) could be made
more customer friendly.
(Like strategies to manage inventory, improving staff skills could also help to
manage expenses.)

Controlling expenses
In order to improve its ability to control expenses, a business might:
• change inventory management practices
Finding an alternative supplier who can provide cheaper inventory could mean
a reduction in Cost of Goods Sold, while better quality inventory might allow an
increase in selling price, both of which would lead to higher Gross Profit. Changing
ordering and handling procedures could reduce storage costs, inventory losses and
even inventory write-downs, or generate price discounts.
Ethical Having said that, the requirements for ethical purchasing remain, and may even
considerations be a source of profit in the long run as customers respond to socially responsible
trading practices. (See Chapter 9 for a detailed discussion of inventory management
principles and Chapter 5 regarding ethical purchasing.)
• change staff management practices
Different rostering systems, appropriate incentives and extra training may improve
staff productivity and performance, leading to more effective utilisation of human
resources.
Savings may be possible by reviewing and then matching more closely the number
of staff to the level of sales. However, staff who are qualified and committed may
actually generate more sales, and lower sales returns, than those paid more cheaply.
In any case, it is not possible to simply cut wage rates unilaterally without
expecting a negative response from employees and, in many cases, legal action for
breaching fair work practices and employment law.
• change non-current asset management practices.
This could include reviewing electricity usage and adopting energy saving practices
and devices or researching cheaper prices from different suppliers.
Assets that are inefficient, under-utilised or unreliable are ultimately expensive,
and should be replaced or removed. This could include almost any non-current asset,
such as office equipment, fixtures and fittings, shelving, delivery vehicles or even
premises (with rent a significant expense).
Choosing between options for improvement must always be done with knowledge
of the individual business in mind, and to this end non-financial information is also
critical. For example:
• the number of competitors in the area
• the number of customers in particular locations
• the number of repeat sales
• the number of sales returns
• the number of customer complaints
and even
• the number of website hits
• the predicted weather for the next month
can all influence which strategies are implemented.
And all of this must still be done with ethical considerations in mind. Notwithstanding
the cost savings, a business owner may for ethical reasons decide to choose a more
expensive option because it is more socially or environmentally responsible.
Goods produced by suppliers who pay their employees fairly, electricity and gas
generated through ‘green power’, or assets that produce less waste and fewer
greenhouse emissions may be chosen in spite of higher costs from their use. The
owner must consider the health of the business within the society and environment in
which it operates: one cannot be healthy unless the other is too.


1 Explain how an Income Statement can be used by a business to assess its
trading performance.
2 Explain how an Income Statement can be used by a business to plan for future
trading activities.
3 List five strategies that might be used to generate more revenue.
4 List five strategies that might be used to improve expense control.
5 Explain the importance of non-financial information in decision-making to
improve profit.
6 Explain why ethical considerations must be taken into account by business Ethical
owners when choosing strategies to improve profitability. considerations
10.6 Financial indicators

By reporting revenues earned and expenses incurred, the Income Statement identifies
the individual reasons why a particular profit (or loss) occurred. However, it does so in
absolute dollar terms.
Financial indicators on the other hand present information about profitability – the profitability
ability of the firm to earn profit – in relative terms, comparing items from the Income the ability of a business to
Statement against each other and against items from the Balance Sheet. This will earn profit as expressed in
relative terms by comparing
be explored in detail in Chapter 18, but it is worth considering two of these financial
profit against a base like sales,
indicators here in the context of using the Income Statement to assist decision-making. assets or owner’s equity
Net Profit Margin (NPM)

Competition in many markets means that earning revenue is a challenging exercise for
most small businesses. With this in mind, it is vital that once a sale is made the business
retains, as profit, as much of that revenue as possible.
The Net Profit Margin (NPM) calculates the percentage of Net sales revenue that Net Profit Margin (NPM)
is retained as Net Profit. Put another way, it measures how much of each dollar of Net a profitability indicator that
sales revenue remains as Net Profit after expenses are deducted. As a result, it is a indicates expense control by
calculating the percentage
good indicator of overall expense control.
of Net sales revenue that is
Net Profit Margin is calculated as shown in Figure 10.10: retained as Net Profit
Figure 10.10 Formula: Net Profit Margin
Net Profit
Net Profit Margin (NPM) = × 100
Net Sales
A high Net Profit Margin means that a large percentage of Net sales revenue is
retained as Net Profit (because a low percentage is consumed by expenses).

Example Using the information from the previous example:

In September 2025, Pulse Music had earned $34 000 in Net sales and $3 330
in Net Profit.
The Net Profit Margin of Pulse Music would be calculated as shown in Figure 10.11:
Figure 10.11 Calculation: Net Profit Margin
Net Profit
Net Sales
$3 330
= × 100
$34 000
= 9.79%
Study tip
This Net Profit Margin indicates that 9.79% of Net sales is retained as Net Profit,
or 90.21% of Net sales is consumed by expenses. Put another way, it means that for
When assessing
every $1 of Net sales generated, almost 10 cents is retained as Net Profit.
performance, look
backwards (to previous Whether this Net Profit Margin would be seen as satisfactory or not would depend
figures), forwards on a comparison against previous periods, budgeted performance and competitors’
(to budget figures) performance (industry averages).
and sideways (to
competitors or industry Gross Profit Margin (GPM)
averages). Because the Net Profit Margin uses Net Profit in its calculation, it can be used to assess
overall expense control. If Gross Profit is used instead, we are able to assess expense
control specifically as it relates to inventory and Cost of Goods Sold.
Gross Profit Margin (GPM) The Gross Profit Margin (GPM) calculates the percentage of Net sales revenue
a profitability indicator that that is retained as Gross Profit, indicating the average-mark up on all goods sold during
measures the average mark-up
a particular Period.
by calculating the percentage
of Net sales revenue that is
Gross Profit Margin is calculated as shown in Figure 10.12:
retained as Gross Profit
Figure 10.12 Formula: Gross Profit Margin
Gross Profit
Gross Profit Margin (GPM) = × 100
Net Sales
A high Gross Profit Margin means that a large percentage of Net sales revenue is
retained as Gross Profit (because a low percentage is consumed by Cost of Goods Sold).
Example Using the information from the previous example:

In September 2025, Pulse Music had earned $34 000 in Net sales and $12 400 in
Gross Profit.

The Gross Profit Margin of Pulse Music would be calculated as shown in

Figure 10.13:
Figure 10.13 Calculation: Gross Profit Margin
Gross Profit
Gross Profit Margin (GPM) = x 100
Net Sales
$12 400
= x 100
$34 000
= 36.47%
This Gross Profit Margin indicates that 36.47% of Net sales revenue is retained as
Gross Profit, or 63.53% of Net sales is consumed by Cost of Goods Sold. Put another
way, it means that for every $1 of Net sales generated, approximately 37 cents is
retained as Gross Profit.
Given that it does not account for Other expenses, the Gross Profit Margin will always
be higher than the Net Profit Margin. The only exception would be if the business had
no Other expenses, but this would be highly unlikely.

1 Define the term profitability.
2 Explain why financial indicators can be useful in assessing profitability.
3 Show the formula to calculate the Net Profit Margin.
4 Explain how the Net Profit Margin can be used to assess profitability.
5 Show the formula to calculate the Gross Profit Margin.
6 Explain how the Gross Profit Margin can be used to assess profitability.
7 Identify three benchmarks that can be used to assess the Net Profit Margin
and Gross Profit Margin.
8 Explain why the Gross Profit Margin is always higher than the Net Profit
Margin.

10.7 C
ommunicating information: graphical
representations
Source
documents
The information presented earlier in this chapter in the Income Statement took the form of a
financial report. In many cases information presented in this form will be just what the owner
is interested in seeing, and the owner will be able to interpret the report to make decisions.
Having said that, Understandability requires financial information to be presented
in a way that is comprehensible to (can be understood by) users, meaning it should
be presented clearly and concisely. Even for users who have a high level of financial
literacy, one way of ensuring this occurs is to utilise graphical representations of the
information in the reports.
Trends: line graphs

When representing changes in a particular item over time, line graphs can be a useful
way of presenting information.
Example Uplift Cranes has presented the following information relating to its activities from
2023–2025:
2023 2024 2025

Sales revenue 1 000 000 1 200 000 1 500 000
Cost of Goods Sold 600 000 900 000 1 000 000
Gross Profit 400 000 300 000 500 000
An analysis of the raw figures may lead the accountant to particular conclusions,
but trends and relationships between items may be more obvious to the owner if the
information is represented graphically. (In this endeavour a spreadsheet program can be
very helpful.)
Figure 10.14 uses a line graph to represent the information for Uplift Cranes:
Figure 10.14 Line graph
Uplift Cranes
Gross Profit 2023 – 2025
1600
1400
1200
1000
‘000s
800
600
400
200
0
2023 2024 2025
Sales COGS Gross Profit

The graph provides a visual representation of the increase in Sales revenue over
the three years; the larger than proportional increase in Cost of Goods Sold leading
to a decrease in Gross Profit in 2024; and the smaller increase in Cost of Goods Sold
leading to a bigger increase in Gross Profit in 2025. The graph also shows clearly that
the change in the gap between Sales and Cost of Goods Sold determines the change
in Gross Profit.
A similar approach could be applied to any data over time, including financial indicators
like Net Profit Margin and Gross Profit Margin.
Constructing line graphs using spreadsheets

Spreadsheet programmes like Excel and Numbers (just to name two) present data in
columns (running left to right) and rows (running up and down), allowing the data in
each ‘cell’ to be sorted and manipulated. This means mathematical processes (like
addition, subtraction, division and multiplication) can be applied using formulae allowing
calculations to be made independent of the actual numbers involved. As a consequence,
results can change automatically in response to changes in the data.
In the case of the Income Statement, spreadsheets also make the creation of
graphical representations like Figure 10.14 relatively easy, with the graphs also changing
automatically to reflect changes in the data.
To create the graph in Figure 10.14, the data had to be rearranged in the spreadsheet
Figure 10.15 Line graph: Spreadsheet

A B C D
1 Sales COGS Gross Profit
2 2023 1000 600 400
3 2024 1200 900 300
4 2025 1500 1000 500
Any spaces were removed to ensure the data was recognised as numbers (and
not text), and the number of ‘thousands’ was also removed to allow the data to be
represented more clearly.
The program used to create Figure 10.13 also had a function – in the menu bar at the
top – which then allowed for the automatic creation of the graphs (followed by some
manipulation to improve the presentation, e.g. colours and headings).
Proportions: pie charts

When representing the components of a particular item, like individual items that make
up Sales revenue or Total expenses, pie charts can be helpful.
Example Finn Fashions has presented the following information relating to its activities for
July 2025:
July
Sales revenue 85 000
less Cost of Goods Sold 45 000
Gross Profit 40 000
Less Inventory loss 3 000
Less Other expenses
Advertising 3 000
Discount expense 1 400
Rent 12 000
Wages 10 000
Net Profit 10 600
Vertical analysis of the While the owner could review each of the expense amounts, presenting them as
Income Statement a percentage of Sales revenue (sometimes called a Vertical analysis of the Income
a representation of individual
Statement), a pie chart allows the owner to examine their relative importance.
expenses as a percentage of
Sales revenue to allow for an
Figure 10.16 shows how a pie graph can be used to represent the relative size of
assessment of their relative each expense:
importance
Figure 10.16 Pie chart
Finn Fashions
July 2025
Cost of Goods Sold

Inventory loss
Advertising
Discount expense
Rent
Wages
Net Profit
From this graph it is clear that Cost of Goods Sold is the single biggest component
of expenses, consuming more than half of Sales revenue, and therefore most deserving
of attention. Efforts to improve smaller expenses, like Discount expense, may improve
profit, but by only a small amount.

Constructing pie charts using spreadsheets

Before the spreadsheet program was able to construct the graph in Figure 10.16, it was
necessary to convert the dollar figures into a percentage of Sales. Figure 10.17 shows
how the spreadsheet was constructed and the percentage calculated:
Figure 10.17 Pie chart: Spreadsheet

A B C Formula in cell
1 Item $ %
2 Sales revenue 85 000 100% =B2/B$2
3 Less Cost of Goods Sold 45 000 53% =B3/B$2
4 Gross Profit 40 000 47% =B4/B$2
5 Less Inventory loss 3 000 4% =B5/B$2
6 Adjusted Gross Profit 37 000 43% =B6/B$2
7 Less Other expenses
8 Advertising 3 000 4% =B8/B$2
9 Discount expense 1 400 2% =B9/B$2
10 Rent 12 000 14% =B10/B$2
11 Wages 10 000 12% =B11/B$2
12 Net Profit 10 600 12% =B12/B$2
The formulae shown in the additional column use a relative cell reference (meaning
it changes from B2 to B3 etc) for each item but an absolute cell reference (meaning it
always uses the figure in cell B2) for the Sales revenue. Absolute cells are designated
by the use of a ‘$’ prior to the row or column which will not change. In this way, every
percentage shown in column C is calculated by dividing the item by the Sales revenue
of $85 000.
As with the line graph in Figure 10.12, the spreadsheet programme had short cuts on
the menu bar to enable the creation of the pie chart, with only minor changes necessary
for formatting.

1 Referring to one Qualitative characteristic, explain the purpose of using
graphical representations to communicate Accounting information.
2 Explain the purpose of preparing a line graph.
3 Explain the role of a spreadsheet in preparing a line graph.
4 Explain the purpose of preparing a pie chart.
5 Explain the use of a spreadsheet in preparing a pie chart.

Where have we been?

• Profit is calculated by matching revenues earned against expenses incurred in that Period.
• Closing the ledger is necessary to:
– transfer revenue and expense amounts to calculate profit for the current Period
– reset the revenue and expense accounts to zero in readiness for the next Period.
• Revenue and expense accounts must be closed to the Profit and Loss Summary account at the end of
the Period. Profit is then transferred from the Profit and Loss Summary account to the Capital account.
• The Drawings account is transferred to the Capital account at the end of the Period.
• The Income Statement aids decision-making by detailing the revenues earned and expenses incurred
during the Period, and in the process showing both Gross Profit and Net Profit.
• The Income Statement and Profit and Loss Summary account should both calculate the same Net Profit figure.
• Financial indicators like Net Profit Margin and Gross Profit Margin can be used to assess performance.
• Businesses can adopt strategies to generate revenue and control expenses.
• Graphical representations can assist Understandability in communicating financial information.
Exercises
this book.

Closing the ledger
Rugged Rugs has provided the following ledger accounts for August 2025:
General Ledger
Inventory
Aug. 1 Balance 10 000 Aug. 5 Cost of Sales 17 000
16 Cost of Sales 650 13 Cost of Sales 15 000
19 Account Payable – Khari Rugs 34 000 21 Advertising 400
31 Inventory loss 500
Sales
Aug. 5 Bank 34 000
13 Account Receivable – CB Floors 28 000
Sales returns
Aug. 16 Account Receivable – CB Floors 1 300
Interest revenue
Aug. 4 Bank 1 500
Cost of Sales
Aug. 5 Inventory 17 000
13 Inventory 15 000
Wages
Aug. 24 Bank 12 000
Rent expense
Aug. 12 Bank 9 000
Advertising
Aug. 3 Bank 8 000
21 Inventory 400
Inventory loss
Aug. 31 Inventory 500
Required
a Explain the purpose of closing the ledger.
b Record the closing entries and transfer of profit or loss in the General Journal of Rugged Rugs as at
31 August 2025 (Memo 41).
c Post the General Journal to the General Ledger of Rugged Rugs.
d Explain why the Inventory account is balanced rather than closed.
e Explain how the Profit and Loss Summary account will be reported in the Balance Sheet of Rugged
Rugs as at 31 August 2025.


Closing the ledger
Jigsaw World has provided the following ledger accounts for December 2025:
General Ledger
Cash sales
Dec. 3 Bank 18 000
21 Bank 12 000
Credit sales
Dec. 19 Account Receivable – Toyland 27 000
27 Account Receivable – Big Q 23 000
Sales returns
Dec. 26 Account Receivable – Toyland 1 000
Inventory gain
Dec. 31 Inventory 1 200
Freight inwards
Dec. 8 Bank 1 600
Cost of Sales
Dec. 3 Inventory 9 000 Dec. 26 Inventory 500
19 Inventory 13 500
21 Inventory 6 000
27 Inventory 11 500
Wages
Dec. 12 Bank 16 000
26 Bank 14 500
Rent expense
Dec. 2 Bank 8 500
Discount expense
Dec. 30 Account Receivable – Big Q 1 300

Required
a Record the closing entries and transfer of profit or loss in the General Journal of Jigsaw World as at
31 December 2025 (Memo 13).
b Post the General Journal to the General Ledger of Jigsaw World.
c Calculate Adjusted Gross Profit for Jigsaw World for the year ended 31 December 2025.
d Explain how closing the ledger ensures Relevance in the financial reports.

Closing the ledger and transferring drawings
On 30 June 2025, the Trial Balance of Wombat Plants showed the following:
WOMBAT PLANTS
Bank 1 700
Capital – Withered 45 900
Drawings 2 000
GST Clearing 1 000
Inventory 45 000
Inventory loss 300
Loan – ANZ (repayable $2 000 per annum) 16 000
Sales 82 500
Sales returns 2 500
Wages 11 000
Water and supplies expense 15 000
Totals 149 900 149 900
Drawings consisted of $1 600 cash and $400 in inventory.
Required
a Record the closing entries and transfer of profit or loss in the General Journal of Wombat Plants as at
30 June 2025. A narration is not required.
b Record the transfer of drawings in the General Journal of Wombat Plants as at 30 June 2025 (Memo
152).
c Show how the Profit and Loss Summary, Capital and Drawings accounts would appear in the General
Ledger of Wombat Plants after all closing and balancing entries had been made.
d Explain why Drawings is not closed to the Profit and Loss Summary account.
* e Prepare the equities side of the Balance Sheet of Wombat Plants as at 30 June 2025.


Income statement
On 30 June 2025, the General Journal of Frosty Fridges showed the following closing entries:
FROSTY FRIDGES
General Journal
June 30 Sales 122 600
Discount revenue 1 800
Sales returns 2 000
Profit and Loss Summary 122 400
Closing revenue accounts to P&L Summary account
June 30 Profit and Loss Summary 98 900
Advertising 3 000
Customs duty 2 500
Inventory loss 500
Rent expense 12 000
Wages 19 000
Closing expense accounts to P&L Summary account
June 30 Profit and Loss Summary 23 500
Capital – B. Ding 23 500
Transfer of Net Profit to Capital account
June 30 Capital – B. Ding 5 600
Drawings 5 600
Transfer of Drawings to Capital account
The owner of Frosty Fridges has argued that it would not matter if her Drawings was reported as part
of Wages.
Required
a Show how the Profit and Loss Summary and Capital accounts would appear in the General Ledger of
Frosty Fridges after all closing and balancing entries had been made.
* b Prepare an Income Statement for Frosty Fridges for the year ended 30 June 2025.
c Referring to your answer to part ‘b’, explain your treatment of Customs duty.
d Referring to one Qualitative characteristic, explain why Frosty Fridges should still prepare an Income
Statement even when it knows the Net Profit for the period.
e The owner has stated that as owner’s equity increased, the firm’s assets must also have increased.
State one reason why this may be incorrect.
f Referring to financial and ethical considerations, discuss whether the owner’s Ethical
Drawings should be reported as part of Wages. considerations


Income statement
The Trial Balance for Precious Paintings as at 31 October 2025 showed the following:
PRECIOUS PAINTINGS
Trial Balance as at 31 October 2025
Advertising 450
Bank 3 520
Capital – Lovegood 14 200
Cost of Sales 9 600
Delivery vehicle 20 000
Discount expense 70
Discount revenue 50
Drawings 1 500
Freight in 610
Freight out 800
GST Clearing 350
Inventory 14 000
Inventory loss 400
Loan – Commonwealth Bank (repayable $5 000 p.a.) 20 000
Rent expense 2 400
Sales 17 500
Wages 2 300
Totals 58 450 58 450
Precious Paintings employs one full-time shop assistant.
Required
a Record the General Journal entries to close the expense accounts of Precious Paintings as at 31 October
2025. A narration is not required.
b Show how the Profit and Loss Summary and Capital accounts would appear in the General Ledger of
Precious Paintings after all closing and balancing entries had been made.
* c Prepare an Income Statement for Precious Paintings for October 2025.
d Referring to your answer to part ‘c’, explain your treatment of Freight out.
e State two reasons why the owner may be disappointed with Net Profit for October 2025.
f Using an example from the information provided, explain how an increase in Other expenses might lead
to an increase in Net Profit.
* g Prepare a classified Balance Sheet for Precious Paintings as at 31 October 2025.


Income statement
On 31 May 2025, the Trial Balance of Rest Easy Beds showed the following:
REST EASY BEDS
Trial Balance as at 31 May 2025
Advertising 230
Bank 3 410
Buying expenses 900
Capital – J. Snooze 26 790
Cost of Sales 8 380
Drawings 1 500
GST Clearing 350
Inventory 14 000
Inventory gain 300
Loan – Bank of Hope (repayable $5 000 p.a.) 15 000
Office furniture 7 650
Rent expense 1 800
Sales 12 000
Sales returns 1 200
Wages 2 120
Totals 59 900 59 500
Required
a Explain how it is possible for Rest Easy Beds to have an Inventory gain and an Inventory write-down in
the same period.
b Record the General Journal entries to close the revenue accounts of Rest Easy Beds as at 31 May 2025.
A narration is not required.
* c Prepare an Income Statement for Rest Easy Beds for May 2025.
d Referring to your answer to part ‘c’, explain your reporting of Discount revenue.
e Referring to your answer to part ‘c’, explain why the owner might be concerned about the quality of the
firm’s sales staff.
f Explain two actions the owner might take to improve the Net Profit of Rest East Beds.
* g Prepare a classified Balance Sheet for Rest Easy Beds as at 31 May 2025.


Income statement
EduToys provided the following Trial Balance as at 31 December 2025:
EDUTOYS
Trial Balance as at 31 December 2025
Advertising 8 000
Bank 2 500
Capital – A. Teacher 69 430
Drawings 4 000
Electricity 3 400
GST Clearing 270
Import duties 1 200
Inventory 14 800
Loan – ANZ Bank (repayable $500 per month) 84 000
Premises 97 000
Sales 99 000
Wages 21 000
Totals 266 670 266 670
The owner claims that EduToys holds and sells only the finest quality items.
Required
a Referring to one Accounting assumption, explain why the ledger must be closed.
b Record the General Journal entries to transfer Net Profit or Loss and Drawings to the Capital account as
at 31 December 2025. Narrations are not required.
* c Prepare an Income Statement for EduToys for the year ended 31 December 2025.
d Explain two actions the owner could take to improve Adjusted Gross Profit.
e Explain how a reduction in Discount expense might lead to a decrease in Net Profit.
* f Prepare a classified Balance Sheet for EduToys as at 31 December 2025.
g Referring to your answer to part ‘c’, discuss whether it is ethical for the owner Ethical
to make this claim. considerations


Net Profit Margin
Franklin Howard Motors has provided the following information relating to its trading activities for 2023
to 2025:
FRANKLIN HOWARD MOTORS
Income Statement (extract) for:
2023 $ 2024 $ 2025 $
Sales 810 000 900 000 980 000
Sales returns 5 000 8 000 12 000
Net Profit 86 000 90 000 92 000
To increase profit, the owner is considering increasing spending on advertising in 2026.
Required
a Explain what is measured by the Net Profit Margin.
b Calculate the Net Profit Margin for Franklin Howard Motors for 2024 and 2025.
c Referring to your answer to part ‘b’, explain whether the firm’s ability to control its overall expenses has
improved or worsened in 2025.
d Evaluate whether the owner’s plan to increase spending on advertising is likely to improve profitability in
2026.
e Explain two actions the owner might take to improve the Net Profit Margin without affecting Sales.
f Referring to one Qualitative characteristic, explain the purpose of constructing graphical representations
of financial information.
g Prepare a graph to show the trend in Sales, Sales returns and Net Profit from 2023 to 2025.


Gross Profit Margin
Martha’s Backyard sells garden furniture and has provided the following information relating to its activities
for 2025:
MARTHA’S BACKYARD
Income Statement for 2025
$ $
Sales 480 000
Sales returns 3 200 476 800
Cost of Goods Sold
Buying expenses 10 000 238 400
Inventory write-down 6 900
Other expenses
Administration expenses 13 900
Gas and electricity 10 000
Rent expense 35 000
Wages 89 000 154 000
Net Profit 57 500
• In 2024 the Gross Profit Margin of Martha’s Backyard was 42%.
• The owner of Martha’s Backyard thinks she can generate a higher Gross Profit Margin by cutting back on
wages paid to staff in 2026.
Required
a Referring to the Income Statement, identify whether Martha’s Backyard pays its Accounts Payable early.
b Explain what is measured by the Gross Profit Margin.
c Calculate the Gross Profit Margin for Martha’s Backyard for 2025.
d Referring to your answer to part ‘c’, suggest two possible reasons for the change in
the Gross Profit Margin from 2024 to 2025.
e Referring to financial and ethical considerations, evaluate the owner’s plan to Ethical
improve the Gross Profit Margin in 2026. considerations
f Prepare a graph to show the proportion of Net sales consumed by each
expense in 2025.
g Referring to your answer to part ‘f’, explain how presenting information in this way could improve
expense control.


Income statement
Zara and Luke is a homewares shop in Brunswick selling items like lamps, rugs, vases and small furnishings.
The owner has provided the firm’s Trial Balance as at 30 April 2025:
ZARA AND LUKE
Trial Balance as at 30 April 2025
Advertising 1560
Bank 5 160
Capital 63 080
Commission revenue 350
Cost of Sales 8 250
Drawings 1 500
Electricity expense 620
Freight in 300
GST Clearing 4 700
Interest expense 50
Inventory 46 000
Mortgage – Bank of Melven 490 000
Premises 520 000
Sales 16 900
Sales returns 400
Telephone charges 90
Wages 3 100
Totals 624 530 624 530
• $1 100 of wages paid was incorrectly recorded as Advertising plus GST (Memo 65).
• A physical inventory count on 30 April 2025 determined there was $45 610 of inventory on hand
(Memo 66).
• The business employs one shop assistant who is paid minimum wages.
• Sometimes Zara and Luke receives a commission for displaying for sale goods made by a local pottery
business, but it has just been informed that the pottery business may be using dangerous chemicals to
clean its equipment.
• The Loan – Bank of Melven is repayable $500 per month.

Required
a Explain whether Zara and Luke owns the shop it uses for its operations.
b Record Memo 65 and Memo 66 in the General Journal of Zara and Luke. Narrations are not required.
c Record the closing entries and transfer of profit in the General Journal of Zara
and Luke as at 30 April 2025. A narration is not required.
* d Prepare an Income Statement for Zara and Luke for April 2025.
e Referring to at least one financial and at least one ethical consideration,
discuss whether Zara and Luke should continue to display for sale Ethical
the goods made by the local pottery business. considerations
f Explain two actions the owner might take to improve profit without changing
total expenses.
* g Prepare a Balance Sheet for Zara and Luke as at 30 April 2025.
h Explain how the owner can ensure that the valuation shown for ‘Fixtures and fittings’ is a Faithful
representation.


Income statement
Heruni Kohli is the owner of Prime Windows, a business that sells windows and other construction materials.
The business makes sales across the state but is based in a small town about 500 km from Melbourne where
Heruni also lives with her husband and young family. The town has a population of about 500 people, 15 of
whom are employed by JB Constructions, Prime Windows’ main supplier.
Heruni has provided the firm’s Trial Balance as at 30 June 2025:
PRIME WINDOWS
Accounts Payable – JB Constructions 140 000
Accounts Receivable – BuildWell 48 000
Accounts Receivable – GQ Homes 36 000
Bank 680
Buying expenses 4 300
Capital 262 670
Drawings 31 700
GST Clearing 3 800
Insurance 1 200
Inventory 146 000
Loan – QV Finance 179 400
Rent expense 25 000
Sales 420 000
Sales returns 1 500
Shelving 145 000
Vehicle expenses 16 400
Vehicles 180 000
Wages 53 100
Totals 1 006 750 1 006 750
• Heruni is concerned that the business is not well known in the wider building industry.
• Prime Windows has been approached by an interstate supplier who has quoted cost prices 10% below
those currently being paid to JB Constructions. Heruni is keen to reduce costs but is mindful of the social
consequences of her decisions.
• The Loan – QV Finance was used to purchase new vehicles during June 2025. It is to be repaid in
monthly instalments of $600.

Required
a Referring to the Trial Balance, explain whether Prime Windows sells on credit terms.
b Show how the Profit and Loss Summary and Capital accounts would appear in the General Ledger of
Prime Windows after all closing and balancing entries had been made.
* c Prepare an Income Statement for Prime Windows for the 6 months ending 30 June 2025.
d Referring to your answer to part ‘c’, explain why Heruni is likely to be correct in asserting that the
business is not well known.
e Discuss the financial and ethical considerations of Prime Windows changing to Ethical
the interstate supplier. considerations
f Referring to your answer to part ‘c’, explain two actions Heruni could take to
improve the Gross Profit of Prime Windows without changing suppliers.
* g Prepare a Balance Sheet for Prime Windows as at 30 June 2025.
h Explain one reason why Heruni should be concerned about the relationship between Net Profit and
Drawings for the 6 months ended 30 June 2025.

Chapter 11
Reporting for cash

After completing this chapter, you should be able to: • prepare a Cash Flow Statement
• explain the need to report for cash • explain the uses of the Cash Flow Statement
• prepare a Statement of Receipts and Payments • explain the difference between cash and profit
• explain the role of the Bank account in reporting • calculate and analyse Cash Flow Cover (CFC)
for cash • identify reasons why a firm’s cash and profit
• define the terms ‘cash surplus’ and ‘cash deficit’ performance may differ.
• define and identify Operating, Investing and
Financing cash flows
Key terms
After completing this chapter, you should be familiar • Cash Flow Statement
with the following terms: • Operating activities
• Statement of Receipts and Payments • Investing activities
• cash surplus • Financing activities
• cash deficit • Cash Flow Cover (CFC).

C hapter 11 R eporting for cash 295
11.1 Reporting for cash

Accounting exists as an information system, and as part of that system, Accounting
reports have the function of communicating financial information to the owner to assist
decision-making.
The previous chapters were concerned mainly with reporting for profit and, given
that earning a profit is the primary reason for being in business, this is certainly a valid
concern. After all, owners must have accurate information about revenues and expenses
if they are to improve the trading performance of their firms.
However, many profitable businesses still fail because they have not paid sufficient
attention to managing their cash. Many small business owners (incorrectly) assume that
cash and profit are the same thing, and that if they can sell their products at a profit then
they will automatically have cash available to pay their debts. Unfortunately, this is not
the case. Cash and profit are different measures of performance, and there are many
possible reasons why a firm that is earning a profit can still suffer from a lack of cash.
Given that cash and profit are different, it is important that the owner is provided
with different information on both items. (If you are still questioning whether cash and
profit are actually different things, skip ahead to ‘11.5 Cash versus profit’ to check!)
Without information on both cash and profit, the owner will not be able to manage both
effectively.
Recording for cash
Source
documents
In terms of the Accounting equation, any reporting for cash must be based on the
recording that has already occurred. Data about cash could be garnered directly from the
source documents (cash receipts – manual, electronic, EFT, credit card; cheque butts;
EFT receipts), but this information would apply to individual transactions only, and would
not be sorted in any way.
Instead, reporting for cash is based on the information already recorded in the Bank
account in the General Ledger, which combines cash receipts (recorded on the debit
side) and cash payments (recorded on the credit side) to allow for the calculation of a
closing Bank balance. The same information is also available in the Bank Statement (even
though the timing of some transactions that appear in the Bank account in the General
Ledger might not appear in the Bank Statement until the next Period and vice-versa).

The Statement of Receipts and Payments
Source
documents
Statement of Receipts and

Payments
an Accounting report that
Given the information recorded in the Bank account, the most basic way of reporting
details cash received and paid
during a Period, and the change for cash is to detail cash received and cash paid during the period, and then identify
in the firm’s bank balance over the change in the firm’s bank balance. This is achieved by preparing a Statement of
that period Receipts and Payments.
Example As at 31 December 2025, the Bank account of Makris Manchester showed the
following:
General Ledger
Bank
Dec. 1 Balance 13 500 Dec. 3 Electricity/GST Clearing 550
2 Loan – Aust. Bank 25 000 4 GST Clearing 1 500
5 Capital 5 000 7 Shelving/GST Clearing 11 000
12 Cash sales/GST Clearing 23 100 10 Accounts Payable 26 000
20 Accounts Receivable 19 000 12 Inventory/GST Clearing 13 200
24 Cash sales/GST Clearing 24 200 15 Wages 16 000
29 Accounts Receivable 22 500 19 Insurance/GST Clearing 1 320
21 Drawings 6 700
23 Accounts Payable 15 400
23 Loan – Aust. Bank 2 000
26 Office equipment/GST Clearing 4 950
29 Wages 15 000
31 Balance 9 280
132 300 132 300
Rather than list every individual cash transaction as recorded in the Bank account,
receipts and payments are summarised according to their purpose before they are
reported in the Statement of Receipts and Payments. For example, all Cash sales are
aggregated and reported as a single figure as are receipts from Accounts Receivable,
payments to Accounts Payable, payments for Inventory, payments for Wages and cash
Drawings.

Using this information, the Statement of Receipts and Payments would appear as
Figure 11.1 Statement of Receipts and Payments

MAKRIS MANCHESTER
Statement of Receipts and Payments for December 2025
$ $
Cash Receipts
Cash sales 43 000
GST received 4 300
Receipts from Accounts Receivable 41 500
Loan – Aust. Bank 25 000
Capital contribution 5 000 118 800
Less Cash Payments
Payments to Accounts Payable 41 400
Inventory 20 000
Wages 31 000
Electricity 500
GST settlement 1 500
Shelving 10 000
Drawings 6 700
Insurance 1 200
GST paid 3 620 123 020
Surplus (Deficit) (4 220)
Add Bank Balance at start (1 December 2025) 13 500
Bank Balance at end (31 December 2025) 9 280
In common with all Accounting reports, this statement identifies the who (Makris
Manchester), the what (Statement of Receipts and Payments) and the when (the month
ended 31 December 2025) about which it is reporting. As with the Income Statement,
the when refers to a period of more than one day, and so states that it is for the month
(rather than as at, which applies to the Balance Sheet).
Reporting GST cash flows

Where the cross-reference of a transaction includes GST Clearing, it indicates GST was
involved and the GST amount is calculated by dividing the transaction amount by 11.
These individual amounts for GST received or GST paid can then be added together to
determine the total GST cash flows.
By contrast, the GST settlement ($1 500) is identifiable because the cross-reference
is only GST Clearing. This amount is reported separately because, unlike GST paid, it is
paid to the ATO to settle the GST debt from the previous period.

Surplus (deficit)
cash surplus By deducting payments from receipts, the cash surplus or cash deficit can be calculated:
an excess of cash receipts over
cash payments, leading to an
increase in the bank balance Surplus (Deficit) = Cash Receipts – Cash Payments
cash deficit
an excess of cash payments A cash surplus occurs when cash received is greater than cash paid during the
over cash receipts, leading to a period, and it will lead to an overall increase in the bank balance. A cash deficit occurs
decrease in the bank balance when cash received is less than cash paid, and it will lead to an overall decrease in the
bank balance.
Note that the closing Balance of the Bank account in the General Ledger matches
the Bank balance at end in the Statement of Receipts and Payments (which in this
case is $9 280). Both use the same data, but because the Statement of Receipts and
Payments summarises the sources of cash (cash receipts) and uses of that cash (cash
payments), it allows the owner to identify not only whether the firm’s cash balance has
increased or decreased, but also the main reasons why this has occurred. As a result,
it is more useful to the owner in making decisions about the firm’s cash performance.

1 Explain the basic function of all Accounting reports.
2 Explain why it is important to report for both cash and profit.
3 Explain why reports for cash are prepared from the Bank account in the
General Ledger rather than the source documents.
4 Explain the function of a Statement of Receipts and Payments.
5 Explain how the information reported in the Statement of Receipts and
Payments differs from the data recorded in the Bank account in the General
Ledger.
6 Explain how GST received and GST paid are determined.
7 Explain why a GST settlement is reported separately from GST paid.
• cash surplus
• cash deficit.
11.2 The Cash Flow Statement
Source
documents
Cash Flow Statement While the Statement of Receipts and Payments is a good starting point for assessing
an Accounting report that changes in the firm’s cash position, it is somewhat limited in its uses because it only
details all cash inflows and classifies the cash transactions as receipts or payments. Information about cash is
outflows from Operating, more useful for decision-making if it classifies common sources and uses of cash, and
Investing and Financing
separately identifies their effect on the bank balance. The Cash Flow Statement reports
activities, and the overall
on cash inflows (cash received) and cash outflows (cash paid), separately identifying
change in the firm’s cash
balance cash flows relating to Operating activities, Investing activities and Financing activities.

Operating activities
Operating activities are all cash flows related to the firm’s day-to-day trading activities. Operating activities
Operating inflows will include Cash sales, receipts from Accounts Receivable, GST cash flows related to day-to-
received, and any other cash revenues. Operating outflows will include all payments day trading activities
related to expenses (including interest), payments to Accounts Payable, GST settlement
and GST paid.
Investing activities
Investing activities are cash flows relating to the purchase or sale of non-current assets. Investing activities
In effect this will mean there are only two possible Investing items: cash received from cash flows related to the
the sale of a non-current asset (Investing inflow) and cash paid for the purchase of a purchase and sale of non-
current assets
non-current asset (Investing outflow).
Financing activities
Financing activities cash flows related to changes
Financing activities are cash flows that are the result of changes in the firm’s financial in the financial structure of the
structure. In essence, this will mean only cash transactions that change Loans and firm
Owner’s equity such as receiving or repaying the principal of a loan or cash contributions
or drawings by the owner.
Study tip
Using the same information that was reported in the Statement of Receipts and
Payments in Figure 11.1, the Cash Flow Statement for Makris Manchester would appear
as shown in Figure 11.2: When classifying cash
flows, work from the
Figure 11.2 Cash Flow Statement bottom up: identify the
MAKRIS MANCHESTER Financing and Investing
Cash Flow Statement for December 2025 activities first, so the
$ $ remainder must be
CASH FLOWS FROM OPERATIONS Operating activities.
Cash sales 43 000
GST received 4 300
Receipts from Accounts Receivable 41 500 88 800
Payments to Accounts Payable (41 400)
Inventory (20 000)
Wages (31 000)
Electricity (500)
GST settlement (1 500)
Insurance (1 200)
Interest expense (600)
GST paid (3 620) (99 820)
Net Cash Flows from Operations (11 020)
CASH FLOWS FROM INVESTING ACTIVITIES
Shelving (10 000)
Office equipment (4 500) 14 500
Net Cash Flows from Investing activities (14 500)
CASH FLOWS FROM FINANCING ACTIVITIES Study tip
Capital contribution 5 000 30 000
Drawings (6 700) Resist the temptation
Loan – Aust. Bank (2 000) 8 700 to classify interest as
Net Cash Flows from Financing activities 21 300 ‘Financing’. Interest is a
Net Increase (Decrease) in cash position (4 220) payment for an expense,
Add Bank Balance at start (1 December 2025) 13 500
so interest is always
‘Operating’.
Bank Balance at end (31 December 2025) 9 280

Just like the Statement of Receipts and Payments, the Cash Flow Statement reports
all cash inflows and outflows and, as a consequence, calculates the same overall change
in cash position, leading to the same cash or bank balance at the end of the Period. This
also remains the same as the balance calculated in the Bank account in the General
Ledger.
However, there are important differences.
First and most importantly, rather than one group of cash receipts and one group
of cash payments, items are classified under the three headings allowing the owner to
assess the firm’s performance in managing its cash from Operations, Investing activities
and Financing activities.
As a consequence, the Net increase in cash position (or in this case decrease of
$4 220) is calculated not by simply deducting total cash payments from total cash
receipts, but by calculating the Net Cash Flows from each activity, and then adding
these figures together:
Net Cash Flows from Operations $(11 020)

+ Net Cash Flows from Investing activities $(14 500)
+ Net Cash Flows from Financing activities $21 300
Net increase (decrease) in cash position $(4 220)
Second, in the Cash Flow Statement headings like ‘Cash inflows’ and ‘Cash outflows’
may be used but usually, by convention, cash outflows are simply identified by the use
of brackets. This applies to individual items as well as the Net Cash Flows.
Assessing Net Cash Flows

Positive Net Cash Flows from Operations is important because it means the business
is generating sufficient cash from its day-to-day trading activities to meet its operating
requirements, and also provide cash for Investing and Financing activities. By contrast,
negative Net Cash Flows from Operations not only uses any available cash on hand,
but also means funds are not being generated for Investing and Financing activities.
Continued in future periods, this would mean no cash to meet payments and, ultimately,
an inability to operate (without cash from Investing and Financing activities).
Negative Net Cash Flows from Investing activities is more expected, as a trading
business will usually spend more on purchasing non-current assets than it generates
from their sale (when they are older and in need of replacement). From time to time,
Investing cash flows will be positive, but only when non-current assets are sold and this
is likely to be infrequent
Net Cash Flows from Financing activities could be positive or negative. Negative
Investing cash flows could mean Financing cash flows are positive as the purchase of
non-current assets is financed by loans and/or capital. However, the loan principal – plus
interest – will need to be repaid in the future and this, plus the owner’s Drawings, could
result in negative Financing cash flows in a subsequent period.
In this example, the firm’s overall cash position has decreased by ($4 220), largely
because of the negative Net Cash Flows from Operations of ($11 020). Fortunately, Net
Cash Flows from Financing activities of $21 300 is positive meaning, even after funding
the Net Cash Flows from Investing activities of ($14 500), Makris Manchester still has
$9 280 left in its Bank account.
An analysis of the Cash Flow Statement indicates that Makris Manchester used the
Loan of $25 000 to purchase the Shelving for $10 000 and Office equipment for $4 500,
with the remainder still in the Bank account. However, the timing of the cash flows

(see the Bank account on page 296) seems to indicate that the Capital contribution of
$5 000 was necessary to ensure there were sufficient funds in the Bank account to pay
Accounts Payable $26 000 on 10 December 2025.
Graphical representations
The Understandability of the Cash Flow Statement may be enhanced further if Net Cash
Flows – from Operations, Investing activities and Financing activities – are represented
graphically.
Figure 11.3 shows how the cash flows of Makris Manchester for December 2025
could be represented as a bar graph:
Figure 11.3 Bar graph: Net Cash Flows
Makris Manchester
2025 Net Cash Flows
20000
15000
10000
5000 Investing activities
0 Financing activities
–5000
Net change in cash position
–10000
–15000
–20000
From this graph, it is clear that cash flows are negative for both Operating and
Investing activities, but that Financing activities have made a significant contribution to
cash on hand. However, the overall result is negative; there has been a Net Decrease
in cash position meaning there is less cash on hand.
Trends
To show the trend over time a line graph could be used.
As at 1 January 2022, Timeless Watches had $10 000 in its Bank account. The Example
following information was provided about the firm’s cash flows from 2023
to 2025:
2023 2024 2025

Net Cash Flows from Operations 65 000 65 000 65 000
Net Cash Flows from Investing activities 0 –40 000 0
Net Cash Flows from Financing activities –60 000 –20 000 –80 000
Net increase (decrease) in cash 5 000 5 000 –15 000
Bank balance at end 15 000 20 000 5 000
• The owner withdraws $60 000 every year.
• During 2024, the business used a loan to purchase non-current assets worth
$40 000.
• Half of the loan ($20 000) was repaid in 2024 with the remaining half ($20 000)
to be repaid in 2025.

Figure 11.4 shows the line graph to represent this information:
Figure 11.4 Line graph: Trend in Net Cash Flows
Timeless Watches
Net Cash Flows
80000
60000
40000
20000
0
– 20000
– 40000
– 60000
– 80000
–100000
Operating activities Investing activities Financing activities Bank balance
Note the relationship between Investing activities and Financing activities. Financing
cash flows are always negative due to the $60 000 Drawings per year. However, in 2024
negative Investing cash flows for the purchase of the non-current assets is matched by
less negative Financing cash flows as the business has taken out a loan. When the loan
is repaid in 2025, Financing cash flows are negative, but as no further purchases of non-
current assets are made Investing cash flows are zero.
As a consequence of this alignment, the Bank balance reflects the changes in
Operating cash flows, with the positive Operating cash flows in 2023–2025 keeping the
Bank balance above zero. However, should Operating cash flows fall – perhaps due to
a loss of sales, or an increase in cash paid for inventory – the Bank balance might fall
(and in an extreme case move into overdraft.)

1 Define the following terms as they relate to the Cash Flow Statement and
identify one cash inflow and one cash outflow under each classification:
• Operating activities
• Investing activities
• Financing activities.
2 Explain one reason why it may be more beneficial to prepare a Cash Flow
Statement rather than a Statement of Receipts and Payments.
3 Describe how cash outflows are usually identified in a Cash Flow Statement.
4 Explain why it is important for a business to generate positive Net Cash Flows
from Operations.
5 Explain the possible relationship between Net Cash Flows from Investing
activities and Net Cash Flows from Financing activities.
6 Explain how information about timing can influence an assessment of cash
flows.
7 Referring to one Qualitative characteristic, explain the purpose of using
graphical representations to communicate information about cash flows.
8 Identify which type of graph might be useful to represent:
• Net Cash Flows in a particular year
• Net Cash Flows over time.

11.3 Uses of the Cash Flow Statement
Source
documents
Poor management of cash is one of the main reasons why small businesses fail. In
this regard, the Cash Flow Statement is a vital tool for improving the owner’s decision-
making in relation to cash management.
By reporting what has already happened as a result of the firm’s cash activities, the
Cash Flow Statement allows the owner to:
• assess the firm’s performance against its cash targets
This is done by detailing the sources and uses of cash in a particular period so that
areas of over and under performance can be identified and corrective action taken to
improve cash.
Comparisons of actual and budgeted (expected) cash inflows and cash outflows
will highlight where performance was better or worse than expected. Strategies can
then be implemented to generate more cash inflows and/or control cash outflows
more effectively in the next Period.
In particular, the owner would want to assess whether the business is generating
enough cash from its Operating activities to fund its Investing and Financing activities
(see below).
• plan for future cash activities
This is done by informing the formulation of the next set of cash targets (budgets).
By providing a basis for the next set of budgeted cash inflows and cash outflows,
the Cash Flow Statement will aid in setting cash targets for the future. This may
include levels of cash sales or collections from Accounts Receivable, payments to
Accounts Payable or for expenses, or the financing and purchasing of non-current
assets using loans and capital contributions.
• calculate financial indicators to support analysis and interpretation.
Financial indicators such as the Cash Flow Cover (CFC) can be used to compare
elements of the Cash Flow Statement with other items from the reports, allowing
for an assessment in relative as well as absolute terms. (This is covered below and
in more detail in Chapter 19.)
Strategies to generate cash

Whereas profit is, in essence, about earning revenue and controlling expenses,
generating cash is about:
• generating cash inflows
• minimising cash outflows.
Generating cash inflows

To generate more cash inflows, the owner may:
• increase sales revenue
Sales revenue will generate cash directly from cash sales, but also in the form of
receipts from Accounts Receivable, so any measures to improve sales (like changing
selling prices, advertising, changing the inventory mix, improving customer service
or even changing location) should also lead to higher cash inflows.

However, if sales increase through lax credit checks on Accounts Receivable, or

Accounts Receivable are not followed up adequately, cash may not be generated
even if sales increase. This means strategies to generate sales (as described in
Chapter 10) must be complemented by strategies to manage Accounts Receivable
(as described in Chapter 6) if cash inflows are to improve.
• implement strategies to manage Accounts Receivable
Even without an increase in sales, strategies to manage Accounts Receivable
(as described in Chapter 6 like credit checks, discounts for early settlement and
reminders) can still generate higher cash inflows.
These strategies should always be legal and ethical, and also consider the long
as well as short-term interests of the business. Leniency in collecting cash from
Accounts Receivable in the short-term may result in the continuing operation of that
customer, and sales and cash inflows well into the future.
Ethical • use loans and capital contributions to finance the purchase of non-current
considerations assets
Loans and capital contributions give the business access to more funds than it
currently has, allowing it to purchase non-current assets to generate sales (and
therefore cash).
Loans do incur an interest charge, but the cost of any interest should be considered
against the long-term benefits generated by the asset, with repayments made over
that longer period. Capital, on the other hand, provides interest-free cash and has no
set time for repayment, but it is limited to the funds of the owner, so if the owner’s
funds are limited, so are the funds of the business. (Capital contributions can also
have a negative effect on the Return on Owner’s Investment, but more on this in
Chapter 18.)
Minimising cash outflows

In order to minimise its cash outflows, a business might:
• reduce expenses
Almost all actions to reduce expenses would have a flow-on effect to reduce cash
payments and lead to more cash retained on hand. (The exceptions might be Inventory
losses and Inventory write-downs, which do not involve a flow of cash. However,
if these expenses reduce, their may be a reduction in purchases of inventory, and
consequently the cash payments they require.)
Lower expenses may however have negative consequences for sales, especially
Ethical
for expenses like Cost of Sales (due to poorer quality inventory), wages (due to
considerations
fewer staff on hand to serve customers or staff with fewer years of experience) or
advertising. And unethical behaviour in cutting costs – dangerously or dishonestly –
can in the end cost more rather than less.
• utilise the credit terms offered by suppliers
Slower payments to Accounts Payable will mean cash is retained for longer and
then is able to be used to meet other payments. It may mean discounts are lost and
although payments are later, they are higher, but provided the credit terms are not
exceeded, this can be a useful strategy for managing cash outflows.
• reduce cash drawings or loan repayments
If the owner can reduce what they withdraw from the business, this will leave more
cash to meet other payments. (However, Drawings may be providing a ‘wage’ for
the owner, and it may not be possible to live on a reduced amount.)
• defer purchases of non-current assets
In some cases, it may be possible to ‘put off’ cash payments until the firm’s cash
position improves, leaving cash to be used for other purposes. This ‘benefit’ must

be weighed against the ‘cost’ of not having the asset (which might otherwise be
generating sales, and cash) or in the case of a loan, a higher interest charge.
• organise a bank overdraft
Many businesses operate with a bank overdraft to help them manage times when
cash is scarce. The cost of interest is a consideration, but the flexibility of an overdraft
can be an important tool for meeting cash requirements,
Other non-financial information can also be important in managing cash. For
example:
• the number of expected sales in the next period might affect whether the business
is adventurous or cautious with the amount of cash it keeps on hand
• the credit rating of a particular Account Receivable might affect the credit terms
offered and the strictness and speed with which they are enforced
• the length and strength of a relationship with a particular Account Payable might
affect how quickly debts are paid
• the age of existing assets might affect how quickly a new asset is purchased.
Many of the ethical considerations in generating profit also apply to the cash flows Ethical
that follow, but purchases from and payments to Accounts Payable, and sales to and considerations
receipts from Accounts Receivable have their own ethical dimensions (see Chapters 5
and 6).
Generating cash from the sale of banned or dangerous goods; or minimising cash
outflows by using suppliers who do not meet legal standards (for example, in waste
disposal), generate social and environmental costs, and are not only unethical but, in
certain cases, illegal.
Similarly, while tax minimisation may fall within the boundaries of the law, tax
avoidance does not. Businesses are obliged to pay their fair share of tax, and activities
like keeping a second, ‘secret’ set of accounts designed to ‘hide’ sales (and the GST tax
obligations they generate) must be actively discouraged by the accountant.

1 Explain how a Cash Flow Statement can be used by a business to assess its
cash performance.
2 Explain how a Cash Flow Statement can be used by a business to plan for
future cash activities.
3 List five strategies that might be used to generate more cash inflows.
4 List five strategies that might be used to minimise cash outflows.
5 List three pieces of non-financial information that might inform the
management of cash.
6 Explain why a business must record and report its cash sales in an ethical Ethical
manner. considerations

11.4 Financial indicators

Liquidity refers to the ability of the firm to generate cash so that it can meet its short-
term debts as they fall due. As the main resource used to meet these debts, the level
of cash on hand is a key determinant of a firm’s liquidity, but there are other factors to
consider. For example, a firm with little cash on hand may have no liquidity problems if
its short-term obligations are also low, and a business that has little cash on hand but
can generate cash quickly might also be said to be highly liquid.
In essence then, liquidity is not measured by reference to one ‘amount’ of cash on hand,
but by considering all of the sources of liquid funds available to the business, and then
comparing them against its current obligations. This will be explored in detail in Chapter 19,
but it is worth considering here as one of the indicators that can be used to assess liquidity.
Cash Flow Cover

Cash Flow Cover (CFC) Cash Flow Cover (CFC) assesses liquidity by comparing the Net Cash Flows from
a liquidity indicator that Operations against the current liabilities that the firm will have to meet. Specifically, it
measures the number of measures the number of times average current liabilities can be met using the Net Cash
times Net Cash Flows from
Flows from Operations.
Operations is able to cover
average current liabilities Cash Flow Cover is calculated as shown in Figure 11.5:
Figure 11.5 Formula: Cash Flow Cover
Net Cash Flows from Operations
Cash Flow Cover (CFC) =
Average Current Liabilities
A high Cash Flow Cover means that the cash generated by Operating activities can
cover current liabilities a large number of times, meaning the business has good liquidity
and should be able to meet its short-term debts as they fall due.
Example OBM sells office equipment and has provided the following information relating to
its cash performance for July 2025:
Net Cash Flows from Operations $105 000
Current liabilities as at 1 July 2025 $59 000
The Cash Flow Cover of OBM would be calculated as shown in Figure 11.6:
Figure 11.6 Calculation: Cash Flow Cover
$105 000
=
($59 000 + 61 000) /2
$105 000
=
$60 000
= 1.75 times
This Cash Flow Cover indicates that Net Cash Flows from Operations can cover
average Current liabilities 1.75 times. In general, an increase in this indicator suggests
liquidity has improved while a decrease suggests it has worsened, and the longer the
period being examined the more times the business would expect the average current
liabilities to be covered.
There is no set benchmark at which the Cash Flow Cover would be considered
satisfactory. However, it can be compared against the Cash Flow Cover from previous
periods, budgeted performance and competitors’ performance (industry averages) to
determine whether it has improved or worsened.

1 State what is measured by the Cash Flow Cover (CFC).
2 Show the formula to calculate the Cash Flow Cover.
3 Explain what is indicated by an increase in the Cash Flow Cover.
4 State three benchmarks that could be used to assess the adequacy of the
Cash Flow Cover.
11.5 Cash versus profit

The introduction to this chapter highlighted the fact that many profitable small businesses
still end up failing, largely due to an inability to manage cash effectively. It is all too
common to hear of businesses that are selling their products at a profit but end up being
unable to pay their debts because they can’t manage their cash, and ultimately end up
going out of business.
But how can this be? How can a firm that is earning a profit suffer from a lack of cash
to pay its bills? Conversely, how can a firm that is trading at a loss still boast a healthy
Study tip
bank balance?
The simple answer is that cash and profit are different resources, and business
owners need to understand this difference in order to manage both effectively. The Although these are
change in a firm’s bank balance is calculated by comparing cash inflows and cash the general reasons
outflows in a Period, whereas profit is determined by comparing revenues earned and why cash and profit
expenses incurred in that period and, as we have seen a number of times, these items performance may differ,
are not necessarily the same. The main differences are: they are not nearly
• some cash items do not affect profit specific enough in an
• some profit items do not affect cash exam situation. Refer to
• some items affect both cash and profit, but by differing amounts. the specific examples
below.
Cash items that do not affect profit
Some items are reported only in the Cash Flow Statement, as they only affect cash on
hand; because they are not revenues or expenses, they are not reported in the Income
Statement:
• Some cash inflows are not revenues.
Capital contributions and loans received are cash inflows that increase Bank, but
they are not revenues and so have no effect on profit. Items such as these will
explain why a firm has been able to generate an increase in its cash balance even if
it has incurred a Net Loss.
• Some cash outflows are not expenses.
Cash drawings, loan repayments and cash purchases of non-current assets are payments
that will decrease Bank, but they are not expenses and so leave profit unchanged. This
may explain why a firm has suffered a decrease in cash despite earning a profit.
• GST cash flows are not revenues or expenses.
In the case of GST cash flows, if the total GST received (including any GST refund)
is greater than the total GST paid (including any GST settlement), there will be an
increase in cash; if the opposite occurs, there will be a decrease in cash. In either
case, there will be no effect on profit, as GST is neither a revenue nor an expense.

Study tip Cash inflows that are not revenues Cash outflows that are not expenses
Capital contribution Cash drawings
Loan received Loan repayments
Except for GST, these Cash payments for non-current assets
differences would
GST received (including GST refund) GST paid (including GST settlement)
be reported as either
Investing or Financing
Profit items that do not affect cash
activities in the Cash
Flow Statement: this is Just as some items are reported only in the Cash Flow Statement, other items are
the best place to start reported only in the Income Statement:
when looking for reasons • Some revenues are not cash inflows.
why cash and profit Inventory gain is a good example, as it is a revenue that increases profit, but as it
results are different. represents a gain of inventory, not cash, it will not affect cash on hand. This may
explain why a firm can earn a profit, but still suffer a decrease in cash.
• Some expenses are not cash outflows.
Inventory loss and Inventory write-down are expenses that will decrease profit, but
as they are not cash outflows will not affect cash on hand. Expenses such as these
Study tip
may explain why a firm can generate more cash without earning a profit.
Revenues that are not cash inflows Expenses that are not cash outflows
More examples of this
kind will come to light Inventory gain Inventory loss
throughout Unit 4. Inventory write-down
Items that affect both profit and cash, but by different amounts
We have so far considered items that affect one report, but not the other; that is, they
have an effect on cash or an effect on profit but not both. But many items affect both
cash and profit. Where the item affects both, but by differing amounts, the firm’s profit
will not be the same as its cash performance:
• Credit sales and receipts from Accounts Receivable
Credit sales will increase profit immediately, but it may not involve a cash flow until
much later. Conversely, cash received from Accounts Receivable will increase Bank,
but it is not revenue. Thus, the different amounts reported as Credit sales and receipts
from Accounts Receivable could explain why cash and profit are not the same:
– if Credit sales is greater than receipts from Accounts Receivable, the firm may
have more profit than cash.
– if Credit sales is less than receipts from Accounts Receivable, the firm may have
less profit than cash.
• Cost of Sales and cash paid for inventory
The way inventory is paid for can also mean that cash and profit are not the same.
Cost of Sales represents the expense incurred when inventory is sold, but this may
not be the same as the amount of cash paid for inventory as cash purchases or
payments to Accounts Payable:
– if Cost of Sales is greater than cash paid for inventory, it will reduce profit more
than it reduces cash.
– if Cost of Sales is less than cash paid for inventory, it will mean a greater reduction
in cash than in profit.
Revenue/expense Cash inflow/outflow

Credit sales Receipts from Accounts Receivable
Cost of Sales Cash purchases of inventory
Payments to Accounts Payable

In reality, there will usually be a combination of reasons why a firm’s cash and profit
performance differ.
• A firm may earn profit but suffer a decrease in cash due to:
Reason Examples
Cash outflows that decrease cash but are not Cash drawings
expenses and so do not affect profit Loan repayments
Cash payments for non-current assets
Overall more GST paid than received,
including GST settlement
Revenues that increase profit but are not Inventory gain
cash inflows and so do not affect cash
Revenue items that increase profit more than Credit sales greater than receipts from
the corresponding cash inflow increases cash Accounts Receivable
Expense items that decrease profit less than Cost of Sales less than cash paid for
the corresponding cash inflow decreases inventory
cash
Study tip
• A firm may suffer a loss but generate an increase in cash due to:
When looking for reasons

Reason Examples
to explain the difference
Cash inflows that increase cash but are not Capital contribution between cash and
revenues and so do not affect profit Loan received
profit performance, look
Overall more GST received than paid
(including GST refund) for opposites: capital
contribution versus
Expenses that decrease profit but are not cash Inventory loss
outflows and so do not affect cash Inventory write-down drawings; loan received
versus repaid; inventory
Revenue items that increase profit less than the Credit Sales less than Receipts from
corresponding cash inflow increases cash Accounts Receivable loss versus gain; and
expenses prepaid versus
Expense items that decrease profit more than Cost of Sales greater than Payments for
the corresponding cash outflow decreases cash Inventory accrued.

