BMAN10621(A): Fundamentals of Financial Reporting

Workshops
2013-14

Workshop 2 Solutions
Accounts Preparation Exercise
(level of difficulty: Elementary to Intermediate)

Solution to Question 1 Valencia

A word of advice!
When figuring out the effect of each transaction on the companys accounts, it is useful to
think of the accounting equation:
Assets = Equity + Liabilities,
which in its expanded form is equivalent to
Assets + Expenses = (opening) Equity + Revenues + Liabilities
While going through each transaction below, one needs to make sure that the above equation
holds for each individual transaction. Otherwise, your new Balance Sheet will not balance!
EXPANDED ACCOUNTING EQUATION WORKINGS + NOTES

BMAN10621(A): Fundamentals of Financial Reporting

Workshops
2013-14

Note for Transaction 5: The closing inventories should be valued at the lower value
between their cost and their net realisable value. The net realisable value for one box
of inventories is 2,000, which is lower compared to its cost of 4,300. Therefore,
closing inventories should be written down by 2,300 (4,300 - 2,000). Thus,
closing inventories should be valued at: 37,500 - 2,300 = 35,200.
We can use the closing inventory value to compute the cost of inventories that were
sold during the year, i.e. the cost of goods sold or cost of sales.
Cost of Sales = Opening Inventories + Inventory Purchases Closing Inventories
Cost of Sales = 19,400 (from previous Balance Sheet) + 122,600 (from Transaction
1) 35,200
Cost of Sales = 106,800
Note for Transaction 6: From the previous Balance Sheet, we know that Valencia
owed 3,600 for wages at the end of the previous accounting year. During the current
accounting period it paid 35,500 for wages. Part of the money paid for wages during
the current period was spent to repay wages owed from the previous period.
Therefore, the money paid that relates only to wages incurred in the current
accounting period is equal to: 35,500 - 3,600 = 31,900. We also know that at the
end of the current period, Valencia still owes 2,200 for wages. Therefore, the wage
expense for the current accounting period is equal to the money paid for current
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BMAN10621(A): Fundamentals of Financial Reporting

Workshops
2013-14
period wages plus the money still owed for wages incurred in the current period, i.e.
31,900 + 2,200 = 34,100.
Note for Transaction 7: The annual depreciation expense when using the straight line
method of depreciation is computed as: (asset purchase cost residual value) / useful
life = (82,600 0) / 5 years = 16,520.

BMAN10621(A): Fundamentals of Financial Reporting

Workshops
2013-14

Part a.
Valencias Income Statement
Valencia
Income Statement for the year ended 31 January 2011

132,400

Sales revenue
Cost of sales

(106,800)

Gross profit

25,600

Transactions
3
5

Operating Expenses
Wages

(34,100)

Motor vehicle depreciation

(16,520)

6
(50,620)

Operating profit (loss)

(25,020)

Profit (loss) for the year

(25,020)

The column with transaction numbers is not required it is for information only.

BMAN10621(A): Fundamentals of Financial Reporting

Workshops
2013-14

Valencias Balance Sheet

Valencia
Balance Sheet (Statement of Financial Position) as at 31 January 2011

Non-current assets
Motor vehicles
Less: Accumulated depreciation
[30,000+16,520]

82,600
(46,520)

Current assets
Inventories
[19,400+122,600-106,800]
Trade receivables
[32,700+126,200-120,200]

7
36,080

35,200
38,700

Total Assets

Transactions

1&5
73,900

2&3

109,980

Equity
Original
Retained profit
[32,300-25,020]

42,000
7,280

Liabilities
Current Liabilities
Bank overdraft1
[1,400+6,200+120,200-114,500-35,500]
Trade payables
[28,200+122,600-114,500]
Accruals (wages)
[3,600-3600+2,200]

Income
statement

22,200

2, 3, 4, 6

36,300

1&4

2,200

Total Equity and Liabilities

49,280

60,700

109,980

The column with transaction numbers is not required it is for information only.

Note that when the closing cash balance is negative, it is presented as a current liability called Bank
overdraft. This is a short-term loan that the business has taken from the bank in the form of an
overdraft.

BMAN10621(A): Fundamentals of Financial Reporting

Workshops
2013-14

Part b.
The following are suggestions and outline explanations.

Transaction 1 (buying inventories on credit) recognise purchase (even

though cash is paid later)

Transaction 2 (credit sales) recognise sale (even though cash is received

later)

Transactions 5 (cost of sales) match the expense made for purchase of

goods that were sold during the year with revenue received from the sale of
those goods.

Transaction 6 (wages expense) match the wages expense incurred during

the 12 month period with the revenues they helped generated during the same
period, even though not all wages have been paid for yet (matching principle).
For that purpose, the business creates an accrual (liability) in the Balance
sheet.

Transaction 7 (depreciation expense) when we buy a non-current asset we

do not record an immediate expense, but instead we record the purchase of an
asset. Then, gradually each year we record an expense called depreciation for
using up the asset during the year to help the business generate revenues
during the same period (matching principle). In other words, we match the
gradual usage of the asset with the revenues it helps generate in each period.

