Accounting Book Very Essential

BQOE III
FUNDAMENTALS
OF ACCOUNTING
AND FINANCE
Noor Asma Jamaludin
Nor Asma Lode
Junaidah Hanim Ahmad
Azlan Zainol Abidin
Amin Ali
Norazita Marina Abd. Aziz
Project Directors: Prof. Dr. Mansor Fadzil
Prof. Dr. Shaari Abd. Hamid
Open University Malaysia
Module Writers: Noor Asma Jamaludin

Nor Asma Lode
Junaidah Hanim Ahmad
Azlan Zainol Abidin
Amin Ali
Norazita Marina Abd. Aziz
Universiti Utara Malaysia
Moderators: Assoc Prof. Dr. Arfah Salleh

Assoc. Prof. Hashanah Ismail
Universiti Putra Malaysia
Azlina Abdul Aziz

Loo Sze Wei
Rosila Abu Zarin
Translated & Edited: Pearson (M) Sdn. Bhd.
Compiled by: Lilian Kek Siew Yick

Desktop Publishing: Centre for Instructional Design and Technology

Printed by: Meteor Doc. Sdn. Bhd.

Lot 47-48, Jalan SR 1/9, Seksyen 9,
Jalan Serdang Raya, Taman Serdang Raya,
43300 Seri Kembangan, Selangor Darul Ehsan
First Printing, January 2009

Copyright @ Open University Malaysia (OUM), BQOE III
All rights reserved. No part of this work may be reproduced in any form or by any means
without the written permission of the President, Open University Malaysia (OUM).
Version January 2009

Table of Contents
Course Guide ix-xi
Topic 1 Accounting Environment 1

1.1 Introduction to Accounting 2
1.1.1 Definition of Accounting 2
1.1.2 Users of Accounting Information 2
1.1.3 Branches of Accounting 3
1.1.4 Professional Accounting Bodies in Malaysia 4
1.2 Fundamental Accounting Concepts 6
1.2.1 Qualitative Characteristics of
Accounting Information 6
1.2.2 Accounting Assumptions 10
1.2.3 Basic Principles of Accounting 13
1.2.4 Accounting Constraints 16
1.3 Accounting Equation 17
1.3.1 Analysis of Transaction 17
1.3.2 Summary of Analysis 22
1.4 Types and Objectives of Financial Statements 24
1.4.1 Income Statement 25
1.4.2 Statement of Changes in Owner's Equity 25
1.4.3 Balance Sheet 26
1.4.4 Cash Flow Statement 27
Summary 33
Topic 2 Recording Process 34

2.1 Chart of Accounts 35
2.2 Format of Account 37
2.3 Rules of Debit and Credit 38
2.3.1 Normal Balance 39
2.4 Steps in Recording Process 41
2.4.1 Journal 41
2.4.2 Journalising and Posting of Entry 42
2.4.3 Example of Analysis and Summary Transactions 49
2.4.4 Trial Balance 73
Summary 77
Tutorial Question 78
iv w TABLE OF CONTENTS
Topic 3 Financial Statements 79

3.1 Annual Report and Users of Financial Statements 80
3.2 Income Statement 82
3.3 Balance Sheet 85
3.3.1 Assets 87
3.3.2 Liabilities 88
3.3.3 OwnersÊ Equity or ShareholderÊs Equity 89
3.3.4 Summary of Basic Accounting 90
3.4 Statement of Retained Earnings 94
3.5 Cash Flow Statement 94
3.5.1 Preparing Cash Flow Statement 95
3.5.2 Differentiating Cash Resources and Usage 98
Summary 104
Topic 4 Financial Statement Analysis 105

4.1 Financial Ratio Analysis 106
4.1.1 Income Statement 108
4.1.2 Balance Sheet 108
4.2 Liquidity Ratio 110
4.2.1 Net Working Capital 110
4.2.2 Current Ratio 111
4.2.3 Quick Ratio 112
4.3 Asset Management Ratio 113
4.3.1 Account Receivable Turnover 114
4.3.2 Average Collection Period 115
4.3.3 Inventory Turnover 116
4.3.4 Average Inventory Sales Period 117
4.3.5 Fixed Asset Turnover 118
4.3.6 Total Asset Turnover 118
4.4 Leverage Ratio 120
4.4.1 Debt Ratio 121
4.4.2 Debt-Equity Ratio 121
4.4.3 Equity Multiplier 122
4.4.4 Interest Coverage Ratio 123
4.5 Profitability Ratio 124
4.5.1 Gross Profit Margin 125
4.5.2 Net Profit Margin 126
4.5.3 Operating Profit Margin 126
4.5.4 Return on Asset 127
4.5.5 Return on Equity 127
4.5.6 Earnings Per Share 128
TABLE OF CONTENTS v v
4.6 Market Value Ratio 128

4.6.1 Price Earnings Ratio 129
4.6.2 Dividend Yield Ratio 130
4.7 Conducting A Complete Ratio Analysis 132
4.7.1 DuPont Analysis 132
4.7.2 Summarising All Financial Ratios 134
4.8 Weakness in Financial Ratio 136
Summary 141
Topic 5 Time Value of Money 144

5.1 Concept of Compounding and Future Value 145
5.1.1 Time Line 145
5.1.2 Compounding Interest 146
5.1.3 Calculation of Future Value Using Schedule 148
5.1.4 Graphical Illustration of Future Value 149
5.2 Concept of Discounting and Present Value 151
5.2.1 Calculation of Present Value 152
5.2.2 Calculation of Present Value (Principal)
Using Schedule 154
5.2.3 Graphical Illustration of Present Value 156
5.3 Single Cash Flow Money Value 157
5.4 Series Cash Flow Money Value 158
5.4.1 Annuity 158
5.4.2 Derivation Cash Flow 166
5.4.3 Perpetuity 170
5.5 Compounding and Discounting More Than
Once a Year 172
5.6 Continuous Compounding and Discounting 173
Summary 176
Answers 178
COURSE GUIDE
INTRODUCTION
Fundamentals of Accounting and Finance is a preparatory course for open entry
learners who intend to pursue postgraduate programmes in Masters in
Management (MM) and Masters of Business Administration (MBA).
This course provides learners with fundamental knowledge in the area of

accounting and finance.
COURSE OBJECTIVES
This course integrates the fundamental concepts of Financial Accounting and
Financial Management.
The first section of this course handles the introduction to the fundamental
accounting concepts. This section will also elaborate on the process of preparing
accounting information starting from the journal entries to the preparation of
financial statement or report. Students will then be taught on how to evaluate,
use and apply the financial information provided. At the end of this course, you
should be able to:
1. understand the fundamental concepts of accounting;
2. describe the meaning of accounting information, its role as well as its
importance;
3. elaborate the process of preparing accounting information from beginning
until the completion of the accounting cycle;
4. discuss the functions and information contained in financial statements;
5. analyse the financial performance of a company using financial ratio
analysis; and
6. apply the concept of the time value of money in computing cash flows.
COURSE SYNOPSIS
Topic 1 discusses the Accounting Environment. It introduces you to accounting
fundamentals, involving the definition of accounting, users of accounting
information, branches of accounting, professional accounting bodies in Malaysia
as well as the fundamental concepts found in accounting. Also discussed are the
accounting assumptions and the four main types of financial statements in
financial reporting, namely Income Statement, Statement of Changes in Equity,
Balance Sheet and Cash Flow Statement.
x w COURSE GUIDE
Topic 2 discusses the Recording Process. It revolves around the usage of accounts
as well as the rules of debit and credit for each type of accounts (asset, liability
and owner equity accounts). The rule of debit and credit will also include the
normal balance for each type of accounts.
This topic also tracks the steps taken in the recording process, which include the
journal entry, transfer of entries to ledger and consequently the preparation of
balance sheet. A complete example of the whole process is included to provide
better understanding.
Topic 3 discusses on the different types of financial statements used in business

such as the income statement, balance sheet, statement of retained earnings and
cash flow statement. You will get to understand the functions well as the
information contained in the financial statements.
Topic 4 discusses the usage of financial ratio analysis such as the liquidity ratio,
asset management, leverage, profitability, and market value ratio. Besides that,
this topic also discuss on the DuPont analysis and the overall financial analysis.
Topic 5 exposes students to the basic concept for time value of money, which is
the concept of present value and future value. You will learn the application and
formula for the time value of money for single cash flow and net cash flow,
annuity, perpetuity and derivation cash flow. The discussion will also include
compounding and discounting methods that occurs more than once a year and
compounding and discounting that occurs continuously.
REFERENCES
Emery, D.R., et. al. (1997). Principles of Financial Management. (1st ed.). Prentice
Hall.
Gitman, L.J. (2005). Principles of Managerial Finance, (11th ed.). Addison Wesley.
Horngren C. T., Harrison W. T. Jr. and Bamber L. S. (2002), Accounting (5th ed.),
Prentice Hall, New Jersey.
Larson Kermit D., Wild John J., Chiappetta Barbara, (2004) Fundamentals
Accounting Principles, (17th ed.), McGraw Hill.
Lasher, W.R. (2005). Practical Financial Management, (4th ed.). South-Western

Thomson Learning.
Roger, H.H et al. (1997), Accounting: A Business Perspective, (7th ed.), Irwin US.
COURSE GUIDE v xi
Scott, D.F. Jr., et. al. (1998). Basic Financial Management (8th ed.). Prentice Hall.
Warren C.S., Reeve J. M. and Fess P. E. (2004), Accounting (21st ed.),

International Thompson Publishing, Ohio, USA.
Warren et. Al (2001), Accounting: Customized by School Of Accountancy UUM

for Business Accounting Students, Thompson Learning.
Weygandt Jerry J., Keiso Donald E., Kimmel Paul D., (2004) Accounting
Principles, (7th ed.), John Wiley & Sons, Inc.
EVALUATION
Refer to the CAPL website at http://capl.oum.edu.my for the evaluation method
for this course.
Topic 1w Accounting
Environment
LEARNING OUTCOMES
At the end of this topic, you should be able to:
1. explain the meaning, role and importance of accounting;
2. state the users and branches of accounting;
3. describe the main functions of professional accounting bodies in
Malaysia;
4. describe the qualitative characteristics of financial information,
assumptions, principles and constraints in accounting;
5. explain the accounting equation;
6. analyse transactions based on the accounting equation; and
7. list 4 main financial statements in financial reporting.
w INTRODUCTION
Accounting plays an important role in our daily lives without us realising it.
Accounting is a financial information system that helps us make better economic
decisions.
We might assume that accounting is only important to businessmen or

accountants. In fact, we also need accounting in our daily lives. We need financial
information to make economic decisions. For example, when making a decision
on buying a new car, we need to know the total net revenue in a month (gross
revenues minus all expenses) to know whether we can afford to buy the car. We
also need to estimate other costs that might be involved in having a car.
2 w TOPIC 1 ACCOUNTING ENVIRONMENT
The above example is only a decision at an individual level. For a business entity,
it might need to make a decision on whether to buy a new building or just rent it
for operational purposes. Even though it is a higher level decision, the decision-
maker still requires the necessary financial information.
In this topic, you will be introduced to the basics of accounting. Among them are
the definition and branches of accounting, users of accounting information,
professional accounting bodies in Malaysia as well as the fundamental concepts
in accounting.
1.1 INTRODUCTION TO ACCOUNTING
You often heard the word ‘accounts’ in your daily lives. However, have
you ever thought about the meaning of accounts or accounting? What do
you understand about accounting?
1.1.1 Definition of Accounting

Accounting is an information system that prepares reports on the economic
activities of an entity for users to help them make better decisions. More
accurately, accounting is:
A process to identify, measure, record and present the economic information

of an entity to the users in order to help them make evaluations or economic
decisions.
Economic information are information related to economic activities; whereas an

entity refers to a business unit.
1.1.2 Users of Accounting Information

Users of accounting information are parties that use the accounting information
for specific purposes. The information required by the users might differ between
one group and another. Users of accounting information can be divided into two
groups - internal users and external users.
Internal users are parties that have direct access to the resources of an entity and
usually involved in the management of the entity, for example the management
TOPIC 1 ACCOUNTING ENVIRONMENT v 3
of the company. Meanwhile, external users would be the parties who do not have
direct access to the resources of the company and do not involved in the
management of the company. The other differences between these two groups
are summarised in Table 1.1.
Table 1.1: Differences between Internal Users and External Users
Internal Users External Users

Types of Information that can help them Information required are different
information make planning and exercise depending on the type of decisions
required control over the entity. made.
Example:
Investor:
Require information on the
profitability of the company before
making decision to invest.
Loan providers:
Require information on the
stability and liquidity of the
company before making decision
on giving out credit.
How does the Using the status or position in Limited to what is made available
information the company. by the company.
been obtained Example
Annual report published by the
company.
1.1.3 Branches of Accounting

Accounting is divided into several different branches or other specialised fields.
Among them are:
(i) Financial Accounting;
(ii) Management Accounting;
(iii) Taxation; and
(iv) Auditing.
These branches are not static as they evolving in time and requirement. This
financial accounting course will combine two of the most basic and important
accounting branches; that are financial accounting and management accounting.
Therefore, it is important for you to know some of the differences between these
two branches, as shown in Figure 1.2.
Table 1.2: Differences between Financial Accounting and Management Accounting
Financial Accounting Management Accounting

Preparation of Preparation of financial reports Preparation of financial and
report of an entity for external and non-financial information that
internal users but focus is given are required by parties in the
to the external users. company for planning,
evaluating and controlling
purposes of the operations of
an entity.
Standard or Financial reports produced are Report is produced at any time
Format periodically and in accordance based on requirement and is
to specified standard or format. not subject to any standard or
format.
1.1.4 Professional Accounting Bodies in Malaysia

We also need to familiarise ourselves with the organisations that are involved in
the accounting profession in Malaysia. The organisations are:
(a) Malaysian Institute of Accountants (MIA)

MIA was established under the Accountants Act 1967 as the main
accounting body in the country. Overall, it functions as the core body in
regulating the accounting profession. Other major functions of MIA as
discussed in the Accountants Act 1967 are:
(i) to set the required qualification in order to become a member;
(ii) to provide training and education for practitioners or those who are
interested in becoming accounting practitioners;
(iii) to control the accounting practices in Malaysia; and
(iv) to protect the accounting interest in Malaysia.
(b) The Malaysian Institute of Certified Public Accountants (MICPA)

MICPA, formally known as „The Malayan Association of Certified Public
Accountants‰, was established in 1958 under the Companies Ordinances.
On 6 July 1964, the name was changed to „The Malaysian Association of
Certified Public Accountants‰ to reflect the change of name from Malaya to
Malaysia. Since February 2002, it is known as „The Malaysian Institute of
Certified Public Accountants‰. Among the main objectives and functions of
MICPA are:
(i) to advance the accounting theories and practices in all aspects;

(ii) to train and evaluate the competent members;
(iii) to ensure the independence of professional accountants; and
(iv) to oversee the practices and professional conducts of its members.
(c) Malaysian Accounting Standards Board (MASB)

MASB was established under the Financial Reporting Act 1997. Among the
main functions of MASB are:
(i) to set and approve new accounting standards;
(ii) to revise or accept the usage of existing standards as approved
accounting standards; and
(iii) to develop the conceptual accounting framework.
(d) Financial Reporting Foundation (FRF)

FRF was established under the Financial Reporting Act 1997 together with
MASB. Among the main functions of FRF are:
(i) to provide opinion to MASB on matters to be implemented;
(ii) to evaluate the performance of MASB; and
(iii) to be responsible for the overall funding of the operation of MASB,
including to approve its budget.
EXERCISE 1.1
1. Provide examples of common decisions made by both internal and
external users.
2. How does Financial Accounting and Management Accounting assist
users in making decision?
1.2 FUNDAMENTAL ACCOUNTING CONCEPTS
What are the important qualitative characteristics of accounting

information?
1.2.1 Qualitative Characteristics of Accounting

Information
In this section, you will be exposed to the qualitative characteristics of accounting
information. Qualitative characteristics of accounting information refer to the
characteristics that must be present in the accounting information to make it
useful. These characteristics are divided into two categories; primary and
secondary qualities.
The primary qualities of accounting information are relevant and reliability,

while the secondary qualities are comparability and consistency. In summary,
accounting information is only useful if it has relevant, reliability, comparability
and consistency qualities.
Figure 1.1 shows the summary for qualitative characteristics of accounting

information.
Figure 1.1: Qualitative characteristics of accounting information
(a) Relevant
In everyday terms, we might describe relevant as important or being
related. In accounting, relevant is described as something that makes a
difference in arriving at a decision. In other words, something is said to be

relevant if it influences or affects the decision being made.
The extent to which information is considered relevant depends on its

importance in decision making and may differ between one decision maker
to another. Information that is relevant to you might not be relevant to
another person and vice versa.
For example, suppose you are an investor and you intend to buy shares of a
public listed company. What kind of information might be relevant to your
needs? You might want to know the profitability and performance of the
said company for the past five years, including new projects or products for
the company that will be profitable in the future. This information is
relevant as it will influence your decision. Suppose the information that you
obtained showed that the company is experiencing continuous losses for the
past five years and it does not have any new projects. Will you still proceed
with the proposal to invest in the company? Probably not.
Figure 1.2 shows an example of performance information of a company in

order to assist investors in decision making.
Figure 1.2: Performance information of a company to assist investor in decision making.
After knowing the meaning of relevant, you must also know how certain
information are said to be relevant. To become relevant, the information
must have three characteristics, namely feedback value, forecast value and
timeliness.
(i) Feedback Value

Relevant information must be able to assist users in substantiating or
correcting early expectations matters at hand.
(ii) Forecast Value
Relevant information must be able to assist users in forecasting.
(iii) Timeliness
Relevant information must be obtained before it becomes obsolete or
unusable.
(b) Reliability
Reliability means that users can rely or depend on the said information to
make good decisions. This characteristic is important because users might
not have the time or expertise to evaluate some information. Generally,
users simply depend on the information presented by the related entity and
assume it to be true. This information is then used in decision making.
Reliability does not mean that the said information must be precise. This is
because in accounting there are a lot of information that involves estimation
and approximation that might not be precise. What is important is that the
estimation and approximation made must be reliable.
Reliable information must have the following characteristics:

(i) Verifiable
This means that the accounting information could be verified
objectively by another person using the same method.
(ii) Objective
Objective in this case means that the information is not biased.
Information contained in the financial statements must be able to fulfil
the requirements of various users and not concentrating on certain
groups only.
(iii) Trustworthy
Information presented is based on the actual result of economic
activities using specified methods.
(c) Comparability
Comparability means that the information can be compared whether among
companies, industries or different periods. This will enable users to identify
the similarities or differences that might exist in the said information. This
characteristic is important because information that can be compared is
more useful.
This example might help you to understand comparability. Let us assume

that you were told that the net profit of a business in the year 2000 was RM5
million. Is this information useful? This information would only be
meaningful if you can compare it with the net profit of the business in the
year 1999 or the net profit of other businesses in the same industry as
shown in Figure 1.3. Thus, financial statements contained in the Annual
Report also include information on the previous year in addition to the
current year for comparison purposes.
Figure 1.3: Profitability comparison
(d) Consistency
Consistency means that an entity must use the same accounting procedures
in every period. It is for the purpose of enabling comparison to be made
more effectively. In other words, a company cannot change their accounting
procedure every year. This does not mean that the company cannot change
the accounting procedure at all. Changes can still be made, but the company
must make complete disclosure in the financial statement to explain to the
users why they are making the changes and the effect of the changes
towards the financial statements.
In your opinion, what will happen to a business entity if it only presents

the qualitative characteristics of main accounting information in its annual
report?
EXERCISE 1.2
1. State the qualitative characteristics of accounting information.
2. Explain the meaning of comparability provide an example to show
its role in making accounting information useful.
1.2.2 Accounting Assumptions

In this section you will be exposed to accounting assumptions. There are four
accounting assumptions, created to aid the reporting entity and the users, which
are generally accepted. They are:
(a) Assumption of Separate Entity

For the purpose of accounting, an entity is assumed to be separate from its
owner and also other entities. An accounting entity is an economic entity in
its own right which controls resources involving economic activities. All
activities relating to the accounting entity must be separated from the
ownerÊs activities or other accounting entitiesÊ activities. The examples
below should explain this concept clearly.
Example 1:
Assume that you own a business, your personal economic activities must be
kept separate from the businessÊ economic activities. If you wish to buy
products for personal use, you cannot take the businessÊ money and assume
that as part of the business activities. Instead, you must record it as
drawings. The Drawings Account shows the money or products from the
business taken by the owner for personal use.
Example 2:
Supposing you have just set up a business which offers computer repair
services. As it is a small business and you are the sole proprietor, the
businessÊ cash is deposited into your private account. Assume that on 31
December 2003, the bank balance of your account is RM5,000. Based on
your record, RM1,000 is the money from your business and the balance of
RM4,000 is funds for your studies.
If you did not comply with the assumption of separate entity and assume
RM5,000 is the money from your business, you might make an inaccurate
business decision. You might feel that your business has adequate funds
while in fact only RM1,000 is the businessÊ cash. Although all the money
belongs to you, from the accounting perspective, RM1,000 is for the
business funds and the balance of RM4,000 is the money for your education
purposes.
Segregation would enable you to evaluate the financial status of the

business much better and to make accurate decisions to enhance the
performance of the business. If an owner has more than one business entity,
each entity must be assumed as separate entity from the others. Please refer
to the example below.
Assuming that Mr. Ali owns three different businesses, all three are
considered to be separate from accounting perspective. Accounting records
must be maintained separately; assets and liabilities for each business
cannot be mixed together. Segregation would enable the owner to know the
performance for each business.
As a simple example, suppose that Mr. AliÊs businesses show the following
result on 31 December 2003:
Business Transaction (RM)

Business 1 Profit 6,000
Business 2 Loss 8,000
Business 3 Profit 12,000
If the assumption of separate entity is not complied with and all the entities
are assumed as one, Mr. Ali will have an overall business profit of
RM10,000 [RM6,000 + (-8,000) + RM12,000]. Based on this result, Mr. Ali
might be satisfied and might not take any measures for improvement.
However, by preparing separate accounts, Mr. Ali will know that Business 2
is facing problems as it is suffering a loss of RM8,000, while Business 3 is
performing very well with a profit of RM12,000.
(b) Assumption of Going Concern

According to this assumption, an entity is assumed to continue to exist and
in operation in the future. This assumption is important because it enables
the principle of historical cost to be applied. According to the historical cost
principle, all assets and liabilities must be recorded at the purchase price
(original cost). For most assets, this cost would be depreciated throughout
the life span of the assets to depict its usage. However, asset of property
would not be depreciated as its value would always appreciate.
As an example, a machine with a life span of 25 years will be depreciated

for 25 years based on the assumption of going concern. With this
assumption, the entity would continue to exist for a period of more than 25
years. If we assume that the entity would exist only for another 10 years in
absence of this assumption, we obviously cannot use 25 years as the basis
for calculating the depreciation.
The assumption also enables users to make decisions without any doubt or
worries. Suppose you are interested to invest in a company that has
consistently achieved high profits in the past few years. However, you were
informed that the company would exist only for another five years. Would
you still continue with your plan to invest in the said company? Generally,
we will only invest when we believe the company will continue to exist in
the future.
(c) Assumption of Monetary Unit

According to this assumption, all economic activities are measured and
valued in currency unit. In Malaysia, the currency unit used is Malaysian
Ringgit (RM). Only transactions that can be stated in currency unit will be
recorded for accounting purposes. Currency unit enables the transactions to
be summarised, reported and compared. Before the existence of currency,
transactions were conducted by way of exchanging goods (barter system).
The non-existence of currency unit had created difficulties in ascertaining
the value of transactions. With a countryÊs standard currency unit, we
would be able to value every product.
However, this assumption has two weaknesses, that are:

(i) It restricts the scope of accounting. Only transactions that can be
measured in monetary terms will be taken into account, neglecting
other factors that have impact on the business.
(ii) It assumes that the value of currency is constantly stable, whereas we
know that the currency value is always changing.
(d) Assumption of Accounting Period

In the assumption of going concern, we assumed that the entity will
continue to operate for an unlimited period. However, users (whether
manager, shareholders, loan providers or other parties) require periodical
measurements to help them making decisions. With this assumption, the
lifetime of the entity is divided into a certain period for the purpose of
reporting its economic activities. Normally the period selected is one year.
Financial reports must be produced every accounting year.
The selected accounting period can start from 1 January and ends on 31
December, or starts from 1 July and ends on 30 June the following year, and
so on depending on the operation of the company. For example, if an entity
is established on 1 March, it might choose an accounting period that starts
from 1 March and ends on 28 February of the following year. This
accounting period can be changed if the entity feels that there is a need to
do so.
Figure 1.4 shows examples of accounting period.
Starting Date Ending Date

1 January 2001 30 December 2001
1 July 2002 30 June 2003
1 March 2002 28 February 2003
Figure 1.4: Examples of accounting period
There are also companies which produce reports within a period of less than a
year, for example monthly, quarterly or half yearly. These reports are known as
interim reports. Interim report is normally produced to fulfil the requirement of
users that might need a more up-to-date report.
There is a company that has obtained high profits consistently for the
past 5 years and would exist for a period of another 10 years. Would you
invest in the company? Explain your decision.
1.2.3 Basic Principles of Accounting
The word income is used daily especially in relation to business.