1 Identify the three main reasons why the change in a firm’s cash position may
be different from its profit over the same period.
2 Identify two cash inflows that are not revenues. Explain the effect these
items will have on both cash and profit.
3 Identify three cash outflows that are not expenses. Explain the effect these
items will have on both cash and profit.
4 Explain how an inventory gain may be the reason why a firm can earn a profit,
despite suffering a decrease in cash.
5 Identify two items that will be reported as expenses in the Income Statement
but will not be reported as cash outflows in the Cash Flow Statement.
6 Explain how cash and profit will differ if:
• Credit sales is greater than receipts from Accounts Receivable
• Credit sales is less than receipts from Accounts Receivable
• Cost of sales is greater than cash paid for inventory
• Cost of sales is less than cash paid for inventory.

Where have we been?

• The Statement of Receipts and Payments reports cash received and paid, and the change in the firm’s
bank balance over a Period.
• The Cash Flow Statement reports cash inflows and cash outflows relating to Operating activities,
Investing activities and Financing activities, and the change in the firm’s cash balance over a Period.
• Operating activities are cash flows related to day-to-day trading activities.
• Investing activities are cash flows related to the purchase and sale of non-current assets.
• Financing activities are cash flows related to changes in the financial structure of the firm.
• The Cash Flow Statement is used to aid decision-making and planning.
• The Cash Flow Cover (CFC) measures how many times current liabilities can be ‘met’ by Net Operating
Cash Flows.
• Cash and profit are different measures of performance, and there are many possible reasons why a firm
that is earning a profit can still suffer from a lack of cash:
– Some cash inflows are not revenues.
– Some cash outflows are not expenses.
– Some revenues are not cash inflows.
– Some expenses are not cash outflows.
– Some items affect both cash and profit, but by differing amounts.
Exercises
this book.

Statement of Receipts and Payments
Crafty Cabinets has provided the following information relating to its cash transactions for July 2025:
Cash Receipts $ Cash Payments $

Cash sales 100 000 Payments to Accounts Payable 70 000
Receipts from Accounts Receivable 50 000 Electricity 2 400
GST received 10 000 Interest 600
Capital contribution 15 000 Office expenses 5 000
Wages 30 000
Purchase of equipment 5 600
Drawings 40 000
GST paid 3 100
Loan repayment 6 000
Rent 18 000
• The bank balance of Crafty Cabinets as at 30 June 2025 was $8 600 DR.
• Rent is paid in advance in July each year.
Required
* a Complete the Bank account in the General Ledger of Crafty Cabinets as at 31 July 2025. Transaction
dates are not required.
* b Prepare a Statement of Receipts and Payments for Crafty Cabinets for July 2025.
c State one reason why the owner would be unhappy with the cash performance of the firm during
July 2025.
d Explain one way to improve the information reported to the owner about the firm’s cash performance.

Exercise 11.2 W B Page 249

Cash Flow Statement
Boof Hair Care Products has provided its Bank account from its General Ledger as at 30 June 2025:
General Ledger
Bank
Date * Cross-reference Amount $ Date * Cross-reference Amount $
Capital 10 000 July 1 Balance 13 500
Cash sales/GST Clearing 55 000 Electricity/GST Clearing 1 650
Insurance/GST Clearing 1 980
Wages 28 000
Drawings 12 000
Display cabinets/GST Clearing 6 600
June 30 Balance 2 270
90 000 90 000
* Transaction dates not provided.
Required
a Calculate GST paid for the year ended 30 June 2025.
* b Prepare a Cash Flow Statement for Boof Hair Care Products for the year ended 30 June 2025.
c Referring to your answer to part ‘b’, explain your treatment of Drawings.
d Suggest one reason why the owner may have made the Capital contribution of $10 000.
e Explain one benefit of preparing a Cash Flow Statement rather than a Statement of Receipts and
Payments.


Cash Flow Statement
Flip Flops specialises in the sales of thongs, and Bank account from its General Ledger as at 30 September 2025:
General Ledger
Bank
Date * Cross-reference Amount $ Date * Cross-reference Amount $
July 1 Balance 1 500 Inventory/GST Clearing 5 500
Loan – Bodgey Bank 25 000 Loan 1 000
Cash sales/GST Clearing 11 000 Electricity/GST Clearing 550
Rent/GST Clearing 2 640
Wages 6 000
Drawings 2 000
Shelving/GST Clearing 1 760
44 500 44 500
* Transaction dates not provided.
The owner, Karl Winefeld, is happy that the bank balance has increased so much over the quarter.
Required
a Calculate GST paid for quarter ended 30 September 2025.
* b Prepare a Cash Flow Statement for Flip Flops for the quarter ended 30 September 2025.
c Construct a bar graph to show the Net Cash Flows from Operating, Investing and Financing activities for
Flip Flops for the quarter ended 30 September 2025.
d Discuss whether the owner should be happy with the firm’s cash performance for the quarter ended 30
September 2025.
e Explain two actions the owner could take to improve the cash performance of Flip Flops.

Katherine Quinn owns Mighty Winds, a shop specialising in electric fans, and has provided the following data
from her financial records for 2025:
$ $
GST paid 380 Cash sales 60 000
Loan repayment – principal 12 000 Interest paid 1 850
Electricity paid 1 200 GST received 6 000
Discount expense 2 400 Wages owing 1 600
Wages paid 6 000 GST on Credit sales 10 000
GST settlement 3 000 Cash purchase of office furniture 2 600
Payments to Accounts Payable 45 000 Interest owing 1 700
Required
a Calculate Net Cash Flows from Operations for Mighty Winds for 2025.
b Referring to your answer to part ‘a’, explain your treatment of Interest owing.
c Explain the importance of Net Cash Flows from Operations to the success of a trading business.
d Explain two actions the owner of Mighty Winds could take to improve cash inflows.


Got It Covered sells car seat covers and has provided the following data from its financial records for April 2025:
$ $
Credit sales 28 000 GST refund 300
Interest expense paid 4 800 Receipts from Accounts Receivable 15 000
Discount expense 850 Drawings 1 800
Credit purchase of inventory 32 000 Cash sales 16 000
GST on credit purchases 3 200 GST on cash sales 1 600
GST paid 1 900 Rent paid 15 000
Required
a Calculate Net Cash Flows from Operations for Got It Covered for April 2025.
b Referring to your answer to part ‘a’, explain your treatment of Discount expense.
c Explain why the GST received and GST refund must be reported separately in the Cash Flow Statement.
d Explain two actions the owner of Got It Covered could take to reduce cash outflows.

Rag Doll Fashions has provided the following data from its financial records for the six months ending
31 December 2025:
$ $
Cash sales 47 000 GST received 4 700
Cash purchase of inventory 15 000 GST paid on purchase of inventory 1 500
Cash purchase of fittings 5 600 GST paid on purchase of fittings 560
Deposit paid on furniture 800 Drawings of inventory 2 800
Required
a In terms of the Cash Flow Statement, explain what is meant by the term ‘Investing activities’.
b Calculate Net Cash Flows from Investing activities for Rag Doll Fashions for the six months ended 31
December 2025.
c Referring to your answer to part ‘b’, explain your treatment of Cash purchase of inventory.
d Explain why the GST paid on purchase of fittings is not reported as an Investing activity.
e Referring to your answer to part ‘b’, discuss whether the owner should be concerned about the Net
Cash Flows from Investing activities for Rag Doll Fashions for the six months ended 31 December 2025.


Neil Ng Enterprises has provided the following data from its financial records for November 2025:
$ $
Loan repayment 12 000 Cash purchase of shelving 10 000
Interest expense 4 800 Receipt of loan 20 000
Cash purchase of vehicle 32 000 GST settlement 1 200
GST paid 5 600
Required
a Calculate Net Cash Flows from Investing activities for Neil Ng Enterprises for November 2025.
b State one reason why GST paid is greater than 10% of Net Cash Flows from Investing activities for
November 2025.
c Suggest three ways the purchase of the new vehicle may have been financed.
d Explain how negative Net Cash Flows from Investing activities may lead to an increase in Net Profit.

Eden-Monaro Motors has provided the following data from its financial records for the year ending 30
June 2025:
$ $
Credit sales 100 000 Interest paid 1 800
Receipt of Loan – NAB 12 000 Net Profit 16 000
Wages paid 800 Cash drawings 25 000
Payments to Accounts Payable 35 000 Drawings of inventory 700
Required
a In terms of the Cash Flow Statement, explain what is meant by the term ‘Financing activities’.
b Calculate Net Cash Flows from Financing activities for Eden-Monaro Motors for the year ended 30 June
2025.
c Referring to your answer to part ‘b’, explain your treatment of Interest paid.
d Given that at 1 July 2024 the Capital account had a balance of $48 000, complete the Capital account in
the General Ledger of Eden-Monaro Motors as at 30 June 2025.


Flash Dance Wear has provided the following data from its financial reports for the 6 months ended
31 December 2025:
$ $
Repayment of loan principal 15 000 Cash sales 50 000
Cash drawings 8 700 Cash purchase of shop fittings 6 500
Receipts from Accounts Receivable 20 000 Cash contribution by owner 30 000
Credit purchase of inventory 32 000 Contribution of vehicle by owner 3 800
Required
a Referring to one Qualitative characteristic, explain how the valuation of the vehicle contributed by the
owner would have been determined.
b Calculate Net Cash Flows from Financing activities for Flash Dance Wear for the six months ended
31 December 2025.
c Explain why a capital contribution is not reported in the Income Statement.
d Explain how positive Net Cash Flows from Financing activities may lead to a reduction in Net Profit.

Cash Flow Cover
Hales Kitchens sells kitchen items and has provided the following information relating to its cash performance
for April 2025:
Net Cash Flows from Operations $120 000

• The Cash Flow Cover of Hales Kitchens for March 2025 was 2.4 times, and its budgeted Cash Flow
Cover for April 2025 was 3.6 times.
• As at 30 April 2025, Hales Kitchens has a bank overdraft of $7 800.
Required
a Calculate the Cash Flow Cover of Hales Kitchens for April 2025.
b Suggest one possible reason for the change in the Cash Flow Cover of Hales Kitchens from March to
April 2025.
c Explain one reason why the owner would be satisfied with the Cash Flow Cover for April 2025.
d Explain one reason why the owner would not be satisfied with the Cash Flow Cover for April 2025.
e Discuss whether Hales Kitchens will be able to meet is short-term debts as they fall due.


Cash versus profit
Buzz Wax Products has provided the following extract from its General Ledger for August 2025:
General Ledger
Bank
Accounts Receivable ? Aug. 1 Balance 2 500
Sales/GST Clearing 11 000 Accounts Payable 4 300
Capital 5 000 Inventory/GST Clearing 3 300
Wages 5 000
Computer/GST Clearing 1 100
Drawings 2 450
• During the period a 10% settlement discount worth $410 was given to Accounts Receivable.
• Credit sales for the period was $2 000 plus GST.
• Cost of Sales for the period was $4 500.
• During August 2025, the business incurred a Net Loss of $1 650.
Required
a Calculate GST paid for August 2025.
b Calculate cash received from Accounts Receivable for August 2025.
* c Prepare a Cash Flow Statement for Buzz Wax Products for August 2025.
d Referring to your answer to part ‘c’, explain why the owner should be concerned about the firm’s cash
position but not about its cash performance for August 2025.
e Identify two examples from the Cash Flow Statement that explain how Buzz Wax Products was able to
record an increase in cash despite suffering a Net Loss. Explain your response.
f Explain how the Cash Flow Statement can aid decision-making.


Cash versus profit
Saw Miller Furniture has provided the following extract from its General Ledger for the quarter ended
30 June 2025:
General Ledger
Bank
Apr. Accounts Receivable 36 500 Apr. 1 Balance 1 600
Sales/GST Clearing 27 500 Inventory/GST Clearing 44 770
Capital 6 000 Admin. exp./GST Clearing 3 300
Loan – GIN Bank 20 000 Wages 11 900
Equipment/GST Clearing 15 180
Drawings 13 500
Insurance/GST Clearing 6 600
Loan – GIN Bank 1 100
• All inventory is purchased using cash.
• Accounts Receivable were granted a settlement discount of $1 500.
• Credit sales for the period was $24 200 including GST.
• Cost of sales for the period was $23 500.
• The business has negotiated an overdraft limit of $8 000.
• The average current liabilities of Saw Miller Furniture for the quarter ended 30 June 2025 was $8 000.
• The Cash Flow Cover for Saw Miller Furniture for the previous quarter was –4.3 times.
Required
a State whether the balance of Accounts Receivable as at 30 June 2025 would be higher or lower than the
balance as at 1 April 2025. Justify your answer.
b Calculate GST paid for the quarter ended 30 June 2025.
* c Prepare a Cash Flow Statement for Saw Miller Furniture for the quarter ended 30 June 2025.
d State why the owner had to contribute additional capital during the quarter.
e Saw Miller Furniture reported a profit of $6 200 for the quarter ended 30 June 2025. Using two examples
other than drawings, explain how Saw Miller Furniture was able to earn a Net Profit despite a significant
fall in cash during the same period.
f Calculate the Cash Flow Cover of Saw Miller Furniture for the quarter ended 30 June 2025.
g Referring to your answer to part ‘f’, explain whether the liquidity of Saw Miller Furniture has improved or
worsened.
h Explain two actions the owner could take to improve the cash performance of Saw Miller Furniture.


Cash versus profit
Full Collection commenced business on 1 January 2025 when the owner deposited $20 000 into the business
bank account.
On the same day a bank loan of $50 000 was received from the Kyneton Bank. Interest on the loan is
6% per annum, and repayments of interest and principal will occur on the first of every month, beginning on
1 February 2025.
During January 2025 the following transactions occurred:
• A warehouse was rented, and six months’ rent was paid in advance, totalling $6 600 including GST.
• $7 000 plus GST was paid for office equipment.
• All sales are on credit at a mark-up of 100%. During January 2025, the business invoiced customers for
$40 000 plus GST. As at 31 January 2025, $15 000 of this was still owing.
• Inventory is purchased on credit and paid for in the month following purchase.
• Wages of $15 000 were paid.
• Cartage in of $4 400 including GST was paid.
• Advertising worth $1 000 plus GST will be carried out in February 2025.
• Drawings were $8 000, consisting of $7 500 cash and $500 worth of inventory.
Required
a Calculate GST paid for January 2025.
* b Prepare a Cash Flow Statement for Full Collection for January 2025.
* c Prepare an extract of the Income Statement for Full Collection which shows Gross profit for January
2025. A full Income Statement is not required.
d Explain, providing two examples, why Full Collection made a Net Loss yet at the same time generated
an increase in cash for January 2025.
e Discuss the performance of Full Collection for January 2025.


Cash flows
Giacomo Batusta owns The Glass House, a firm that sells glassware from a shop at Watergardens Shopping
Centre, and has provided the following information for October 2025:
• As at 31 October 2025, the firm’s bank account was $560 overdrawn.
• $5 700 was paid to Accounts Payable earning discount revenue of $300.
• Cash sales was $6 700 plus GST.
• A GST refund of $500 was received on 3 October 2025.
• Accounts Receivable owed $5 600 and paid in full, receiving a $400 settlement discount.
• Cost of sales for the period was $1 800.
• Cash purchases of inventory was $3 190 including GST.
• Wages paid was $1 000.
• Interest expense of $100 was paid.
• Cash drawings for the period was $2 110.
• New shelving worth $1 600 plus GST was purchased by EFT.
Required
a Calculate the total decrease in the Accounts Payable balance for October 2025.
b Calculate GST paid for October 2025.
* c Prepare a Cash Flow Statement for The Glass House for October 2025.
* d Complete the Bank account in the General Ledger of The Glass House as at
31 October 2025. Transaction dates are not required.
e Giacomo is concerned that the bank overdraft has increased despite the business generating positive
Net Cash Flows from Operations. Explain, giving two examples from the Cash Flow Statement, how
this occurred.
f Explain one action the owner could take to improve the firm’s cash performance without changing its
Net Cash Flows from Operations.
Giacomo provided the following graph representing the firm’s cash activities for November 2025:
$ 10000
$ 6000 Net Cash Flows form

Operations
$ 2000 Net Cash Flows form Investing
Activities
– $ 2000
Net Cash Flows form Financing
– $ 6000 Activities
– $ 10000
Net Cash Flows
Required
g State whether the firm’s bank balance increased or decreased during November 2025. Justify your
answer.
h Explain one reason why Giacomo should be concerned about the firm’s Net Cash Flows from
Operations for November 2025.
i Explain two actions the owner could take to improve Net Cash Flows from Operations without changing
cash sales.
j Discuss whether Giacomo should be concerned about the firm’s Net Cash Flows from Investing
activities for November 2025.


Cash versus profit
Ruby Ice owns Bling Rings, a reputable jewellery store, and has provided the following information for the
year ended 30 June 2025:
• As at 1 July 2024, the firm had a bank balance of $30 000 DR, the balance of Accounts Receivable was
$35 000 DR and $1 100 was owed to the ATO.
• All sales and purchases are made on credit. Credit sales for the period were $198 000 including GST but
Sales returns were $1 500 plus GST. All sales are marked up 100%.
• Receipts from Accounts Receivable amounted to $170 280 and a Discount expense of $1 720 was
incurred.
• The balance of Accounts Payable decreased by $127 100 including a settlement discount of $1 400.
There were no purchase returns during the year.
• A loan for $15 000 was taken out from QZ FinCo and used to purchased display cabinets worth $8 000
plus GST.
• A payment was made to the ATO to settle the GST liability owing at the start of the period.
• $13 500 cash was withdrawn by the owner for her private use.
• The following expenses were paid:
– Wages $34 500
– Administration expenses $1 000 plus GST
– Rent expense $11 000 plus GST
– Insurance $4 620 including GST
– Interest expense $3 000
Required
a Explain how the decision to make all sales on credit affects the cash cycle of Bling Rings.
b Calculate the percentage discount granted to Accounts Receivable.
c Calculate GST paid (to suppliers) for the year ended 30 June 2025.
d Calculate cash paid to Accounts Payable for the year ended 30 June 2025.
e Complete the Accounts Receivable account in the General Ledger of Bling Rings as at 30 June 2025.
Transaction dates are not required.
* f Prepare a Cash Flow Statement for Bling Rings for the year ended 30 June 2025.
g Using two examples, explain how Bling Rings was able to earn a Net Profit despite suffering negative
Net Cash Flows from Operations.
h Explain one action the owner could take to improve both Net Cash Flows from Operations and Accounts
Receivable Turnover.

Recording,
reporting,
budgeting and
Unit 4
decision-making
In Unit 4 of the VCE Accounting course, we will cover the following

chapters:
Chapter 12 alance day adjustments: prepaid and
B
accrued expenses 322
Chapter 13 Accounting for non-current assets 1 345
Chapter 14 Accounting for non-current assets 2 373
Chapter 15 Bad and doubtful debts 400
Chapter 16 Balance day adjustments: Revenues 418
Chapter 17 Budgeting 438
Chapter 18 Evaluating performance: profitability 478
Chapter 19 Evaluating liquidity 509

Chapter 12
Balance day adjustments: prepaid and
accrued expenses

After completing this chapter, you should be able to: • identify and record the payment of an accrued
• define and identify revenue, expenses and profit expense in a subsequent period
• explain how the Period, Going concern and Accrual • distinguish between an accrued expense and an
basis assumptions and the Qualitative characteristic Account Payable
of Relevance affect the calculation of profit • report prepaid and accrued expenses in the Balance
• define the term ‘balance day adjustment’ Sheet
• explain the purpose of a balance day adjustment • explain the purpose of a Post-adjustment Trial
• identify and record expenses paid in advance in the Balance
General Journal and General Ledger • prepare a Post-adjustment Trial Balance
• record balance day adjustments for prepaid and • prepare reports from a Post-adjustment Trial
accrued expenses in the General Journal and Balance
General Ledger • explain ethical considerations in relation to
• state the effect of balance day adjustments on the recording, reporting and decision-making.
Accounting equation
Key terms
After completing this chapter, you should be familiar • Pre-adjustment Trial Balance
with the following terms: • Post-adjustment Trial Balance.
• balance day adjustment (BDA)
• prepaid expense
• accrued expense

Chapter 12 Balance day adjustments: prepaid and accrued expenses 323
12.1 The need for balance day adjustments

Chapter 1 introduced the four Accounting assumptions that influence the way
Accounting information is generated. The Going concern assumption states that reports
are prepared on the assumption that the business will continue to operate into the
future, and this allowed for the recognition of assets that would produce economic
benefits and liabilities that were expected to be settled, in the future. At the same time,
the need to determine profit led to the adoption of the Period assumption, which states
that reports are prepared for a period of time, and only those revenues and expenses
occurring within that Period should be used to calculate profit.
With this in mind, Chapter 10 introduced the idea of closing the ledger in order to
calculate profit for the current Period. Revenues and expenses from outside the current
Period were excluded, as were other non-revenue or expense items. This chapter goes
one step further, to consider whether, before closing, the amounts recorded in the
General Ledger accounts provide a complete and accurate picture of the revenues
earned and expenses incurred in the current Period.
Revenues and expenses

Remember the definitions of revenues and expenses outlined in Chapter 1:
• Revenues: increases in assets or decreases in liabilities that result in increases in
owner’s equity, other than those relating to contributions from the owner.
• Expenses: decreases in assets or increases in liabilities that result in decreases in
owner’s equity, other than those relating to distributions to the owner.
Note that neither definition refers to cash, meaning the movement of cash (and a
change in Bank) is not required for an item to be recognised as a revenue or expense.
For revenues, the asset that increases may be Bank (for a Cash sale) but does not
have to be; it could be Accounts Receivable (for a Credit sale) or some other asset, such
as Inventory (for an inventory gain). With Discount revenue, there is actually no change
in assets at all: it is the result of a decrease in liabilities (Accounts Payable). This means
that revenue is recognised when the assets increase or the liabilities decrease; that is, Study tip
when the revenue is earned, and this is usually at point of sale.
For expenses, the decrease in assets may be Bank (for cash expenses), but equally
Expenses should be
it may be Accounts Receivable (for Discount expense) or Inventory (for an inventory
recognised when they
loss). This means expenses are recognised when the assets decrease or the liabilities
are incurred. This is like
increase; that is when the expense is incurred – when the goods or services have been
saying they should be
consumed. recognised when they are
As a result of applying these definitions, and the Going concern and Period ‘used up’ or consumed.
assumptions, profit under the Accrual basis assumption is calculated as revenues
earned less expenses incurred for the current Period.
Balance day adjustments

In Chapter 10, the unspoken assumption we made before closing the ledger was that
the revenue accounts already showed the amount earned and expense accounts already
showed the amount incurred. Thus, when we calculated profit, we assumed it would be
the correct figure.
Unfortunately, this is not always the case. If at balance day (the end of the Period)
there is revenue that has been earned but not yet received (such as interest revenue still
owing to the business), this will not appear in the revenue accounts even though it should
be used to calculate profit for the current Period. At the same time, revenue that has
been received but not yet earned (like deposits on future sales) will appear in the revenue
accounts, even though it should not be used to calculate profit for the current Period.

324 UNIT 4 RECORDING, REPORTING, BUDGETING AND DECISION-MAKING
Similarly, if there are expenses that have been incurred but not yet paid (such as
electricity that has been consumed but will not be paid for until the next period), this will
not appear in the expense accounts even though it should be used to calculate profit
for the current Period; whereas expenses that have been paid but not yet incurred (like
rent paid in advance) will appear in the ledger accounts, even though they should not be
used to calculate profit for the current Period.
If any of these circumstances existed, closing the ledger calculation would allow for
the calculation of profit, but that profit would be inaccurate.
balance day In situations such as these, a balance day adjustment (BDA) is necessary to
adjustment (BDA) change (or adjust) the ledger accounts so that the revenue accounts include all, and only,
a change made to a revenue revenues earned and the expense accounts include all, and only, expenses incurred in
or expense account on
the current Period. This will ensure that closing the ledger will not only allow for the
balance day so that revenue
accounts show revenues calculation of profit, but also that the profit figure will be accurate.
earned and expense accounts Balance day adjustments then are made to ensure that profit is calculated accurately
show expenses incurred in a by matching revenues earned against expenses incurred in the current Period. As a
particular Period result, they ensure Relevance in the Accounting reports by ensuring that the Income
Statement (and, for that matter, the Balance Sheet) includes all information that is
capable of making a difference to decision-making, while excluding information that is
not (such as revenue earned or expenses incurred outside the current Period).
Types of balance day adjustments

Study tip The balance day adjustments covered in this course refer to both revenues and
expenses, including:
• Inventory losses and gains (covered in Chapter 8)
Adjusting entries must • Prepaid expenses and Accrued expenses (this chapter)
be made before closing • Depreciation (Chapters 13 and 14)
entries (ABC: Adjust
• Bad debts (Chapter 15)
Before Closing).
• Unearned revenue and Accrued revenue (Chapter 16)

1 Explain how the Going concern and Period assumptions affect the calculation
of profit.
• revenue
• expense.
3 Explain how profit is calculated under the Accrual basis assumption.
4 Explain why profit may be inaccurate if balance day adjustments are not
recorded.
5 Explain the purpose of a balance day adjustment.
6 Explain how balance day adjustments ensure Relevance in the Accounting
reports.
7 List:
• five balance day adjustments that relate to expenses
• three balance day adjustments that relate to revenues.

12.2 Prepaid expenses

Frequently, an amount will be paid for an item that is not consumed at the time the
payment is made. For instance, when a business pays for rent or insurance they usually
pay in advance, covering the next month or even the forthcoming year. The same could
be said for supplies and materials such as office supplies, which are purchased in bulk,
but are not used immediately. These are common payments, but at the time they are
paid should we consider them to be expenses?
The short answer is no. The definition of an expense refers to a decrease in assets
(or increase in liabilities) that decreases owner’s equity, and when cash is paid for items
like this, Bank will certainly decrease. However, at the time of purchase all of the rent,
insurance or office supplies will still remain available for use – they will actually provide a
benefit at some point in the future – so they have not yet been incurred but are actually
assets.
This means that an item that is paid for in advance but not yet incurred is actually a
current asset called a prepaid expense (in this case, Prepaid rent, Prepaid insurance or prepaid expense
Prepaid office supplies). And given there is no overall change in assets, there can be no a current asset that has been
paid in advance in the current
change to owner’s equity, meaning the cash purchase of a prepaid expense is not an
Period but is yet to be incurred
expense at all, but simply swapping one current asset (Bank) for another (Prepaid expense).
On 1 October 2025, Wendell Windows paid $1 200 (plus $120 GST) for insurance Example
for the next 12 months (Cheque 63). Reports are prepared every month and on
31 October 2025 the accountant asked for the General Ledger to be closed and
reports prepared (Memo 19).
Cash purchase of a prepaid expense
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Because the payment is made for the next 12 months, this payment represents the
purchase of a current asset called Prepaid insurance and this account must be debited
by $1 200. GST Clearing is also debited $120 to recognise the decrease in the liability to
the ATO, with a corresponding credit to the Bank account for $1 320.

This payment would be recorded in the General Journal as shown in Figure 12.1:
Figure 12.1 General Journal: Cash purchase of a prepaid expense

General Journal
Oct. 1 Prepaid insurance 1 200
GST Clearing 120
Bank 1 320
Cash payment for 12 months insurance (paid in advance) (Chq. 63)
Figure 12.2 shows how the accounts would appear after posting the General Journal
to the General Ledger:
Figure 12.2 General Ledger: Cash purchase of a prepaid expense

General Ledger
Prepaid insurance (CA)
Oct. 1 Bank 1 200
GST Clearing (L)

Oct. 1 Bank 120 Oct. 1 Balance 2 100
Bank (A)
Oct. 1 Balance 4 600 Oct. 1 Prepaid insurance / 1 320
GST Clearing

As a result of the payment, the effect on the Accounting equation would be:

Assets Decrease (Decrease Bank $1 320, increase Prepaid insurance $1 200) 120
At this point, there is no expense amount recorded in the General Ledger accounts;
it is all recorded as a current asset.
BDA: Expense incurred
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Prepaid expenses are recorded as current assets because at the time of payment, none
of the amount has been consumed; it is all a future economic benefit. However, by
the time balance day arrives (the day on which the ledger is closed, and the reports

are prepared) at least part of this prepaid expense is likely to have been incurred or
consumed. In other words, part of the asset has become an expense.
It is therefore necessary to adjust the ledger accounts so that:
• the Insurance expense account shows the amount incurred (consumed) in the
current Period and
• the Prepaid expense account only shows the amount still to be incurred in future
Periods.
Calculating the expense incurred

In this example, the $1 200 worth of Prepaid insurance was purchased on 1 October
2025, but this was paid to cover the next 12 months. The monthly expense incurred can
then be calculated as shown in Figure 12.3:
Figure 12.3 Calculation: Expense incurred
$1 200 Prepaid insurance

Insurance expense =
12 months
= $100 per month
Recording the expense incurred

Given that reports are prepared every month, by balance day (31 October 2025) an
expense of one month or $100 will be consumed and this must be debited to the
Insurance expense account to recognise the amount incurred. At the same time, the
Prepaid insurance account must be credited to record the decrease in this current asset.
Figure 12.4 shows the General Journal entries to record this balance day adjustment:
Figure 12.4 General Journal: BDA – Expense incurred

Study tip
General Journal
Date Details Debit $ Credit $ Calculate the amount
Oct. 31 Insurance 100 incurred (consumed/used
Prepaid insurance 100 up): this is the amount to
Balance day adjustment to record one month’s insurance use in the balance day
adjustment.
incurred (Memo 19)
After posting this General Journal entry, the General Ledger would appear as shown
in Figure 12.5:
Figure 12.5 General Ledger: BDA – Expense incurred

General Ledger Study tip
Prepaid insurance (CA)
When adjusting a prepaid
Oct. 1 Bank 1 200 Oct. 31 Insurance 100
expense, ‘take away’ the
Insurance (E) amount incurred (from
the current asset).
Oct. 31 Prepaid insurance 100
Note that the Bank and GST Clearing accounts are unaffected, as at balance day no
cash has been exchanged, and no GST has been involved: the balance day adjustment
simply increases the expense (Insurance) and decreases the asset (Prepaid insurance).


As a result of the adjustment for the Insurance expense incurred:

Assets Decrease (Prepaid insurance) 100
Owner’s equity Decrease (Increase insurance expense decreases Net Profit) 100
Closing the ledger

Only after the ledger accounts have been adjusted – so that the expense account shows
the amount incurred in the current Period and the asset account shows the amount yet
to be incurred – are they ready to be closed, or balanced.
Figure 12.6 shows how the Prepaid insurance account would appear after it had
been balanced and the Insurance expense account after it had been closed to the Profit
and Loss Summary account:
Figure 12.6 General Ledger: After closing and balancing

General Ledger
Study tip Prepaid insurance (CA)
Oct. 1 Bank 1 200 Oct. 31 Insurance 100
A reminder that all
Balance 1 100
expense accounts are
1 200 1 200
closed in one General
Journal entry, with Nov. 1 Balance 1 100
each expense account
Insurance (E)
credited, and one debit
to the Profit and Loss Date Cross-reference Amount $ Date Cross-reference Amount $
Summary account. Oct. 31 Prepaid insurance 100 Oct. 31 Profit and Loss Summary 100
100 100
The Insurance account is reset to zero in readiness for the next Period, but the
balance of $1 100 left in the Prepaid insurance account ($1 200 paid less $100 incurred)
represents the amount unused, or yet to be consumed; or the amount that will be
incurred in a future Period. This is the new current asset balance.
Had the balance day adjustment not been recorded, the current asset Prepaid
insurance would have been overstated by $100, and the Insurance expense understated
by $100, meaning Net Profit and owner’s equity would be overstated by $100.
Instead, as a consequence of the balance day adjustment these items are reported
accurately, meaning Net Profit and the Balance Sheet are also accurate, and include all
the Relevant information that is capable of making a difference to decision-making.

1 Explain why a prepaid expense is classified as a current asset.
2 Explain the effect on the Accounting equation of a cash purchase of a prepaid
expense.
3 Show the General Journal entries necessary to record the balance day
adjustment when a prepaid expense is incurred.
4 Explain the effect on the Accounting equation of the balance day adjustment
when a prepaid expense is incurred.
5 Explain how a balance day adjustment for a prepaid expense which has been
incurred ensures Relevance in the reports.

12.3 Accrued expenses

Prepaid expenses are paid before they are consumed, but it is also likely that some
expenses will be paid after they are consumed. For example, at balance day there may
be wages owing to employees for work that has already been done, or electricity that
has been consumed but not paid.
accrued expense
Because this amount has been incurred in the current Period it must be added to the
a current liability that arises
expense amount. In addition, the amount owing should also be recorded as a liability, when an expense has been
with the amount still owing for an expense that has already been incurred called an incurred in the current Period
accrued expense. but has not yet been paid
On 23 August 2025, Mixwell Sports paid $1 500 (plus $150 GST) for electricity it Example
had used. By balance day on 31 August 2025 a further $300 of electricity had been
consumed but had not been paid (Memo 15).
BDA: Accrued expense
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Prior to making any balance day adjustments, expense accounts will only show the
amounts paid so the Electricity account of Mixwell Sports would appear as shown in
Figure 12.7:
Figure 12.7 General Ledger: Expense account (before BDA)

General Ledger
Electricity (E)
Aug. 23 Bank 1 500
However, before the accounts can be closed and reports can be prepared, the
accountant must ascertain whether any additional amounts have been incurred, but not
yet paid. If there are, these must be added to the expense accounts before the closing
entries are made.
• the extra amount incurred (but not yet paid) in the current Period is added to the
expense account and
• the amount owing (which will be paid in the next Period) is shown in the current
liability account – Accrued expense.
Recording the accrued expense

In this example, an extra $300 worth of electricity has been incurred, and this must
be added to the Electricity account by a debit entry. At the same time, the Accrued
electricity account must be credited to recognise the current liability for the amount still
owing to the electricity company.

Figure 12.8 General Journal: BDA – Accrued expense

General Journal
Aug. 31 Electricity 300
Accrued electricity 300
Balance day adjustment to record electricity incurred but
not yet paid (Memo 15)
After posting this General Journal entry, the General Ledger would appear as shown
in Figure 12.9:
Figure 12.9 General Ledger: BDA – Accrued expense

General Ledger
Electricity (E)
Aug. 23 Bank 1 500
31 Accrued electricity 300
Accrued electricity (CL)

Study tip Aug. 31 Electricity 300
As with the adjustment for the consumption of a prepaid expense, this adjustment
When adjusting an
does not change Bank, nor does it affect GST Clearing. Rather, it increases expenses
accrued expense, ‘add
(decreasing profit) and increases liabilities in the Balance Sheet.
on’ the extra amount
This example also illustrates the fact that an expense does not have to involve a
incurred (to the amount
already paid). decrease in Bank; in fact, there is no decrease in assets at all in this case. Rather, the
expense increases as a result of an increase in liabilities (Accrued electricity).

As a result of the balance day adjustment for the Accrued electricity:

Assets No effect
Liabilities Increase (Accrued electricity) 300
Owner’s equity Decrease (Increase Electricity expense decreases Net Profit) 300
Closing the ledger

For an accrued expense, the amount of the balance day adjustment ($300) is not the
total expense for the Period. Rather, it is simply the extra amount owing: the amount
that has been incurred but not yet paid. It is added to the amount paid to calculate
the total expense incurred for the Period, and it is this total expense incurred ($1 800)
which is closed to the Profit and Loss Summary account. However, the amount accrued
(owing) will be reported as a current liability in the Balance Sheet.

Figure 12.10 shows how the Electricity expense account would appear after it
had been closed to the Profit and Loss Summary account, and the Accrued electricity
account after it had been balanced:

General Ledger
Electricity (E)
Aug. 23 Bank 1 500 Aug. 31 Profit and Loss Summary 1 800
31 Accrued electricity 300
1 800 1 800

Aug. 31 Balance 300 Aug. 31 Electricity 300
300 300
Sept. 1 Balance 300 Study tip
Note how the amount closed to the Profit and Loss Summary account ($1 800) is
greater than the amount of the adjustment ($300), as the total expense incurred includes For an item to be
recognised as an
both the $1 500 paid, and the $300 still owing at the end of the Period.
expense, the definition
Had the balance day adjustment not been recorded, the Electricity expense would
requires an item to be
have been understated by $300, meaning Net Profit and owner’s equity would be
incurred; payment is not
overstated by $300, and the current liability Accrued electricity would have been necessary.
understated by $300.
Payment of accrued expenses in subsequent periods
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Sometime in the next Period, the amount owing as an accrued expense will be paid.
Therefore, the next time cash is paid to the supplier, we must recognise that while
some of the amount paid may represent an expense of the current Period, at least some
of the payment relates to the previous Period. In other words, some of the amount paid
reduces the liability for accrued expenses – expenses incurred and accrued last Period.
On 4 September 2025, Mixwell Sports paid $1 650 (including $150 GST) to the Example
electricity company (EFT Trans. 9077). (continued)
Recording the payment in a subsequent period

The $1 650 paid will decrease Bank and this must be recorded via a credit entry.
However, this is not all Electricity expense incurred in September 2025.
For a start, it includes $150 which must be debited to GST Clearing to decrease the
liability to the ATO. This leaves us with $1 500 that has been paid for electricity. But how
much relates to electricity that was consumed in September 2025?
Remember that on 31 August 2025 a balance day adjustment was made to record
$300 of electricity that had been incurred in August 2025 but had not yet been paid.
That adjustment meant that at 31 August 2025 $300 was owed for Accrued electricity.
When the payment is made on 4 September 2025, some of the $1 500 is being
used to pay off this earlier debt. That is, $300 is paid to decrease the Accrued electricity
liability, so only the remaining $1 200 represents Electricity expense incurred during
September 2025.
The payment of electricity on 4 September 2025 would be recorded in the General
Journal as shown in Figure 12.11:
Figure 12.11 General Journal: Payment in subsequent period

General Journal
Aug. 31 Accrued electricity 300
Electricity 1 200
GST Clearing 150
Bank 1 650
Payment of electricity bill for August / September 2025
(EFT Trans. 9077)
After posting the General Journal to the General Ledger, the accounts would appear
Figure 12.12 General Ledger: Payment in subsequent period

General Ledger
Sept. 4 Bank 300 Sept. 1 Balance 300
Electricity (E)
Sept. 4 Bank 1 200
GST Clearing (A/L)

Sept. 4 Bank 150 Sept. 1 Balance 2 400
Bank (A)
Sept. 1 Balance 6 500 Sept. 4 Accrued electricity / 1 650
Electricity / GST Clearing

As a result of the payment of Accrued electricity and Electricity:
Liabilities Decrease (Accrued electricity $300, GST Clearing $150) 450
Owner’s equity Decrease (Increase Electricity expense decreases Net Profit) 1 200
As was noted in Chapter 4, not all expenses are subject to GST, so when paying a
non-GST item in a subsequent period (such as Wages or Interest expense) it will not
be necessary to account for the GST. However, it is likely that it will still be necessary

to split the payment as part Accrued wages, part Wages expense; or as part Accrued
interest, part Interest expense.
Accrued expense versus Account Payable

An accrued expense occurs when an expense has been incurred, but the payment
has not yet been made. An Account Payable occurs when items are purchased, but
the payment has not been made. Given the obvious similarity, what is the difference?
When should an amount owing be recorded as an accrued expense? When should it be
recorded as an Account Payable?
To start with, accrued expenses must relate specifically to expenses. The amounts
must be owing for items that have already been incurred, rather than for assets. But,
more importantly, accrued expenses are not due for repayment at balance day, because
no invoice has been received. Accrued expenses occur when balance day falls before
an item has been paid, but also before it is due for payment. Thus, an accrued expense
will be verified not by an invoice, but by something like a memo. If an invoice has been
received, the transaction is simply a credit transaction and the amount owing should be
shown as Accounts Payable.

1 Explain why an accrued expense is classified as a current liability.
2 Show the General Journal entries necessary to record an accrued expense.
for an accrued expense.
4 Explain why the payment of an accrued expense in a subsequent period
requires the payment to be split in the General Journal.
5 Explain the effect on the Accounting equation of the payment of an accrued
expense in a subsequent period.
6 Distinguish between an accrued expense and Accounts Payable.

12.4 The Post-adjustment Trial Balance
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Pre-adjustment Trial
Balance The idea of preparing a Trial Balance was introduced in Chapter 3 as part of the process
a list of all General Ledger of recording in the General Ledger. Its function was to check that total debits equal total
accounts and their balances credits, thereby helping to detect errors in the recording process.
before balance day adjustments Technically, this should have been titled a Pre-adjustment Trial Balance, as it was
have been made
prepared before any balance day adjustments had been recorded. However, balance
Post-adjustment Trial day adjustments change the General Ledger accounts after the Trial Balance has already
Balance
been prepared; they increase certain expenses, decrease certain current assets, and
a list of all General Ledger
accounts and their balances increase certain current liabilities. This means it may be useful to prepare a Post-
after balance day adjustments adjustment Trial Balance, to check that even after the balance day adjustments have
have been made been made, the total debits equal the total credits.
Example Kingston Homewares has provided the following Pre-adjustment Trial Balance:
KINGSTON HOMEWARES
Pre-adjustment Trial Balance as at 30 June 2025
Inventory 34 000
Prepaid rent expense 6 000
Bank 1 000
Loan – Wonderbucks 45 000
Capital – Gemeika 29 000
Sales 101 000
Sales returns 1 000
Wages 20 000
Electricity 8 000
Advertising 4 000
Totals 195 000 195 000
Additional information as at 30 June 2025:

• Inventory loss $1 000
• Rent incurred $700
• Accrued wages $200

The entries to record these balance day adjustments in the General Journal (with the
narrations omitted) are shown in Figure 12.13 below:
Figure 12.13 General Journal: Balance day adjustments

General Journal
June 30 Inventory loss 1 000
Inventory 1 000
Rent expense 700
Prepaid rent expense 700
Wages 200
Accrued wages 200
After these balance day adjustments were posted to the ledger accounts, a Post-
adjustment Trial Balance would be prepared, as is shown in Figure 12.14:
Figure 12.14 Post-adjustment Trial Balance

KINGSTON HOMEWARES
Post-adjustment Trial Balance as at 30 June 2025
Inventory 33 000
Bank 1 000
Loan – Wonderbucks 45 000
Capital – Gemeika 29 000
Sales 101 000
Sales returns 1 000
Wages 20 200
Electricity 8 000
Advertising 4 000
Inventory loss 1 000
Rent expense 700
Accrued wages 200
Totals 195 200 195 200
Obviously, the balance day adjustments were posted correctly – at least in terms of
debits matching credits – because this Post-adjustment Trial Balance still balances (at a
new total of $195 200).
Preparing the Post-adjustment Trial Balance also assists in ensuring that the closing
entries and the Income Statement use the correct amounts: the adjusted figures for
the amounts incurred rather than the unadjusted figures, which did not account for any
balance day adjustments. This ensures that the reports provide information that is both
Relevant (as it is capable of making a difference to decision-making) and also a Faithful
representation of the firm’s performance and position (as the information is complete
and accurate).

Indeed, it could be argued that deliberately excluding this information would be

unethical, as the reports would not provide an accurate and complete representation of
the firm’s activities and might be misleading to the users of those reports.

1 Explain the difference between a Pre-adjustment Trial Balance and a Post-
adjustment Trial Balance.
2 Explain how a Post-adjustment Trial Balance can assist in the preparation of an
accurate Income Statement.
3 Explain how the inclusion of balance day adjustments upholds both Relevance
and Faithful representation.
Ethical 4 Explain the ethical reasons for including using the Post-adjustment Trial
c onsiderations Balance to prepare financial reports.
Where have we been?

• Balance day adjustments are made so that an accurate profit can be calculated by comparing revenue
• Balance day adjustments may be necessary for:
– Inventory losses and gains (covered in Chapter 8)
– Prepaid expenses and Accrued expenses (this chapter)
– Depreciation (Chapters 13 and 14)
– Bad debts (Chapter 15)
– Unearned revenue and Accrued revenue (Chapter 16)
• Each balance day adjustment for an expense increases the expense, thus decreasing profit and owner’s
equity.
• Adjustments for prepaid expenses decrease assets; adjustments for accrued expenses increase liabilities.
• Balance day adjustments have no effect on cash but will change Net Profit and the items in the Balance
Sheet.
• A Post-adjustment Trial Balance should be prepared after the balance day adjustments have been posted to
the ledger to check that total debits still equal total credits.

Exercises
Please note: asterisks indicate that an answer for that question is available in the selected answers section at the end of this
book.

Prepaid expense
On 1 March 2025, Dom’s Large Goods paid $6 000 (plus $600 GST) to cover the next six months’ rent (Cheque
34). The firm closes its ledger accounts and prepares its financial reports on 30 June each year and on 30 June
2025 the accountant requested that this be done (Memo 51).
Required
a Record Cheque 34 in the General Journal of Dom’s Large Goods.
b Referring to one Accounting assumption, explain why some of the rent paid should be reported as an
expense for the year ending 30 June 2025.
c Calculate Rent expense for the year ending 30 June 2025.
d Record the balance day adjustment for Rent expense for the year ending 30 June 2025 in the General
Journal of Dom’s Large Goods.
e Explain the effect of the adjustment for Rent expense on the Accounting equation of Dom’s Large
Goods.
f Show how the Rent expense and Prepaid rent expense accounts would appear in the General Ledger of
Dom’s Large Goods as at 30 June 2025 after all closing and balancing entries had been made.

Prepaid expense
On 11 February 2025, Ronnie’s Car Parts paid $300 (plus GST) for office supplies (Cheque 153).
On 28 February 2025, $60 worth of office supplies was still on hand (Memo 84).
Required
a Record the payment for office supplies in the General Journal of Ronnie’s Car Parts.
b Calculate Office supplies expense for February 2025.
c Show the General Journal entries necessary to record Office supplies expense for February 2025.
d Show how the Office supplies expense and Prepaid office supplies accounts would appear in the
General Ledger of Ronnie’s Car Parts as at 28 February 2025 after all closing and balancing entries had
been made.
e Show how Prepaid office supplies would be reported in the Balance Sheet of Ronnie’s Car Parts as at
28 February 2025.


Prepaid expense
Maxwell’s Shoes presented the following extract from its Balance Sheet as at 31 March 2025:
Current assets: Prepaid insurance $1 800
The yearly insurance premium was paid in advance on 1 January 2025. The business prepares reports
monthly, and the next balance day occurs on 30 April 2025.
Required
a Referring to one Qualitative characteristic, explain why balance day adjustments are necessary.
b Calculate Insurance expense for April 2025.
c Record Insurance expense for April 2025 in the General Journal of Maxwell’s Shoes. A narration is not
required.
d State the effect on the Accounting equation of Maxwell’s Shoes if the adjustment for Insurance expense
was not made.
e Show how Prepaid insurance would be reported in the Balance Sheet of Maxwell’s Shoes as at
31 July 2025.

Prepaid expense
On 27 June 2025, Halifax Furniture paid $2 200 (including GST) for advertising in Furniture Trader magazine
(EFT Trans. 307). The advertisements will appear once a month for five months, with the first advertisement
appearing in July 2025 (Memo 82).
Required
a Record Cheque 307 in the General Journal of Halifax Furniture.
b Explain how the amount paid for advertising would be reported in the Balance Sheet of Halifax Furniture
as at 30 June 2025.
c Calculate Advertising expense for the quarter ended 30 September 2025.
d Record the balance day adjustment for Advertising expense for the quarter ended 30 September 2025 in
the General Journal of Halifax Furniture.
e Show how the Advertising expense and Prepaid advertising accounts would appear in the General
Ledger of Halifax Furniture as at 30 September 2025 after all closing and balancing entries had been
made.
f Explain the effect on the Net Profit of Halifax Furniture for the quarter ended 30 September 2025 if the
adjustment for Advertising expense was not made.


Prepaid expense
During 2024, Clive Rap opened his own music shop called Hard MC. On 31 August 2024, Clive paid $1 650
(including GST) to cover rent for the six months from 1 September 2024 to 28 February 2025 (Cheque 233).
During December 2024, the firm was informed that, beginning in March 2025, rent would increase, so on
28 February 2025 the firm paid $1 800 (plus $180 GST) for rent for the six months from 1 March to 31 August
2025 (Cheque 297). The firm prepares its reports on 30 June each year.
Required
a Calculate Rent paid for the year ended 30 June 2025.
b Calculate Rent expense for the year ended 30 June 2025.
c Referring to your answers to parts ‘a’ and ‘b’, explain why Rent paid and Rent expense are different
amounts.
d Show the General Journal entries necessary to record Rent expense for the year ended 30 June 2025.
e Show how the Rent expense and Prepaid rent expense accounts would appear in the General Ledger of
Hard MC as at 30 June 2025 after all closing and balancing entries had been made.
f Explain the effect on the Accounting equation of Hard MC if the adjustment for Rent expense was not
made.

Accrued expense
During 2025, Strong Arm Security Devices paid $11 000 (including $1 000 GST) for advertising, but as at
31 December 2025 a further $3 000 was still owing (Memo 44).
Required
a Calculate Advertising expense for 2025.
b Referring to one Qualitative characteristic, explain why the advertising owing should be included in the
Advertising expense for 2025. Show the General Journal entries necessary to record advertising owing
as at 31 December 2025.
c State the effect of the adjustment for advertising owing on the Accounting equation of Strong Arm
Security Devices.
d Show how the Advertising expense and Accrued advertising accounts would appear in the General
Ledger of Strong Arm Security Devices as at 31 December 2025 after all closing and balancing entries
had been made.
e Explain how Accrued advertising would be reported in the Balance Sheet of Strong Arm Security
Devices as at 31 December 2025.


Accrued expense
After a series of break-ins, Jim’s Gems employed a security guard on 12 June 2025. The security guard works
seven days per week and is paid wages of $1 260 per fortnight. Wages were last paid to cover the fortnight
from 12 June to 25 June 2025 inclusive (Memo 17).
Required
a Calculate Accrued wages as at 30 June 2025.
b Record Accrued wages as at 30 June 2025 in the General Journal of Jim’s Gems.
c Show how the Wages and Accrued wages accounts would appear in the General Ledger of Jim’s Gem’s
as at 30 June 2025 after all closing and balancing entries had been made.
d Record the payment of wages on 9 July 2025 (EFT Trans. 236) in the General Journal of Jim’s Gems.
e Referring to one Accounting assumption, explain why only some of the wages paid on 9 July 2025
should be reported as an expense for July 2025.

Accrued expense
On 1 November 2025, Millie Hall borrowed $24 000 to set up her business, Hall Antiques. It is an interest-only
loan, due to be paid back in five years’ time. Interest is calculated at 8% p.a. and is payable in two separate
payments on 30 April and 31 October each year.
Required
a Calculate Interest incurred for the year ended 30 June 2025.
b Show the General Journal entries necessary to record Accrued interest expense as at 30 June 2025. A
narration is not required.
c Show how the Interest expense and Accrued interest expense accounts would appear in the General
Ledger of Hall Antiques as at 30 June 2025 after all closing and balancing entries had been made.
d Explain the effect on the Net Profit of Hall Antiques for the year ended 30 June 2025 if the adjustment
for Accrued interest expense was not made.
e Record the payment of interest on 31 October 2025 in the General Journal of Hall Antiques. A narration
is not required.
f State the effect on the Accounting equation of Hall Antiques of the payment of interest on 31 October
2025.


Accrued expense
During April 2025, Bright Lights paid electricity worth $4 400 (including GST), but incurred electricity worth
$4 600 (Memo 31). On 14 May 2025, the firm paid a further $2 500 (plus GST) for electricity (Cheque 196).
Required
a Calculate Accrued electricity as at 30 April 2025.
b Show the General Journal entries to record Accrued electricity as at 30 April 2025.
c Show how the Electricity expense and Accrued electricity accounts would appear in the General Ledger
of Bright Lights as at 30 April 2025 after all closing and balancing entries had been made.
d State the effect on the Accounting equation of Bright Lights if the balance day adjustment for Accrued
electricity was not recorded.
e Record Cheque 196 in the General Journal of Bright Lights.

Accrued expense
As at 31 July 2025, the General Ledger of Brooke Irrigation Supplies showed Accrued cleaning expenses of
$450. On 5 August 2025, the business paid $1 870 (including GST) for cleaning (Cheque 201). This was the
only payment for cleaning during August 2025. As at 31 August 2025, $510 was owing for cleaning expenses
(Memo 12).
Required
a Record Cheque 201 in the General Journal of Brooke Irrigation Supplies.
b Calculate Cleaning expenses for August 2025.
c Record the balance day adjustment for Accrued cleaning expenses as at 31 August 2025 in the General
Journal of Brooke Irrigation Supplies.
d Complete the Accrued cleaning expenses account in the General Ledger of Brooke Irrigation Supplies as
at 31 August 2025.
e Explain the effect on the Accounting equation of Brooke Irrigation Supplies if the balance day adjustment
for accrued cleaning was not recorded.
f State one Accounting assumption that would be breached if the adjustment for Accrued cleaning
expenses was not made. Justify your answer.


Reporting prepaid and accrued expenses
Pickford Paints has provided the following Pre-adjustment Trial Balance as at 30 June 2025:
PICKFORD PAINTS
Advertising 3 850
Bank 1 050
Capital – Pickford 27 250
Drawings 4 300
Freight in 600
GST Clearing 120
Loan – Bank of Wilco 40 000
Sales 96 500
Sales returns 700
Inventory 45 600
Wages 29 600
Totals 194 470 194 470
• The Loan – Bank of Wilco is repayable at $6 000 p.a.
• A physical inventory count on 30 June 2025 showed inventory on hand worth $45 200.
• Monthly rent expense is $900.
• $1 200 wages remained owing to employees at 30 June 2025.
• Reports are prepared monthly.
Required
a Record the balance day adjustments in the General Journal of Pickford Paints on 30 June 2025.
* b Prepare a Post-adjustment Trial Balance for Pickford Paints as at 30 June 2025.
c Show the General Journal entries necessary to close the ledger, and transfer drawings to the Capital
account. Narrations are not required.
d Referring to one Accounting assumption, explain the purpose of making balance day adjustments.
* e Prepare an Income Statement for Pickford Paints for June 2025.
f Explain one action Pickford Paints could take to improve the effectiveness of its advertising.
* g Prepare a classified Balance Sheet for Pickford Paints as at 30 June 2025.
h Explain how the use of a Post-adjustment Trial Balance ensures Relevance in the reports.


Reporting prepaid and accrued expenses
Maranelli Sports has provided the following Pre-adjustment Trial Balance as at 31 December 2025:
MARANELLI SPORTS
Pre-adjustment Trial Balance as at 31 December 2025
Advertising 8 200
Bank 2 300
Capital – Maranelli 85 430
Drawings 31 000
Fittings and fixtures 26 800
GST Clearing 320
Interest expense 1 800
Inventory 32 000
Mortgage – HH Finance 180 000
Premises 240 000
Prepaid insurance 1 500
Sales 191 600
Sales returns 1 200
Wages 27 000
Totals 478 530 478 530
• A physical inventory count on 31 December 2025 showed inventory on hand worth $31 700.
• As at 31 December 2025, Prepaid insurance amounted to $600.
• A lump sum repayment of $12 000 is made on the principal of the Mortgage – HH Finance on 1 January
each year. Interest is charged at 6% p.a., and payable on 28 February and 31 August each year.
• The ledger was last closed and reports were prepared on 30 June 2025.
Required
a Show the General Journal entries necessary to record the balance day adjustments on
31 December 2025. Narrations are not required.
* b Prepare a Post-adjustment Trial Balance for Maranelli Sports as at 31 December 2025.
c Show the General Journal entries necessary to close the ledger and transfer
drawings to the Capital account. Narrations are not required.
d Explain how balance day adjustments ensure the Income Statement reflects the Accrual basis assumption.
* e Prepare an Income Statement for Maranelli Sports for the six months ended 31 December 2025.
f Assess the sales mark-up applied by Maranelli Sports for the six months ended 31 December 2025.
g Explain two strategies Maranellis Sports could implement to improve expense control.
* h Prepare a classified Balance Sheet for Maranelli Sports as at 31 December 2025.
i Explain why it would be unethical to deliberately exclude the effects of balance Ethical
day adjustments on the Balance Sheet. c
onsiderations


Reporting for prepaid and accrued expenses
Alannah Fashions has provided the following Pre-adjustment Trial Balance as at 31 March 2025:
ALANNAH FASHIONS
Pre-adjustment Trial Balance as at 31 March 2025
Advertising 1 750
Bank 4 100
Capital – Alannah 48 350
Drawings 21 000
GST Clearing 400
Interest expense 90
Inventory 39 000
Loan – FinCo. 15 000
Prepaid office supplies 180
Prepaid rent 6 000
Sales 62 400
Sales returns 400
Wages 9 000
Totals 170 760 170 760
• The Loan – Finco is an interest-only loan, due for repayment on 31 December 2030.
• As at 1 March 2025, there was $12 000 inventory on hand, but Alannah decided to increase the range of
clothing the business had for sale.
• A physical inventory count on 31 March 2025 showed inventory on hand worth $41 200, but Alannah
decided to write this down to $40 400.
• Yearly rent is paid on 1 August each year.
• On 28 February 2025, Accrued wages was $310. As at 31 March 2025, $360 was owing to employees in
unpaid wages. The next payment of $1 600 for wages is due on 2 April 2025.
• At 31 March 2025, $70 of office supplies were still on hand.
Required
a Given that reports are prepared monthly, show the General Journal entries to record the balance day
adjustments on 31 March 2025. Narrations are not required.
* b Prepare a Post-adjustment Trial Balance for Alannah Fashions as at 31 March 2025.
c Show the General Journal entries necessary to close the ledger, and transfer Drawings to the Capital
account. Narrations are not required.
d Complete the Profit and Loss Summary account.
* e Prepare an Income Statement for Alannah Fashions for March 2025.
f State two reasons why it may have been necessary to write down the inventory.
g Calculate the total cash paid to employees during March 2025.
* h Prepare a classified Balance Sheet for Alannah Fashions as at 31 March 2025.
i Referring to the information supplied, suggest one reason why the GST Clearing account has a debit
balance. Justify your answer.
j Record the payment of wages on 2 April 2025 in the General Journal. A narration is not required.
k Explain the effect of the payment on 2 April 2025 on the Accounting equation of Alannah Fashions.

Chapter 13
Accounting for non-current assets 1

After completing this chapter, you should be able to: • explain the effect of depreciation expense on the
• identify the characteristics of a depreciable non- Accounting equation
current asset • define the term ‘cost’ as it refers to non-current
• define depreciation, and other related terms assets
• explain the purpose of depreciation, and its • record the purchase of a non-current asset in the
relationship to the Accounting assumptions and General Journal and General Ledger
Qualitative characteristics • record the receipt of a loan to purchase a non-
• calculate depreciation expense using the straight- current asset in the General Journal and General
line method Ledger
• record depreciation expense in the General Journal • report for the cash purchase of a non-current asset
and General Ledger and receipt of a loan in the Income Statement, Cash
• report for depreciation expense in the Income Flow Statement and Balance Sheet.
Statement and Balance Sheet
Key terms
After completing this chapter, you should be familiar • Residual value (RV)
with the following terms: • Useful life (Life)
• depreciable asset • depreciable value
• finite life • Accumulated depreciation
• depreciation • Carrying value
• depreciation expense • cost of a non-current asset.
• Historical cost (HC)

13.1 Non-current assets

In order to earn revenue, a business must combine a number of key variables, including
products that are in demand; selling prices that the market is willing to pay; sales staff
who know about their products and the needs of their customers; and an advertising
strategy that communicates this effectively.
Similarly, we have already discussed the importance of effective management of
inventory, Accounts Receivable and Accounts Payable to ensure profit is earned and
debts are paid. All of these are elements of success that demand the attention of the
owner.
However, the infrastructure that supports actions in these areas can sometimes be
overlooked. The premises from which the business operates, the shelving on which its
products are displayed, the state of the vehicles it uses to transport its staff and goods,
and even the office equipment which supports its administration all contribute to the
firm’s success or failure.
This chapter considers these non-current assets – the economic resources controlled
by the business which are not held for resale but rather are used for a number of years,
providing economic benefits for more than the next 12 months.
Assets and expenses

There seems to be a (misguided) school of thought that looks upon assets as ‘good’
because they help companies to earn profit, but expenses as ‘bad’ because they reduce
that profit. But if this were the case, why would a business have expenses at all? Why
put up with paying wages, rent, advertising or electricity expenses when all they do is
lower profit?
The simple answer is that, just like assets, these expenses are necessary –
necessary to help earn revenue and generate profit. A business that had no employees,
no premises, no advertising and no electricity could simply not do its job. In this way,
assets and expenses have something in common: they both assist in the earning of
revenue.
However, there is a key difference between an asset and an expense, and this is an
application of the Period assumption: an asset will provide a benefit to future Periods,
while an expense is incurred (consumed) within a particular Period.
Depreciable assets
Items such as vehicles, office equipment and shop fittings are controlled by the
business and will provide an economic benefit for more than 12 months, and so should
be recorded as non-current assets when they are purchased.
At the same time, just because assets such as these will last for more than 12 months
does not mean they will last forever. As they age they wear out, and as their life expires
depreciable asset so too does their ability to earn revenue. This means they are depreciable assets – they
a non-current asset that have a finite life and will be useful for a fixed period of time, but at some point, in the
has a finite life and must be future, they will no longer be able to earn revenue.
depreciated over its life
If depreciable assets will not last forever, it means that their value is in fact being
finite life ‘consumed’, but this consumption is happening over time. (We may not be able to see
the limited period of time this consumption but that does not mean that it is not happening). This means that every
(usually measured in years or year part of the value of the asset is consumed, until – at the end of its life – the asset’s
sometimes in units of use) for
revenue-earning capacity is wholly consumed, and it is unable to earn revenue any longer.
which a non-current asset will
exist Under the Accrual basis assumption that part of the asset’s value that is consumed
each year should be recognised as an expense incurred, and the process of calculating
how much value has been incurred in each Period is called depreciation.