BMAN10621(A): Fundamentals of Financial Reporting

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2013-14

More Detailed Explanations on each Transaction and how to use this

information to prepare the Income Statement and Balance Sheet
Transaction 1
This is a simple straightforward transaction. The business purchased inventories on
credit. This leads to an increase in inventories (asset) of 122,600 and an increase in
trade payables (liabilities) by the same amount.
Assets

+Expenses

+122,600
(inventories)

= (opening)
Equity
0

+ Revenues

+ Liabilities

+122,600
(trade
payables)

Notice, that when the business buys inventories it DOES NOT incur an expense. On
the contrary, it buys an asset. An expense will be recorded once these inventories are
sold by the business in the form of cost of sales, as the matching principle dictates.
Transaction 2
This is another straightforward transaction. By cash sales, we mean sales for which
customers paid for the goods immediately by cash. This means that all remaining
sales (132,400 - 6,200 = 126,200) were made on credit, i.e. to credit customers
who have not paid for the goods yet, but will pay for them in the future. Remember
that all revenues should be recorded, whether or not the cash has been received for the
sale.
The effect of cash sales of 6,200 is to increase revenues by 6,200 and to increase
cash (assets) by the same amount.
The effect of sales on credit of 126,200 (i.e. 132,400 - 6,200) is to increase
revenues by 126,200 and to increase trade receivables (assets), as the customers owe
Valencia money.

Assets

+Expenses

+126,200
(trade
receivables)
+6,200 (cash)

= (opening)
Equity
0

+ Revenues

+ Liabilities

+132,400
(sales)

BMAN10621(A): Fundamentals of Financial Reporting

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2013-14

Transaction 3
Credit customers are customers who owe Valencia money from sales made to them by
Valencia in the past. The amounts owed to Valencia by credit customers are shown as
trade receivables in Valencias accounts. This transaction will increase cash (assets)
by 120,200, and reduce trade receivables (assets) by the same amount, as these
amounts are no longer owed to Valencia but have been received.
Assets

+Expenses

-120,200
(trade
receivables)
+120,200
(cash)

= (opening)
Equity
0

+ Revenues

+ Liabilities

Transaction 4
On the opening balance sheet, there were trade payables of 28,200. Further goods
have been purchased on credit during the year (transaction 1), so transaction 4 is
dealing with payments that have been made to the credit suppliers. These will reduce
cash and reduce the trade payables liability.
Assets

+Expenses

-114,500
(cash)

= (opening)
Equity
0

+ Revenues

+ Liabilities

-114,500
(trade
payables)

Transaction 5
We have shown the inventory purchases in transaction 1. However, the cost of sales
must be calculated to match against the revenues for sale of goods during the year.
Cost of sales = opening inventories + purchases closing inventories
The information given in transaction 5 is about the value of closing inventories. These
should be shown at the lower of cost and net realisable value. However, the net
realisable value of the damaged box of inventory is only 2,000, compared with the
cost of 4,300. It does not matter that the inventory has not been sold before the year
end the estimated net realisable value is used.

BMAN10621(A): Fundamentals of Financial Reporting

Workshops
2013-14
This means that there is a reduction of 2,300 in the value of closing inventory, so
instead of the initial 37,500, it should be valued at 35,200.
Having calculated the closing inventory, we now have all the information we need in
order to compute the Cost of Sales.
Cost of sales = opening inventory 19,400 + purchases 122,600 closing inventory
35,200 = 106,800
Assets

+Expenses

-106,800
(inventories)

+106,800
(cost of sales)

= (opening)
Equity
0

+ Revenues

+ Liabilities

Transaction 6
On the opening balance sheet, there was an accrual for wages of 3,600. This
represented wages which had not been paid by Valencia at last years end date (31
January 2010). The amount of wages paid during the year to 31 January 2011 will
therefore include this amount, and it should be removed from the accruals on the
balance sheet, as it is no longer unpaid by 31 January 2011.
Wages have been earned by Valencias employees in the year to 31 January 2011,
most of which have been paid. However, in transaction 6, wages of 2,200 have been
earned relating to the year ended 31 January 2011, but have not been paid by Valencia
at 31 January 2011. The full wages expense for the year should be included in the
income statement, and the unpaid wages will need to be included as an accrual
(current liability) on the balance sheet as at 31 January 2011.
The wages expense can be worked out as a balancing figure required to make the
balance sheet equation balance.
Wages expense = cash paid opening accrual + closing accrual
Wages expense = 35,500-3,600+2,200 = 34,100
Assets

+Expenses

-35,500 (cash)

+34,100
(wages
expense)

= (opening)
Equity
0

+ Revenues

+ Liabilities

-3,600
(accrual)
+2,200
(accrual)

BMAN10621(A): Fundamentals of Financial Reporting

Workshops
2013-14

Transaction 7
The depreciation expense must first be calculated for the year, using the straight line
depreciation formula, with zero residual value and a useful life of 5 years.
Annual depreciation expense = cost residual value
useful life (years)
= 82,600 - 0
5
= 16,520
The depreciation expense needs to be shown as an expense in the income statement,
but it will also increase the accumulated depreciation which reduces the assets
carrying values in the balance sheet.
Assets

+Expenses

-16,520
(accumulated
depreciation)

+16,520
(depreciation
expense)

= (opening)
Equity
0

+ Revenues

+ Liabilities

Preparing the Income Statement and Balance Sheet using the above information
Its usually best to start with the Income Statement, as the profit for the year from the
income statement will be needed to complete the equity section of the Balance Sheet.
The relevant columns from the accounting equation for preparing the Income
Statement are Revenues and Expenses. For the Balance Sheet, the relevant
columns for preparing it are Assets, Liabilities and Equity (including the profit/loss
figure from the income statement).
You need to follow the appropriate format/layout when presenting your Income
Statement and Balance Sheet. Marks are also given for the title and format/layout of
the financial statements, so make sure you pay attention to these aspects as well.

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