However, do you know what is meant by income?
After understanding the qualitative characteristics of information and accounting

assumptions, you will be exposed to the basic principles of accounting, which are
the principles used in the process to identify, measure, evaluate and report
financial information. There are four basic principles that you must know:
(a) Principle of Historical Cost

According to this principle, all business resources will be recorded based on
historical cost, which is the original cost at time of purchase. Although the
value of the resources might change in the future, no adjustment will be
made to recognise the changes in the value.
For example, you want to buy a piece of land for your business site. The
seller set the price at RM80,000. You do not agree with the price and ask the
seller to sell it RM70,000. After negotiation, the seller agreed with the price
of RM72,000. In this case, the land would be recorded at the value of
RM72,000 in your financial statement. Five years later, you wish to revalue
the land. The assessor informed you that the value of the land had
appreciated to RM120,000. Although there is a high appreciation in value,
you must still record it at the value of RM72,000, which is the original cost
of the land during the purchase.
The principle of historical cost is justified by its high reliability. The value
recorded in the financial statement is based on the original cost at the time
of purchase supported by documentation. This advantage is also a
weakness for certain parties. These parties criticised the failure of the
principle to recognise any possible changes in asset value. Regardless, this
principle is still adopted.
(b) Principle of Income Recognition

Principle of income recognition provides guidance regarding when and
how to recognise income. The three conditions that must be complied with
before income is recognised are:
? The seller had performed the necessary actions to obtain the income (for
example, providing the goods for trade or rendering services);
? The amount of income can be measured objectively; and
? The income can be collected.
Normally, income is recognised at the point of sale. The point of sale refers
to a situation whereby ownership has been transferred from the seller to the
buyer, notwithstanding whether the cash has been received or not. For an
entity that offers services, the point of sale is when the service has been
provided to the customer.
However, in certain cases, the point of sale method is inappropriate. There

are several different methods that can be used, for instance the percentage
of completion and cash basis methods.
(i) Percentage of Completion Method is normally used by companies
involved in the construction industry which takes a long time to
complete. For example, a housing project might take three years to
complete. It would be inappropriate to recognise the revenue only
after the project is completed. This is because revenue and expenses
accrued throughout the duration of the project that could be
determined periodically based on the degree of completion. This
method is more appropriate because it complies with the accounting
period principle and provides a true picture of the project

development.
(ii) Cash Basis Method complies with the basis of cash accounting.
According to this method, revenue is only recognised when cash is
received. This method is applied in credit transactions when cash
receipts are not assured.
(c) Principle of Matching

This principle matches the expense (effort) with the revenue (benefit
obtained from the effort). The matching of the revenue with the expense
will be done when the transaction has completed. To comply with this
principle, two steps will be involved, which are:
(i) First Step
Recognition of the revenue for a specific period.
(ii) Second Step
Recognition of all the expenses involved in ascertaining the revenue.
For example, when we provide services to customers, we will recognise the

revenue according to the principle of income recognition. Then, we will
recognise all the expenses involved in generating the revenue and match
them with the revenue. The difference between the revenue and the expense
will be either profit or loss. If revenue is more than expense, the difference
will be net profit. However, if the revenue is less than expenses, the
difference will be recognised as net loss. Figure 1.5 summarises the concept
of profit and loss.
Figure 1.5: The relationship between revenue and expense
(d) Principle of Full Disclosure

The principle stresses for the full disclosure of all relevant information and
material in the financial statement whether in the statement itself or in the
notes to the accounts. This is to ensure that the users can make proper
decisions. The disclosure of financial statements will be explained in detail
in Unit 2.
ACTIVITY 1.3
1. Explain the weaknesses exist in the assumption of monetary unit.

2. Describe THREE conditions that must be fulfilled before revenue can
be recognised.
1.2.4 Accounting Constraints

We have seen the principles that must be complied with in accounting. However,
there are constraints or obstructions that might result in these principles not
being complied with. The main constraints in accounting are:
(a) Cost-Benefit Relationship

Before deciding on obtaining specific information, a company would
normally analyse the cost involved and the benefit that may be gained from
the information. If the cost of obtaining the information is very high but the
benefit generated is not so much, the company might not reveal the
information even though all information must be completely disclosed in
accordance with the principle of full disclosure.
(b) Materiality
Materiality refers to the effect of an item towards the overall operation of
the entity. An item is considered immaterial if it does not affect the decision
that will be made. Materiality is often measured based on size. A
transaction that involves a huge amount is normally treated as material. A
material transaction must be disclosed in detail, while immaterial
transactions are sometimes combined or not disclosed in detail.
For example, a small amount of expense like a purchase of stamps and fares
are combined into one account known as sundry expenses. Another
example will be the practice of approximation. You can see examples in the
annual report published by companies. Generally, companies would not
record the cents value, but instead will round the figures up to the nearest
ringgit (example: RM471.20 is recorded as RM471). For larger companies, it
might make the approximation to the nearest hundred ringgit (example:
RM525,795 is recorded as 525,800).
1.3 ACCOUNTING EQUATION
A business has assets valued at RM120,000. RM50,000 is the owner’s

capital and the balance is bank loan. What is the accounting equation?
Accounting equation is the basis of accounting that will always be used each time
we record a transaction. It consists of three components or basic elements, which
are asset, liability and ownerÊs equity.
What is meant by asset? Asset is the resources that can bring economic benefit,
owned by the entity. For example, cash, building and fittings.
For each resource, there must be a claim or rights on it. A simple example, if you
own some money, the money belongs to you. If you buy a vehicle with bank loan,
the ownership of the vehicle is claimed by the bank until you have settled your
loan. In other words, the vehicle is not owned by you (but is owned by the bank)
until you have settled your entire loan.
It is the same in business. Every asset owned by the business can be claimed
either by the owner itself, or loan providers. Rights or claims made by the loan
providers are known as liabilities, whereas the rights or claims made by the
owner itself are known as equities.
Loan providers have priority over the rights to the business assets. If the entity is
facing problems, it must first settle its loans. The owner can only claim his rights
if there are assets left. Therefore, liability is put ahead of ownerÊs equity in the
accounting equation as shown below:
Accounting Equation:
ASSET = LIABILITY + OWNERÊS EQUITY
1.3.1 Analysis of Transaction

You must always remember that the accounting equation is always equal
regardless of the transaction that has transpired. All transactions can be stated by
changes in the three components of the accounting equation. Now we will look at
a few common transactions and analyse the results on the accounting equation.
We will use the example of a sole proprietor business owned by Reen. Reen, who
is skilled in the computer field, has established her own company on 1 November
2000. For a start, the business (Reen Cyber Service) offers services in computer
consultancy. If successful, Reen intends to expand her business to selling
computers. The following is a list of transactions incurred by Reen Cyber Service
throughout the month of November 2000:
Table 1.3: List of Transactions for Reen Cyber Service, November 2000
Date
No. Transactions
(Nov)
1 1 Reen invested cash of RM30,000 into Reen Cyber Service.
2 2 Purchased a piece of land valued at RM20,000. The business
paid cash RM5,000 and the balance is financed by bank loan.
3 4 Purchased office supplies valued at RM2,700 on credit.
4 15 Received revenue from consultancy services provided to
customer. The customer paid RM15,000 cash.
5 30 Paid staff salary expense RM4,250; rental expense RM1,600;
utility expense RM900 and other expenses RM550.
6 30 Made payment for account payable of RM1,900.
7 30 Unused office supplies valued at RM1,100.
8 30 Reen withdrew money from the business amounting to
RM4,000 for her personal use.
All the transactions above are pertaining to Reen Cyber Service. The personal
transactions of the owner (Reen) will not be taken into account if it does not
involve the business. Now we have to analyse each transaction to see their effects
on the accounting equation.
Transaction 1: Reen invested cash of RM30,000 into Reen Cyber Service. Again, it
needs to be emphasised that we are only interested in transactions involving
Reen Cyber Service, and not ReenÊs personal transactions. Therefore, even though
the cash owned by Reen was reduced by RM30,000, the cash owned by Reen
Cyber Service has increased by RM30,000. This capital was contributed by Reen.
Therefore, ownerÊs equity will increase by RM30,000.
Transaction ASSET = LIABILITY + OWNERÊS EQUITY

Cash Capital, Reen
1 30,000 = 30,000
Transaction 2: The business entity purchased a piece of land valued at RM20,000,

paying RM5,000 by cash and the balance of RM15,000 being financed by bank
loan.
From this transaction, the business will have a new asset (land) valued at
RM20,000. The businessÊ cash is reduced by RM5,000 while a new liability of
RM15,000 is created. Bank loan is always represented by the account Notes
Payable (NP). Note that the equation still holds true. The asset section increased
by RM15,000 and the liability section also increased by RM15,000.
„Balance‰ shows the final balance for each item after every transaction.
Transaction ASSET = LIABILITY + OWNERÊS EQUITY

Cash + Land NP Capital, Reen
Balance 30,000 = 30,000
2 -5,000 + 20,000 = 15,000
Balance 25,000 20,000 = 15,000 30,000
Transaction 3: Purchased office supplies valued at RM2,700 on credit. The asset

will increase by RM2,700. The purchase by credit will create a new liability,
which is Account Payable (AP).
OWNERÊS
Transaction ASSET = LIABILITY +
EQUITY
Capital,
Cash + Land + Supplies NP + AP
Reen
Balance 25,000 + 20,000 = 15,000 + 30,000
3 2,700 = 2,700
Balance 25,000 20,000 2,700 = 15,000 2,700 30,000
Normally, office supplies bought are not only used in the current accounting
period. The purchase of office supplies are prepaid expenses. The usage of office
supplies for the specific period is recorded by using the account Supplies
Expenses.
Transaction 4: Received revenue from consultancy services provided to customer.

The customer paid RM15,000 cash.
OWNERÊS
EQUITY
Capital,
Reen
Balance 25,000 + 20,000 + 2,700 = 15,000 + 2,700 + 30,000
4 +15,000 = 15,000
service
revenue
Balance 40,000 20,000 2,700 = 15,000 2,700 45,000
Service revenue is one of the components in ownerÊs equity. The other

components are expenses and drawings. Revenue will increase the ownerÊs
equity while expenses and drawings will reduce it.
Figure 1.6 shows the effect of revenue, capital, expenses and drawings on ownerÊs
equity.
Revenue ↑ = Owner’s equity ↑
Capital ↑ = OwnerÊs equity ↑
Expenses ↑ = OwnerÊs equity ↓
Drawings ↑ = OwnerÊs equity ↓
Figure 1.6: Analysis of transaction
Transaction 5: Paid salary expense RM4,250; rental expense RM1,600; utility

expense RM900 and other expenses RM550.
OWNERÊS
EQUITY
Cash + Land + Supplies NP + AP Capital,
Reen
Balance 40,000 + 20,000 + 2,700 = 15,000 + 2,700 + 45,000
5 4,250 = -4,250 paid
salary
1,600 1,600 paid
rental
-900 -900
paid utility
-550 -550
paid sundry
Balance 32,700 + 20,000 + 2,700 = 15,000 + 2,700 + 37,700
In this transaction, all the expenses were paid by cash. Therefore, cash will
decrease according to the amount involved. Each expense item has to be recorded
separately and cannot be combined. As explained in transaction 4, expenses will
reduce ownerÊs equity.
Transaction 6: Made payment for account payable of RM1,900. When the business
paid RM1,900, cash will decrease by RM1,900 and liability will also decrease by
RM1,900.
OWNERÊS
EQUITY
Reen
Balance 32,700 + 20,000 + 2,700 = 15,000 + 2,700 + 37,700
6 1,900 = -1,900
Balance 30,800 + 20,000 + 2,700 = 15,000 + 800 + 37,700
Transaction 7: At the end of the month, the unused office supplies were valued at
RM1,100. The office supplies was originally bought for RM2,700. The value of
office supplies used up during the period is RM1,600 (RM2,700 < RM1,100)
OWNERÊS
EQUITY
Reen
Balance 30,800 + 20,000 + 2,700 = 15,000 + 800 + 37,700
7 -1,600 -1,600 = -1,600
Supplies
expenses
Balance 30,800 + 20,000 + 1,100 = 15,000 + 800 + 36,100
Transaction 8: Reen took RM4,000 of the businessÊ cash for personal use.
OWNERÊS
EQUITY
Reen
Balance 30,800 + 20,000 + 1,100 = 15,000 + 800 + 36,100
8 4,000 = -4,000 cash
drawings
Balance 26,800 + 20,000 + 1,100 = 15,000 + 800 + 32,100
Drawings is the reverse of capital investment. Capital investment will increase

the capital (example in the form of cash) of the business. Drawings will reduce
the capital. At the end of the accounting period, the drawings account will be
closed and the balance will be transferred to the capital account. Therefore,
drawings will be recorded as a reduction in capital account. Although both
drawings and expenses reduced capital, there is a clear difference between these
two types of accounts. Drawings are not for the purpose of generating revenue,
but for the ownerÊs personal use.
1.3.2 Summary of Analysis

Some important items that we must be aware of during the analysis of
transaction:
(a) Each transaction will affect, either as an increase or decrease, one or more
components in the accounting equation. However, each transaction will
definitely involve more than one item in the financial statements;
(b) The accounting equation explained at the earlier stage will always be equal.
You can examine this yourself by looking into the „Balance‰ section after
every transaction analysis; and
(c) OwnerÊs equity will increase with investment from the owner and revenue,
while drawings by the owner and expenses will reduce ownerÊs equity.
Table 1.4 is a summary of analysis for all the transactions of Reen Cyber Service.
After all the transactions have been recorded, we will discover that the
accounting equation will still be equal.
Table 1.4: Analysis of Transaction for R.C.S, November 2000

OWNER
EQUITY
Capital,
Reen
1 30,000 = 30,000
investment
by Reen
Balance 30,000 = 30,000
2 -5,000 20,000 = 15,000
Balance 25,000 20,000 = 15,000 + 30,000
3 + 2,700 = 2,700
Balance 25,000 + 20,000 + 2,700 = 15,000 + 2,700 + 30,000
4 15,000 = 15,000
service
revenue
Balance 40,000 + 20,000 + 2,700 = 15,000 + 2,700 + 45,000
5 4,250 = -4,250
paid
salary
-1,600 -1,600
paid
rental
-900 -900
paid
utility
-550 -550
paid
sundry
Balance 32,700 + 20,000 + 2,700 = 15,000 + 2,700 + 37,700
6 1,900 = -1,900
Balance 30,800 + 20,000 + 2,700 = 15,000 + 800 + 37,700
7 1,600 = -1,600
bought
supplies
Balance 30,800 + 20,000 + 1,100 = 15,000 + 800 + 36,100
8 4,000 = -4,000
cash
drawings
Balance 26,800 + 20,000 + 1,100 = 15,000 + 800 + 32,100

47,900 = 15,800 + 32,100
47,900 = 47,900
1.4 TYPES AND OBJECTIVES OF FINANCIAL

STATEMENT
After the transactions have been identified, analysed and recorded, we need to
prepare a report for the users. This report is the final product of the accounting
process and is known as financial statement. There are four types of financial
statement that you need to know:
(a) Income Statement;
(b) Statement of Changes in OwnerÊs Equity;
(c) Balance Sheet; and
(d) Cash Flow Statement.
These statements are interconnected with one another. The title for each
statement must contain the reporting entityÊs name, type of statement and the
reporting period covered. In this section, we will see in summary, the format for
each of the four statements based on the transactions for Reen Cyber Service. We
will learn about the preparation of each statement in detail in Unit 2.
Figure 1.7: Types of business
Let us take a look at Figure 1.7. Generally, businesses are divided into three
types, which are sole proprietorship, partnership and company. Sole
proprietorship is owned by a single owner while partnership is owned by 2 to 20
owners. Financial statements for these two types of business are not subject to the
standards released by MASB. Therefore, there might be several formats used by
these two types of business.
Companies are divided into private limited and public listed companies. Private
limited companies can be owned by 2 to 50 owners. However, there are unlimited
number of owners for public listed companies. The preparation of financial
statements for companies is subject to the standards released by MASB, whether

in the form of accounting method, disclosure and reporting format.
1.4.1 Income Statement

This statement is also known as Profit and Loss statement which lists all the
revenues and expenses incurred by the entity for a specific period. The difference
between the revenue and expense will result in either net profit or net loss. Excess
of revenue over expense will give us net profit, while expense in excess of
revenue will give us net loss. Figure 1.8 shows the income statement for Reen
Cyber Service for the month ended 30 November 2000.
Reen Cyber Service

Income Statement
for the month ended 30 November 2000
RM RM
Service revenue 15,000
Expenses:
Salary expenses 4,250
Rental expenses 1,600
Utility expenses 900
Supplies expenses 1,600
Sundry expenses 550 (8,900)
Net profit 6,100
Figure 1.8: Income statement/Profit and loss statement
1.4.2 Statement of Changes in Owner’s Equity

This statement shows the changes in ownerÊs equity for a specific accounting
period. OwnerÊs equity will increase when the owner makes a capital investment
or when the entity gains net profit. OwnerÊs equity will decrease when the owner
makes drawings or when the entity incurs net loss. Figure 1.9 shows the
statement of changes in ownerÊs equity for Reen Cyber Services.
Reen Cyber Service

Statement of Changes in OwnerÊs Equity
RM
Opening Capital < 1 November 30,000
(+) Net profit 6,100
36,100
(-) Drawings (4,000)
Closing Capital < 30 November 32,100
Figure 1.9: Statement of changes in ownerÊs equity
1.4.3 Balance Sheet

This statement is also known as the financial position statement, listing all the
assets, liabilities and ownerÊs equity of the entity on a specific date. The purpose
of this statement is to show the financial status of the entity on a specific date.
There are two formats normally used, which are the statement format and
accounts format. The accounts format places the asset on the left side with
liability and ownerÊs equity on the right side (refer to Figure 1.10 and Figure 1.11)
Reen Cyber Service

Balance Sheet
as at 30 November 2000
ASSETS RM LIABILITIES AND OWNERÊS EQUITY RM

Current Assets: Liabilities:
Cash 26,800 Current Liabilities:
Supplies 1,100 Account payable 800
27,900 Long-term liabilities:
Fixed Assets: Notes payable 15,000
Land 20,000 Total liabilities 15,800
Owner Equity:
Capital 32,100
TOTAL LIABILITIES AND
TOTAL ASSETS 47,900 OWNERÊS EQUITY 47,900
Figure 1.10: Balance Sheet in accounts format

In the statement format, the asset, liability and ownerÊs equity are listed
vertically.
Reen Cyber Service

Balance Sheet
as at 30 November 2000
RM RM
Fixed Assets:
Land 20,000
Current Assets:
Cash 26,800
Supplies 1,100
27,900
(<) Current liabilities:
Account payable (800)
27,100
Net current assets 47,100
Financed by:
OwnerÊs equity:
Capital, Reen 32,100
Long term liabilities:
Notes payable 15,000
47,100
Figure 1.11: Balance Sheet in statement format
1.4.4 Cash Flow Statement

This statement reports all the cash receipts and payments of the entity in a
specific period. Through this statement, the users will know the sources of cash
received and why cash is paid. The difference between cash inflows and outflows
will provide the final cash account balance of the entity. This balance will be the
same as the cash amount shown in the Balance Sheet. In the cash flow statement,
cash transactions are divided according to the type of activities, which are
operating, investing and financing activities. Figure 1.12 shows the cash flow
statement for Reen Cyber Services.
Reen Cyber Services

Cash Flow Statement
RM RM RM
Cash from operating activities:
Cash received from customers 15,000

(<) Expenditure paid 7,300
Payment to supplier 1,900 (9,200)
Net cash flow from operating activities 5,800
Cash from investing activities:

Payment for purchase of land (5,000)
Net cash flow from investing activities (5,000)
Cash flow from financing activities:

Investment by owner 30,000
(<) Drawings by owner (4,000)
Net cash flow from financing activities 26,000
Net cash flow for entity and cash account balance as at 30 November 26,800
Figure 1.12: Cash flow statement
Discuss the issues that might arise if a business entity did not disclose
the relevant information in its financial statement.
Further information regarding the professional accounting bodies in

Malaysia can be obtained from the following websites:
Malaysian Institute of Accountants (MIA) www.mia.org.my

The Malaysian Institute of Certified Public www.micpa.com.my
Accountants (MICPA)
Malaysian Accounting Standards Board (MASB) www.masb.org.my
Financial Reporting Foundation (FRF) www.masb.org.my
EXERCISE 1.4
1. Fill the blanks with the most accurate answer:
(a) Financial statement prepared on a yearly basis complies with the
assumption of ______________.
(b) The principle that requires the economic resources of the entity
to be recorded at the original cost at time of purchase is the
principle of ___________.
(c) _____________ information must have feedback value, forecast
value and is presented on a timely basis.
(d) The professional body responsible for setting the accounting
standards in Malaysia is _______________________________.
(e) The qualitative characteristic that enables users to depend or rely
on the information presented is _____________.
(f) The principle that matches the revenue with the expenses in the
specific accounting period is ___________________.
(g) Not all accounting information can be disclosed in detail due to
constraints of ___________________ and __________________.
(h) The branch of accounting that prepares specialised information
for internal users and not subject to specified standard or format
is ______________.
(i) According to the assumption of _____________, the entity is
assumed to continue to exist and in operation in the future.
(j) Revenue is normally recognised when ________________.
(k) The statement that shows the cash flow of an entity for a specific
period is _______________.
(l) ____________________ lists all the assets, liabilities and ownerÊs
equity of an entity in a specific period.
2. If revenue = RM12,000; expense = RM8,400 and drawings by owner =

RM2,000; how much is the net profit or net loss for that period?
A. Net profit RM5,600
B. Net loss RM3,600
C. Net profit RM1,600
D. Net profit RM3,600
3. Which of these is NOT a qualitative characteristic of accounting

information?
A. Materiality
B. Reliability
C. Relevant
D. Comparability
4. One example of internal user is:

A. Inland Revenue Board
B. Investor
C. Creditors
D. Management
5. If the total assets increased by RM15,000 and the total liabilities decreased
by RM10,000; ownerÊs equity had:
A. increased by RM5,000
B. decreased by RM5,000
C. increased by RM25,000
D. decreased by RM25,000
6. For the purpose of simplifying accounting, the business owner and

business entity are assumed as the same.
True False
7. The accounting period for all businesses must start from 1 January and
ends at 31 December each year.
True False
8. Income statement shows the net profit or loss of a business entity at a

specific date.
True False
9. Determine the appropriate amount in the spaces marked „?‰

(a) 84,000 = ? + 38,000
(b) ? = 72,000 + 28,000
(c) 125,000 = 50,000 + ?
10. State the effects of the following transactions on the asset, liability and
ownerÊs equity. An example is shown in transaction (a):
Transaction Effect
(a) Paid debts to supplier. Asset decreased, Liability
decreased.
(b) Purchased office equipment
by cash.
(c) Owner took cash from the
business for personal use.
(d) Paid staff salary for the
current period.
(e) Received cash from customer
to settle his account receivable.
(f) Owner contributed office
equipment for business use.
11. Mr. Ashwin established a tour agency on 1 June 2001. The transactions
for the month are as follows:
(a) Deposited cash into the business account totalling RM20,000.
(b) Purchased supplies on credit for RM800.
(c) Made payment to supplier for RM620.
(d) Received cash on the services provided for RM4,200.
(e) Paid staff salary of RM1,000.
(f) Paid transportation of RM700 and sundry expenses of RM150.
(g) Paid office rental of RM1,200.
(h) Charged customer RM2,500 for services provided.
(i) Supplies unused at the end of the period is valued at RM250.
(j) Mr. Ashwin took cash from the business totalling RM750 for his
personal use.
Required:
(a) State the effect of each transaction and the balance after each
transaction using the accounting equation format that you have
learned.
(b) Create the accounting equation for Mr. Ashwin business after the
last transaction for that month.
12. Below are the assets and liabilities accounts balances for Seri
Consultation Services as at 31 December 2000 including the revenue and
expense incurred throughout the year 2000. On 1 January 2000, the
capital of Miss Seri Devi (the owner) is RM22,200. Throughout the year,
she made a cash drawings of RM6,000 but no records of it has been
made.
Account Amount (RM)

Accounts payable 1,200
Accounts receivable 18,755
Supplies 8,480
Tax expenses 4,200
Sundry expenses 1,265
Utility expenses 7,350
Service income 78,750
Cash 23,300
Required:
Based on the information given, prepare:
(a) Income statement for the year ended 31 December 2000.
(b) Statement of Changes in OwnerÊs Equity for the year ended 31
December 2000.
(c) Balance Sheet as at 31 December 2000.
In this topic, you have learned and discovered:
1. The users of accounting information consist of internal users and external

users.
2. The difference between financial accounting and management accounting

are:
? Financial accounting prepares the financial report for external users
while management accounting prepares the monetary and non-financial
information for internal users.
? The financial reports in financial accounting is produced periodically
and subject to specified format while the report for management
accounting is produced according to specific needs and not subject to
specified standards.
3. The professional bodies involved in the accounting profession are

Malaysian Institute of Accountants (MIA), The Malaysian Institute of
Certified Public Accountants (MICPA), Malaysian Accounting Standards
Board (MASB) and Financial Reporting Foundation (FRF).
4. The assumptions and fundamental principles of accounting consist of:

? assumption of separate entity;
? assumption of going concern;
? assumption of monetary unit;
? assumption of accounting period;
? principle of historical cost;
? principle of income recognition;
? principle of matching; and
? principle of full disclosure.
5. The accounting equation is fundamental in accounting and it consists of

three components, namely asset, liability and ownerÊs equity.
6. Financial statement is the final product of the accounting process and it

consists of Income Statement, Statement of Changes in OwnerÊs Equity,
Balance Sheet and Cash Flow Statement.
Topic 2 w Recording
Process
LEARNING OUTCOMES
At the end of this topic, you should be able to:
1. describe the chart of accounts for recording and summarise the effect
of transactions on financial statement;
2. explain the format of accounts used;
3. list the rule of debit and credit for each type of accounts;
4. prepare journal entries;
5. transfer entries to ledger; and
6. prepare trial balance.
w INTRODUCTION
After studying how to analyse transactions, we will now learn about recording.
Recording is the most important step in accounting for a business entity.
However, before recording, we must identify the event that had occurred. Only
events that occur to the business entity will be recorded in the entityÊs book. Not
all events are transactions, for example, recruitment of staff. Although it will
affect the entity economically, this event is not considered a transaction.
TOPIC 2 RECORDING PROCESS v 35
2.1 CHART OF ACCOUNTS
Why must transactions be recorded in accounts and not some other

format?
When we analysed the transactions in the example of Reen Cyber Service, we

have recorded and summarised the transactions that occurred using the
accounting equation format. Although this format is easy to understand, it will
become difficult to use when there are a lot of transactions to be recorded daily.
In the example, we have analysed 8 transactions in a period of one month. In an

actual situation, a medium-sized service firm may have several transactions in a
day. If we use that accounting equation format, we will need a huge amount of
space. Whenever there is a new item, we must add it into the limited columns
available. We need to reshuffle the whole original format to accommodate this
change. This also applies if errors are detected. It would be difficult for us to
make any alteration without re-arranging the whole original format.
As a result, the accounting system was created to show the increase or decrease
of each item in the financial statement separately. The separate recording of each
item is known as account. As an example, cash account is a separate recording
especially to show the increase or decrease in the cash item. This also applies to
other items like account payable, service revenue and salary expense.
The group of accounts in a business entity is known as ledger. The list of

accounts in the ledger is known as a chart of accounts. Chart of accounts was
created particularly to enable the users of financial statements to refer to specific
accounts. Each account is given a special number as reference. These accounts are
normally listed systematically in the financial statement. Normally in the chart of
accounts, balance sheet items (asset, liability and ownerÊs equity) are put in front,
followed by income statement items (revenue and expense). Figure 2.1
summarises the concept of ledger and chart of accounts.
36 w TOPIC 2 RECORDING PROCESS
Figure 2.1: Ledger and chart of accounts
Figure 2.1 explains the chart of accounts clearly. This chart will be used as an
example in this topic. New accounts will be introduced in the following units
when the entity increases its business scope. The chart is created by the entity
itself. Therefore, the chart of accounts between one entity and another entity
might be different.
For Reen Cyber Service, its chart of accounts consists of only two digits. The first
digit will show the type of account (example: 1 for asset account, 2 for liability
account, 3 for ownerÊs equity account, 4 for revenue account and 5 for expense
account). The second digit will show the account itself. For larger businesses, the
chart might consist of three to four digits. If the entity has a branch at different
location, the first digit might be used to show the branch location.
Table 2.1: Chart of Accounts for Reen Cyber Service
Accounts in Balance Sheet Accounts in Income Statement
1 ASSETS 4 REVENUE
11 Cash 41 Service revenue
12 Account receivable
14 Supplies
15 Insurance prepayment
17 Land
18 Office equipment
2 LIABILITIES 5 EXPENSES
21 Account payable 51 Salary expenses
22 Notes Payable 52 Rental expenses
23 Deferred Rental 53 Utility expenses
54 Supplies expenses
3 OWNERÊS EQUITY 55 Sundry expenses
31 Capital, Reen
32 Drawings, Reen
EXERCISE 2.1
Which of these events can be considered as a transaction and must be
recorded? Please discuss.
(a) The death of a branch manager.
(b) The capital contribution of the owner into the business.
2.2 FORMAT OF ACCOUNT

Each account has three sections:
(a) Title or name of the account, which is the name of the items recorded in that
particular account.
(b) Debit section on the left side.
(c) Credit section on the right side.
The debit and credit section are used to record either the increase or decrease in
the specific account. However, do remember that, debit does not necessarily
show an increase and that credit does not necessarily show a reduction. It
depends on the type of account. This subject will be explained in detail later
under the rule of debit and credit.
Accounts are also known as T-accounts due to their shapes that look like the
letter T.
Account Title
Debit Credit
(left) (right)
Figure 2.2: T-Account (simple format )
Each section of the T-account should have four columns in the debit section and
four columns in the credit section.
Debit Account Title Credit

Date Description Reference Amount Date Description Reference Amount
Figure 2.3: T-Account (detailed format )
There is another format of account known as the three column account. Although
in fact there are actually six columns in this accountÊs format, the three columns
refer to the debit, credit and balance columns. An advantage of this format is that
it can show the latest account balance at any particular time.
Date Description Reference Debit Credit Balance
Figure 2.4: Three column account format
2.3 RULES OF DEBIT AND CREDIT
What will happen if the rule of debit and credit are not complied with
while recording the business transaction?
We have previously stated that asset, liability and ownerÊs equity are the three
main components in the accounting equation. Other items that are involved
include drawings, revenue and expense. Every transaction that occurs will
involve debit and credit and every transaction will affect at least two accounts.
For every transaction, the total debit must be equal to the total credit. This is the
basis of the double entry system. This rule of debit and credit is important to
ensure that we make accurate recording. Table 2.2 shows the rules of debit and
credit for each type of accounts.
Table 2.2: Rules of Debit and Credit

Type of Account Increase Decrease
Asset Debit Credit
Liability Credit Debit
Capital Credit Debit
Drawings Debit Credit
Revenue Credit Debit
Expense Debit Credit
Do you understand the rules listed in Table 2.2? Table 2.2 shows that when the
asset account increases, we will debit the said account. For example, when the
entity receives cash, we will debit cash account.
When the asset account decreases, we will credit the said account. For example,
when the entity made cash payment, we will credit the entityÊs cash account.
Referring to Table 2.2, we will discover that the nature of the asset account is
opposite to that of the liability and ownerÊs equity accounts. To observe this more
clearly, please refer back to the accounting equation we had learned:
The asset item is on the left side while the liability and ownerÊs equity are on the
right side. Asset is the economic resources owned by the entity while liability and
owner equity are parties claiming ownership on the asset. Therefore, asset is the
opposite of liability and ownerÊs equity.
2.3.1 Normal Balance

Normal balance is included in the rule of debit and credit. This refers to the
balance ordinarily shown in the account.
Let us take the asset account as an example. When asset increases, the account is
debited. When asset decreases, the account is credited. Therefore, the normal
balance for asset account is debit. This is because the reduction in asset normally
would not exceed the increase that had occurred. As a simple example, if we
have cash of RM1,000 in the bank, normally we cannot withdraw more than the
said value. Table 2.3 shows the rules of debit and credit including the normal
balances for each type of accounts.
Table 2.3: The Rules of Debit and Credit Including Normal Balances
Type of Account Increase Decrease Normal Balance
Asset Debit Credit Debit
Liability Credit Debit Credit
Capital Credit Debit Credit
Drawings Debit Credit Debit
Revenue Credit Debit Credit
Expense Debit Credit Debit
Note that the normal balance for each account is the same as the increase in the
said account.
The rule of normal balance is important as it may help you to identify errors. For
example, if the land account has a credit balance, you might have made a mistake
in recording. However, you must also remember that normal balance is the
balance that is ordinarily shown. The cash account that normally has a debit
balance can also have a credit balance. This occurs when a company has
withdrawn more cash than what is available. This might occur if the company
has an overdraft agreement with the bank. When an entity has an overdraft
agreement with the bank, it will be allowed to withdraw more money than what
it is available in its account. The amount that can be withdrawn is subject to
agreement.
Identify the characteristics that allow an event to be viewed as a

transaction and therefore must be recorded?
2.4 STEPS IN RECORDING PROCESS

Once the entityÊs transactions are identified, they must be recorded according to
the accounting procedure specified. Recording begins with journal entry, then
post to ledger and finally preparation of trial balance. This process can be
illustrated in Figure 2.5.
Figure 2.5: Steps in recording process
2.4.1 Journal
Journal is the first book to be used in the recording process. Recording in journals
(journalising) is the first process of recording. Transactions are recorded
chronologically in the journal before been transferred to ledger. There are two
main types of journal, the general journal and special journal.
(a) General Journal

General journal is the journal normally owned by all entities. This journal
can be used to record all kinds of transaction like sales, purchases, cash
receipts and cash payments.
(b) Special Journal

Large businesses normally have many transactions. Special journals are
created to avoid confusion due to many entries made in the general journal.
The type of special journal created depends on the needs of the entity.
For example, an entity that have numerous cash transactions might want to
create Cash Receipts Journal and Cash Payment Journal that will be
specially used for cash transactions. All the other transactions can still be
recorded in the General Journal. This segregation will simplify recording
and control. Among the special journals that are commonly used are:
(i) Purchase Journal: particularly for recording purchases of goods on

credit.
(ii) Sales Journal: particularly for recording sales of goods on credit.
(iii) Cash Receipt Journal: particularly for recording all cash received.
(iv) Cash Payment Journal: particularly for recording all cash payment.
However, this course will only emphasise to the general journal. The format of
general journal is shown in Figure 2.6.
Figure 2.6: Format of general journal
It is important to ensure that journalising is done correctly. This is because these

information will be transferred to ledger for the purpose of preparing the
financial statement. Errors made in the journal will result in errors in the
financial statement. The name of accounts used must be specified in the
beginning and used consistently in order to avoid confusion.
In your opinion, what are the appropriate journals for a book shop in a
school? Please discuss.
2.4.2 Journalising and Posting of Entry

After the transactions have been recorded in the journal, it will be posted to the
ledger. This process is known as transfer of entry or posting. We will now record
the transactions of Reen Cyber Service in the General Journal and then post them
to the ledger using the T-account format.
Transaction 1: On I November, Reen invested RM30,000 as capital for Reen Cyber

Service business. From our analysis in Topic 1, we know that this transaction will
increase the cash and ownerÊs equity by RM30,000. According to the rules of
debit and credit, the increase in asset account (cash) will be debited and increase
in ownerÊs equity account (capital) will be credited.
When recording, note that the name of the account to be debited is listed first,
followed by the name of account to be credited. The name of the credited account
will be aligned slightly to the right to differentiate it from the account to be
debited.
Journal entry:
General Journal pg 1
Date Description Reference Debit Credit

Nov 1 Cash 30,000
Capital, Reen 30,000
(Cash invested by Reen)
Journal 1: General Journal for Transaction 1
Post to ledger:
Cash
Nov 1 Capital, Reen 30,000
Capital, Reen
Nov 1 Cash 30,000
Ledger 1: Ledger for Transaction 1
Transaction 2: On 2 November, the business purchased a piece of land valued at

RM20,000. A total of RM5,000 cash had been paid while the balance is financed
by bank loan (notes payable).
Note that even though this transaction involves more than two accounts, the total
amount of debit is still equal to the total amount of credit.
Journal entry:

Nov 1 Land 20,000
Cash 5,000
(Purchased land by cash and
bank loan)
Post to ledger:
Land
Nov 2 Cash 5,000

Notes Payable 15,000
Cash
Nov 1 Capital, Reen 30,000 Nov 2 Land 5,000
Notes Payable
Nov 2 Land 15,000
Transaction 3: On 4 November, the business bought office supplies valued at

RM2,700 on credit.
Journal entry:

Nov 4 Supplies 2,700
Accounts Payable 2,700
(Purchased office supplies
by credit)
Post to ledger:
Supplies
Nov 4 AP 2,700
Accounts Payable
Transaction 4: On 15 November, the business received revenue from consultancy

services provided to a customer. The customer paid cash of RM15,000.
Journal entry:

Nov 15 Cash 15,000
(Cash received for services
provided)

Post to ledger:
Cash

15 Service revenue 15,000
Service revenue
Nov 15 Cash 15,000
Transaction 5: On 30 November, the business paid salary expenses (RM4,250),

rental expenses (RM1,600), utility expenses (RM900) and sundry expenses
(RM550).
Journal entry:

Nov 30 Salary expenses 4,250
Sundry expenses 550
Cash 7,300
(Cash payment for the said
expenses)
Post to ledger:
Cash

15 Service revenue 15,000 30 Salary expenses 4,250
Sundry expenses 550
Salary expenses Rental expenses

Nov 30 Cash 4,250 Nov 30 Cash 1,600
Utility expenses Sundry expenses

Nov 30 Cash 900 Nov 30 Cash 550
Transaction 6: On 30 November, the business paid its debt to the supplier of

supplies purchased on 4 November for RM1,900.
Journal entry:

Nov 30 Accounts Payable 1,900
Cash 1,900
(Payment to accounts
payable)
Post to ledger:
Cash

Sundry expenses 550
30 Accounts payable 1,900
Accounts Payable
Nov 30 Cash 1,900 Nov 4 Supplies 2,700

Transaction 7: Unused office supplies on 30 November were valued at RM1,100.
Journal entry:

Nov 30 Supplies expenses 1,600
Supplies 1,600
(Recording usage of
supplies)
Post to ledger:
Supplies
Nov 4 Accounts payable 2,700 Nov 30 Supplies 1,600
Supplies expenses

Transaction 8: On 30 November, Reen took RM4,000 cash from the business for
her personal use.
Journal entry:

Nov 30 Drawings, Reen 4,000
Cash 4,000
(Cash drawings by owner)

Post to ledger:
Cash

Sundry expenses 550
30 Drawings, Reen 4,000
Drawings, Reen
Nov 30 Cash 4,000

How are you doing so far? Can you understand the recording process at this
stage? By using the same transactions, we have prepared the journal entries and
transferred them to ledger. The journalising and posting process that we have
done is a very simple example for you to better understand the basic process,
emphasising only on the date, accounts and amounts involved. In the next
example, we will perform postings in detail involving reference column.
2.4.3 Example of Analysis and Summary of

Transaction
The double entry system is very useful for analysing the effects of transactions.
According to the system, every transaction will affect at least two items in the
financial statements. In analysing the transactions, three important things that
must be dealt with:
(a) Determine whether the transaction will affect the asset, liability, ownerÊs
equity, revenue or expense accounts.
(b) For every account involved, determine whether the account will increase or
decrease.
(c) Decide whether the increase or decrease should be recorded as debit or
credit.
You might feel difficult at this stage to make an analysis, or feel there are too
many things to remember. However, with familiarisation and frequent practice,
you will find that these three things can be done simultaneously.
We will now continue with the example of Reen Cyber Service by extending the
transactions to December. In December, we will see more transactions. We will
analyse the transactions one by one with emphasis given on the types of
transaction that have not been analysed before. The transactions throughout
December are listed in Table 2.4.
Table 2.4: Transactions for the month of December

Date
No. Transactions
(Dec 2000)
1 1 Paid insurance premium of RM4,800 for coverage against losses
due to fire and burglary for a period of 24 months.
2 1 Paid office rental for the month of December of RM1,600.
3 1 A company planned to rent the land owned by Reen Cyber
Service. The business rented the land for three months for RM720.
The tenant paid the amount in cash.
4 4 Purchased office equipment by credit from Office Equipment Sdn.
Bhd. totalling RM3,600.
5 6 Paid RM360 to advertise the business in the newspaper.
6 11 Paid RM800 for the transaction on 4 December.
7 13 Paid salary of temporary staff for RM1,900 for the first two weeks
of December.
8 16 Received RM6,200 cash from customer for services provided.
9 16 Provided services valued at RM3,500 to a customer. The customer
promised to pay next month.
10 20 Made another payment of RM1,800 for transaction on 4 December.
11 21 Customer made payment for account receivable of RM1,300.
12 23 Purchased supplies by cash for RM2,900.
13 27 Paid salary of temporary staff for RM2,400 for the last two weeks
of December.
14 31 Paid telephone and electricity bill for the month December for
RM620 and RM450 respectively.
15 31 Received cash of RM5,740 from customer on the services provided.
16 31 Billed customer for the services provided of RM2,240.
17 31 Reen made cash drawings of RM4,000.
Transaction 1: Paid insurance premium for 24 months totalling RM4,800.
Have you ever paid insurance premium? If you own a vehicle, you will be
familiar with paying insurance premium. Insurance premium must be paid at the
beginning of the coverage period. Payment made in advance is known as prepaid
expenses and it is an asset. The asset you get is the insurance coverage for 24
months starting from 1 December 2000.
Analysis 1 and 2: Prepaid insurance account (asset) increased by RM4,800.

Accounts involved and Cash account (asset) reduced by RM4,800.
effects of transaction
Analysis 3: Prepaid insurance account (asset) increased: debit

Rule of debit and credit Cash account (asset) reduced: credit
Journal entry:

Dec 1 Prepaid insurance L15 4,800
Cash L11 4,800
(Paid insurance premium for
24 months)
Post to ledger:
Prepaid Insurance Account No: 15

Dec 1 Cash J2 4,800
Cash Account No: 11

Dec 1 Prepaid insurance J2 4,800

In this example, we did not use the T-account format. Instead, we used the three
column account format to make you more familiar with the different types of
accounting format available. This format is better as it can show the balance after
each transaction. The balance column is supposed to show final balance after each
transaction including the previous transactions in November. However, in this
section, the column is left blank to avoid confusion. After completing all the
transactions, we will combine all the processes of journal entries and entry post to
ledger. After that, you will be able to understand better the function of the balance
column in this three column account format.
Note that for reference purposes, the account number (refer to the chart of
accounts in section 1) must be recorded in the Reference column in the journal,
while the page of general journal is recorded in the Reference column in the
accounts.
Transaction 2: Paid RM1,600 rental for the month of December .
This transaction is prepaid expense as the rental expenses was paid at the
beginning of December. However, it is different from transaction 1 in terms of
the coverage period.
In transaction 1, the premium paid was for a period of 24 months. In this

transaction, the rental paid was only for one month. For such a short period, we
normally do not use the prepaid rental account. This is easier as we need not
make any adjustments at the end of the period.
Analysis 1 and 2: Rental expenses account (expense) increased by RM1,600.

Accounts involved and Cash account (asset) reduced by RM1,600.
Analysis 3: Rental expenses account (expense) increased: debit

Rule of debit and credit Cash account (asset) reduced: credit
Journal entry:

Dec 1 Rental expenses L52 1,600
Cash L11 1,600
(Paid rental expenses for December month)

Post to ledger:
Rental expenses Account No: 52

Dec 1 Cash J2 1,600
Cash Account No: 11

Dec 1 Rental expenses J2 1,600
Do you still remember the accounting constraints on materiality that we

had studied earlier? Can you relate it to the recording of transaction 2?
Transaction 3: Received RM720 from the landÊs tenant for rental of three months.
In this transaction, the business received payment in advance of the specific

period. This created an obligation or commitment on the business. By receiving
three months rental in advance, Reen Cyber Service is responsible to supply land
for rental in that three month period.
This is a liability (the business ÂowesÊ services to the tenant) and the account
created is deferred rental account. The deferred rental will be recognised as rental
revenue at the end of the period when the services have been provided.
Analysis 1 and 2: Cash account (asset) increased by RM720.

Accounts involved and Deferred rental account (liability) increased by RM720.
Analysis 3: Cash account (asset) increased: debit

Rule of debit and credit Deferred rental account (liability) increased: credit
Journal entry:

Dec 1 Cash L11 720
Deferred rental L23 720
(Cash received for three months rental)
Post to ledger:
Cash Account No: 11

Dec 1 Deferred rental J2 720
Deferred rental Account No: 23

Dec 1 Rental expenses J2 720

Transaction 4: Purchased office equipment on credit for RM3,600.
Analysis 1 and 2: Office equipment account (asset) increased by RM3,600.

Accounts involved and Accounts payable (liability) increased by RM3,600.
Analysis 3: Office equipment account (asset) increased: debit

Rule of debit and credit Accounts payable (liability) increased: credit
Journal entry:

Dec 1 Office equipment L8 3,600
Accounts payable L21 3,600
(Purchased office equipment on credit)
Post to ledger:
Office Equipment Account No: 18

Dec 4 Accounts payable J2 3,600
Account Payable No: 15

Dec 1 Office equipment J2 3,600
Transaction 5: Paid RM360 for advertisement in newspaper.
For large businesses that always advertise their products or services. For
advertisement that involves large sums, a specific account (Advertisement
expenses) will be created for this purpose. However, if the advertisement
expenses seldom occur and immaterial, it is often recorded as sundry expenses.
In the example of Reen Cyber Service, we will use the sundry expenses account
to record this expense.
Analysis 1 and 2: Sundry expenses account (expense) increased by RM360.

Accounts involved and Cash account (asset) decreased by RM360
Analysis 3: Sundry expenses account (expense) increased: debit

Rule of debit and credit Cash account (asset) decreased: credit
Journal entry:

Dec 6 Sundry expenses L55 360
Cash L11 360
(Payment for advertisement expenses)
Post to ledger:
Sundry Expenses Account No: 55

Dec 6 Cash J2 360
Cash Account No: 11

Dec 6 Sundry expenses J2 360

Transaction 6 : Paid supplier (for transaction on 4 December) amounting to RM800.
Analysis 1 and 2: Accounts payable (liability) decreased by RM800.

Accounts involved and Cash account (asset) decreased by RM800.
Analysis 3: Accounts payable (liability) decreased: debit

Journal entry:

Dec 11 Accounts payable L21 800
Cash L11 800
(Payment for accounts payable)
Post to ledger:
Accounts payable No: 21

Dec 11 Cash J2 800
Cash Account No: 11

Dec 11 Account payable J2 800
Transaction 7: Paid salary of temporary staff for the first two weeks of December
totalling RM1,900.
Analysis 1 and 2: Salary expenses account (expense) increased by RM1,900.

Accounts involved and Cash account (asset) decreased by RM1,900.
Analysis 3: Salary expenses account (expense) increased: debit

Journal entry:

Dec 13 Salary expenses L51 1,900
Cash L11 1,900
(Salary payment for temporary staff)
Post to ledger:
Salary expense Account No: 51

Dec 13 Cash J2 1,900
Cash Account No: 11

Dec 13 Salary expenses J2 1,900
Transaction 8: Received cash for services provided for RM6,200:
Analysis 1 and 2: Cash account (asset) increased by RM6,200.

Accounts involved and Service revenue account (revenue) increased by RM6,200.

Rule of debit and credit Service revenue account (revenue) increased: credit
Journal entry:

Dec 16 Cash L11 6,200
Service revenue L41 6,200
(Received cash for services provided)
Post to ledger:
Cash Account No: 51

Dec 16 Service revenue J2 6,200
Service revenue Account No: 41

Transaction 9: Billed customer for RM3,500 for services provided.
Analysis 1 and 2: Accounts receivable (asset) increased by RM3,500.

Analysis 3: Accounts receivable (asset) increased: debit

Journal entry:

Dec 16 Accounts receivable L12 3,500
(Billed customer for services provided)
Post to ledger:
Accounts receivable No: 12


Dec 16 Accounts receivable J2 3,500
Transaction 10: Payment of RM1,800 to supplier (for transaction on 4 December).
Analysis 1 and 2: Accounts payable (liability) decreased by RM1,800.

Analysis 3: Accounts payable (liability) decreased: debit

Journal entry:

Dec 20 Accounts payable L21 1,800
Cash L11 1,800
(Payment to accounts payable)
Post to ledger:
Accounts payable No: 12

Cash Account No: 11

Dec 20 Accounts payable J3 1,800

Transaction 11: Customer paid cash RM1,300 as payment on its accounts

receivable.
Analysis 1 and 2: Cash account (asset) increased by RM1,300

Accounts involved and Accounts receivable (asset) decreased by RM1,300

Rule of debit and credit Accounts receivable (asset) decreased: credit
Journal entry:

Dec 21 Cash L11 1,300
Accounts receivable L12 1,300
(Payment received for accounts
receivable)
Post to ledger:
Cash Account No: 11

Accounts Receivable No: 12


Transaction 12: Purchased supplies by cash for RM2,900.

Analysis 1 and 2: Supplies account (asset) increased by RM2,900.
Analysis 3: Supplies account (asset) increased: debit
Journal entry:
Date Account and Description Reference Debit Credit
Dec 23 Supplies L14 2,900
Cash L11 2,900
(Purchased supplies by cash)
Post to ledger:
Supplies Account No: 14
Cash Account No: 11
Dec 23 Supplies J3 2,900
Transaction 13: Paid salary of temporary staff for the last two weeks of December
totalling RM2,400.
Analysis 1 and 2: Salary expenses account (expense) increased by RM2,400.
Analysis 3: Salary expenses account (expense) increased: debit
Journal entry:
Dec 27 Salary expenses L51 2,400
Cash L11 2,400
(Payment for salary of temporary
staff)
Post to ledger:
Salary expenses Account No: 51
Cash Account No: 11

Dec 27 Salary expenses J3 2,400
Transaction 14: Made payment for telephone and electricity bill for December,
RM620 and RM450, respectively.
The payment of bills like electricity, water and telephone are normally grouped
into the utility expenses account. This is because the expenses incurred are
normally immaterial in terms of amount and significance until the entity has to
open a separate account for each type of bill. Therefore, the total utility expenses
paid on this date is RM1,070.
Analysis 1 and 2: Utility expenses account (expense) increased by RM1,070.

Analysis 3: Utility expenses account (expense) increased: debit
Journal entry:
Dec 31 Utility expenses L53 1,070
Cash L11 1,070
(Payment for telephone and electricity bill
for December)
Post to ledger:
Utility expenses Account No: 53
Cash Account No: 11
Dec 31 Utility expenses J3 1,070
Transaction 15: Received cash RM5,740 for services provided.

Analysis 1 and 2: Cash account (asset) increased by RM5,740.
Journal entry:
Dec 31 Cash L11 5,740
(Received cash for services
provided)
Post to ledger:
Cash Account No: 11
Transaction 16: Billed customer for RM2,240 for services provided.

Analysis 1 and 2: Accounts receivable (asset) increased by RM2,240
Accounts involved and Service revenue account (revenue) increased by RM2,240
Analysis 3: Accounts receivable (asset) increased: debit
Journal entry:
Dec 31 Accounts receivable L12 2,240
Post to ledger:
Account Receivable No: 12
Transaction 17: Owner made cash drawings of RM4,000.