C hapter 13 Accounting for non - current assets 1 347
(Assets that have an infinite or never-ending life – where the economic benefit will
continue forever – are not depreciable assets, as they may be used, but are never used
up or consumed. This may apply to an asset such as land, but few other items.)
Depreciation of non-current assets

Although frequently used to describe the expense, the term depreciation actually refers
to the process – the Accounting procedure – that creates depreciation expense.
Depreciation – the allocation of the cost of a non-current asset over its Useful life – depreciation
is an attempt to calculate how much of the asset’s value has been incurred (consumed) the allocation of the cost of
in each Period of its life. It therefore spreads out or allocates the cost of the asset over a non-current asset over its
Useful life
the years in which it is useful for earning revenue, rather than treating all of the cost as
an expense in any one year.
As a result of this process, depreciation expense is created representing that part depreciation expense
of the cost or value of a non-current asset that has been incurred in the current Period. that part of the cost of a non-
current asset that has been
incurred in the current Period
Depreciation does not involve any payment of cash. Indeed, the cash payment relating
to each non-current asset will be recorded only at the time the asset is purchased.
However, depreciation does affect the Income Statement and the Balance Sheet.
By calculating the expense incurred in the current Period, the process of depreciation
upholds the Accrual basis assumption, allowing profit to be calculated accurately by
matching revenues earned and against expenses incurred in a particular Period.
Depreciation does this by recognising as an expense only that part of the cost of a non-
current asset that is incurred (consumed) in the current Period.
This will also ensure that the Income Statement upholds Relevance by including all
information that may be capable of making a difference to decision-making, as it will
show the expense incurred in the current Period. The Balance Sheet will also show a
more Relevant valuation of the vehicle (more on this in the following pages).
On 1 January 2025, Lane Grove Furniture paid $32 000 (plus $3 200 GST) for a Example
new delivery vehicle. It is expected that it will be kept for five years.
Let us deal first with the GST which is excluded from our consideration of depreciation
because it is not included in the cost of the vehicle; it actually represents a reduction in Study tip
the GST liability owed to the ATO.
But what about the vehicle itself?
If the GST Clearing
At purchase date (1 January 2025), the vehicle is clearly a non-current asset. The
account has a debit
vehicle is an economic resource controlled by the firm, and the entire $32 000 is a future balance, GST paid will
economic benefit (in terms of the deliveries it can do) which will exist for more than 12 increase this asset,
months (until the vehicle can no longer make deliveries). rather than decrease a
By 31 December 2025, the situation will have changed. Assuming that the business liability.
still has the vehicle, it has not been entirely consumed so the entire $32 000 should
not be reported as an expense for the year ended 31 December 2025. Indeed, the
vehicle will still be available to provide an economic benefit in future Periods (2026 and
onwards), and so should still be reported as a non-current asset.
However, the vehicle is a depreciable asset with a finite life: slowly but surely, the
productive capacity of the vehicle will be consumed. This will not happen in one Period,
but rather over a number of Periods, so part of the asset’s value should be reported as
an expense for the year ended 31 December 2025, and this amount will be calculated
by the process of depreciation.

The remainder – the part yet to be incurred (consumed) – should be reported as a

non-current asset; that is, $32 000 less the amount consumed so far.

1 Define the term non-current asset and list three examples of non-current assets.
2 Explain what assets and expenses have in common.
3 Referring to the Going concern assumption, explain the key difference
between an asset and an expense.
4 Identify the characteristics of a depreciable non-current asset.
5 Explain why it is not necessary to calculate depreciation for assets such as land.
6 Define the terms:
• depreciation
• depreciation expense.
7 Referring to the Accrual basis assumption, explain the purpose of depreciating
non-current assets.
8 Explain the effect of depreciation on a firm’s bank balance.
9 Explain how depreciation supports Relevance in the financial reports.
10 Explain why GST is excluded from the consideration of depreciation.
13.2 C
alculating depreciation expense: straight-line
method
There are a number of different ways to calculate depreciation expense, each of which
makes different assumptions about the way the asset contributes to revenue, and
therefore the way the cost of the asset is incurred.
Straight-line method
The straight-line method of calculating depreciation expense assumes that non-current
assets contribute evenly to revenue, doing the same job in the last year of their life as
they did in their first. This would be most evident in assets such as fixtures and fittings
or office furniture, which perform the same function, and therefore make the same
contribution to revenue earning, year after year.
As a result, this method assumes that the value of a non-current asset is incurred
evenly over its life and allocates the same depreciation expense every year. (If this
depreciation expense was plotted on a graph the line would be a straight line, giving the
method its name.)
Depreciation expense under the straight-line method is calculated as shown in
Figure 13.1:
Historical cost (HC) Figure 13.1 Formula: Depreciation expense using Straight-line method
the original purchase price of
the non-current asset
Historical cost (HC) – Residual value (RV)
Residual value (RV) Depreciation expense =
Useful life (Life)
the estimated value of the
non-current asset at the end of = $ per annum
its useful life
Useful life (Life) The basic premise is to divide the Historical cost (HC) of the asset by the number
the estimated period of time
of years for which it is used (Life), thus determining how much of that cost is incurred
for which the non-current asset
will be used by the current per year.
entity to earn revenue (usually (Because each non-current depreciable asset is different in terms of its Useful life
measured in years) (Life) and Residual value (RV), each must be depreciated individually.)
On 1 January 2025, Big Cycles purchased office furniture for $5 000 (plus $500 Example
GST). The furniture will be kept for three years, at which time it will have an
estimated Residual value of $800.
This office furniture will earn revenue for three years, so its cost must be allocated over
those three years. Figure 13.2 shows the calculation of Depreciation of Office furniture:
Figure 13.2 Calculation: Depreciation expense using Straight-line method
HC – RV
Depreciation expense =
Life
$5 000 – $800
=
3 years
$4 200
=
3 years
=
$1 400 per annum
In this example, the depreciation process calculates that the business is consuming,
and therefore incurring, $1 400 worth of the furniture’s value each year. This amount
would be recorded as an expense in the Income Statement and would also decrease
the value at which the furniture is valued in the Balance Sheet.
Depreciable value
If the business plans to use the asset until it is utterly worthless, then the Residual value
will simply be zero, and the entire cost of the asset will be incurred over the life of the
asset by the business.
However, the business may dispose of the asset while it still has some value. In
this case, the Residual value must be deducted from the Historical cost, because this is
the amount that will not be incurred by the current business but by another Accounting
entity. The amount calculated by deducting Residual value from Historical cost (in the
top line of the equation) is known as the depreciable value – the total value of the asset depreciable value
that will be consumed by the current owner/entity and must be allocated as depreciation the total value of the asset that
expense over its Useful life. will be consumed by the current
entity, and so must be allocated
In this example, $800 worth of Residual value will still exist when Big Cycles is
as depreciation expense over
finished with the office furniture (and will be consumed by the next owner), so although its useful life
the asset was purchased for $5 000, only $4 200 will be consumed by Big Cycles.
Time or use?
Note also that the straight-line method does not depreciate the asset more or less
depending on use; a desk does not deteriorate any faster or slower depending on how
long someone is sitting there. In fact, the straight-line method assumes that the asset
is consumed over time, not according to use, and this is reflected in the formula which
uses ‘Useful life’ (measured in years) rather than some measure of use.
Use of estimates
One of the key issues in calculating depreciation expense using the straight-line method
is estimating the asset’s Residual value and Useful life. Without these estimates,
depreciation expense cannot be calculated, but the very fact that Residual value and
Useful life are estimates raises questions about the extent to which the reports can
claim to provide a Faithful representation of the firm’s performance and position.
However, there are two reasons why non-current assets must still be depreciated.
First, depreciation ensures that the Income Statement includes Relevant information
that may affect decision-making about profit, by showing the expense related to non-
current assets that has been incurred in the current Period. Put simply, to omit this
information would undermine decision-making.
Similarly, by showing Accumulated depreciation in the Balance Sheet, it ensures that
assets are shown at their Carrying value, which is vital for decision-making about their
replacement. (This will be discussed in detail later in this chapter.)
Further, even though it is difficult to Verify the Residual value and Useful life, and
therefore the exact amount of depreciation expense, it remains true that reporting no
depreciation expense would mean an even less Faithful representation of the firm’s
performance. That is, the depreciation expense calculated using estimates of Residual
value and Useful life may not be correct, but it is less incorrect than reporting no
depreciation expense at all. As a result, depreciation based on estimates still provides a
more Faithful representation than leaving out depreciation altogether.

1 Explain the assumption about how assets contribute to revenue that underlies
the straight-line method of depreciation.
2 Show the formula for calculating depreciation expense using the straight-line
method.
• Historical cost
• Residual value
• Useful life.
4 Explain why each non-current asset must be depreciated individually.
5 Referring to one Accounting assumption, explain why Residual value is
deducted from Historical cost when calculating depreciation expense using the
straight-line method.
6 Explain why depreciation may be said to undermine the Faithful representation
of the reports.
7 Explain how depreciation ensures Relevance in the reports.
8 Explain how depreciation contributes to the Faithful representation of the
reports.

13.3 Calculation issues: straight-line method

The rate of depreciation
The formula used so far calculates the amount of depreciation expense expressed in
dollar terms, but depreciation can also be expressed as a rate or percentage of the
Historical cost.
The formula to calculate the rate of depreciation is shown in Figure 13.3:
Figure 13.3 Formula: Depreciation rate
Depreciation expense
Depreciation rate = ×100
Historical cost
= % per annum
Using the example regarding the office furniture, the depreciation rate would be
calculated as shown in Figure 13.4:
Figure 13.4 Calculation: Depreciation rate
Depreciation rate = × 100
Historical cost
$1 400
= × 100
$5 000
= 28% per annum
This means 28% per annum of the asset’s cost will be consumed each year for the
three years of its life.
The more mathematically aware readers may at this point be a little puzzled: 28%
for three years means only 84% of the asset’s cost will be consumed (28% × 3 years
= 84%). What happens to the remaining 16% of the cost? Why is it not allocated as
depreciation expense?
The answer is that the Residual value accounts for the remaining $800 (or 16% ×
$5 000), which is not allocated as a depreciation expense as it will not be incurred by Big
Cycles, but by a different entity when it takes control of the asset.
Calculating depreciation using the rate

In cases where the rate of depreciation is given, the depreciation expense (in dollar
terms) can be calculated by simply multiplying the rate by the Historical cost as is shown
in Figure 13.5:
Figure 13.5 Formula: Depreciation expense using the rate
Depreciation expense = Historical cost × Depreciation rate
= $ per annum
Using the formula or the rate to calculate depreciation expense will produce exactly
the same answer; the choice of method depends only on the information available.

Depreciating of a non-current asset for less than a year

Because the life of the asset is usually measured in years, both formulae (using RV
and Life, or just the Rate) calculate depreciation expense in terms of amount per year.
However, if by balance day the firm has had control of the asset for less than a year, the
depreciation expense figure will need to be applied on a pro-rata basis; if the business
has had the asset for only one month, then only one month’s worth of depreciation
expense (1/12 of a year) should be charged as an expense.
Example On 1 March 2025, Carlton Clothing purchased shop fittings for $9 000 (plus $900
GST). The shop fittings are to be depreciated at 15% p.a. Balance day is 30 June
2016.
Depreciation expense for the year would be calculated as shown in Figure 13.6:
Study tip
Figure 13.6 Calculation: Depreciation expense using the rate for one year
Pay very careful attention Depreciation expense = Historical cost × Depreciation rate

to the date on which
= $9 000 × 15% p.a.
the asset is acquired,
and the balance day, as = $1 350 per annum
this will determine how
many months’ worth of However, this vehicle was purchased on 1 March 2025, so at balance day (30 June
depreciation expense
2025) the vehicle had been under the control of the business for only four months (March,
need to be applied.
April, May and June 2025). As a result, only four months’ worth of depreciation should be
charged as an expense for the period ending 30 June 2025, as is shown in Figure 13.7:
Figure 13.7 Calculation: Depreciation expense using the rate for less than a year
Study tip Depreciation expense = Depreciation expense p.a. × Fraction of year

= $1 350 per annum × 4/12 months
= $450
Rather than multiply by
fractions, such as 1/4 The depreciation expense for the four months from purchase until balance day is
or 1/2, it can be safer to $450, and only this amount should be reported in the Income Statement for the year
multiply by the number ended 30 June 2025. The following year, the firm will have control of the vehicle for the
of months out of 12; for
full 12 months, and so for the year ended 30 June 2026 depreciation expense should
example, 3/12 or 6/12.
be reported as $1 350.
For example, how many
months is 1/3 of a year?
(Did you think three? The Review questions 13.3
answer is four!) 1 Show the formula for calculating the rate of depreciation.
2 Show the formula for calculating depreciation expense using the rate of
depreciation.
3 Explain why calculating depreciation expense using the rate may not allocate
the entire cost of a non-current asset over its life.
4 Referring to one Accounting assumption, explain why it is not always accurate
to report depreciation expense per annum.
5 Explain the process for calculating depreciation expense when the firm has
had control of the asset for less than a year.

13.4 Recording depreciation
Source
documents
As was noted earlier, depreciation is a balance day adjustment. As a result, it is recorded

in the General Journal on balance day – at the end of the Period – in common with other
balance day adjustments like Inventory loss, Prepaid rent which has been incurred or
Accrued wages.
On 1 January 2025, Mixwell Paints purchased a new van for $32 000 plus Example
$3 200 GST. As at 31 December 2025 (balance day), depreciation on the van had
been calculated as $4 800 per year (Memo 51).
Depreciation calculates that part of the cost of a non-current asset that has been
incurred in the current Period. This amount would be recorded by debiting a new
expense account called Depreciation of Van.
At the same time, depreciation expense also decreases the value at which the
asset is reported in the Balance Sheet. After all, the non-current asset is an economic
resource, but by depreciating the asset we are recognising that some of the value of
this resource has now been consumed. A reduction in the value of an asset would
normally be recorded as a credit entry, but rather than credit the asset account directly,
the credit entry is made to a new account called Accumulated depreciation of Van. This
account is a negative asset account.
Whereas Depreciation expense refers to the amount incurred in the current Period,
Accumulated depreciation refers to the amounts of depreciation expense that have Accumulated depreciation
accumulated (or built up) over the life of the asset so far. Accumulated depreciation will the total value of a non-current
grow every year as the depreciation expense for each Period is added to it. asset that has been incurred
over its life thus far
Figure 13.8 shows how this balance day adjustment for depreciation expense would
be recorded in the General Journal:
Figure 13.8 General Journal: Depreciation expense
General Journal
Dec. 31 Depreciation of Van 4 800
Accumulated depreciation of Van 4 800
Yearly depreciation on van – straight-line method (Memo 51)
Note that the accounts are titled ‘Depreciation of Van’ and ‘Accumulated depreciation
of Van’ rather than just ‘Depreciation’ or ‘Accumulated depreciation’. Given that most
businesses will depreciate more than one non-current asset, it is imperative to identify
precisely which asset is being depreciated.

The General Journal entry in Figure 13.8 would be posted to the General Ledger as
Figure 13.9 General Ledger: Depreciation expense

General Ledger
Van (A)
Study tip Jan. 1 Bank 32 000
Depreciation of Van (E)

Depreciation is an
Dec. 31 Accum. dep. of Van 4 800
area where intelligent
abbreviations can be Accumulated depreciation of Van (–A)
used. Date Cross-reference Amount $ Date Cross-reference Amount $
Dec. 31 Depreciation of Van 4 800
Note that as a result of recording the balance day adjustment for depreciation expense
there is no change to the actual Van account – it continues to be shown in the General
Ledger at its original purchase price of $32 000 which is Verifiable and, as a consequence,
provides a Faithful representation of its value at the time it was purchased.

The balance day adjustment for depreciation expense has the following effect on the

Assets Decrease (Increase Accumulated depreciation of Van) 4 800
Owner’s equity Decrease (Depreciation of Van expense decreases Net Profit) 4 800
Closing and balancing the ledger

As an expense, the Depreciation of Van account must be closed to the Profit and Loss
Summary account at the end of each Period. In fact, it will open and close on the very same
day, leaving it with a zero balance at the end of the Period. Accumulated depreciation of
Van, on the other hand, is a negative asset and therefore an ongoing account; it will be
balanced at the end of the Period, with its balance carried forward to the next.
Figure 13.10 shows how the General Ledger accounts would appear after closing
and balancing:

General Ledger
Dec. 31 Accum. dep. of Van 4 800 Dec. 31 Profit and Loss Summary 4 800
4 800 4 800
Accumulated depreciation of Van (–A)

Dec. 31 Balance 4 800 Dec. 31 Depreciation of Van 4 800
4 800 4 800
1/1/26 Balance 4 800

The entry to close the Depreciation of Van account would be made at the same
time that all the expense accounts (such as Cost of Sales, Wages and Advertising)
were closed. The depreciation expense account would never be closed on its own. (See
Chapter 10 for a reminder.)
Subsequent periods
Depreciation in subsequent periods will be recorded using the same debit and credit
entries as those shown in Figure 13.8 and posted to the General Ledger as shown in
Figure 13.9. While the Depreciation of Van account would continue to open and close
on the same day, reflecting only the depreciation expense for that current Period, the
balance of the Accumulated depreciation of Van account would continue to grow as it
‘accumulated’ the amounts of depreciation expense incurred across the entire life of
the asset thus far.
Figure 13.11 shows how the Depreciation of Van and Accumulated depreciation of
Van accounts would appear after closing and balancing on 31 December 2026:
Figure 13.11 General Ledger: Subsequent periods

General Ledger
31/12/26 Accum. dep. of Van 4 800 31/12/26 Profit and Loss Summary 4 800
4 800 4 800
Accumulated depreciation of Van (–A)

31/12/26 Balance 9 600 1/1/26 Balance 4 800
31/12/26 Depreciation of Van 4 800
9 600 9 600
1/1/27 Balance 9 600
The Depreciation of Van account had been closed at the end of 2025, so the
depreciation expense for 2026 is the only entry in that account until it is closed again on
31 December 2026.
However, the Accumulated depreciation of Van account already had a balance of
$4 800: the amount accumulated from last year (2025). When depreciation (of $4 800)
for the current year (2026) is recorded, the balance of this account increases to $9 600.
Once again, the account would be balanced in readiness for the next period (2027).

1 Show the General Journal entries to record the balance day adjustment for
depreciation expense.
2 State one reason why the ledger accounts must name the asset being
depreciated.
3 State the effect of depreciation expense on the Accounting equation.
4 Referring to one Accounting assumption, explain the difference between
Depreciation expense and Accumulated depreciation.
5 Explain why the Depreciation expense account must be closed at the end of
the Period.
6 Explain why the balance of the Accumulated depreciation account is greater
than the depreciation expense in the second year of an asset’s life.

13.5 Reporting depreciation
Source
documents
Once depreciation expense has been recorded in the General Ledger, it will affect both
the Income Statement and the Balance Sheet.
The Income Statement

Reporting depreciation in the Income Statement is probably the easiest part of
Accounting for depreciation. Because depreciation is an expense, it is reported in the
Income Statement with all the ‘Other expenses’, such as Wages, Advertising and Rent
expense. Figure 13.12 shows how Depreciation of Van would be reported in the Income
Statement for 2026:
Figure 13.12 Income Statement: Depreciation expense

MIXWELL PAINTS
Income Statement for 2026
$ $
Revenue
Sales 212 000
less Sales returns 2 000 210 000
Buying expenses 3 000 127 000
Gross Profit 83 000
less Inventory loss 500
add Other revenue
82 900
Less Other expenses
Advertising 6 000
Depreciation of Van 4 800
Rent expense 17 000
Wages 31 000 59 200
Net Profit 23 700
Only the depreciation expense (the amount consumed in the current Period) is
reported in the Income Statement. Accumulated depreciation is a negative asset, not
an expense, and so must not be reported in the Income Statement.
The Balance Sheet

The first effect of depreciation on the Balance Sheet is via owner’s equity. As we have
already seen, depreciation expense decreases Net Profit and in terms of the Balance
Sheet, this decreases owner’s equity.

The second effect occurs on the asset side. Accumulated depreciation reports the
value of the asset that has been consumed over its life so far, and the balance of this
negative asset account is reported directly under the asset itself, as shown in Figure 13.13:
Figure 13.13 Balance Sheet: Accumulated depreciation

MIXWELL PAINTS
Balance Sheet (extract) as at 31 December 2026
$ $
Non-current assets
Van 32 0001
Less Accumulated depreciation 9 6002 22 4003
Note that now instead of just reporting the asset as one figure, three are involved:
1 Historical cost $32 000
To ensure the reports continue to provide a Faithful representation of the asset it
must always be reported initially at its Historical cost (its original purchase price) as
this amount is Verifiable by reference to the source document, and thus neutral and
free from bias.
2 Accumulated depreciation $9 600
Because some of the asset’s value has been consumed, it is no longer appropriate to
report it at its Historical cost alone; in order to ensure Relevance, the Balance Sheet
must also report the asset’s Accumulated depreciation – the total value of the asset
that has been consumed over its life so far. In this case, the Van has been depreciated
$4 800 per year for each of the two years the asset has been under the firm’s control.
3 Carrying value $22 400
The Carrying value is calculated by deducting any Accumulated depreciation from Carrying value
the Historical cost of the asset. It represents the unallocated cost of the asset; that the value of a non-current
is, the value of the asset that is yet to be incurred and therefore yet to be allocated asset that is yet to be incurred/
allocated as an expense, plus
as Depreciation expense (plus any Residual value). Because this Carrying value is
any Residual value
yet to be incurred, it represents a future economic benefit, which should by now be
obvious as the definition of an asset!
Subsequent periods
As the asset is depreciated, it will be the Accumulated depreciation figure that increases,
thus decreasing the Carrying value. For example, the van owned by Mixwell Paints will
appear in successive Balance Sheets as shown in Figure 13.14:
Study tip
Figure 13.14 Balance Sheet: successive periods
MIXWELL PAINTS
Balance Sheet (extract) as at 31 December Carrying value is also
2025 2026 2027 2028 known as carrying cost,
Non-current assets written-down value,
Van 32 000 32 000 32 000 32 000 unallocated cost and
Less Accumulated depreciation 4 800 9 600 14 400 19 200 book value.
27 200 22 400 17 600 12 800
Ethical
Given its effect on the Income Statement and the Balance Sheet, it might be said that c onsiderations
the omission from the reports of the effects of depreciation is actually unethical as
omitting depreciation expense would mean the reports would not include all Relevant
information which might make a difference to decision-making.
Specifically, an Income Statement which did not report depreciation expense would
understate expenses and overstate profit, and it might lead the owner to make poor
decisions about expense control. As a result, a Balance Sheet which did not include
the effects of depreciation would overstate owner’s equity, but it would also overstate
the value of non-current assets, which might negatively affect decisions about asset
replacement and those based on the net worth of the business.
Representing depreciation graphically

In order to satisfy Understandability, reports must be prepared in a manner that is readily
understandable by the user, with the preparation of graphs one simple strategy that can
be employed. Preparing a graph can make it easier for the owner to understand both the
idea of depreciation and its effect on the Accounting reports.
Figure 13.15 shows how the Depreciation expense, Accumulated depreciation and
Carrying value could be represented graphically:
Figure 13.15 Graphing depreciation
Mixwell Paints
Depreciation
35000
30000
25000
20000
15000
10000
5000
0
2025 2026 2027 2028 2029
Depreciation expense Accumulated depreciation Carrying value
This graph clearly shows why it is called the ‘straight-line’ method, as the amount of
Depreciation expense ($4 800) is constant every year, creating a straight line across the
life of the asset.
The Accumulated depreciation grows at a constant rate, increasing every year by
the amount of the Depreciation expense ($4 800). At the same time, the Carrying value
starts at the Historical cost ($32 000) and moves in exactly the opposite direction,
decreasing every year by the amount of the Depreciation expense ($4 800) and ending
at the Residual value of $8 000 (if the graph shows the asset’s entire Useful life).

1 Explain why Depreciation expense is reported in the Income Statement but
Accumulated depreciation is not.
2 Referring to the appropriate Qualitative characteristics, explain why the original
purchase price of a non-current asset must be reported in the Balance Sheet.
3 Define the term ‘Carrying value’.
4 Referring to one Qualitative characteristic, explain why non-current assets
must be reported at their Carrying value in the Balance Sheet.
Ethical
5 Explain why it would be unethical to omit the effects of depreciation from the
considerations
Income Statement and Balance Sheet.
6 Explain why the line for Depreciation expense under the straight-line method
is ‘flat’.
7 Explain why the lines for Carrying value and Accumulated depreciation move in
opposite directions over the life of the asset.
8 Explain why the line for Carrying value does not end at zero.

13.6 Purchasing non-current assets

As was stated at the beginning of this chapter, the process of depreciation involves
allocating the cost of a non-current asset over its Useful life. So far, we have only
examined assets whose cost is their purchase price. However, it is quite common for a
business to modify an asset, or incur costs for its installation, that must also be included
in this definition of cost. After all, if these other costs will provide a future economic
benefit over the life of the asset, then they should be classified as non-current assets
and depreciated over the life of the asset.
Cost of a non-current asset cost of a non-current asset

all costs incurred in order to
The cost of a non-current asset is thus defined as all costs incurred in order to bring
bring the asset into a location
the asset into a location and condition ready for use, which will provide a benefit for the and condition ready for use,
life of the asset. Such costs might include the purchase price/supplier’s price, delivery which will provide a benefit for
costs, modification costs and installation costs. the life of the asset
On 28 February 2025, Danny’s Donuts paid cash to purchase a new oven. The Example
document is shown below:
Oven’s Ovens
Back Porepunkah Rd, Bright VIC 3741
ABN: 01 320 664 989
Sold to: Danny’s Donuts Tax invoice

Clyde St, Myrtleford 3737 28 February 2025
ABN: 32 001 656 887
Items Total $
Commercial oven (Cookmaster 1000) 22 000
Installation fee 3 000
Maintenance fee (first year of operations) 1 000
GST (10%) 2 600
Total 28 600
Amount paid (EFT Trans. 3002) 28 600
Balance owing nil

Recording: cash purchase of a non-current asset
Source
documents
We have already noted that the GST is not part of the cost of the asset, as it does not
affect the economic benefit provided by the asset. Instead, it leads via debit entry in the
GST Clearing account to a decrease in the liability owed to the ATO and a reduction in
the next GST settlement (or perhaps even a GST refund).
What of the other costs?
Both the Supplier’s price ($22 000) and the Installation fee ($3 000) are necessary to
bring the asset into a condition and location ready for use. But just as importantly, they will
not be consumed in one year, but will bring a benefit over the life of the asset. This means
they must be included in the depreciable cost of the asset as shown in Figure 13.16:
Figure 13.16 ‘Cost’ of a non-current asset
Supplier’s price for the oven $22 000

plus Installation fee $3 000
Cost of oven $25 000
This figure of $25 000 is the amount which will be debited to the Oven account in the
General Ledger and used as the cost in the calculation of depreciation. There will be no
separate account for Installation fee.
The Maintenance fee ($1 000) on the other hand may also be a necessary cost, but
it only covers the first year of operations, so its benefit will be consumed and therefore
incurred within a year. This means it is not part of the value of a non-current asset. Any
costs where the benefit does not extend for the life of the asset are not included in the
cost of the asset, but rather treated separately.
Indeed, as this amount is paid in advance, and expected to provide a benefit for only
the next 12 months, it is in fact a current asset called Prepaid maintenance fee. It should
not be recorded as part of the cost of the oven, but rather debited to its own separate
ledger account and then be subject to a balance day adjustment at the end of the Period
to calculate the maintenance fee expense incurred.
Figure 13.17 shows how the cash purchase of the oven would be reported in the
General Journal of Danny’s Donuts:
Figure 13.17 General Journal: Cash purchase of a non-current asset
General Journal
Feb. 28 Oven 25 000
Prepaid Maintenance fee 1 000
GST Clearing 2 600
Bank 28 600
Cash purchase of oven and prepayment of maintenance
fee for first year of operations (EFT Trans. 3002)

Figure 13.18:
Figure 13.18 General Ledger: Cash purchase of a non-current asset

General Ledger
Bank
Feb. 1 Balance 12 000 Feb. 28 Oven / 28 600
Prepaid Maintenance fee /
GST Clearing
Oven (NCA)
Feb. 28 Bank 25 000
Prepaid Maintenance fee (CA)

Feb. 28 Bank 1 000
GST Clearing (A/L)

Feb. 28 Bank 2 600 Feb. 1 Balance 4 500
In the Bank account, there are actually three accounts named in the cross-reference
as the cash paid covered the cost of the Oven, the Prepaid Maintenance fee and the
GST paid, but the cross-reference in these accounts is simply Bank as this is the only
account to which they are linked.
Reporting: cash purchase of a non-current asset
Source
documents
In terms of the Income Statement, the cash purchase of a non-current asset does
not create a revenue or expense so there is nothing to report until the balance day
adjustments are recorded for depreciation expense and any prepaid expenses which
have been incurred.
In terms of the Cash Flow Statement, however, the cash purchase of a non-current
asset creates cash flows in two areas. As a cash outflow related to the purchase of a
non-current asset, the cash paid for the non-current asset itself (in this case the $25 000
paid for the Oven) will be reported as an Investing activity, while the cash paid for
prepaid expenses (Prepaid Maintenance fee $1 000) and the GST paid ($2 600) will be
reported as Operating activities as they relate to the day-to-day trading activities of
the firm.

Figure 13.19 shows an extract of the Cash Flow Statement of Danny’s Donuts for
February 2025 showing these cash flows:
Figure 13.19 Cash Flow Statement (extract): Cash purchase of a non-current asset
DANNY’S DONUTS
Cash Flow Statement (extract) for February 2025
$ $
CASH FLOWS FROM OPERATING ACTIVITIES
Study tip Sales * 55 000
GST received * 5 500 60 500
Payments to Accounts Payable * (24 000)
Even though the purchase Wages * (10 000)
of a non-current asset
Electricity * (1 500)
is an Investing activity,
Advertising * (2 000)
paying GST is a day-to-
day trading activity, so GST paid * (2 950)
GST on the purchase of Prepaid Maintenance fee (1 000) (41 450)
a non-current asset is Net Operating Cash Flows 19 050
reported as an Operating CASH FLOWS FROM INVESTING ACTIVITIES
cash flow.
Cash purchase of oven (25 000)
* Other probable cash flows have been added to show a more complete report.
Note that although $2 600 GST was paid on the purchase of the Oven and Prepaid
Maintenance fee, the $2 950 reported in the Cash Flow Statement also includes the GST
paid on the Advertising ($200) and Electricity ($150). Further even though it includes
GST paid on the purchase of a non-current asset (the Oven), the payment of GST is a
day-to-day trading activity, so the entire amount is reported as an Operating activity.
In the Balance Sheet, the cash purchase will actually result in an overall decrease in
assets and liabilities, as although the non-current asset Oven increases, and the current
asset Prepaid Maintenance fee also increases, the current asset Bank decreases
by more, as it includes the payment to decrease the GST liability. This is shown in
Figure 13.20:
Figure 13.20 Balance Sheet (effects): Cash purchase of a non-current asset
DANNY’S DONUTS
Balance Sheet (effects) as at 28 February 2025
$ $
Bank Decrease 28 500 GST Clearing Decrease 2 600
Prepaid Maintenance fee Increase 1 000
Non-current Assets
Oven Increase 25 000
Total Assets Decrease 2 600 Total Equities Decrease 2 600
Purchase of a non-current asset using a loan

Given the large amounts of cash required to purchase some non-current assets (such as
equipment, vehicles and even premises), it is common for a business to take out a loan
first, and then use these funds to purchase the asset. In cases such as this, the entries
to purchase the asset do not change, but an initial entry is required to show the receipt
of cash from the loan.
Danny’s Donuts had financed the purchase of the new oven by taking out a loan of Example
$30 000 from Bank South on 16 February 2025 (EFT Trans. 2982).
Recording: receipt of a loan
Source
documents
The receipt of the cash from Bank South would be recorded in the General Journal as
Figure 13.21 General Journal: Receipt of loan
General Journal
Feb. 16 Bank 30 000
Loan – Bank South 30 000
Receipt of loan from Bank South to finance purchase of
new oven (EFT Trans. 2982)
Following the cash purchase of the oven (as shown in Figure 13.16), the Bank
account would appear as shown in Figure 13.22:
Figure 13.22 General Ledger: Cash purchase of a non-current asset using a loan
General Ledger
Bank
Feb. 1 Balance 12 000 Feb. 28 Oven / 28 600
16 Loan – Bank South 30 000 Prepaid Maintenance fee /
GST Clearing
Reporting: receipt of a loan
Source
documents
The receipt of the loan increases assets (Bank) and also increases liabilities (Loan – Bank
South), meaning it does not change owner’s equity and therefore is does not meet
the definition of a revenue or expense. As a result, it is not reported in the Income
Statement.
In the Cash Flow Statement, the receipt of the loan is reported as a Financing activity
as it is a cash flow that changes the firm’s financial structure, making it more reliant on
borrowed funds.

Figure 13.23 shows an extract of the Cash Flow Statement of Danny’s Donuts for
February 2025 including the receipt of the loan:
Figure 13.23 Cash Flow Statement (extract): Cash purchase of a non-current asset using
a loan
DANNY’S DONUTS
Cash Flow Statement (extract) for February 2025
$ $
CASH FLOWS FROM OPERATING ACTIVITIES
Sales * 55 000
GST received * 5 500 60 500
Payments to Accounts Payable * (24 000)
Wages * (10 000)
Electricity * (1 500)
Advertising * (2 000)
GST paid * (2 950)
Prepaid Maintenance fee (1 000) (41 450)
Net Operating Cash Flows 19 050
Cash purchase of oven (25 000)
CASH FLOWS FROM FINANCING ACTIVITIES
Loan – Bank South 30 000
* Other probable cash flows have been added to show a more complete report.
In the Balance Sheet, both assets (Bank) and liabilities (Loan – Bank South) increase
by the amount of the cash received.

1 Define the term ‘cost’ as it refers to non-current assets.
2 Identify three costs that might be included in the cost of a non-current asset.
3 Explain why GST is excluded from the cost of a non-current asset.
4 Explain why yearly costs are excluded from the cost of a non-current asset.
5 Explain how the cash purchase of a non-current asset is reported in the
Income Statement.
6 Explain how the following items related to the cash purchase of a non-current
asset are reported in the Cash Flow Statement:
• Non-current asset
• Prepaid expenses
• GST paid.
7 Explain why the amount of GST paid reported in the Cash Flow Statement is
likely to be different from the amount of GST paid on the cash purchase of a
non-current asset.
8 Explain how the receipt of a loan is reported in the Cash Flow Statement.

Where have we been?

• Depreciation is the allocation of the cost of a non-current asset over its Useful life.
• Depreciation expense represents that part of the value of a non-current asset which is incurred in a
particular Period, upholding the Accrual basis assumption.
• The purpose of depreciation is to ensure that an accurate profit is calculated by comparing revenues
earned against expenses incurred in the current Period.
• The straight-line method assumes that non-current assets contribute evenly to revenue over their life. As
a result, depreciation expense is allocated even over the asset’s life.
• The cost of an asset includes all costs incurred in order to bring the asset into a location and condition
ready for use, which will provide a benefit for the life of the asset.
• The estimates used for Residual value and Useful life raise questions about the Faithful representation
of reports which include depreciation. However, depreciation is important for upholding Relevance, and
reports with depreciation provide a more Faithful representation than those without.
• Some businesses will finance the purchase of a non-current asset by taking out a loan.
• Cash paid for a non-current asset is an Investing outflow, but the GST paid is an Operating outflow.
• The receipt of a loan is a Financing inflow.
Exercises
this book.

Calculating depreciation
On 1 July 2025, Shovel and Shift purchased new office furniture for $15 000 plus GST. It is expected that the
office furniture will have a Useful life of five years and will be disposed of at that time for $3 000.
Required
a Define the term ‘depreciation’.
b Using the straight-line method, calculate Depreciation of Office furniture for the year ended 30 June 2025.
c Explain why the GST paid on the purchase of the office furniture is not included in the calculation of
depreciation.
d Explain why the Residual value of the office furniture is deducted from its Historical cost in the
calculation of depreciation expense.

Calculating depreciation
On 1 July 2024, Fragrant Perfumes purchased shelving for $33 000 including GST. The shelving has an
estimated Useful life of eight years and a Residual value of $6 000.
Required
a Referring to one Accounting assumption, explain why it is necessary to depreciate non-current assets.
b Using the straight-line method, calculate Depreciation of Shelving for the year ended 30 June 2025.
c Calculate the rate of Depreciation of Shelving per annum.
d Discuss whether depreciation means the financial reports provide a more or less Faithful representation.


Calculating depreciation: rate
Glenda’s Good Guys purchased a new van on 31 December 2024 for $40 000 plus GST. The van is to be
depreciated using the straight-line method at 10% per annum for the next eight years.
Required
a Calculate Depreciation of Van for the year ended 31 December 2025.
b Referring to one Qualitative characteristic, explain why depreciation expense must be included in the
Income Statement.
c Explain the effect of depreciation on the firm’s bank balance.
d Calculate the Residual value of the van.

Calculating depreciation: less than a year
On 31 January 2025, Knight’s Prawns purchased new cabinets for $1 800 plus $180 GST. It is decided that the
cabinets will be depreciated using the straight-line method at 20% per annum (Memo 44).
Required
a Referring to one Accounting assumption, explain why the cabinets should not be depreciated for a full year.
b Calculate Depreciation of Cabinets for the year ended 30 June 2025.
c State the effect on the Net Profit of Knights Prawns for the year ended 30 June 2025 if a full year of
depreciation expense had been reported as an expense.
d Calculate Depreciation of Cabinets for the year ended 30 June 2026.

Recording depreciation
On 1 July 2024, Roamin’ Blinds purchased new blind-cutting equipment, paying $13 200 cash including GST.
The equipment is expected to last for six years, at which time it will have a Residual value of $3 000. On 30
June 2025, the Accounting department received Memo 27 to say that depreciation on the equipment had not
yet been recorded.
Required
a Calculate Depreciation of Equipment for the year ended 30 June 2025.
b Record Depreciation of Equipment for the year ended 30 June 2025 in the General Journal of Roamin’ Blinds.
c Post the General Journal entries (from part ‘b’) to the relevant accounts in the General Ledger of Roamin’
Blinds.
d Show how Equipment would be reported in the Balance Sheet of Roamin’ Blinds as at 30 June 2025.
e Referring to one Qualitative characteristic, explain why the asset must be shown in the Balance Sheet at
its Carrying value.


Jungle Jane sells gym equipment. Its owner has presented the following extract from the firm’s Balance Sheet:
JUNGLE JANE
$ $
Non-current Assets
Office furniture 29 000 1
less Accumulated depreciation 9 000 2 20 000 3
• The office furniture has an estimated Residual value of $2 000.
• The Income Statement for the year ended 30 June 2025 showed Depreciation of Office furniture of $3 000.
Required
a Explain what is represented by the amounts labelled 1, 2 and 3.
b Record Depreciation of Office furniture for the year ended 30 June 2025 in the General Journal of
Jungle Jane.
c Post the General Journal entries (from part’ ‘b’) to the relevant accounts in the General Ledger of
Jungle Jane.
d Show how Office furniture would be reported in the Balance Sheet of Jungle Jane as at 30 June 2027.
e Calculate the Useful life of the office furniture.

As at 30 June 2024, Frosty Fridges had shop fittings that had been purchased for $20 000 but had a current
Carrying value of $16 000. On 31 March 2025, $5 500 including GST was paid for additional shop fittings.
Depreciation is allocated using the straight-line method at the rate of 10% per annum (Memo 23).
Required
a Calculate Accumulated depreciation of Shop fittings as at 30 June 2024.
b Calculate Depreciation of Shop fittings for the year ended 30 June 2025.
c Record Depreciation of Shop fittings for the year ended 30 June 2025 in the General Journal of Frosty
Fridges.
d Show how the Depreciation of Shop fittings and Accumulated depreciation of Shop fittings accounts
would appear in the General Ledger after all closing and balancing entries had been made.
e Referring to one Qualitative characteristic, explain why the original purchase price of the asset is
disclosed in the Balance Sheet.
f Show how the Shop fittings would be reported in the Balance Sheet of Frosty Fridges as at 30 June 2025.


Cash purchase of a non-current asset
On 1 May 2025, Showcase World had $14 000 worth of display cabinets. On 14 May 2025, it ordered more
display cabinets at a cost of $6 600 (including $600 GST) from Carl’s Cabinets (Order 32). The cabinets were
delivered on 23 May 2025 and on this date Showcase World paid the amount owing to Carl’s Cabinets (Ch. 45).
Required
a Explain why Order 32 would not be recorded in the General Journal of Showcase World.
b Referring to the definitions, explain why the new cabinets would not be recognised as an asset of
Showcase World as at 14 May 2025.
c Record Cheque 45 in the General Journal of Showcase World.
d Identify one other source document that Showcase World should use in relation to this transaction, and
describe how it should be used.

Cost of a non-current asset
On 1 July 2024, Eileen’s Ladders purchased a computer-linked cash register system for $10 000 plus GST and
paid an additional cost of $4 800 plus GST for an annual software licence fee (Cheque 233). Eileen decided to
use the straight-line method of depreciation, determining that the system will have a Useful life of five years
and a Residual value of $1 000.
Required
a Explain why the software licence fee should not be included in the cost of the cash register.
b Record Cheque 233 in the General Journal of Eileen’s Ladders.
c Calculate Depreciation of Cash register for the year ended 30 June 2025.
d Calculate the rate of depreciation on the cash register.
e Show how the Cash register would be reported in the Balance Sheet as at 30 June 2025.
f Explain the effect of Depreciation of Cash register on the Accounting equation of Eileen’s Ladders as at
30 June 2025.

Cash purchase of a non-current asset
On 1 April 2025, Matt’s Mats paid cash for a new delivery van. The document for the purchase is shown below:
Dan’s Vans TAX INVOICE: X36

105 Blackburn Rd
Nunawading VIC 3110
ABN: 173 254 009
CASH SALE: Matt’s Mats, Naismith St, Blackburn VIC 3130
ABN: 90 361 253 007
Details Total
Delivery van 21
000
1 April 2025 Fitting of shelves 1 500
Service contract (12 months) 1 200
GST 2
370
Total price $26
070
Amount received $26
070
Balance owing
nil

• On 1 April 2025, Matt’s Mats took out a loan for $25 000 to purchase the van, which it paid for via EFT
transfer (No. 3201)
• Matt expects to have the delivery van for five years and then dispose of it for $6 500.
• The van will be depreciated using the straight-line method.
Required
a Record the receipt of the loan in the General Journal of Matt’s Mats.
b Calculate the cost of the delivery van.
c Referring to your answer to part ‘b’, explain your treatment of the cost of the delivery van.
d Record the purchase of the delivery van in the General Journal of Matt’s Mats.
e Referring to your answer to part ‘d’, show how EFT transfer 3201 would be reported in the Cash Flow
Statement of Matt’s Mats for the year ended 30 June 2025.
f Calculate Depreciation of Van for the year ended 30 June 2025.
g Show how the service contract would be reported in the Balance Sheet of Matt’s Mats as at 30 June 2025.
h Show how the Van would be reported in the Balance Sheet of Matt’s Mats as at 30 June 2026.

Depreciation for less than one year
Scratch and Dent Discounters present the following extract from their Balance Sheet as at 1 July 2025:
SCRATCH AND DENT DISCOUNTERS

Balance Sheet (extract) as at 1 July 2024
$ $
Non-current Assets
Office furniture 8 000
less Accumulated depreciation 1 600 6 400
• A specially designed office chair was purchased for cash on 31 January 2025 for $4 800 plus GST
(Cheque 132)
• Office furniture is depreciated at 10% per annum using the straight-line method (Memo 35).
Required
a Referring to one Accounting assumption, explain why the office furniture should be depreciated.
b Calculate Depreciation of Office furniture for the year ended 30 June 2025.
c Record Depreciation of Office furniture for the year ended 30 June 2025 in the General Journal of
Scratch and Dent Discounters.
d Show how the Depreciation of Office furniture and Accumulated depreciation of Office furniture
accounts would appear in the General Ledger of Scratch and Dent Discounters after all closing and
balancing entries had been made.
e Show how Office furniture would be reported in the Balance Sheet of Scratch and Dent as at 30 June 2025.


Reporting depreciation
Tim Barr owns Hack and Saw, a store specialising in the sale of saws, chainsaws and axes. The business has
provided its Pre-adjustment Trial Balance as at 30 June 2025:
HACK AND SAW

Accumulated depreciation of Display equipment 12 100
Administrative expenses 10 500
Bank 5 300
Capital – Barr 68 000
Display equipment 49 000
Drawings 16 000
GST Clearing 400
Inventory 38 000
Loan – DR Finance (repayable $500 per month) 35 000
Prepaid advertising 2 800
Rent expense 26 000
Sales 160 000
Wages 36 000
Totals 280 800 280 800
• A physical Inventory count on 30 June 2025 showed $37 100 inventory on hand.
• The display equipment is to be depreciated at 15% p.a.
• A seven-month advertising campaign was paid in advance on 1 February 2025.
• A payment of $1 500 administrative expenses has been incorrectly posted to Wages.
• Reports are prepared yearly.
Required
a Explain the purpose of making balance day adjustments.
b Show the General Journal entries necessary to record the additional information. Narrations are not
required.
* c Prepare a Post-adjustment Trial Balance for Hack and Saw as at 30 June 2025.
d Show the General Journal entries necessary to close the ledger and transfer Drawings to the Capital
account. Narrations not required.
* e Prepare an Income Statement for Hack and Saw for the year ended 30 June 2025.
f Evaluate the mark-up applied by Hack and Saw for the year ended 30 June 2025.
g State two actions Hack and Saw could take to improve Net Profit without changing Adjusted Gross
Profit.
* h Prepare a classified Balance Sheet for Hack and Saw as at 30 June 2025.
i Discuss whether the amount of drawings taken by the owner in the year ended 30 June 2025 is
appropriate.


Reporting depreciation
Nguyen Ski Gear has provided the following Pre-adjustment Trial Balance as at 31 December 2025:
NGUYEN SKI GEAR

Pre-adjustment Trial Balance as at 31 December 2025
Accumulated depreciation of Vehicle 8 000
Bank 9 600
Capital – Nguyen 32 620
Cost of sales 48 000
Drawings 14 000
GST Clearing 700
Inventory 24 000
Loan – NAB (repayable $9 000 p.a.) 21 000
Sales 120 900
Sales returns 900
Vehicle 40 000
Wages 36 000
Totals 201 520 201 520
• A physical inventory count on 31 December 2025 showed $24 700 Inventory on hand.
• The vehicle is to be depreciated at 10% p.a.
• As at 31 December 2025, $900 wages were still owing to employees.
• Prepaid rent expense as at 31 December 2025 was $6 000.
• The last reports were prepared on 30 June 2025.
Required
a Show the General Journal entries necessary to record the additional information. Narrations are not
required.
* b Prepare a Post-adjustment Trial Balance for Nguyen Ski Gear as at 31 December 2025.
c Referring to one Accounting assumption, explain the purpose of closing entries.
d Show the General Journal entries necessary to close the ledger and transfer Drawings to the Capital
account. Narrations not required.
* e Prepare an Income Statement for Nguyen Ski Gear for the six months ended 31 December 2025.
f Explain what the Income Statement reveals about the reputation of Nguyen Ski Gear.
* g Prepare a classified Balance Sheet for Nguyen Ski Gear as at 31 December 2025.
h Referring to your answer to part ‘g’, identify one item that can be used to support the view that the
firm’s financial position is sound. Justify your answer.


Accounting for non-current assets
On 1 March 2025, the shop fittings of Funk Fashions were destroyed in a fire, so the owner (Colin Miller)
contributed some fittings that he had purchased for his own home (Memo 6). Colin had purchased the fittings
in 2016 paying $12 000, but at the end of February 2025 had them professionally valued at $9 400. He estimates
that they will be of use for four years, and by the end of their Useful life expects to sell them for $1 000.
Required
a Record Memo 6 in the General Journal of Funk Fashions.
b Referring to one Qualitative characteristic, justify your valuation of the shop fittings as at 1 March 2025.
c Calculate Depreciation of Shop fittings for the year ended 30 June 2025.
d Record Depreciation of Shop Fittings for the year ended 30 June 2025 in the General Journal of Funk
Fashions. A narration is not required.
e Show how the following accounts would appear in the General Ledger of Funk Fashions as at 30 June
2025, after all balancing and closing entries have been made:
• Shop fittings
• Depreciation of Shop fittings
• Accumulated depreciation of Shop fittings.
f Show how Shop fittings would appear in the Balance Sheet of Funk Fashions as at 30 June 2026
and 2027.

Accounting for non-current assets
On 31 October 2024, Rendle Clothing borrowed $25 000 from FCC Finance to purchase a new delivery van.
On the same day, the business purchased a van, paying cash. The van was advertised for $24 000 plus
GST, but the owner bargained with the salesperson who agreed to provide the van and $500 worth of on-road
costs for $24 200 including GST. Installation of heavy-duty suspension cost a further $900 plus GST, and the
van has been insured for fire and theft with OOMY Insurance at an annual cost of $4 800 plus GST. The van is
expected to have a Useful life of five years, after which it can be traded in on a new one with a trade-in value
of approximately $4 900.
Required
a Calculate the cost of the van purchased on 31 October 2024.
b Referring to your answer to part ‘a’, explain your treatment of:
• the heavy-duty suspension
• insurance.
c Record the receipt of the loan and the cash purchase of the van in the General Journal of Rendle
Clothing. Narrations are not required.
d Referring to one Accounting assumption, explain why the entire cost of the van cannot be treated as an
expense in the year ended 30 June 2025.
e Calculate Depreciation of Van for the year ended 30 June 2025 using the straight-line method.
f Record Depreciation of Van for the year ended 30 June 2025 in the General Journal of Rendle Clothing.
g Referring to at least two Qualitative characteristics, discuss the ethical Ethical
considerations of reporting for depreciation. c
onsiderations
h In July 2025, the delivery driver fell ill so the van was not used for deliveries for
two months. Explain whether the van should be depreciated for July and August 2025.

Chapter 14
Accounting for non-current assets 2

After completing this chapter, you should be able to: • identify and explain the reasons for a profit or loss
• calculate depreciation expense using the reducing on the disposal of a non-current asset
balance method • record a trade-in of a depreciable non-current
• justify the selection of a particular depreciation asset in the General Journal and General
method Ledger
• explain the effect on the Accounting reports of • report a profit or loss on the disposal of a
using different depreciation methods non-current asset in the Income Statement.
• record a cash sale of a depreciable non-current
asset in the journals and General Ledger
Key terms
After completing this chapter, you should be familiar • under-depreciation
with the following terms: • over-depreciation
• loss on disposal of non-current asset • trade-in.
• profit on disposal of non-current asset

14.1 Methods of depreciation

Chapter 13 introduced the process of depreciation for non-current assets. This process
is applied because although non-current assets provide an economic benefit for more
than 12 months (through their contribution to revenue), most do not provide an economic
benefit forever; they have a finite Useful life. This means that gradually, over their Useful
life, their value is being consumed or incurred by the business.
The process of depreciation is applied as a mechanism for calculating depreciation
expense, which is that part of the cost of a non-current asset that has been consumed,
or incurred, in the current Period. As a result, depreciation expense upholds the Accrual
basis assumption by ensuring profit is calculated accurately by comparing revenues
earned against expenses incurred in the current Period. It also ensures that the reports
(the Income Statement and the Balance Sheet) include all information that is useful for
decision-making, therefore upholding Relevance.
Chapter 13 introduced only one method of depreciation – the straight-line method. This
chapter introduces an alternative – the reducing balance method. These methods do not
differ in terms of how they are recorded or reported, but they do differ in terms of:
• their assumption about how assets contribute to revenue
• how they allocate depreciation expense over the life of the asset and, as a
consequence,
• how they calculate depreciation expense.
Straight-line method
The straight-line method of depreciation assumes that the asset will contribute evenly
to revenue, doing much the same job when it is old as when it is new. Typically, this
would include assets with few moving parts such as office furniture or fixtures and
fittings. The value (cost) of such an asset is therefore assumed to be consumed evenly
over the life of the asset, and this must be reflected by the depreciation expense.
As a result, the straight-line method attempts to match the revenue-earning pattern
of the asset by allocating depreciation expense evenly over the life of the asset and
reporting the same amount of depreciation expense each year.
Reducing balance method

However, not all assets contribute to revenue evenly over their lives. An asset with
moving parts (such as equipment, a photocopier or a vehicle) is likely to be more efficient
and productive when it is new, and therefore contribute more to revenue at the start
of its Useful life than at its end. The value (cost) of an asset that contributes more to
revenue when it is new (and less as it ages) is therefore consumed more at the start of
its Useful life than at its end.
As a consequence, the reducing balance method allocates more depreciation expense
at the start of the asset’s life. Under this method, as the asset ages, its contribution to
revenue decreases and so too does the depreciation expense.
Using the reducing balance method ensures that the depreciation expense and the
revenue the asset earns are matched in each Period. Both are higher at the start but
reduce over the life of the asset.


1 Referring to one Accounting assumption, explain the purpose of depreciating a
non-current asset.
2 State the assumption that underlies the straight-line method of depreciation in
relation to how assets contribute to revenue.
3 Explain how the straight-line method of depreciation allocates depreciation
expense over the life of the asset.
4 State the assumption that underlies the reducing balance method of
depreciation in relation to how assets contribute to revenue.
5 Identify three non-current assets that should be depreciated using the reducing
balance method of depreciation.
6 Explain how the reducing balance method of depreciation allocates
depreciation expense over the life of the asset.
14.2 C
alculating depreciation expense: reducing
balance method
Under the straight-line method, depreciation expense is the same each year because it
is calculated as a percentage of the Historical cost of the asset (which, as the original
purchase price, does not change). By contrast, the reducing balance method calculates
depreciation expense as a percentage of the Carrying value, and as the Carrying value
decreases every year so too does the depreciation expense.
On 1 January 2025, Finch Fabrics purchased a cutting machine for $10 000 Example
plus $1 000 GST. The asset is expected to have a Useful life of five years and a
Residual value of $2 000 and is to be depreciated at 27.52% per annum using the
reducing balance method. Balance day is 31 December 2025 (Memo 91).
Reducing balance rate of depreciation

The first thing to note about the reducing balance method is that it always uses a rate (or
%), but the first thing that may strike you about the example above is that the rate is not
given as a simple figure, but rather as 27.52%! As a rule of thumb, the reducing balance
rate is approximately 1.5 times the straight-line rate. However, the word approximately
is important: it is not exactly 1.5 times.
The formula for calculating the rate of depreciation under the reducing balance
method is actually quite complicated, and is shown in Figure 14.1:
Study tip
Figure 14.1 Formula: Depreciation rate for Reducing balance method
(√ )
You do not need to
n Residual value
Depreciation rate = 100 1− know this formula as the
Historical cost
reducing balance rate
where 'n' refers to the 'number' of years for which the non-current asset will be will always be specified
used to earn revenue; that is, its Useful life. in this course. (Phew!)

Fortunately, knowledge of this formula is beyond the requirements of VCE Accounting

and if the rate is known (which in this course it will be!) calculating depreciation expense
simply involves multiplying the Carrying value by the rate.
The formula for calculating depreciation expense under the reducing balance method
is shown in Figure 14.2:
Figure 14.2 Formula: Depreciation expense for Reducing balance method
Depreciation expense = Depreciation rate × Carrying value

= $ for the year
where:
Carrying value = Historical cost less Accumulated depreciation
Because the Carrying value decreases every Period, so too does the depreciation
expense when calculated using the reducing balance method.
That is, the Depreciation expense of each Period will increase the Accumulated
depreciation, leading to a decrease in Carrying value and a subsequent decrease in
Depreciation expense in the next Period.
Depreciation expense for the year ended 31 December 2025

Using the reducing balance formula, the depreciation expense for the cutting machine
for Finch Fabrics for the year ended 31 December 2025 would be calculated as shown in
Figure 14.3:
Figure 14.3 Calculation: Depreciation expense for Year ended 31 December 2025

= 27.52% × $10 000
= $2 752
For the first year of the asset’s life, its Carrying value will be the same as its Historical
cost (that is, $10 000), and Depreciation expense will be $2 752. This would be recorded
Study tip in the General Journal using the same debits and credits as those used for the straight-
line method, as shown in Figure 14.4:
To see that the General

Figure 14.4 General Journal: Year ended 31 December 2025
Journal entries to record
General Journal
depreciation are the
same regardless of Date Details Debit $ Credit $
method, compare the Dec. 31 Depreciation of Cutting machine 2 752
accounts used in Figure Accumulated depreciation of Cutting machine 2 752
14.4 with those used in Yearly depreciation on cutting machine – 27.52%
Figure 13.8. reducing balance method (Memo 91)
As it is the first year of the asset’s life, the Accumulated depreciation at the end of
the year would also be $2 752, and the asset would thus be reported in the Balance
Sheet as shown in Figure 14.5:

Figure 14.5 Balance Sheet (extract): Year ended 31 December 2025

FINCH FABRICS
$ $
Non-current Assets
Cutting machine 10 000
Depreciation expense for the year ended 31 December 2026

For the second year of the asset’s life (2026), its Carrying value would be reduced by the
value of Accumulated depreciation from 2025. Using this new Carrying value ($7 248),
the Depreciation expense for 2026 would be calculated as shown in Figure 14.6:
Figure 14.6 Calculation: Depreciation expense for Year ended 31 December 2026

= 27.52% × $7 248
= $1 995
Because of the Accumulated depreciation from 2025 ($2 752), the Carrying value for
2026 has decreased (from $10 000 to $7 248), resulting in a decrease in Depreciation
expense (from $2 752 to $1 995). Thus, the reducing balance method allocates more
Depreciation expense at the start of the asset’s life, and less as it ages.
This pattern will continue for the life of the asset, as shown in Figure 14.7:
Figure 14.7 Reducing balance depreciation over time *

2025 2026 2027 2028 2029
Balance Sheet as at 31 December:
Cutting machine 10 000 10 000 10 000 10 000 10 000
Less Accumulated depreciation Nil 2 752 4 747 6 193 7 241
Study tip
Carrying value 10 000 7 248 5 253 3 807 2 759
Income Statement for the year:
Depreciation of Cutting machine 2 752 1 995 1 446 1 048 759 See Section 13.3 for
* Some figures adjusted for rounding purposes a reminder of how to
calculate depreciation
Calculating depreciation for less than a year for less than a year (but
Just like the straight-line method, the reducing balance method calculates depreciation remember to use the
reducing balance formula
for a year. Should the asset be under the control of the firm for less than a year, or the
to calculate depreciation
Period be less than a year, the amount would need to be adjusted. The safest way to
expense in the first
do this is to divide the yearly depreciation expense by 12 (months), then multiply by the
place!)
number of months within the Period for which the firm has had control of the asset.

1 Explain how the straight-line and reducing balance methods differ in their
calculation of depreciation expense.
2 Show the formula for calculating depreciation expense under the reducing
balance method of depreciation.
3 Referring to the formula, explain why the reducing balance method of
depreciation allocates less depreciation expense over the life of the asset.

14.3 Comparing depreciation methods

Although the method of calculation will change the amount of depreciation expense,
many aspects remain the same regardless of which method is chosen.
These include:
• the General Journal entries required to record depreciation expense; that is
DR Depreciation of Non-current asset (E)
CR Accumulated depreciation of Non-current asset (–A)
• the reporting of depreciation expense in the Income Statement (under ‘Other
expenses’) and Accumulated depreciation in the Balance Sheet (as a negative asset)
• the effect on the Accounting equation and Balance Sheet; that is:
– an increase in Accumulated depreciation leading to a decrease in assets
– an increase in expenses leading to a decrease in Net Profit and decrease in owner’s
equity.
What will differ depending on the depreciation method is the amount of depreciation
expense charged in each Period:
• Using the straight-line method, depreciation expense will be the same each year.
This does not mean that the asset is not ageing, or that its productive capacity is
not being consumed, just that it is being consumed, and its cost incurred, evenly
over its life.
• Using the reducing balance method, depreciation expense will be higher at the
start and decrease as the asset ages.
Effect over the life of the asset

If the fabric cutting machine (from the previous example) had been depreciated using
the straight-line method, depreciation expense would be $1 600 per year – a rate of 16%
(of the Historical cost). This compares with a reducing balance method rate of 27.52%
(of the Carrying value).
Figure 14.8 shows how the straight-line and reducing balance methods would
generate differing amounts for depreciation expense and, as a result, different results in
the Income Statement and Balance Sheet over the life of the asset:
Figure 14.8 Comparison of straight-line and reducing balance methods

Straight-line method Reducing balance method
(Historical cost × 16%) (Carrying value × 27.52%)
Historical Accumulated Carrying Depreciation Historical Accumulated Carrying Depreciation
Year cost depreciation value expense cost depreciation value expense
2025 10 000 Nil 10 000 1 600 10 000 Nil 10 000 2 752
2026 10 000 1 600 8 400 1 600 10 000 2 752 7 248 1 995
2027 10 000 3 200 6 800 1 600 10 000 4 747 5 253 1 446
2028 10 000 4 800 5 200 1 600 10 000 6 193 3 807 1 048
2029 10 000 6 400 3 600 1 600 10 000 7 241 2 759 759
Total depreciation (over life) 8 000 Total depreciation (over life) 8 000
Carrying value (end of life) 2 000 Carrying value (end of life) 2 000
The straight-line method allocates $1 600 depreciation expense per year, for every
year of the asset’s Useful life. In comparison, the reducing balance method allocates
more depreciation expense than the straight-line method in 2025 ($2 752) and 2026
($1 995), but less in 2027 ($1 446), 2028 ($1 048) and 2029 ($759).

This difference in depreciation expense can be represented graphically, as shown in

Figure 14.9:
Figure 14.9 Depreciation expense: graphical comparison
Straight-line v. Reducing balance methods
3000
2500
2000
1500
1000
500
0
2025 2026 2027 2028 2029
As a result of this difference in the depreciation expense, in the early years the
reducing balance method will cause Net Profit to be lower than it would be using the
straight-line method, but in later years Net Profit would be higher than if the straight-line
method was used.
In terms of the Balance Sheet, the reducing balance method will mean the Carrying
value of the asset decreases faster than using the straight-line method. This is shown
in Figure 14.10:
Figure 14.10 Carrying value: graphical comparison
Carrying value
Straight-line v. Reducing balance methods
12000
10000
8000
6000
4000
2000
0
2024 2025 2026 2027 2028 2029
Although Figure 14.10 shows the difference in Carrying value at the end of each
individual Period, it also shows that both methods end up at the same point: a Carrying
value at the end of the asset’s life of $2 000, which matches its estimated Residual
value. This is because although each method gives a different depreciation expense in
each Period, both methods will (if the rates have been calculated accurately) calculate
the same total depreciation expense over the life of the asset. In this example, both
methods result in a total depreciation of $8 000 and a final Carrying value of $2 000.

Selecting a depreciation method

The key factor to consider in choosing a depreciation method is the revenue-earning
pattern of the asset:
• If the asset contributes evenly to revenue and its cost is consumed evenly over its
life, the straight-line method should be used as it allocates depreciation expense
evenly over the life of the asset.
• If the asset contributes more to revenue and its cost is consumed more at the start of
its life and less as it ages, the reducing balance method should be used as it allocates
more depreciation expense at the start of the asset’s life and less as it ages.
It is the asset itself, and how it contributes to revenue, that determines which
method of depreciation is appropriate. Therefore, a business may use the straight-line
method for some assets and the reducing balance method for others.
While this choice exists, the Qualitative characteristic of Comparability demands that
once a method is chosen, that method should be used from one Period to the next.
This allows reports to be compared from one period to the next, allowing the users to
identify similarities and differences in performance (rather than just differences caused
by a change of depreciation method). Changing depreciation methods is possible, but
the change must be clearly disclosed in the reports.
Indeed, the choice of depreciation method is subject to ethical considerations.
Ethical Choosing a method so that the firm’s performance is presented in a particular (usually
considerations favourable) light is unethical, as is not impartial or objective. Further, such an approach
may compromise the ability of the reports to provide a Faithful representation of the
firm’s performance and position, as the information would be the result of bias.
In short, a depreciation method should be selected on the basis of one criteria alone:
that the method reflects, as much as possible, the revenue earning pattern of the asset
and allocates depreciation expense accordingly to provide the best possible matching
of revenues earned and expenses incurred, and therefore the most accurate calculation
of profit under the Accrual basis assumption.

1 State three ways in which the effect of depreciation is the same under both
the straight-line and reducing balance methods.
2 Compared to the straight-line method, explain how the reducing balance
method of depreciation will affect Net Profit during each Period.
3 Explain how the choice of method of depreciation affects total depreciation
over the life of the asset.
4 Explain the main factor to be considered in selecting a method of depreciation.
5 Referring to one Qualitative characteristic, explain why depreciation methods
should not be changed between periods.
Ethical 6 Referring to one Qualitative characteristic, explain the ethical considerations in
c onsiderations choosing a method of depreciation.

14.4 Disposal of a non-current asset

Unlike sales of inventory which occur every day, sales of non-current assets by trading
firms are relatively rare. Indeed, by their very definition non-current assets are expected
to be of use to a business for more than 12 months, and many – like fixtures and fittings,
vehicles and especially premises – would be expected to be in use for many years.
However, from time to time businesses will need to replace their non-current assets as
they age and wear out or as new and better assets become available for use. When this
occurs, the accounts of the business must show that the asset – and any Accumulated
depreciation that goes with it – has been disposed of and is no longer available for use.
Further, unless the asset has been ‘scrapped’ (dumped at the tip!), there is likely to
be some small gain from the disposal, which could be:
• cash from the sale of the non-current asset or
• a trade-in towards the purchase of a new non-current asset. Study tip
In either case, recording the disposal of a non-current asset involves recording:
1 the disposal of the non-current asset (as measured by its Carrying value)
Disposal of an asset
2 the revenue that has been earned from its disposal (the proceeds on disposal)
refers to both sale of
and then
an asset as well as
3 the profit or loss on the disposal of the asset (measured by the difference between
trade-in.
these two amounts).
Transferring the Carrying value (the ‘cost price’) of the asset

Assets are recorded in the General Ledger at their Historical cost – their original purchase
price – so when an asset is disposed of, this value must be ‘removed’ from the asset
account. At the same time, any Accumulated depreciation associated with the asset
must also be removed.
Taken together, these entries will result in the assets of the business being reduced
by the Carrying value of the asset which has been disposed of or, put another way, the
value of the asset ‘lost’ is measured by its Carrying value.
On 31 January 2025, Duke Industries sold some equipment for $1 100 Example
cash (Receipt 17). The equipment had originally been valued at $12 000, but
Accumulated depreciation amounted to $10 000 when it was sold.
Study tip
Because the equipment has been sold it is no longer in the firm’s possession or
control, so it is removed from the accounts by crediting the Equipment account using its
Historical cost of $12 000. Simultaneously, the Accumulated depreciation of Equipment Although this example
account is debited $10 000 so that this amount is also removed. refers to a sale of a non-
current asset, the entries
Both amounts are transferred via a debit entry to a new account called Disposal of
would be identical if the
Equipment, which acts as a temporary account simply for the purpose of calculating any
asset were traded in.
profit or loss on the disposal of the non-current asset.
The General Journal entries to transfer the Carrying value of the equipment are
Study tip
Figure 14.11 General Journal: Transferring the Carrying value
General Journal
There is no narration
recorded here because
Jan. 31 Disposal of Equipment 12 000 although this process is
Equipment 12 000 being explained in three
Accumulated depreciation of Equipment 10 000 steps, it is in fact one
Disposal of Equipment 10 000 General Journal entry.

Figure 14.12 shows how the General Ledger accounts would appear after posting
the General Journal:
Figure 14.12 General Ledger: Transferring the Carrying value

General Ledger
Equipment (A)
Jan. 1 Balance 12 000 Jan. 31 Disposal of Equipment 12 000
Accumulated depreciation of Equipment (−A)

Jan. 31 Disposal of Equipment 10 000 Jan. 1 Balance 10 000
Disposal of Equipment
Jan. 31 Equipment 12 000 Jan. 31 Accum. dep. of 10 000
Equipment
At this stage, both the Equipment and Accumulated depreciation of Equipment

accounts have a zero balance as the asset has been sold, and the Disposal of Equipment
account has a debit balance of $2 000, representing the Carrying value of, and the
expense incurred for, the equipment sold.
Recording the proceeds on disposal (the ‘selling price’) of the asset

At the same time as the asset is removed from the accounts, the business will also
receive some form of revenue from the buyer, with these Proceeds from the sale of the
asset increasing in assets (via Bank, or for a trade-in, the new non-current asset) and
owner’s equity.
In the case of a cash sale, Bank will increase via a debit entry, with a corresponding
Study tip credit entry recorded in the Disposal of Equipment account as shown in Figure 14.13:
Figure 14.13 General Journal: Proceeds on cash sale

These entries are General Journal
slightly different if the Date Details Debit $ Credit $
asset is traded-in – see Jan. 31 Bank 1 100
Section 14.6.
Disposal of Equipment 1 100
This amount of $1 100 would be reported as an Investing inflow in the Cash Flow
Statement because it is a cash inflow related to the sale of a non-current asset and might
be reported as Cash received from sale of equipment or Proceeds from sale of equipment.
The proceeds from the sale would be posted to the General Ledger as shown in
Figure 14.14:
Figure 14.14 General Ledger: Proceeds on cash sale

General Ledger
Bank (A)
31 Disposal of Equipment 1 100
Equipment
Bank 1 100

The Disposal of Equipment account now shows the Carrying value of the asset that
has been disposed of (on the top line) and the proceeds from the disposal (on the second
line), and with this information the profit or loss on the disposal of the equipment can
be calculated.
Recording the profit or loss on disposal

Although the Disposal of Non-current asset account shows both the expense incurred
by the disposal (the Carrying value of the asset) and the revenue earned from the
disposal (the proceeds from the sale), only the net effect (the overall profit or loss on
disposal) will be reported in the Income Statement. Thus, the Disposal of Non-current
asset account must be closed, and its balance transferred to a separate account called
either ‘Profit on Disposal of Non-current asset’ or ‘Loss on Disposal of Non-current
asset’.
Loss on disposal of a non-current asset

Where the proceeds on sale is less than the Carrying value of the asset, a loss on loss on disposal of
disposal of non-current asset has been earned. non-current asset
Figure 14.15 shows that in this case a Loss on Disposal of Equipment has occurred an expense incurred when the
proceeds from the disposal
as the Proceeds from sale of equipment is less than the Carrying value of the equipment:
of a non-current asset is less
than its Carrying value when
Figure 14.15 Calculation: Profit (loss) on disposal of a non-current asset disposed
Proceeds from sale of equipment $1 100

less Carrying value 2 000
Loss on Disposal of Equipment (900)
This loss is also reflected in the Disposal of Equipment account (from Figure 14.14),
which has a debit balance (of $900) just like an expense account. This confirms that
there has been a Loss on Disposal of Equipment.
The Disposal of Equipment account must therefore be credited $900 so that it
closes and is set to zero, with a corresponding debit recorded in the Loss on Disposal of
Equipment account to record the overall expense incurred on the disposal of the asset.
The General Journal entry to record the Loss on Disposal of Equipment is shown in
Figure 14.16:
Figure 14.16 General Journal: Loss on disposal of non-current asset

General Journal
Jan. 31 Loss on Disposal of Equipment 900
Disposal of Equipment 900
Disposal of equipment – cash sale at a loss (Rec. 17)
As noted above, although the disposal has been shown here as three separate
components, it is one transaction. All three components (the transfer of the Carrying
value, the recording of the proceeds on disposal and the transfer of the loss on disposal)
form one entry to record the one transaction. As a consequence, the narration is made
only at the end of the General Journal entry.

Following the recording of this loss on disposal, the General Ledger accounts would
Figure 14.17 General Ledger: Loss on disposal of non-current asset

General Ledger
Equipment
Bank 1 100
Loss on Disposal of 900
Equipment
12 000 12 000
Loss on Disposal of Equipment (E)

Jan. 31 Disposal of Equipment 900
The Disposal of Equipment account has been closed and now has a zero balance,
and the Loss on Disposal of Equipment account shows the overall loss incurred on the
profit on disposal of sale ($900), which will be closed to the Profit and Loss Summary account at the end of
non-current asset
the period and reported in the Income Statement with the ‘Other expenses’.
a revenue earned when the
proceeds from the disposal of
a non-current asset are greater Profit on disposal of a non-current asset
than its carrying value when If the Disposal of Asset account has a credit balance, like a revenue account, it would
disposed represent a profit on disposal of non-current asset because the proceeds from the
sale would be greater than the Carrying value.
Example As at 31 October 2025, the accounts of Mallacoota Wines showed the following:
General Ledger
Disposal of Furniture
Oct. 31 Furniture 8 000 Oct. 31 Accum. dep. of 6 000
Furniture
Bank 2 300
This account currently has a credit balance of $300, representing a Profit on disposal
of Furniture because the proceeds from sale are greater than the Carrying value, as is
Figure 14.18 Calculation: Profit (loss) on disposal of a non-current asset
Proceeds from sale of furniture $2 300

less Carrying value 2 000
Profit on Disposal of Furniture 300
The Disposal of Furniture account must therefore be debited $300 so that it closes
and is set to zero, with a corresponding credit recorded in the Profit on Disposal of
Furniture account to record the overall revenue earned on the disposal of the asset.

The General Journal entry to record the Loss on Disposal of Furniture is shown in
Figure 14.19:
Figure 14.19 General Journal: Profit on disposal of non-current asset

General Journal
Jan. 31 Disposal of Furniture 300
Profit on Disposal of Furniture 300
Disposal of furniture – cash sale for a profit (Rec. 41)
Following the recording of this profit on disposal, the General Ledger accounts would
Figure 14.20 General Ledger: Profit on disposal of non-current asset

General Ledger
Oct. 31 Furniture 8 000 Oct. 31 Accum. dep. of 6 000
Profit on Disposal of 300 Furniture
Furniture Bank 2 300
8 300 8 300
Profit on Disposal of Furniture (R)

Oct. 31 Disposal of Furniture 300
As a revenue account, Profit on Disposal of Furniture would be closed to the Profit

and Loss Summary account at the end of the Period with other revenues, such as Sales,
(Sales returns), Inventory gain and Discount revenue, and in the Income Statement it
would be reported (with Discount revenue) as ‘Other revenues’.

1 List the three steps involved in recording the disposal of a non-current asset.
2 State one reason why the asset is measured by its Carrying value rather than
its Historical cost when it is sold or traded in.
3 Show the General Journal entries necessary to record the cash sale of a non-
current asset at a loss.
4 Explain how the proceeds from the cash sale of a non-current asset would be
reported in the Cash Flow Statement.
5 Define the terms:
• loss on disposal of a non-current asset.
• profit on disposal of a non-current asset.
6 State what is indicated if the Disposal of Non-current asset account has a:
• debit balance
• credit balance.
7 Show the General Journal entries necessary to close the Disposal of Non-
current asset account if it has a credit balance.
8 Explain why Profit on Disposal of Non-current asset is reported under ‘Other
revenues’ in the Income Statement.

14.5 Profit or loss on disposal of a non-current asset

Given that depreciation is an attempt to calculate the value of a non-current asset that
has been incurred in each period of its life, the Carrying value of that asset is also an
attempt to gauge the asset’s value (to the business) at any point in time. (This is not its
market value.) And because the proceeds from sale are based on the sale document
(and therefore cannot be ‘incorrect’), a profit or loss on the disposal of the asset indicates
that this Carrying value (and the depreciation that lead to its Carrying value) was in some
way inaccurate.
under-depreciation
when insufficient depreciation Loss on disposal of a non-current asset
expense has been allocated A loss on the disposal of a non-current asset occurs when the proceeds from its
over the life of a non-current disposal (its resale value) is less than its Carrying value. Put another way, a loss
asset due to overstating occurs when the Carrying value is too high or overstated, because the asset has been
its Residual value and/or
under-depreciated: not enough depreciation expense has been written off over the
Useful life, resulting in an
overstatement of the asset’s
asset’s life.
Carrying value In terms of the calculation of depreciation expense, under-depreciation may be
because the Residual value and/or Useful life were overstated, perhaps because the
original estimates did not anticipate that the asset would be:
• damaged
Study tip This would automatically reduce its resale (residual) value and could also decrease its
Useful life below what was originally anticipated.
• outdated or superseded by a newer, technologically superior model.
‘Poor estimates’ is a This would also reduce its resale value.
‘poor explanation’, as Thus, a loss on disposal occurs when the asset’s Carrying value is overstated (greater
it does not distinguish than the proceeds from its disposal), which could be caused by under-depreciation
between over-
because the Residual value and/or Useful life was overstated (perhaps because the
depreciation and under-
asset was damaged, superseded by a newer model or not in demand).
depreciation.
Profit on disposal of a non-current asset

over-depreciation
In contrast to a loss, a profit on the disposal of a non-current asset occurs when the
when excess depreciation
expense has been allocated proceeds from its disposal (its resale value) is greater than its Carrying value. Put another
over the life of a non-current way, a loss occurs when the Carrying value is too low or understated, because the asset
asset due to understating has been over-depreciated: too much depreciation expense has been written off over
its residual value and/or the asset’s life.
useful life, resulting in an In terms of the calculation of depreciation expense, over-depreciation may be
understatement of the asset’s
because the Residual value and/or Useful life were understated, perhaps because the
carrying value
original estimates did not anticipate that the asset would be:
• in good condition
Study tip This would increase its resale (residual) value and could also increase its Useful life.
• in high demand.
This may be because it is rare and would also increase its resale value.
The reasons for a profit Thus, a profit on disposal occurs when the asset’s Carrying value is understated
are the opposite of
(less than the proceeds from its disposal), which could be caused by over-depreciation
the reasons for a loss:
because the Residual value and/or Useful life was understated (perhaps because the
understand one set of
asset was in good condition or high demand).
reasons and simply
reverse them for the
other result.


1 Define the term ‘under-depreciation’.
2 State two causes of under-depreciation.
3 State two reasons why the Residual value may be overstated.
4 Explain how under-depreciation may lead to a loss on the disposal of a
non-current asset.
5 Define the term ‘over-depreciation’.
6 State two causes of over-depreciation.
7 State two reasons why the Residual value may be understated.
8 Explain how over-depreciation may lead to a profit on the disposal of a
non-current asset.
14.6 Trade-in of a non-current asset

trade-in
In some situations, a firm will not sell an asset for cash, but rather use the asset it is
proceeds from the disposal of
disposing as a trade-in on a newer model. This would mean that rather than receiving a non-current asset in the form
cash for the sale of the asset, the firm would receive a reduction in the amount payable of a reduction in the amount
for the purchase of a new non-current asset. payable for the purchase of a
new non-current asset
On 30 April 2025, Lexis Midnight Runners purchased a new delivery van worth Example
$30 000 (plus $3 000 GST) from IQ Motors (EFT Trans. 2026). As part of the
purchase, the firm traded-in an old delivery van with a Carrying value of $1 200
(cost $26 000 less Accumulated depreciation $24 800) for $700.
Carrying value
When traded-in, the entries to record the disposal of the old delivery van at its Carrying
value are the same as those used for a sale, with a credit to Van, a debit to Accumulated
depreciation of Van to remove the asset, and corresponding entries in the Disposal of
Van account (see Figure 14.11).
Proceeds on disposal
Indeed, even the credit to Disposal of Van to record the proceeds from the disposal is
the same. However, for a trade-in there is no debit to Bank to show the cash received
from the sale. Instead, the non-current asset account itself is debited to recognise this
is what the proceeds have been put towards – the purchase of the new asset.
(As there is no cash flow, the trade-in is not reported in the Cash Flow Statement.)
Profit (or loss) on disposal

The final step of recording the loss on disposal is recorded in the same way as it was for
a cash sale, with a credit to the Disposal of Van account to close this temporary account
and a debit to the Loss on Disposal of Van account to show the expense incurred.

Figure 14.21 shows how the trade-in of the old van, and purchase of the new van,
would be recorded in the General Journal:
Figure 14.21 General Journal: Trade-in and cash purchase of a non-current asset
General Journal
Apr. 30 Disposal of Van 26 000
Van 26 000
Disposal of Van 24 800
Van 700
Disposal of Van 700
Loss on Disposal of Van 500
Disposal of Van 500
Van 29 300
GST Clearing 3 000
Bank 32 300
Trade-in of old van for $700 on cash purchase of new
van for $30 000 plus GST (EFT Trans. 2026)
The cash paid for the purchase of the new van is not $33 000 ($30 000 plus GST)
because $700 has been deducted from this amount for the trade-in value. And while
the entries to record the purchase of the new van might look odd because the GST
paid ($3 000) is not 10% of the single debit of $29 300, the GST paid is 10% of the total
debits of $30 000 ($700 plus $29 300) in the Van account.
After the trade-in and purchase are posted to the General Ledger, and the Disposal
of Van account has been closed, the accounts would appear as shown in Figure 14.22:
Figure 14.22 General Ledger: Trade-in and cash purchase of a non-current asset
General Ledger
Van (A)
Apr. 1 Balance 26 000 Apr. 30 Disposal of Van 26 000
30 Disposal of Van 700
Bank 29 300
Accumulated depreciation of Van (−A)
Apr. 30 Disposal of Van 24 800 Apr. 1 Balance 24 800
Disposal of Van
Apr. 30 Van 26 000 Apr. 30 Accum. dep. of Van 24 800
Van 700
26 000 26 000
Loss on Disposal of Van (E)

Apr. 30 Disposal of Van 500
GST Clearing (L)

Apr. 30 Bank 3 000 Apr. 1 Balance 4 900
Bank (A)
Apr. 1 Balance 42 000 Apr. 30 Van/GST Clearing 32 300

The accounts show that the old vehicle is gone, and the new vehicle (valued at
$30 000) is recorded in the Van account.
As always, the Disposal of Van account has been closed, and the $500 loss has been
transferred to the Loss on Disposal of Van account, and the Van account has a new
balance of $30 000 representing the Historical cost of the new van that has just been
purchased.

1 Show the General Journal entries necessary to record a trade-in and cash
purchase of a non-current asset.
2 Explain why only some of the entries to record a trade-in and cash purchase
of a non-current asset are the same as those for a cash sale of a non-current
asset.
3 Explain how a trade-in is reported in the:
• Cash Flow Statement
• Income Statement. (Be careful!)

14.7 R
eporting profit or loss on disposal of a
non-current asset
As we already know (from Section 14.4), only the overall profit or loss on Disposal of
Non-current asset is reported in the Income Statement.
Loss on disposal of a non-current asset

If the proceeds from disposal are less than the Carrying value of the asset, the asset
will be sold at a loss. As an expense, the Loss on Disposal of Non-current asset account
must be closed to the Profit and Loss Summary account at the end of the Period along
with all the other expenses such as Cost of Sales, Wages and Rent expense. (See
Chapter 10 for closing revenue and expense accounts.)
In the Income Statement, Loss on Disposal of Non-current asset will be reported
under Other Expenses, as shown in Figure 14.23:
Figure 14.23 Income Statement: Loss on Disposal of a non-current asset

LEXIS MIDNIGHT RUNNERS
Income Statement for quarter ended 30 April 2025
$ $
Revenue
Sales 61 300
Less Sales returns 1 300 60 000
Freight in 2 000 37 000
Gross Profit 23 000
Less Inventory loss 300
Add Other revenue
23 400
Less Other expenses
Wages 14 050
Advertising 2 700
Rent expense 4 000 21 600
Net Profit 1 800
Profit on disposal of a non-current asset

The opposite of a loss is true for a Profit on Disposal of Non-current asset account:
it would be closed to the Profit and Loss Summary account with the other revenue
accounts, such as Sales, (Sales returns), Inventory gain and Discount revenue, and
reported in the Income Statement under Other revenue. This is shown in Figure 14.24:

Figure 14.24 Income Statement: Profit on Disposal of a non-current asset

MALLACOOTA WINES
Income Statement for year ended 31 December 2025
$ $
Revenue
Sales 145 900
Less Sales returns 900 145 000
Customs duty 2 000 41 000
Less Inventory loss 1 000
Add Other revenue
Profit on Disposal of Vehicle 300 800
103 800
Less Other expenses
Wages 53 000
Advertising 11 500
Rent expense 16 000 81 800
Net Profit 22 000
Note that the Carrying value of the non-current asset is not disclosed as a separate
expense, and the proceeds from disposal is not disclosed as a separate revenue: it is
only the overall profit or loss on disposal that is reported in the Income Statement.

1 Explain how a loss on disposal of a non-current asset would be reported in the
Income Statement.
2 Explain how a profit on disposal of a non-current asset would be reported in
the Income Statement.

Where have we been?

• The reducing balance method of depreciation assumes that the asset contributes more to revenue at the
start of its life, and less as it ages, and allocates more depreciation at the start of the asset’s life, and less
as it ages.
• The reducing balance method calculates depreciation expense as a percentage of the asset’s Carrying value.
• Over the life of the asset, the straight-line and reducing balance methods will allocate the same total
depreciation expense.
• Comparability demands that depreciation methods are not changed from period to period, ensuring the
reports can be compared.
• Recording the disposal of a non-current asset involves:
– transferring the Carrying value of the asset
– recording the proceeds from the disposal
– recording the profit or loss on disposal.
• The cash received from the sale of a non-current asset is an Investing cash inflow.
• A loss on disposal of a non-current asset occurs when the Carrying value of the asset is greater than the
proceeds from its sale, because it has been under-depreciated.
• A profit on the disposal of a non-current asset occurs when the Carrying value of the asset is less than
the proceeds from its sale, because it has been over-depreciated.
• Only the overall profit or loss on the disposal of a non-current asset is reported in the Income Statement,
as Other revenue (for a profit) or Other expense (for a loss).
Exercises
this book.

Purchase of a non-current asset
On 30 April 2025, Neil Downe purchased a new computer for his business, Knibs and Pens. The document
relating to the purchase was received on 30 April 2025 when the computer was delivered:
CRASH COMPUTERS TAX INVOICE: X.24

ABN: 34 354 365 887
Wells Rd
Frankston VIC 3199 TAX INVOICE
Customer: Knibs and Pens (ABN: 56 575 334 102)
Elizabeth St, Dandenong VIC 3175
Date Details Total
30 April 2025 Computer system and software 2 400
Installation 250
Subtotal 2 650
GST 265
Total invoice price $2 915
Knibs and Pens paid Crash Computers in full on 30 April 2025 using Cheque 196.
Required
a Record Cheque 196 in the General Journal of Knibs and Pens.
b Referring to your answer to part ‘a’, explain your treatment of installation.
c Explain the effect of Cheque 196 on the Accounting equation of Knibs and Pens.
d Explain why Cheque 196 would be insufficient to verify the GST paid on 30 April 2025.
e Referring to one Accounting assumption, explain why the entire cost of the computer should not be
reported as an expense for April 2025.

Purchase of a non-current asset
On 1 April 2025, Matt’s Mowers purchased a new photocopier. The document relating to the purchase is
shown below:
Phil’s Photocopiers
Main St Tax invoice: 36
Mornington VIC 3931 ABN: 35 444 000 121
Customer: Matt’s Mowers (ABN: 65 555 760 012)

Ferntree Gully VIC 3156
Date Details Total
1/4/25 Photocopier T – 1000 21 000
Fitting of card-identification system 1 500
Technical assistance (12-month period) 1 200
Subtotal 23 700
GST 2 370
Total invoice price $26 070
Amount paid $26 070
Balance owing nil
Required
a Define the term ‘cost’ as it applies to non-current assets.
b Record this transaction in the General Journal of Matt’s Mowers. A narration is not required.
c Referring to your answer to part ‘b’, explain your treatment of the cost of the technical assistance.
d Show how the cost of technical assistance would be reported in the Balance Sheet of Matt’s Mowers as
at 30 April 2025.

Depreciation methods
On 30 September 2025, Kristine’s Kites purchased new shelving for $12 000 and a new sewing machine for
$500 from Trojan Products (EFT Trans. 3009). GST charged on the purchase amounted to $1 250. Kristine has
not yet selected a depreciation method.
Required
a Record EFT Transaction 3009 in the General Journal of Kristine’s Kites.
b Referring to one Accounting assumption, explain why it is necessary to depreciate non-current assets.
c Explain why the straight-line method should be used to depreciate the shelving.
d Explain why the reducing balance method should be used to depreciate the sewing machine.
e Explain why the shelving and sewing machine would still need to be depreciated separately even if the
same depreciation method was used.


Reducing balance depreciation
On 1 July 2024, Benanee Rubber purchased a new delivery van for $32 000 plus GST. The van is to be
depreciated at 20% per annum using the reducing balance method (Memo 12).
Required
a State the assumption that underlies the reducing balance method of depreciation in relation to how
assets contribute to revenue.
b Calculate Depreciation of Van for the year ended 30 June 2025.
c Record Depreciation of Van for the year ended 30 June 2025 in the General Journal of Benanee Rubber.
d Show how the van would appear in the Balance Sheet of Benanee Rubber as at 30 June 2025.
e Calculate Depreciation of Van for the year ended 30 June 2026.

Reducing balance depreciation
As at 30 June 2025, the Balance Sheet of Heavenly Designs showed the following:
$ $
Non-current Assets
Computers 10 000
Both assets are depreciated at 18% per annum using the reducing balance method.
Required
a Calculate Depreciation of Computers for the year ended 30 June 2026.
b Record Depreciation of Computers for the year ended 30 June 2026 in the General Journal of Heavenly
Designs. A narration is not required.
c Show how the Computers would be reported in the Balance Sheet of Heavenly Designs as at 30 June 2026.
d Explain one reason why the owner should change the method of depreciation used for the Shop fittings.
e Referring to one Qualitative characteristic, explain one reason why the owner should not change the
method of depreciation used for the Shop fittings.
f Given that they were purchased on 1 July, calculate the year in which the Shop fittings were purchased.

Comparing depreciation methods
On 1 July 2025, Babyland purchased shop equipment for $13 200 including GST. The owner argues that the
only way to uphold the Qualitative characteristic of Comparability is to depreciate the shop equipment at 10%
per annum using the straight-line method. The accountant has argued that the Shop equipment should be
depreciated at 15% using the reducing balance method.
Required
a Suggest one reason why the owner might (incorrectly) argue that Comparability requires the use of the
straight-line method of depreciation.
b Referring to your answer to part ‘a’, state one reason why the owner is incorrect.
c Identify one extra piece of information you would require before agreeing with the accountant. Justify
your answer.

d Calculate Depreciation of Shop equipment for the year ended 31 December 2025 using the straight-line
method.
e Calculate Depreciation of Shop equipment for the year ended 31 December 2025 using the reducing
balance method.
f Explain how the choice of depreciation method will affect Net Profit for the year ended 31 December 2025.
g Calculate depreciation expense for the year ended 31 December 2026 to 2030 under both the straight-
line and reducing balance methods to model how Net Profit is affected by the choice of depreciation
method over the life of the asset.

Graphing depreciation
Justinian Printing has provided the following graphs relating to depreciation of its non-current assets:
$8000
$12000
$7000
$10000
$6000
$8000 $5000
$6000 $4000
$4000 $3000
$2000
$2000
$1000
$0
$0
2015 2016 2015 2018 2019 2015 2016 2015 2018 2019
Photocopiers Office equipment
Depreciation expense Depreciation expense
Line A Line B
Required
a Identify the depreciation method used for the:
• Photocopiers
• Office equipment
Justify your answers.
b Identify the lines labelled ‘Line A’ and ‘Line B’. Justify your answers.
c Identify the Historical cost of the Photocopiers.
d Discuss whether the owner should change the method used to calculate Depreciation of Photocopiers.
e Explain the effect on the Carrying value of the Office equipment at the end of its Useful life if the owner
had used the other depreciation method.


Cash sale of a non-current asset
On 1 August 2025, Party Pots sold a van for $3 000 cash (Receipt 31). The van had been purchased for $24 000
and already depreciated by $19 000 at the time of sale.
Required
a Record Receipt 31 in the General Journal of Party Pots.
b Show how the Van, Accumulated depreciation of Van, Disposal of Van and profit or loss on Disposal of
Van accounts would appear after the General Journal was posted to the General Ledger of Party Pots.
c Explain the effect of Receipt 31 on the Accounting equation of Party Pots.
d Explain how the proceeds from the sale would be reported in the Cash Flow Statement of Party Pots for
August 2025.

As at 31 December 2024, the Balance Sheet of Triffic Toys showed the following:
TRIFFIC TOYS
Balance Sheet as at 31 December 2024
$ $
Non-current Assets
Fittings 36 000
The fittings are depreciated using the straight-line method at 10% per annum. On 31 March 2025, the
fittings were sold for $2 700 cash (Receipt 96).
Required
a Calculate the Carrying value of the fittings as at 31 March 2025.
b Record Receipt 96 in the General Journal of Triffic Toys.
c Show how the Fittings, Accumulated depreciation of Fittings, Disposal of Fittings and profit or loss on
Disposal of Fittings accounts would appear after the sale was posted to the General Ledger of Triffic Toys.
d Suggest two reasons for the profit or loss on the disposal of the fittings.
e Show how the profit or loss on the disposal of the fittings would be reported in the Income Statement of
Triffic Toys for March 2025.
f Calculate Accumulated depreciation of Fittings to model the effect on profit or loss on Disposal of
Fittings if they were sold:
• for $2 000 on 30 April 2025
• for $1 200 on 30 June 2025.


An extract from the General Ledger of Vicki’s Vinyls as at 31 October 2025 showed the following:
Oct. 16 Furniture 8 000 Oct. 16 Accum. dep. of Furniture 5 000
Bank 1 900
The sale of furniture was verified by Receipt 33.
Required
a Explain how the proceeds from the disposal of furniture would be reported in the Cash Flow Statement
of Vicki’s Vinyls for October 2025.
b Calculate the profit or loss on Disposal of Furniture.
c Explain one reason for the profit or loss on Disposal of Furniture.
d Show how the profit or loss on Disposal of Furniture would be reported in the Income Statement of
Vicki’s Vinyls for October 2025.
e Show how the Disposal of Furniture would have been recorded in the General Journal of Vicki’s Vinyls.

Trade-in of a non-current asset
On 1 May 2025, a van purchased for $30 000 by Swing Seats and already depreciated by $20 000 was traded
in for $7 000 on a new van, bought for $40 000 (plus GST) from Dodge Motors (EFT Trans. 2119).
Required
a Define the term ‘trade-in’.
b Record EFT Transfer 2119 in the General Journal of Swing Seats.
c Show how the Van, Accumulated depreciation of Van, Disposal of Van, profit or loss on Disposal of Van
and Bank accounts would appear after the disposal was posted to the General Ledger of Swing Seats.
d Define the term ‘under-depreciation’.
e State two causes of under-depreciation.
SWING SEATS


Trade-in of a non-current asset
Quilts Inc. recently traded in its cash register and purchased a much newer version. The old cash register
was purchased for $4 400 including GST, but had been depreciated by $3 100 at the time of trade-in. The tax
invoice for the transaction is shown below:
Cash Controllers INVOICE: A330

ABN: 45 765 300 118
Moore St, Moe VIC 3825 Terms: 10/7. n/60
Tax invoice
Charge to: Quilts Inc. (ABN: 52 590 436 466)
Keilor Rd, Essendon VIC 3040
Date Details Qty Unit price Total
1 June 25 Electronic cash register 1 6 000 6 000
GST 600
Invoice price 6 600
less Trade In 500
Cash paid (Cheque 113) 6 100
Balance owing nil
Required
a Record tax invoice A330 in the General Journal of Quilts Inc.
b Show how the Cash register and Disposal of Cash register accounts would appear after the disposal was
posted to the General Ledger of Quilts Inc.
c Explain how the value of the trade-in should be reported in the Income Statement for Quilts Inc. for
June 2024.
d Explain how the payment to Cash Controllers on 1 June 2025 would be reported in the Cash Flow
Statement of Quilts Inc. for June 2025.


Disposal of a non-current asset and financial reports
Kyabram Kites has provided the following Pre-adjustment Trial Balance as at 30 June 2025:
KYABRAM KITES
Accumulated depreciation of Fittings 24 000
Advertising 1 000
Bank 390
Capital – Darling 34 720
Cost of sales 14 820
Drawings 3 200
Fittings 60 000
GST Clearing 1 060
Inventory 26 670
Loan – Northern Bank (repayable $500 per month) 24 000
Sales 33 400
Sales returns 300
Wages 5 250
Totals 126 300 126 300
• On 30 June 2025, some fittings were traded in for $1 200 on new shop fittings, which cost $9 000 (plus
$900 GST) from Fits Well. The old fittings had been purchased for $5 000 but had a Carrying value of $2 000.
• Fittings are depreciated at 10% per annum using the reducing balance method.
• A physical inventory count on 30 June 2025 showed an Inventory loss of $170.
• As at 30 June 2025, $140 Interest expense was accrued, and Prepaid rent expense was $1 200.
• Reports are prepared monthly.
• The owner has suggested switching to the straight-line method of depreciation in an attempt to make
the firm look more profitable.
Required
a Record the additional information in the General Journal of Kyabram Kites. Narrations are not required.
* b Prepare a Post-adjustment Trial Balance for Kyabram Kites as at 30 June 2025.
c Show the General Journal entries necessary to close the expense accounts.
* d Prepare an Income Statement for Kyabram Kites for June 2025.
e Suggest two actions Kyabram Kites could take to improve Adjusted Gross Profit without changing its mark-up.
f Model the effect on Net Profit for June 2025 if Kyabram Kites had calculated Depreciation of Fittings at:
• 10% using the straight-line method
• 7% using the straight-line method.
g Referring to your answer to part ‘f’, explain why the owner’s suggestion will not make the firm look
more profitable.
h Explain why the owner’s suggested course of action may be said to be Ethical
unethical. considerations
* i Prepare a classified Balance Sheet for Kyabram Kites as at 30 June 2025.

Chapter 15
Bad and doubtful debts

After completing this chapter, you should be able to: • record the writing off of a bad debt in the General
• distinguish between doubtful debts and bad debts Journal and General Ledger
• explain how the Period and Accrual basis • explain the effect on the Accounting equation of
assumptions create a need to allow for doubtful bad debts and allowances for doubtful debts
debts • report bad debts expense in the Income Statement
• record the creation of an allowance for doubtful and Allowance for doubtful debts in the Balance
debts in the General Journal and General Ledger Sheet
• explain the circumstances in which a debt will be • discuss ethical considerations in business decision-
written off as ‘bad’ making.
Key terms
After completing this chapter, you should be familiar • Accounts Receivable Aging Analysis
with the following terms: • Allowance for doubtful debts.
• bad debt
• doubtful debt

C hapter 15 B ad and doubtful debts 401
15.1 Credit sales and Accounts Receivable

For most businesses, offering credit to customers is an important means of generating
sales. It allows customers to obtain goods when they do not have enough cash or
when they do have cash but want to delay payment, so they can use their existing cash
for other purposes. As a result, making sales on credit can mean higher sales overall,
and under the Accrual basis assumption these credit sales will increase profit, as the
revenue is recognised as being earned at the point of sale, with the asset Accounts
Receivable increasing as a result.
‘Bad’ and ‘doubtful’ debts

However, offering credit sales is not without its costs and risks. Even with the best
procedures to ‘screen’ customers and follow up on debts that are late, businesses that
sell on credit are still likely to suffer a certain number of bad debts – debts that must bad debt
be ‘written off’ as irrecoverable or uncollectable because the Account Receivable is a debt that must be ‘written
unable to pay. This would usually be because the business has received confirmation off’ as irrecoverable or
uncollectable because it
that the customer is in liquidation or has been declared bankrupt. These bad debts
has been confirmed that the
reduce Accounts Receivable and are recognised as expenses as they also decrease Account Receivable is unable
owner’s equity by decreasing Net Profit. to pay due to liquidation or
bankruptcy
Doubtful debts
Where the bad debt occurs in the same Period as the credit sale from which it has
come, the Income Statement will also uphold the Accrual basis assumption as the
expense incurred (the bad debt) will be matched against the revenue earned (from the
credit sale) in that Period.
Unfortunately, not all debts are identified as being ‘bad’ in the Period in which the
credit sale is made: in many cases it takes months before the business is able to confirm
that a debt is uncollectable. This creates a dilemma for the accountant who will know
that at least some of the credit sales are likely to turn into bad debts and not be collected
from the Accounts Receivable, but will not know which ones, for how much, or when.
In response, it is necessary to estimate an amount of doubtful debts – debts that doubtful debt
are unlikely to be collected in the future but have not yet been ‘written off’ (as it has not a debt that is unlikely to be
been confirmed that Accounts Receivable will be unable to pay) – and use this estimate collected in the future but has
not yet been ‘written off’ as it
to make a balance day adjustment for Bad debts expense.
has not been confirmed that the
Like depreciation expense, the amount calculated will be an estimate and not Account Receivable is unable
Verifiable as there will be no source document to prove its accuracy. However, it will be to pay
less inaccurate than simply reporting Accounts Receivable in full, and not reporting any
bad debts at all until the Accounts Receivable is confirmed as being bankrupt. Further,
using the amount estimated to be doubtful to inform the balance day adjustment allows
the Bad debts expense to be recognised in the Period in which the credit sale is made,
thereby upholding the Accrual basis assumption and ensuring that profit is calculated
accurately by matching the expense incurred (Bad debt) in the same Period as the
revenue earned (Credit sale).
Faithful representation and Relevance

Together, estimating doubtful debts ensures that the Income Statement and Balance
Sheet provide a more Faithful representation of the firm’s performance and position,
and the owner has all Relevant information that may affect decision-making.
Indeed, it may be argued that omitting the effects of Bad debts expense from the
Income Statement and Balance Sheet is actually unethical, as it would mean the reports

represented the firm’s profit and position in a more favourable light, but one that was
Ethical ultimately inaccurate. The reports would actually be misleading, so any decisions made
considerations based on the information they contained could be false and ultimately damaging to the
business and its owner.

1 Explain why many businesses offer credit terms.
2 Referring to the definitions of the Elements of the reports, explain why a credit
sale is recognised as revenue.
3 Define the term ‘bad debt’ and describe the circumstances in which a debt
would be written off as bad.
4 Define the term ‘doubtful debt’.
5 Referring to the Accrual basis assumption, explain why it is necessary to
record a balance day adjustment for Bad debts expense in the Period when
credit sales are made.
6 Referring to two Qualitative characteristics, explain why is necessary to
recognise and report Bad debts expense.
Ethical 7 Explain why recognising Bad debts expense in the Accounting reports is an
considerations ethical consideration.
15.2 B
alance day adjustment: Bad debts expense
(Allowance for doubtful debts)
Rather than identifying specific amounts from specific Accounts Receivable that may
not be collected, the amount for doubtful debts is usually calculated using:
• a Accounts Receivable Ageing Analysis
This is a listing of amounts yet be collected from Accounts Receivable classified
by the length of time for which they have been owing, with the oldest amounts
considered least likely to be collected.
OR
• the Income Statement approach
Based on historical data, this method estimates that a certain percentage of the
firm’s Net credit sales in the Period is likely to be uncollectable. This is the method
used in this course.
Example GUR Gullible sells cleaning equipment and has provided the following extract from
its Pre-adjustment Trial Balance as at 30 September 2025:
GUR Gullible
Pre-adjustment Trial Balance as at 30 September 2025
Sales 120 000
Sales returns 3 000
• Data from previous years suggests that 2% of Net credit sales will be doubtful
of collection.
• At 30 September 2025, the accountant asked for a balance day adjustment to
be recorded to recognise bad debts for September 2025 (Memo 103).

Calculating doubtful debts

Under the Income Statement approach, the business estimates doubtful debts as a
percentage of Net credit sales. Figure 15.1 shows how this would be calculated for GUR
Gullible for September 2025:
Figure 15.1 Calculation: Doubtful debts (Income Statement approach)
Doubtful debts = Estimated rate × Net credit sales

= 2% × ($120 000 – $3 000)
= 2% × $117 000
= $2 340
In this example, $2 340 of the Net credit sales of $117 000 is considered doubtful of
collection.
Balance day adjustment: Bad debts expense (Allowance for doubtful

debts)
Source
documents
Once the estimated doubtful debts has been calculated, this must be recorded by
making a balance day adjustment to ensure that the Accrual basis assumption is upheld
and that profit is calculated accurately by matching revenue earned against expenses
incurred in the current Period.
Because it is not confirmed that specific doubtful debts will be written off, the
estimated doubtful debts is not credited directly against the balance of the Accounts
Receivable account. Instead, an Allowance for doubtful debts account is created to Allowance for doubtful
record the amount of Net credit sales from the current Period that is expected to be debts
written off as a bad debt at some point in a future Period. a negative asset account that
records the balance of doubtful
As a negative asset account, the Allowance for doubtful debts account is credited
debts (that are unlikely to be
$2 340, with the corresponding debit recorded in the Bad debts account to recognise collected in the future but have
the expense incurred, as a result of credit sales made, in the current Period. not yet been written off)
Figure 15.2 shows how this creation of the allowance for doubtful debts would be
recorded in the General Journal:
Figure 15.2 General Journal: Bad debts expense, Allowance for doubtful debts
General Journal
Sept. 30 Bad debts 2 340
Allowance for doubtful debts 2 340
Creation of Allowance for doubtful debts – 2% of Net credit
sales (Memo 103)

This would be posted to the General Ledger as shown in Figure 15.3:
Figure 15.3 General Ledger: Bad debts expense, Allowance for doubtful debts
General Ledger
Allowance for doubtful debts (–A)

Study tip
Sept. 30 Bad debts 2 340
Allowance for Doubtful Bad debts (E)

debts is a negative asset Date Cross-reference Amount $ Date Cross-reference Amount $
account like Accumulated Sept. 30 Allowance for 2 340
depreciation.
doubtful debts
Note that the balance day adjustment does not affect the Accounts Receivable
account, as no specific debt – and indeed, no specific Account Receivable – has been
written off. Instead, an estimate of what is doubtful of collection has been recorded
in the Bad debts expense account, creating an Allowance for doubtful debts (negative
asset) in the process.
Effect on Accounting equation

The balance day adjustment to record Bad debts and create the Allowance for doubtful
debts thus has the following effect on the Accounting equation:

Assets Decrease (Increase Allowance for doubtful debts) 2 340
Owner’s equity Decrease (Bad debts expense decreases Net Profit) 2 340
Reporting: Bad debts expense and Allowance for doubtful debts
Source
documents
Following the recording of the balance day adjustment, the Bad debts account would
then be closed to the Profit and Loss Summary account with all other expense accounts
and reported in the Income Statement under ‘Other expenses’, helping to ensure
that the Accrual basis assumption is upheld, and that profit is calculated accurately by
comparing revenues earned against expenses incurred in the current Period.
By contrast, as a negative asset account, the Allowance for doubtful debts would be
balanced and then reported in the Balance Sheet with Accounts Receivable as shown
in Figure 15.4:

Figure 15.4 Balance Sheet: Allowance for doubtful debts

GUR Gullible
Balance Sheet as at 30 September 2025
$ $
Current Assets
less Allowance for doubtful debts 2 340 62 660
This ensures that the Balance Sheet provides a Faithful representation of the amount owed
by Accounts Receivable, as the information is not only accurate but also complete. In turn, this
ensures that the report contains all the information that may be Relevant to decision-making.
Decision-making: Bad debts expense
Source
documents
Given the negative effect of Bad debts expense on Net Profit, businesses should do
everything possible to increase the likelihood that their Accounts Receivable will in fact
pay and pay on time. This will begin before the credit sale is made in the first place, and
include:
• offering discounts for quick settlement
• sending invoices promptly Study tip
• conducting extensive credit checks
• sending reminder notices
• threatening legal action See Section 6.7 for a
• employing a debt collection agency full discussion of these
• denying access to credit facilities strategies.
• developing a strong relationship with each customer
• appointing an Accounts Receivable Officer / Clerk
• considering non-financial information, all while
• acting in an ethical manner.

1 Show how doubtful debts is calculated using the Income Statement approach.
2 Referring to one Accounting assumption, explain the purpose of making a
balance day adjustment for bad debts.
3 Explain the role of the Allowance for doubtful debts account.
4 Show the General Journal entries to record the balance day adjustment for Bad
debts expense.
5 Explain why the balance day adjustment for bad debts does not affect the
Accounts Receivable account.
6 Show the effect on the Accounting equation of the balance day adjustment for
Bad debts expense.
7 Explain how the reporting of Bad debts expense in the Income Statement
upholds the Accrual basis assumption.
8 Explain how the reporting of Allowance for doubtful debts in the Balance Sheet
ensures Relevance and Faithful representation.
9 List four strategies that might be used to reduce the likelihood of bad debts.

15.3 Subsequent periods

Under the Income Statement approach to doubtful debts, Bad debts expense is
recognised and recorded in the Period when the credit sale is made. This means in
the next Period, when the debt is confirmed as ‘bad’ and must be written off, there is
actually no expense to record. Instead, the amount owing by the Account Receivable is
reduced, and so too is the Allowance for doubtful debts and the GST Clearing.
Example During September 2025, GUR Gullible made a credit sale to I. Karntpae for goods
worth $1 500 plus GST. On 16 October 2025, GUR Gullible received notification
that I. Karntpae had been declared bankrupt and would be unable to pay the
$1 650 owing. The accountant of GUR Gullible decided to write off the debt as bad
(Memo 129).
Writing off a bad debt
Source
documents
As the $1 650 is no longer receivable from I. Karntpae, Accounts Receivable must be

credited to reduce the asset. However, Bad debts expense has already been recorded
via the balance day adjustment on 30 September 2025 (in the period when the credit
sale was made) so there is no need to record the expense again. Indeed, to do so
would be to double count the Bad debts expense, this time outside the Period in
which it was incurred.
Instead, the Allowance for doubtful debts is debited $1 500 thereby reducing or
‘using up’ some of the allowance created via the balance day adjustment at the end of
the previous Period. The GST Clearing account is also debited $150 to recognise that
because the cash will not be collected from the Account Receivable, it does not need to
be forwarded to the ATO, so this liability decreases.
Figure 15.5 shows the General Journal entries to record the writing off of the bad
debt:
Figure 15.5 General Journal: Writing off Bad debt

General Journal
Sept. 30 Allowance for doubtful debts 1 500
GST Clearing 150
Accounts Receivable * 1 650
Debt written off as uncollectable due to bankruptcy
(I. Karntpae) (Memo 129)
* If individual accounts were used this entry would need to name the Account Receivable.

This would be posted to the General Ledger as shown in Figure 15.6:
Figure 15.6 General Ledger: Writing off Bad debt

General Ledger
Oct. 1 Balance 65 000 Oct. 16 Allowance for 1 650
doubtful debts/
GST Clearing

Oct. 16 Accounts Receivable 1 500 Oct. 1 Balance 2 340
GST Clearing (L)

Oct. 16 Accounts Receivable 150 Oct. 1 Balance 4 500
The fact that the Allowance for doubtful debts account has a remaining balance
means that the amount which was doubtful – expected to turn ‘bad’ – has not yet been
written off, and it could be said that the amount recorded as Bad debts at the end of
September 2025 was overstated. However, this is only true in terms of the current
Period: other debts from credit sales made in September 2025 may turn out to be
uncollectable in future Periods, meaning that the estimate of doubtful debts may still
prove to be correct over the life of the business.
Effect on Accounting equation

Although this entry changes two assets, it does so by different amounts leading to the
following effect on the Accounting equation:

Assets Decrease (Decrease Accounts Receivable $1 650; 150
decrease All. for doubtful debts $1 500)
Liabilities Decrease 150
Note that there is no effect on owner’s equity as the Bad debts expense was
recorded in the previous Period (when the credit sale and the balance day adjustment
were made).

Accounts Receivable account

Given this entry to write off a bad debt, it is perhaps worth revisiting how the Accounts
Receivable account might appear in the General Ledger. Figure 15.7 shows the entries
that might appear in the Accounts Receivable account:
Figure 15.7 General Ledger: Accounts Receivable account

General Ledger
Jan. 1 Balance 1
46 000 Jan. 8 Bank/Discount expense 3
50 530
55 000 17 Sales returns/GST Clearing
4
5 720
21 Allowance for 2 750
doubtful debts/
GST Clearing5
30 Balance 6 42 000
101 000 101 000
Feb. 1 Balance 6 42 000
In terms of transactions and events, these entries then represent:
On the debit side On the credit side:

1. Amount owing at start (of current Period) 3. Cash received plus Discount expense
2. Credit sales including GST 4. Sales returns including GST
5. Bad debt written off
6. Amount owing at end (of current Period)
Total debits Total credits
6. Amount owing at start (of next Period)
With the exception of the Balances, an Accounts Receivable account is likely to have
more than one of each of these entries as it will make credit sales, receive cash and
receive returns more than once each Period. (Hopefully, it will not have to write off bad
debts too many times!). However, the cross-references would be the same, meaning
the account contained a summary of all the transactions affecting all the firm’s Accounts
Receivable.
Balance day adjustment: Subsequent period

In the previous example (in Section 15.2), there was no existing balance in the Allowance
for doubtful debts account, so the amount calculated as doubtful debts ($2 340) was
exactly the same as the amount used in the balance day adjustment to record Bad debts
expense and create the allowance. However, where there is an existing balance in the
Allowance for doubtful debts account, this will affect the amount of the balance day
adjustment to record the Bad debts expense.
Example The Net credit sales of GUR Gullible for October 2025 was $123 000. Once again
doubtful debts was estimated to be 2% of Net credit sales and as at 31 October
2025 the balance of Accounts Receivable (before balance day adjustments) was
$72 000.

Calculating doubtful debts

As before, doubtful debts is calculated as a percentage of Net credit sales, and doubtful
debts for October 2025 is shown in Figure 15.8:
Figure 15.8 Calculating doubtful debts: Income Statement approach
Doubtful debts = Estimated rate × Net credit sales

= 2% × $123 000
= $2 460
For October 2025, $2 460 is considered doubtful of collection.
Balance day adjustment: Bad debts expense (Allowance for doubtful

debts)
Source
documents
The balance day adjustment to record Bad debts expense must reflect the estimated
doubtful debts for the Period, but it must also take into account any existing balance in
the Allowance for doubtful debts account.
Figure 15.9 shows the Allowance for doubtful debts account for GUR Gullible as it
would appear prior to the balance day adjustment for October 2025:
Figure 15.9 General Ledger: Allowance for doubtful debts – existing balance
General Ledger
840
In this example, Net credit sales for October 2025 are expected to result in doubtful
debts of $2 460, but the Allowance for doubtful debts account already shows an existing
balance of $840. As a result, the balance day adjustment to be recorded as at 31 October
2025 must only record the difference as calculated in Figure 15.10:
Figure 15.10 Calculation: Bad debts expense
Bad debts = Doubtful debts (current Period) – Existing balance (All. for doubtful debts)
= $2 460 – $840
= $1 620

Although $2 460 is estimated to be doubtful of collection from Net credit sales made
in October 2025, the existing balance of $840 in the Allowance for doubtful debts account
means that only $1 620 must be recorded as the balance day adjustment for October
2025. That is, because Bad debts expense was overstated in September 2025, it must
be understated in October 2025 to compensate.
Over the life of the business the correct amount of doubtful debts may still be written
off as bad, but within each Period the amount recognised as Bad debts may be over or
understated.
Figure 15.11 shows the balance day adjustment to record the Bad debts expense
and the increase in the Allowance for doubtful debts in the General Journal:
Figure 15.11 General Journal: Bad debts expense, Allowance for doubtful debts
General Journal
Oct. 31 Bad debts 1 620
Creation of allowance for doubtful debts – 2%
of Net credit sales (Memo 103)
Figure 15.12 shows the General Ledger after posting this General Journal entry, and
closing and balancing the accounts as appropriate:
Figure 15.12 General Ledger: Bad debts expense, Allowance for doubtful debts
General Ledger
Nov. 1 Balance 72 000

31 Balance 2 460 Oct. 31 Bad debts 1 620
3 960 3 960
Nov. 1 Balance 2 460
Bad debts (E)

Oct. 31 Allowance for 1 620 Oct. 31 Profit and Loss 1 620
doubtful debts Summary
1 620 1 620
Although the entry to record the balance day adjustment for Bad debts expense
for October 2025 is only $1 620, the final balance of the Allowance for doubtful debts
account – taking into account the existing balance of $840 – ends up as $2 460, which
is the estimated amount of doubtful debts based on the Net credit sales of $123 000
for October 2025.

Reporting: Bad debts expense and Allowance for doubtful debts
Source
documents
The $1 620 recorded as Bad debts for October 2025 would be reported under Other
expenses in the Income Statement, and this is the amount by which the Accounting
equation would change:

Assets Decrease (Increase Allowance for doubtful debts) 1 620
Owner’s equity Decrease (Bad debts expense decreases Net Profit) 1 620
However, in terms of the Balance Sheet the amount reported as Allowance for
doubtful debts as at 31 October 2025 would be $2 460, as shown in Figure 15.13:
Figure 15.13 Balance Sheet: Allowance for doubtful debts

GUR Gullible
Balance Sheet as at 31 October 2025
$ $
Current Assets

1 Explain why there is no expense to record when a debt is written off as ‘bad’.
2 Show the General Journal entries to write off a bad debt.
3 Explain the circumstances that would lead to Bad debts expense being
overstated in one Period.
4 Show the effect on the Accounting equation of the entries to write off a bad
debt.
5 Show the Accounts Receivable account might appear if it included one of each
type of transaction.
6 Explain how an existing balance in the Allowance for doubtful debts account
can affect the balance day adjustment for Bad debts expense.

Where have we been?

• Offering credit sales is a way of generating more sales and profit.
• Bad debts are debts that must be ‘written off’ as irrecoverable or uncollectable because the Account
Receivable is unable to pay.
• Doubtful debts are debts that are unlikely to be collected in the future but have not yet been written off.
• The balance day adjustment for Bad debts allows the expense to be recognised in the Period in which
the credit sale is made, thereby upholding the Accrual basis assumption.
• Estimating doubtful debts ensures that the Income Statement and Balance Sheet provide a more Faithful
representation of the firm’s performance and position, and the owner has all Relevant information that
may affect decision-making.
• Recognising Bad debts expense in the reports is an ethical consideration.
• Doubtful debts is calculated using the Income Statement approach, and recorded as Bad debts expense
and Allowance for doubtful debts
• Allowance for doubtful debts is a negative asset that is reported with Accounts Receivable in the Balance
Sheet.
• When a bad debt is written off it is not recorded as an expense, but decreases the Accounts Receivable,
Allowance for doubtful debts and GST Clearing accounts.
• Previous balances in the Allowance for doubtful debts account must be taken into account when
recording the balance day adjustment for Bad debts expense.
Exercises
this book.

During August 2025, Flicker Films had Net credit sales of $130 000 plus GST. As at 31 August 2025, Accounts
Receivable had a balance of $42 000 but reports from previous periods indicate that about 3% of Net credit
sales are doubtful debts. On 31 August 2025, the accountant asked for bad debts expense to be recorded
(Memo 27).
Required
a Define the term ‘doubtful debts’.
b Calculate doubtful debts for Flicker Films for August 2025.
c Record Memo 27 in the General Journal of Flicker Films.
d Referring to your answer to part ‘c’, explain how the balance day adjustment for Bad debts expense
upholds the Accrual basis assumption.
e Show how the Bad debts expense, Allowance for doubtful debts and Accounts Receivable accounts
would appear in the General Ledger of Flicker Films as at 31 August 2025.
f Show how Accounts Receivable would be reported in the Balance Sheet of Flicker Films as at
31 August 2025.