Analysis 1 and 2: Drawings account (contra owner equity) increased by RM4,000
Analysis 3: Drawings account (contra owner equity) increased: debit
Notes: Although the drawings account is a type of owner equity account, it has an opposite feature
against the ownerÊs equity. Therefore, we will put the word ÂcontraÊ to show the difference.
Journal entry:
Dec 31 Drawings, Reen L32 4,000
Cash L11 4,000
(Cash drawings by Reen).
Post to ledger:
Drawings, Reen Account No: 32
Cash Account No: 11
Dec 31 Drawings, Reen J3 4,000
After analysing all the transactions one by one, we will now combine all the
journal entries and entries posting involved throughout the month of November
and December 2000.
The following are the general journal entries and postings throughout November
and December 2000.
GENERAL JOURNAL pg 1
Nov 1 Cash L11 30,000
Capital, Reen L31 30,000
(Investment by Reen)
2 Land L17 20,000
Cash L11 5,000
Notes payable L22 15,000
(Purchase of land by cash and
bank loan)
4 Supplies L14 2,700
(Purchase of supplies on credit)
15 Cash L11 15,000
provided)
30 Salary expenses L51 4,250
Rental expenses L52 1,600
Utility expenses L53 900
Sundry expenses L55 550
Cash L11 7,300
(Payment of expenses by cash)
30 Account payable L21 1,900
Cash L11 1,900
30 Supplies expenses L54 1,600
Supplies L14 1,600
(Recording of supplies usage)
30 Drawings, Reen L32 4,000
Cash L11 4,000
Dec 1 Prepaid Insurance L15 4,800
Cash L11 4,800
(Paid insurance premium for 24
months)
1 Rental expenses L52 1,600
Cash L11 1,600
(Paid rental for December)
1 Cash L11 720
Deferred rental L23 720
(Cash received for three months
rental)
4 Office equipment L18 3,600
(Purchased office equipment by
credit)
6 Sundry expenses L55 360
Cash L11 360
(Payment for advertisement
expenses)
11 Accounts payable L21 800
Cash L11 800
Cash L11 1,900
(Payment for salary of
temporary staff)
16 Cash L11 6,200
provided)
16 Accounts receivable L11 3,500
(Billed customer for services
provided)
Dec 20 Accounts payable L12 1,800
Cash L11 1,800
21 Cash L11 1,300
(Received payment for accounts
receivable)
23 Supplies L14 2,900
Cash L11 2,900
(Purchased of supplies by cash)
Cash L11 2,400
(Payment for salary of temporary staff)
31 Utility expenses L53 1,070
Cash L11 1,070
(Payment of telephone and electricity
bill)
31 Cash L11 5,740
(Received cash for services provided)
31 Accounts receivable L12 2,240
31 Drawings, Reen L32 4,000
Cash L11 4,000
Journal 26: General Journal for Reen Cyber Service for the month of November and
December 2000.
GENERAL LEDGER
Cash Account No: 11
Nov 1 Capital, Reen J1 30,000 30,000
2 Land J1 5,000 25,000
15 Service revenue J1 15,000 40,000
30 Salary expenses J1 4,250 35,750
Rental expenses J1 1,600 34,150
Utility expenses J1 900 33,250
Sundry expenses J1 550 32,700
30 Accounts payable J1 1,900 30,800
30 Drawings, Reen J1 4,000 26,800
Dec 1 Prepaid insurance J2 4,800 22,000
Rental expenses J2 1,600 20,400
Deferred rental J2 720 21,120
6 Sundry expenses J2 360 20,760
11 Accounts payable J2 800 19,960
21 Accounts receivable J3 1,300 23,760
23 Supplies J3 2,900 20,860
31 Utility expenses J3 1,070 17,390
31 Drawings, Reen J3 4,000 19,130
* It was previously explained that the ÂBalanceÊ column will show the updated
balance after each transaction. Can you relate to it now?

Dec 16 Service revenue J2 3,500 3,500
21 Cash J3 1,300 1,100

Nov 4 Accounts payable J1 2,700 2,700
30 Supplies expenses J1 1,600 1,100
Dec 23 Cash J3 2,900 4,000
Prepaid insurance Account No: 15

Dec 1 Cash J2 4,800 4,800
Land Account No: 17

Nov 2 Cash J1 5,000 5,000
Notes payable J1 15,000 20,000

Dec 4 Accounts payable J2 3,600 3,600
Accounts Payable No: 22

Nov 4 Supplies J1 2,700 2,700
30 Cash J1 1,900 800
Dec 4 Supplies J2 3,600 4,400
11 Cash J2 800 3,600
20 Cash J3 1,800 1,800
Notes Payable Account No: 22

Nov 2 Land J1 15,000 15,000
Deferred Rental Account No: 23

Dec 1 Cash J2 720 720
Capital, Reen Account No: 31

Nov 1 Cash J1 30,000 30,000
Drawings, Reen Account No: 32

Nov 30 Cash J1 4,000 4,000
Dec 31 Cash J3 4,000 8,000
Service Revenue Account No: 41

Nov 15 Cash J1 15,000 15,000
Dec 16 Cash J2 6,200 21,200
Accounts receivable J2 3,500 24,700
31 Cash J3 5,740 30,440
Accounts receivable J3 2,240 32,680
Salary Expenses Account No: 51

Nov 30 Cash J1 4,250 4,250
Dec 13 Cash J2 1,900 6,150
27 Cash J3 2,400 8,550
Rental Expenses Account No: 52

Nov 30 Cash J1 1,600 1,600
Dec 1 Cash J2 1,600 3,200
Utility Expenses Account No: 53

Nov 30 Cash J1 900 900
Dec 31 Cash J3 1,070 1,970
Supplies Expenses Account No: 54

Nov 30 Supplies J1 1,600 1,600

Nov 30 Cash J1 550 550
Dec 6 Cash J2 360 910
2.4.4 Trial Balance

Trial balance is a list of all the accounts used including the corresponding balances at
a specific date. Normally the trial balance would be prepared at the end of the
specific accounting period and the debit and credit totals need to be equal.
The main purpose of preparing the trial balance is to ensure that the total debit
and credit balances are the same. Unequal amount of total balances indicate that
errors had happened in any one of the stages in the recording process, whether
during the journal entry, posting to ledger or the preparation of the trial balance
itself.
However, it must always be kept in mind that a balanced trial balance does not
necessarily mean that there are no errors. Examples of errors that can occur even
though the trial balance is balanced are:
(a) the transaction has not been recorded at all in the journal;
(b) the transaction entry has not been posted to the ledger;
(c) the transaction of entry posted to ledger had been done twice; and
(d) the usage of wrong account during journalising or posting.
In the first case, the transaction was not recorded at all. Both the debit and credit
sections were not affected. Therefore, the trial balance will be balanced, only the
total would be less than what it should have been. In the second case, the
transaction had been recorded in the journal without being posted to ledger. The
result is the same as with the first case because the trial balance is prepared based
on the ledger balance.
In the third case, the entry was posted correctly, but twice. The trial balance will
be balanced, only the total would be more than what it should have been. In the
final case, the debit and credit amount is equal, only that they have been
recorded on the wrong side of the accounts. The final balance of the trial balance
would be the same as it should be, but there will be errors in the last balance of
the individual accounts. For example, when a business purchased supplies by
cash, the correct entry should be to debit the supplies account and to credit the
cash account. However, a mistake was made by debiting cash and crediting
supplies. Although the accounts have been recorded wrongly, the trial balance
will still be balanced. Only the individual balances in the cash account and
supplies account will be incorrect. This error is quite difficult to detect as the final
amount in the trial balance is still equal.
EXERCISE 2.2
1. What is meant by account, ledger and chart of accounts?
2. State TWO account format of that you have learned. Which is the
easier format? Which format will show the latest balance after each
transaction?
3. Drawings and expense will reduce ownerÊs equity. Discuss the

difference between these two terms.
4. Which of the following accounts have a normal debit balance?

A. OwnerÊs capital
B. Deferred rental
C. Prepaid expense
D. Service revenue
5. A credit balance in which account might indicate an error?

A. Rental revenue
B. Accounts payable
C. Drawings
D. Capital
6. Group the following accounts according to its type (asset, liability,

ownerÊs equity, revenue or expense):
(a) Vehicle
(b) Insurance expenses
(c) Prepaid insurance
(d) Rental revenue
(e) Deferred rental
(f) Supplies
(g) Supplies expenses
(h) Accounts receivable
7. Cindy established Cindy Insurance Agency on 1 April 2001. The

effects of all transactions throughout April 2001 are summarised in
the following schedule:
OwnerÊs
Asset = Liability +
Equity
Capital,
Trans. Cash + AR + Supplies = AP +
Cindy
a. +5,000 +5,000
Capital,
Cindy
b. +275 +275
c. +3,250 +3,250
Service
revenue
d. 750 -750
Paid rental
expense
e. -125 -125
f. +1,875 +1,875
Service
revenue
g. -577 -390
Paid utility
expense
-187
Paid
sundry
expense
h. -1,250 -1,250
Paid salary
expense
i. -162 -162
Paid
supplies
expenses
j. -500 -50 -550
Drawings,
Cindy
Required:
(a) Prepare the journal entries for all the above transactions.
(b) Transfer the entries to ledger using the 3 column account format.
(c) Prepare the trial balance as at 30 April 2001.
8. The following are the chart of accounts and accounts balances

for Edlin Enterprise on 1 February 2001:
Account Balance as at 1/2/01
Accounts
No (RM)
101 Cash 15,238
102 Accounts receivable 4,575
104 Supplies 427
108 Office equipment 8,400
301 Capital, Edlin 26,910
302 Drawings, Edlin <
401 Service revenue <
501 Rental expenses <
502 Advertisement expenses <
503 Utility expenses <
509 Sundry expenses <
Transactions involving Edlin Enterprise throughout the month of

February 2001 are:
Date Transaction
Feb 1 Purchased office supplies by cash RM274.
2 Edlin withdrew cash from business totalling RM2,000 for personal use.
5 Received RM2,740 cash from customer for payment on accounts
receivable.
9 Purchased office equipment valued at RM4,000 on credit. The seller
agreed to give a discount of RM150 from the amount.
15 Made payment to accounts payable for RM1,200.
18 Received cash for services provided for RM580.
25 Paid RM420 to advertise its business in the newspaper.
28 Paid telephone bills (RM75 for EdlinÊs house and RM135 for business)
and electricity bills (RM42 for EdlinÊs house and RM80 for business).
All the payments had been made using money from his savings.
29 Paid RM1,200 for rental of business premises.
30 Paid RM220 to repair the office equipment.
Required:
(a) Prepare the journal entries to record all the above transactions by
using the accounts listed in the chart of accounts for Edlin
Enterprise.
(b) Post the entries to ledger by using the three column account
format.
(c) Prepare the trial balance as at 28 February 2001.
The important matters discussed in this topic were:

1. The chart and format of accounts used to present the financial report of an
organisation.
2. The rules of debit and credit are fundamental to the double entry system.
3. The rules of normal balance for each type of account are used to assist in
identifying errors in recording.
4. Steps in recording beginning from journal entry, posting entries to ledger
and preparation of the trial balance.
TUTORIAL QUESTION
w INTRODUCTION
The main purpose of this activity is to enable you to understand the analysis of
transactions and recording process. The comprehensive question that follows
will cover this entire unit.
w QUESTION
The balances of assets and liabilities accounts for the business of Anggun Rias as
at 1 January 2001 are:
Accounts Balance (RM)

Cash 2,500
Supplies 980
Land 30,000
Accounts payable 2,350
Anggun Rias is owned by Mrs. Disdi and operated as a sole proprietor business
offering services in image consultancy. The transactions incurred by the business
throughout the month of January 2001 are as follows:
(a) Mrs. Disdi made a cash investment of RM5,000 for market expansion.
(b) Received RM2,920 in cash from customers for services provided.
(c) Paid creditors RM1,350.
(d) Paid RM2,000 office rental for the month of January.
(e) Billed customers for RM4,245 for services provided.
(f) Purchased supplies valued at RM280 on credit.
(g) Sent staff to attend beautification course, the fees of RM500 was paid by
cash. Mrs. Disdi has a special allocation for staff training.
(h) Received cash from customer for RM2,000 as payment on accounts
receivable.
(i) The value of the balance of supplies at the end of the month was calculated
at RM750.
(j) Paid staff salary amounting to RM2,000, utility expenses of RM800 and
RM155 in expenses. Mrs. Disdi took supplies valued at RM100 for personal
use.
w QUESTION
1. Determine the amount of asset, liability and ownerÊs equity for the business
of Anggun Rias as at 1 January 2001.
2. Analyse each transaction using the accounting equation format that you
have learned. For each transaction, show the increase or decrease that has
occurred. Also show the balance after each transaction.
3. Prepare:
(a) Income Statement for the month of January 2001.
(b) Statement of Changes in OwnerÊs Equity for the month of January
2001.
(c) Balance Sheet as at 31 January 2001.
(d) Cash Flow Statement for the month of January 2001.
To resolve this problem, you must:

1. understand what is meant by asset, liability and ownerÊs equity. You must
also be familiar with several examples of the common accounts used for
each type of account.
2. know the structure of the accounting equation and the effect of transactions
on the components in the equation.
3. be familiar with the formats of the four main financial statements in
financial reporting.
Topic 3w Financial
Statements
LEARNING OUTCOMES
At the end of this topic, you should able to:
1. identify the accounts contained in the income statement and in
the balance sheet;
2. prepare the statement of retained earnings and cash flow
statement; and
3. interpret the financial statements prepared.
w INTRODUCTION
Financial statement is a summary data on asset, liability and equity as well as
income and expenditure of a business for a specific period. Financial statement is
used by financial managers to evaluate the companyÊs status and for making the
companyÊs future planning.
In this chapter, you will learn about the four main financial statements, which are
the income statement, balance sheet, statement of retained earnings and cash
flow statement. In the beginning, you will be exposed to the basic format of each
financial statement. Subsequently, you will learn how to prepare each of the
financial statement. Understanding of the financial statements are important as
these financial statements will assist in evaluating the companyÊs performance.
80 w TOPIC 3 FINANCIAL STATEMENTS
3.1 ANNUAL REPORT AND USERS OF

FINANCIAL STATEMENTS
Who are the users of financial statements? What sort or type of

information is required by them?
Figure 3.1: Information in the annual report
Companies are required to report their businessÊs financial status at the end of
each accounting period in the annual report.
Annual reports usually contain messagesÊ from the chairman, financial

statements and notes explaining the practices and policies adopted in reporting
the companyÊs accounts.
There are two types of information in an annual report. The first section is the
message from the chairman. It reports the companyÊs achievement throughout
that year and discusses on new developments that will affect the companyÊs
future operations. The second section will report on the basic financial statements
such as the income statement, balance sheet, statement of retained earnings and
cash flow statement.
Financial statements illustrate the operations and financial status of a company.

Detailed data are prepared for past two or three years together with a summary
TOPIC 3 FINANCIAL STATEMENTS v 81
of the main statistics for the past five or ten years. Normally, financial statements
are followed by notes explaining in detail the items found in the statements.
These notes explain the policies or accounting practices that were used in the
preparation of the financial statements. For example, further notes on inventory
might explain the method of inventory recording being adopted by the company.
Several groups of users are interested in the information contained in the

financial statements. They examine the statements in detail and interpret the
information according to their own interests. The objective of the analysis is the
evaluation on the specific aspect of the companyÊs performance. The information
required by the user depends on the type of intended decision. We can divide the
users of financial statements into two groups:
Figure 3.2 Two groups of users of financial statements
(a) Internal users include the manager and other officers that operate the
business. They are responsible in planning the strategies and operations of
the company. Therefore, they use the financial statements to obtain
information on the overall companyÊs performance.
(b) External users of the company are not directly involved in the operations of
the company. They comprise of users whom have direct interest in the
company (such as shareholders, investors and creditors) and users whom
have indirect interest in the company (such as customers, tax agent and
labour organisations).
Shareholders and potential investors use financial statements to help them to

interpret what will happen to the company in the future. Short-term creditors
will look at the companyÊs liquidity while long-term creditors look at the ability
of the company to settle the interests and payment of the long-term principal
debts.
The Companies Act 1965 stipulates that at least four of the following financial
statements must to be included in the annual reports, which are:
•
•
income statements;
•
balance sheet;
•
statement of retained earnings; and
cash flow statement
Let us look at these financial statements and the relationship between each of
them by basing on the financial statements of Company FAZ as an example.
3.2 INCOME STATEMENT
What are the usages of income statement to the financial operations of a

company?
Income statement measures the operating performance of a company for a

specific period, normally for a period of one year ending at a specific date,
usually at 31 December.
Monthly statements are also prepared for the usage of the management who
required more frequent information to enable more prudent decisions to be
made. Yearly quarter statements are also prepared for shareholders of public
companies.
Income statements provide information to evaluate the firmsÊ performances. To

measure a firmÊs performance, several important aspects in the income statement
must be given priority:
• Sales figure can be compared with the firmÊs sales for the previous year and
the expected sales in the future. This information can be used for the firmÊs
•
future planning.
Gross profit/gross loss can be compared with the sales figure to show
•
profit from the products/services sold.
Firm expenditures can be compared with the firmÊs expenditures for the
previous year to see which policy can be adopted to reduce costs.
Table 3.1 is the income statement of Company FAZ for year ended 31 December
2002. This statement starts with sales revenue that is the sales value in ringgit
throughout the accounting period. Cost of goods sold is deducted from the sales
revenue to obtain gross profit of RM70,000. This total is the amount obtained
from sales to cover the financial operating costs and tax.
All the operating expenditures such as sales expenses, general and

administrative expenses and depreciation expenses will be listed and totalled to
obtain the total operating expenditure. This total will then be deducted from the
gross profit to obtain profit from operations of RM37,000. Profit from operations
is the profit obtained from activities of manufacturing and selling of products; it
does not take into account the financial costs and tax. Profit from operations is
also known as profit before interest and tax.
Thereafter, the financial cost that is the interest expenses of RM7,000 will be
deducted from the profit from operations to obtain the profit before tax of
RM30,000. After deducting tax, we will obtain profit after tax (or profit before
preference shares) of RM18,000.
Any dividends for preference shares must be deducted from the profit after tax
to obtain net profit. This total is also known as profit available to the ordinary
shareholders and is the total obtained by the company on behalf of ordinary
shareholders throughout the specific period. Normally, reports on earnings per
share are provided at the last section of the income statement. Earnings per share
show the total obtained by the company throughout the specific period for each
ordinary share. In year 2002, Company FAZ obtained RM17,000 for the ordinary
shareholders or RM0.17 for each share issued (total ordinary shares is 100,000).
Earnings per share are often referred as the Âbottom lineÊ to show that earnings
per share are the most important item in the income statement compared to the
other items.
Figure 3.3: CompanyÊs objectives are to increase earnings and maximise profit
If you are one of the preference shareholders in Company FAZ, how

would the information contained in the company’s financial statements
be useful to you?
Table 3.1: Income Statement
Company FAZ
Income Statement
for the Year Ended 31 December 2002
RM
Sales 170,000
Less: Cost of goods sold 100,000
Gross profit 70,000
Less: Operating expenditure
Sales expenses 8,000
Administrative and general expenses 15,000
Depreciation expenses 10,000
Total operating expenditure 33,000
Profit before interest and tax 37,000
Interest 7,000
Profit before tax 30,000
Tax (40%) 12,000
Profit after tax 18,000
Less: Dividend for preference shares 1,000
Net profit (or profit available for ordinary shareholders) 17,000
Earnings per share = Net profit/ total ordinary shares 0.17
3.3 BALANCE SHEET
Explain in further detail the difference between asset, liability and equity.
Balance sheet is a statement that summarises the status of a company at a specific

point of time. Balance sheet shows the accounts for assets, liabilities and equities. It
balances the companyÊs assets (what it owns) with its financing, either debts
Table 3.2: Balance Sheet
Company FAZ
Balance Sheet
As at 31 December 2002 and 2001
31-12-2002 31-12-2001
RM RM
Assets
Current assets
Cash 40,000 30,000
Marketable securities 60,000 20,000
Account receivables 40,000 50,000
Inventory 60,000 90,000
Total current assets 200,000 190,000
Long-term assets
Land and building 120,000 105,000
Machines and equipment 85,000 80,000
Fixtures and fittings 30,000 22,000
Vehicles 10,000 8,000
Others (including lease) 5,000 5,000
Total fixed assets 250,000 220,000
Less: Accumulated depreciation 130,000 120,000
Fixed assets, net 120,000 100,000
TOTAL ASSETS 320,000 290,000
Liabilities and Equities

Current liabilities
Account payable 70,000 50,000
Notes payable 60,000 70,000
Tax accrual 10,000 20,000
Total current liabilities 140,000 140,000
Long-term debts 60,000 40,000
Total liabilities 200,000 180,000
Equities
Preference shares 10,000 10,000
Ordinary shares, RM10 par value,
4,500 shares 12,000 12,000
Paid-up capital above par 38,000 38,000
Retained earnings 60,000 50,000
Total equities 120,000 110,000
TOTAL LIABILITIES AND EQUITIES 320,000 290,000

3.3.1 Assets
Assets are valuable economy resources owned by the business. It can be used in
several activities such as manufacturing, usage and exchange. Assets have
Âservice potentialÊ or will Âbring economic benefit in the futureÊ. Assets have the
capability to provide services or generate benefit to the business entity that owns
it. In businesses, services or economic benefit will generate cash inflow (receiving
cash) to the business.
Assets can be categorised into current assets and long-term assets. Assets are
listed in the balance sheet according to its liquidity level from the most liquid to
the less liquid. Therefore, current assets are arranged first, followed by fixed
assets.
(a) Current Assets

Current assets are assets that can be converted into cash in the shortest
period, which is within a year or less. The current assets for Company FAZ
comprised of:
•
•
Cash
•
Marketable securities
•
Account receivables
Inventory
Cash is the most liquid of current assets. Marketable securities such as

government bills or deposit certificates are short-term investments that are
highly liquid. Marketable securities can sometimes be seen as a form of cash
due to its high liquidity. Account receivables are debts owed by customers
who bought goods by credit from the company. Inventory comprised of
raw materials, work in process and finished goods held by the company.
Other current assets which are not in Company FAZÊs balance sheet are
prepaid expenses (prepayment). Prepaid expenses are expenses that have
been paid in advance by cash but the benefits from the expenses have not
been received. Examples of prepaid expenses are prepaid rental, prepaid
insurance and office supplies.
(b) Long-Term Assets

Long-term assets are assets that are held by the company for a rather long
period, which is more than a year. Long-term assets are categorised into
fixed assets, other long-term assets and intangible assets. The long-term
assets of Company FAZ only comprised of fixed assets.
Fixed assets are land and buildings, machines and equipment, fixtures and
fittings and vehicles. Usually, a company will report the total fixed asset
that is the original cost of all the fixed assets owned by the company. From
that total, the company will deduct the accumulated depreciation for all
fixed assets to obtain net fixed assets. All fixed assets must be depreciated
except for land. This is because the value of land will always increase while
the values of other fixed assets such as machines and equipment, as well as
vehicles will decrease when the life span of the asset increases.
Other long-term assets comprise of long-term investments (such as bonds

and shares) prepaid expenses and account receivables that involve a period
of more than a year.
Besides current assets and fixed assets, a business might show intangible
assets in its balance sheet. Intangible assets are long-term assets that cannot
be physically seen and usually provides a competitive advantage compared
to the competitors. Examples of intangible assets are patents, franchise
licences, licences, trademarks, copyrights and goodwill. Although these
assets cannot be physically seen, it is recorded using the same method as
the other fixed assets. This means that the assets will be recorded at its
original cost and this cost will be amortised throughout its lifetime. Among
the intangible assets that are famous are the patent of Polaroid, the
franchise of McDonald and the trademark of Colonel SanderÊs Kentucky
Fried Chicken.
If you used a private vehicle to conduct the company’s business, would

that vehicle be considered a company’s asset?
3.3.2 Liabilities
Most businesses have been in situations where they need to take loans to finance
the businessÊs assets or to buy assets such as raw materials on credit. Liabilities
are claims made by creditors on the company assets. In other words, liabilities
are debts and obligations of a company. Liabilities comprise of current liabilities
and long-term liabilities.
If a situation occurs where the company is unable to pay its business liabilities,
the creditors can force the company to be liquidated. In this situation, the
creditorsÊ claims must be settled first before the company can settle the claims of
the shareholders.
(a) Current Liabilities

Current liabilities are short-term debts, or debts that will mature within the
period of one year or less. Company FAZÊs current liabilities are:
•
•
Account payable;
•
Notes payable; and
Tax accrual
Account payable is the obligation of the company towards its suppliers

when the company purchases raw materials and finished goods on credit.
Notes payable is a written obligation of Company FAZ. The obligation is
with the Bank for the loan to purchase vehicles for the usage of the
company. The company also has tax accrual, that is the tax that must be
paid to the government but still outstanding.
Other current liability that is not in the balance sheet of Company FAZ is
deferred income. Deferred income is cash that had been received from
customers but the services or products paid had not been provided.
Examples of deferred income are deferred rental and deposit from
customers.
(b) Long-Term Liabilities

Long-term liabilities are the responsibilities or obligations that mature in a
period of more than a year. These claims might be in the type of bonds,
long-term notes payable and lease.
Bonds are a type of fixed income securities that are issued by companies.
Notes payables are a type of credit transaction that involves a written
agreement between the company and creditors. Mortgage loans are long-
term loan that use the assets (such as land and buildings) as a mortgage for
the loan. Notes payable can also be mortgaged with the other assets as a
security for the loan. A lease is a contractual agreement between the lessor
and the lessee. The lessor gives the right to the lessee to use the asset for a
specific period and will impose charges for usage of the asset.
3.3.3 Owners’ Equity or Shareholder’s Equity

OwnersÊ or shareholdersÊ claim towards the assets are known as ownersÊ equity
or shareholdersÊ equity. In the balance sheet of Company FAZ, the ownersÊ
equity comprised of:
(a) preference shares;

(b) ordinary shares;
(c) paid up capital above par; and
(d) retained earnings
Preference shares are securities that provide fixed return dividend to its holders.
Preference shareholders do not have ownership in the company.
Ordinary shares are securities that reflect the ownership of the company.
Ordinary shareholders are the real owners of the company. They will receive
returns in dividends that will be paid to them in cash or shares (bonus issues).
There will be situations where the par value (stated value) is not equal to the
market price of the ordinary shares at the time of issue. Cash earnings from the
issuance of shares might be equal, more or less from the par value. When this
situation occurs, the company will record the issuance of shares at the par value
in the Ordinary Shares account and the difference between the par value and the
shareÊs selling price (surplus earnings) will be recorded in a separate account
known as Paid Up Capital Above Par.
Retained earnings are the total accumulated earnings since incorporation that
had not been distributed to the shareholders as dividend but was re-invested into
the company. It is important to remember that retained earnings are not cash but
are earnings that have been used to finance the companyÊs assets.
3.3.4 Summary of Basic Accounting