Cleary Cabinets sells kitchen cabinets and as at 1 March 2025 the balance of its Accounts Receivable account
was $85 000. During March 2025, the following transactions occurred:
March 8 Credit sale of inventory for $140 000 plus GST

15 Sales return of goods worth $8 000 plus GST
23 Sale of goods to Accounts Receivable for $66 000 including GST
Reports from previous periods indicate that about 5% of Net credit sales is doubtful and on 31 March 2025
the accountant asked for the balance day adjustments for March 2025 to be recorded (Memo 96).
Required
a Identify the source documents that would have verified the transactions on 8 and 15 March 2025.
b Calculate doubtful debts for Cleary Cabinets for March 2025.
c Record Memo 96 in the General Journal of Cleary Cabinets.
d Show how the Bad debts expense, Allowance for doubtful debts and Accounts Receivable accounts
would appear in the General Ledger of Cleary Cabinets after posting the General Journal.
e State the effect on the Accounting equation of Cleary Cabinets as at 31 March 2025 of the balance day
adjustment to record Bad debts expense.
f Explain how the recording of Bad debts expense ensures that the Qualitative characteristics of
Relevance and Faithful representation are upheld.
g Explain two reasons why the owner of Cleary Cabinets should be concerned about the firm’s
management of Accounts Receivable.

As at 31 August 2025, Dodge Dishwashers was owed $1 650 by Account Receivable – Des T. Chute for
$1 500 worth of sales plus GST. The firm’s GST balance at this date was $2 000 credit and it had a balance of
$2 300 in its Allowance for doubtful debts account.
On 14 September 2025, the owner of Dodge Dishwashers went to visit Chute only to find that he had
moved three months ago and left no forwarding address. She decided to write off the debt as bad (Memo 43).
Required
a Define the term ‘bad debt’.
b Record Memo 43 in the General Journal of Dodge Dishwashers.
c Referring to one Accounting assumption, explain how writing off a bad debt affects Net Profit.
d Show how the Account Receivable – Des T. Chute, Allowance for doubtful debts and GST Clearing
accounts would appear in the General Ledger of Dodge Dishwashers as at 30 September 2025.
e Explain two actions the owner of Dodge Dishwashers might take to reduce bad debts.


On 1 March 2025, the accounts of Terrific Tellies showed Accounts Receivable of $19 500 with $2 200 of that
amount owed by Ian Solvent. On 25 March 2025, the owner of Terrific Tellies, Travis Milton, received a letter
from a solicitor stating that Ian Solvent would be declaring bankruptcy and would only be able to pay 20c
of every dollar owed. The letter was accompanied by a cheque from Ian Solvent for which Travis issued
Receipt 31. Travis has decided to write off the remainder as a bad debt (Memo 52).
Required
a Record the information received on 25 March 2025 in the General Journal of Terrific Tellies.
b Show how the Accounts Receivable account would appear after this information was posted to the
General Ledger of Terrific Tellies.
c Referring to your answer to part ‘a’, explain the effect of this information on the
Accounting equation of Terrific Tellies. Ethical
d Referring to Qualitative characteristics and ethical considerations, discuss considerations
whether Travis was correct in writing off the bad debt.

Bad and doubtful debts: subsequent periods
As at 30 November 2025, the Balance Sheet of Wishart Wells showed the following:
WISHART WELLS
Balance Sheet as at 30 November 2025
$ $
Current Assets
• During December 2025, the business made credit sales of $165 000 including GST but sales returns
amounted to $12 000 plus GST. Receipts from Accounts Receivable for December 2025 amounted to
$145 000.
• On 12 December 2025, the owner received notification that a customer, Hope Springs, had been
declared bankrupt and would not be able to pay any of the $990 it owed (Memo 201).
• It is usual that 5% of Net credit sales ends up being written off as uncollectable.
Required
a Record Memo 201 in the General Journal of Wishart Wells.
b Calculate doubtful debts for Wishart Wells for December 2025.
c Record the balance day adjustment for Bad debts expense for December 2025 in the General Journal of
Wishart Wells. A narration is not required.
d Referring to your answers to part ‘b’ and ‘c’, explain why these amounts are different.
e Show how the Accounts Receivable, Allowance for doubtful debts and Bad debts expense accounts
would appear in the General Ledger of Wishart Wells as at 31 December 2025 after all closing and
balancing entries had been recorded. Transaction dates are not required.
f Show how Accounts Receivable would be reported in the Balance Sheet of Wishart Wells as at 31
December 2025.


Jorge Nielson owns and operates a small trading business called Nordic Supplies, selling a range of snowboards,
skis and clothing. On 28 February 2025 the accounts of Nordic Supplies showed the following balances:
• Account Receivable – Elsa Tours $32 000
• Account Receivable – I.C. Tusche $1 540
• Allowance for doubtful debts $1 500
• GST Clearing $950 CR
Elsa Tours and I.C. Tusche are the only Accounts Receivable of Nordic Supplies, and the only documents relating
to I.C. Tusche for March 2025 (which have yet to be recorded in the books of Nordic Supplies) are shown below:
Document A
Nordic Supplies TAX INVOICE

ABN: 36 701 410 302 Invoice: B905
Mansfield Hwy
Mansfield VIC 3724
Terms: 5/7, n/30
Charge to: I.C. Tusche
Treetops Chalet, Mt Buller
2 Mar. 25 Thriller Snow Board 1 800 800
GST 80
Total $ 880
Document B
To: The Accountant

From: Jorge Nielson
Date: 29 March 2025
Subject: I.C. Tusche
MEMO 7
Today we received 25 cents in the dollar of the outstanding debt of I.C. Tusche
(Rec. 77). However, the insolvency firm representing I.C. Tusche has advised us that
the remainder of the debt is irrecoverable.
Document C
To: The Accountant

From: Jorge Nielsen
Date: 31 March 2025
MEMO 12 Subject: Balance day adjustments
Doubtful debts to be calculated as 4% of Net credit sales.
• Sales for March 2025 was $176 000 including GST. 60% of sales are made on cash terms.
• Sales returns for March 2025 was $4 000 plus GST.
• During March 2025 Elsa Tours paid $55 300 to Nordic Supplies and received a discount of $2 700.
• Nordic Supplies purchases the Thriller Snow Board for $500 plus GST.
• Nielsen is reluctant to write off the debt from I.C. Tusche believing that with time the customer may be able to pay.
Required
a Record the documents in the General Journal of Nordic Supplies. Narrations are not required.
b State the effect on the Accounting equation of Nordic Supplies if Document A was not recorded.
c Referring to one Qualitative characteristic, explain why the bad debt must be recognised on 29 March 2025.
d Show how the following accounts would appear in the General Ledger of Nordic Supplies as at
31 March 2025 after all closing and balancing entries have been recorded:
• Account Receivable – Elsa Tours. Transaction dates are not required.
• Account Receivable – I.C. Tusche
• Allowance for doubtful debts
• Bad debts expense
e Show how Accounts Receivable would be reported in the Balance Sheet of Nordic Supplies as at
31 March 2025.
Nielsen has stated that bad debts are reducing his revenue and leaving him with less cash.
f Identify one part of Nielsen’s statement that is correct. Justify your answer.
g Identify one part of Nielsen’s statement that is incorrect. Justify your answer.
h Discuss whether Nordic Supplies should continue making sales to I.C. Tusche.

Accounting reports
Jamie Tape operates a sports store called Omni Sports. His main customers are the Western Football Club
and the Eagles Soccer Club, both of whom use the credit facilities Jamie offers and they frequently receive a
discount for early payment.
On 31 October 2025, Jamie provided the following information:
Omni Sports
Pre-adjustment Trial Balance as at 31 October 2025
Account Receivable – Eagles SC 1 320
Account Receivable – Western FC 27 500
Accumulated depreciation of Fixtures and fittings 9 000
Advertising 2 500
Bank 5 100
Capital 33 830
Drawings 4 500
GST Clearing 3 900
Insurance 100
Inventory 65 000
Loan – QZ Bank (repayable $1 200 per month) 55 000
Prepaid rent 12 000
Sales 75 000
Sales returns 3 500
Van 36 000
Wages 5 400
Totals 256 920 256 920
• A physical Inventory count on 31 October 2025 showed $64 100 inventory on hand.
• Yearly rent was paid in advance on 31 May 2025.
• $410 is still owing to the local paper for an advertisement which was run on 30 October 2025.
• The van is depreciated at 10% p.a. using the straight-line method. Fixtures and fittings are depreciated at
15% p.a using the reducing balance method.
• On 31 October 2025, the business was informed that Eagles SC had been declared bankrupt and would
be unable to pay any of the amount owing.
• All sales are made on credit and doubtful debts are 3% of Net credit sales.
• A payment of $1 650 for Insurance including GST had been incorrectly posted to Wages.
• Reports are prepared every month.
Required
a Referring to one Accounting assumption, explain the purpose of making balance day adjustments.
b Show the General Journal entries necessary to record the additional information. Narrations are not
required.
* c Prepare a Post-adjustment Trial Balance for Omni Sports as at 31 October 2025.
* d Prepare an Income Statement for Omni Sports for October 2025.
e Referring to two expenses, explain the ethical considerations of recognising and reporting balance day
adjustments.
f Explain two actions Omni Sports could take to improve its Adjusted Gross Profit without changing Sales
revenue.
g Referring to ethical and financial considerations, discuss whether the employees
of Omni Sports should be given a pay rise in November 2025.
Ethical
* h Prepare a classified Balance Sheet for Omni Sports as at 31 October 2025. considerations
i Discuss whether the owner of Omni Sports should be happy with its financial
position as at 31 October 2025.

Chapter 16
Balance day adjustments: Revenues

After completing this chapter, you should be able to: • distinguish between accrued revenue and
• explain how the Period and Accrual basis Accounts Receivable
assumptions and the Qualitative characteristic of • explain the effect of balance day adjustments for
Relevance affect the calculation of profit unearned and accrued revenue on the Accounting
• identify and record unearned revenue in the equation
General Journal and General Ledger • report unearned and accrued revenues in the
• identify and record accrued revenue in the General Balance Sheet
Journal and General Ledger • discuss ethical considerations in business decision-
• identify and record the receipt of accrued revenue making.
in a subsequent period
Key terms
After completing this chapter, you should be familiar
with the following terms:
• unearned revenue
• accrued revenue.

C hapter 16 B alance day adjustments : R evenues 419
16.1 The need for balance day adjustments

Chapter 12 pointed out that balance day adjustments are made to ensure that revenue
accounts show revenues earned and expense accounts show expenses incurred in the
current Period, so an accurate profit can be calculated. Thus, under the Accrual basis
assumption profit is calculated by matching revenue earned against expenses incurred
in the current Period.
Types of balance day adjustments

So far we have covered balance day adjustments that ensure that expense accounts
show the amounts incurred including:
• Inventory losses (Chapter 8)
• Prepaid expenses and Accrued expenses (Chapter 12)
• Depreciation expense (Chapters 13 and 14)
• Bad debts expense (Chapter 15)
The only revenue we have covered to date is Inventory gain, so this chapter addresses
two other balance day adjustments to ensure that revenue accounts show the amounts
earned:
• unearned revenues
• accrued revenues.
Definitions
It is worth remembering that revenue is defined as an increase in assets or a reduction
in liabilities that leads to an increase in owner’s equity. The definition does not require
that cash be received for revenue to be recognised; the receipt of cash may or may not
be involved. For example, Credit sales increase Accounts Receivable rather than cash;
Inventory gain increases Inventory; and Discount revenue actually decreases Accounts
Payable. Further, many transactions are not revenues even when cash is received, such
as receipts from Accounts Receivable, loans and capital contributions.
For a trading firm, in most cases revenue is recognised as being earned at the point
of sale as this is when the economic benefit can be measured reliably. This is the key
to recognising revenue as earned: some type of economic benefit has been received
(either by assets increasing or liabilities decreasing) and owner’s equity has increased
as a consequence, but not as a result of contributions by the owner.

1 Explain the purpose of making balance day adjustments.
2 Define the term ‘revenue’.
3 State three non-cash revenue items.

16.2 Unearned revenues

Although perhaps less frequent than a prepaid expense, it is possible for a firm to receive
cash from the customer prior to supplying the goods. This would be the case if a firm
accepted subscriptions, such as to a magazine; rented out extra space in its warehouse;
offered lay-by facilities; or accepted cash as a deposit to secure a sale. (Section 16.3
covers the last possibility.)
In cases such as these, the firm would have received the cash, but because it has
not supplied anything to the
customer, it has not earned any
revenue. In fact, it owes the goods
or service to the customer, and
this present obligation to transfer an
unearned revenue
economic resource (the goods/service
a current liability that arises
when cash is received in that the customer has already paid for)
advance for revenue that is yet means that the business has a liability called
to be earned unearned revenue.
Example The Bag Emporium owns a warehouse and rents out some office space to a
small courier business. On 1 August 2025, the Bag Emporium received $4 200
plus $420 GST for use of the office space for the next six months (Receipt 541).
Reports are prepared monthly (Memo 412).
Cash receipt of unearned revenue
Source
documents
When cash is received in advance (or prepaid), it must be recorded as a current liability
in the General Journal and General Ledger accounts.
The $4 620 cash received from the courier company will be recorded as a debit in
the Bank account. Of this amount $420 is GST that is now owed to the ATO, and this
will be recorded as a credit to the GST Clearing account.
What of the remaining $4 200?
The key here is that this amount covers the next 6 months meaning it is received in
advance of providing the use of the office space. Therefore, on 1 August 2025, when
the cash is received, none of the office space has been provided to the courier business,
therefore no revenue has been earned. In fact, The Bag Emporium owes to the courier
company use of the office space (for six months), so this cash receipt is in fact a liability –
Unearned rent revenue.

Figure 16.1 shows how this cash receipt would be recorded in the General Journal:
Figure 16.1 General Journal: Cash receipt of unearned revenue

General Journal
Aug. 1 Bank 4 620
Unearned rent revenue 4 200
GST Clearing 420
Cash received for next 6 months’ rent of office space (Rec. 541)
Figure 16.2 shows how the accounts would appear after posting the General Journal
to the General Ledger:
Figure 16.2 General Ledger: Cash receipt of unearned revenue

General Ledger
Bank
Unearned rent revenue / 4 620
GST Clearing
Unearned rent revenue (CL)

Aug. 1 Bank 4 200
GST Clearing (L)

Bank 420
The cross-reference in the Bank account identifies both Unearned rent revenue and
GST Clearing, as both are sources of the cash received.

As a result of the receipt of cash, the effect on the Accounting equation would be:
Assets Increase (Bank) 4 620
Liabilities Increase (Unearned rent revenue $4 200; GST Clearing $420) 4 620
This entry increases Bank and increases two liabilities: Unearned rent revenue and
GST Clearing. At this point, there is no revenue recorded in the General Ledger; no rent
has been provided, so no rent revenue has been earned.
Balance day adjustment: Revenue earned
Source
documents
Unearned revenues are recorded as current liabilities because when the cash is received,
none of the amount has been earned; it is a present obligation to provide the good or
service. If by balance day, the good/service has been provided to the customer, the
business will have fulfilled its obligation and therefore met the liability, so the revenue has
been earned. This is a good example of a revenue in the form of a decrease in a liability
(unearned revenue) rather than the usual increase in assets created by a cash or credit sale.
• the revenue account shows the amount earned in the current Period and
• the Unearned revenue account only shows the amount still owing to customers, or
to be earned in future Periods.
Calculating the revenue earned

In the example, $4 200 was received on 1 August 2025 but this related to the next six months,
so the monthly Rent revenue earned can then be calculated as shown in Figure 16.3:
Figure 16.3 Calculation: Revenue earned
$4 200 Unearned rent revenue
Rent revenue earned =
6 months
= $700 per month
Recording the revenue earned

Study tip This revenue is only earned as the rent is provided each month, so by balance day
on 31 August 2025 one month’s worth of rent ($700) would be earned and this must
be credited to the Rent revenue account. At the same time, the amount owed to the
Calculate the amount customer will decrease, so Unearned rent revenue must be debited to recognise the
earned: this is the
reduction in this liability.
amount to use in the
balance day adjustment.
Figure 16.4 General Journal: BDA – Revenue earned

General Journal
Aug.31 Unearned rent revenue 700
Rent revenue 700
Balance day adjustment to record one month’s rent revenue
earned (Memo 412)
Figure 16.5:
Figure 16.5 General Ledger: BDA – Revenue earned

General Ledger
Aug. 31 Rent revenue 700 Aug. 1 Bank 4 200
Rent revenue (R)

Study tip
Aug. 31 Unearned rent revenue 700
When adjusting unearned
Note that the Bank and GST Clearing accounts are unaffected, as at balance day no
revenue, ‘take away’ the
cash has been exchanged, and no GST has been involved: the balance day adjustment
amount earned (from the
simply increases the revenue (Rent revenue) and decreases the liability (Unearned rent
current liability).
revenue).

As a result of the adjustment for the Rent revenue earned:
Assets No effect
Liabilities Decrease (Unearned rent revenue) 700
Owner’s equity Increase (increases Net Profit) 700
As a consequence of the balance day adjustment, a liability becomes a revenue,
decreasing liabilities and increasing owner’s equity. Assets do not change.
Closing the ledger

Only after the ledger accounts have been adjusted – so that the revenue account shows
the amount earned in the current Period and the liability account shows the amount yet
to be earned – are they ready to be closed, or balanced.
Figure 16.6 shows how the Unearned rent revenue account would appear after it had
been balanced and the Rent revenue account after it had been closed to the Profit and
Loss Summary account:

General Ledger
Aug. 31 Rent revenue 700 Aug. 1 Bank 4 200
Balance 3 500
4 200 4 200 A reminder that all
revenue accounts are
closed in one General
Rent revenue (R) Journal entry, with each
Date Cross-reference Amount $ Date Cross-reference Amount $ revenue account debited,
Aug. 31 Profit and Loss Summary 700 Aug. 31 Unearned rent revenue 700
and one credit to the
Profit and Loss Summary
700 700
account.
The balance of the Rent revenue is reset to zero in readiness for the next Period, but
the balance of $3 500 left in the Unearned rent revenue account ($4 200 received less
$700 earned) represents the amount still owing, or yet to be earned; or the amount that
will be earned in future Periods. This is the new current liability balance.
Had the balance day adjustment not been recorded, the current liability Unearned
rent revenue would have been overstated by $700, and the Rent revenue understated
by $700, meaning Net Profit and owner’s equity would be understated by $700.
Instead, as a consequence of the balance day adjustment these items are reported
accurately, meaning Net Profit and the Balance Sheet are also accurate, and include all
the Relevant information which is capable of making a difference to decision-making.

1 Define the term unearned revenue.
2 Explain why unearned revenue is classified as a current liability.
3 Explain the effect on the Accounting equation of cash received as unearned
revenue.
adjustment when unearned revenue is earned.
when unearned revenue has been earned.
6 Explain how a balance day adjustment for unearned revenue which has now
been earned ensures Relevance in the reports.

16.3 U
nearned sales revenue: sales of inventory
involving a deposit
Section 16.2 described the recording of unearned revenue, where cash is received in
advance for revenue that is yet to be earned. Once the revenue is earned, entries are
necessary to record the revenue earned and the reduction in the liability owed to the
customer.
This applies to all unearned revenues, but Unearned Sales revenue is a particular type
of unearned revenue, because it includes the provision of inventory. Unearned Sales
might occur when a new product (such as a phone or electronic device) is released, and
customers pay in advance to ensure they are among the first to own the item. It might
also occur when a customer pays a deposit on an item of inventory in order to secure
the sale. When this inventory is provided, entries are required to record the revenue
earned and the reduction of the liability, but also the inventory leaving the business.
Example Wollard Prints sells a signed and framed poster of the Australian soccer team for
$1 200 (plus $120 GST). On 14 September 2025, Wollard Prints received a deposit
of $500 from B. Hogan for the sale of one poster (Receipt 135). On 23 October
2025, Hogan collected the poster, paying the balance in cash (Receipt 139). The
poster has a cost price of $650.
Cash deposit
Source
documents
Recording the deposit

In common with any cash received for unearned revenue, the deposit received on 14
September 2025 increases cash in the Bank account via a debit entry, and creates a
Study tip liability (in this case, Unearned Sales revenue) via a credit entry.
However, because this is simply a deposit to guarantee the sale – and not a receipt of
the full amount of cash for the sale – the transaction does not identify any GST received.
Deposits do not include
GST. As a result, GST need not be recorded in the General Journal, as shown in Figure 16.7:
Figure 16.7 General Journal: Cash deposit (no GST)

General Journal
Sept. 14 Bank 500
Unearned Sales 500
Cash deposit received on sale of poster (Receipt 135)
As a result, this deposit might be one of the reasons why the cash of Wollard Prints
increased more than its profit, as the $500 received is a cash inflow but not revenue for
September 2025.

Cash sale (following a deposit)
Source
documents
Recording the sale (following a deposit)

Once the customer (Hogan) collects the poster on 23 October 2025, the Sales revenue
of $1 200 has been earned and this must be recorded as a credit entry, along with a
$120 credit to the GST Clearing account to recognise the increase in the GST liability to
the ATO. This leaves a total of $1 320 that must be paid by the customer. Study tip
$500 has already been received as Unearned Sales but because the economic
resource (the poster) has been transferred to the customer this liability will decrease via
a debit entry. The remaining $820 received as cash will be recorded as a debit to the Where a deposit
is involved, GST is
Bank account.
recognised at the point
Finally, the debit to increase Cost of Sales and the credit to decrease Inventory must
of sale.
be recorded at the cost price of $650.
Figure 16.8 shows the General Journal entry to record this information:
Figure 16.8 General Journal: Cash sale (following deposit)

General Journal
Oct. 23 Bank 820
Unearned Sales 500
Sales 1 200
GST Clearing 120
Cost of Sales 650
Inventory 650
Cash sale of one poster following deposit (Rec. 139)
Because $500 had already been received in September 2025, this sale would result
in a cash inflow in October 2025 of only $820 (Cash sales $700 plus GST received $120),
but Sales revenue of $1 200. As a result, it might contribute to profit being bigger than
the increase in cash for October 2025.

Following these transactions, the General Ledger would appear as shown in

Figure 16.9:
Figure 16.9 General Ledger: Cash sale (following deposit)

General Ledger
Bank (A)
Unearned Sales (CL)

Oct. 23 Sales revenue 500 Oct. 1 Balance 500
Sales (R)
Oct. 23 Unearned Sales/Bank 1 200
GST Clearing (L)

23 Bank 120
Cost of Sales (E)

Oct. 23 Inventory 650
Inventory (A)
Oct. 1 Balance 35 000 Oct. 23 Cost of Sales 650
The Sales revenue account has one credit entry for $1 200 but two cross-references
to indicate that the cash for the sale comes from the $500 deposit (Unearned Sales)
received in September 2025 and the $700 cash received in October 2025.
Note that the cash deposit was received in September 2025, but by the next Period
– October 2025 – this account would have been balanced, leaving the cross-reference
in the Unearned Sales revenue account as Balance.

As a result of recording the cash sale following a deposit:
Assets Increase (Increase Bank $820, decrease Inventory $650) 170
Liabilities Decrease (Decrease Unearned Sales $500; increase GST Clearing $120) 380
Owner’s equity Increase (Profit = Sales $1 200 less Cost of sales $650) 550
Credit sale (following a deposit)

In the previous example, the customer (Hogan) paid cash for the balance remaining
when collecting the goods on 23 September 2025.
In the event that the sale is made on credit, the same information must be recorded
with the only difference being that it would be Accounts Receivable rather than Bank
which is credited, and in this case for the amount not yet received.

Figure 16.10 General Journal: Credit sale (following a deposit)

General Journal
Sept. 23 Accounts Receivable 820
Unearned Sales 500
Sales 1 200
GST Clearing 120
Cost of Sales 650
Inventory 650
Credit sale of one poster following deposit (Inv. 139)

1 Identify two situations that may lead to the receipt of a deposit.
2 Show the debit and credit entries required to record the receipt of a deposit.
3 Explain how GST is accounted for when a deposit is received on a sale.
4 Show the debit and credit entries required to record a cash sale following a
deposit.
5 State the effect on the Accounting equation of a cash sale following a deposit.
6 Show the debit and credit entries required to record a credit sale following a
deposit.
16.4 Accrued revenue

Unearned revenues are received before they are earned, but in some cases revenues
will be received after they are earned. For example, interest on a term deposit may
have been earned but is not due to be received until next month. Other items such as
royalties and commissions may only be received after they have been earned, but all
must be recognised as revenue in the Period in which they are earned.
In order to uphold the Accrual basis assumption, it is necessary to adjust revenue
accounts so that they show all revenue earned, and not just revenue received. This
means that any additional amounts earned but not yet received must be added to the
revenue accounts.
accrued revenue
At the same time, the amount owing to the business for this revenue earned but not a current asset which arises
yet received should also be recognised as a current asset called accrued revenue, as at when revenue has been earned
some time in the future the cash will be received. but cash is yet to be received
On 1 August 2024, Kilvington Kites invested $10 000 in a term deposit, earning Example
interest at 9% per annum. Interest is received on 31 January and 31 July each
year by EFT. The firm prepares its reports on 30 June each year (Memo 81).

Revenue received
Source
documents
On 31 January 2025, the Kilvington Kites would receive interest revenue for the first six
months of the term deposit, calculated as shown in Figure 16.11:
Figure 16.11 Calculation: Interest earned and received
Interest revenue (Aug. 2024 – Jan. 2025) = $10 000 × 9% p.a. × 6/12 months
= $450
This interest would have been received as cash on 31 January 2025, and as a result
the General Ledger as at 30 June 2025 would appear as shown in Figure 16.12:
Figure 16.12 General Ledger: Interest earned and received

General Ledger
Bank (A)
1/7/24 Balance 12 000
31/1/25 Interest revenue 450
Interest revenue (R)

31/1/25 Bank 450
The next interest receipt is not due until 31 July 2025 – sometime in the next Period
– so the $450 currently shown in the Interest revenue account represents the amount
actually received by 30 June 2025. But is this the total Interest revenue earned for the
year ending 30 June 2025?
Balance day adjustment: Accrued revenue
Source
documents
Before the reports can be prepared, the accountant must determine if any additional
revenue has been earned but not yet received. If it has, this accrued revenue must be
added to the revenue account before the closing entries are made.
• the extra amount earned (but not yet received) in the current Period is added to the
revenue account and
• the amount owing (which will be received in the next Period) is shown in the
current asset account – Accrued revenue.

Calculating accrued revenue

In this example, there are five more months between the last receipt of interest (31
January 2025) and the balance day (30 June 2025) in which the business will still be
earning interest revenue. Figure 16.13 shows how this Accrued interest revenue would
be calculated:
Figure 16.13 Calculation: Accrued interest revenue
Accrued interest revenue (Feb. – June 2025) = $10 000 × 9% p.a. × 5/12 months
= $375
Recording accrued revenue

An extra $375 worth of interest has been accrued, and this must be added to the Interest
revenue account by a credit entry. At the same time, the Accrued interest revenue
account must be debited to recognise the current asset for the amount still owing from
the finance company.
Figure 16.14 General Journal: BDA – Accrued revenue

General Journal
Sept. 23 Accrued interest revenue 375
Interest revenue 375
Balance day adjustment to record 5 months interest revenue
earned but not yet received (Memo 81)
Figure 16.15:
Figure 16.15 General Ledger: Interest earned and received

General Ledger
Bank (A)
1/7/24 Balance 12 000

31/1/25 Bank 450
30/6/25 Accrued interest revenue 375
Accrued interest revenue (CA)

As with the adjustment for unearned revenue, this adjustment does not change When adjusting an
Bank, nor does it affect GST Clearing. Rather, it increases revenue and increases assets accrued revenue, ‘add
in the Balance Sheet. on’ the extra amount
received (to the
This example also illustrates the fact that revenue does not have to involve an inflow
amount already
of cash; rather, the revenue increases as a result of an increase in the asset Accrued
received).
interest revenue.


As a result of the balance day adjustment for Accrued interest revenue:
Assets Increase (Accrued interest revenue) 375
Owner’s equity Increase (Increase Interest revenue increases Net Profit) 375
Accrued revenue versus Accounts Receivable

Given our understanding of credit sales, Accrued revenue and Accounts Receivable may
seem very similar, as both are current assets which result from situations where the
revenue is earned before the cash is received. However, they are different in a subtle
but important way.
Accounts Receivable are generated when sales are made on credit, with the revenue
earned at the point of sale (as verified by the invoice). By contrast, Accrued revenue
is generated from transactions other than sales, where there is no point of sale to
establish that the revenue has been earned.
Further, accrued revenues are not due to be received at balance day: they occur
when the balance day falls before an item has been received, but also before it is due
to be received. Thus, an Accrued revenue will be verified not by an invoice, but by
something like a memo. If an invoice has been sent, the transaction is simply a credit
sale and the amount owing should be shown as Accounts Receivable.
Closing the ledger

For an Accrued revenue, the amount of the balance day adjustment ($375) is not the
total revenue earned for the Period. Rather, it is simply the extra amount owing: the
amount that has been earned but not yet received. It is added to any amounts received
to calculate the total revenue earned for the Period, and it is this total revenue earned
($825) which is closed to the Profit and Loss Summary account. The amount accrued
(owing) will be reported as a current asset in the Balance Sheet.
Figure 16.16 shows how the Interest revenue account would appear after it had
been closed to the Profit and Loss Summary account, and the Accrued interest revenue
account after it had been balanced:

General Ledger
30/6/25 Profit and Loss Summary 825 31/1/25 Bank 450
Study tip
30/6/25 Accrued interest revenue 375
825 825
For an item to be
recognised as a revenue,
the definition requires Date Cross-reference Amount $ Date Cross-reference Amount $
an item to be earned; 30/6/25 Interest revenue 375 30/6/25 Balance 375
receipt of cash is not 375 375
necessary. 1/7/25 Balance 375

Note how the amount closed to the Profit and Loss Summary account ($825) is
greater than the amount of the adjustment ($300), as the total revenue earned includes
both the $450 received and the $375 accrued and still owing at the end of the Period.
Had the balance day adjustment not been recorded, Interest revenue would have
been understated by $375, meaning Net Profit and owner’s equity would also be
understated by $375, and the current asset Accrued interest revenue would have been
understated by $375.
Receipt of accrued revenue in subsequent periods
Source
documents
Sometime in the next Period, the amount owing to the business as accrued revenue will
be received. Therefore, when the cash is received some may represent a revenue of
the current Period, but at least some of the receipt will relate to the previous Period. In
other words, some of the amount received reduces the asset represented by accrued
revenue – revenue earned and accrued last Period.
On 1 August 2024, Kilvington Kites invested $10 000 in a term deposit, earning Example
interest at 9% per annum. Interest is received on 31 January and 31 July each (restated)
year. The firm prepares its reports on 30 June each year (Memo 81).
Recording the receipt in a subsequent period

On 31 July 2025, the business will once again receive $450 interest (as was the case
on 31 January 2025 – see Figure 16.10). However, not all of this will be Interest revenue
earned in the year ended 30 June 2026 as it includes $375 of interest that had been
earned (but not yet received) in the year ended 30 June 2025. That is, the Accrued
interest revenue earned last Period will be received this Period as part of the $450
received.
This means that of the $450 cash received on 31 July 2025, $375 is Accrued interest
revenue earned last Period, and only the remaining $1 200 represents Interest revenue
earned in the current Period.
The receipt of interest on 31 July 2025 would be recorded in the General Journal as
Figure 16.17 General Journal: Receipt in subsequent period

General Journal
July 31 Bank 450
Accrued interest revenue 375
Interest revenue 75
Receipt of interest on term deposit for February – July 2025
(EFT Trans. 3015)

Once the General Journal has been posted to the General Ledger, the accounts
would appear as shown in Figure 16.18:
Figure 16.18 General Ledger: Receipt in subsequent period

General Ledger
Bank (A)
1/7/25 Balance 15 000

1/7/25 Balance 375 31/7/25 Bank 375

31/7/25 Bank 75
Note that because it was closed on 30 June 2025 the Interest revenue account
was empty before this receipt was recorded. By contrast, the Accrued interest revenue
account was balanced on 30 June 2025 so the only cross-reference in the account
was ‘Balance’, but as the amount owing has been received its balance has now been
reduced to zero.

As a result of the receipt of Accrued interest revenue and Interest revenue:

Assets Increase (Increase Bank $450, decrease Accrued interest rev. $375) 75
Owner’s equity Increase (Interest revenue increases Net Profit) 75

1 Define the term ‘accrued revenue’.
2 Explain why accrued revenue is classified as a current asset.
3 Distinguish between accrued revenue and Accounts Receivable.
adjustment for accrued revenue.
for accrued revenue.
6 Explain why the receipt of accrued revenue in a subsequent period requires
the receipt to be split in the General Journal.
7 Explain the effect on the Accounting equation of the receipt of accrued
revenue in a subsequent period.

Where have we been?

• Balance day adjustments are necessary so that an accurate profit is calculated by comparing revenue
• Balance day adjustments may be necessary for:
– Inventory losses and gains
– Prepaid expenses
– Accrued expenses
– Depreciation expense
– Bad debts expense
– Unearned revenues
– Accrued revenues.
• Each balance day adjustment for revenue increases revenue, thus increasing profit and owner’s equity.
• Adjustments for unearned revenues decrease liabilities; adjustments for accrued revenues increase assets.
• Balance day adjustments have no effect on cash but will change Net Profit and the items in the Balance Sheet.
Exercises
this book.

Unearned revenue
On 1 March 2025 Sol’s Small Goods received $9 000 rent (plus $900 GST) from the solicitor who rents out
the top floor of the building (Receipt 54). The solicitor pays rent in advance for the next six months, and Sol’s
Small Goods prepares its financial reports on 30 June 2025 (Memo 44).
Required
a Record Receipt 54 in the General Journal of Sol’s Small Goods.
b Referring to one Accounting assumption, explain why only part of the rent received should be
recognised as revenue for the year ended 30 June 2025.
c Calculate Rent revenue earned for the year ending 30 June 2025.
d Record the balance day adjustment for Rent revenue for the year ending 30 June 2025 in the General
Journal of Sol’s Small Goods.
e Explain the effect of the adjustment for Rent revenue on the Accounting equation of Sol’s Small Goods.
f Show how the General Ledger accounts would appear after posting the journals in parts ‘a’ and ‘c’. Balance
the Unearned Rent revenue account and close the Rent revenue account.

Cash sale involving a deposit
On 16 January 2025 Clink Glassware received a deposit of $400 on a bulk order from one of its customers
(Receipt 84). The goods, which had a selling price of $5 000 (plus $500 GST) and a cost price of $2 300, were
delivered on 27 February 2025, with the customer paying the balance in cash (Receipt 92).
Required
a Record Receipt 84 in the General Journal of Clink Glassware.
b Explain how the deposit would be reported in the Balance Sheet of Clink Glassware on 31 January 2025.
c Record the sale on 27 February 2025 in the General Journal of Clink Glassware.
d Referring to your answer to part ‘c’, state two reasons why the amount recorded in the Bank account
does not equal the amount recorded in the Sales account.
e Show how the General Ledger accounts would appear after posting the journals in parts ‘a’ and ‘c’.


Credit sale involving a deposit
During December 2024 Terry’s Appliances received a deposit of $350 from Hartwells for a washing machine
that sells for $1 400 plus GST (Receipt 107). The washing machine, which had a cost price of $920, was
delivered on 4 January 2025, with the balance on credit (Invoice 44). Reports are prepared every month.
Required
a Explain the effect of the deposit on the Accounting equation of Terry’s Appliances.
b Referring to one Qualitative characteristic, explain why the deposit is not recognised as revenue for
December 2024.
c Record the sale on 4 January 2025 in the General Journal of Terry’s Appliances.
d State the effect of the sale on 4 January 2025 on the Accounting equation of Terry’s Appliances.
e Show how the General Ledger accounts would appear after posting the journals in part ‘c’.

Credit sale involving a deposit
Insensitel recently advertised for sale a new version of its award-winning Game Station console. The
console is purchased for $120 plus GST and is sold for $275 including GST. On 13 November 2025, Spot On
department stores ordered 30 game consoles, paying a 20% deposit on the total invoice price (Receipt 90).
On 26 November 2025, Insensitel delivered all 30 game consoles to Spot On (Invoice 201).
Required
a Calculate the cash received by Insensitel on 13 November 2025.
b Explain why it would be unethical to report the transaction on 13 November 2025 as revenue.
c Explain why no GST is recognised on 13 November 2025.
d Record the transactions on 13 and 26 November 2025 in the General Journal of Insensitel. Narrations are
not required.
e Show how the General Ledger accounts would appear after posting the General Journal in part ‘d’.
f State the effect on the Accounting equation of Insensitel if the sale on 26 November 2025 had not been
recorded.

Accrued revenue
During August 2025 Gavin Jewellery received $6 000 interest revenue, but as at 31 August 2025 it was still
owed $700 interest from one of its investments (Memo 95).
Required
a Referring to one Accounting assumption, justify why the interest owing should be included in the
Interest revenue account for August 2025.
b Record Accrued interest revenue as at 31 August 2025 in the General Journal of Gavin Jewellery.
c Explain the effect of the adjustment for Accrued interest revenue on the Accounting equation of Gavin
Jewellery.
d Show how the Interest revenue and Accrued interest revenue accounts would appear in the General
Ledger of Gavin Jewellery as at 31 August 2025 after all closing and balancing entries have been made.
e Explain how Accrued interest revenue would be reported in the Balance Sheet of Gavin Jewellery as at
31 August 2025.


Accrued revenue
On 1 March 2025 Diana’s Delicacies invested $50 000 in a 10-year term deposit at a fixed rate of 12% per
annum. Interest revenue is directly credited to the firm’s bank account in equal instalments on the last day of
May, August, November and February. This is verified by the bank statement. Balance day is 30 June 2025.
Required
a Calculate Interest revenue received on 31 May 2025.
b Calculate Accrued interest revenue as at 30 June 2025.
c Record the balance day adjustment for Accrued interest revenue for the year ended 30 June 2025 in the
General Journal of Diana’s Delicacies. A narration is not required.
d Show how the Interest revenue and Accrued interest revenue accounts would appear in the General
Ledger of Diana’s Delicacies as at 30 June 2025 after all closing and balancing entries have been made.
e Record the receipt of interest on 31 August 2025 in the General Journal of Diana’s Delicacies.
f Explain why only some of the interest received on 31 August 2025 should be reported as revenue for
the year ended 30 June 2026.

Accrued revenue
During April 2025 Weights World received Commission revenue of $8 000 plus GST for weights it had sold on
behalf of specialist gyms. As at 30 April 2025, a further $4 000 was still owing (Memo 54). On 3 May 2025,
$6 600 including GST was received for commission revenue (Receipt 31).
Required
a Calculate Commission revenue earned for April 2025.
b Record the Commission revenue owing as at 30 April 2020 in the General Journal of Weights World.
c Explain the effect on the Net Profit of Weights World for April 2025 if the adjustment for Accrued
commission revenue was not made.
d Record Receipt 31 in the General Journal of Weights World.
e State the effect of Receipt 31 on the Accounting equation of Weights World.
f Show how the Commission revenue and Accrued commission revenue accounts would appear in the
General Ledger of Weights World after all the information was recorded.

Accrued revenue
On 1 September 2024 Sound Waves invested $5 000 into a six-month term deposit, with interest earned
at 6% per annum, payable at the end of the six-month term. On maturity at 28 February 2025, $5 150 was
received from the bank (EFT Trans. 619).
Required
a Record the Interest revenue earned for the year ended 31 December 2024 in the General Journal of
Sound Waves. A narration is not required.
b Record the cash received on 28 February 2025 in the General Journal of Sound Waves.
c Discuss how the cash received on 28 February 2025 would be reported in the Cash Flow Statement of
Sound Waves for the year ended 31 December 2025.


Reporting for prepaid and accrued revenues
Rawson Rugs has provided the following Trial Balance as at 31 December 2025:
RAWSON RUGS
Trial Balance as at 31 December 2025
Accumulated depreciation of Premises 19 500
Advertising 340
Allowance for doubtful debts 500
Bank 2 100
Capital – Parker 51 040
Cartage in 990
Depreciation of Premises 3 900
Drawings 8 610
GST Clearing 390
Inventory 38 750
Inventory gain 130
Mortgage – Bank of Erica (repayable $12 000 p.a.) 100 000
Premises 130 000
Profit on disposal of vehicle 650
Sales 43 000
Sales returns 860
Term deposit (matures 15 April 2030) 3 600
Unearned Sales 1 680
Wages 5 900
Totals 247 960 247 960
• Reports are prepared on 31 December each year. Balance day adjustments for expense items have
already been recorded.
• During the financial year a customer returned a rug that had been soiled during the delivery to her house.
This rug was thrown away.
• The Term deposit was taken out on 1 December 2025. Interest is earned at 5% per annum, with interest
for December 2025 due to be received on 3 January 2026.
• Unearned Sales relates to a deposit received from F. Khari; the rugs had a selling price of $3 300 including
GST and a cost price of $2 000. The rugs, and Receipt 401, were delivered on 31 December 2025.
Required
a Referring to one Accounting assumption, explain the purpose of making balance day adjustments.
b Show the General Journal entries necessary to record the additional information on 31 December 2025.
* c Prepare a Post-adjustment Trial Balance for Rawson Rugs as at 31 December 2025.

* d Prepare an Income Statement for Rawson Rugs for the year ended 31 December 2025.
e Referring to your answer to part ’d’, identify two items that were affected by the rug that was returned
and thrown away.
* f Prepare a classified Balance Sheet for Rawson Rugs as at 31 December 2025.

Revenues, records and reports
MM’s Music has provided the following extract from its Trial Balance as at 30 June 2025:
MM’s MUSIC
Trial Balance (extract) as at 30 June 2025
Accrued wages 1 900
Bank 1 800
GST Clearing 630
Inventory 83 460
Loan – QuickFin (repayable $600 per month) 25 000
Sales 160 000
Sales return 3 000
Unearned Sales 16 000
• On 30 June 2025 a vehicle was traded in for $3 100 on a new vehicle with a cost price of $23 000 plus
GST. The new van was purchased using the cash borrowed from QuickFin earlier in the month. The old
vehicle had been purchased for $20 000, and had a Carrying value of $3 500 at the time of the trade-in.
• During June 2025 a sale for $4 000 plus GST was made to A. Gerling (Invoice 36). The inventory had a
cost price of $2 500, but Gerling had paid a $500 deposit earlier in the month.
• Interest revenue of $350 had been earned but not yet received.
Required
a Suggest two possible reasons (other than damage) for the Inventory write-down.
b Record the additional information in the General Journal of MM’s Music. Narrations are not required.)
c Suggest two reasons for the profit or loss on the disposal of the vehicle.
d Referring to one Qualitative characteristic, explain the purpose of closing the ledger.
e Show the General Journal entries necessary to close the revenue accounts.
* f Prepare a Balance Sheet for MM’s Music as at 30 June 2025 showing the firm’s Current Assets and
Current Liabilities. A full Balance Sheet is not required.
g Referring to your answer to part ‘f’, explain your classification of GST Clearing.

Chapter 17
Budgeting

After completing this chapter, you should be able to: • distinguish between cash and profit items in
• define ‘budgeting’ budgeted reports
• distinguish between budgeted and actual reports • prepare a Schedules of Receipts from Accounts
• explain the purposes of budgeting Receivable and Payments to Accounts Payable
• explain the benefits of using spreadsheets to • reconstruct ledger accounts to determine budgeted
prepare budgeted reports figures
• describe the budgeting process • prepare variance reports for cash and profit
• prepare budgeted reports for cash, profit and • distinguish between favourable and unfavourable
financial position variances
• explain the uses of budgeted reports • discuss ethical considerations in business
• suggest strategies to address problems identified decision-making.
by budgeted reports
Key terms
After completing this chapter, you should be familiar • Schedule of Payments to Accounts Payable
with the following terms: • Budgeted Income Statement
• budgeting • Budgeted Balance Sheet
• budget • variance report
• Budgeted Cash Flow Statement • variance
• Schedule of Receipts from Accounts • Cash Flow Statement Variance Report
Receivable • Income Statement Variance Report.

C hapter 17 B udgeting 439
17.1 Budgeting
So far this text has dealt only with historical transactions, concentrating on how to
identify, record, report and analyse events that have already occurred. This is a logical
starting point to analyse business performance, as without information on what has
already happened, it is difficult to identify areas that may need to be improved.
However, it is also important to keep an eye on the future. Business owners must
attempt to predict what will happen in the future, so that they can plan ahead and be
prepared for what is likely to occur. This is the focus of budgeting: the process of budgeting
preparing reports that estimate or predict the financial consequences of likely future the process of predicting/
transactions, with the term budget referring to the reports created by this process. estimating the financial
consequences of future events
In common with all accounting reports, budgets have a role in both planning and
decision-making. Specifically, budgeting: budget
• assists planning by predicting what is likely to occur in the future.
predicts/estimates the financial
This allows the owner to prepare so that possible problems may be managed and consequences of future events
possible opportunities may be taken.
• aids decision-making by providing a standard against which actual performance can
be measured.
This allows the owner to identify areas in which performance is unsatisfactory, so
that remedial action can be taken. This can include the calculation of budgeted ratios
and other indicators of performance.
Budgeted reports
A small business owner could prepare a budget on just about any area of business
performance, ranging from how many sales are made in a month, to how much will be
spent on advertising, and how many returns will be made. This course concentrates on
three general-purpose budgets:
• Budgeted Cash Flow Statement
A report that shows all expected future cash inflows and cash outflows, the actual
bank balance at the start of the period, and the expected bank balance at the end of
the period
• Budgeted Income Statement
A report that shows all expected future revenues and expenses, and the expected
Gross Profit, Adjusted Gross Profit and Net Profit
• Budgeted Balance Sheet
A report that shows all expected assets, liabilities and owner’s equity at some point Study tip
in the future.
If you can prepare
Budgeted versus actual reports
reports, you can prepare
Budgeted reports differ from the actual, or historical, reports we have prepared so far budgeted reports,
in two key ways: because they contain the
1 Budgets report future events rather than historical events. They focus on what will same types of items.
happen rather than what has already happened.
2 As a consequence, budgets use estimates or predictions rather than actual,
verifiable data.
In all other ways, budgeted reports are the same as actual reports; they use the
same headings, and include the same items.

The importance of budgeted sales

As we have seen in earlier chapters, the Accounting reports are interconnected, with
transactions reported in one affecting items reported in another, and this is no different
for budgets.
In terms of budgeting, it is essential that the preparation of budgeted reports begin
with an accurate estimate of budgeted sales. Sales is the driver of business activity, and
many other transactions are dependent on, and vary directly (or sometimes indirectly)
with, the level of sales.
In terms of the Budgeted Cash Flow Statement and Budgeted Income Statement:
• sales is the main revenue item and generates significant cash inflows, either as
cash sales or, if credit sales are involved, as Receipts from Accounts Receivable
• the level of sales will be crucial in estimating the expenses that vary with the
number of units sold (such as Cost of Sales and Wages) and their corresponding
cash outflows
• the level of sales will affect how much Inventory is purchased, which will, in turn,
affect cash paid to Accounts Payable.
The Balance Sheet does not report sales directly, but because it uses figures derived
from the other two reports, its accuracy is also dependant on an accurate estimate of
sales. At the very least, the expected bank figure will come straight from the Budgeted
Cash Flow Statement and the expected Net Profit or Loss will be determined in the
Budgeted Income Statement.
Spreadsheets
Using software that utilises spreadsheets is often helpful in preparing budgeted reports,
as it allows the owner to:
• express certain items as functions of others
This means changes in one figure can lead automatically to changes in others.
For instance, formulae can be used in a spreadsheet to link the level of sales to
cash inflows like Receipts from Accounts Receivable in the Budgeted Cash Flow
Statement; to expenses like Cost of Sales and Wages in the Budgeted Income
Statement; and to the calculation of Inventory for the Budgeted Balance Sheet.
• model responses to scenarios and courses of action.
Spreadsheets can be used to generate any number of reports based on ‘what if’
scenarios, providing the owner with information that takes into account alternative
situations and courses of action so that better decisions can be made.


1 Define the term ‘budgeting’.
2 Explain how budgets assist planning.
3 Explain how budgets assist decision-making.
4 Identify the information that is reported in a:
• Budgeted Income Statement
• Budgeted Balance Sheet.
5 State two differences between the information presented in budgeted reports
and actual reports.
6 Explain why it is important to have an accurate estimate of budgeted sales.
7 Explain two advantages of preparing budgeted reports using spreadsheets.
17.2 The budgeting process

It has been said that failing to plan is planning to fail, so the preparation of budgeted
reports should be one of the first steps in starting a new business. However, budgeting
should be a continuous process; budgets should be compared against actual reports to
allow problems to be identified, decisions should be made based on that assessment,
and then new budgets should be prepared for the next period.
This budgeting process is shown in Figure 17.1:
Figure 17.1 The budgeting process
Budgeted reports are prepared,

predicting what is likely to occur
Decisions are made to improve business Actual reports are prepared to detail
performance for the next period what has happened in the current period
Variance reports are prepared to

highlight differences/problem areas
A budget has limited value if it is not used to make decisions to improve business
performance in the future. In addition, it makes little sense to develop a budget for one
period without preparing another budget for the next period. Under the Going Concern
principle, businesses are assumed to be continuous, so the budgeting process should
be continuous too.
The information presented in the budgeted reports should be based on the historical
data, but allowances must be made for changes and the effect of new business
decisions. Obviously, a new business will not have any historical data on which to rely;
this makes budgeting harder for new businesses, but no less important.

1 Explain why budgeting is described as a process.
2 Outline the various stages in the budgeting process.
3 Explain the role of historical data in the preparation of budgeted reports.

17.3 The Budgeted Cash Flow Statement

In order to survive, a small business must have sufficient cash to meet its obligations.
These obligations will include making payments to Accounts Payable, paying expenses
(such as Wages, Rent and Advertising), meeting loan repayments and providing drawings
for the owner. In order to do this, the business must generate sufficient cash inflows,
chiefly through its cash sales and receipts from Accounts Receivable.
Budgeted Cash Flow The Budgeted Cash Flow Statement attempts to predict all future cash inflows and
Statement cash outflows, and thus the estimated bank balance at the end of the budgeted period, to
an Accounting report that assist the owner in assessing the firm’s ability to meet its obligations over the budget period.
attempts to predict all future
Just as the Cash Flow Statement classified the inflows and outflows as Operating,
cash inflows and cash outflows,
and thus the estimated bank Investing and Financing activities, so too must these classifications be present in the
balance at the end of the Budgeted Cash Flow Statement.
budget period
Operating activities are all cash flows related to the firm’s day-to-day trading activities,
and typical Operating cash flows for a trading business might include:
Operating cash inflows Operating cash outflows

Cash sales Cash purchases (of Inventory)
Receipts from Accounts Receivable Payments to Accounts Payable
Other revenue received Other expenses paid
GST received GST paid
GST refund GST settlement
Ideally, the budgeted Net Cash Flows from Operations will be positive. This means
that the business is expected to generate sufficient cash from its Operations to meet
its ongoing obligations.
However, by preparing the Budgeted Cash Flow Statement the owner will be
forewarned if the Operating cash flows are expected to be negative. The owner can then
take steps to address the cash shortage before it occurs by implementing strategies to
generate cash inflows and minimise cash outflows.
Generating cash inflows

To generate more cash inflows, the owner may look to:
• increase sales revenue by changing selling prices, advertising, the inventory mix;
improving customer service; or even changing location (see Section 10.5 for more
details)
• increase receipts from Accounts Receivable by managing Accounts Receivable
through credit checks, discounts for early settlement and reminders (see Section
6.7 for more details).
Reducing cash outflows

To reduce cash outflows, the owner may look to:
• defer payments to Accounts Payable to utilise the full length of time available under
the credit terms
• reduce cash paid for expenses by finding an alternative (cheaper) supplier, changing
inventory handling procedures, changing rosters for staff, providing extra training,
adopting energy-saving practices, replacing costly non-current assets or even
moving to cheaper premises (see Section 10.5 for more details).
These strategies should always be legal and ethical and should also consider the long-
as well as short-term interests of the business so that a short-term gain in terms of cash
does not generate long-term costs in terms of both cash and profit. The owner must be
particularly mindful of reducing cash paid for expenses as the benefits that expenses Ethical
provide are vital in the earning of sales, and hence the generation of cash inflows; considerations
cutting expenses may make the cash situation worse rather than better.
Investing activities are all cash flows relating to the purchase or sale of non-current
assets and would typically include:
Investing cash inflows Investing cash outflows

Proceeds from cash sale of a non-current asset Cash purchase of a non-current asset
Given that non-current assets are frequently expensive, and sales of non-current
assets are rare, it will be common for budgeted Net Cash Flows from Investing activities
to be negative.
Financing activities are all cash flows that are the result of changes in the firm’s financial
structure, and would typically include:
Financing cash inflows Financing cash outflows

Loan (receipt of) Loan repayment (principal only)
Capital contribution (cash only) Cash drawings
Whether Net Cash Flows from Financing activities is positive or negative will depend
very much on whether the business is expanding or simply continuing its operations as
they are. There may in fact be a relationship between Financing and Investing activities;
negative Investing cash flows (due to the purchase of non-current assets) could be
financed by positive Financing cash flows (in the form of a loan or capital contribution).
Denzel Washing Machines will begin trading on 1 March 2026, and has provided Example
the following estimates for its first month of operations:
• The owner will make a capital contribution of $30 000 to commence operations.
• Cash sales are estimated to be $24 000 plus GST.
• Credit sales are estimated to be $17 600 including GST. Of this amount,
$11 000 is expected to be received in March 2026.
• All inventory will be purchased on credit. Purchases for March 2026 are
expected to be $35 000 plus $3 500 GST. At the end of March 2026, it is
anticipated that $6 500 will be owed to Accounts Payable.
• Cost of Sales is expected to be $20 000 and, based on the experience of similar
firms, Inventory loss is expected to be $300.
• The following expenses will be incurred during March 2026:
– Wages $8 000
– Advertising $1 300 (plus $130 GST)
– Depreciation of Office equipment $100
• Rent for the next six months will be paid on 1 March 2026: $9 000 plus $900 GST
• New office equipment worth $5 000 (plus $500 GST) will be purchased on
1 March 2026 using cash.
• Cash drawings will be $1 000. Drawings of inventory is expected to be $600.
• On 31 March 2026, $10 000 will be borrowed from AXC Bank to purchase a
new vehicle. Beginning in April 2026, $500 will be paid off the principal each
month. The vehicle will not be purchased until April 2026.

The Budgeted Cash Flow Statement for Denzel Washing Machines is shown in
Figure 17.2:
Figure 17.2 Budgeted Cash Flow Statement
DENZEL WASHING MACHINES

Budgeted Cash Flow Statement for March 2026
$ $
CASH FLOWS FROM OPERATIONS
Cash sales 24 000
Receipts from Accounts Receivable 1
11 000
GST received 2
2 400 37 400
Payments to Accounts Payable 3
(32 000)
Wages (8 000)
Advertising (1 300)
(9 000)
GST paid 5
(1 530) 51 830
Net Cash Flows from Operations (14 430)
Office equipment (5 000)
Net Cash Flows from Investing activities (5 000)
Capital contribution 30 000
Loan – AXC Bank 10 000 40 000
Drawings (1 000)
Net Cash Flows from Financing activities 39 000
Net Increase (Decrease) in Cash Position 19 570
Add Bank Balance at start (1 March 2026) Nil
Bank Balance at end (31 March 2026) 19 570
Note the following in Figure 17.2:

1 Credit sales is a revenue but not a cash flow: only the cash received from Accounts
Receivable ($11 000) is reported here.
2 GST received is calculated as 10% of the Cash sales figure; that is, $24 000 Cash
sales × 10% GST = $2 400 GST received
3 Credit purchases of inventory plus GST ($35 000 + $3 500 = $38 500) will create a
debt to Accounts Payable, but at the end of March 2026 only $6 500 will remain
owing, meaning the difference will be paid; that is,
$38 500 − $6 500 = $32 500 paid to Accounts Payable
4 Regardless of how much has been incurred, the total cash paid for rent ($9 000) is
Study tip reported here, but because it is paid in advance it is titled Prepaid rent expense.
5 Total GST paid is calculated by adding the GST paid on advertising, prepaid rent and
office equipment; that is,
Reading skills are $130 Advertising + $900 Prepaid rent + $500 Office equipment = $1 530 GST paid
essential in budgeting
In addition, note that not all the transactions are reported in the Budgeted Cash Flow
questions; you will find
most of the answers in Statement, because not all involve cash. In this example, Credit sales and Credit purchases
the question itself if you (and the GST related to each), Cost of Sales, Inventory loss, Depreciation of Office equipment
look hard enough. and Drawings of inventory have been excluded as they are non-cash transactions. They
may affect other budgeted reports, but not the Budgeted Cash Flow Statement.

Consecutive periods
The preceding budget relates only to one month taken in isolation, but it would be wise
for a business to prepare budgets for consecutive months to show the effect of monthly
variations; that is, separate budgets for March, April, May, etc. could be prepared and
presented side by side to show trends in inflows and outflows from month to month.
Such a budget may appear as shown in Figure 17.3:
Figure 17.3 Budgeted Cash Flow Statement: consecutive periods

Budgeted Cash Flow Statement for March–May 2026
March April May
Cash sales 24 000 28 000 27 000
Receipts from Accounts Receivable 11 000 15 000 13 000
GST received 2 400 2 800 2 700
GST refund – – 1 100
Total Operating Inflows 37 400 45 800 43 800
Payments to Accounts Payable (32 000) (36 000) (33 000)
Wages (8 000) (9 000) (8 500)
Advertising (1 300) (1 300) (1 300)
Prepaid rent (9 000) – –
GST paid (1 530) (130) (830)
Total Operating Outflows (51 830) (46 430) (43 630)
Net Cash Flows from Operations (14 430) (630) 170
Proceeds on Sale of Equipment – – 1 600
Office equipment (5 000) – (7 000)
Net Cash Flows from Investing Activities (5 000) Nil (5 400)
Capital contribution 30 000 – –
Loan – AXC Bank 10 000 – –
Drawings (1 000) (1 000) (1 000)
Net Cash Flows from Financing Activities 39 000 (1 000) (1 000)
Net Increase (Decrease) in Cash Position 19 570 (1 630) (6 230)
Add Bank Balance at start Nil 19 570 17 310
Bank Balance at end 19 570 17 310 11 080
Note how the balance at the end of March of $19 570 is then transferred to become
the balance at the start of April; April’s closing balance of $17 310 becomes the opening
balance for May; and so on.
This type of budget allows the owner to identify monthly and even seasonal trends
and can be very useful for identifying when to undertake a particular cash activity, such
as the purchase of a non-current asset or repayment of a loan.
In general, more frequent budgets will be more accurate, and therefore more useful
as benchmarks for comparison. In addition, they will allow for the earlier detection of
problems, so that corrective action can be taken in a timely fashion, and can perhaps
stop a small problem from becoming large.
Uses of the Budgeted Cash Flow Statement

Planning
The Budgeted Cash Flow Statement aids planning by allowing the owner to prepare in
advance for an expected cash surplus or cash deficit.
Should the budget predict an overall Net Decrease in Cash Position, the owner might:
• defer the purchase of non-current assets, or use credit facilities or a loan for a purchase
• defer loan repayments
• take less cash as drawings
• make a cash capital contribution
• organise (or extend) an overdraft facility.
Should the budget predict an overall Net Increase in Cash Position, the owner might
use the extra cash to:
• purchase more/newer non-current assets
• increase loan repayments
• increase cash drawings
• expand trading activities by increasing advertising or employing more staff, for example.
Alternatively, a business starting a period with a bank overdraft may choose to do
nothing and let the expected cash surplus bring its bank balance back into the black.
Decision-making
In addition, the Budgeted Cash Flow Statement aids decision-making because it sets
a standard (benchmark) for the assessment of the firm’s actual cash performance. By
comparing budgeted and actual cash flows, the owner can identify problem areas, and
then act to correct the situation.
Specifically, the owner could assess:
• the effectiveness of advertising in generating cash sales
• procedures for collecting cash from Accounts Receivable
• policies for making payments to Accounts Payable
• the level of cash payments for expenses
• the level of cash drawings
• the adequacy of finance for the purchase of non-current assets.

1 Define the following terms as they relate to the Budgeted Cash Flow
Statement, and provide one example of an inflow and one example of an
outflow that would fall under each of these headings:
• Operating activities
• Investing activities
• Financing activities.
2 Explain why it is important that budgeted Net Cash Flows from Operations is
positive.
3 State two actions the owner could take to:
• generate estimated Operating cash inflows
• reduce estimated Operating cash outflows.
4 State two expected expenses that will not be reported in the Budgeted Cash
Flow Statement.
5 Explain why it is usual for Net Cash Flows from Investing activities to be
negative.
6 Explain the possible relationship between the cash flows from Investing and
Financing activities.
7 Explain two benefits of preparing budgets more frequently than once a year.
8 Explain how the Budgeted Cash Flow Statement can assist planning.
9 State three actions the owner could take to address a budgeted cash decrease.
10 State three actions the owner could take to utilise a budgeted cash increase.
11 Explain how the Budgeted Cash Flow Statement can assist decision-making.

17.4 Calculating cash flows

In the example in 17.2, we reported Receipts from Accounts Receivable in the Budgeted
Cash Flow Statement rather than Credit sales as we were interested only in reporting
cash flows. This distinction is very important; the credit sale and receipt of the cash may
even take place in different Periods.
In some cases, it may be necessary to calculate how much will be received from
Accounts Receivable during the budget period from Credit sales made in previous
periods and, in some cases, the current Period. Integral to this type of calculation
is knowledge of the historical behaviour of Accounts Receivable in making their
repayments. The business owner needs to be able to estimate approximately how long
Accounts Receivable take to pay.
Schedule of Receipts from
Schedule of Receipts from Accounts Receivable Accounts Receivable
Based on the information in the Accounts Receivable ledger, owners can estimate a table used to calculate how
much cash will be received from
what percentage of Accounts Receivable will pay within a month of the sale, within
Accounts Receivable in the
two months, and so on, thereby allowing them to calculate the expected Receipts budget period as a consequence
from Accounts Receivable for the budget period. This calculation is facilitated by the of Credit sales in the current
preparation of a Schedule of Receipts from Accounts Receivable. and previous periods
Facial Attractions sells make-up and other cosmetics, and it wants to prepare a Example
Budgeted Cash Flow Statement for October, November and December 2026. On
30 September 2026, its owner provided the following Sales data:
Actual sales July $21 000
August 20 000
September 22 000
Budgeted sales October 19 000
November 23 000
December 25 000
• Sales figures do not include GST.
• 20% of Sales are made on cash terms; 80% are made on credit.
In preparing a Budgeted Income Statement no further calculations would be

necessary as information relating to expected Sales revenue for each month is already
provided. However, in order to prepare a Budgeted Cash Flow Statement, it is necessary
to calculate expected Receipts from Accounts Receivable.
To do this, it is first necessary to calculate how much of the total Sales figure is cash
sales, and how much is made on credit. This is shown in Figure 17.4:
Figure 17.4 Schedule of cash and credit sales
Month Total sales Cash sales 20% Credit sales 80%

July 21 000 4 200 16 800
August 20 000 4 000 16 000
September 22 000 4 400 17 600
October 19 000 3 800 15 200
November 23 000 4 600 18 400
December 25 000 5 000 20 000

The Cash sales figures for October to December can go straight into the Budgeted
Cash Flow Statement (as Operating inflows) as they represent cash flows in the months
when the sale is made. (Cash sales for July to September are outside the budget period,
and so are excluded.)
As these are Sales, GST will also be received at the rate of 10% of the Cash sales
figure. The cash receipts arising from Cash sales for October to December 2026 would
thus be as shown in Figure 17.5:
Figure 17.5 Budgeted Cash Flow Statement: Cash sales and GST received
FACIAL ATTRACTIONS
Budgeted Cash Flow Statement for October – December 2026
October November December
Cash sales 3 800 4 600 5 000
GST received 380 460 500
However, it is still necessary to calculate how much cash will be received in October
to December 2026 as a result of Credit sales in earlier months. In order to do this, we
must first add to our Credit sales the GST we will charge Accounts Receivable, as both
amounts must be collected. This is shown in Figure 17.6:
Figure 17.6 Credit sales and GST
Credit sales GST charged Credit sales

Month (excluding GST) (10%) (including GST)
July 16 800 1 680 18 480
August 16 000 1 600 17 600
September 17 600 1 760 19 360
October 15 200 1 520 16 720
November 18 400 1 840 20 240
December 20 000 2 000 22 000
Given the total amount owed to the business by Accounts Receivable (Credit sales
including GST), it is now possible to calculate Receipts from Accounts Receivable from
those Credit sales. This requires more information about the repayment patterns of the
firm’s Accounts Receivable:
Example Based on an analysis of the Accounts Receivable of Facial Attractions, the owner
(continued) expects:
• 25% of Accounts Receivable will pay in the month after the sale. These
Accounts Receivable receive a 5% discount.
• 60% of Accounts Receivable will pay two months after the sale.
• 15% pay in the third month after sale.

Based on this information, we can prepare a Schedule of Receipts from Accounts

Receivable like the one shown in Figure 17.7: Study tip
Figure 17.7 Schedule of Receipts from Accounts Receivable
Credit sales The Schedule of

Month (incl. GST) October November December Receipts from Accounts
July 18 480 2 772 Receivable is not a
August 17 600 10 560 2 640 budgeted report; it is
September 19 360 4 598 11 616 2 904 simply a technique
October 16 720 3 971 10 032
used to calculate
Receipts from Accounts
November 20 240 4 807
Receivable, which can
December 22 000
then be shown in the
Budgeted Receipts from Accounts Receivable 17 930 18 227 17 743 Budgeted Cash Flow
Statement.
The months across the top of the table (October, November, December 2026) are
those for which the budget is being prepared. The months down the left side (July to
December 2026) are those for which Sales data is available.
If we examine the amount owing for credit sales made in September 2026, we
can see how the calculations were made. Based on the analysis of when Accounts
Receivable pay, 25% of the September Credit sales figure ($19 360 including GST) less
the 5% discount will be collected in the month after the sale; that is, in October 2026.
This is shown in Figure 17.8:
Figure 17.8 Calculation: Cash received from Accounts Receivable
Study tip
Credit sales (including GST) $19 360
x 25% (received one month after sale) 4 840
With the discount, don’t
less 5% discount (5% x $4 840) 242
just multiply $19 360 by
Cash received from Accounts Receivable (in October 2026) $ 4 598 20% (that is, 25% less
5%); this would give the
discount to all Accounts
A further $11 616 (60% of $19 360) will be collected two months later in November Receivable, rather than
2026, and the final $2 904 (15% of $19 360) will be collected three months after the just those who pay
sale in December 2026.The same process applies to the other months to show that within one month.
although a credit sale is made in one month, the cash may be received over a number
of months. This shows that Credit sales made in September 2026 will result in Receipts
from Accounts Receivable in October, November and December 2026.
From the point of view of the Budgeted Cash Flow Statement, it also means that
cash received from Accounts Receivable in October 2026 will come from Credit sales
made in July, August and September 2026, so if the figures in the columns for October,
November and December 2026 are added together, the answer is the estimated
Receipts from Accounts Receivable for each month.
Including this information produces a Budgeted Cash Flow Statement as shown in
Figure 17.9:
Figure 17.9 Budgeted Cash Flow Statement including Receipts from Accounts Receivable
FACIAL ATTRACTIONS
Budgeted Cash Flow Statement (extract) for October–December 2026
October November December
Cash sales 3 800 4 600 5 000
GST received 380 460 500
Receipts from Accounts Receivable 17 930 18 227 17 743

Although the cash received from Accounts Receivable includes some GST, it is not
necessary to identify this amount separately as the GST is only identified at the point of
sale: only GST received on cash sales must be reported separately.
Schedule of Payments to Schedule of Payments to Accounts Payable

Accounts Payable This technique can also be applied to calculate Payments to Accounts Payable, with credit
a table used to calculate how
purchases substituting for credit sales. In order to draw up a Schedule of Payments
much cash will be paid to
Accounts Payable in the budget to Accounts Payable, information is required on how frequently Accounts Payable are
period as a consequence of paid so that the business can calculate when and how much Accounts Payable will be
credit purchases in the current paid during the budget period.
and previous periods

1 Referring to one Accounting assumption, explain why it may be necessary to
prepare a Schedule of Receipts from Accounts Receivable when preparing a
Budgeted Cash Flow Statement.
2 Explain the role of historical data in the preparation of a Schedule of Receipts
3 Explain why Receipts from Accounts Receivable must be calculated using
credit sales including GST.
4 Explain why the GST must be identified when cash sales are shown in the
Budgeted Cash Flow Statement.
5 State one reason why the GST is not identified when cash is received from
17.5 The Budgeted Income Statement

Given that the main objective of a trading business is to earn a profit, the owner should
plan ahead for how to achieve this goal. In addition, the firm must have some type of
Budgeted Income Statement benchmark against which it can assess its trading (profit) performance. Both of these
an Accounting report that aims are met by the preparation of a Budgeted Income Statement, which attempts to
shows expected future predict revenues and expenses for the budget period.
revenues and expenses and, as
a result, the expected profit for
Cash versus profit
the budget period
At this point it is probably worth remembering that cash and profit are different measures
of performance, and therefore the items reported in the Budgeted Income Statement will
not necessarily be the same as those reported in the Budgeted Cash Flow Statement.
Study tip Whereas the Budgeted Cash Flow Statement reports expected cash inflows and cash
outflows over the budget period, the Budgeted Income Statement reports expected
revenues earned and expected expenses incurred over the budget period.
Strictly speaking, As some cash items are not revenues or expenses, they will be omitted from the
proceeds from the cash Budgeted Income Statement altogether:
sale of a non-current
asset represent revenue.
Cash inflows that are not revenues Cash outflows that are not expenses
However, it is only the
overall profit (or loss) GST received GST paid
on the disposal that is GST refund GST settlement
reported in the Budgeted Proceeds from the cash sale of a non-current asset Cash payment for a non-current asset
Income Statement. Capital contribution of cash Cash drawings
Receipt of loan Repayment of loan principal

However, the Budgeted Income Statement will include some revenues and expenses
that are not reported as cash flows:
Revenues that are not cash inflows Expenses that are not cash outflows
Inventory gain Inventory loss
Inventory write-down
Profit on disposal of non-current asset Loss on disposal of non-current asset
Bad debts expense
Finally, some of the items will affect both budgets, but the amounts may differ:
Revenue/expense Cash inflow/outflow

Credit sales Receipts from Accounts Receivable
Cost of Sales Payments for Inventory
Other revenue earned Other revenue received
Other expense incurred Other expense paid
Let’s use the information that was used to generate the Budgeted Cash Flow
Statement in Figure 17.2 to illustrate how the Budgeted Income Statement will appear,
but this time with the revenues and expenses highlighted.
• The owner will make a capital contribution of $30 000 to commence
operations.
– Wages $8 000
• Rent for the next six months will be paid on 1 March 2026: $9 000 plus
$900 GST

The Budgeted Income Statement for March 2026 is shown in Figure 17.10:
Figure 17.10 Budgeted Income Statement
Budgeted Income Statement for March 2026
$ $
Revenue
Cash sales 24 000
Credit sales 1
16 000 40 000
Gross Profit 20 000
less Inventory loss 300
Less Other expenses
Wages 8 000
Advertising 1 300
Depreciation of Office equipment 100
Rent expense 1 500
2
10 900
Net Profit 8 800
Note the following in Figure 17.10:

1 Credit sales of $17 600 includes GST. Thus, the amount of Credit sales revenue is
only $16 000; that is,
$17 600 × 10/11 = $16 000 Credit sales
2 Prepaid rent expense is not shown in this report as it is the purchase of a current
asset. However, of the $9 000 paid one month has been incurred and must be
recognised as an expense; that is,
$9 000 × 1/6 months = $1 500 Rent Expense
Uses of the Budgeted Income Statement

The Budgeted Income Statement aids planning because it indicates the future
requirements of the firm relating to issues such as staffing, which may require hiring or
firing; inventory levels; or advertising campaigns.
It also aids decision-making by providing a standard against which trading
performance can be measured, allowing problems to be identified and corrective action
taken. This benchmark can act as a target or goal to motivate staff and management.
Specifically, the owner could assess:
• the level of sales and the effectiveness of advertising
• the mark-up achieved
• the level of inventory loss to assess inventory management procedures
• expense control
• staff performance.


1 Explain the difference between a Budgeted Cash Flow Statement and a
Budgeted Income Statement.
2 State two examples of:
• cash inflows that are not revenues
• cash outflows that are not expenses.
3 State two examples of:
• revenues that are not cash inflows
• expenses that are not cash outflows.
4 Explain how a Budgeted Income Statement can be used to assist planning.
5 Explain how a Budgeted Income Statement can be used to assist decision-making.
6 State three areas of business performance the owner might assess by using
the Budgeted Income Statement as a benchmark.
17.6 The Budgeted Balance Sheet Budgeted Balance Sheet

predicts assets, liabilities and
The Budgeted Balance Sheet attempts to predict the firm’s assets, liabilities and owner’s equity at some point in
owner’s equity at some point in the future. the future
– Wages $8 000
• Rent for the next six months will be paid on 1 March 2026: $9 000 plus $900 GST

The budgeted Balance Sheet as at 31 March 2026 is shown in Figure 17.11:
Figure 17.11 Budgeted Balance Sheet

Budgeted Balance Sheet as at 31 March 2026
$ $ $ $
Bank 1
19 570 Accounts Payable 6 500
Inventory 2 14 100 Loan – AXC Bank 6 6 000 12 500
Accounts Receivable 3
6 600
7 500 Non-current Liabilities
GST Clearing 5
1 030 48 800 Loan – AXC Bank 6 4 000
Non-current Assets Owner’s equity
Office equipment 5 000 Capital – Denzel 30 000
less Accumulated depreciation 100 4 900 add Net Profit 7
8 800
38 800
less Drawings 8 1 600 37 200
Note the following in Figure 17.11.

1 Bank: See Figure 17.2: Budgeted Cash Flow Statement (Bank Balance at end)
2 Inventory: See Figure 17.12
3 Accounts Receivable: Credit sales including GST ($17 600) less Receipts from
Accounts Receivable ($11 000)
4 Prepaid rent expense: Prepaid rent expense ($9 000) less Rent expense ($1 500)
5 GST Clearing: See Figure 17.13
6 Loan – AXC Bank: Repayable $500 per month (12 × $500 = CL; remainder NCL)
7 Net Profit: See Figure 17.10: Budgeted Income Statement (Net Profit)
8 Drawings: Cash drawings ($1 000) plus Drawings of inventory ($600)
It is worth considering in detail how two of these items in the budgeted Balance
Sheet – Inventory and GST Clearing – were calculated. Given our knowledge of double-
entry Accounting, we will express the calculation in the form of a ledger account.
Figure 17.12 shows the Inventory account, used to calculate the balance on hand as
at 31 March 2026:
Figure 17.12 Inventory account

General Ledger
Inventory (A)
March 1 Balance Nil March 31 Cost of Sales 20 000
31 Accounts Payable 35 000 Drawings 600
Inventory loss 300
Balance 14 100
35 000 35 000

Figure 17.13 shows the GST Clearing account, used to calculate the balance owing
as at 31 March 2026:
Figure 17.13 GST Clearing account

General Ledger
GST Clearing (A/L)
March 31 Bank 1 530 March 1 Balance Nil
Accounts Payable 3 500 31 Bank 2 400
Balance 1 030
5 030 5 030
The debit balance in this account means GST Clearing is an asset: a present economic
resource (the refund owed to the business by the ATO) controlled by the business.
This has occurred because the business has just started, so it has purchased more
inventory than it has sold and purchased a number of assets such as Office equipment
and Prepaid rent expense. Thus, the GST on purchases ($1 530 + $3 500) is greater than
the GST on sales ($2 400 + $1 600).
Uses of the Budgeted Balance Sheet

The Budgeted Balance Sheet can be used as a planning document. By detailing the
expected Carrying value of non-current assets at some time in the future, it helps the
owner prepare for their replacement. When used in conjunction with the Budgeted
Cash Flow Statement, it can also be used to plan for the repayment of loans, and to set
the level for drawings for the coming period.
In addition, it also aids decision-making by setting a benchmark for indicators that
assess liquidity and stability. Specifically, it will allow the owner to calculate the Budgeted
Working Capital Ratio, which can be used to assess liquidity; and the Debt Ratio, which
can be used to assess stability. (These ratios are covered in detail in Chapter 19.)

1 State three items reported in the Budgeted Balance Sheet that are affected by
the transactions reported in the:
• Budgeted Income Statement.
2 Explain how the Budgeted Balance Sheet can be used to assist planning.
3 Explain how the Budgeted Balance Sheet can be used to assist decision-
making.

Study tip
17.7 Account reconstruction
The preceding example illustrated how ledger accounts can be used to calculate closing
To select which account balances for the Budgeted Balance Sheet. This is not the only use of ledger accounts
to reconstruct, think of in the budgeting process. If the closing balance is already known, it is possible to work
the transaction that is backwards to calculate other figures that may be necessary to complete the Budgeted
missing: it will appear Cash Flow Statement or the Budgeted Income Statement.
in two ledger accounts. Where only some information is known, knowledge of ledger accounts and double-
Then choose the account entry Accounting can be used to calculate missing or unknown figures by reconstructing
for which the best the relevant ledger account. Reconstructing a ledger account involves three steps:
information is available. 1 Identify the entries which would be expected in a particular ledger account.
2 Match these entries with figures that are known.
3 Complete the ledger account to calculate the figures that are not known.
Example On 1 July 2025, Kings Sportswear had Accounts Receivable of $12 000. During
July 2025, Credit sales were expected to be $88 000 including GST, and Sales
returns were budgeted to be $1 200 plus GST. Discount expense was expected to
be $400 and a Bad debt for $900 plus GST was to be written off. At 31 July 2025,
Accounts Receivable was expected to be $15 000.
The data above is sufficient to prepare the Budgeted Income Statement as Credit
sales is known ($80 000), and the Budgeted Balance Sheet can be prepared as Accounts
Receivable at the end is known ($15 000). However, the Budgeted Cash Flow Statement
cannot be prepared, as Receipts from Accounts Receivable is unknown. There is
insufficient information to prepare a Schedule of Receipts from Accounts Receivable (as
collection details are not given), but it is possible to reconstruct the Accounts Receivable
account.
Step 1: Identify expected entries

Including every transaction this course has covered so far, a complete Accounts
Receivable account, excluding amounts, would appear as shown in Figure 17.14:
Figure 17.14 Accounts Receivable template

Study tip
General Ledger
Devise a code to Date Cross-reference Amount $ Date Cross-reference Amount $

remember the number of July 1 Balance July Bank /
entries in each account. Sales/GST Clearing Discount expense
Accounts Receivable Sales returns/GST Clearing
has six entries: two on Allowance for doubtful
the debit side, and four
debts/GST Clearing
on the credit side. For
example, you could call it 31 Balance
‘the 2 by 4 account’.
Aug. 1 Balance
Keep in mind that although we are calculating Receipts from Accounts Receivable,
it will be identified in the Accounts Receivable account by the cross-reference Bank.
Also note that the line Bank / Discount expense entry has been split across two lines

to separate the cash received from Accounts Receivable (Bank) from the Discount
expense. Finally, note that the bad debts written off is cross-referenced to Allowance
for doubtful debts – Bad debts expense is only used in the balance day adjustment to
create the allowance.
Step 2: Match amounts

After entering the information that is known, the Accounts Receivable account would
Figure 17.15 Accounts Receivable account: Including amounts

General Ledger
July 1 Balance 12 000 July Bank /
Sales/GST Clearing 88 000 Discount expense 400
Sales returns/GST Clearing 1 320
Allowance for doubtful 900
debts/GST Clearing
31 Balance 15 000
The Sales returns figure was provided as $1 200 plus GST, meaning the total figure
to be recorded here is $1 320 ($1 200 plus $120 GST).
Step 3: Complete the ledger account

By completing the account, the missing figure – which in this case is Receipts from
Accounts Receivable – can be determined. This is shown in Figure 17.16:
Figure 17.16 Accounts Receivable account: Complete

General Ledger
July 1 Balance 12 000 July Bank / 82 380
Sales/GST Clearing 88 000 Discount expense 400
Sales returns/GST Clearing 1 320
Allowance for doubtful 900
debts/GST Clearing
31 Balance 15 000
100 000 100 000
The total on the debit side equals $100 000, so this must also be the total on the
credit side but in order to make the credit entries total $100 000, Receipts from Accounts
Receivable must be $82 380, which can now be reported in the Budgeted Cash Flow
Statement.

The same approach could be used to reconstruct other ledger accounts, such as
Study tip Accounts Payable which is shown in Figure 17.17:
Figure 17.17 Accounts Payable template

This account is almost General Ledger
the opposite of Accounts Accounts Payable (L)
Receivable, but it has no Date Cross-reference Amount $ Date Cross-reference Amount $
bad debts (Allowance for
Bank / Start Balance
doubtful debts) entry.
Discount revenue Inventory/GST Clearing
Inventory/GST Clearing
End Balance
End Balance
The Inventory / GST Clearing entry on the credit side is credit purchases; the same
entry on the debit side is purchase returns.
Figure 17.18 shows the template for the Inventory account:
Figure 17.18 Inventory template

General Ledger
Inventory (A)
Start Balance Cost of Sales 4
Accounts Payable1 Cost of Sales 5
Bank 2 Cost of Sales 6
Cost of Sales 3 Accounts Payable 7
Advertising
Drawings
Inventory write-down
Inventory gain * Inventory loss *
End Balance
End Balance
* Inventory loss or Inventory gain will be recorded, but not both
Given the number of entries in the Inventory account, it is worth clarifying a few:
Debit side Credit side

1. Credit purchases 4. Cash sales (cost price)
2. Cash purchases 5. Credit sales (cost price)
3. Sales returns (cost price) 6. Unearned sales (cost price)
7. Purchase returns
An actual Inventory account may have any number of each of these entries (except
Inventory loss or gain, which will be recorded as one or the other but not both).
Further, although Cost of Sales may come from three different types of sale, it would
only be reported as a single figure in the Budgeted Income Statement, and hence may
in some cases be provided as only one figure. Note also the links between the Accounts
Payable and Inventory accounts relating to credit purchases and purchase returns.

Figure 17.19 shows the template for the GST Clearing account:
Figure 17.19 GST Clearing template

General Ledger
GST Clearing (A/L)
Bank 1
Start Balance
Bank 2
Bank 6
Accounts Payable 3 Accounts Receivable 7
Accounts Payable 8
End Balance
End Balance
The entries in the GST Clearing account are:
Debit side Credit side

1. GST settlement 6. GST on cash sales
2. GST on cash purchases 7. GST on credit sales
3. GST on credit purchases 8. GST on purchase returns
4. GST on sales returns
5. GST on bad debt written off
This example assumes a credit balance (GST liability) to begin with, so a GST
settlement is also likely: in the case of a debit balance (GST asset) a GST refund would
be expected.
In terms of the Budgeted Cash Flow Statement, only the three bank entries (GST
settlement, GST on cash purchases and GST on cash sales) would be reported.
The template for the Capital account is shown in Figure 17.20:
Figure 17.20 Capital template

General Ledger
Capital (Oe)
Drawings Start Balance
Profit and Loss Summary Bank
Asset
Profit and Loss Summary
End Balance
End Balance
The cross-reference Profit and Loss Summary refers to the Net Profit or Loss for the
period, so only one of these entries will appear at any one time. If a profit is generated,
it will appear on the credit side of the Capital account; if a loss is incurred, it will appear
on the debit side.

Finally, the template for the Disposal of Non-current asset account would appear as
Figure 17.21 Disposal of Non-current asset template

General Ledger
Disposal of Non-current asset
Non-current asset Acc. dep. of NCA
Profit on Disposal of NCA Bank (or NCA)
Loss on Disposal of NCA
Where the asset is sold for cash the second credit entry will be Bank, but if the asset
is traded-in the cross-reference will be to the Non-current asset account itself, and the
account will show either a Profit on Disposal of Non-current asset or a Loss on Disposal
of Non-current asset, but not both.
This list is by no means exhaustive; any ledger account could be reconstructed
Study tip to calculate a missing figure, for any of the three general-purpose budgets. The only
restriction is the need to know three of the ‘big four’ pieces of information.
For Accounts Receivable and Accounts Payable, this means at least three of the
If only two of the big
opening balance, the closing balance, Credit sales (for Accounts Receivable) or Credit
four figures are known,
there may still be purchases (for Accounts Payable), and Receipts from Accounts Receivable or Payments
enough information to to Accounts Payable. For Inventory, it means three of the opening balance, the closing
reconstruct a related balance, Cost of Sales and Purchases (cash or credit).
account (for example,
Inventory and Accounts
Payable are linked),
which may allow for the 1 State the purpose of reconstructing a ledger account.
calculation of the third 2 List the three steps involved in reconstructing a ledger account.
figure and therefore the 3 Explain when it would be more appropriate to reconstruct the Accounts Receivable
reconstruction of the account rather than prepare a Schedule of Receipts from Accounts Receivable.
original account. 4 Show the templates for the following ledger accounts:
• Accounts Payable
• Inventory
• GST Clearing
• Capital
• Disposal of NCA.
17.8 Variance reports: cash and profit

variance report This chapter has noted a number of times the benefit of budgets in terms of providing a
an Accounting report that benchmark for the assessment of actual performance. By comparing actual and budgeted
compares actual and budgeted figures, significant differences (and problems in particular) can be identified, allowing
figures, highlighting variances so
the owner to make decisions to improve the firm’s performance. This comparison is
that problems can be identified
and corrective action taken facilitated by the preparation of a variance report, an Accounting report that compares
actual and budgeted figures, highlighting variances (differences between the actual
variance
the difference between actual
and budgeted amounts) so that problems can be identified and corrected. It is prepared
and budgeted figures, usually once the actual figures are available, but before the next budget.
described as favourable or
unfavourable

This course concentrates on two variance reports:

• Cash Flow Statement Variance Report
• Income Statement Variance Report.
Cash Flow Statement Variance Report

A Cash Flow Statement Variance Report compares actual and budgeted cash flows.
Cash Flow Statement
In appearance, it is very similar to a Budgeted Cash Flow Statement, but it has additional Variance Report
columns for actual figures and the calculation of the variance. an Accounting report that
Figure 17.22 shows the Cash Flow Statement Variance Report for Denzel Washing compares actual and budgeted
Machines for March 2026: cash flows, highlighting
variances as favourable or
unfavourable depending on
Figure 17.22 Cash Flow Statement Variance Report
their effect on budgeted cash
DENZEL WASHING MACHINES on hand
Cash Flow Statement Variance Report for March 2026
Budget Actual Variance F/U
Cash sales 24 000 29 000 5 000 F Study tip
Receipts from Accounts Receivable 11 000 8 000 3 000 U
GST received 2 400 2 900 500 F
Total Operating inflows 37 400 39 900 2 500 F Variance reports are also
known as performance
Payments to Accounts Payable (32 000) (30 000) 2 000 F
reports, as they assess
Wages (8 000) (8 600) 600 U
the firm’s performance in
Advertising (1 300) (1 100) 200 F meeting its budget.
Prepaid rent expense (9 000) (9 000) – –
GST paid (1 530) (1 610) 80 U
Total Operating outflows (51 830) (50 310) 1 520 F
Net Cash Flows from Operations (14 430) (10 410) 4 020 F
Office equipment (5 000) (5 000) – –
Net Cash Flows from Investing activities (5 000) (5 000) – –
CASH FLOW FROM FINANCING ACTIVITIES
Capital contribution 30 000 30 000 – –
Loan – AXC Bank 10 000 11 000 1 000 F
Drawings (1 000) (1 200) 200 U
Net Cash Flows from Financing activities 39 000 39 800 800 F
Net Increase (Decrease) in cash position 19 570 24 390 4 820 F
add Bank Balance at start Nil Nil – –
Bank Balance at end 19 570 24 390 4 820 F
As noted above, a variance is simply the difference between the budgeted figure and
the actual figure. Whether it is favourable or unfavourable depends, in the Cash Flow
Statement Variance Report, on its effect on budgeted cash. A variance is favourable (F)
if it means cash will be higher than expected in the budget; a variance is unfavourable
(U) if it means cash will be lower than expected in the budget.
In this example, the variance in the Loan – AXC Bank is reported as favourable
because cash will increase more than expected. The fact that the liabilities will also
increase does not affect its classification in the Cash Flow Statement Variance Report.
Similarly, Payments to Accounts Payable is classified as favourable, even though it could
mean the balance owed to Accounts Payable is higher than expected.

Overall, the cash variance is favourable by $4 820, largely because Net Operating
Study tip Cash Flows were favourable by $4 020, with this the result of a favourable variance in
both cash inflows by $2 500 and cash outflows by $1 520. That is, the firm generated
more cash than expected from Operating activities and had lower cash outflows, and
If there is no variance
this translated into a higher bank balance than budgeted.
at all, then it is
neither favourable nor
unfavourable. Uses of the Cash Flow Statement Variance Report
It is possible that the variances revealed in the Cash Flow Statement Variance Report are
caused simply by poor budgeting. However, this does not mean the report is useless; it
should be used in planning the next budget, so that it is more accurate.
Assuming the variances are not caused by poor estimates, then the Cash Flow
Statement Variance Report is a valuable aid to decision-making. The unfavourable
variances should be investigated, and their cause identified. This will allow the owner to
take corrective action.
In this example, Denzel Washing Machines may be concerned at the unfavourable
variance in Receipts from Accounts Receivable; does it indicate a decline in Credit sales,
poor collection policies or something else?
When using the report in this way, it is also important to consider the links between
items. For instance, an unfavourable variance in Advertising may actually generate
a favourable variance in Cash sales, in turn leading to an unfavourable variance in
Wages.
Income Statement Variance Income Statement Variance Report

Report In the same way that a Cash Flow Statement Variance Report compares actual and
an Accounting report that budgeted cash flows, an Income Statement Variance Report can be prepared to
compares actual and budgeted compare actual and budgeted revenues and expenses.
revenues and expenses,
Variances in this report are classified as favourable or unfavourable depending on
highlighting variances as
favourable or unfavourable their effect on budgeted profit. In the Income Statement Variance Report, a variance is
depending on their effect on favourable (F) if it means profit will be higher than expected in the budget; a variance is
budgeted profit unfavourable (U) if it means profit will be lower than expected in the budget.

Figure 17.23 shows the Income Statement Variance Report for Denzel Washing
Machines for March 2026:
Figure 17.23 Income Statement Variance Report

Income Statement Variance Report for March 2026
Budget Actual Variance F/U
Revenue
Cash sales 24 000 29 000 5 000 F
Credit sales 16 000 14 000 2 000 U
Cost of Sales 20 000 19 000 1 000 F
Gross Profit 20 000 24 000 4 000 F
less Inventory loss 300 900 600 U
Adjusted Gross Profit 19 700 23 100 3 400 F
less Other expenses
Wages 8 000 8 600 600 U
Advertising 1 300 1 100 200 F
Depreciation of Office equipment 100 100 – –
Rent expense 1 500 1 500 – –
Net Profit 8 800 11 800 3 000 F
In this case, there is a $3 000 favourable variance in Net Profit, largely because of a $5 000
favourable variance in Cash sales. Even with an overall increase in sales, Cost of Sales was
favourably lower than expected, perhaps indicating lower cost prices for suppliers (or a
higher selling price charged to customers). The unfavourable variance in Wages makes
sense given the increase in sales particularly if it was due to an increase in sales volume.
Uses of the Income Statement Variance Report

The Income Statement Variance Report can be used for exactly the same purposes
as the Cash Flow Statement Variance Report: as a planning document and to aid
decision-making.
The preceding report identifies that Sales overall has increased, so this may
explain the unfavourable variances in Wages and even Inventory loss. However, the
unfavourable variance in Inventory loss is worth investigating as it may be caused by
poor inventory management procedures, which may need to be improved. Without the
budget providing the benchmark, and the variance report making the comparison, this
problem may not have been identified.

1 State what information is shown in a:
2 Define the term ‘variance’.
3 Explain when a variance would be considered to be favourable if reported
in the:
4 Explain how a variance report can be used to assist planning.
5 Explain how a variance report can be used to assist decision-making.

Where have we been?

• Budgeting is the process of preparing reports that estimate or predict the financial consequences of likely
future transactions.
• Budgets assist planning by predicting what is likely to occur in the future and aid decision-making by
providing a benchmark or yardstick (a standard) against which actual performance can be measured.
• Budgeted cash and budgeted profit are not necessarily the same.
• Budgeted figures can be calculated by preparing Schedules (of Receipts from Accounts Receivable/
Payments to Accounts Payable) or by reconstructing ledger accounts.
• Variance reports compare actual and budgeted figures, highlighting variances so that problems can be
identified and corrected.
• A variance is the difference between the budgeted figure and the actual figure, and is classified as
favourable or unfavourable depending on its effect on bank or profit.
Exercises
this book.

Budgeted Cash Flow Statement
On 1 July 2026 Top Hats had $2 700 in its bank account. It has provided the following list of expected
transactions for July 2026:
• Cash sales are expected to be $12 000 plus GST. Credit sales are expected to be $5 000 plus GST, but
only 60% is expected to be collected in July 2026.
• All inventory is sold at a 50% mark-up.
• Cash purchases of inventory will be $4 000 (plus GST).
• Drawings will consist of $1 200 cash and $300 worth of inventory.
• The following expenses will be paid:
– Advertising $2 100 plus GST
– Wages 3 600
– Interest expense 230
• $400 wages will be owing at the end of July 2026.
• Yearly rent will be paid on 1 July 2026, costing $8 400 plus GST.
• The monthly loan repayment of $1 600 will be made on 14 July 2026.
• New shop fittings worth $3 850 (including GST) will be purchased for cash from Fitts Best.
Required
a Calculate budgeted GST paid for July 2026.
* b Prepare a Budgeted Cash Flow Statement for Top Hats for July 2026.
c Suggest two actions the owner may take to plan for the outcome predicted in the Budgeted Cash Flow
Statement.
d Prepare an extract of the Budgeted Cash Flow Statements for Top Hats for July 2026 to model the
effect on Operating Cash Flows
• Cash sales of $15 000 plus GST
• Credit sales of $10 000 plus GST
e Referring to your answer to part ‘d’, explain whether Top Hats should be aiming to increase its Cash
sales or Credit sales to improve its cash position.


Budgeted Cash Flow Statement: consecutive periods
Lockhardt Locks has provided the following information regarding its expected activities for January to March 2026:
• As at 1 January 2026, the business had $3 400 in the bank.
• Sales are made on cash-only terms and are budgeted to be $26 000 in January, $27 000 in February and
$25 000 in March. GST will also be received on these amounts.
• Inventory is purchased on credit, with Accounts Payable paid the month following purchase. Credit
purchases for December 2025 were $12 000 but are expected to rise to $13 000 in January, and $13 500
in February and March. GST will also be owing on these amounts.
• The following expenses will be paid each month:
– Wages $4 000
– Advertising $1 300 plus GST
– Interest expense $150
• Rent for the next six months will be paid during January $9 900 inclusive of GST.
• In January 2026, the business will sell an old vehicle for $1 900 cash, and in February 2026 will pay cash
for a new vehicle, which will cost $21 000 plus GST.
• A GST settlement of $1 600 is due in January 2026.
• Monthly cash drawings will be $2 000.
• A repayment on the principal of a loan is due on 21 January 2026 – $1 500.
• The owner plans to contribute $15 000 cash and some office equipment worth $4 200 in March 2026.
Required
a Calculate budgeted GST paid for January, February and March 2026.
* b Prepare a Budgeted Cash Flow Statement for Lockhardt Locks for January, February and March 2026.
c Suggest two actions the owner might take to address any problems revealed by your answer to part ‘b’.
d Explain one benefit of preparing a Budgeted Cash Flow Statement for consecutive periods.

Schedule of Receipts from Accounts Receivable
Bats ‘n’ Balls has provided the following budgeted information relating to its credit sales during 2026:
Month Credit sales $

August (actual) 8 000
September (actual) 9 000
October (budgeted) 10 000
November (budgeted) 11 000
December (budgeted) 12 000
• GST will also be charged on these amounts.
• It is expected that 70% of Accounts Receivable will pay in the month following the sale, while the
remaining 30% will pay in the second month.
Required
a Suggest one reason for the trend in Sales from August to December 2026.
b Prepare a Schedule of Receipts from Accounts Receivable for October, November and December 2026.
c Referring to the information provided, explain one reason why budgeted Net Profit and Budgeted Net
Increase (Decrease) in Cash Position are likely to be different for December 2026.
d Explain how the preparation of a Budgeted Cash Flow Statement can assist planning.


Schedule of Receipts from Accounts Receivable
Jazzy Jackets has provided the following information to aid in the preparation of its Budgeted Cash Flow
Statement for April, May and June 2026:
Month Credit sales $ Cash sales $

January 50 000 43 000
February 40 000 32 000
March 45 000 35 000
April 35 000 27 000
May 30 000 32 000
June 20 000 26 000
• The amounts above do not include GST.
• It is expected that 50% of Accounts Receivable will pay in the month of sale, 30% of Accounts
Receivable will pay in the month following the sale, and the remaining 20% will pay in the second month
following the sale.
Required
a Calculate budgeted Receipts from Accounts Receivable for April, May and June 2026.
b Prepare an extract of the Budgeted Cash Flow Statement for Jazzy Jackets that shows Operating cash
inflows for April, May and June 2026.
c Explain how the preparation of a Budgeted Cash Flow Statement can assist decision-making.

Schedules and the Budgeted Cash Flow Statement
On 1 January 2026 Betty’s Bags commenced operations. Projected purchases and sales for the first four
months are:
Month Credit purchases $ Credit sales $ Cash sales $

January 12 000 20 000 30 000
February 13 000 25 000 34 000
March 14 000 28 000 36 000
• The amounts above do not include GST.
• Betty’s Bags allows a 5% discount if Accounts Receivable pay within the month that the sale occurred.
It is expected that 40% of the Sales will be collected within the discount period, 35% by the end of the
month after purchase, 20% in the following month, and that 5% will be uncollectable.
• Of credit purchases, 50% are paid in the month of purchase, with the remainder paid in the following
month.
• Monthly expenses include Advertising of $2 500 (plus GST), Wages of $1 800 and Depreciation on
Equipment of $1 000. No prepaid or accrued expenses are expected.
• Cash drawings will be $3 000 per month.
• Betty is concerned that there is no provision for extra staff to cope with rising sales.

Required
a Calculate budgeted Receipts from Accounts Receivable for January, February and March 2026.
b Calculate budgeted Payments to Accounts Payable for January, February and March 2026.
c Prepare an extract of the Budgeted Cash Flow Statement for Betty’s Bags that shows the Operating
activities for January, February and March 2026.
d Referring to your answer to part ‘c’, explain your treatment of Depreciation of Equipment.
e Explain how cash drawings would be reported in the Budgeted Cash Flow Statement.
f Prepare extracts of the Budgeted Cash Flow Statement for Betty’s Bags for March 2026 to model the
effect on Operating activities if the business decided to set Wages to:
• 10% of Sales
• 20% of Sales.
g Referring to your answer to part ‘f’, explain whether Betty’s Bags can afford to increase staff to cope
with increasing sales.

Budgeted reports
Dana’s Detergents will begin trading operations on 1 May 2026, and has provided the following estimates for
its first month of operations:
• Shelving worth $6 000 (plus GST) will be purchased using cash.
• Credit sales are estimated to be $13 200 including GST. Accounts Receivable owing at the end of May
2026 is expected to be $3 500.
• All inventory will be purchased on credit. Purchases for May 2026 are expected to be $40 000 plus GST.
At the end of May 2026, it is anticipated that $12 000 will be owed to Accounts Payable.
• All sales will be marked up 50% and based on industry averages Inventory loss is expected to be $500.
• Six months’ advertising will be paid in advance on 1 May 2026, at a cost of $1 200 plus GST. There will
be no other prepayments or accruals.
• The following expenses will be incurred during May 2026:
– Wages $2 000
– Depreciation of Shelving $ 50
– Rent expense $1 000 (plus GST)
• On 31 May 2026, a loan for $35 000 will be received from ZNA Bank. The loan will be used to purchase a
van in June 2026. Each month, $500 will be paid off the principal, starting on 30 June 2026.
Required
* a Prepare a Budgeted Cash Flow Statement for Dana’s Detergents for May 2026.
* b Prepare a Budgeted Income Statement for Dana’s Detergents for May 2026.
c Explain two reasons why the budgeted Net Increase in Cash Position is much larger than the budgeted
Net Profit for May 2026.
d Show how the Inventory and GST Clearing accounts would appear in the General Ledger as at 31 May
2026. Transaction dates are not required.
* e Prepare a Budgeted Balance Sheet for Dana’s Detergents as at 31 May 2026.
f Prepare Budgeted Income Statements for Dana’s Detergents for May 2026 to model the effect on
budgeted Net Profit if sales were marked up:
• 100%
• 150%.
g Explain one reason why the modelling in your answer to part ‘f’ may be inaccurate.


Budgeted reports
On 30 June 2026, the Balance Sheet of Jacuzzi Joint showed the following:
JACUZZI JOINT
$ $ $ $
Inventory 28 000 GST Clearing 950
Accounts Receivable 7 480 Accrued interest expense 300 11 150
less Allowance for doubtful debts (500) Non-current Liabilities
Prepaid rent expense 6 000 44 980 Loan – APS Finance 30 000
Non-current Assets Owner’s equity
Office equipment 24 000 Capital – Jacqui 20 630
less Accumulated depreciation (7 200) 16 800
The owner has provided the following information to assist in the preparation of budgeted reports for
July 2026:
Month Credit purchases $ Credit sales $ Cash sales $

June 9 000 17 000 19 000
July 11 000 18 000 22 000
These amounts do not include GST.
• All inventory is marked up 100%.
• The owner expects an Inventory loss of $300 for July 2026.
• Credit sales are received 60% in the month of the sale and 40% in the month after the sale.
• All purchases are made on credit. Amounts owing to Accounts Payable are paid in the month following
purchase to earn a 5% discount.
• Six months’ rent was prepaid on 1 May 2026.
• Wages paid during July 2026 will be $7 500, but $800 for wages is expected to be owing at the end of
July 2026.
• Doubtful debts for July 2026 are expected to be 4% of Net credit sales.
• Depreciation of Office equipment for July 2026 will be $300.
• Electricity expense will be $200 plus GST. This amount will be paid in full during July 2026.
• In July 2026, $450 will be paid to cover the Interest expense for May, June and July 2026.
• During July 2026, new office equipment costing $13 200 (including GST) will be purchased for cash.
• On 31 July 2026, the owner plans to contribute $10 000 cash and her own vehicle worth $23 000.
Drawings of cash by the owner will be $3 100.
• A GST settlement will be made in July 2026.
• The Loan – APS Finance is an interest-only loan due in full in October 2028.

Required
a Calculate budgeted Receipts from Accounts Receivable for July 2026.
b Calculate budgeted Payments to Accounts Payable for July 2026.
* c Prepare a Budgeted Cash Flow Statement for Jacuzzi Joint for July 2026.
d Calculate budgeted Bad debts expense for July 2026.
* e Prepare a Budgeted Income Statement for Jacuzzi Joint for July 2026.
f Explain two reasons why the Net Cash Flows from Operations is budgeted to be greater than the Net
Profit for July 2026.
g Show how the Inventory and GST Clearing accounts would appear in the General Ledger as at 31 July
2026. Transaction dates are not required.
*
h Prepare a Budgeted Balance Sheet for Jacuzzi Joint as at 31 July 2026.

Account reconstruction
Moving Boxes sells cardboard boxes for people who are moving house and has provided the following
information relating to their Accounts Receivable account:
Balance as at 1 July 2025 $50 000

Budgeted balance as at 30 June 2026 $40 000
Budgeted Credit sales for the year ended 30 June 2026 $110 000 including GST
Budgeted Discount expense $4 500
Required
a For each item above, identify the budgeted report in which the item will appear.
b Reconstruct the Accounts Receivable account to determine budgeted Receipts from Accounts
Receivable for the year ended 30 June 2026.
c Explain the importance of budgeted Sales in the budgeting process.


Bully Hides sells leather products and has provided the following information relating to its expected
transactions for 2026:
Actual balances as at 31 December 2025:
• Accounts Receivable $35 000
• Accounts Payable $13 000
Budgeted balances as at 31 December 2026:
• Accounts Receivable Increase of $10 000 from start of year
From the Budgeted Income Statement for 2026:
• Cash sales * $70 000
• Credit sales * $60 000
• Sales returns * 5% of Credit sales
• Discount revenue $1 500
• Bad debts expense 10% of Net credit sales
• Discount expense $2 300
Other information for 2026:
• Cash purchases * $30 000
• Credit purchases * $45 000
• Bad debts written off * $4 000
* Figures do not include GST.
Required
a Reconstruct the Accounts Receivable account to determine budgeted Receipts from Accounts
Receivable for 2026.
b Prepare an extract from the Budgeted Cash Flow Statement for Bully Hides for 2026 that shows
Operating cash inflows.
c Reconstruct the Accounts Payable account to determine budgeted Payments to Accounts Payable for
2026.


Tony’s Tyre Emporium has provided the following information relating to its expected transactions for the year
ended 30 June 2026:
Actual balances as at 1 July 2025:
• Inventory $31 000
From the Budgeted Income Statement for the year ended 30 June 2026:
• Sales * $70 000
• Sales returns * $1 200
• Inventory gain $4 000
• Discount revenue $2 000
Expected balances as at 30 June 2026:
• Inventory $26 000
Other information:
• Cash purchases* $10 000
• Drawings of ($12 000 cash; $3 000 inventory) $15 000
• Sales mark-up 100%
* Figures do not include GST.
Required
a Reconstruct the Inventory account to determine budgeted credit purchases for the year ended
30 June 2026.
b Reconstruct the Accounts Payable account to determine budgeted Payments to Accounts Payable for
the year ended 30 June 2026.


Simply Stunning sells hair care products to hairdressers in Melbourne and has provided the following Cash
Flow Statement Variance Report for the year ended 30 June 2026:
SIMPLY STUNNING
Cash Flow Statement Variance Report for the year ended 30 June 2026
Budgeted Actual Variance Fav./Unfav.
Cash sales 85 000 94 000
GST received 8 500 9 400
Payments to Accounts Payable (115 000) (136 000)
Prepaid rent expense (12 000) (15 000)
GST paid (1 440) (1 590)
Wages (30 000) (26 000)
Advertising (2 400) (900)
Interest expense (2 700) (3 100)
GST settlement (3 700) (4 600)
Net Cash Flows from Operations 25 460 5 410
Proceeds on sale of equipment 5 000 3 000
Shelving – (12 000)
Net Cash Flows from Investing Activities 5 000 (9 000)
CASH FLOW FROM FINANCING ACTIVITIES
Capital contribution – 20 000
Loan (5 000) –
Drawings (36 000) (40 000)
Net Cash Flows from Financing Activities (41 000) (20 000)
Net Increase (Decrease) in Cash Position (10 540) (23 590)
Add Bank Balance at start 8 500 8 500 – –
Bank Balance at end (2 040) (15 090)
Sophie had organised an overdraft limit with the bank of $6 000.
Required
a Explain one benefit of preparing a Cash Flow Statement Variance Report.
b Complete the Cash Flow Statement Variance Report for Simply Stunning for the year ended 30 June
2026.
c State whether the variance in Payments to Accounts Payable is favourable or unfavourable. Justify your
answer.
d Suggest one possible reason for the Capital contribution.
e Explain the effect on the actual closing bank balance of the variances in Investing activities.
f Assess the cash performance of Simply Stunning for the year ended 30 June 2026.
g Identify two assets that will differ as at 30 June 2026 as a consequence of the variances in the Cash
Flow Statement Variance Report. Justify your answer.


Bright Lights has provided the following partially completed Cash Flow Statement Variance Report for the year
ended 30 June 2026:
BRIGHT LIGHTS
Cash Flow Statement Variance Report (extract) for the year ended 30 June 2026
Budgeted Actual Variance Fav./ Unfav.
Payments to Accounts Payable (45 000) 5 000 F
Interest Expense (800) 300 U
GST Paid (6 000) (4 500)
Prepaid Rent expense (12 000)
Sale of Shelving 5 000 1 000 U
Van (17 000) (23 000)
Loan 7 500 2 500 F
Drawings (25 000) (15 000)
• The $12 000 budgeted payment for Prepaid rent expense failed to take into account $300 in Prepaid rent
expense at 1 July 2025 and Prepaid rent expense of $500 at 30 June 2026.
• The owner has argued that the Loan variance is unfavourable because it increases the firm’s liabilities.
Required
a Calculate the actual payment for Prepaid rent expense for the year ending 30 June 2026.
b Complete the Cash Flow Statement Variance Report (extract) for Bright Lights for the year ended
30 June 2026.
c Explain why the Loan variance is favourable.
d Given that Credit sales decreased, suggest one possible reason for the variance in Receipts from
e Explain one possible effect of Financing activities on the firm’s actual Net Profit for the year ended 30
June 2026.


Income Statement Variance Report
Toot and Twang sells musical instruments from a shop in Melton, and has provided the following Income
Statement Variance Report for the year ended 30 June 2026:
TOOT AND TWANG

Income Statement Variance Report for the year ended 30 June 2026
Revenue
Sales 120 000 110 000
Cost of Sales 70 000 55 000
Gross Profit 50 000 55 000
add Inventory gain (loss) 1 500 (4 200)
Adjusted Gross Profit 51 500 50 800
add Other revenue
Profit on Disposal of Vehicle 1 500 6 500
53 000 57 300
Less Other expenses
Wages 18 000 19 000
Rent 12 000 14 000
Depreciation of Vehicles 2 300 1 600
Interest expense 1 400 1 800
Net Profit/(Loss) 19 300 20 900
Required
a Explain the importance of variance analysis in the budgeting process.
b Complete the Income Statement Variance Report for Toot and Twang for the year ended 30 June 2026.
c Explain whether the variance in Cost of Sales is favourable or unfavourable.
d Suggest one possible reason for the variance in Depreciation of Vehicles.
e Explain why the owner should be concerned about the firm’s profit performance when compared to the
budget.


Income Statement Variance Report
Blades, which sells kitchen knives and cutting utensils, has provided the following Income Statement Variance
Report for the year ended 30 June 2026:
BLADES
Income Statement Variance Report for the year ended 30 June 2026
Revenue
Sales 105 000 90 000
Sales Returns 8 500 4 500 F
96 500
Cost of Sales 48 000 54 000
Cartage In 3 000 1 000
Gross Profit 45 500

Less Inventory Loss 1 800 2 300
Less Other expenses
Wages 28 000 5000 U
Rent 15 000 18 000
Depreciation – Equipment 1 400 2 200
Interest 800 300 F
Net Profit/(Loss)
The business had an overdraft of $4 000 as at 1 July 2025.
Required
a Complete the Income Statement Variance Report for Blades for the year ended 30 June 2026.
b Suggest two possible reasons for the variance in Sales returns.
c Suggest one possible reason for the variance in Interest expense.
d Explain the implications of the variance in Gross Profit.
e Assess the profit performance of Blades for the year ended 30 June 2026.


Account reconstruction and budgeted reports
Seth Bayes is the proprietor of Bayes Surfboards, which sells surf gear on the Victorian west coast. He has
provided the following information to assist in the preparation of budgets for 2026:
BAYES SURFBOARDS
Assets and equities as at 31 December 2025
Assets $ Equities $
Accounts Receivable 19 100 Bank 5 000
less Allowance for doubtful debts (1 500) Accrued wages 700
GST Clearing 3 000 Accounts Payable 41 800
Inventory 62 400 Capital – Bayes 69 500
Less Accumulated depreciation (18 000)
Expected transactions for 2026:

• Credit sales are expected to be $300 000 and will include $20 000 for December 2026. GST will also be
charged on these amounts.
• Accounts Receivable usually pay in the month following sale to take advantage of a 2% settlement discount.
• Credit purchases are budgeted to be $140 000 plus GST and as at 31 December 2026 $37 400 is
expected to be owing to Accounts Payable.
• All inventory is sold at a 100% mark-up.
• Other estimates for 2026 include:
Occupancy expenses $47 000 plus GST Depreciation of Shop fittings $3 400
Office expenses $39 000 plus GST Cash drawings $12 000
Wages expense $35 000 Inventory loss $2 500
• A GST refund is due from the ATO in 2026.
• A new advertising contract will be signed and paid on 30 September 2026, with the payment of $1 980
including GST covering 12 months starting on 1 October 2026.
• Early in December 2026 Seth will borrow $10 000 from AX Bank to finance the purchase of new shop
fittings early in 2027. The loan will be repaid in full in December 2027, but interest of $600 due on
31 December 2026 will not be paid until the next working day on 1 January 2027.
• In November 2026, some old shop fittings will be sold to a local supermarket at a profit of $300. The shop
fittings were originally worth $4 800, but by the sale date will have accumulated depreciation of $4 400.
• Doubtful debts are expected to be 1% of Net credit sales.
• Aside from the expected transactions there will be no other prepayments or accruals as at
31 December 2026.
Required
a Calculate the cash proceeds from the disposal of the shop fittings.
b Calculate budgeted Receipts from Accounts Receivable for 2026.
c Calculate budgeted Payments to Accounts Payable for 2026.
d Calculate budgeted GST paid for 2026.
* e Prepare a Budgeted Cash Flow Statement for Bayes Surfboards for 2026.
f Explain one advantage of preparing budgets more than once a year.
g Show how the Inventory and GST Clearing accounts would appear in the General
Ledger as at 31 December 2026.
* h Prepare an extract of the Budgeted Balance Sheet of Bayes Surfboards as at 31 December 2026 that
shows Current Assets and Current Liabilities. A full Balance Sheet is not required.
i Explain how a Budgeted Balance Sheet can be used to assist planning.

C H A P T E R 17 BUDGETING 477

Account reconstruction and budgeted reports
Poppy Marcel is the proprietor of Digital Masters, which sells digital cameras from a shop in Torquay. She has
requested some assistance in preparing the budgets and has provided the following information:
DIGITAL MASTERS
Account balances as at 30 June 2025
Debit $ Credit $
Accounts Receivable 18 000 Acc. depreciation – Shop fittings 21 600
Inventory 135 000 Accounts Payable 13 700
Prepaid photocopier rent 1 000 Accrued wages 1 300
Shop fittings 48 000 Allowance for doubtful debts 800
GST Clearing 3 400 Bank 38 400
Capital – Marcel 129 600
Total debits 205 400 Total credits 202 000
Anticipated transactions for the year ended 30 June 2026:

• Cash sales are expected to be $42 000 plus GST and Credit sales of $180 000 plus GST. Accounts
Receivable as at 30 June 2026 are expected to be $19 000.
• All inventory is purchased on credit and sold at a 50% mark-up.
• Other estimates for the year include:
– Purchases of inventory $121 000 plus GST
– Sales returns 5% of Credit sales
– Discount expense 2% of Credit sales
– Wages expense $29 000
– Depreciation of Shop fittings $5 300
– Cash drawings $53 000
– Inventory loss 1% of Sales
– Doubtful debts 1% of Net credit sales
• Poppy is currently renting a photocopier at $550 including GST per month, payable 12 months in
advance. Poppy has received notification that the rent will increase to $660 including GST per month
commencing with the next payment due on 1 September 2025.
• On 1 April 2026, the business will invest $6 000 in a three-year term deposit. Interest is earned at 8% per
annum, payable on 31 March each year.
• Estimated balances as at 30 June 2026 include:
– Inventory $106 780
– Bank overdraft $27 620
– GST Clearing $6 180 CR
Required
a Calculate budgeted Photocopier rent expense for the year ended 30 June 2026.
b Calculate budgeted Interest revenue for the year ended 30 June 2026.
c Calculate budgeted Bad debts expense for the year ended 30 June 2026.
*d Prepare a Budgeted Income Statement for Digital Masters for the year ended 30 June 2026.
e Explain how the preparation of a Budgeted Income Statement could assist with planning to achieve an
improved Gross Profit.
*f Prepare an extract of the Budgeted Balance Sheet of Digital Masters as at 30 June 2026 that shows
Current and Non-current Assets. A full Balance Sheet is not required.
Poppy has received advice that a $3 000 advertising campaign would mean sales would be 5% higher than
originally budgeted.
* g Prepare a Budgeted Income Statement for Digital Masters for the year ended 30 June 2026 to model
the effect of the advertising campaign.

Chapter 18
Evaluating performance: profitability

After completing this chapter, you should be able to: • identify the limitations of using financial information
• define ‘profitability’, and distinguish between profit • distinguish between financial and non-financial
and profitability information
• analyse profitability using trends, variances, • analyse and evaluate profitability using financial
benchmarks and profitability indicators and non-financial information
• calculate and explain various profitability indicators • suggest strategies to improve profitability
• explain the relationships between various • discuss ethical considerations in business
profitability indicators decision-making.
Key terms
After completing this chapter, you should be familiar • Return on Assets (ROA)
with the following terms: • Asset Turnover (ATO)
• analysing • expense control
• interpreting • vertical analysis.
• efficiency
• stability Course advice:
• trend In VCE Accounting students will not be required
• horizontal analysis to calculate financial indicators in the examination.
• benchmark However, calculations are included in this text as an
• profitability indicators essential mechanism for understanding the information
• Return on Owner’s Investment (ROI) these indicators present.
• Debt Ratio

C hapter 1 8 E valuating performance : profitability 479
18.1 Analysis and interpretation of profitability
Source
documents
To this point most of this text has been devoted to the first three phases of the
Accounting process: gathering source documents, recording the data so it is classified analysing
and summarised, and reporting the information that is then generated. However, at examining the financial reports
various points financial indicators have been introduced to help assess and explain in detail to identify changes or
differences in performance
financial performance to support the provision of advice. This chapter concentrates
on this last phase of providing advice based on an analysis and interpretation of the interpreting
examining the relationships
information presented in the Accounting reports to help the owner make more informed
between the items in the
decisions. financial reports in order to
In Accounting terms, analysing involves examining the reports in great detail to explain the cause and effect
identify changes or differences in performance, while interpreting involves examining of changes or differences in
the relationships between the items in the reports in order to explain the cause and performance
effect of those changes or differences. Once the causes and effects of changes or
differences in performance are understood, a course of action can be recommended to
the owner to assist decision-making.
Any analysis of business performance must include an assessment of:
efficiency
• profitability: the ability of the business to earn profit, measured by comparing its
the ability of the business to
profit against a base, such as sales, assets or owner’s equity manage its assets and liabilities
• liquidity: the ability of the business to meet its short-term debts as they fall due
stability
• efficiency: the ability of the business to manage its assets and liabilities the ability of the business to
• stability: the ability of the business to meet its debts and continue its operations in meet its debts and continue its
the long term. operations in the long term
Rather than being discrete and separate, these areas of performance are inter-
connected, with changes in efficiency affecting profitability, and changes in liquidity
affecting stability. Indeed, many indicators can be used to assess performance in more
than one area, and business survival depends on having both satisfactory profitability
and satisfactory liquidity: a profitable business will still fail if it cannot pay its debts.
However, it is still worth taking a particular focus to assess performance. This chapter
concentrates on an assessment of profitability, while liquidity is addressed in Chapter
19. In the process, the firm’s efficiency and stability will also be assessed.
Assessing profitability
At its most elemental, a firm’s ability to earn profit is dependent on its ability to:
• earn revenue and
• control expenses.
Consequently, any assessment of profitability must examine the firm’s performance
in these two areas, with an analysis of the Income Statement a logical starting point.
However, an assessment of profitability must not concentrate on profit (in dollar
terms) alone. Many factors may affect a firm’s ability to earn revenue and control its
expenses, and the significance of these factors must be considered when assessing
profitability. The size of the business (in terms of the assets it controls), the size of the
investment by the owner, and the level of sales are all significant in determining how
much profit a business is able to earn.

For example, a firm with assets of $750 000 under its control is likely to generate a
much larger profit (in dollar terms) than a firm with only $50 000 worth of assets under
its control. Comparing these firms on the basis of profit alone will not tell us which one
is more able to use its assets to earn profit, it will simply tell us that one firm had more
assets to use. However, if the profit was expressed per dollar of assets, a comparison
of the ability of each firm to earn profit if it had the same asset base would be possible,
showing which was more profitable.
Profitability is more than assessing the firm’s profit; it is about assessing the firm’s
capacity or ability to earn profit, assuming all these other factors were equal. Expressing
profit relative to another measure allows for comparisons between different firms and
different periods.
Obviously, the level of profit is an important measure of performance, and an
assessment of profitability may begin with an examination of profit, and the revenues
and expenses by which it was derived. But it must then go further by comparing that
profit against a base of some sort to examine the firm’s ability to use its sales, its assets
or the owner’s contribution to earn profit. In this sense profitability is a relative measure.

1 Explain the purpose of analysing and interpreting Accounting reports.
2 Explain the relationship between analysing and interpreting Accounting
reports.
• profitability
• liquidity
• efficiency
• stability.
4 State the two basic factors on which the ability to earn a profit is dependent.
5 Explain how profitability can be assessed between different firms.