Assuming that a newly started business was self financed by the businessÊs
owner. This means that all the companyÊs assets belongs or claimable by the
businessÊs owner.
This relationship can be shown by the equation below:
Assets = OwnerÊs Equity
However, businesses are normally financed by the businessesÊ owners and

creditors. Therefore, claims on the assets are equal to the claims by the creditors
(liabilities) added with the claims by the owner of the business (ownerÊs equity)
towards the assets. This relationship can be shown in the equation below:
Assets = Liabilities + OwnerÊs Equity

The equation above is known as the summary of basic accounting where the total
assets must be equal to the total liabilities plus owner's equity. Owner's equity is
equal to total assets less total liabilities. This is because the assets of a business
are financed by either the creditors or the owner. To determine the owner's
portion (owner's equity), we must deduct the creditors' portion (liabilities) from
the assets. The balance will be the claim of the owner on the business's assets. As
the creditors' claims would be given priority over the owner's claims upon
liquidation, the owner's claims are also known as residual equity.
By using the summary of basic accounting, connect the relationship

between cash, account payable, account receivable, retained
earnings, marketable securities and ordinary shares.
EXERCISE 3.1
1. Balance sheet is the statement on the financial status of a

company for a specific period.
(a) True (b) False
2. Income statement is the statement that attempts to measure the

result of a company's operating decisions at specific point of
time.
(a) True (b) False
3. Fixed assets are items would not be converted into cash within a
period of one year.
(a) True (b) False
4. Investments in financial securities are considered as current

assets
(a) True (b) False
5. Which is FALSE?
A. Assets = Liabilities + Owner's Equity
B. Assets < Liabilities = Owner's Equity
C. Assets + Liabilities = Owner's Equity
D. Assets < Owner's Equity = Liabilities
6. Mark on each of the accounts listed below as follows:

(a) In column (1), state the appropriate statement < whether the
account is in the Income Statement (IS) or the Balance Sheet
(BS)
(b) In column (2), state whether the account is a current asset

(CA), fixed asset (FA), current liabilities (CL), long term
liabilities (LTL), shareholder's equity (SE), income (I) or
expenditure (EX).
Account (1) Statement (2) Type of Account
Account payable _______________ ___________________
Account receivable _______________ ___________________
Accrual _______________ ___________________
Building _______________ ___________________
General expenses _______________ ___________________
Interest expenses _______________ ___________________
Sales expenses _______________ ___________________
Operating expenses _______________ ___________________
Administrative expenses _______________ ___________________
Tax _______________ ___________________
Preference sharesÊ dividends _______________ ___________________
Sales revenue _______________ ___________________
Long-term debts _______________ ___________________
Inventory _______________ ___________________
Cost of goods sold _______________ ___________________
Paid up capital above par _______________ ___________________
Notes payable _______________ ___________________
Retained earnings _______________ ___________________
Equipments _______________ ___________________
Ordinary shares _______________ ___________________
Preference share _______________ ___________________
Marketable securities _______________ ___________________
Depreciation _______________ ___________________
Accumulated depreciation _______________ ___________________
Land _______________ ___________________
Cash _______________ _________________
7. Use the relevant items listed below to prepare the income

statement for Company PC for period ending 31 December 2001.
Items Value as at 31 December 2001

(RM Â000)
Account receivable 3,500
Accumulated depreciation 2,050
Cost of goods sold 2,850
Depreciation expenses 550
General and administrative expenses 600
Interest expenses 250
Preference sharesÊ dividends 100
Sales revenue 5,250
Sales expenses 350
ShareholdersÊ equity 2,650
Tax Rate = 30%
8. Use the relevant items from the list below to prepare the balance
sheet for Company ODC as at 31 December 2001.
Item Value at 31 December 2001

(RM Â000)
Account payable 2,200
Account receivable 4,500
Accrual 550
Building 2,250
General expenses 3,200
Depreciation expenses 450
Sales revenue 3,600
Long-term loans 4,200
Inventory 3,750
Equipments 2,350
Machines 4,200
Paid up capital above par 3,600
Note payable 4,750
Retained earnings 2,100
Ordinary shares (at par) 900
Preference shares 1,000
Marketable securities 750
Land 2,000
Cash 2,150
3.4 STATEMENT OF RETAINED EARNINGS

Statement of retained earnings showed how the retained earnings account in the
balance sheet is adjusted between two dates of the balance sheet. Statement of
retained earnings will adjust the net profit generated throughout the period and
any dividends paid, with the changes in the retained earnings in the beginning
and ending of the year. Table 3.3 showed the statement of retained earnings for
Company FAZ for year ended 31 December 2002.
The statement showed that the company started with a retained earnings of
RM50,000 on 31 December 2001 or 1 January 2002 and profit after tax of
RM18,000 (data obtained from the income statement). From this total, the
company had paid dividends for preference shares of RM1,000 and dividends for
ordinary shares of RM7,000. Therefore, the retained earnings had increased by
RM10,000 from RM50,000 as at 1 January 2002 to RM60,000 as at 31 December
2002.
Table 3.3: Statement of Retained Earnings
Company FAZ
Statement of Retained Earnings
Retained earnings, 1 January 2002 RM50,000

+ Net profit (throughout year 2002) 18,000
Dividends paid (throughout year 2002)
Preference shares RM1,000
Ordinary shares 7,000 8,000
Retained earnings, 31 December 2002 RM60,000
3.5 CASH FLOW STATEMENT
What will affect the status of cash and marketable securities of a

company?
Cash flow statement shows how the activities in a company such as operating,
investing and financing activity that can influence the status of cash and
marketable securities. Cash flow statement is the statement that summarises the
cash flow throughout a specific period, normally for the current year ended. Data
from the balance sheet and income statement are used to prepare the cash flow
statements.
Cash flow statement can assist the finance manager to:

• evaluate the companyÊs capability to generate positive cash flow in the
•
future; and
evaluate the companyÊs capability to settle debts, pay dividends and
provide loans.
(a) Operating Activities

Operating activities refer to the activities that are directly related to the
production of products, sales and services of the company such as the sales
and purchases of goods/services, rental income, fees income, wages and
salaries of employees, utility expenses and rental expenses.
(b) Investing Activities

Investing activities refer to the activities that are related with the buying
and selling of long-term assets such as the sale and purchase of fixed assets,
selling of investments, buying of stocks and bonds (investing) and loans to
other entities.
(c) Financing Activities

Financing activities refer to the activities that are related to the current
liabilities and long-term liabilities as well as ownerÊs equity such as
repayment of loans, short-term and long-term loans and shares buyback.
3.5.1 Preparing Cash Flow Statement

Data obtained from the balance sheet together with the net profit, depreciation
and dividends obtained from the income statement can be used to prepare the
cash flow statement. You can do this by using the three steps below:
Step 1 Classify the data into one of these three components:
(a) Cash flow from operating activities

(b) Cash flow from investing activities
(c) Cash flow from financing activities
Step 2 List the data according to the arrangement in Table 2.4. All resources
and net profit including depreciation are positive cash flow, which is
the cash flowing in; while all usages, any losses and dividends payable
are negative cash flow, which is the cash flowing out. Obtain the total
for the items in each component.
Step 3 Add the total from each component to obtain the „Increase (or decrease)
of net cash and marketable securities‰. To check whether you had
prepared the statement correctly, ensure that the value is equal to the
changes in cash and marketable securities for the relevant year by
looking at the opening and closing balances of cash and marketable
securities in the balance sheet.
Table 3.4: Components and Data Sources that Must be Included into the
Cash Flow Statement
RM
Cash Flow from Operating Activities
Net profit (Net loss) IS
Depreciation and other non-cash charges IS
Changes in all current assets BS
(except cash and marketable securities)
Changes in all current liabilities BS
(except notes payable)
Cash flow from operating activities xx
Cash Flow from Investing Activities

Changes in total fixed assets BS
Changes in the companyÊs interest BS
Cash flow from investing activities xx
Cash Flow from Financing Activities

Changes in notes payable BS
Changes in long-term loans BS
Changes in shareholdersÊ equity BS
(other than retained earnings)
Cash flow from financing activities xx
Increase (or decrease) in cash and marketable securities ___

XX
Data Sources
BS = Balance Sheet
IS = Income Statement
Example of Cash Flow Statement: Company FAZ

The cash flow statement of Company FAZ for year ended 31 December 2002 is
shown in Table 2.5. Based on this cash flow statement, the company had enjoyed
an increase of RM50,000 in cash and marketable securities for the year 2002 (refer
to Table 3.5). The cash of the company increased by RM10,000 while the
marketable securities increased by RM40,000 between the two dates.
Table 3.5: Cash Flow Statement of Company FAZ
Company FAZ
Cash Flow Statement
as at 31 December 2002
RM RM
Net Profit 18,000
Depreciation 10,000
Decrease in account receivable 10,000
Decrease in inventory 30,000
Increase in account payable 20,000
Decrease in tax accrual (10,000)
Cash flow from operating services 78,000
Cash Flow from Investing Activities

Increase in total fixed assets (30,000)
Cash flow from investing activities (30,000)
Cash Flow from Financing Activities

Decrease in short term notes payable (10,000)
Increase in long term loan 20,000
Changes in shareholders' equity -
Dividends paid (8,000)
Cash flow from financing activities 2,000
Net increase in cash and marketable securities 50,000

(a) Cash Flow from Operating Activities

The operating activities in the cash flow statements showed that the profit
after tax of Company FAZ is RM18,000 for year 2002. Depreciation expenses
of RM10,000 deducted from the income statement had been added back
into the cash flow statement as it is not cash outflow.
Account receivable had decreased by RM10,000 which means that the

company had collected credit accounts from its customers. Inventory had
also decreased from RM90,000 in year 2001 to RM60,000 in year 2002,
representing cash resources of RM30,000 to the company. In the liabilities
section, notice that the account payable had increased by RM20,000. This
means that the company had increase its debts from the suppliers and this
represents cash inflow. Tax accrual had decreased by RM10,000 indicating
that the company had used RM10,000 cash to pay tax.
(b) Cash Flow from Investing Activities

Fixed assets of Company FAZ had increased by RM30,000 between 31
December 2001 and 31 December 2002. This increment reflected in the cash
outflow used to by additional assets.
(c) Cash Flow from Financing Activities

Notes payable of Company FAZ has decreased by RM10,000 indicating
cash outflow as the company paid its shor-term loans. Long-term liabilities
increased by RM20,000 indicating cash inflow. The company obtained loans
to acquire additional cash.
3.5.2 Differentiating Cash Resources and Usage

Before we can prepare the cash flow, we must classify the cash flow from
operating, investing and financing activities into cash resources or usage. Table
2.6 lists the basic cash resources and usage.
Several issues that can help you to classify between cash resources and usage:
Table 3.6: Cash Resources and Usage
Cash Resources Cash Usage

Decrease in asset Increase in asset
Increase in liability Decrease in liability
Net profit Net loss
Depreciation Payment of dividends

Sale of shares Shares Buyback
(a) Decrease in the asset account is a cash inflow resource while increase in the
asset account is a cash usage or cash outflow.
Company bought new assets by cash. Therefore, any increase in the asset
items between the two dates of the balance sheets will indicate that cash
outflow had occurred. Any decrease in the asset items will indicate cash
inflow as the company had sold the assets to obtain cash.
(b) Increase in the liability account and ownerÊs equity is a cash inflow
resources and a decrease in the liability account is cash usage.
The company might use cash to settle its liability and claims on the assets.
Therefore, any decrease in the liability items, preference shares or ordinary
shares between the two dates of balance sheets indicates cash outflow. To
obtain additional cash, the company can make loans. Therefore, any
increase in the liability items, preference shares or ordinary shares
indicated cash inflow.
(c) Depreciation is a cash flow resource as is not cash expenses (non-cash

charges). Non-cash expenditures are all expenses deducted from sales in
the income statement but actually do not involve any cash outflow
throughout the period. Depreciation and amortisation are examples of non-
cash expenses.
(d) Direct changes in the retained earnings are not included in the cash flow
statement as these items affects the retained earnings and are shown as
profit after tax (or loss after tax) and cash dividends.
Table 3.7 shows changes in the balance sheet items of Company FAZ between 31
December 2001 and 31 December 2002.
Table 3.7: Changes in the Balance Sheet Items

Company FAZ
Changes in the Balance Sheet Items between 31 December 2001
and 31 December 2002
Classification
31-12-01 31-12-02 Changes Resource Usage
Assets
RM RM RM RM RM
Cash 30,000 40,000 +10,000 10,000
Marketable securities 20,000 60,000 +40,000 40,000
Account Receivable 50,000 40,000 <10,000 10,000
Inventory 90,000 60,000 <30,000 30,000
Total fixed assets 220,000 250,000 +30,000 30,000
Less:
Accumulated
Depreciation (120,000) (130,000) <10,000 10,000
Liabilities
Account payable 50,000 70,000 +20,000 20,000
Notes payable 70,000 60,000 <10,000 10,000
Tax accrual 20,000 10,000 <10,000 10,000
Long-term loan 40,000 60,000 +20,000 20,000
Equities
Preference shares 10,000 10,000 0
Original shares at par 12,000 12,000 0
Paid-up capital 38,000 38,000 0
Retained earnings 50,000 60,000 +10,000 10,000
TOTAL 100,000 100,000
From Table 3.7, we found that:

• Account receivable decreased by RM10,000 and this is considered as a cash
•
resource as when debts are collected, the company obtain cash.
Inventory decreased by RM30,000 and this is considered a cash resource as
•
the company obtained cash from the product sold.
Total fixed assets increased by RM30,000 and this is considered as cash
•
usage as the company uses the cash to buy fixed assets.
Increased in account payable and long-term loans of RM20,000 are
considered cash sources as the company increased its debt with suppliers.
• Notes payable and tax accrual decreased by RM10,000 and this are
considered as cash usage as the cash was used to settle debts to the
creditors and tax to the government.
These types of classifications (based on Table 2.6) are made on every item in the
balance sheet. The result of these classifications will be totalled to obtain the total
cash resources and total cash usage. If these classifications are done correctly, the
total cash resources will be equal to the total cash usages.
YOUR IDEA
All sorts of support and loan assistance had been provided by the
government through organisations such as the Perbadanan Usahawan
Nasional Berhad (PUNB) to encourage the participation of bumiputera in the
area of entrepreneurship. Many have grabbed this opportunity to be involved
in their own businesses covering various economic sectors but not all of
them succeeded. What is your opinion on this matter?
EXERCISE 3.2
1. In the Cash Flow Statement, you will see that both interest
expenses and dividends paid in the section of financing activities.
(a) True (b) False
2. Depreciation expense is one of the items that will be deducted

from the net profit to determine the cash flow from operating
activities.
(a) True (b) False
3. Profit from the sale of fixed assets will be deducted from the net
profit to ascertain the cash flow from operating activities.
(a) True (b) False
4. Payment to suppliers for the purchase of materials will be

included into the cash flow statement in the section of cash from
financing activities.
(a) True (b) False
5. Information included in the cash flow statement are obtained

from _______________.
A. income statement
B. balance sheet
C. income statement and balance sheet
6. Interest expenses are regarded as _________________ in the

income statement and ___________ in the cash flow statement.
A. operating expenses; item from operating activity

B. financing expenses; item from financing activity
C. operating expenses; item from financing activity
D. financing expenses; item from operating activity
7. Hugo Enterprise begun the year 2000 with retained earnings of

RM92,800. Throughout year 2000, the company obtained
RM37,700 after tax. From this amount, preference shareholders
were paid dividends of RM4,700. At the end of year 2000, retained
earnings of the company total RM104,800. 14,000 units of ordinary
shares were issued throughout year 2000.
(a) Prepare the retained earnings statement for the year ended
31 December 2000 (ensure that you calculate and include the
total dividends of ordinary shares paid in the year 2000).
(b) Calculate the earnings per share for year 2000.
(c) How much dividend per share was paid by the company to
the ordinary shareholders for the year 2000?
8. Profit after tax of year 2001 for Company Ceria is RM186,000. The
closing balance for retained earnings for year 2001 and 2000 were
RM812,000 and RM736,000 accordingly. How much dividend did
the company paid in the year 2000?
9. Classify each of the following items as funds resource (R) or usage

(U), or neither (N) both.
Item Changes (RM) Cash Flow

Cash + 1,000 ________________
Account payable - 10,000 ________________
Notes payable + 5,000 ________________
Long term loans - 20,000 ________________
Inventory + 2,000 ________________
Fixed assets + 4,000 ________________
Account receivable - 7,000 ________________
Net profit + 6,000 ________________
Depreciation + 1,000 ________________
Share buyback + 6,000 ________________
Cash dividend + 8,000 ________________
Sale of Share +10,000 ________________
Financial statements represents the financial outlook of a company. Information

from the income statements; balance sheet; statement of retained earning and
cash flow statement are used to measure the companyÊs current financial status
as well as financial planning for the future. Having a clear understanding of
financial statements will prepare you to analyse the financial ratio in the next
topic.
Topic 4 w Financial
Statement
Analysis
LEARNING OUTCOMES
At the end of this topic, you should able to:
1. calculate and define three liquidity ratios, which are the net
working capital, current ratio and quick ratio;
2. calculate and explain the six asset management ratios, which are
the account receivable turnover ratio, average collection period,
inventory turnover, average inventory sales period, fixed assets
turnover and total assets turnover;
3. calculate and explain the three financial leverage ratios, which
are the debt ratio, debt equity ratio, equity multiplier and interest
coverage ratio;
4. calculate and explain the four profitability ratios, which are the
gross profit margin, net profit margin, return on asset and return
on equity;
5. calculate and explain the two market value ratios which are price
earnings ratio and dividend yield ratio; and
6. calculate the DuPont analysis and explaining its advantages to
the finance managers.
w INTRODUCTION
Financial analysis is an evaluation of the companyÊs financial achievement for the
previous years and its prospect in the future. Normally the evaluation will
involve analysis of the companyÊs financial statement. Information from the
financial statement is used to identify the relative strengths and weaknesses of
the company compared to its competitor and providing indication on areas that
needs to be investigated and improved.
106 w TOPIC 4 FINANCIAL STATEMENT ANALYSIS
Finance manager use the financial analysis for the companyÊs future planning.
For example, shareholders and potential investors are interested in the level of
returns and risks of the company. Creditors are interested in the short-term
liquidity level and the ability of the company to settle its interests and debts.
They will also emphasis on the profitability of the company as they want to
ensure that the companyÊs performance is good and will be successful. Therefore,
the finance manager must know the entire aspects of the financial analysis that
are being focused by several parties having their own interests in evaluating the
company.
Beside the finance manager, the management also uses the financial analysis to
monitor the companyÊs achievement from time to time. Any unexpected changes
will be examined to identify the problems that need to be dealt with.
4.1 FINANCIAL RATIO ANALYSIS
What is the relevance in calculating the financial ratios for short term and
long term operations? Should its value be in accordance with the average
performance of the industry? Please explain.
Financial ratio analysis involves the calculation of several ratios that will enable
the manager to evaluate the performance and financial status of the company by
comparing its financial ratios with the financial ratios of other companies. These
ratios are divided into five groups or categories, which are:
(a) Liquidity Ratio

Liquidity ratio refers to the companyÊs ability to fulfil its short-term
maturity claims or obligations.
(b) Asset Management Ratio
Asset management ratio refers to the efficiency of the company to use its
assets and how fast specific accounts can be converted into sales or cash.
(c) Leverage Ratio
Leverage ratio refers to the level of debt usage or the ability of the company
to fulfil its financial claims such as interest claims.
(d) Profitability Ratio
Profitability ratio refers to the effectiveness of the company in generating
returns from investments and sales, for example, gross profit margin, net
profit margin, operating profit margin, return from assets and returns from
equity.
TOPIC 4 FINANCIAL STATEMENT ANALYSIS v 107
(e) Market value Ratio

Market value ratio refers to the ability of the company to create market
values in excess of its investment costs. Liquidity, asset management and
leverage ratios measure the companyÊs risk while the profitability ratio
measures the companyÊs returns.
Within the short-term period, liquidity, asset management and profitability ratios
are important to the management of the company as these ratios provide critical
information on the companyÊs short-term operations. If a business is unable to
sustain within the short-term period, it would be irrelevant to discuss its long-
term prospects.
Before preparing the ratio analysis, the finance manager must have consideration
to the following issues:
• One ratio is unable to give complete information on the status of the
company. This means that several categories of ratios must be looked at
simultaneously before any conclusion can be made.
• Comparisons between the financial ratios for one company with other
companies in the industry must be made at the same point of time. Industry
average is not a figure that must be achieved by a company. There are
many companies that had been managed efficiently but the performance of
their financial ratios is much higher or lower than the performance of the
industry average. The obvious difference between the financial ratios of the
company and the industry average is an indication to the analysers to check
on the ratio further.
• Use the financial statements that have been audited. This will show the
actual status of the company.
• Use the same method to evaluate items in the financial statement that will
be compared. For example, to record inventory, a company might use
different accounting methods such as the first-in-first-out, first-in-last-out
or moving average method. Choose only one of these methods for
comparison purposes. Different methods will provide different ratio values.
Therefore, actual evaluation cannot be done.
Financial statements of the company are the main input for the manager who
intend to prepare the ratio analysis for its company. Each example of the ratios
that will be discussed in the next section will be using the financial information
extracted from the income statement and balance sheet of Company ABC (refer
to Table 4.1 and Table 4.2).
4.1.1 Income Statement

The income statement for Company ABC for the year ended 31 December 2001
and 31 December 2002 are shown in Table 2.8. The income statement shows the
operating performance of the company for a specific period.
Table 4.1: Income Statement for Company ABC
Company ABC
Income Statement
for the Year Ended 31 December 2001 and 2000
2001 2000
RM RM
Sales 307,400 256,700
Less: Cost of goods sold 208,800 171,000
Gross profit 98,600 85,600
Less: Operating expenses
Sales expenses 10,000 10,800
Administrative and general expenses 19,400 18,700
Lease expenses 3,500 3,500
Depreciation expenses 23,900 22,300
Total operating expenses 56,800 55,300
Profit before interest and tax (operating profit) 41,800 30,300
Less: Interest expense 9,300 9,100
Profit before tax 32,500 21,200
Less: Tax (29%) 9,400 6,100
Profit after tax 23,100 15,100
Less: Preference sharesÊ dividend 1,000 1,000
Profit available for ordinary shareholders 22,100 14,100
Earnings per share 0.29 0.18
4.1.2 Balance Sheet

Balance sheet shows the overall value of various assets and claims on these assets
at a specific point of time. For Company ABC, the balance sheet shows the assets,
liabilities and equities as at 31 December 2001 and 31 December 2000 as shown in
Table 4.2.
Table 4.2: Balance Sheet
Company ABC
Balance Sheet
as at 31 December 2001 and 31 December 2000
2001 2000
RM RM
Assets
Current Assets
Cash 36,300 28,800
Account receivable 50,300 36,500
Inventory 28,900 30,000
Total current assets 122,300 100,400
Net Fixed Assets 237,400 226,600
Total Assets 359,700 327,000

Current liabilities
Account payable 38,200 27,000
Notes payable 7,900 9,900
Accruals 15,900 11,400
Total current liabilities 62,000 48,300
Long-term loans 102,300 96,700
Total liabilities 164,300 145,000
Equities
Preference shares 20,000 20,000
Ordinary shares, RM2.50 par value, 19,100 19,000
100,000 shares issued 2001: 76,262;
2000: 76,244
Paid-up capital above par 42,800 41,800

Retained earnings 113,500 101,200
Total equities 195,400 182,000
Total liabilities and shareholders' equities 359,700 327,000
4.2 LIQUIDITY RATIO
What do you understand by the definition of liquidity?
Liquidity refers to the ability of asset to be converted easily into cash without
affecting the value of the asset. Liquidity ratios refer to the ability of the company
to discharge its claims or short-term obligations by cash and assets that can be
converted into cash in a short period. Liquidity is important in operating the
business activities. A poor liquidity status is an early indication that the company
is facing fundamental problems. The liquidity ratios are shown in Figure 2.4.
Figure 4.1: Liquidity ratio
4.2.1 Net Working Capital

Net working capital is the difference between the total current assets with the
total current liabilities. It measures the funds (cash and items that can be easily
converted into cash) that are owned by the company in managing its daily
operating activities. The higher the value of the working capital, the better as this
shows that the company is able to settle its short-term debts with surplus funds
for its daily operating activities.
Net working capital of Company ABC for the year 2001 is calculated as follows:
Net working capital = Current assets < Current liabilities (2.1)

= RM122,300 < RM62,000
= RM60,300
Industry average = RM42,700
Based on the calculation above, the net working capital of Company ABC is
higher than the industry average. This shows that Company ABC is able to settle
its short-term debts and has higher surplus funds than the other companies in the
industry to manage its daily operations.
4.2.2 Current Ratio

Current ratio measures the ability of the company to fulfil its long-term loans
using its current assets. The higher the value of this ratio, the better the liquidity
status of the company. This shows that the company is able to settle short-term
debts using its current assets.
Current ratio is obtained by dividing the current assets with the current
liabilities. The current ratio of Company ABC is as follows:
Current Assets (2.2)

Current ratio =
Current Liabilities
RM122,300
= RM 62,000
= 1.97
Industry average = 2.05
The current ratio of Company ABC is 1.97 which is lower compared with the
industry average of 2.05. This shows that for every ringgit of current liability, the
company only has RM1.97 current assets for its payment compared to the other
companies in the industry that has RM2.05 to settle their current liabilities.
However, the current ratio of the company is not too low for concern.
Current ratio of 2.0 times is acceptable; however, this acceptance depends on the
type of industry. For example, current ratio of 1.0 is satisfactory for industries
such as utilities that have a rather stable business but unsatisfactory for
industries such as manufacturing due to business volatility.
The current ratio can be connected to the net working capital;

•
•
If the current ratio is equal to 1.0, the net working capital is zero.
•
If the current ratio is less than 1.0, then the net working capital is negative.
If the current ratio is more than 1.0, the net working capital is positive.
4.2.3 Quick Ratio

Quick ratio measures the ability of the company to pay its short-term loans
quickly. Quick ratio is a liquidity test that is more stringent compared to the net
working capital and current ratio. This is because quick ratio only takes into
consideration the cash and assets that can easily be converted into cash.
Inventory is not included with the other liquid assets due to the longer period for
the inventory to be converted into cash. Expenses prepaid are also not included
as it cannot be converted into cash. Therefore, it cannot be used to settle the
current liabilities.
Quick ratio is obtained when the most liquid current assets (cash, marketable
securities and account receivables) are divided with current liabilities. The higher
the quick asset ratio compared with the current liabilities, the better the liquidity
level of the company to settle its short-term loans quickly.
The calculation of quick ratio for Company ABC is as follows:
Current Assets-(Inventory+ Prepayments) (2.3)

Quick ratio =
Current liability
RM122,300 < RM28,900
= RM62,000
= 1.51 times
Industry average = 1.43 times
The quick ratio of Company ABC is 1.51 times, it is higher compared to the
industry average of 1.43 times. This means that the liquidity level of the
company is better compared to the other companies in the industry. For every
ringgit of current liability, the company has RM1.51 cash and assets that can
easily converted into cash to pay its short-term debts immediately. This is better
compared to other companies in the industry that only has RM1.43 to pay their
short-term debts immediately.
EXERCISE 4.1
1. The following data is taken from the financial statements of

Company Fazrul
1999 1998
Sales RM640,000 RM560,000
Cost of sold goods 380,000 360,000
Cash 30,000 26,000
Account receivable 70,000 62,000
Inventory 150,000 140,000
Prepayment items 10,000 10,000
Net fixed assets 300,000 260,000
Current liabilities 120,000 140,000
Based on the data above, calculate the following liquidity ratios for the
years 1998 and 1999:
(a) Net working capital
(b) Current ratio
(c) Quick ratio
4.3 ASSET MANAGEMENT RATIO

Asset management ratio measures the efficiency of the management in using the
assets and specific accounts to generate sales or cash.
Ratios that can be used to measure the efficiency in asset management are shown
in Figure 4.2.
Figure 4.2: Asset management ratio
4.3.1 Account Receivable Turnover

Account receivable turnover measures the ability of the company to collect debts
from its customers. It provides the total of account receivables collected
throughout the year. The higher the ratio, the better as it is an indication that:
•
•
The company can collect debts from its customers quickly;
•
The company has low bad debts; and
The company can use the funds for the next investments
Account receivable turnover is the net credit sales revenue (if unavailable, use
the total sales) divided by the account receivables (or average account
receivable).
Credit sales (2.4)

Account receivable turnover =
Account receivable
RM307,400
= RM50,300
= 6.11 times
The account receivable turnover for the company unsatisfactory compared to the
industry average. This may indicate the inefficiency of the credit department in
credit collection.
4.3.2 Average Collection Period

Average collection period showed the average days taken by the company to
collect the account receivable. Assuming there are 360 days in a year. The
comparison between the average periods with the companyÊs credit term could
measure the efficiency of the company in collecting debts from its customers.
Average collection period of Company ABC is as follows:
360 (2.5)
= Account Receivable Turnover
360
= 6.11
= 58.92 days
Industry average = 44.3 days
The average collection period of Company ABC are 58.92 days which is
unsatisfactory compared with the performance of the industry average of 44.3
days. On average, Company ABC takes 58.92 days to collect its account
receivables while other companies in the industry only takes an average of 44.3
days to collect debts from their customers.
If the credit period for Company ABC is 30 days, the average collection period of
58.2 days is unsatisfactory. This means, on average, the customers did not settle
their payments with the period specified. This could also indicate that the credit
management or credit department is inefficient or both. If the collection period
extends for several years without changes to the credit policy, the company must
take action to expedite the collection of account receivables. However, if the
companyÊs credit period is 60 days and the average collection period is 58.92
days, this shows a practical collection period.
The average collection period can also be calculated using formula 2.6.
Account receivables (2.6)

Average collection period =
Yearly sales/360
RM50,300
= RM307,400/360
= 58.92 days
4.3.3 Inventory Turnover

Inventory turnover measures the efficiency of inventory management. It shows
the number of times the inventory can be sold in a year. The higher the inventory
turnover, the better, as it is an indication that the company is able to sell its
inventory quickly and reduce the chances of obsolete inventory.
Inventory turnover is obtained by dividing the cost of goods sold with inventory.
The calculation of inventory turnover for Company ABC is shown as follows:
Cost of goods sold (2.7)

Inventory turnover =
Inventory
RM208,800
=
RM28,900
= 7.22 times
Inventory turnover for Company ABC of 7.22 times is mush better if it is

compared with the industry average of 6.6 times. This means that the company
can sell its inventory 7.22 times in a year compared to the other companies in the
industry that can only sell their inventory 6.6 times in a year. This might be
because the company does not keep surplus inventory. Surplus inventory is not
productive and it is an investment that does not provides any return.
If the company holds too high inventory, the funds that could be invested
elsewhere would be held by the inventory. Furthermore, the transportation and
holding cost of the inventory will be high and the company is at risk of damage
or obsolete. However, the company might lose sales if it is unable to fulfil the
customerÊs demands due to low inventory keeping. Therefore, the manager must
be efficient in managing its inventory.
Several issues that must to be considered in calculating inventory turnover.

(a) Notice that the cost of goods sold and not sales (as might be done by some
companies) is used as the numeric figure as inventory is recorded at cost.
(b) The usage of sales as the numeric figure a number is not appropriate as it
will increase the value of inventory turnover.
(c) Must remember that for comparison, the company must ensure that the
method of inventory recording must be similar between the company and
the industry.
(d) The inventory turnover can be changed into number of days when it is
divided with 360 days (average number of days a year). This ratio is known
as the average inventory sales period as discussed in the next section.
4.3.4 Average Inventory Sales Period

The average inventory sales period shows the number of days taken to make one
round of inventory sales. The high average inventory sales period is less
unsatisfactory as this indicates that the company took longer time to sell its
inventory.
For Company ABC, the average inventory sales period is 50 days as calculated
below:
360 (2.8)
Average inventory sales period =
Inventory turnover
360
Average inventory sales period =
7.22
Average inventory sales period = 49.86 days

Average inventory sales period = 55.30 days
The average inventory sales period for Company ABC of 49.86 days is better
compared to the performance for the industry of 55.30 days. This indicates that
the company takes shorter time to sell its inventory compared to the other
companies in the industry.
This ratio can also be calculated using the following formula:
Inventory (2.9)
= Cost of goods sold/360
RM28,900
=
RM208,800/360
= 49.83days
Industry average = 55.30 days
4.3.5 Fixed Asset Turnover

Fixed asset turnover shows the efficiency of the company in using its fixed assets
to generate sales. The higher this ratio, the better because it shows indicated
efficient asset management.
This ratio is obtained when the sales is divided by the net fixed assets. The
calculation of fixed asset turnover for Company ABC is as follows:
Sales (2.10)
Fixed asset turnover = Net Fixed assets
RM307,400
=
RM237,400
= 1.29 times
The fixed asset turnover ratio for Company ABC is lower compared to the other
companies in the industry indicating that the asset management of the company
in generating sales is less efficient compared to the other companies. This might
be because the company has lots of fixed assets or unsatisfactory sales.
4.3.6 Total Asset Turnover

The total asset turnover shows the efficiency of the company in using all its assets
to generate sales. Usually, the higher this ratio, the more efficient the usage of the
assets. This ratio might be the most frequent ratio referred by management as it
can show the overall efficiency of the companyÊs operations.
Total asset turnover of Company ABC is as follows:
Sales (2.11)
=
Total assets
RM307,400
=
RM359,700
= 0.85 times
This performance is more satisfactory compared to the industry in average.

However, analysers must be careful in using the fixed asset turnover and total
asset turnover ratio because the calculation of these ratios uses the history costs
of the assets.
Some companies may have old assets or new assets. Therefore, it might not be
appropriate to compare the fixed asset ratio. Companies that owned new fixed
assets normally will show lower fixed asset turnover. Therefore, the difference in
the performance of the asset turnover might be due to the costs of the assets and
not the efficiency of the managementÊs operations.
The economic and technology status of the country will influence the
operations of a business. To ensure that the company stays competitive
and is expanding, what effective actions that can be taken?
EXERCISE 4.2
1. The following data was taken from the financial statements of

Fazrul Company. Based on the data below, calculate the asset
management ratios for the years 1998 and 1999. Assume that there
are 365 days in a year.
1999 1998
Sales RM640,000 RM560,000
Cost of goods sold 380,000 360,000
Cash 30,000 26,000
Account receivables 70,000 62,000
Inventory 150,000 140,000
Prepayment items 10,000 10,000
Net fixed assets 300,000 260,000
Current liabilities 120,000 140,000
(a) Account receivables turnover

(b) Average collection period
(c) Inventory turnover
(d) Average inventory sales period
(e) Fixed asset turnover
(f) Total asset turnover
4.4 LEVERAGE RATIO

Leverage ratio measures a company' level of debt funding and the ability of the
company to fulfil its financial demands such as interest claim. Leverage ratios are
shown in Figure 4.3.
Figure 4.3: Leverage ratio
Leverage occurs when a company is being funded by debt. Debts include all
current liabilities and long-term liabilities. Debt is one of the main sources of
funding. It provides tax advantage as interest is a tax deductible item. The costs
of debt transactions are also lower as debts are easier to obtain compared to the
issuance of shares. Usually, the more debt in relative to total assets, the higher
the financial leverage of the company.
Leverage ratios can be divided into two groups, that is:
(a) ratios to evaluate the debt level used by the company such as debt ratio,
debt-equity ratio and equity multiplier; and
(b) ratios to see the ability of the company in fulfilling its claims or obligations
to the creditors such as interest coverage ratio.
Normally, analysers would focus their attention on the long-term loans as the
company is bound by interest payments for a longer period and at the end of that
period, the company must repay the principal amount of the loan. As
creditors'claims must be settle first before any earnings can be distributed to the
shareholders, potential shareholders will usually look at the debt level and the
ability of the company to repay the company's debts.
Creditors will also focus on the leverage ratios as the higher the debt level, the
higher the probability of the company being unable to settle the debts of all its
creditors. Therefore, the management of the company must prioritise on the
leverage ratio as it attracts attention from several parties that are concerned with
the debt level of the company.
4.4.1 Debt Ratio

Debt ratio measures the percentage of total asset that are financed by debts.
Creditors prefer lower debt ratio as the lower the debt ratio, the higher the
protection for their losses upon liquidation. Unlike the preference of creditors for
a lower debt ratio, the management might choose a higher leverage to increase
earnings. This is because they do not like to issue new equity as they fear the
degree of control in the company will reduce. The higher the debt ratio, the
higher the percentage of assets being funded by debts.
The debt ratio of Company ABC is:
Total liabilities
Debt ratio = X 100 (2.12)
Total assets
RM164, 300
= X 100
RM359, 700
= 45.7%
Industry average = 40.0%
The debt ratio of the company is 45.7% higher compared to the industry average
of 40%. Potential creditors might be reluctant to provide additional loans to the
company as they worry that the company would be incapable to settle the
interest and principal payment, due to its rather high debt ratio.
4.4.2 Debt-Equity Ratio

Debt equity ratio measures the total long-term debts for each ringgit of equity.
The lower this ratio, the better it is because it shows that the total equity owned
by the company exceeds the long-term debts.
The debt-equity ratio of Company ABC is:
Long - term liabilities

Debt-equity ratio = (2.13)
Shareholders equity
RM102, 300
= X 100
RM195, 400
= 52.4%
Industry average = 50%
The debt equity ratio of the company is higher compared to the industry average.
This shows that the long-term debt of the company is 52.4% more compared to
the shareholders' equity.
4.4.3 Equity Multiplier

Equity multiplier shows the asset ownership for each ringgit of equity. Debt ratio
and equity multiplier provides the same information but in different approach.
Debt ratio of 40% means that the company is being funded by 40% debts. Based
on the balance sheet identity:
Asset = Liability + Equity
From this information, we know that the company is being funded by 60%
equity. Equity multiplier is 100/60 = 1.67 times. Therefore, when the debt ratio of
Company ABC is 45.7%, thus the equity multiplier is 100/54.3 = 1.84 times.
In general,
1
Equity multiplier = (2.14)
1 - Debt ratio
Total asset
=
Total equity
RM359, 700
=
RM195, 400
= 1.84 times
The equity multiplier of the company is higher compared to the industry

average. This shows that the funding of the company's assets via equity is higher
compared to the other companies in the industry.
4.4.4 Interest Coverage Ratio

Creditors and other parties intend to know the company's ability to make interest
payments periodically by using the current operation's income. Interest coverage
ratio is used to decide the number of times the company can repay all its interest
expenses with the current income. This ratio is obtained by dividing the
operations profit with interest expenses.
Interest coverage ratio of Company ABC is:

Profit before interest and tax
= (2.15)
Interest expenses
RM41, 800
=
RM 9, 300
= 4.49 times
Interest coverage ratio of 4.49 times is more satisfactory compared to the industry
average performance of 4.3 times. This indicates the interest expenses margin
with current income.
Interest coverage ratio can also be calculated by using the following formula:
Interest coverage ratio = Net profit + Interest expenses + Tax expenses (2.16)
Interest expenses
= RM22,100 + RM9,300 + RM9,400

RM9,300
= 4.39 times
EXERCISE 4.3
1. The summary balance sheet and income statement of Adiy
Corporation are as below:
Adiy Corporation
Balance Sheet Income Statement
Assets: Sales (all credit) RM6,000,000
Cash RM 150,000 Cost of goods sold 3,000,000
Account receivable 450,000 Operating expenses 750,000
Inventory 600,000 Interest expenses 750,000
Net fixed assets 1,800,000 Tax 420,000
Net Profit 1,080,000

Liabilities and Equities:
Account payable 150,000
Long-term liabilities 1,200,000
Equities 1,500,000
(a) Calculate the financial ratios for Adiy Corporation based on the
information given above. Assume that there are 365 days in a year.
(b) Debt ratio
(c) Interest coverage ratio
(d) Return on assets
(e) Average collection period
(f) Total asset turnover
4.5 PROFITABILITY RATIO

The profitability ratio measures the effectiveness of the company in generating
returns from investments and sales. It is used as a sign to determine the
business's efficiency and effectiveness in achieving its profit objective.
Profitability ratios are shown in Figure 4.4.
Figure 4.4: Profitability ratio
4.5.1 Gross Profit Margin

Gross profit margin measures the profit for each ringgit of sales that can be used
to pay the sales and administration expenditures. The higher the gross profit
margin, the better the status of the company as this shows lower expenditures or
costs involved in implementing sales activities.
Gross profit margins can be obtained by dividing the gross profit with sales. It
shows the balance percentage for each ringgit of sales after the company had
paid all the costs of goods.
Gross Profit
Gross Profit Margin = X 100 (2.17)
Sales
RM98, 600
= X 100
RM307, 400
= 32.1%
Gross profit margin of 32.1% is higher compared to the industry average of 30%.
This shows that the purchasing management and cost of the company are better
compared to the industry average. The company generates 32.1 cents profit after
deducting all costs of goods for each ringgit of sale.
4.5.2 Net Profit Margin

Net profit margin measures the ability of the company to generate net profit from
each ringgit of sale after deducting all expenditure including the cost of goods
sold, sales expenditures, general and administrative expenditures, depreciation
expenses, interest expenses and tax. The higher the net profit margin, the better
the status of the company as this shows an efficient purchasing management
with low purchasing costs.
Net profit margin is calculated by dividing the profit after tax with sales. Net
profit margin of Company ABC is as follows:
Profit after tax

Net profit margin = X 100 (2.18)
Sales
RM23, 100
= X 100
RM307, 400
= 7.5%
The net profit margin for the company of 7.5% is higher compared to the
industryÊs performance of 6.4%. This shows that the management of purchasing
and related purchasing costs are better compared to the industry average. The
company had managed to generate 7.5 cents net profit for each ringgit of sale
compared to the industry average that only managed to generate 6.4 cents for
each ringgit of sale.
4.5.3 Operating Profit Margin

The operating profit margin measures the efficiency of operations in reducing
costs and increasing returns before interest and tax. The higher the result of this
ratio, the better as it indicates that the company is able to operate efficiently. The
operating profit margin of Company ABC is:
Operating Profit
Operating Profit Margin = X 100 (2.19)
Sales
RM41, 800
= X 100
RM307, 400
= 13.6%
The operating profit margin of company ABC is better compared to the industry
average. This shows that the company is more efficient in its operations and
control its operating expenditures to generate high earnings before interest and
tax.
4.5.4 Return on Asset

Return on asset or return on investment measures the effectiveness of the
company in using its assets to generate profit. The higher this ratio, the better the
status of the company as it indicates the management's efficiency in using its
assets to generate profit.
Profit after tax

Return on Asset = X 100 (2.20)
Total Assets
RM23, 100
= X 100
RM359, 700
= 6.42%
Return on assets of the company is better compared to the industry average that
only contributes 4.8%. This shows that the company is better in managing its
assets to generate profit compared to the other companies in the industry.
4.5.5 Return on Equity

Return on equity measures the efficiency of the company in generating profit for
its ordinary shareholders. The higher the ratio, the better as the company is able
to generate high profit for its owners.
Profit after tax

Return on Equity = X 100 (2.20)
Shareholders' Equity
RM23, 100
= X 100
RM195, 400
= 11.8%
Return on equity of the company is 11.8% more satisfactory compared to 8% for

the industry average. This shows that the management of the company is more
efficient compared to the industry average. The calculation of return on equity
will be discussed further when we discuss the DuPont analysis.
4.5.6 Earnings Per Share

Earnings per share calculate the net profit that is generated from each ordinary
share. This information is often given priority by the management and investors
as it is regarded as an important indication of the company's success. Therefore,
the bigger the value of this ratio, the better the status of the shareholders.
Earnings per share is obtained by dividing the net profit with the number of
shares issued
Earnings per share = Profit available to ordinary shareholders (2.22)

Number of ordinary shares issued
= RM22,100
76,262
= RM0.29
Industry average = RM0.26
The company obtained RM0.29 for each unit of shares issued compared to the
industry average of only RM0.26. The value of this difference is small and in
practice, this value does represent the actual amount that will be distributed to
the shareholders.
4.6 MARKET VALUE RATIO
Provide the differences between price earnings ratio and dividend yield
ratio.
Market value ratio measures the ability of the company to generate market
values in excess of its investment costs. This aspect is very important as these
market value ratios are directly related to the objective of the company, that is to
maximise shareholders' wealth and value of the company. Therefore, it can be
said that the value of market value ratio influences the market's reaction and
investors' confidence towards the ability of the company's management in
generating profit efficiently and effectively.
Market value ratios are shown in Figure 4.5.
Figure 4.5: Market value ratio
4.6.1 Price Earnings Ratio

Price earnings ratio shows the total ringgit that the investor is willing to pay for
each ringgit of profit reported by the company. The level of price earnings ratio
shows the degree of confidence of the investors towards the future performance
of the company. The higher the price earnings ratio, the higher the confidence of
the investors towards the company's future.
Price earnings ratio can be obtained when the market price per share is divided
by the earnings per share. To calculate the price earnings of Company ABC, we
assumed that the market price for the company's share is RM3.23.
Market price per share (2.23)

Price Earnings Ratio =
Earnings per share
RM3.23
= RM0.29
= 11.1
Industry average = 1.25
The ratio shows that the degree of confidence of the investors towards the
company is significantly higher compared to the industry average as the
investors are willing to pay 11.10 times more for each company's share compared
to 1.25 for each share in the industry average.
You can see this price earning ratio in share prices section in the newspaper.
However, newspapers provides current price ratio instead of latest profits.
Investors prioritise more on the price relative to future earnings.
4.6.2 Dividend Yield Ratio

There are investors who will buy ordinary shares to receive dividends. Others
will be more interested in the growth of their share market value. Dividend yield
ratio measures the rate of return in the form of dividends received from a share
investment. Assume that Company ABC practices a stable dividend policy and
pays dividends of RM0.15 per share. This means that the investors will receive
return from dividends of 4.6%.
A lot of companies try to maintain paying a stable dividend and, if possible,

increases the dividends so that investors will receive more returns from their
share holdings. There are companies that pay small dividends and there are
those that do not pay any dividends to their shareholders. This is because they
put in more effort to expand their businesses by retaining and reinvesting the
profit obtained.
Dividend per share

Dividend Yield = (2.24)
Market price per share
RM0.15
= X 100
RM3.23
= 4.6%
EXERCISE 4.4
1. ___________ is the ability of the company to fulfil its current
liabilities' obligations by using its current assets.
2. Current ratio is similar to _________ divided with ___________.
______ is included in the calculation of current ratio but excluded
from the calculation of the quick ratio.
3. Inventory turnover is obtained by dividing ___________ with
_______________.
4. Ratio of total liabilities to ____________ is used to ascertain the
level of debt in the capital structure.
5. Return on equity is obtained when ______________ is divided with
____________.
6. Price earnings ratio is equal to ______________ per share divided
with _____________ per share.
X-Cell and N-Hance are two companies operating in the same
industry. The financial information for both companies as at 31
December 2000 are as follows
X-Cell N-Hance
Total assets RM3,000,000 RM1,600,000
Total liabilities 1,800,000 960,000
Total equities 1,200,000 640,000
Net sales 3,700,000 1,880,000
Interest expenses 90,000 38,000
Tax expenses 240,000 100,000
Net profit 380,000 180,000
Earnings per share 5.60 2.10
Market price per share of ordinary shares 35.00 26.50
Dividends per share for ordinary shares 2.40 0.50
For each of the company, calculate the following ratios:
X-Cell N-Hance
(a) Return on assets _______________ _______________
(b) Return on equity _______________ _______________
(c) Net profit margin _______________ _______________
(d) Total asset turnover _______________ _______________
(e) Debt ratio _______________ _______________
(f) Equity multiplier _______________ _______________
(g) Interest coverage ratio _______________ ____________ __
(h) Price earnings ratio _______________ _______________
(i) Dividend yield ratio _______________ _______________
4.7 CONDUCTING A COMPLETE RATIO

ANALYSIS
As stated above, one ratio is not sufficient to evaluate all aspects of the
company's financial status. Therefore, the manager must conduct a complete
ratio analysis to cover all aspects of liquidity, asset management, leverage,
profitability and market value ratio.
The two approaches can be conducted are:
(a) DuPont Analysis < looks at the main sections that contribute to the
companyÊs financial performance.
(b) Summary of financial ratio analysis < looks at all the financial aspects of the
company to identify sections that required further investigations or
improvements.
4.7.1 DuPont Analysis

DuPont analysis is used by finance managers to evaluate the financial status of a
company. The DuPont analysis combines the income statement and the balance
sheet to become two measurements of profitability.
(a) return on assets; and
(b) return on equity
The first step in DuPont analysis is to show the DuPont formula:
Return on asset = Net profit margin x Total asset turnover

= Profit after tax x Sales
Sales Total assets
= 7.5% x 0.85 times
= 6.4%
In the DuPont formula, the net profit margin measures the profitability of sales
while the total asset turnover shows the efficiency of management in using assets
to generate sales.
The value of return on asset is calculated by using the DuPont formula is the
same as the value of return on assets calculated directly parting section 2.10.4.
However, the DuPont formula allows the company to evaluate its return on asset
by separating it into two different components that is the profit on sales and
efficiency in asset management.
The second step in DuPont analysis is to connect the return on asset with return
on equity. This relationship can be shown below.
Return on equity = Return on assets x Equity multiplier
= Profit after tax × Total assets

Total asset Total equity
= 6.4% x 1.84 times
= 11.8%
When the values for return on asset and equity multiplier are replaced in the
formula above, the result is 11.8%, same as calculated directly in topic 2.10.5.
However, the DuPont analysis has the advantage of allowing the manager to
evaluate the return on equity by looking at three separate components, which
are:
(a) profit on sales;

(b) efficiency of asset management; and
(c) effect of using debts in funding assets
If the DuPont analysis is extended, the return to the owner can be evaluated by
looking at each important dimension as shown in Figure 4.6.
Figure 4.6: Extended DuPont analysis

From Figure 4.6, we found that the return on equity for Company ABC (11.8%) is
higher compared to the industry average (8%). This higher return on equity is
influenced by the companyÊs higher return on asset compared to the industry
and less influenced by the pattern of funding as illustrated by the equity
multiplier. (Return on asset of the company is 6.41% while the return on asset of
the industry is only 4.8%. The difference in equity multiplier between the
company and the industry is quite marginal, 1.84 times for the company and 1.67
times for the industry).
The difference in returns between the company and the industry is influenced by
the difference in net profit margin compared to the difference in total assets
turnover. The difference in profit margin between the company and industry is
significant. (7.5% for the company and 6.4% for the industry) compared to the
difference in total assets turnover (0.85 times for the company and 0.75 times for
the industry).
Net profit margin of the company is influenced by the higher operating profit
margin compared to the gross profit margin. Therefore, the higher return on
equity for the company is due to the management efficiently in managing its
operations.
4.7.2 Summarising All Financial Ratios

The performance of Company ABC is valued based on five groups of ratio,
which are:
(a) liquidity;
(b) asset management;
(c) leverage;
(d) profitability; and
(e) market value
The companyÊs financial ratios can be compared with the ratio of other
equivalent companies, or with the industry average at one point of time. These
comparisons provides explanations on the financial status and performance of
the company relatively compared to the performance of its competitors. This
analysis uses industry average as a benchmark or standard of comparison.
When the industry average cannot be obtained, comparisons are usually made
with other companies in the same industry. This benchmark is assumed as the
suitable value for a company in the same industry. The assumption here is for the
companies in the same industry to have an almost identical financial ratio. If the
ratio of a company shows a significant difference with the standard ratio, then
further investigation must to be done to find the source of that difference.
For evaluation, a companyÊs financial ratio is compared to the industryÊs ratios

one by one, and then classified as satisfactory or unsatisfactory, depending upon
the direction and how far it has diverted from standard.
Figure 2.10 summarises the comparison between Company ABCÊs financial ratios
with the industry average for the year 2001. From Figure 2.10, we can make a
summary that:
(a) Liquidity
The companyÊs achievement in current ratio and quick ratio are much
different compared with the industry. Overall, the companyÊs liquidity is
rather satisfactory.
(b) Asset Management