18.2 Tools for assessing profitability

There are various tools available to assess profitability, including:
• trends
• variances
• benchmarks
• profitability indicators.
Trends
Trends are the patterns formed by changes over time, and in terms of profitability the trend
identification of the trends in revenues and expenses from one period to the next is the pattern formed by changes
facilitated by analysing consecutive Income Statements. over time
Clear View Windows has provided the following (summarised) Income Statements Example
for the year ended 31 December:
General Journal
CLEAR VIEW WINDOWS
Income Statement for the year ended 31 December
2023 $ 2024 $ 2025 $
Sales 100 000 112 000 115 000
Less Cost of Goods Sold 62 000 72 800 78 200
Gross Profit 38 000 39 200 36 800
Less Inventory loss 700 600 500
Adjusted Gross Profit 37 300 38 600 36 300
Less Other expenses 25 000 25 600 26 000
Net Profit 12 300 13 000 10 300
The reports show that Sales increased every year: first by $12 000 from 2023 to
2024, then by a further $3 000 in 2025. The trend in Sales is favourable: it is higher
every year. The trend in Inventory loss is also favourable as it decreased every year and
the fact that this has happened despite higher sales is particularly pleasing; perhaps
inventory procedures were more effective.
However, there is an unfavourable upward trend in Cost of Goods Sold and Other
expenses. As a consequence, a $12 000 increase in Sales in 2024 resulted in an increase
in Net Profit of only $700, and Net Profit is actually lower in 2025 despite Sales being
$15 000 higher than it was in 2023.
In order to aid the Understandability of the Accounting information, trends may be
presented as line or bar graphs. This makes them easier to understand for users who
have little or no Accounting knowledge.

Figure 18.1 shows a line graph showing Sales, Gross Profit and Net Profit for 2023
to 2025:
Figure 18.1 Trends: Sales, Gross Profit and Net Profit
Clear View Windows

140000
120000
100000
80000 Sales
Gross Profit
60000
Net Profit
40000
20000
0
2023 2024 2025
The rising trend in Sales is clear, but the increasing gap between Sales and Net Profit
is cause for concern.
In this example, both Sales and Cost of Goods Sold increased, but the fact that
Gross Profit decreased in 2025 indicates that Cost of Goods Sold increased by more.
horizontal analysis We can reach this conclusion intuitively, but preparing a horizontal analysis will show
comparing reports from the numerical proof as it calculates the change in items from one period to the next,
one period to the next, and expressing the change in both dollar and percentage terms so that the relative size of
identifying the increase or
the changes can be assessed.
decrease in specific items in
the report Using the information above for 2023 and 2024, the horizontal analysis of the Income
Statement would appear as shown in Figure 18.2:
Figure 18.2 Horizontal analysis of the Income Statement
Increase/
2023 $ 2024 $ Decrease Difference $ Difference %
Sales 100 000 112 000 Increase 12 000 12.0
Less Cost of Goods Sold 62 000 72 800 Increase 10 800 17.4
Gross Profit 38 000 39 200 Increase 1 200 3.2
Less Inventory loss 700 600 Decrease 100 14.3
Adjusted Gross Profit 37 300 38 600 Increase 1300 3.5
Less Other expenses 25 000 25 600 Increase 600 2.4
Net Profit 12 300 13 000 Increase 700 5.7
The percentage difference is calculated by dividing the difference (in dollar terms) by
the previous year’s figure; for example, Sales: 12 000/100 000 × 100 = 12%.
This horizontal analysis shows that although Sales has increased by 12% in 2024,
Cost of Goods Sold has actually increased by 17.4% (a larger increase), and this has
led to Gross Profit only increasing by 3.2%, and Net Profit by only 5.7%. In this case,
although revenue capacity has improved, expense control has worsened.
Variances
Trends highlight changes from one period to the next, but they don’t allow the owner
to assess whether they have met the firm’s goals for that period. This assessment is
performed using a Variance report, which highlights the difference between actual and
budgeted figures, so that problem areas can be identified and addressed. These reports
are invaluable tools for assessing profitability because they draw attention to areas in which
performance has been below expectation. (See Chapter 17 for a more detailed discussion.)
Benchmarks
In terms of profit and profitability, it is impossible to say whether a result is satisfactory
without reference to a benchmark of some sort: an acceptable standard against which benchmark
the firm’s actual performance can be assessed. There is no set level of profitability that an acceptable standard
is considered to be satisfactory, but a firm may compare its actual profit performance against which the firm’s actual
performance can be assessed
against:
• performance in previous periods
This allows for the preparation of a horizontal analysis and identification of trends.
Using this benchmark enables an assessment of whether profitability has improved
or worsened from one period to the next.
• budgeted performance for the current period
This allows for the preparation of a variance report and enables an assessment of
whether profitability was satisfactory or unsatisfactory in terms of meeting the firm’s
goals/expectations.
• performance of similar firms
This is sometimes expressed as an ‘industry average’. It allows the firm’s performance
to be compared against other firms operating under similar conditions. This is
sometimes known as an ‘inter-firm’ comparison.
Profitability indicators
In addition to the tools outlined above, the owner may ask the accountant to calculate
any number of profitability indicators. (These are sometimes known as ‘profitability profitability indicators
ratios’, even though most are actually presented as percentages.) These indicators measures that express an
express an element of profit in relation to some other aspect of business performance. element of profit in relation to
some other aspect of business
As a result, differences in profitability between years and also between businesses can
performance
be assessed, as the indicator expresses profitability according to a common base.
This course considers the following indicators:
• Return on Owner’s Investment (ROI)
• Return on Assets (ROA)
• Asset Turnover (ATO)
• Net Profit Margin (NPM)
• Gross Profit Margin (GPM).
Some of these indicators have been explored in previous chapters, but this chapter
also considers how they relate to each other.

• trend
• benchmark
• variance
• profitability indicator.
2 Explain how trends can be used to assess profitability.
3 Explain how variances can be used to assess profitability.
4 Describe three benchmarks that can be used to assess profitability.
5 List five indicators that can be used to assess profitability.

18.3 Return on Owner’s Investment (ROI)

Return on Owner’s From an investor’s point of view, the main measure of profitability is Return on
Investment (ROI) Owner’s Investment (ROI), which measures the profit (return) earned per dollar of
a profitability indicator that capital invested by the owner. As a result, it indicates how effectively the business has
indicates how effectively a
used the owner’s funds to earn profit, which is useful in helping the owner to decide
business has used the owner’s
capital to earn profit between alternative investments.
Figure 18.3 shows how Return on Owner’s Investment is calculated:
Figure 18.3 Formula: Return on Owner’s Investment (ROI)
Net Profit
Return on Owner’s Investment (ROI) = × 100
Average Capital
Given the Net Profit figure is earned over a period, but capital is measured at a particular
point in time, Average Capital is used in the calculation of Return on Owner’s Investment
so that any increases or decreases in capital over the year are accounted for.
Figure 18.4 shows how Average Capital is calculated:
Figure 18.4 Formula: Average Capital
Capital at start + Capital at end
Average Capital =
2
Example The following data was provided by two clothing stores:

Carl’s Clothing Anna’s Attire
Net Profit $14 000 $10 000
Capital – 1 July 2024 $72 000 $41 000
Capital – 30 June 2025 $68 000 $39 000
Clearly Carl’s Clothing has earned more profit than Anna’s Attire, but the owner’s
investment is also higher. From an investor’s point of view, which is more profitable?
The Return on Owner’s Investment for each business would be calculated as shown
in Figure 18.5:
Study tip
Figure 18.5 Calculation: Return on Owner’s Investment (ROI)
When entering these Carl’s Clothing Anna’s Attire

figures in your calculator, $14 000 $10 000
ROI = × 100 ROI = × 100
press ‘=’ before dividing, ($72 000 + $68 000) / 2 ($41 000 + $39 000) / 2
or you’ll only divide $14 000 $10 000
= × 100 = × 100
the last figure (not the $70 000 $40 000
total) by 2. = 20% = 25%

The figures show that despite earning less profit, Anna’s Attire is actually more
profitable for its owner; for every dollar she has invested, Anna earns $0.25 profit,
whereas for every dollar he has invested, Carl only earns $0.20 profit. Even though
Carl has earned $4 000 more profit than Anna, he has had to make a substantially larger
investment of his own funds to do so.
Benchmarks
As with most profitability indicators, there is no set level at which Return on Owner’s
Investment would be considered satisfactory, but it could be compared against:
• the Return on Owner’s Investment from previous periods
• the budgeted Return on Owner’s Investment
• the Return on Owner’s Investment of similar businesses/alternative investments.
This last benchmark is particularly important, because Return on Owner’s Investment
assesses profitability from an investor’s point of view. Although we have approached this
course from the perspective that the owner is also the operator, we must not lose sight
of the fact that the owner has invested his or her own money in the business. By doing
so, the owner has given up the opportunity to invest elsewhere, and therefore forgone
the return that might be earned by investing in property, shares, financial products
or other valuables, such as art, wine, antiques or even sporting memorabilia. For this
reason, the Return on Owner’s Investment must be comparable with the interest rate
on a term deposit, the rent earned on property, the dividend earned on shares, or simply
the return earned by similar businesses.
In fact, given the risk the owner takes by investing, and the long hours many owners
work, he or she may require a Return on Owner’s Investment that is higher than these
alternative investments. On the other hand, a small business owner may be willing to
accept a slightly lower return as a trade-off for the satisfaction that comes from running
his or her own business.
Changes in Return on Owner’s Investment

Return on Owner’s Investment can also be used to assess changes in profitability from
one period to the next.
Filmore Doors has provided the following information relating to its trading Example
activities for the year ended 31 December:
2024 2025
Net Profit $6 400 $5 400 Study tip
Average Capital $40 000 $30 000
Return on Owner’s Investment 16% 18%
Profitability indicators
are the function of
In 2025 Net Profit decreased by $1 000 (from $6 400 to $5 400), and yet the Return whatever is in their top
on Owner’s Investment increased from 16% to 18%: how is this possible? The answer line and bottom line; if
the indicator changes,
lies in the fact that the (average) capital decreased, meaning the owner is earning profit
it is because one, or
on a smaller base. This may mean the business is more reliant on debt (or has a higher
both, of these lines has
Debt Ratio; see Section 18.4), and thus the risk to the business is increased, but from
changed.
the point of view of the owner as an investor, it results in improved profitability.


1 State what is measured by Return on Owner’s Investment (ROI).
2 Show the formula to calculate Return on Owner’s Investment.
3 Explain why the formula to calculate Return on Owner’s Investment uses
Average Capital.
4 List three benchmarks that could be used to assess the adequacy of the Return
on Owner’s Investment.
5 Explain the significance of the ‘return on similar investments’ as a benchmark
for assessing the Return on Owner’s Investment.
6 Explain how the Return on Owner’s Investment can increase even though
profit has decreased.
18.4 Debt Ratio

Section 18.3 referred to the fact that the Return on Owner’s Investment can increase
without an increase in profit if the owner’s capital reduces. This point illustrates that
the Return on Owner’s Investment is not just reliant on profit, but also depends on the
financial structure of the business: whether it has relied on owner’s capital to purchase
the assets that earn its profit or has instead relied on borrowed funds.
Thus, an analysis of the Return on Owner’s Investment must also include an analysis
Debt Ratio of the Debt Ratio, which measures the percentage of a firm’s assets that are financed
a stability indicator that by liabilities, and thus indicates the extent to which the business is reliant on liabilities/
measures the percentage of a debt (rather than owner’s capital) to purchase its assets.
firm’s assets that are financed
Figure 18.6 shows how the Debt Ratio is calculated:
by liabilities
Figure 18.6 Formula: Debt Ratio
Total Liabilities
Debt Ratio = × 100
Total Assets
Study tip
A high Debt Ratio means a greater reliance on borrowed funds (liabilities) to
purchase assets and, consequently, a lower reliance on funds contributed by the
The Debt Ratio is
owner. This measure of the firm’s long-term stability can be used to evaluate the level
sometimes referred to as
of risk associated with the business. However, it will have implications for the firm’s
‘gearing’.
profitability, particularly its Return on Owner’s Investment.
Example The following data was provided by two shoe shops:

High Fashions Low Riders
Net Profit $8 000 $8 000
Capital $32 000 $80 000
Total Liabilities $68 000 $20 000
Total Assets $100 000 $100 000

Although both firms have earned the same Net Profit ($8 000), the Return on
Owner’s Investment is higher for High Fashions (24%) than it is for Low Riders (18%).
The reason for this difference is revealed by the Debt Ratio of each business, which is
Figure 18.7 Calculation: Debt Ratio
High Fashions Low Riders

68 000 20 000
Debt Ratio = × 100 Debt Ratio = × 100
100 000 100 000
= 68% = 20%
Although both firms are the same size (with assets of $100 000 under their control),
68% of the assets of High Fashions are funded from liabilities, with the remaining 32%
financed using funds from the owner’s capital. This relatively high Debt Ratio, and
therefore low reliance on capital, explains the higher Return on Owner’s Investment at
24%. It could, however, mean that High Fashions is exposed to a greater risk of financial
collapse (see below).
For Low Riders, only 20% of the assets are funded from liabilities with the majority
(80%) financed by the owner. This low reliance on debt means less risk, but it also
means a higher reliance on owner’s capital, and thus a lower Return on Owner’s
Investment (10%).
Benchmarks
In assessing the Debt Ratio, it should be compared against previous periods, and the
budgeted Debt Ratio, but the comparison against similar firms is particularly useful,
as (by definition) they operate in the same industry, using similar assets and selling
similar products. However, the Debt Ratio cannot be assessed in isolation: it should be
assessed in conjunction with the Return on Owner’s Investment.
Risk and return

A high Debt Ratio means the firm is more heavily reliant on borrowed funds than it
is on the owner’s capital, and this is one way of increasing the Return on Owner’s
Investment without actually increasing profit. With a higher Debt Ratio, the business is
using someone else’s funds to buy the assets to earn profit, but the owner still receives
all that profit.
However, a higher Debt Ratio means there is a higher risk that the business will be
unable to repay its debts and meet the interest payments. Further, interest rate rises
could have a significant impact on profit and cash as the business is carrying so much
debt.
On the other hand, a low Debt Ratio means the firm is not very reliant on borrowed
funds and is therefore at relatively low risk of being unable to repay its debts. However,
it also means that most of the finance used to purchase assets has come from the
funds of the owner, and as the owner has had to contribute more personal funds, a
lower Return on Owner’s Investment will ensue.
The owner must judge carefully so that the Debt Ratio is high enough to maximise
the Return on Owner’s Investment, but not too high that it will create difficulties for the
business in relation to its debt burden.


1 Explain what is measured by the Debt Ratio.
2 Show the formula to calculate the Debt Ratio.
3 Explain the significance of ‘similar firms’ in assessing the Debt Ratio.
4 Explain why a high Debt Ratio might mean a higher risk of financial collapse.
5 Explain why a high Debt Ratio is likely to result in a high Return on Owner’s
Investment.
18.5 Return on Assets (ROA)

Whereas Return on Owner’s Investment assesses profitability from an investor’s point
Return on Assets (ROA) of view, Return on Assets (ROA) assesses profitability from a manager’s point of view.
a profitability indicator that Specifically, it measures Net Profit per dollar of assets controlled by the business. As a
indicates how effectively a result, it indicates how effectively the firm has used its assets to earn profit.
business has used its assets to
Figure 18.8 shows how Return on Assets is calculated:
earn profit
Figure 18.8 Formula: Return on Assets (ROA)
Net Profit
Return on Assets (ROA) = × 100
Average Total Assets
Just as the formula for Return on Owner’s Investment used Average Capital, Return
on Assets uses Average Total Assets. (If total assets has not changed significantly over
the period, or an average cannot be calculated, total assets at the end of the period may
be used.)
Example The following data was provided by two book stores:

Barry’s Books Tina’s Texts
Net Profit $15 000 $18 700
Total Assets – 1 January 2024 $73 000 $105 000
Total Assets – 31 January 2024 $77 000 $115 000
The first point to note from the figures is that Tina’s Texts has earned more profit,
but this may be simply because it has more assets; that is, it is a larger business, and
is therefore capable of generating larger sales and profit. But which is more profitable?
The Return on Assets for each business would be calculated as shown in Figure 18.9:
Figure 18.9 Calculation: Return on Assets (ROA)
Barry’s Books Tina’s Texts

$15 000 $18 700
ROA = × 100 ROA = × 100
($73 000 + $77 000) / 2 ($105 000 + $115 000) / 2
$15 000 $18 700
= × 100 = × 100
$75 000 $110 000
= 20% = 17%

The figures show that it is actually Barry’s Books that is more profitable, as it earns
$0.20 profit from every dollar of assets it controls, whereas Tina’s Texts only earns
$0.17 profit per dollar of assets.
Barry is using his firm’s assets more effectively to earn profit, and this could be for a
number of reasons: perhaps his inventory is in higher demand, or his store is in a better
location, or his expense control is better. As the manager, Tina may wish to adopt some
of Barry’s strategies (if he is willing to tell!).
Benchmarks
The preceding example used the Return on Assets of a similar business as a benchmark,
but it could also be assessed against the Return on Assets from previous periods or
the budgeted Return on Assets.
Return on Owner’s Investment and Return on Assets

Study tip
As many small business owners are both investors and managers, they will need to look
at both the Return on Owner’s Investment and the Return on Assets when assessing
profitability. One thing they will notice is that the Return on Owner’s Investment will The exact size of the gap
always be higher than the Return on Assets. This is because Owner’s equity will always between ROI and ROA
be lower than Total Assets, which in turn is due to its borrowings – its liabilities. Only will depend on the firm’s
in a firm that has no liabilities, which is extremely unlikely, will the Return on Owner’s Debt Ratio.
Investment be the same as the Return on Assets.
Changes in Return on Assets

When assessing changes in the Return on Assets, it is important to keep in mind the
figures that are used in its formula: on the top line, the profit the business has earned,
and on the bottom, the assets it controls. If assets increase, and Net Profit increases by
a smaller proportion, then the Return on Assets will fall, indicating that the assets have
not been used as profitability. On the other hand, if Net Profit increases by more than
assets, the Return on Assets will rise, indicating improved use of assets and improved
profitability.
The Net Profit figure itself is of course reliant on the two basic factors we identified
earlier: earning revenue and controlling expenses. Therefore, assuming assets do not
change, an improvement in the Return on Assets may be the result of an improved
ability to earn revenue or better expense control, or both. A deterioration in the Return
on Assets would, of course, be caused by the opposite. Either way, the Return on
Assets will depend heavily on the firm’s ability to earn revenue and control its expenses,
so this is the next phase in our analysis of profitability.

1 State what is measured by Return on Assets (ROA).
2 Show the formula to calculate Return on Assets.
3 List three benchmarks that could be used to assess the adequacy of the Return
on Assets.
4 Explain why Return on Owner’s Investment will always be higher than Return
on Assets.
5 Identify two factors that could cause an increase in the Return on Assets.

18.6 Earning revenue: Asset Turnover (ATO)

Asset Turnover (ATO) Asset Turnover (ATO) is an efficiency indicator as it indicates how efficiently the firm
an efficiency indicator that has used it assets to generate revenue. However, as earning revenue is one of the keys
indicates how productively a to earning profit, Asset Turnover will have a direct and significant effect on, and thus be
business has used its assets to
an important tool for assessing, profitability.
earn revenue
Figure 18.10 shows how Return on Assets is calculated:
Figure 18.10 Formula: Asset Turnover (ATO)
Net Sales
Asset Turnover (ATO) =
Specifically, this indicator measures the number of times in a period the value of
assets is earned as Sales revenue: the higher the Asset Turnover, the more capable the
firm is of using its assets to earn revenue.
Example Pino’s Plant Nursery has provided the following information relating to its trading
activities for the year ended 30 June:
2024 2025
Sales $100 000 $125 500
Sales returns $4 000 $4 000
Average Total Assets $80 000 $90 000
Average assets increased (by $10 000) in 2025, so an increase in Sales revenue is

expected. However, has the firm used these extra assets more or less productively than
it did in 2024?
The Asset Turnover for each year would be calculated as shown in Figure 18.11:
Figure 18.11 Calculation: Asset Turnover (ATO)
2024 2025
$100 000 – $4 000 $125 500 – $4 000
ATO = ATO =
$80 000 $90 000
$96 000 $121 500
= =
$80 000 $90 000
= 1.2 times = 1.35 times
In 2024, the business earned 1.2 times the value of its assets as revenue, and this
has risen to 1.35 times in 2025. This confirms that Pino’s Plant Nursery has earned more
revenue in 2025 not only because it has more assets, but because it has used those
assets more productively.

Benchmarks
The preceding example compared Asset Turnover against a previous period, but it could
equally be assessed against the budgeted Asset Turnover, or the Asset Turnover of
similar businesses. In cases where an expansion is planned, and average assets are
expected to increase, budgeted Asset Turnover may be the best benchmark to use for
assessment, as it reflects the firm’s goal for increased Sales revenue on a greater asset
base.
Asset Turnover and Return on Assets

The similarity between Asset Turnover and the Return on Assets reflects the fact that
they both assess the firm’s ability to use its assets; the only difference being that
Return on Assets relates to profit, whereas Asset Turnover relates only to revenue.
Theoretically, an increase in Asset Turnover (meaning an increased ability to earn Sales
revenue) should mean an increase in the Return on Assets, and increased Net Profit.
However, this is not always the case.
Let us return to the previous example (Pino’s Plant Nursery) with additional
information provided:
Pino’s Plant Nursery has provided the following information relating to its trading Example
activities for the year ended 30 June:
2024 2025
Sales $100 000 $125 500
Asset Turnover 1.2 times 1.35 times
Return on Assets 15% 14%
As noted previously, the Asset Turnover shows the business is more productive, Study tip
in terms of using its assets to earn revenue, in 2025. However, the figures show that
in spite of this increase in Asset Turnover, profitability (as measured by the Return on
Assets) has actually fallen (by 1 percentage point). When indicators are
The only difference between the Asset Turnover and the Return on Assets is the already expressed as
percentages, the change
difference between Sales revenue and Net Profit, i.e. expenses. Therefore, where the
should be described in
Asset Turnover and the Return on Assets move in different directions, or to differing
terms of percentage
degrees, it indicates a change in expense control. In this example, the Asset Turnover
points.
increased, and the Return on Assets decreased, indicating worse expense control.

1 State what is measured by Asset Turnover (ATO).
2 Show the formula to calculate Asset Turnover.
3 List three benchmarks that could be used to assess the adequacy of a firm’s
Asset Turnover.
4 Explain how the relationship between a firm’s Asset Turnover and its Return
on Assets can be used to assess its expense control.

18.7 Controlling expenses

We noted in Chapter 13 that expenses should not necessarily be looked on as ‘bad’,
because they assist in the earning of revenue. This does not mean that the firm
should be happy to see more and more of its Sales revenue being consumed by
expenses. After all, every dollar that is consumed by expenses means one dollar less
Net Profit. This means the firm’s ability to control its expenses is a key factor in its
ability to earn profit.
expense control Expense control refers to the firm’s ability to manage its expenses so that they
the firm’s ability to manage its either decrease or increase no faster than Sales revenue. This last point may seem a
expenses so that they either little odd: why should the owner settle for anything less than a reduction in expenses?
decrease or, in the case of
Remember that in the pursuit of greater Sales, it is unavoidable that some expenses
variable expenses, increase no
faster than Sales revenue will increase. Expenses such as Cost of Sales and Wages vary directly with the level of
Sales, so it is logical that as Sales volume increases, these expenses will increase too.
Provided they do not increase more than Sales, we can consider this to be evidence of
satisfactory expense control. Should they actually increase by less than Sales, we would
consider this to be evidence of improved expense control.
If expense control improves, then profitability should also improve and there are two
indicators that calculate the percentage of each dollar of Sales that is retained as profit:
• Net Profit Margin (NPM)
• Gross Profit Margin (GPM).
In assessing these indicators, we will use the benchmarks established earlier in this
chapter, namely:
• performance in previous periods
• budgeted performance
• performance of similar firms.

1 Define the term ‘expense control’.
2 State two reasons why the owner of a small business will tolerate increases in
some expenses.
3 State two profitability indicators that assess expense control.

18.8 Net Profit Margin (NPM)

Competition in many markets means that earning revenue is a challenging exercise
for most small businesses. With this in mind, it is vital that once a sale is made, the
business retains as much of that revenue as profit as is possible. The Net Profit Margin
(NPM) measures the percentage of Sales revenue that is retained as Net Profit. Put
another way, it measures how much of each dollar of Sales revenue remains as Net
Profit after expenses are deducted. As a result, it is a good indicator of expense control.
Figure 18.12 shows how the Net Profit Margin is calculated:
Figure 18.12 Formula: Net Profit Margin (NPM)
Net Profit
Net Sales
Due to differences in Sales revenue, comparing Net Profit between businesses and
between periods can be difficult; it is difficult to isolate how much of the difference
is due to expense control, and how much is simply due to different Sales revenue.
Because this indicator expresses Net Profit per dollar of Sales, it can identify changes in
profit independent of changes in Sales revenue.
Misha’s Shoe Barn has provided the following information from its Income Example
Statement for the year ended 30 June:
2024 2025
Sales $73 000 $81 100
Net Profit $14 400 $15 200
As would be expected, higher Sales revenue in 2025 has generated extra profit, but
has it generated enough extra profit? Has expense control changed?
The Net Profit Margin for each year would be calculated as shown in Figure 18.13:
Figure 18.13 Calculation: Net Profit Margin (NPM)

2024 2025
$14 400 $15 200
NPM = × 100 NPM = × 100
$73 000 – $1 000 $81 100 – $1 100
$14 400 $15 200 Study tip
= × 100 = × 100
$72 000 $80 000
= 20% = 19%
Deducting the NPM
from 100 will reveal the
The figures reveal that in 2024, 20c of every dollar of Sales revenue was retained as
percentage of each Sales
Net Profit, but in 2025 this fell to 19c per dollar. Alternatively, 80c was consumed by
dollar that is consumed
expenses in 2024, and this increased to 81c in 2025. This means that expense control
by expenses.
was worse in 2025.

Net Profit Margin, Asset Turnover and Return on Assets

The earlier discussion of Return on Assets highlighted that the ability of a firm to use
its assets to earn profit depends on its ability both to earn revenue and to control its
expenses. We now have an indicator that measures each of these factors:
• Asset Turnover measures the ability of the firm to use its assets to earn revenue.
• Net Profit Margin measures the ability of the firm to control its expenses and retain
Sales revenue as Net Profit.
Thus, Return on Assets depends on both the Asset Turnover and the Net Profit
Margin.
Figure 18.14 shows that this relationship is borne out mathematically too:
Figure 18.14 Return on Assets = Asset Turnover x Net Profit Margin
Return on Assets = Asset Turnover × Net Profit Margin

Net Sales Net Profit
= ×
Average Total Assets Net Sales
Net Profit
=
‘Cancelling down’ proves that the Return on Assets, and therefore profitability,
depends on the ability of the firm to use its assets to earn revenue (as measured by
Asset Turnover) and to control its expenses (as measured by the Net Profit Margin).

1 State what is measured by the Net Profit Margin (NPM).
2 Show the formula to calculate the Net Profit Margin.
3 Explain the relationship between Asset Turnover, Net Profit Margin and Return
on Assets.

18.9 Gross Profit Margin (GPM)

Because the Net Profit Margin uses Net Profit in its calculation, it can be used to assess
overall expense control. If Gross Profit is used instead, we are able to assess expense
control specifically as it relates to inventory and Cost of Goods Sold. Thus, the Gross
Profit Margin (GPM) measures the percentage of Sales revenue that is retained as
Gross Profit.
Figure 18.15 shows how the Gross Profit Margin is calculated:
Figure 18.15 Formula: Gross Profit Margin (GPM)
Gross Profit
Gross Profit Margin (GPM) = × 100
Net Sales
Gross Profit is the difference between Sales revenue and Cost of Goods Sold and is
used to assess the adequacy of the firm’s mark-up: the difference between the selling
price and the cost price of its inventory. Therefore, the Gross Profit Margin can be used
to assess the average mark-up on all goods sold during a particular period.
Misha’s Shoe Barn has provided the following information from its Income Example
Statement for the year ended 30 June: (continued)
2024 2025
Sales $73 000 $81 100
Gross Profit $38 160 $44 800
Net Profit $14 400 $15 200
Net Profit Margin 20% 19%
By calculating the Net Profit Margin, it was established that although Net Profit
increased, this was only due to higher Sales. In fact, the Net Profit Margin fell in 2025,
indicating worse expense control overall. So which expense(s) is (are) the cause?
The Gross Profit Margin for each year would be calculated as shown in Figure 18.16:
Figure 18.16 Calculation: Gross Profit Margin (GPM)
2024 2025
$38 160 $44 800
GPM = × 100 GPM = × 100
$73 000 – $1 000 $81 100 – $1 100
$38 160 $44 800
= × 100 = × 100
$72 000 $80 000
= 53% = 56%
In 2024, 53c of each dollar of Sales was retained as Gross Profit. In 2025, this rose to
56c per dollar, reflecting a higher average mark-up. Put another way, 47c of every Sales
dollar was consumed by Cost of Goods Sold in 2024 ($1 less 47c Cost of Goods Sold =
53c Gross Profit), but this fell to 44c per dollar in 2025. Why? Although Sales revenue
and Gross Profit both increased, Gross Profit increased (proportionally) more, due to a
(proportionally) smaller increase in Cost of Goods Sold.

Given that the Gross Profit Margin increased, poor control of Cost of Goods Sold is
not responsible for the decrease in the Net Profit Margin, so the increase must have
come from Other expenses.
Changes in mark-up
A higher Gross Profit Margin means a higher average mark-up: on average, a bigger gap
between selling and cost prices. This could occur if:
• selling prices increased and cost prices remained constant
• cost prices decreased and selling prices remained constant
• both increased, but selling prices increased by more
• both decreased, but cost prices decreased by more.
Increasing selling prices will increase the average mark-up, but it carries the risk of
lowering demand, and thus reducing the volume of sales. This could mean that while
the Gross Profit Margin increases, Gross Profit (in dollars) may actually decrease. That
is, the business may make more Gross Profit per item but make fewer actual sales. If
the drop in the number of sales outweighs the increase in profit per item, Gross Profit
will actually fall.
Finding a cheaper supplier will avoid this risk, but it carries a risk of its own. If the
quality of the inventory is reduced, this could cause a decrease in sales volume, or an
increase in Sales returns or Inventory losses (through damage). All these factors could
potentially undermine the benefits of a higher average mark-up. This does not mean the
business should not look for a cheaper supplier, but it does mean the business must be
vigilant about the quality of its inventory.
Assuming the business can maintain its sales volume (the number of sales it makes)
and customer satisfaction, a higher mark-up will mean not only a higher Gross Profit
Margin, but also a higher Gross Profit.

1 State what is measured by the Gross Profit Margin (GPM).
2 Show the formula to calculate the Gross Profit Margin.
3 Explain two ways a business could increase its average mark-up.
4 Explain how an increase in mark-up could lead to a decrease in Gross Profit.

18.10 Vertical analysis of the income statement

The Net Profit Margin and Gross Profit Margin divide the appropriate profit figure by
Sales revenue. This allows for an evaluation of expense control by assessing what had
happened to each dollar of Sales revenue. This approach can be applied to every item in
the Income Statement in what is known as a vertical analysis. vertical analysis
The vertical analysis for Misha’s Shoe Barn is shown in Figure 18.17: a report that expresses every
item as a percentage of a
base figure; in this case, Sales
Figure 18.17 Vertical analysis of the Income Statement
revenue
MISHA’S SHOE BARN
Income Statement for the year ended 30 June
2024 2025
$ % $ %
Sales revenue 72 000 100 80 000 100
Gross Profit 38 160 53 44 800 56
Less Inventory loss 720 1 800 1
less Other expenses
Advertising 3 600 5 4 800 6
Rent expense 7 200 10 7 200 9
Wages 12 240 17 16 800 21
Net Profit 14 400 20 15 200 19
By comparing the vertical analysis from one year to the next, we can see changes
not just in expense amounts (as would be shown in a horizontal analysis), but changes
in expenses as a percentage of Sales. That is, it shows what each revenue and expense
would be if Sales had been constant.
This vertical analysis confirms what we identified by calculating the Net Profit Margin
and Gross Profit Margin:
• Sales revenue increased by $8 000, and this led to an increase in Net Profit of $800.
However, the Net Profit Margin decreased from 20% to 19%, indicating a slight
deterioration in expense control.

• The Gross Profit Margin increased from 53% to 56%, indicating a higher average
mark-up.
• Although Inventory loss increased, this was in proportion to the increase in Sales
revenue, so as a percentage of revenue it was constant (at 1%). Expense control
here was satisfactory.
• Higher Sales led to higher wages, but the expense increased proportionately more
than Sales revenue, increasing from 17% to 21% of Sales revenue. The same
applies to advertising, which increased from 5% to 6% of Sales revenue.
• As a fixed expense, Rent expense was constant in dollar terms, but as Sales
revenue increased, it absorbed less of each dollar of Sales, decreasing from 10%
to 9%.
Graphical representations
Given that not all business owners are accountants, presenting a vertical analysis in a
pie chart is one way of ensuring Understandability in the Accounting reports.
Figure 18.18 shows the pie chart representing the vertical analysis of the Income
Statement for 2025:
Figure 18.18 Graphical representation of vertical analysis
Misha's Shoe Barn

Income Statement 2025
Cost of Good Sold

Inventory loss
Advertising
Rent expenses
Wages
Net Profit
This pie chart shows that Cost of Goods Sold is clearly the most significant expense,
consuming almost half of every Sales dollar, so action here may prove very effective in
terms of improving profitability. On the other hand, Inventory loss is relatively small, so
even if inventory management was improved significantly, only a small improvement in
profitability is likely.

1 Explain what is shown in a vertical analysis of the Income Statement.
2 Referring to one Qualitative characteristic, explain one benefit of preparing a
vertical analysis as a pie chart.

18.11 Non-financial information

The assessment of profitability in this chapter has relied primarily on the Income
Statement and profitability indicators, which are themselves derived in large part from
the Income Statement. These are obviously very important in evaluating profitability, but
there are limits on the ability of this information to assist the owner in making financial
decisions. These include the fact that:
• the reports use historical data, so they do not guarantee what will happen in the
future
• many indicators rely on averages, and this may conceal details about individual
items
• firms use different Accounting methods, which can undermine the Comparability of
the reports and profitability indicators
• the reports contain limited information and there may be many items of information
simply not reported in an Income Statement.
As a consequence of these limitations, the owner should not rely on profitability
indicators and the Income Statement alone. In fact, non-financial information – information
that is not expressed in dollars and cents or reliant on dollars and cents for its calculation
and cannot be found in the financial statements – can be just as important in aiding
decision-making.
The types of non-financial information that could be useful to the owner of a small
business are impossible to quantify, but in assessing the firm’s performance the owner
may want information about:
• the firm’s relationship with its customers
Given the inherent difficulties of attracting customers, it is vital that small businesses
retain those customers they already have. It is therefore essential to have feedback
from current customers on their degree of satisfaction (or dissatisfaction) with
current products and services offered by the firm. This could be assessed by:
– customer satisfaction surveys
– the number of repeat sales
– the number of sales returns
– the number of customer complaints
– the number of sales enquiries/catalogue requests
– the degree of brand recognition, based on market research.
• the suitability of inventory
Businesses must assess the suitability of their inventory on a continuous basis to
ensure that they are meeting the demands of consumers. The level of sales reports
how much was sold, but it gives little feedback on whether customers were satisfied
with their purchase. Not every customer can be surveyed, but useful data may be:
– the number of sales returns (especially if the firm keeps detailed records on the
reasons for those returns)
– the number of purchase returns (and the most frequent reasons for the returns)
– the number of customer complaints.
• the firm’s relationship with its employees
Although not reported directly in the Income Statement, the performance of
employees has a direct and significant bearing on whether a profit or loss is
generated. Staff may be responsible for important tasks, such as generating sales or
managing inventory, so appraising their performance and satisfaction is an important
part of assessing the firm’s performance. This could be measured by:
– structured performance appraisals
– the average length of employment (staff turnover)

– the number of employee complaints

– the number of sick days taken.
• the state of the economy
Even the most profitable business will struggle to survive in a difficult economic
environment, so the state of the economy must be factored in to any evaluation of
profitability. Specifically, the owner may wish to consider:
– the consumer confidence index
– the unemployment rate
– the number of competitors in the market.
• other factors
Ethical Businesses do not operate in a vacuum, but in a social, geographical, environmental,
c onsiderations political and ethical climate, and the factors affecting this climate will also affect the
business. As a result, a business may need to consider data like:
– the average age of its customers
– the number / percentage of customers in favour of recyclable packaging or ‘fair
trade’ practices
– the number of days inventory takes to arrive from suppliers
– the distance from the business to the closest train station or bus stop
– the types and toxicity of pollutants generated when the goods are produced
– the law and suggested changes
– the season / time of the year (e.g. summer / winter, Christmas, school holidays)
and even
– the average daily temperature or rainfall (i.e. the weather!).
A successful business owner will therefore operate with one eye on the financial
information generated by the Accounting system, and the other on the non-financial
information it can obtain about the economy and society in which the business operates.
Armed with this information, good decisions are not guaranteed but they are at least
more likely.

1 Explain four limitations of relying solely on the Income Statement and
profitability indicators to evaluate profitability.
2 Define the term ‘non-financial information’.
3 State two measures that could be used to assess:
• the firm’s relationship with its customers
• the suitability of inventory
• the firm’s relationship with its employees
• the state of the economy
• other factors affecting business performance.

18.12 Strategies to improve profitability

The whole point of gathering and recording financial data, reporting financial information,
and analysing and interpreting the financial reports is to enable the accountant to assist
the owner in making decisions. In many cases the accountant will do this by providing
advice: suggesting strategies to improve the firm’s performance.
If profitability is a function of the firm’s ability to earn revenue and control its expenses,
then strategies to improve profitability should concentrate on these two areas.
Earning revenue
To improve its ability to earn revenue, a business might:
Change selling prices • Decrease selling prices to generate a higher volume of sales
• Increase selling prices to generate greater revenue per sale
Market more strategically • Increase advertising
and effectively • Targeted marketing more accurately
• Refocus advertising
Implement strategies to • Maintain an appropriate inventory mix
manage inventory • Promote the sale of complementary goods
Move to a better location • Closer to customers, potential and existing
Improve customer service • Staff training – service and/or product knowledge and skills
• Extra services (such as deliveries, wrapping, internet/phone
access and product advice)
• More customer friendly internal procedures (such as
ordering)
Controlling expenses
To improve its ability to control expenses, a business might: Study tip
Change inventory management • Find an alternative supplier who can provide cheaper
practices and/or better quality inventory See Section 10.5 for
• Change ordering and handling procedures a detailed discussion
Change staff management • Different rostering systems, matching the number of of strategies to earn
practices staff to the level of sales revenue and control
• Incentives expenses, and Section
• Extra training
9.8 regarding the
Change non-current asset • Adopt energy saving practices and devices management of
management practices • Change utility suppliers for cheaper prices
inventory.
• Replace inefficient non-current assets
The specific nature of the advice given to the owner will depend in large part on the
circumstances of the individual business in question: what is right for one may not be
appropriate for another. The accountant’s role is to provide guidance and assistance so
that decisions are made in an informed manner, but ultimately it is up to the owner to
decide what course of action to take.

1 State three strategies that could be used to improve a firm’s ability to earn
revenue.
2 State three strategies that could be used to improve a firm’s ability to control
its expenses.

Where have we been?

• Analysing involves examining the reports in detail to identify changes or differences in performance
whereas interpreting involves examining the relationships between items in the reports in order to
explain the cause and effect of those changes or differences.
• Profitability is about assessing the firm’s capacity or ability to earn profit, assuming all other factors were
equal.
• There are various tools available to assess profitability, including trends, variances, benchmarks and
profitability indicators.
• Benchmarks for assessing profitability include performance in previous periods, budgeted performance
and the performance of other similar firms.
• Profitability indicators express an element of profit in relation to some other aspect of business
performance.
• Return on Owner’s Investment assesses profitability from an investor’s point of view.
• The Debt Ratio has implications for both the risk (long-term stability) and return (Return on Owner’s
Investment).
• Return on Assets assesses profitability from a manager’s point of view.
• The Net Profit Margin and Gross Profit Margin assess expense control.
• The Return on Assets depends on the Asset Turnover and the Net Profit Margin.
• Evaluating profitability is limited by the use of historical data, the use of averages, different Accounting
methods and limited information.
• A business may require non-financial information about its relationship with its customers, its inventory,
its relationship with its employees, the state of the economy and other factors.
Exercises

Profitability
Vince Iaconis is the owner of Cheltenham HiFi, which last year earned $25 000 profit. His friend Marinda
Rendle is the owner of Mentone Stereo Store, which earned $16 000 profit for the same period. Vince has
stated that because his firm’s profit is higher, his firm must be more profitable.
Required
a Explain why Vince’s statement is incorrect.
b State two bases that profit could be compared against in an assessment of profitability.

Return on Owner’s Investment
Karl’s Kites is a kite shop owned and run by Karl Largerflag. Karl has provided the following information relating
to its performance over the last two years:
2024 2025
Net Profit $15 000 $14 400
Average Capital $150 000 $120 000

Karl is considering whether to continue as the owner or sell the business and invest in a property trust that
is currently earning 8% per year.
Required
a Calculate the Return on Owner’s Investment for Karl’s Kites for 2024 and 2025.
b Explain the cause(s) of the change in the Return on Owner’s Investment from 2024 to 2025.
c State two reasons why Karl should be happy with the firm’s profitability in 2025.
d State one reason why Karl should be concerned about the firm’s profitability in 2025.

Return on Owner’s Investment and Debt Ratio
Babbling Brooke sells ponds and other garden ornaments, and has provided the following information relating
to its performance over the last two years:
2024 2025
Net Profit $22 000 $10 000
Return on Owner’s Investment 10% 12.5%
Total Liabilities $180 000 $320 000
Total Assets $400 000 $400 000
Required
a State whether profitability improved or worsened in 2025. Justify your answer.
b Calculate the Debt Ratio for Babbling Brooke for 2024 and 2025.
c Explain the effect of the change in the Debt Ratio on the long-term stability of Babbling Brooke.
d Explain the effect of the change in the Debt Ratio on the profitability of Babbling Brooke.
e Discuss whether the owner should be pleased about the change in the firm’s performance in 2025.

Return on Owner’s Investment and Return on Assets
Legend Guitars and Axeman’s Heaven are competitors in selling musical instruments. The following information
relates to their trading performance for 2025:
Legend Guitars Axeman’s Heaven

Net Profit $12 000 $12 000
Average Owner’s equity $80 000 $40 000
Debt Ratio 33% 73%
Required
a State what is measured by Return on Assets.
b Calculate the Return on Assets for each firm for 2025.
c Explain why the Return on Owner’s Investment is higher for Axeman’s Heaven than Legend Guitars.
d From a manager’s point of view, state which firm is more profitable. Justify your answer.
e Explain why a firm’s Return on Owner’s Investment will always be greater than its Return on Assets.
f State one other indicator the accountant would need to consider before giving advice to improve
profitability. Explain the role of this indicator.


Return on Assets and Asset Turnover
Only Bikes has presented the following information relating to its performance for 2024 and 2025:
2024 2025
Sales revenue $300 000 $448 000
Net Profit $15 000 $16 800
Return on Assets 7.5% 6%
The owner of Only Bikes argues that expense control must have improved in 2025 because Net Profit
increased.
Required
a State what is measured by Asset Turnover.
b Calculate Asset Turnover for Only Bikes for 2024 and 2025.
c Explain why Asset Turnover has changed from 2024 and 2025.
d Referring to Asset Turnover and Return on Assets, explain why the owner’s assertion is incorrect.
e Suggest two strategies the owner could adopt to improve Net Profit in 2026 without changing Asset
Turnover.

Asset Turnover and Net Profit Margin
Filmore Fittings sells hardware and homewares, and has provided the following information relating to is
performance for 2025:
Filmore Fittings Industry average

Return on Owner’s Investment 20% 12.5%
Net Profit Margin 10% 12.5%
Required
a State two reasons why the Return on Assets of Filmore Fittings is lower than the industry average.
b State two benchmarks other than the industry average that could be used to assess the Return on
Assets of Filmore Fittings.
c Suggest two strategies Filmore Fittings could adopt to improve its Asset Turnover in 2026.
d Explain why an improvement in expense control could still see total expenses increase in 2026.
e Assuming it had the same total assets as the industry average ($500 000), state whether the Debt Ratio
of Filmore Fittings for 2025 would be:
• higher than the industry average
• lower than the industry average
• the same as the industry average
• unable to be determined.


Net Profit Margin
All the Weights sells gym equipment, and has provided the following information about its profit performance
for 2024 and 2025:
2024 2025
Sales $153 000 $175 000
Net Profit $8 500 $11 000
Required
a Referring to the information above, identify one indicator that supports the claim that the firm’s ability to
earn revenue has worsened.
b State the reason for the decrease in the firm’s Asset Turnover.
c State what is measured by the Net Profit Margin.
d Calculate the Net Profit Margin for 2024 and 2025.
e Explain why the firm’s Return on Assets has increased in 2025.

Gross Profit Margin
Holly’s Golf Gear has provided the following information:
2025
Sales revenue $122 300
Sales returns $2 300
Gross Profit $75 000
Adjusted Gross Profit $72 000
Net Profit $45 000
Gross Profit Margin – 2023 60%
Required
a Explain what is measured by the Gross Profit Margin.
b Calculate Gross Profit Margin for 2025.
c State two strategies the owner could adopt to improve the Gross Profit Margin in 2026.
d Explain how increasing selling prices in 2026 could lead to an increase in the Gross Profit Margin but a
decrease in Gross Profit.
e Suggest two strategies that the owner could adopt in 2026 to improve the adjusted Gross Profit without
changing the Gross Profit Margin.


Gross Profit Margin
The Gross Profit Margin of Campbell Paints fell from 55% in 2024 to 52% in 2025. In response, the owner has
decided to increase spending on advertising.
Required
a Suggest two possible reasons for the change in the Gross Profit Margin from 2024 to 2025.
b Explain why the owner’s plan of action will not lead to an improvement in the Gross Profit Margin.
c State one way of improving the Gross Profit Margin without affecting Asset Turnover.
d Explain how the owner’s plan of action could lead to:
• an improvement in the Net Profit Margin
• a worsening in the Net Profit Margin.
e State two pieces of non-financial information the owner may want to see to assess the quality of his
inventory.
f State one limitation of relying on the Gross Profit Margin to assess the firm’s profitability.

Vertical analysis of the Income Statement
Woolly Good is a clothing shop, and it has provided a vertical analysis of its Income Statements for the year
ending 31 December 2024 and 2025:
WOOLLY GOOD
Income Statement for the year ended 31 December:
2024 2025
$ % $ %
Sales revenue 90 000 100 120 000 100
Gross Profit 52 200 58 66 000 55
Less Inventory loss 1 800 3 2 400 2
Less Other expenses
Advertising 11 700 13 13 200 11
Rent expense 9 000 10 12 000 10
Wages 15 300 17 21 600 18
Net Profit 13 500 15 16 800 14
Required
a List three possible reasons for the increase in Sales revenue.
b State whether overall expense control has improved or worsened in 2025. Justify your answer.
c Explain how a reduction in the Gross Profit Margin has been beneficial for the firm in 2025.
d State two reasons why the owner should not be concerned about the decrease in the Adjusted Gross
Profit Margin.
e Suggest two strategies the firm could adopt in 2026 to improve its control of wages.
f Suggest one possible reason to explain why Rent expense increased.
g Discuss whether the change in advertising has been beneficial to the firm’s overall profitability in 2025.
h State two pieces of non-financial information the owner could use to assess the firm’s relationship with
its staff.


Analysing profitability
Clarke Doors is owned by Bryan Clarke and has provided the following information relating to its performance
in 2024 and 2025:
Clarke Doors
160000
140000
120000
100000
80000 Sales
Gross Profit
60000
40000
20000
0
2024 2025
• Total Assets was $350 000 in both 2024 and 2025.
• Return on Owner’s Investment and Net Profit Margin did not change from 2024 to 2025.
• When Bryan started the business in 1990 he employed John Willesee as the bookkeeper. Bryan recently
received an approach from a bookkeeping company called Quick-a-Count which promised it could provide
the same service for 15% less than Bryan pays John, but Bryan has heard that it also owns labour hire
companies overseas who regularly exploit their employees.
Required
a Based on the information provided, explain whether the following indicators would have improved or
worsened in 2025:
• Asset Turnover
• Gross Profit Margin.
b Explain one possible cause of the change in the Asset Turnover of Clarke Doors in 2025.
c Explain one possible cause of the change in the Gross Profit Margin of Clarke Doors in 2025.
d Referring to Sales revenue, Gross Profit and Net Profit Margin, discuss the expense control of Clarke
Doors in 2025.
e Suggest one possible action Bryan could take to improve the Gross Profit Margin in
2026. Ethical
f Referring to financial and ethical considerations, discuss whether using Quick-a- considerations
Count would be good for the short and long-term profitability of Clarke Doors.


Analysing profitability
Peter Cole Enterprises has presented the following graphs relating to its profitability for 2024 and 2025:
Peter Cole Enterprises

Cost of Goods Sold

Inventory loss
Advertising
Rent expenses
Wages
Net Profit
Peter Cole Enterprises

Cost of Goods Sold

Inventory loss
Advertising
Rent expenses
Wages
Net Profit
• Sales revenue was $100 000 in 2024 and $120 000 in 2025.
• Rent expense was $18 000 in each year.
• Total Assets remained the same, but the Debt Ratio decreased in 2025.
Required
a Referring to information provided, identify one reason for the increase in Sales revenue in 2025.
b Referring to the graphs, explain why the Rent expense segment (the light blue segment) is smaller in
2025.
c Suggest two strategies Peter may have used to cause the change in Inventory loss in 2025.
d State whether Wages expense (in dollar terms) would be higher, lower or the same in 2025. Justify
your answer.
e Explain why the Gross Profit Margin would be lower in 2025.
f Discuss whether profitability improved, worsened or remained the same in 2025.

Chapter 19
Evaluating liquidity

After completing this chapter, you should be able to: • analyse and evaluate liquidity and efficiency using
• define ‘liquidity’ financial and non-financial information
• analyse liquidity and efficiency using trends, • suggest strategies to improve liquidity and manage
variances, benchmarks and liquidity indicators inventory, Accounts Receivable and Accounts
• calculate and explain various liquidity and efficiency Payable.
indicators • discuss ethical considerations in business decision-
• explain the relationship between liquidity and making.
efficiency indicators
Key terms
After completing this chapter, you should be familiar Course advice:
with the following terms: In VCE Accounting students will not be required to
• Working Capital Ratio (WCR) calculate financial indicators in the examination.
• Quick Asset Ratio (QAR). However, calculations are included in this text as
an essential mechanism for understanding the
information these indicators present.

19.1 Assessing liquidity
Source
documents
Chapter 18 discussed the tools and techniques that can be employed to evaluate
profitability, with the aim of providing business owners with advice to aid their decision-
making. This chapter takes a similar approach but concentrates instead on an assessment
of liquidity.
Liquidity refers to the ability of a business to meet its short-term debts as they fall
due. Any assessment of liquidity should begin by analysing the level of liquid funds
that is available to meet short-term obligations. This will obviously include cash that is
already on hand, but it will also include cash that can be generated from inventory and
Accounts Receivable. However, it should also analyse the speed at which those liquid
resources become available, so that we can assess whether the cash will be available
in time to meet the firm’s short-term obligations.
Tools for assessing liquidity

The same types of tools that were used to assess profitability can be applied to an
assessment of liquidity:
• trends
• benchmarks
• variances
• liquidity indicators.

C hapter 19 E valuating liquidity 511
In terms of identifying trends and variances, the primary sources of information

will be the Cash Flow Statement and Budgeted Cash Flow Statement, which detail
the actual and expected inflows and outflows of cash. (This was covered in detail in
Chapter 17.) In fact, the Budgeted Cash Flow Statement is essential to an analysis
of liquidity, as it details all expected cash inflows and cash outflows, and states
categorically whether the business will be able to meet its cash obligations for the
coming year.
In Chapter 18, we assessed profitability against three key benchmarks, and these
can be applied to assess liquidity:
• liquidity in previous periods
• budgeted liquidity
• liquidity of similar businesses.
In addition, some of the liquidity indicators have their own specific benchmark against
which liquidity can be measured.
Indicators for assessing liquidity

Further, the following indicators to assess the level of liquidity:
• Working Capital Ratio (WCR)
• Quick Asset Ratio (QAR)
• Cash Flow Cover (CFC), covered in Chapter 11.
and the following efficiency indicators can be used to assess the speed of liquidity:
• Inventory Turnover (ITO), covered in Chapter 9
• Accounts Receivable Turnover (ARTO), covered in Chapter 6
• Accounts Payable Turnover (APTO), covered in Chapter 5.

1 Define the term ‘liquidity’.
2 Explain the role of the Budgeted Cash Flow Statement in evaluating liquidity.
3 State three indicators that are used to assess the level of liquidity.
4 State three indicators that are used to assess the speed of liquidity.

19.2 Working Capital Ratio (WCR)

Working Capital Ratio The Working Capital Ratio (WCR) assesses liquidity by comparing current assets and
(WCR) current liabilities. Specifically, the Working Capital Ratio measures how many dollars of
a liquidity indicator that current assets are available to meet each dollar of current liabilities. As a result, the ratio
measures the ratio of current
indicates whether the business will be able to meet its short-term debts (its current
assets to current liabilities, to
assess the firm’s ability to meet liabilities) using cash generated from its current assets.
its short-term debts Figure 19.1 shows how the Working Capital Ratio is calculated:
Figure 19.1 Formula: Working Capital Ratio (WCR)
Current assets
Working Capital Ratio (WCR) =
Current liabilites
= Number of times : 1
Example Grant’s Glasses has presented the following extract from its Balance Sheet:
GRANT’S GLASSES
$ $
Accounts Receivable 12 500 Loan – GV Bank 12 000
Inventory 34 000 Accrued wages 500
Prepaid rent expense 1 000 GST Clearing 1 500
Total Current Assets 51 000 Total Current Liabilities 34 000
The Working Capital Ratio would be calculated as shown in Figure 19.2:
Figure 19.2 Calculation: Working Capital Ratio (WCR)
$51 000
Working Capital Ratio (WCR) =
$34 000
= 1.5 : 1
The Working Capital Ratio shows that Grant’s Glasses has $1.50 of current assets
for every $1 of current liabilities.
Assessing the Working Capital Ratio

As was stated earlier, the Working Capital Ratio for the current period can be compared
against previous periods or the budgeted figure to assess whether it has increased
or decreased, but this will not allow us to determine whether it is satisfactory or
unsatisfactory.
The Working Capital Ratio is based on the idea that the cash that can be generated
from current assets (in the next 12 months) should be enough to meet the short-term
debts that fall due in that time. As a result, satisfactory liquidity should exist if the
Working Capital Ratio is at least 1:1, as this would indicate that there is at least $1 of
current assets available to meet every $1 of current liabilities, and the firm would be
able to meet all its short-term debts as they fall due. Grant’s Glasses actually has $1.50

worth of current assets for every dollar of current liabilities, so its level of liquidity is
satisfactory.
A Working Capital Ratio of less than 1:1 means liquidity may be unsatisfactory and the
business may not be able to meet its debts as they fall due, as it has insufficient current
assets to meet its current liabilities. If the situation is not addressed, and Accounts
Payable and others are unable to be paid, the business may be forced into liquidation,
with its assets sold to raise funds to pay its debt.
Working Capital Ratio less than 1:1

If the Working Capital Ratio is less than 1:1, the owner may be required to:
• make a (cash) capital contribution
• seek additional finance by entering into, or extending, an overdraft facility
• take out a loan to purchase non-current assets.
In the long term, borrowing may worsen the cash situation, as the servicing of the
debt would require cash to repay both the principal and interest. However, in the short
term, the survival of the business may depend on the extra finance provided by a loan.
Working Capital Ratio greater than 1:1

Although it is beneficial for the Working Capital Ratio to be above 1:1, a business
owner should also be wary of having a Working Capital Ratio that is too high, as this
may indicate that the business has excess current assets that are idle, and not being
employed effectively.
This can be apparent in a number of different current assets:
• Bank
Business bank accounts pay very small amounts of interest, thus there is little to gain
from keeping more cash in the bank than is necessary to meet obligations (expected
and unexpected). A business would be better off using excess cash to retire debt,
expand operations, or even to make other investments (e.g. a term deposit) where it
will be able to earn a greater return on its funds.
• Inventory
A large amount of inventory could incur additional storage costs, and increase the
possibility of inventory loss, damage and technical obsolescence, which could require
an Inventory write-down.
A large Accounts Receivable figure might indicate an increasing group of ‘ageing’
Accounts Receivable. The older a debt becomes the less likely it is to be received and
the greater the probability that the debt will go ‘bad’; that is, become uncollectible.
Where the Working Capital Ratio is too high the owner may:
• use excess cash by:
– repaying debts
– purchasing non-current assets
– taking extra drawings
• allow inventory levels to run down before reordering
• implement strategies to collect amounts outstanding from Accounts Receivable.
Bank overdraft
Although a bank overdraft is a current liability and must be included as such in the
calculation of the Working Capital Ratio, it is unlikely that an overdraft will be called in
(for repayment) as long as it remains under the limit. Indeed, the extra amount available
under a bank overdraft may represent a source of additional funds and this must be
considered when analysing what the Working Capital Ratio reveals about liquidity.


1 State what is measured by the Working Capital Ratio (WCR).
2 Show the formula to calculate the Working Capital Ratio.
3 Explain why the Working Capital Ratio should be at least 1:1.
4 Explain the dangers of having a Working Capital Ratio that is too high.
5 State two actions the owner may be required to take if Working Capital
Ratio is:
• too low
• too high.
6 Explain how the availability of a bank overdraft might affect an analysis of the
Working Capital Ratio.
19.3 Quick Asset Ratio (QAR)

Underlying the use of the Working Capital Ratio to assess the level of liquidity is the
assumption that all current assets can be liquidated immediately if cash is needed
to meet short-term debts. However, there are some practical difficulties with this
assumption in relation to:
• Inventory
Most trading businesses would already be trying to sell their inventory as fast as
they can, so there is no guarantee that all their inventory will suddenly be sold, just
because the firm is facing liquidity problems. And there is virtually no chance of this
happening immediately. As a result, it is questionable whether these assets can be
relied on as sources of liquid funds.
• Prepaid expenses
Prepaid expenses cannot normally be ‘liquidated’ or converted back into cash. If the
business has entered into a contract and paid for a 12-month lease, it is not likely to
be able to ask for a refund, even if it faces liquidity difficulties.
Quick Asset Ratio (QAR) In order to overcome these deficiencies, the Quick Asset Ratio (QAR) can be used
a liquidity indicator that as an alternative indicator of the level of liquidity. It assesses the firm’s ability to meet
measures the ratio of quick its immediate debts using its immediate assets.
assets to quick liabilities, to
Figure 19.3 shows how the Quick Asset Ratio is calculated:
assess the firm’s ability to meet
its immediate debts
Figure 19.3 Formula: Quick Asset Ratio (QAR)
Current assets less Inventory and Prepaid expenses
Quick Asset Ratio (QAR) =
Current liabilities
= Number of times : 1
The Quick Asset Ratio is a modification of the Working Capital Ratio as it excludes
inventory and prepaid expenses from current assets as they may not be easily converted
to cash in a time of crisis.

Wilson’s White Goods has presented the following extract from its Balance Sheet: Example
WILSON’S WHITE GOODS
$ $
Accounts Receivable 15 000 Bank 5 000
Prepaid Rent expense 9 000 Accrued electricity 1 000
GST Clearing 2 000
A comparison of the Working Capital Ratio and Quick Asset Ratio is shown in Study tip
Figure 19.4:
Figure 19.4 Comparison: Working Capital Ratio and Quick Asset Ratio Although prepaid
expenses are excluded
Working Capital Ratio Quick Asset Ratio
from quick assets,
$75 000 $15 000
WCR = QAR = accrued expenses
$25 000 $25 000 are included as quick
= 3:1 = 0.6 : 1 liabilities as they will still
have to be repaid.
This data indicates that although the business has $3 of current asset for each $1 of
current liabilities, it only has 60c of quick assets for every $1 of quick liabilities.
Assessing the Quick Asset Ratio

Although the Quick Asset Ratio is a slightly different measure of liquidity, the benchmarks
for assessing its adequacy remain the same as those used to assess the Working Capital
Ratio. That is, the Quick Asset Ratio should be at least 1:1 but can also be compared to the
Quick Asset Ratio from previous periods or the budget to identify increases or decreases.
In this case, the Working Capital Ratio indicates that the business has $3 of current
assets for every $1 of current liabilities and, as a result, its liquidity is satisfactory; there
should be sufficient current assets to meet its current liabilities as they fall due.
However, the Quick Asset Ratio suggests that liquidity is unsatisfactory because the
firm will have only 60c of quick assets to pay quick liabilities. What does this mean for
liquidity? Will the business be able to meet its short-term debts or not?
The fact that the Working Capital Ratio is satisfactory, but the Quick Asset Ratio is
unsatisfactory is a direct result of the fact that the business has a large investment in its
inventory and prepaid expenses. Given the difficulties in liquidating prepaid expenses,
the firm’s ability to meet its debts will depend heavily on its ability to sell its inventory
on time: if the inventory can be sold, the firm should be able to meet its debts as they
fall due; if not, liquidity problems may result.