The companyÊs inventory management is quite satisfactory. The company
might face problems with its account receivables as the collection period for
company is higher compared to the industry. Therefore, attention had to be
given to the management of account receivables.
(c) Leverage
The level of the companyÊs debts is higher than the industry average.
However, the ability of the company to pay interests is better compared to
the industry.
(d) Profitability
Profitability, relative to the investors (as seen in the return on asset and
return on equity ratios) of the company is better compared to the industry.
This is the same with the gross profit margin and net profit margin.
(e) Market Value

The companyÊs shares were sold at the lower price earnings ratio than the
industry. This is the same for dividends yield ratio which is smaller
compared with the industry.
Table 4.1: Summary of Ratio Analysis for Company ABC Compared with the
Industry Average for Year 2001
Company ABC Industry Average Notes*

Liquidity Ratio
Current ratio 1.97 times 2.05 times US
Quick ratio 1.51 times 1.43 times US
Asset Management Ratio

Account receivable turnover 6.11 times 8.24 times US
Average collection period 58.92 days 44.3 days US
Inventory turnover 7.22 times 6.6 times S
Average inventory sales period 49.86 days 55.30 days US
Fixed asset turnover 1.29 times 1.35 times US
Total asset turnover 0.85 times 0.75 times S
Leverage Ratio
Debt ratio 45.7% 40.0% US
Debt-equity ratio 52.4% 50% S
Interest coverage ratio 4.49 times 4.3 times S
Profitability Ratio
Gross profit margin 32.1% 30% S
Net profit margin 7.5% 6.4% S
Return on assets 6.42% 4.8% S
Return on equity 11.80% 8.0% S
Earnings per share RM0.29 RM0.26 S
Market Value Ratio

Price earnings ratio RM11.1 RM1.25 US
Dividend yield ratio RM0.046 RM0.50 US
* S = Satisfactory US = Unsatisfactory
4.8 WEAKNESSES IN FINANCIAL RATIO

Financial ratio is an important tool in financial analysis but when the users apply
the financial ratios, they must take into consideration the weaknesses related to
these financial ratios. Among the weaknesses are:
(a) The accuracy of the financial ratio depends on the accuracy of the data
found in the financial statements.
(b) In using the financial ratio for industrial comparison purposes, the users
must take into consideration that the industry ratio is only a rough
estimate. This is due to the difficulty to obtain the entire firms in the same
industry.
(c) Financial ratio is a relative measurement and does not show the actual size
of the firm.
(d) Financial ratio is used to measure the status of the firm but it can not show
the issues that had caused the situation.
Please visit the following websites to obtain additional information

regarding the topics discussed in this chapter.
http://www.ppkm.net/
Description: Persatuan Pasaran Kewangan Malaysia was established with
the objective to provide an organisation for individuals who are actively
engaged in the foreign exchange and financial markets in Malaysia.
http://www.finpipe.com/equity/finratan.htm
Description: Introduction of Financial Ratio Analysis
http://www.investopedia.com/university/ratios/
Description: Steps and explanations on the calculations of Financial Ratio
Analysis
http://www.credit-to-cash-advisor.com/Document.asp?lid=120
Description: Detail explanation on DuPont Analysis including a convenient
web calculator.
EXERCISE 4.5
1. When ratio comparisons show an obvious change in the financial

status of a company, the manager should investigate the matter
further.
(a) True (b) False
2. In the DuPont Analysis, return on equity is the result of

multiplying three other ratios: net profit margin, total asset
turnover and return on asset.
(a) True (b) False
3. Net profit divided by total asset is ___________ ratio.
A. Return on equity
B. Current ratio
C. Gross profit margin
D. Return on asset
4. Dividend yield ratio is:
A. Total money distributed to shareholders.

B. Dividends paid to shareholders divided by retained
earnings.
C. Dividends per share divided by price per share.
D. Retained earnings divided by sales.
5. Use the following information to calculate the net profit.
Return on asset = 2%
Total asset turnover = 0.5 times
Cost of goods sold = RM105,000
Gross profit margin = 30%
6. Calculate the return on equity based on the information below:

Sales = RM100,000
Net profit = RM3,000
Total assets = RM150,000
Total liabilities = RM75,000
7. Listed below are several transactions made by Fima Corporation

along with the financial ratios.
For each of the transactions, state whether there is an increase,
decrease or unchanged to the ratio listed next to the related
transaction.
Transaction Financial Ratio
(a) Selling of inventory on credit Current ratio
(b) Issuing ordinary shares to collect cash Return on equity
(c) Issuing long term bonds for cash Debt ratio
(d) Declaring and paying cash dividends Dividend yield
for ordinary shares
(e) Collecting account receivable Account receivable turnover
(f) Making cash loans by issuing long - Return on assets
term notes payable
8. The finance manager of Lily Corporation provided the following

financial information to you to prepare the company's financial
analysis.
Lily Corporation
Balance Sheet as at 31 December 2000
RM RM
Cas 1,000 Account payable 9,000
Account receivable 8,900 Accrual account 6,675
Inventory 4,350
Total current liabilities 15,675 Total current asset 14,250
Total fixed asset 35,000 Long-term loans 4,125
Accumulated
Depreciation 13,250
Net fixed asset 21,750
Total liabilities 19,800
Ordinary shares 1,000
Total equity 16,200
Total asset 36,000 Total liability and equity 36,000
RM
Sales 100,000
Gross profit 13,000
Operating expenditure 11,000
Operating profit 2,000
Interest expenses 500
Profit before tax 1,500
Tax 420
Net Profit 1,080
Based on the financial information above, calculate the following

financial ratio:
(a) Current ratio __________________
(b) Quick ratio __________________
(c) Average collection period __________________
(d) Inventory turnover __________________
(e) Fixed asset turnover __________________
(f) Total asset turnover __________________
(g) Debt ratio __________________
(h) Interest coverage ratio __________________
(i) Gross profit margin __________________
(j) Operating profit margin __________________
(k) Net profit margin __________________
(l) Return on asset __________________
(m) Return on equity __________________
9. Complete the balance sheet for Company Amri based on the

following information. Assume that there are 360 days in a year.
Gross profit margin = 38.7%
Inventory turnover = 6 times
Average collection period = 31 days
Sales = RM720,000
Current ratio = 2.35 times
Total asset turnover = 2.81 times
Debt ratio = 49.4%
Company Amri
Balance Sheet
RM RM
Assets Liability and OwnersÊ Equity
Current asset Current liabilities
Cash 8,005 Account payable 28,800
Marketable securities Notes payable
Account receivable Accruals 18,800
Inventory Total current liabilities
Total current assets 159,565
Long-term liabilities
Total fixed assets Total liabilities
Net fixed asset ShareholdersÊ equity
Ordinary shares 30,000
Paid up capital 6,400
Total assets Total equity
Total liabilities and equity
Financial analysis ratio is suitable to be used when the company wants to

interpret the financial statements of the company. Liquidity ratios such as net
working capital, current ratio and quick ratio enables the measurement of the
companyÊs ability to fulfil its short-term maturity claims. Asset management
ratios measure the companyÊs efficacy in using the assets. The examples of this
ratio includes account receivable turnover, average collection period, inventory
turnover, average inventory sales period, fixed asset turnover and total asset
turnover.
Leverage ratio measures the level a company being funded by debt or the ability
of a company to fulfil its financial claims such as interest claims. Profitability
ratio measures the effectiveness of the company in generating returns from
investment and sales; for example gross profit margin, net profit margin, return
on assets and return on equity.
Market value ratio such as price earnings ratio and dividend yield ratio,
measures the ability of a company to create values in the market exceeding its
investment costs. This aspect is very important as these ratios are directly
connected with the companyÊs objective that is to maximise shareholderÊs wealth
and value of the company.
The DuPont analysis is used by finance managers to evaluate the financial status
of the company by measuring the two important ratios, which are return on
assets ratio and return on equity ratio while the approach on summarising the
financial ratio analysis is to show all aspects of the companyÊs overall financial
status to identify sectors that require further investigation.
TUTORIAL QUESTION
w INTRODUCTION
This activity is for the purpose of enhancing your further understanding on the
main financial statements that are used to make the future plans of the company.
w PROBLEM
The following are the financial data for Company SAA. The items in the balance
sheet are values as at year ended 2000 and 2001, while the items in the income
statement are income or expenditure throughout the year ended 2000 or 2001 (all
values are in thousand of ringgit).
2000 2001
RMÊ000 RMÊ000
Sales revenue 4,000 4,100
Cost of goods sold 1,600 1,700
Depreciation 500 520
Inventory 300 350
Administrative expenses 500 550
Interest expenses 150 150
Tax 400 420
Account payable 300 350
Account receivable 400 450
Fixed asset, net 5,000 5,800
Long term loan 2,000 2,400
Notes payable 1,000 600
Dividends payable 410 410
Cash and marketable securities 800 300
w QUESTION
(a) Prepare the balance sheet for Company SAA as at year 2000 and 2001. How
much is the shareholdersÊ equity?
(b) Net working capital = Current asset < Current liability. What had happened
to the net working capital throughout the year?
(c) Prepare the income statement for Company SAA for the year ended 2000
and 2001. How much is the retained earnings for year 2001? Compare the
increase in shareholdersÊ equity between these two years.
(d) Assumed the numbers of shares issued are 500,000 units. What is the
earnings per share?
(e) Look at the values of net fixed asset for year 2000 and depreciation for year
2001. How much is the total investment of fixed assets in the year 2001?
(f) Prepare the cash flow statement for Company SAA for year 2001.
Topic 5 w Time Value
of Money
LEARNING OUTCOMES
At the end of this topic, you will be able to:
1. identify the basic concept for time value of money that is known as
the concept of compounding to determine the future time value of an
investment made today;
2. identify the advance concept for time value of money that is known
as the concept of discounting to calculate the present value for a
sum of cash that will be accepted in the future;
3. explain the concept for time value of money for single cash flow and
series cash flow, annuity, perpetuity and derivation cash flow; and
4. analyse the concepts of compounding and discounting that occur
frequently, more than once a year and that occur continuously.
w INTRODUCTION
The public generally, assume time as very precious and must be managed
efficiently. They place the value of time on par with various valuable objects and
one of the globally accepted proverb is 'time is money'. From the financial
management perspective, this proverb is a phrase that can be measured and
proven quantitatively by using the financial mathematics. In fact, this
quantitative prove has developed as one of the basic principles in financial
decisions making known as the concept for time value of money.
TOPIC 5 TIME VALUE OF MONEY v 145
5.1 CONCEPT OF COMPOUNDING AND

FUTURE VALUE
If you were given two choices either an offer of RM1,000 in the

beginning of the year or an offer of RM1,000 at the end of the year,
which offer will you choose?
Rationally, you will certainly choose the offer at the beginning of the year as the
value of money makes this alternative more profitable. The concept of
compounding is the core in the concept for time value of money. The concept of
compounding, in brief, explains that RM1 today is more valuable than RM1 in
the future. This is because RM1 today can be invested to generate interest and
subsequently multiply to become more than RM1 at the end of the investment
year.
Among the reasons why the time value of money makes this alternative more
valuable are:
• In general, individuals are more interested in the present usage than
•
postponing the usage to the future.
During the inflation periods caused by uncontrollable development in the
economy, the real purchasing power of RM1 now is more that the real
•
purchasing power of RM1 in the coming years.
Capital that is obtained now can be invested productively to generate a
higher return in the future.
5.1.1 Time Line

The drawing of time line in Figure 3.1 can ease the understanding of the concept
of time value of money especially for complex problems. Time is divided into
several periods of valuation that is shown along the horizontal line and the
calculation of the period begins from left to right. Time 0 (t0) refers to the present
time or the starting of the first period, time 1 (t1) refers to the end of the first
period or the starting of the second period, time 2 (t2) refers to the end of the
second period or the starting of the third period and so forth.
146 w TOPIC 5 TIME VALUE OF MONEY
Figure 5.1: Time line
5.1.2 Compounding Interest

There are two types of interest that is the simple interest and compounding
interest. Simple interest is the interest that will be paid or accepted based on the
principal amount. Compounding interest refers to the interest that will be paid
not only on the principal amount but also on any interest payable not withdrawn
throughout its period (accumulated interest).
In this topic, we will focus our discussion on compounding interest as in the

calculation for time value of money, only compounding interest is considered.
Example 5.1
If you had invested RM100 in the savings account in a bank with the interest
rates of 10% per year, how much returns will you receive at the end of the first
year? Roughly, you will obtain RM110. These returns can be calculated as
follows:
Returns (F) = Total principal (P) + Total interest (i)

= Total principal (P) + [Total principal (P) x Interest (i)]
= RM100 + 10
= RM100 + RM10 (10%)
= RM110
F1 = P + P(i)
= P(1 + i)
If the stated returns are not withdrawn from the savings account, and the bankÊs
interest rates for the second and third year remained unchanged, how much
return will you receive at the end of the second and third year?
F2 = P (1+i)2
= F1 (1+i)
= RM100 (1 + 0.1)2
= 121
F3 = RM121 + RM12.10
= RM133.10 that is
= F2 +F2 (i)
= F2 (1+i)
= P2 (1+i)2 (1+i)
= P (1+i)3
When the savings period is extended to tn, the total returns that will be obtained
in the period (n) is:
Fn = P (1+i) n (3.1)
The complete time line for savings of RM100 at interest rate of 10% per year is as
follows:
P1 = RM 110 P2 = RM 121 P3 = RM 121

100 + 100(10%) 100 + 100(10%) 100 + 100(10%)
EXERCISE 5.1
1. Salmah keeps RM100 in the savings account at Affin Bank with

interest rate of 5% per year for 5 years. How much return will she
get at the end of the 5 year period?
2. Assume that Ah Seng keeps RM5,000 in the savings account at
Bumiputra Commerce Bank at the interest rate of 10% per year for
2 years. How much return will Ah Seng receive at the end of the
second year?
5.1.3 Calculation of Future Value Using Schedule

Calculation of future value using the formula of Fn = P (1+i) n with the value of n
being more than one sometimes takes a rather long time. Therefore, the usage of
a financial schedule that is the schedule of Future Value Interest Factor (FVIF i,n)
helps to save time in calculations.
The equation 3.2 shows that the future value (FVn) is equivalent to the principal
at the point of time equal to 0 or the original principal amount (PV0) multiply
with the future value factor stated in the schedule of Future Value Interest Factor
(FVIF i,n). This schedule is enclosed in Attachment A.
FVn = PV0 (FVIF i,n) (3.2)
As a basic guide on the usage of the financial schedule, please refer to the extract
on the schedule of Future Value Interest Factor (FVIFi,n) in Table 3.1 to solve
examples 5.2 and 5.3.
Example 5.2
You deposited RM2,000 in the savings account in a bank at a yearly interest rate
of 5% for the period of one year. Upon the completion of one year, how much
return will you receive?
FVn = PV0 (FVIF i,n)

= RM2,000 (FVIF 5%, 1)
= RM2,000 (1.0500)
= RM2,100
Example 5.3
Assume you deposited RM2,000 in the savings account in your bank at a yearly
interest rate of 5% for the period of four years. Upon the completion of four
years, how much return will you receive?
FVn = PV0 (FVIF i,n)

= RM2,000 (FVIF 5%, 4)
= RM2,000 (1.216)
= RM2,432
Table 5.1: Extract from the Future Value Interest Factor (FVIF i, n) Schedule
It must be remembered that sometimes different answer might exist by using

manual calculation compared to the calculations using the schedule. This is due
to the usage of different numbers of decimal points. However, the difference is
not obvious and both answers are acceptable.
EXERCISE 5.2
Use the schedule of Future Value Interest Factor (FVIFi,n) in Attachment

A to calculate the answers for the questions below.
1. Assume that you keep RM5,555 in the savings account at Affin
Bank with an interest rate of 15% per year for 5 years. How much
potential return will you obtain at the end of the 5 year period?
2. If you keep RM4,321 in the savings account at Maybank with an
interest rate of 7% per year for 2 years, how much potential return
will you obtain at the end of the 2 years period?
5.1.4 Graphical Illustration of Future Value

There are three basic elements which will influenced the future value, these are:
(a) principal (amount that was borrowed or invested);
(b) time period (the number of periods or frequency of interest payments); and
(c) interest rate payable (if the money was borrowed) or interest receivable (if
the money was invested).
To show how the interest rate influences the future value of an investment, we
must assume that the principal and the time period are constant. Therefore, any
changes to the future value are caused only by the interest rates. For example,
you intend to deposit RM100 at Bank A, B and C that offer different
compounding interest rates of 8%, 10% and 12%. How much will the future value
of your deposit be in 3 years from now?
Based on the formula
FVn = PV0 (FVIFi, n)
The future value for Bank A that offers an interest rate of 8% is:
FV8%,3 = RM100 (FVIF8%,3)

= RM100 (1.26)
= RM126.00
The future value for Bank B that offers an interest rate of 10% is:
FV10%,3 = RM100 (FVIF10%,3)

= RM100 (1.331)
= RM133.10
The future value for Bank C that offers an interest rate of 12% is:
FV12%,3 = RM100 (FVIF12%,3)

= RM100 (1.405)
= RM140.50
The examples above can also be applied on either the principal value or the time
period by assuming that the other variables are constant. You will discover that
the future value has a positive correlation with the time period (n) and the
interest rate (i) as shown in Figure 5.2.
Figure 5.2: Correlation between interest rate, time period and future value for RM100.
As a bank manager, what are your strategies in attracting more people

to deposit and invest in your bank?
5.2 CONCEPT OF DISCOUNTING AND PRESENT

VALUE
In your opinion, how is the concept of discounting and present value

different from compounding and future value?
The second concept that is related with the time value of money is the concept of
cash flow discounting. This concept is used to ascertain the present value (PV0)
or principal value for a sum of money in the future (FV0) that is discounted at an
interest rate known as rate of return (i) for the valuation period (t).
The process to determine the present value is the reverse process of determining
the future value. The relationship between these two processes is illustrated in
the time line in Figure 5.3.
Figure 5.3: Comparison between future value and present value
5.2.1 Calculation of Present Value

The process of discounting is the reverse process of compounding. The present
value (principal) can be found with a small variation to the basic formula of
calculating the future value (formula 5.1).
Example 5.4
Assume you expect to receive returns of RM2,500 a year from now. How much is
the present value for RM2,500 if the discount rate or rate of return is 8% per year?
FVn = PV0 (1+ i)n
RM2, 500 = PV0 (1+ 0.08)1
RM2, 500
PV0 =
1.08
= RM2, 314.81
RM2,314.81 RM2,500
What is the present value that you must invest if you expect a return of RM2,500
in the period (a) 2 years and (b) 3 years at a discount rate of 8% per year?
FV2 = PV0 (1+i)2
RM2,500 = PV0 (1+0.08)2

RM2,500
PV0 =
(1+1.08)2
PV0 = RM2,143.35
FV3 = PV0 (1+i)3
RM2,500 = PV0 (1+0.08)3
RM2,500
PV0 = (1+1.08) 3
= RM1,984.58
The present value of RM2,500 at a rate of 8% in period 1,2 and 3 years are as
follows:
If the discounting period is extended to tn, the principal amount that must be
invested is
FVn
PV0 = (3.3)
(1+i)n
Or
PV 0 = FVn [1/(1+i)n]
EXERCISE 5.3
1. You want RM1,100 in your account a year from now. How

much investment must you make now if the interest rate
offered by the bank is 10%?
2. Seri Sdn. Bhd. offers a low risk security that promises a
payment of RM3,000 at the end of 2 years period with an offer
of 15% interest rate per year. What is the present value for
RM3,000?
5.2.2 Calculation of Present Value (Principal) Using

Schedule
Similar to the future value factor, the present value factor can also be obtained by
using a schedule that is the Present Value Interest Factor (PVIFi,n) as attached in
Attachment B. The usage of this schedule helps to simplify the calculation of
present value especially in complex problems. The equation 5.4 shows the
present value (PV0) is equal to the future value amount (FVn) multiply with the
present value interest factor (PVIFi,n).
PV0 = FVn (PVIF i,n) (3.4)
As a basic guide on the usage of the financial schedule, please refer to the extract
on the schedule of Present Value Interest Factor (PVIFi,n) in Table 3.2 to solve
examples 5.5 and 5.6.
Example 5.5
Assume you expect to receive RM3,999 in 3 years time from now. How much is
the present value for RM3,999 if the discount rate or rate of return is 9% per year?
PV 0 = FV (PVIF i,n)
= RM3,999 (PVIF 9%,3)
= RM3,999 (0.772)
= RM3,087.23
Example 5.6
You intend to accumulate savings money at the bank for RM5,713 in the period
of 4 years from now. How much savings you must make now if the interest rate
offered by the bank is 10 percent per year?
PV 0 = FV (PVIF i,n)
= RM5,713 (PVIF 10%,4)
= RM5,713 (0.683)
= RM3,901.98
Table 5.2: Extract of Present Value Interest Factor Schedule (PVIF i, n)
It must be remembered that sometimes different answer might exist by using

manual calculation compared to the calculations using the schedule. This is due
to the usage of different numbers of decimal points. However, the difference is
not obvious and both answers are acceptable.
EXERCISE 5.4
Use the schedule of present value interest factor to help you solve the
questions below:
1. Assume that you are given the opportunity to purchase a low

risk security that promised a payment of RM127.63 at the end of
the period of 5 years with an interest rate offer of 5% per year.
How much is the present value for RM127.63?
2. You plan to accumulate savings money in the bank for RM6,213

in a period of 5 years from now. How much savings must you
make now if the interest rate offered by the bank is 12% per year?
5.2.3 Graphical Illustration of Present Value

To show how the interest rate influences the present value (principal) of an
investment, we must assume that the future value (returns) and the time period
are constant. Therefore, any changes to the present value are caused only by the
interest rates.
Example 5.7
You intend to obtain returns of RM1,000 in a period of 3 years in Bank A, B and C

that offer different compounding interest rates of 8%, 10% and 12%. What is the
principal value that you should make?
The principal value for Bank A that offers an interest rate of 8% is:
PV 8%,3 = RM1,000 (PVIF 8%,3)

= RM1,000 (0.7938)
= RM793.80
The principal value for Bank B that offers an interest rate of 10% is:
PV 10%,3 = RM1,000 (PVIF 10%,3)

= RM1,000 (0.7513)
= RM751.30
The principal value for Bank C that offers an interest rate of 12% is:
PV 12%,3 = RM1,000 (PVIF 12%,3)

= RM1,000 (0.7118)
= RM711.80
The examples above can also be applied either in the future value or time period
by assuming that the other variables are constant. You will find that the future
value has a negative relation with the time period (n) and interest rates (i) as
shown in Figure 5.4. This graph explains that the principal value of RM1,000 that
will be received in the future will decrease when the acceptance period is
extended. The rate of decrease for present value is higher with the increase in
discount rates or interest rates.
Figure 5.4: Correlation between interest rate, time period and future value for RM100
5.3 SINGLE CASH FLOW MONEY VALUE

Single cash flow is a cash flow that only occurs once throughout the period of
valuation. Both the concepts of compounding and discounting that were
explained earlier have used the examples of single cash flow.
The examples stated clearly shows that the future value of an amount of single
cash flow invested presently will increase from time to time with the existence of
specific interest rates. In reverse, a sum value of single cash flow that has been
determined in the future will decrease when time approaches zero.
Future value (compounding process)
Figure 5.5: Single Cash Flow: Future value and present value
5.4 SERIES CASH FLOW MONEY VALUE

The concept of future value and present value is not limited to the process of
compounding and discounting single cash flow only. These concepts can be
applied to a series of cash flow.
A series cash flow means that there are a series of receiving or payments of cash
that occur throughout the valuation period. There are several categories of series
cash flow which are annuity, derivation cash flow and perpetuity.
5.4.1 Annuity
Annuity is a series of payment or receiving of the same amount at the same
intervals throughout the period of valuation. Therefore, a cash flow of RM5 each
month for one year is an annuity. While a cash flow of RM5 that is swap
alternately with a cash flow of RM10 each month for a year is not an annuity.
Annuity has a clearly stated starting point and an ending, in other words,
annuity cash flow would not be indefinite. Normally, annuity occurs at the end
of each period and this annuity is known as ordinary annuity. However, in some
cases, annuity occurs at the beginning of the period and this type of annuity is
known as annuity due.
(a) Future Value of Ordinary Annuity

Ordinary annuity is annuity that occurs at the end of each period as shown
in Figure 5.6.
Figure 5.6: Time line of ordinary annuity
The finance manager often makes future planning for the company but they
usually do not know how much investment or savings that must be saved
continuously to accumulate the sum of money required in the future. The future
value of annuity is the number of annuity payments at a specific amount (n) that
will increase at a specific period based on a specific interest rate (i).
Example 5.8
You had deposited RM100 at the end of each year for 3 years continuously in the
account that pays a yearly interest of 10%. How much is the future value of that
said annuity?
The solution can be illustrated by the time line below:
First step : Calculate the future value for t1, t2 and t3.
Second step : Total the three future values to get the future value annuity
(FVA).
First step:
F1 = RM100(1+0.1) 1
= RM100 (1.1)
= RM110
F2 = RM100(1+0.1) 2
= RM100 (1.21)
= RM121
F3 = RM100 (no increase in the future value as the deposit was made at
the end of the third year).
Second step:
FVA3 = F1 + F2 + F3
= RM110 + RM121 + RM100
= RM331
The steps shown in the example above takes time even though it is a simple
example. In cases where the calculation for future value of annuities are for a
period of 20 or 30 years, it will be slow with complicated calculations. Therefore,
we can simplify the calculations by using the formula below:
A [ (1 + i)n – 1]
FVA n = (3.5)
i
FVAn = A(FVIFAi,n ) (3.6)
Equation 3.5 used to solve the future value problems that involve the ordinary
annuity is by manual calculation. While equation 3.6 is the solution formula for
ordinary annuity using schedule. Annuity future value schedule can be obtained
in Attachment C.
Example 5.9
Danon Company deposited RM5,000 at the end of each year for a period of 3
years consecutively in an account that pays a yearly interest of 10 percent. What
is the future value of that annuity?
(i) Manual solution
A [ (1 + i) n - 1]
FVA n =
i
RM5, 000 [(1 + 0.10)3 < 1]
=
0.10
= RM16, 550
(ii) Solution using schedule
FVA n = A (FVIFA i, n )
= RM5, 000
= RM5, 000 (3.310)
= RM16, 550
The time line for future value of ordinary annuity of RM5,000 for 3 years at a rate
of 10% per year is as below:
(b) Future Value of Annuity Due