1 State what is measured by the Quick Asset Ratio (QAR).
2 Show the formula to calculate the Quick Asset Ratio.
3 Explain why the following items are excluded from the calculation of the Quick
Asset Ratio:
• inventory
• prepaid expenses.
4 Explain what is indicated if the Working Capital Ratio is satisfactory, but the
Quick Asset Ratio is unsatisfactory.

19.4 Cash Flow Cover (CFC)

One of the key problems with using both the Working Capital Ratio and the Quick
Asset Ratio is that they rely on static items to measure future cash flows. That is, the
information used in both ratios comes from the Balance Sheet, so it provides no real
indication of the cash flows of the business.
In contrast, the Cash Flow Cover (CFC) assesses liquidity using the actual cash that
the business generates from its Operating activities to meet its financial obligations.
Specifically, it measures the number of times average current liabilities can be met
using the Net Cash Flows from Operations.
Figure 19.5 shows how the Cash Flow Cover is calculated:
Figure 19.5 Formula: Cash Flow Cover (CFC)
If a business cannot generate sufficient cash from its day-to-day Operating activities,
it will require regular contributions from the owner or external financiers in order to
meet its loan repayments and provide cash for the owner’s drawings.
Example Jenny’s Jumpers has provided the following information as at 30 June:
2024 2025
Net Cash Flows from Operations $40 000 $36 000
Current liabilities at start $18 000 $14 000
Current liabilities at end $14 000 $10 000
Clearly, there is less cash available from Operations in 2025, but has liquidity
improved or worsened as a result?
The Cash Flow Cover for each year would be calculated as shown in Figure 19.6:
Figure 19.6 Calculation: Cash Flow Cover (CFC)

2024 2025
$40 000 $36 000
CFC = CFC =
($18 000 + $14 000) / 2 ($14 000 + $10 000) / 2
$40 000 $36 000
= =
$16 000 $12 000
= 2.5 times per year = 3 times per year
In 2024, Net Cash Flows from Operations was able to pay average current liabilities
2.5 times. This has increased to 3 times in 2025, indicating improved liquidity. Why did
this happen? Even though Net Cash Flows from Operations decreased (from $40 000 to
$36 000) in 2026, average current liabilities decreased by proportionately more, leading
to an improvement in the ability of the firm to pay its short-term debts using its operating
cash flows.

Assessing the Cash Flow Cover

Unlike the Working Capital Ratio and Quick Asset Ratio, there is no set benchmark
at which the Cash Flow Cover would be considered satisfactory. However, it can be
compared against the Cash Flow Cover from previous periods, or the budgeted Cash
Flow Cover to assess whether it has improved or worsened, or against the Cash Flow
Cover of similar businesses. In general, the longer the period being examined in the
ratio the more times the business would expect the average current liabilities to be
covered.

1 State what is measured by the Cash Flow Cover (CFC).
2 Show the formula to calculate the Cash Flow Cover.
3 State three benchmarks that could be used to assess the adequacy of the
Cash Flow Cover.
19.5 The speed of liquidity

Our analysis of liquidity so far has been predicated on the notion that a business will
struggle to meet its debts as they fall due if its current/quick assets are less than its
current/quick liabilities. This assessment of the level of liquidity used the Working Capital
Ratio and the Quick Asset Ratio to assess how much cash the business could generate
to meet its short-term obligations.
However, businesses are not static entities; they are constantly generating sales,
which will then turn into cash, which will then be used to purchase more inventory,
to generate more sales, etc. Thus, the level of liquidity is, on its own, an inadequate
measure of a firm’s ability to meet its debts.
In fact, a business can survive in spite of an unsatisfactory level of liquidity, if the
speed of its trading cycle is fast enough. That is, if a business can sell its inventory (and
collect the cash from its customers) before that cash is needed, it will be able to survive
even with a very low Working Capital Ratio. Businesses such as this may never have a
high level of cash on hand but can survive because their turnover is so fast.
Therefore, an assessment of liquidity must also consider the speed of the firm’s:
• Inventory Turnover (ITO)
• Accounts Receivable Turnover (ARTO)
• Accounts Payable Turnover (APTO).
In common with Asset Turnover (from Chapter 18), these indicators actually assess
efficiency: the ability of the firm to manage assets like its inventory, Accounts Receivable
and Accounts Payable. However, because they have a direct and significant effect on
cash flows (namely, Cash sales, Receipts from Accounts Receivable and Payments to
Accounts Payable), they also have a significant effect on liquidity.

1 Explain how a firm with a high turnover can remain solvent despite an
unsatisfactory level of liquidity.
2 Define the term ‘efficiency’ as it relates to the assessment of business
performance.

19.6 Inventory Turnover (ITO)

As the main source of revenue, inventory is also the main source of cash inflows. But
before cash can be collected from cash sales or Accounts Receivable, the inventory
must first be sold. Inventory Turnover (ITO) assesses how effectively the firm has
managed its inventory holdings, by calculating the average number of days taken to sell
inventory.
Inventory Turnover is calculated as shown in Figure 19.7:
Figure 19.7 Formula: Inventory Turnover (ITO)
Average Inventory
Inventory Turnover (ITO) = × 365
Cost of Goods Sold
Average Accounts Receivable is used in an attempt to reflect the amount owed to a

business throughout the period, while multiplying by 365 converts the turnover into days.
Fast Inventory Turnover, as measured by low days, means that, on average, inventory
is sold quickly. This will enhance the firm’s ability to generate cash from the sale of
inventory and assist its liquidity.
Example Markwell Mirrors has provided the following information for the year ended 30 June:
2024 2025
Average Inventory $25 000 $20 000
Cost of Goods Sold $90 000 $100 000
The Inventory Turnover would be calculated as shown in Figure 19.8:
Figure 19.8 Calculation: Inventory Turnover (ITO)

2024 2025
$25 000 $20 000
ITO = × 365 ITO = × 365
$90 000 $100 000
= 101* days = 73 days
* Rounded to nearest day
The figures indicate that in 2024, it took an average of 101 days to sell inventory. The
following year, Inventory Turnover decreased favourably by 28 days; it only took 73 days
(on average) to turn inventory into sales in 2025.
In 2025, Markwell Mirrors not only sold more inventory (as is shown by the increase
in Cost of Goods Sold), but it held less inventory on hand ($25 000 in 2024, down to
$20 000 in 2025). Both factors are responsible for the improvement in Inventory Turnover.
Assessing Inventory Turnover

In the preceding example, the benchmark for assessing Inventory Turnover was the
previous period, to identify an improvement. In terms of assessing whether Inventory
Turnover is satisfactory, it can be compared against the budgeted figure, or the
Inventory Turnover of similar firms.

However, an assessment of Inventory Turnover must also consider the nature

of the goods sold. Goods that are perishable, such as fresh produce, or susceptible
to technological obsolescence should have a fast Inventory Turnover so they are not
subject to inventory loss or Inventory write-down issues. Relatively cheap items should
also be sold much faster than more expensive items, such as luxury cars.
Inventory Turnover: too slow

If Inventory Turnover is too slow (that is, a high number of days), the firm will be less
able to generate sales and, therefore, less able to generate cash inflows (from Cash
sales and Receipts from Accounts Receivable) in time to meet debts as they fall due.
In this case, the business may need to employ strategies to:
• increase sales, such as advertising, changing selling prices or changing the
inventory mix (see Section 10.5 for a detailed discussion) and/or
• decrease the level of Inventory on hand by ordering less, ordering smaller amounts
more frequently (just-in-time ordering) or replacing slow-moving inventory lines.
Inventory Turnover: too fast?

It is also possible that Inventory Turnover could be too fast. Although the business
would be generating high sales volume, it may be because the selling price is too low,
and this would be a loss of potential revenue and profit. Alternatively, it may be because
the firm is holding too little inventory. If this is the case, costs such as delivery may be
higher (because deliveries are more frequent) and the business could lose the possibility
of earning discounts for buying in bulk.
Because it only measures the average time taken to sell inventory, decisions
such as these should not be made on an assessment of Inventory Turnover alone. It
is important that the owner also analyses the inventory cards, so that he or she has
detailed information about the speed at which specific lines of inventory are selling, so
that appropriate decisions can be made.
Study tip
Inventory management
There are certain strategies a business owner can employ to ensure that inventory is See Section 9.8 for a
managed wisely to ensure an appropriate Inventory Turnover: detailed discussion
• Maintain an appropriate inventory mix of these strategies to
• Promote the sale of complementary goods manage Inventory.
• Determine an appropriate level of inventory on hand
Ethical
• Market strategically and effectively (and ethically)
considerations
• Appoint an Inventory Manager.

1 State what is measured by Inventory Turnover (ITO).
2 Show the formula to calculate Inventory Turnover.
3 Explain why fast Inventory Turnover is beneficial for liquidity.
4 State two actions that an owner could take to improve Inventory Turnover.
5 Explain one advantage and one disadvantage of fast Inventory Turnover.
6 Explain the role of inventory cards in an analysis of Inventory Turnover.
7 List four strategies that businesses should use to manage their inventory.

19.7 Accounts Receivable Turnover (ARTO)

In businesses that sell predominantly on a cash basis, the time taken to turn inventory
into sales (Inventory Turnover) also measures the time taken to generate cash; as soon
as the inventory is sold, the cash is collected. Businesses that make credit sales must
wait a little longer: first until the inventory is sold, then again until the cash is received
Thus, how quickly cash is collected from Accounts Receivable is an important factor
influencing liquidity. Accounts Receivable Turnover (ARTO) does provides this information,
assessing how effectively the firm has managed its Accounts Receivable by calculating the
average number of days it takes a firm to collect cash from its Accounts Receivable.
Accounts Receivable Turnover is calculated as shown in Figure 19.9:
Figure 19.9 Formula: Accounts Receivable Turnover (ARTO)
Average Accounts Receivable
Net credit sales (plus GST)
Average Accounts Receivable is used in an attempt to reflect the amount owed to a

business throughout the period, while multiplying by 365 converts the turnover into days.
Fast Accounts Receivable Turnover means it takes (on average) a few days to collect
cash; if cash is collected quickly, it can then be used to meet other debts as they fall due.
Let’s return to Markwell Mirrors, with some information added:
(continued) 2024 2025
Inventory Turnover 101 days 73 days
Average Accounts Receivable $33 000 $38 500
Cash sales including GST $17 600 $18 700
Credit sales including GST $198 000 $220 000
Sales returns including GST $8 800 $9 900
Credit terms offered to customers 30 days 30 days
The Accounts Receivable Turnover would be calculated as shown in Figure 19.10:
Figure 19.10 Calculation: Accounts Receivable Turnover (ARTO)

2024 2025
$33 000 $38 500
ARTO = ARTO =
$198 800 − $8 800 × 365 $220 000−$9 900 × 365
$33 000 $38 500
= $189 200 × 365 = $210 100 × 365
Study tip = 64* days = 67* days
Be careful when
The figures indicate that in 2024 it took an average of 64 days to collect cash from
explaining changes in ITO
Accounts Receivable, but in 2025 this increased unfavourably to 67 days. This means
and ARTO; a decrease in
that, on average, it took three days longer to generate cash from Accounts Receivable
days is an improvement
in liquidity. in 2025, because although Net credit sales increased, average Accounts Receivable
increased by proportionately more.

Turning inventory into cash

Given that Markwell Mirrors sells most of its inventory on credit, its ability to meet its
commitments will depend on the time taken to turn the inventory into Sales (ITO) and
then the time taken to turn Accounts Receivable into cash (ARTO). Thus, in 2025 it will
take the business 140 days to turn inventory into cash: Inventory Turnover 73 days +
Accounts Receivable Turnover 67 days.
Assessing Accounts Receivable Turnover

The three-day increase in the preceding example may not be a significant increase,
but the fact that Accounts Receivable continue to take more than 60 days is of grave
concern, because the firm offers only 30 days credit to its customers. Accounts
Receivable Turnover can be assessed against a previous period to identify increases or
decreases, but it is the credit terms offered to customers (and perhaps the budgeted
Accounts Receivable Turnover) that should be used to determine whether Accounts
Receivable Turnover is satisfactory.
Even if Accounts Receivable Turnover is within the credit terms, it should be noted
that it is an average figure; some Accounts Receivable may be repaying within the credit
terms, while others may be repaying late. In conjunction with Accounts Receivable
Turnover, the owner will need to analyse the Accounts Receivable accounts in the General
Ledger so that each individual Account Receivable can be managed appropriately.
Managing Accounts Receivable

There are certain strategies a business owner can employ to ensure that Accounts
Receivable are managed wisely to ensure an appropriate Accounts Receivable Turnover: Study tip
• Offer discounts for quick settlement
• Send invoices promptly
See Section 6.7 for a
• Conduct extensive credit checks
detailed discussion
• Send reminder notices of these strategies
• Threaten legal action to manage Accounts
• Employ a debt collection agency Receivable.
• Deny access to credit facilities
• Develop a strong relationship with each customer
• Appoint an Accounts Receivable Officer / Clerk
• Consider non-financial information.
In all of this, the business owner and his/her employees must conduct themselves Ethical
legally and ethically, to ensure the business operates within the law and also in a socially considerations
responsible manner.

1 State what is measured by Accounts Receivable Turnover (ARTO).
2 Show the formula to calculate Accounts Receivable Turnover.
3 Explain why Accounts Receivable Turnover is crucial to an assessment of
liquidity.
4 Explain the importance of credit terms offered to customers in assessing
Accounts Receivable Turnover.
5 List the strategies a business could use to improve its Accounts Receivable
Turnover, in the order in which they should be implemented.

19.8 Accounts Payable Turnover (APTO)

Of all the obligations a trading firm must meet, the most persistent is paying for
inventory. If inventory is purchased for cash, the business will leave itself no time to
sell the inventory and collect the cash before the payment must be made. On the other
hand, credit purchases allow the firm some time to sell the inventory and collect the
cash before the supplier must be paid.
However, it is still important that Accounts Payable are paid on time and this means
the business needs information on how long it is taking to pay its Accounts Payable.
Accounts Payable Turnover (APTO) provides this information as it measures the average
number of days taken to pay Accounts Payable, indicating the effectiveness of the firm
in managing its Accounts Payable.
Accounts Payable Turnover is calculated as shown in Figure 19.11:
Figure 19.11 Formula: Accounts Payable Turnover (APTO)
Average Accounts Payable
Accounts Payable Turnover (APTO) = × 365
Net credit purchases (plus GST)
(continued)
2024 2025
Accounts Receivable Turnover 64 days 67 days
Average Accounts Payable $11 000 $13 200
Credit purchases including GST $77 000 $99 000
Purchase returns including GST $3 850 $4 950
Credit terms offered by suppliers 60 days 60 days
The Accounts Payable Turnover would be calculated as shown in Figure 19.12:
Figure 19.12 Calculation: Accounts Payable Turnover (APTO)

2024 2025
$11 000 $13 200
APTO = × 365 APTO = × 365
$77 000−$3 850 $99 000−$4 950
$11 000 $13 200
= × 365 = × 365
$73 150 $94 050
= 55* days = 51* days
The figures indicate that in 2024 Accounts Payable were paid every 55 days; that is,
five days before the credit terms expired. In 2025 this decreased by three days to 51
days; that is, 9 days shorter than the credit terms allowed. This was because although
Net credit purchases and average Accounts Payable increased, average Accounts
Payable increased by a smaller proportion.

Assessing Accounts Payable Turnover

Accounts Payable Turnover can be assessed against a previous period to identify
increases or decreases, but in common with Accounts Receivable Turnover, it is the
credit terms offered by suppliers (and perhaps the budgeted Accounts Payable
Turnover) that should be used to determine whether Accounts Payable Turnover is
satisfactory.
Managing Accounts Payable

Study tip
Having access to credit therefore makes it critical that Accounts Payable are managed
effectively, and this can be done by following some broad principles:
• Develop a strong relationship with each supplier See Section 5.6 for a
• Pay within, but as close as possible to, the credit terms detailed discussion
• Pay early to earn discount revenue (if available, and affordable) of these strategies
• Check each Statement of Account against the Accounts Payable ledger account to manage Accounts
• Appoint an Accounts Payable Officer / Clerk Payable.
• Communicate in a timely fashion.
In all of these dealings, acting in an ethical manner remains essential, as it does in all
Ethical
business decision-making.
considerations
Inventory Turnover, Accounts Receivable Turnover and Accounts

Payable Turnover
The firm’s ability to pay its Accounts Payable will rely heavily on its ability to generate
cash from its inventory. This means Accounts Payable Turnover is reliant on Inventory
Turnover and, if the business deals mainly on credit, Accounts Receivable Turnover.
Figure 19.13 shows this relationship between Inventory Turnover, Accounts Receivable
Turnover and Accounts Payable Turnover in what is sometimes called the ‘cash cycle’:
Figure 19.13 Cash cycle
Sale of Inventory
Receipt from
Purchase of Inventory
Account Receivable
Payment to
Account Payable
The days between the purchase of inventory and sale of inventory is measured by
the Inventory Turnover; the days between the sale of inventory and the receipts from
the Accounts Receivable is measured by the Accounts Receivable Turnover; and the
days between the purchase of the inventory and the payments to the Accounts Payable
is measured by the Accounts Payable Turnover.
In most cases, a business will want its ITO and ARTO to be fast whereas it will want
its APTO to be as slow as possible (without exceeding credit terms). Selling inventory for
cash and buying inventory on credit provides time for the business to sell its inventory
and collect the cash before it has to repay its Accounts Payable.

(continued) Indicator 2025 Benchmark
Inventory Turnover 73 days 2024 Inventory Turnover: 101 days
Accounts Receivable Turnover 67 days Credit terms offered to customers: 30 days
Accounts Payable Turnover 51 days Credit terms offered by suppliers: 60 days
In this example, it takes 73 days (ITO) to sell the inventory, and then a further 67 days
(ARTO) to receive cash from Accounts Receivable, meaning it takes 140 days (73 days
+ 67 days) to generate cash. Although Inventory ITO is faster than last year, it is still too
slow, and ARTO is almost double the credit terms offered to customers meaning some
changes in management are required.
With this in mind, the fact that the business is only taking 51 days (APTO) to pay
Accounts Payable is concerning as it means that the cash outflows are occurring much
faster than cash inflows, and this will put a strain on any cash reserves. If it was to
continue, it could see the business run out of cash, and require a capital contribution just
to keep trading. Given that suppliers offered 60 days, the business would be advised to
slow its payments to Accounts Payable.

1 State what is measured by Accounts Payable Turnover (APTO).
2 Show the formula to calculate Accounts Payable Turnover.
3 Explain the importance of credit terms offered by suppliers in assessing
Accounts Payable Turnover.
4 List the strategies a business could use to manage its Accounts Payable
Turnover, in the order in which they should be implemented.
5 Explain the relationship between Inventory Turnover, Accounts Receivable
Turnover and Accounts Payable Turnover.

Where have we been?

• Liquidity refers to the ability of a business to meet its short-term debts as they fall due.
• The Budgeted Cash Flow Statement is essential to an analysis of liquidity, as it details all expected cash
inflows and cash outflows, and states categorically whether the business will be able to meet its cash
obligations for the coming year.
• The Working Capital Ratio and Quick Asset Ratio assess the level of liquidity and should be at least 1:1.
• Inventory Turnover, Accounts Receivable Turnover and Accounts Payable Turnover assess efficiency: the
ability of the firm to manage its inventory, Accounts Receivable and Accounts Payable.
• Inventory management strategies include determining an appropriate level of inventory on hand;
maintaining an appropriate inventory mix; rotating inventory; ensuring inventory is up-to-date; and
promoting the sale of complementary goods.
• Accounts Receivable management strategies include the use of discounts for quick settlement; prompt
invoicing; extensive credit checks; reminder notices; threats of legal action; debt collection agency; and
threats of not providing credit in the future.
• Accounts Receivable Turnover and Accounts Payable Turnover should be assessed against the credit terms.
Exercises

Liquidity
At the end of 2024, Hilltop Sporting Goods had $12 000 cash in the bank, but by the end of 2025 that had fallen
to $3 500, prompting its owner to say that its liquidity had fallen.
Required
a State two reasons why the owner’s assertion about the firm’s liquidity may be incorrect.
b State two indicators that can be used to assess the level of liquidity.
c State two indicators that can be used to assess the speed of liquidity.

Working Capital Ratio
The Balance Sheet of Wellington Boots as at 31 December 2025 showed Current assets of $34 000 and
Current liabilities of $42 500.
Required
a State what is measured by the Working Capital Ratio.
b Calculate the Working Capital Ratio for Wellington Boots as at 31 December 2025.
c Referring to your answer to part ‘b’, assess the Working Capital Ratio of Wellington Boots.
d Suggest two actions the owner of Wellington Boots may need to take to ensure the business is able to
meet its short-term debts as they fall due.


Working Capital Ratio
Lights of Your Life has provided the following information:
2024 2025
Working Capital Ratio 1.65:1 1.21:1
Required
a Explain one reason why the owner should be concerned about the trend in this indicator.
b Explain one limitation of relying on the Working Capital Ratio to assess liquidity.
c Explain how the budgeted Cash Flow Statement could be used to assess liquidity.

Working Capital Ratio and Quick Asset Ratio
Madden Homewares has provided the following extract from its Balance Sheet:
MADDEN HOMEWARES
$ $
Accrued interest revenue 300 Bank overdraft 12 000
Accounts Receivable 34 100 Accrued electricity 500
Prepaid rent expense 2 150 GST Clearing 900
The Working Capital Ratio of Madden Homewares as at 30 June 2025 was 2.5:1.
Required
a State what is measured by the Quick Asset Ratio.
b Explain why inventory is excluded from the calculation of quick assets.
c Calculate the Quick Asset Ratio of Madden Homewares as at 30 June 2025.
d Referring to your answer to part ‘c’, assess the Quick Asset Ratio of Madden Homewares.
e Explain how the efficiency of Madden Homewares in managing its current assets will affect its liquidity.

Working Capital Ratio and Quick Asset Ratio
Jordan’s Rugs has provided the following information:
2024 2025
Quick Asset Ratio 1.5:1 1.5:1
Required
a Explain one possible reason why the Working Capital Ratio has increased but the Quick Asset Ratio has
stayed the same from 2024 to 2025.
b Explain one negative consequence if the Working Capital Ratio is too high.
c Explain the circumstances in which this firm is likely to:
• have no difficulties meeting its short-term debts
• have difficulties meeting its short-term debts.


Cash Flow Cover
Hair Today has provided the following information:
2024 2025
Average Current liabilities $13 000 $10 000
Net Cash Flows from Operations $39 000 $35 000
Required
a Calculate the Cash Flow Cover for Hair Today for 2024 and 2025.
b Referring to your answer to part ‘a’, explain whether liquidity has improved or worsened from 2024 to 2025.
c Explain the cause(s) of the change in the Cash Flow Cover from 2024 to 2025.
d State two other pieces of information from the Cash Flow Statement that would assist in the
assessment of liquidity.
e Explain why it is important for liquidity that Net Cash Flows from Operations is positive.

Level of liquidity
E-Comms and Virtual World both sell computer systems, and have provided the following information for 2025:
e-Comms Virtual World

Cash Flow Cover 4.6 times 1.25 times
Required
a Explain why the Working Capital Ratio of each firm is higher than its Quick Asset Ratio.
b Explain one reason why Virtual World should be concerned about its Working Capital Ratio.
c Explain how the Balance Sheet of Virtual World as at 31 December 2025 could assist in assessing its liquidity.
d Discuss whether e-Comms will be able to meet its short-term debts as they fall due.
e Identify one other piece of information that would assist in assessing the liquidity of e-Comms. Justify
your answer.


Inventory Turnover
Orlando’s Blooms is a flower shop operating in Horsham. It has provided the following information relating to
its inventory for 2025:
Average inventory $8 000

Budgeted Inventory Turnover 4 days
Required
a State what is measured by Inventory Turnover.
b Calculate Inventory Turnover for Orlando’s Blooms for 2025.
c Referring to your answer to part ‘b’, state two reasons why the owner would consider this Inventory
Turnover to be unsatisfactory.
d Explain how slow Inventory Turnover can have negative consequences for:
• profitability
• liquidity.
e Explain one action the owner could take to improve Inventory Turnover without affecting Gross Profit.

Inventory Turnover
The Light House sells a huge variety of lights and lamps as well as candles, candlesticks and other decorative
items. The owner has provided the following information relating to its inventory for 2025 and 2026:
2025 2026
Average Inventory $34 000 $30 000
Required
a Explain why the owner would be pleased with this trend in Inventory Turnover.
b Explain one negative consequence if Inventory Turnover is too fast.
c Explain the relationship between selling prices and Inventory Turnover.
d State one limitation of using Inventory Turnover to assess the effectiveness of inventory management.
e Explain how inventory cards can assist an assessment of the effectiveness of inventory management.

Ferrante Suits has provided the following information relating to its activities for 2025:
Cash sales $200 000

Credit sales $48 000
Sales returns $3 500
Average Accounts Receivable $6 600
Inventory Turnover 21 days

Required
a State what is measured by Accounts Receivable Turnover.
b Calculate Accounts Receivable Turnover for Ferrante Suits for 2025.
c Referring to your answer for part ‘b’, state whether Accounts Receivable Turnover is satisfactory or
unsatisfactory. Justify your answer.
d Suggest two strategies the owner could implement to improve Accounts Receivable Turnover.
e Explain why this firm’s Accounts Receivable Turnover is unlikely to have a significant impact on its ability
to meet its short-term debts.

Accounts Receivable Turnover and Inventory Turnover
Lowen Lifevests has provided the following information for 2025:
Inventory Turnover 46 days

Accounts Receivable Turnover 25 days
Inventory Turnover (2024) 31 days
Required
a Explain why this firm may have liquidity problems in 2025.
b Identify two facts that support the claim that management of inventory has been worse than
management of Accounts Receivable in 2025.
c Explain the importance of inventory management in terms of meeting short-term debts as they fall due.
d List three inventory management strategies this firm could implement to improve its Inventory Turnover.
e State one benefit and one cost of offering discounts to Accounts Receivable.
f Explain how credit checks can lead to faster Accounts Receivable Turnover.

Pringle Pumps has provided the following information for 2025:
Average Accounts Payable $11 000

Credit purchases $91 250
Purchase returns $2 500
In 2024, Accounts Payable Turnover was 34 days.
Required
a State what is measured by Accounts Payable Turnover.
b Calculate Accounts Payable Turnover for Pringle Pumps for 2025.
c State two reasons why the owner should be concerned about Accounts Payable
Turnover in 2025.
d State two negative consequences of exceeding the credit terms offered by
suppliers. Ethical
e Referring to financial and ethical considerations, discuss the effects on liquidity of c onsiderations
exceeding the credit terms offered by suppliers.


Inventory Turnover, Accounts Receivable Turnover and
Claire’s Clocks has provided the following information relating to its activities for 2024 and 2025:
2024 2025
Accounts Payable Turnover 51 days 64 days
Inventory Turnover – industry average 11 days
Required
a Suggest two reasons that could explain the improvement in Inventory Turnover in 2025.
b Suggest two strategies the owner could adopt to encourage late Accounts Receivable to pay.
c Explain how the change in Accounts Receivable Turnover has affected Accounts Payable Turnover in
2025.
d Referring to one other liquidity indicator, explain how this business could avoid liquidity problems
without raising further external finance in 2025.

Analysing liquidity
G and Otis sells active wear and has provided the following information relating to its financial activities for 2025:
G and Otis
Financial indicators 2025
70 5
4.5
60
4
50 3.5
3
Ratio : 1
40
Days
2.5
30 2
20 1.5
1
10
0.5
0 0
2023 2024 2025
WCR QAR ITO ARTO APTO
• G and Otis offers customers credit terms of 40 days, but most sales are made on cash terms.
• Accounts Payable offer terms of n/60.
Required
a Identify two other pieces of information that may be useful in analysing the Inventory Turnover.
b Discuss the liquidity of G and Otis.
c Explain two actions G and Otis could take in 2026 to improve its liquidity.


Analysing profitability and liquidity
Sachini de Silva is the owner and operator of Silva Smiths, a shop that sells silver and gold ornaments and
decorations. All sales are made on credit. Sachini has provided the following information relating to the firm’s
activities for 2024 and 2025:
Indicator 2024 2025

Accounts Payable Turnover 46 days 44 days
Gross Profit Margin 54% 48%
Net Profit Margin 12% 15%
• At the start of 2025 Silva Smiths lowered selling prices.
• Silva Smiths offers credit terms of n/30.
• Silva Smith’s main supplier offers credit terms of 7/10, n/60.
Required
a Identify two indicators that have improved as a result of Sachini’s decision to lower selling prices at the
start of 2025. Justify your answers.
b State whether Return on Assets in 2025 would be higher or lower than in 2024. Justify your answer.
c Discuss the effect on profitability of the decision to lower selling prices at the start of 2025.
d Discuss the liquidity of Silva Smiths.
e Explain two actions Silva Smiths could take in 2026 to improve its liquidity without changing its Asset
Turnover or Net Profit Margin.

532
Glossary
Account Payable [p. 96] accrued revenue [p. 427]
a supplier from whom goods (usually inventory) or a current asset which arises when revenue has been
services have been purchased on credit, and the earned but cash is yet to be received
amount still owing for those purchases (also called a Accumulated depreciation [p. 353]
‘creditor’) the total value of a non-current asset that has been
Account Receivable [p. 127] incurred over its life thus far
a customer to whom inventory has been sold on advice [p. 9]
credit, and the amount still owing for those sales the provision to the owners of a range of options
(also called a ‘debtor’) appropriate to their aims/objectives, together with
Accounting [p. 3] recommendations as to the suitability of those aims/
the process of collecting and recording financial objectives
data; reporting, analysing and interpreting financial Allowance for doubtful debts [p. 403]
information; and advising users about possible a negative asset account that records the balance of
courses of action to assist decision-making doubtful debts (that are unlikely to be collected in the
Accounting assumptions [p. 11] future but have not yet been written off)
the generally accepted principles that influence the analysing [p. 479]
way Accounting information is generated examining the financial reports in detail to identify
Accounting entity assumption [p. 11] changes or differences in performance
the assumption that the records of assets, liabilities Analysing Chart [p. 44]
and business activities of the entity are kept a tool used to identify the steps for recording
completely separate from those of the owner of the transactions in the General Ledger
entity as well as from those of other entities
asset [p. 18]
Accounting equation [p. 28] a present economic resource controlled by an entity
the rule that states that assets must always equal as a result of past events
liabilities plus owner’s equity
Asset Turnover (ATO) [p. 490]
Accounting process [p. 8] an efficiency indicator that indicates how productively
the process used to generate financial information a business has used its assets to earn revenue
from financial data leading to the provision of advice
to assist decision-making bad debt [p. 401]
a debt that must be ‘written off’ as irrecoverable or
Accounting Standard [p. 10] uncollectable because it has been confirmed that
a technical pronouncement that sets out the required the Account Receivable is unable to pay due to
Accounting for particular types of transactions and liquidation or bankruptcy
events for businesses reporting under company law
balance day adjustment (BDA) [p. 324]
Accounts Payable Turnover (APTO) [p. 113] a change made to a revenue or expense account on
the average number of days it takes for a business to balance day so that revenue accounts show revenues
pay its Accounts Payable earned and expense accounts show expenses
Accounts Receivable Ageing Analysis [p. 146] incurred in a particular Period
a listing of the amount and proportion of Accounts Balance Sheet [p. 29]
Receivable according to the length of time they are an Accounting report that details the business’s
owing assets, liabilities and owner’s equity at a particular
Accounts Receivable Turnover (ARTO) [p. 144] point in time
the average number of days it takes for a business to balancing [p. 54]
receive cash from its Accounts Receivable ruling off an asset, liability or owner’s equity account
Accrual basis assumption [p. 12] to determine its balance at the end of the current
the assumption that revenues are recognised when period and transferring that balance to the next
earned and expenses when incurred, so profit is period
calculated as revenue earned in a particular period Bank Statement [p. 69]
less expenses incurred in that period a report generated by a bank listing all cash deposits
accrued expense [p. 329] into and withdrawals from a particular account
a current liability that arises when an expense has benchmark [p. 483]
been incurred in the current Period but has not yet an acceptable standard against which the firm’s
been paid actual performance can be assessed
G L O S S A RY 533
budget [p. 439] commencing entry [p. 164]

an Accounting report that predicts/estimates the a General Journal entry to establish double-entry
financial consequences of future events records by entering existing asset, liability and
Budgeted Balance Sheet [p. 453] owner’s equity balances in the General Ledger
an Accounting report that predicts assets, liabilities accounts
and owner’s equity at some point in the future Comparability [p. 16]
Budgeted Cash Flow Statement [p. 442] financial information should be able to be compared
an Accounting report that attempts to predict all with similar information about other entities and with
future cash inflows and cash outflows, and thus the similar information about the same entity for another
estimated bank balance at the end of the budget period or another date
period Conceptual Framework [p. 10]
Budgeted Income Statement [p. 450] a statement of generally accepted theoretical
an Accounting report that shows expected future principles that form the frame of reference for
revenues and expenses and, as a result, the expected financial reporting
profit for the budget period correcting entry [p. 166]
budgeting [p. 439] a General Journal entry to correct an error in the way
the process of predicting/estimating the financial a transaction is recorded in the General Journal or
consequences of future events General Ledger
Carrying value [p. 357] cost of a non-current asset [p. 359]

the value of a non-current asset that is yet to all costs incurred in order to bring the asset into
be incurred/allocated as an expense, plus any a location and condition ready for use, which will
residual value provide a benefit for the life of the asset
cash deficit [p. 298] Cost of Goods Sold (COGS) [p. 209]
an excess of cash payments over cash receipts, all costs incurred in getting inventory into a condition
leading to a decrease in the bank balance and location ready for sale
Cash Flow Cover (CFC) [p. 306] cost of inventory [p. 225]
a liquidity indicator that measures the number of all costs incurred in order to bring inventory into a
times Net Cash Flows from Operations is able to condition and location ready for sale
cover average current liabilities Cost of Sales [p. 46]
Cash Flow Statement [p. 298] the value of inventory that has been sold in a
an Accounting report that details all cash inflows and particular period, valued at its cost price
outflows from Operating, Investing and Financing cost price [p. 184]
activities, and the overall change in the firm’s cash the original purchase price of each individual item of
balance inventory
Cash Flow Statement Variance Report [p. 461] credit card receipt [p. 73]
an Accounting report that compares actual and a source document issued for sales made on
budgeted cash flows, highlighting variances as credit card
favourable or unfavourable depending on their effect credit note [p. 104]
on budgeted cash on hand a source document that verifies the return of
cash receipt [p. 69] inventory
a source document used to verify cash received credit purchase [p. 96]
cash surplus [p. 298] a transaction that involves buying inventory on credit,
an excess of cash receipts over cash payments, with the exchange of the inventory on one date,
leading to an increase in the bank balance followed by the exchange of cash at a later date
cheque butt [p. 76] credit sale [p. 127]
a source document used to verify a cash payment a transaction that involves selling inventory on credit,
made by cheque with the provision of the inventory on one date,
classification [p. 30] followed by the receipt of cash at a later date
grouping together items that have some common credit side [p. 39]
characteristic the right-hand side of a ledger account
closing the ledger [p. 259] credit terms [p. 97]
transferring balances from revenue and expense information that details how many days a business
ledger accounts to the Profit and Loss Summary has to pay for a credit transaction, and any applicable
account so that profit can be calculated settlement discount

534 G L O S S A RY
credit transaction [p. 96] doubtful debt [p. 401]

a transaction that involves an exchange of goods or a debt that is unlikely to be collected in the future
services on one date, followed by the exchange of but has not yet been ‘written off’ as it has not
cash at a later date been confirmed that the Account Receivable is unable
cross-reference [p. 41] to pay
the name of the other account affected by a efficiency [p. 479]
transaction, so that both accounts affected by a the ability of the business to manage its assets and
particular transaction can be identified liabilities
current asset [p. 30] EFT receipt [p. 70]
a present economic resource controlled by an entity a source document used to verify a cash transfer
as a result of past events that is reasonably expected received via Electronic Funds Transfer
to be converted to cash, sold or consumed within the equities [p. 27]
next 12 months claims on the assets of a business, consisting of both
current liability [p. 30] liabilities and owner’s equity
a present obligation of an entity to transfer an ethical considerations [p. 5]
economic resource as a result of past events that the social and environmental consequences of a
is reasonably expected to be settled within 12 months financial decision
debit side [p. 39] expense [p. 21]
the left-hand side of a ledger account decreases in assets or increases in liabilities
Debt Ratio [p. 486] that result in decreases in owner’s equity,
a stability indicator that measures the percentage of other than those relating to distributions to
a firm’s assets that are financed by liabilities the owner
delivery docket [p. 170] expense control [p. 492]
a document issued by the supplier to accompany a the firm’s ability to manage its expenses so that they
delivery, listing the type and quantity of all items either decrease or, in the case of variable expenses,
delivered increase no faster than Sales revenue
depreciable asset [p. 346] fair value [p. 159]
a non-current asset that has a finite life and must be the price of an asset contributed by the owner that
depreciated over its life would be received if that asset was sold at the time it
depreciable value [p. 349] was acquired by the business
the total value of the asset that will be consumed Faithful representation [p. 15]
by the current entity, and so must be allocated as financial information should be a faithful
depreciation expense over its useful life representation of the real-world economic event it
depreciation [p. 347] claims to represent: complete, free from material
the allocation of the cost of a non-current asset over error and neutral (without bias)
its useful life financial data [p. 7]
depreciation expense [p. 347] raw facts and figures upon which financial
that part of the cost of a non-current asset that has information is based
been incurred in the current Period financial information [p. 7]
discount expense [p. 139] financial data that has been sorted, classified
an expense in the form of a decrease in assets and summarised into a more useable and
(Accounts Receivable) and owner’s equity, incurred understandable form
when cash is received early from Accounts Financing activities [p. 299]
Receivable a settlement discount is allowed cash flows related to changes in the financial
discount revenue [p. 107] structure of the firm
a revenue in the form of a decrease in liabilities finite life [p. 346]
(Accounts Payable) and an increase in owner’s equity, the limited period of time (usually measured in years
earned when Accounts Payable are paid early and a or sometimes in units of use) for which a non-current
settlement discount is given by the supplier asset will exist
double-entry Accounting [p. 32] First In, First Out (FIFO) [p. 200]
a system that records at least two effects on a method of valuing inventory that assumes that,
the Accounting equation as a result of each unless otherwise indicated, the first items purchased
transaction are the first sold, and therefore values inventory sold
using the earliest cost price on hand

G L O S S A RY 535
footing [p. 52] inventory [p. 180]

an informal process used to determine the balance of goods purchased by a trading firm and held for the
a ledger account purpose of resale at a profit
General Journal [p. 68] inventory card [p. 183]
an Accounting record used to analyse and record a subsidiary Accounting record that records each
each transaction, and to identify its source document individual transaction involving the movement in and
before posting to the General Ledger out of the business of a particular line of inventory
General Ledger [p. 38] inventory count [p. 195]
the collective name for the main group of ledger a physical count of the number of units of each line of
accounts inventory on hand
Going concern assumption [p. 11] inventory gain [p. 198]
the assumption that the business will continue to a revenue earned when the inventory count shows
operate in the future, and its records are kept on that a figure for inventory on hand that is more than the
basis balance shown in the inventory card
Goods and Services Tax (GST) [p. 64] inventory loss [p. 196]
a 10% tax levied by the federal government on an expense incurred when the inventory count shows
most purchases of goods (excluding fresh food) and a figure for inventory on hand that is less than the
services balance shown in the inventory card
Gross Profit Margin (GPM) [p. 274] Inventory Turnover (ITO) [p. 243]
a profitability indicator that measures the average the average number of days it takes for a business to
mark-up by calculating the percentage of Net sales sell its inventory or convert its inventory into sales
revenue that is retained as Gross Profit Inventory write-down [p. 239]
GST Clearing [p. 67] the expense incurred when the Net Realisable Value
a ledger account that records all GST transactions (NRV) of an item of inventory falls below its Cost or
GST refund [p. 68] original purchase price
a cash receipt from the ATO to settle a GST asset Investing activities [p. 299]
from a previous period cash flows related to the purchase and sale of non-
GST settlement [p. 67] current assets
a cash payment to the ATO to settle a GST liability ledger account [p. 38]
from a previous period an Accounting record showing all the transactions
Historical cost (HC) [p. 348] that affect a particular item
the original purchase price of the non-current asset liability [p. 19]
horizontal analysis [p. 482] a present obligation of an entity to transfer an
comparing reports from one period to the next, and economic resource as a result of past events
identifying the increase or decrease in specific items liquidity [p. 114]
in the report the ability of a business to meet its short-term debts
Identified Cost [p. 191] as they fall due
a method of valuing inventory by physically marking loss on disposal of non-current asset [p. 383]
each item in some way so that its individual cost an expense incurred when the proceeds from the
price can be identified disposal of a non-current asset is less than its
Income Statement [p. 267] carrying value when disposed
an Accounting report that details the revenues Lower of ‘Cost’ and ‘Net Realisable Value’
earned and expenses incurred during the current rule [p. 237]
Period inventory should be valued at either its Cost, or its
Income Statement Variance Report [p. 462] Net Realisable Value, using whichever value is lower
an Accounting report that compares actual and materiality [p. 14]
budgeted revenues and expenses, highlighting the size or significance of financial information,
variances as favourable or unfavourable depending on determined by considering whether omitting it
their effect on budgeted profit or misstating it from the reports could influence
interpreting [p. 479] decisions that users make
examining the relationships between the items in the
financial reports in order to explain the cause and
effect of changes or differences in performance

536 G L O S S A RY
memo [p. 158] perpetual system of inventory recording [p. 210]

an internal source document used to verify a recording inventory transactions in inventory cards,
transaction that does not involve cash and is not a then conducting a physical inventory count at the end
sale, purchase or return of inventory of the Period to verify the balances of those inventory
narration [p. 69] cards, in the process detecting any inventory losses
a brief description of a transaction recorded in the or gains
General Journal, including a reference to the relevant Post-adjustment Trial Balance [p. 334]
source document a list of all General Ledger accounts and their
Net Profit Margin (NPM) [p. 273] balances after balance day adjustments have been
a profitability indicator that indicates expense control made
by calculating the percentage of Net sales revenue Pre-adjustment Trial Balance [p. 334]
that is retained as Net Profit a list of all General Ledger accounts and their
Net Realisable Value (NRV) [p. 237] balances before balance day adjustments have been
the estimated selling price of inventory less any costs made
involved in its selling, marketing or distribution prepaid expense [p. 325]
Net Sales [p. 209] a current asset that has been paid in advance in the
overall Sales revenue after the deduction of Sales current Period but is yet to be incurred
returns product cost [p. 226]
non-current asset [p. 30] a cost incurred in order to bring inventory into a
a present economic resource controlled by an entity condition and location ready for sale that can be
as a result of past events that is not held for resale allocated to individual units of inventory on a logical
and is reasonably expected to be used for more than basis
the next 12 months Profit and Loss Summary account [p. 259]
non-current liability [p. 30] a General Ledger account that is used to summarise
a present obligation of an entity to transfer an revenues and expenses so that profit can be
economic resource as a result of past events that is calculated
not required to be settled within 12 months profit on disposal of non-current asset [p. 384]
non-financial information [p. 5] a revenue earned when the proceeds from the
any information that cannot be found in the financial disposal of a non-current asset are greater than its
statements, and is not expressed in dollars and cents, carrying value when disposed
or reliant on dollars and cents for its calculation profitability [p. 273]
Operating activities [p. 299] the ability of a business to earn profit as expressed in
cash flows related to day-to-day trading activities relative terms by comparing profit against a base like
sales, assets or owner’s equity
order confirmation [p. 169]
a document issued by the supplier confirming the profitability indicators [p. 483]
receipt of an order (for inventory) measures that express an element of profit in relation
to some other aspect of business performance
order form [p. 168]
a document issued by a business requesting the purchase invoice [p. 97]
supply of inventory or other goods a source document used to verify a credit purchase of
inventory or other items
over-depreciation [p. 386]
when excess depreciation expense has been allocated purchase return [p. 103]
over the life of a non-current asset due to understating the return to a supplier (Account Payable) of inventory
its residual value and/or useful life, resulting in an bought on credit
understatement of the asset’s carrying value purpose of Accounting [p. 3]
owner’s equity [p. 20] to provide financial information and advice to assist
the residual interest in the assets of an entity after decision-making
the deduction of its liabilities Qualitative characteristics [p. 14]
Period assumption [p. 12] the qualities of the information in financial reports
the assumption that reports are prepared for a Quick Asset Ratio (QAR) [p. 514]
particular period of time, such as a month or year, in a liquidity indicator that measures the ratio of quick
order to obtain comparability of results assets to quick liabilities, to assess the firm’s ability
period cost [p. 231] to meet its immediate debts
a cost incurred in order to bring inventory into a recording [p. 9]
condition and location ready for sale that cannot be sorting, classifying and summarising the data
allocated to individual units of inventory on a logical contained in the source documents so that it is more
basis useable
G L O S S A RY 537
Relevance [p. 14] Statement of Receipts and Payments [p. 296]

financial information must be capable of making a an Accounting report that details cash received and
difference to the decisions made by users by helping paid during a Period, and the change in the firm’s
them to form predictions and/or confirm or change bank balance over that period
their previous evaluations tax invoice [p. 65]
reporting [p. 9] a source document that contains specific information
the preparation of financial statements that required by the ATO to substantiate GST amounts
communicate financial information to the owner Timeliness [p. 16]
Residual value (RV) [p. 348] financial information should be available to decision
the estimated value of the non-current asset at the makers in time to be capable of influencing their
end of its useful life decisions
Return on Assets (ROA) [p. 488] trade-in [p. 387]
a profitability indicator that indicates how effectively proceeds from the disposal of a non-current asset in
a business has used its assets to earn profit the form of a reduction in the amount payable for the
Return on Owner’s Investment (ROI) [p. 484] purchase of a new non-current asset
a profitability indicator that indicates how effectively trading firm [p. 180]
a business has used the owner’s capital to earn profit a firm that purchases goods in order to resell them at
revenue [p. 20] a profit
increases in assets or decreases in liabilities that transaction [p. 8]
result in increases in owner’s equity, other than those an exchange of goods or services with another party
relating to contributions from the owner trend [p. 481]
sales invoice [p. 128] the pattern formed by changes over time
a source document used to verify a credit sale of Trial Balance [p. 52]
inventory to an Account Receivable a list of all the accounts in the General Ledger, and
sales return [p. 134] their balances, to determine if total debits equal total
the return by a customer (Account Receivable) of credits
inventory sold on credit under-depreciation [p. 386]
Schedule of Payments to Accounts Payable [p. 450] when insufficient depreciation expense has been
a table used to calculate how much cash will be allocated over the life of a non-current asset due
paid to Accounts Payable in the budget period as a to overstating its residual value and/or useful
consequence of credit purchases in the current and life, resulting in an overstatement of the asset’s
previous periods carrying value
Schedule of Receipts from Accounts Understandability [p. 17]
Receivable [p. 447] financial information should be understandable
a table used to calculate how much cash will be or comprehensible to users with a reasonable
received from Accounts Receivable in the budget knowledge of business and economic activities, and
period as a consequence of Credit sales in the current presented clearly and concisely
and previous periods unearned revenue [p. 420]
settlement discount [p. 107] a current liability that arises when cash is received in
a reduction in the amount paid by a credit customer in advance for revenue that is yet to be earned
return for early repayment unit cost [p. 226]
shipping confirmation [p. 170] the cost price of each individual item/unit of inventory
a document issued by the supplier confirming that Useful life (Life) [p. 348]
inventory has been dispatched and is being shipped the estimated period of time for which the non-
to the business current asset will be used by the current entity to
source documents [p. 8] earn revenue (usually measured in years)
documents that provide both the evidence that variance [p. 460]
a transaction has occurred and the details of the the difference between actual and budgeted
transaction itself figures, usually described as favourable or
stability [p. 479] unfavourable
the ability of the business to meet its debts and variance report [p. 460]
continue its operations in the long term an Accounting report that compares actual and
Statement of Account [p. 111] budgeted figures, highlighting variances so that
a summary of the transactions a business has had with problems can be identified and corrective action
a particular Account Payable (or Account Receivable) taken
over a certain period of time (usually a month)
538 G L O S S A RY
Verifiability [p. 16] Vertical analysis of the Income Statement [p. 278]
financial information should allow different a representation of individual expenses as a
knowledgeable and independent observers to reach percentage of Sales revenue to allow for an
a consensus (agree) that an event is faithfully assessment of their relative importance
represented Working Capital Ratio (WCR) [p. 512]
vertical analysis [p. 497] a liquidity indicator that measures the ratio of current
a report that expresses every item as a percentage of assets to current liabilities, to assess the firm’s ability
a base figure to meet its short-term debts

539
Selected answers
Chapter 2 10.10 d Net Profit (Loss) = $2 190

2.2 c Total Assets = $92 600 g Total Assets = $608 070
2.3 b Total Assets = $83 190 10.11 c Net Profit (Loss) = $7 750
2.4 a Total Assets = $165 500 g Total Assets = $558 800
2.6 d Total Assets = $103 100
Chapter 11
2.7 b Total Assets = $91 700
11.1 a/b Bank Balance at End = $2 900
Chapter 3 11.2 b Bank Balance at End = $2 270
3.4 e Trial Balance = $183 900 11.3 b Bank Balance at End = $10 500
3.5 e Trial Balance = $37 400 11.11 c Bank Balance at End = $190
3.6 e Trial Balance = $245 130 11.12 c Bank Balance at End = $7 950
3.7 c Trial Balance = $14 000 11.13 b Bank Balance at End = $57 800
3.8 d Trial Balance = $272 380 c Net Profit (Loss) = ($1 250)
g Net Profit = $5 240 11.14 c/d Bank Balance at End = ($560)
h Total Assets = $263 240 11.15 f Bank Balance at End = $10 860
Chapter 4 Chapter 12
4.9 d Trial Balance = $40 246 12.11 b Trial Balance = $195 670
e Net Profit = $910 e Net Profit (Loss) = $1 980
g Total Assets = $36 g Total Assets = $96 650
12.12 b Trial Balance = $482 130
Chapter 7
e Net Profit = $52 550
7.6 d Total Assets = $632 350 h Total Assets = $311 500
Chapter 8 12.13 b Trial Balance = $173 320
8.9 b Net Profit = $14 400 e Net Profit = $26 260
e Total Assets = $174 500 h Total Assets = $113 670
8.10 a Net Profit = $300 Chapter 13

d Total Assets = $64 600 13.12 c Trial Balance = $288 150
Chapter 9 e Net Profit (Loss) = ($8 250)
9.5 c Adjusted Gross Profit = $1 100 h Total Assets = $84 450
9.8 e Adjusted Gross Profit = $1 900 13.13 b Trial Balance = $204 220
9.14 h Adjusted Gross Profit = $19 500 e Net Profit (Loss) = $19 880

g Total Assets = $79 100
Chapter 10
Chapter 14
10.3 e Total equities = $53 700
14.13 b Trial Balance = $131 540
10.4 b Net Profit = $23 500
d Net Profit = $9 640
10.5 c Net Profit (Loss) = $920
i Total Assets = $83 150
g Total Assets = $40 320
10.6 c Net Profit (Loss) = ($2 480) Chapter 15
g Total Assets = $44 570 15.7 c Trial Balance = $257 830
10.7 c Net Profit (Loss) = $2 600 d Net Profit (Loss) = $20 560
f Total Assets = $165 570 h Total Assets = $160 030

540 SELECTED ANSWERS
Chapter 16 17.6 a Bank Balance at End = $36 280

16.9 c Trial Balance = $249 595 b Net Profit = $5 250
d Net Profit (Loss) = $10 855 e Total Assets = $70 050
f Total Assets = $185 545 17.7 c Bank Balance at End = $23 685
16.10 f Current Assets = $107 530; e Net Profit = $9 525
Current Liabilities = $71 300
h Total Assets = $105 585
Chapter 17 17.15 e Bank Balance at End = $25 108
17.1 b Bank Balance at End = ($7 230) h Current Assets = $95 358;
Current liabilities = $55 220
17.2 b Bank Balance at End
17.16 d Net Profit = $24 410
Jan. = $120
f Total Assets = $165 090
Feb. = ($15 160)
g Net Profit = $23 263
Mar. = $4 910

541
Acknowledgments
The author and publisher wish to thank the following sources for permission to reproduce material:
Cover: © Getty Images / Bob Wickham
Images: © Getty Images / Bob Wickham, Chapter Openers, 1-19 / Luca Sage, 1.1 (1) / Hero Images, 1.1 (2) /
Shestock, 1.1 (4) / fatihhoca, 1.2 (1) / Jeanene Scott, 1.3 (1) / David Wall Photo, 1.4 (2) / Kevork Djansezian, 1.4 (1)
/ Westend61, 1.5 (1) / utah778, 1.5 (2) / Tarik Kizilkay, 1.6 (1) / hidako, 2.1 (1) / Trevor Williams, 3.4 (1) / Drazen, 3.5
(1) / OlafSpeier, Exercise 3.5 / Extreme Photographer, Exercise, 3.7, 3.6 / Jay’s photo, Figure 4.10, 4.11 / Songsak
Wilairit, Exercise, 4.2 / Masko, Exercise, 4.6 / Julien McRoberts, Exercise 4.10 / gunner3000, 5.3 / Cat_Chat,
Review Questions 5.1 / utah778, Review questions 5.4 / Warchi, Review questions 5.6 / Tim Hall, Exercise 5.8 /
d3sign, Figure 5.12 / Sefka Pavloca, Exercise 5.2 / DIGITALproshots, Exercise 5.11 / Katerina Andronchik, Figure
6.2 / Infadel, Figure 6.15 / VectorUp, Exercise 6.1 / ONYXprj, Exercise 6.3 / bubaone, Exerecise, 6.4 / Nora Carol
Photography, 6.3 (2) / Thomas Barwick, 6.3 (1) / relif, Exercise 6.2 / Luis Alvarez, Exercise 6.4 / FrankRamspott,
Figure 7.13, 7.14, 7.15 / Dominique Bruneton, Exercise 7.3 / krugll, Exercise 4.10 / bukavik, Exercise, 7.11 /
Westend61, Review questions 7.3 / Alexander Spatari, Exercise 7.11 / Seksan Mongkhonkhamsao, Exercise 7.5
/ Steve Debenport 8.1 (1) / Blend Images - Dave and Les Jacobs, 8.1 (2) / Zephyr18, 8.6 (1) / PM Images, 8.6 (2) /
ilya, Exercise 8.12 / JakeOlimb, Exercise 8.12 / Tarzhanova, 8.5 (1) / shironosov, Review questions 8.11 / Aliyev
Alexei Sergeevich, Exercise 8.5 / YinYang, Exercise 8.9, 8.10 / kundoy, Exercise, 8.8 / ArtKrisShapovalova,
Exercise, 9.5 / artdesigner88, Exercise 9.13 / ShotShare, Review question 9.4 / urbancow, 9.5 / andresr, 9.12 /
maybefalse, 10.2 (1) / metamorworks, 10.2 (2) / Hero Images, 10.4 / chadchai rangubpai, Review questions 10.6
/ Sarin Yapinngam, 10.7 (1) / jxfzsy, 10.7 (2) / Huntstock, Exercises 10.11 / NicoElNino, Exercise, 10.8 / Johner
Images, Exercise, 10.10 / Tom Cockrem, 11.1 / Hiya ZZZImages / Corbis / VCG, Exercise, 11.2 / Zho Hng Xu,
Exercise 11.6 / spyderskidoo, Exercise 11.8 / blackred, Exercise, 11.11 / Elanathewis, 12.2 / Volker Schilchting,
12.2 / Westend61, Exercise, 12.3, Review questions 12.3 / alfexe, Exercise, 12.8 / Michael Jahn, Exercise 9.6 /
nadia_bormotov, Exercise 14.1 / Apola, Exercise 14.2 / AVIcons, Exercise 14.12 / krisanapong detraphipha,
Review questions 14.6 / Gary Conner, Review questions 14.7 / TommL, Review questions 14.11 / Astrakan
Images, Astrakan Image, Exercise, 14.12 / Nerthuz, Exercise, 14.11 / nappelbaum, Exeercise 15.6 / Halfpoint,
Exercise 15.7 / Peter Dazele, Review question, 15.3 / R.Tsubin, 16.2 / bankrx, 16.1 / Mevans, Figure 16.8 / Tetra
images, 17.1 / TACrafts, Exercise 17.10 / David Morgan-Mar, 17.8 / Luca Sage, Exercise 17.9 / Image Source,
Exercises 17.7 / Yaorusheng, Exercise 17.1 / Tomekbudujedomek, Exercise 17.14 / alphaspiri, 18.1 / Brian A
Jackson, 18.7 / sturti, Review question 18.8 / PeopleImage, 18.9 / Roman Kraft, 18.10 / Peter Dazeley, 19.1
(1) / Rolf Bruderer, 19.1 (2) / Youssef Khoury, 19.8 / Jedrzej Kaminski, Exercise 19.15 / Witthaya Prasongsin,
Exercise 19.7.


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Cambridge VCE

Accounting Fourth Edition

Cambridge University Press is part of the University of Cambridge.

© Anthony Simmons, Richard Hardy 2006, 2008, 2012, 2019

First published 2006

Cover and text designed by Shaun Jury

ISBN 978-1-108-46989-0 Paperback

Additional resources for this publication at www.cambridge.edu.au/GO

Reproduction and Communication for educational purposes

For details of the CAL licence for educational institutions contact:

Copyright Agency Limited

Reproduction and Communication for other purposes

ISBN 978-1-108-46989-0 © Simmons et al. 2019 Cambridge University Press

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5.3 Purchase returns * 103

ISBN 978-1-108-46989-0 © Simmons et al. 2019 Cambridge University Press

* includes ethical considerations

ISBN 978-1-108-46989-0 © Simmons et al. 2019 Cambridge University Press

About the authors

I am pleased to be able to recommend this as an excellent resource for VCE accounting

Features of this resource

ISBN 978-1-108-46989-0 © Simmons et al. 2019 Cambridge University Press

Where are we headed?

ISBN 978-1-108-46989-0 © Simmons et al. 2019 Cambridge University Press

1.1 The purpose of Accounting

ISBN 978-1-108-46989-0 © Simmons et al. 2019 Cambridge University Press

At its core, Accounting is about decision-making. Just as history exists as a way of

Accounting for small business

Ethical considerations Ethical

There is no set list of

ISBN 978-1-108-46989-0 © Simmons et al. 2019 Cambridge University Press

Considering all these factors – financial information, non-financial

Review questions 1.1

1.2 Users of financial information

ISBN 978-1-108-46989-0 © Simmons et al. 2019 Cambridge University Press

Financial data versus financial information

Review questions 1.2

ISBN 978-1-108-46989-0 © Simmons et al. 2019 Cambridge University Press

1.3 The Accounting process

Figure 1.1 The Accounting process

Stage 1: source documents

ISBN 978-1-108-46989-0 © Simmons et al. 2019 Cambridge University Press

ISBN 978-1-108-46989-0 © Simmons et al. 2019 Cambridge University Press

Review questions 1.3

1.4 Accounting assumptions

This shared understanding of ‘how Accounting should be done’ rests on a mixture of

ISBN 978-1-108-46989-0 © Simmons et al. 2019 Cambridge University Press

Accounting entity assumption

Transactions between the business and the owner

Going concern assumption

ISBN 978-1-108-46989-0 © Simmons et al. 2019 Cambridge University Press

concern assumption allows us to record these Accounts Receivable (or ‘debtors’) as

Accrual basis assumption

ISBN 978-1-108-46989-0 © Simmons et al. 2019 Cambridge University Press

Similarly, the definition of an expense is satisfied when the consumption of the

Review questions 1.4

ISBN 978-1-108-46989-0 © Simmons et al. 2019 Cambridge University Press

1.5 Qualitative characteristics

ISBN 978-1-108-46989-0 © Simmons et al. 2019 Cambridge University Press