Sometimes we face a situation where the payment of annuity is at the
beginning of a period, for example, the beginning of each month or year.
This type of annuity is known as annuity due where it is different from
ordinary annuity as ordinary annuity is paid at the end of a period.
Annuity due occurs more frequently in future value annuity problems than
present value annuity (PVA). Figure 5.7 shows the timeline for annuity due.
Figure 5.7: Time line for annuity in advance.
The equation of annuity due can be formulated with a little alteration to the
ordinary annuity equation that is by multiplying the equation of ordinary
annuity with (1 + i). This alteration is made because the cash flow for annuity
due occurs at the beginning of a period.
(i) Manual equation
A [ (1 + i) n < 1] (1 + i)
FVA n = (3.7)
i
(ii) Equation using schedule

FVA n = A (FVIFA i,n) (1 + i) (3.8)
Example 5.10 helps you to differentiate between ordinary annuity and annuity
due.
Example 5.10
Danon Company deposited RM5,000 at the beginning of each period for 3 years
consecutively in the account that pays yearly interest of 10 percent. How much is
the future value for that annuity?
(i) Solving manually
⎡ (1 + i)n < 1 ⎤
A =A⎢
n
⎥ (1 + i)
⎣ i ⎦
⎡ [1 + 0.10)3 < 1] (1 + 0.10) ⎤
= RM5, 000 ⎢ ⎥
⎢⎣ 0.10 ⎥⎦
= RM18, 205
(ii) Solving using schedule
FVA n = A (FVIFA i, n ) (1 + i)
= RM5,000 (3.310) (1.10)
= RM18,205
The time line for future value annuity due of RM5,000 for 3 years at an interest
rate of 10% per year is as follows:
t0 t1 t2 t3
RM5,000 RM5,000 RM5,000
RM18,205
From the solution above, we found that the future value for annuity due
(RM18,205 in example 5.10) is higher compared to the future value for ordinary
annuity (RM16,550 in example 5.9). This is because for annuity due, the deposit is
deposited in the beginning of the period and therefore generates interest longer
compared to the ordinary annuity where the deposit is deposited at the end of
the period.
EXERCISE 5.5
Solve the questions below by using the manual formula or schedule

(FVIFA i,n).
1. Assume you had deposited RM100 into the bank at the beginning
of the year for 3 years in the savings account that gives 5% interest
rate. How much can be obtained at the end of the third year?
2. Mr. Yeoh deposited RM10,000 into the bank on 31st December each
year for 5 years at an interest rate of 10%. How much can he obtain
at the end of the fifth year?
(c) Present Value of Ordinary Annuity

Payment of annuity promises a return rate (investment in bonds) and cash
flow (cash flow resulting from investment in equipment and plant).
Therefore, it is important for a finance manager to know the value of the
investment at the present time.
As an example, a finance manager finds that an annuity that promises four

yearly payments of RM500 starting from the current year. How much must
be paid by the finance manager to obtain that annuity? The principal
amount that must be paid by the finance manager is the present value of
ordinary annuity.
The present value of ordinary annuity (PVAn) can be obtained by using the
manual equation (equation 5.9) or by using the financial schedule in
Attachment D (equation 5.10). Both the equations below refer to the present
value annuity (PVA n) equivalent to the annuity cash flow multiply by the
present value annuity factor.
⎧[ 1 –[1/(1 + i) n ] ⎫
(i) Manual equation
PVA n = A ⎨ ⎬
⎩ ⎭
(5.9)
i
(ii) Equation using schedule
PVAn = A (PVIFAi,n) (5.10)
Example 5.11
Taming Company expects to receive RM3,000 at the end of each year for 3
consecutive years. How much is the present value for that annuity if it is
discounted at the rate of 6% per year?
⎧ [ 1 – [1/(1 + i)n ] ⎫
(i) Solution via manual equation:
PVA n = A ⎨ ⎬
⎩ i ⎭
⎧ [ 1 – [1/(1 + i)3 ] ⎫
= RM3, 000 ⎨ ⎬
⎩ 0.06 ⎭
= RM8, 019.04
(ii) Solution via equation using schedule
PVAn = A (PVIFAi, n)
= RM3,000 (PVIFA6%,3)
= RM3,000 (2.673)
= RM8,019
The time line for present value ordinary annuity of RM3,000 for 3 years at a
discounted rate of 6% per year is as below:
t0 i = 6% t1 t2 t3
RM3,000 RM3,000 RM3,000
RM8,019.04
@
RM8,019.00
(d) Present Value of Annuity Due

The concept of forming equation for present value of annuity due is as per
the future value of annuity due where it is based on a small alteration to the
ordinary annuity equation that is by multiplying equation 3.9 and 3.10 with
(1 + i).
[ 1 – [1/(1 + i) n ]
PVA n = A (1 + i) (5.11)
i
Example 5.12 can help you to differentiate between the ordinary annuity with the
annuity due for present value.
Example 5.12
Taming Company expects to receive RM3,000 at the beginning of each year for
consecutive 3 years. How much is the present value of that annuity if it is
discounted at the rate of 6% per year?
(i) Manual solution:

[ 1 < [1/(1 + i)n ]
PVA n = A (1 + i)
i
[ 1 - [1/(1 + 0.063)3 ]
= RM3,000 (1 + 0.06)
0.06
= RM8,500.18
(ii) Solution using schedule:

PVA n = A (PVIFA i,n ) (1 + i)
= A (PVIFA 6%,3 ) (1 + 0.06)
= RM3,000 (2.673) (1.06)
= RM8,500.14
The time line for present value annuity due of RM3,000 for 3 years at a
discounted rate of 6% per year is as below:
t0 i = 6% t1 t2 t3
RM3,000 RM3,000 RM3,000
RM8,500.18
@
RM8,500.14
As per the difference between ordinary annuity and annuity due for future
value, the solution for present value of annuity due (RM8,500 in example 5.12) is
also higher compared to the present value of ordinary annuity (RM8,019.00 in
example 5.11). This is because in annuity due, the deposit is deposited in the
beginning of the period and therefore generates interest longer compared to the
ordinary annuity.
EXERCISE 5.6
1. You are offered an annuity payment of RM100 at the end of each year for
3 years and is deposited into the bank. The interest rate offered is 5% per
year. How much is the present value of that annuity payment?
5.4.2 Derivation Cash Flow

Lots of decision in the financial field, for example the capital budgeting and
dividend payments that involves a mixture of cash flow or cash flow that is
irregular. The calculation of future value and present value of an irregular cash
flow is a combination concept of determining money value for single cash flow
and also annuity.
(a) Future Value of Derivation Cash Flow

The calculation for future value of derivation cash flow involves the
determination of future value for each of the cash flows and subsequently
totalling all that future values. Formula in equation 5.12 shows the future
value (FVn) is obtained by adding each of the cash flow (Pt) that is adjusted
with the exponent (n < t) that is the number of periods in which the interest
is obtained.
Exponent is used in this formula because the last cash flow happens at the
symbol ( Σ ) is the mathematical symbol for a total of a series of value.

end of the last period. Therefore, interest is not obtained for it. The sigma
(i) Manual equation
FVn = ∑ Pt (1 + i)n<1
n
(5.12)
t = 10
If solution by using the schedule is chosen, you can use the formula in 5.2,
5.6 or 5.8 according to the suitability of the cash flow. This is because the
calculation of future value of irregular cash flow is a combination concept
of determining the value of money for single cash flow and also annuity.
Example 5.13
Bikin Fulus Company made a decision to deposit RM2,000 at the end of the first
and second year, withdrawing RM3,000 at the end of the third year and
depositing RM4,000 again at the end of the fourth year. How much is this future
value cash flow at the end of the fourth year if the annual interest rate is 10% per
year?
(i) Solution via manual formula
FVn = ∑ Pt (1 + i)n-1
n
t=4
= (RM2,000)(1.10)4-1 + (RM2,000)(1.10)4-2 + (-RM3,000)(1.10) 4-3

+ (RM4,000)(1.10) 4-4
= RM5,782
Example 3.13 can be illustrated by using the time line as shown below:
(ii) Solution by using schedule

Step 1:
Find the future value of annuity for RM2,000 for 2 years (end of second
year).
RM2,000 (FVIFA 10%, 2) = RM2,000 (2.10)

= RM4,200
Step 2:
Find the future value of RM4,2000 at the end of fourth year.
RM4,200 (FVIFA 10%, 2) = RM4,200 (1.21)

= RM5,082
Step 3:
Find the future value at the end of fourth year for the withdrawal of
RM3,000 that occurred at the end of third year.
–RM3,000 (FVIFA 10%, 1) = –RM3,000 (1.10)

= – RM3,300
Step 4:
The present value cash flow is obtained by adding the result of step 2-3
with the final cash flow of RM4,000. As RM4,000 occurs that the last period,
there is no interest earnings from it.
FV4 = RM5,082 + (-RM3,300) + RM4,000

= RM5,782
(b) Present Value of Derivation Cash Flow
Similar to the concept in determining the future value of derivation cash
flow, the present value of derivation cash flow is also a combination
concept of present value of single cash flow and annuity.
Manual equation:
PV0 = ∑ Pt [1/(1 + i)n ]

n
(5.13)
t=10
If solution by using the schedule is chosen, you can use the formula in present
value of single cash flow, present value of ordinary annuity or present value of
annuity in advance according to the suitability of the type of cash flow stated in
the problem.
Example 5.14
Buat Pitih Company expects to receive RM1,000 at the end of the first and second
year, RM2,000 at the end of the third year and RM4,000 at the end of the fourth
year. How much is the present value cash flow if the yearly interest rate is 10%
per year?
(i) Solution via manual formula
= ∑ Pt (1 + i)n-t
n
PV0
t=10
= [RM1,000][1/(1.10)1 ] + [RM1,000][1/(1.10)2 ] + [RM2,000][1/(1.10)3 ]

+ [RM4,000][1/(1.10) 4 ]
= RM5,970.22
The time line for example 3.14; present value for derivation cash flow is as below:
t0 i = 10% t1 t2 t3 t4
RM1,000 RM1,000 RM2,000 RM4,000
RM909.99
RM826.45
RM1,502.632 RM5,970.22
RM2,732.05
(ii) Solution via schedule
Step 1:
Find the present value for annuity of RM1,000 for 2 years.
RM1,000 (PVIFA 10%, 2) = RM1,000 (1.736)
= RM1,736
Step 2:
Find the present value for RM2,000 that occurs at the end of third year.
RM2,000 (PVIF 10%, 3) = RM2,000 (0.751)
= RM1,502
Step 3:
Find the present value for RM4,000 that occurs at the end of forth year.
RM4,000 (PVIF 10%, 4) = RM4,000 (0.683)
= RM2,732
Step 4:
The present value cash flow is obtained by adding all the previous results
earlier (figure bolded).
PV 0 = RM1,736 + RM1,502 + RM2,732
= RM5,970
5.4.3 Perpetuity
Perpetuity is a type of series cash flow that involves the same amount for each
period continuously. In other words, perpetuity is an annuity that has an infinity
period. An example of perpetuity is the payment of dividends for preference
shares.
The concept for future value of perpetuity is illogical and cannot be used in
making financial decisions as the concept do not predict the period ending point
while future value is something that can be expected. Instead, the concept for
present value of perpetuity can be applied in making financial decisions. For
example, the usage of this concept to determine the present value for preference
shares and present value for pensions.
From the formula of present value of annuity, we know that:
[ 1 < [1/(1 + i)n ]

PVA n = A (5.14)
i
Try to imagine what will happen if the value of n increases. The value of (1 + i)n
will also increase. This will caused 1/(1 + i)n to become smaller. When (n)
approaches infinity, the value of (1 + i)n will become extremely big while the
value of 1/(1 + i)n will approach zero.
The situation above can be summarised as follows:
PV p = P / i (5.15)
Based on this equation, the present value of perpetuity is equivalent to the

payment of annuity amount (P) divided by the interest rate (i). Solution by
schedule and scientific calculator cannot resolve the present value of perpetuity.
This is because schedule PVIFA does not contain the value for infinity and the
same with scientific calculators that do not have an infinity button. It must be
calculated manually by calculation in stages.
Figure 3.19 shows the position of variables in equation 3.15.
t0 i% t1 t2 t60 t= ∞
PVp P P P
Figure 5.19: Present value of perpetuity
Example 5.15
Sukehati Company issued securities that promised a payment of RM100 per year
at the yearly interest rate of 8% to the holders of that security. How much is the
present value for that cash flow?
PVp =P/i
= RM100 / 0.08
= RM1,250
The financial schedule does not provide the factor for present value of perpetuity
because perpetuity involves an infinity period. Therefore, the solution for
perpetuity cases can only depend on manual calculations.
EXERCISE 5.7
1. Consider the perpetuity that pays RM100 per year, with an interest
rate of 10%. How much is the present value of this perpetuity?
5.5 COMPOUNDING AND DISCOUNTING

MORE THAN ONCE A YEAR
The practice of compounding or discounting interest more than once a year is
also known as intrayear compounding or discounting. For example,
compounding or discounting twice a year, three times a year, four times a year or
each month. The frequency of compounding or discounting several times in a
year is a normal practice in making financial decisions.
When the frequency of compounding or discounting for future value or present

value is more than once a year (n x m), the interest rate must also be divided with
the said frequency (i / m). The purpose is to adjust the changes in the period and
interest rate to enable both the variables to change consistently. Therefore, a little
alteration must be made to the formulas that had been learned previously.
The formula for manual solution is:
FV = PV × (1 + i/m)nm (5.16)
FV = Future value
PV = Present value
i = Interest rate
m = Frequency of compounding or discounting in a year
n = Number of years
While the solution by schedule is as follow:
FV = PV x (FVIF i/m,nm) (5.17)

Example 5.16
The future value of RM1 now after 6 years, using the interest rate of 10% per year
with different compounding frequencies.
Presumed Compounding nm i/m FV nm

Once a year 6x1=6 0.1/1=0.01 RM1.772
Twice a year 6 x 2 = 12 0.1/2=0.05 RM1.796
Four times a year 6 x 4 = 24 0.1/4=0.025 RM1.809
Every month 6 x 12 = 72 0.1/12=0.0083 RM1.817
Example 5.17
The present value of RM1 received in 6 years from now, discounted at the
interest rate of 10% per year with different discounting frequencies.
Presumed Discounting nm i/m PV 0

Once a year 6x1=6 0.1/1=0.01 RM0.564
Twice a year 6 x 2 = 12 0.1/2=0.05 RM0.557
Four times a year 6 x 4 = 24 0.1/4=0.025 RM0.553
Every month 6 x 12 = 72 0.1/12=0.0083 RM0.550
The conclusion that can be made based on examples 5.16 and 5.17 is: the higher
the frequency of compounding, the higher the future value of cash flow; and
higher the frequency of discounting, the lower the present value of cash flow.
5.6 CONTINUOUS COMPOUNDING AND

DISCOUNTING
Before this, you were only exposed to situations where the interest is
compounded or discounted at specific discrete intervals whether yearly or twice
a year, monthly and so forth. However, in some cases of time value of money,
interest must be compounded or discounted continuously or at each micro-
second.
Referring to formula 3.16, FV = PV x (1 + i/m) nm, we cannot divide the value (i)
~ 2.71828. The value e is an antilog to 1 and same as pi ( π ) with value of 3.142,

with infinity and multiply (n) with infinity. Instead, we use the term (e) that is e
which cannot be represented by one exact value but only as an estimated value.
The new formula for future value and present value that is compounded and
discounted continuously is as follows.
Future value: FVn = PV0 (e in) (5.18)
Present value: PV0 = FVn (e <in) (5.19)
The estimate number for the symbol e in equation 5.18 and 5.19 is 2.72 (or more
accurately, 2.71828183).
Example 5.18
What is the future value for RM100 that is invested now for 6 years with an
interest rate of 8 percent per year and compounded continuously?
Manual solution:
FVn = PV 0 (e in)
= RM100 (2.72 (0.08)(6))
= RM161.61
Example 5.19
What is the present value of RM161.61 that will be received in 6 years from now
that is discounted continuously at an interest rate of 8 percent per year?
PVn = FVn (e <in)
= 161.61 (2.72 <(0.08)(6)

= RM100
EXERCISE 5.8
1. What is the future value for RM260 that is invested now for 3
years at the interest rate of 10 percent per year and compounded
continuously?
2. What is the present value for RM200 that will be received 5 years
from now and discounted continuously at the interest rate of 6
percent per year?
3. Mr. Sarbat plans to invest RM3,000 a year in the Pension
Investment Scheme for a period of 15 years. Mr. Sarbat wants to
know the result of the RM3,000 investment at the beginning of
each year compared with the end of each year. Calculate the value
differences between the two types of cash flow if the interest rate
is 8 percent per year.
4. Mas Joko Company is considering an investment on a new
machine that involves a total purchase and assembly cost of
RM30,000. The usage of this new machine is expected to generate a
yearly cash flow for 5 consecutive years: end of first year RM4,000,
end of second and third year RM5,000, end of fourth year RM6,000
and end of fifth year RM8,000. If the company requires a yearly
18% rate of return on its investment, is it reasonable for the
company to continue with its investment?
5. Complete the present value for a series of indefinite yearly
payments of RM180, assuming that the interest rate is
(a) 5 percent
(b) 10 percent
6. You have just won a puzzle contest where you were offered two
choice of prizes that is whether to accept RM60,000 today or
RM12,000 at the end of each year for 5 consecutive years. If the
cash flow is discounted at a yearly rate of 12 percent and
compounded twice a year, which choice would you choose?
7. Mrs. Aimi plans to get a loan for a total of RM6,000 at the interest
rate of 10% from a kind-hearted money lender. The money lender
agrees to receive a sum of payment for the same amount at the
end of each year for 4 years. What is the size of payment that Mrs.
Aimi must give to the money lender each year?
8. What is the present value for RM400 that will be received in 7
years from now and discounted continuously at the interest rate of
10 percent per year?
In this topic, you have learnt the importance of time value of money. The concepts
of compounding and discounting are used respectively to compute future value
and present value for single or series of cash flows. The knowledge in this area
would help you to make better financial decisions that involves cash flows.
TUTORIAL QUESTION
w INTRODUCTION
The purpose of these activities is to test your understanding on the basic concepts
in financial management, which is the concept of time value of money, risk and
return as well as leverage. These concepts are important in financial decisions
making.
w PROBLEM 1
Naim and Nadiah are planning in sharing to buy a house 10 years from now with
the expected price of RM100,000. Naim will save RM5,000 every year in his
account beginning a year from now. His last annual savings will be made at the
end of the tenth year. Nadiah will deposit RM4,000 in the account now and
another RM8,000 four years from now.
They also plan to help NaimÊs father (Mr. Roslee) who had just retired and
NadiahÊs sister (Nurul) who had just started her studies in university. Naim will
deposit a sum of money into his fatherÊs account to enable him to withdraw
RM3,600 per year, starting a year from now until his fatherÊs death. While,
Nadiah will deposit RM6,000 into NurulÊs account and will only allow Nurul to
withdraw the same amount every year starting a year from now. As the period of
her studies is four years, Nurul will make four withdrawals.
w ASSIGNMENT
With the assumption that all the accounts will pay an interest of 9%,
compounded yearly, answer the following questions:
(a) How much should be added by Naim and Nadiah at the end of the tenth
year to enable them to buy the said house?
(b) How much is the amount that Naim must deposit into his fatherÊs account?
(c) How much is the amount that Nurul can withdraw every year?
ANSWERS v 177
Answers
TOPIC 1: ACCOUNTING ENVIRONMENT
Exercise 1.1
1. Internal users are people who have direct access to the resources of an
entity and are normally involved in the management of the company; an
example being the companyÊs management. These people are involved in
planning and controlling the activities of the company to enable it to
achieve specified objectives. Examples of common decision making are:
(a) does the company require additional capital or not; if the company
requires additional capital, would the company be applying for loan
or issue shares.
(b) does the company require additional asset; if the company requires
additional asset, would the company be buying or renting it.
(c) how much is the companyÊs excess cash, if any, should be utilised.
(d) how the company is going to overcome insufficient cash flow
problems it might be facing.
(e) the companyÊs strategy to expand the market for its products
External users are people who do not have direct access to the resources of
the company and to not involved in the management of the company.
Examples of external users are investors, loan providers, Inland Revenue
Board, government agencies and the public. The types of decision made are
different according to user groups. For example, investors make decisions
on whether to invest in a company, loan providers make decisions on
whether to approve loans while the Inland Revenue Board decide on the
total tax to be imposed.
2. Financial accounting helps decision makers by preparing the entityÊs

financial reports for external and internal users; but is focused more on
external users. The financial report is released periodically and is subject to
specific standards and formats. The users are able to make decisions on the
performance and status of the company through this report.
Management Accounting provides the financial and non-financial

information required by the management of the company for planning,
178 w ANSWERS
evaluating and controlling the operations of the entity. Reports may be

issued at any time according to requirement and are not subject to any
standards and formats. Through this report, the users are able to take the
necessary measures required for improvement in order to ensure that the
company achieves its objectives.
Exercise 1.2
1. The characteristics of accounting information can be divided into two
categories, primary characteristics and secondary characteristics. The
primary characteristics are comprised of relevant and reliability, while the
secondary characteristics are comparability and consistency.
2. Comparability means that the information can be compared; whether

among companies, among industries or across different periods. Let us
assume that you are interested in investing in a company. You were
informed that the net income of the company in year 2000 was RM10
million. Is this information useful?
Actually, it is only useful if you have other information that can be

compared with that figure. For example, the net income in 1999 for the
company was RM3 million. This information enables you to conclude that
the company has gained a huge increase in net income. What if you were
told that the net income of the company in 1999 was RM19 million? You
might not want to proceed with the investment because the company has
experienced a huge decline in net income. You would not be able to come to
this conclusion by only referring to the RM10 million figure.
Exercise 1.3
1. The weaknesses in the assumption of monetary unit:
(a) Limiting the scope of accounting. This is because only transactions
that can be measured in monetary unit will be taken into
consideration in accounting, whereas there are many other factors that
will also affect the business. For example, the death of the companyÊs
manager, termination of staff, recognition by specific bodies on the
business achievements and other factors. All these cannot be recorded
in the financial statements as it cannot be stated in monetary terms.
(b) Assuming the value of money is stable at all times; when we know
that the currency value fluctuates. You have often heard the
grumblings or even experienced the fluctuation in currency value. We
used to be able to buy several items with RM10 but not so presently.
ANSWERS v 179
In the early days, school children only took 20 cents to school, now
they bring RM2. All these examples show that the currency value has
changed. In other words, the RM1 you have today will not have the
same value as the RM1 you will receive in a couple of monthsÊ time.
The fluctuation in the currency value should have been taken into
account when recording transactions but was ignored.
2. Three conditions that must be fulfilled before revenue can be recognised

are:
(a) The seller had done the necessary action to obtain the revenue (for
example, had supplied the goods for trade or rendered its services to
customer). The revenue cannot be recognised if the goods or services
are not supplied or rendered to the customer, even though the
customer had paid cash.
(b) The amount of revenue can be measured objectively. If the seller had
handed over the goods or provided the services, but have not
determined the amount that must paid by the customer, then the
revenue cannot be recognised.
(c) For credit transactions, the revenue can be collected. The seller had
handed over the goods or provided the services and had stated the
amount to be paid by the customer. If the seller is confident that cash
is collectable from the customer, then the revenue will be recognised
at the point of sale. However, if the seller is uncertain, then the
revenue will only be recognised when cash is received.
Exercise 1.4
1. (a) accounting period
(b) historical cost
(c) relevant
(d) Malaysian Accounting Standards Board
(e) reliability
(f) principle of matching
(g) cost benefit relation, materiality
(h) management accounting
(i) going concern
(j) point of sale
(k) Cash Flow Statement
(l) Balance Sheet
180 w ANSWERS
2. D
3. A
4. D
5. C
6. False
7. False
8. False
9. (a) 46,000
(b) 100,000
(c) 75,000
10. (a) Asset increased, Asset decreased or has no effect on the Asset
(b) Asset decreased, OwnerÊs Equity decreased
(c) Asset decreased, OwnerÊs Equity decreased
(d) Asset increased, Asset decreased or has no effect on the Asset
(e) Asset increased, OwnerÊs Equity increased
ANSWERS v 181
11.
ASSET = LIABILITY + O.EQUITY
Trans + Capital,
Cash + AR + Supplies = AP
action Ashwin
a. +20,000 +20,000
Investment by
Ashwin
Balance 20,00 = 20,000
b. +800 +800
Balance 20,000 800 = 800 20,000
c. -620 -620
Balance 19,380 800 = 180 20,000
d. +4,200 +4,200
180 Service revenue
Balance 23,580 800 24,200
e. -1,000 -1,000
Salary expenses
Balance 22,580 800 = 180 23,200
f. -700 -700
Transportation
expenses
-150 -150
Sundry expense
Balance 21,730 800 = 180 22,350
g. -1,200 -1,200
Rental expenses
Balance 20,530 800 = 180 21,150
h. +2,500 +2,500
Service revenue
Balance 20,530 2,500 800 = 180 23,650
i. -550 -550
Supplies
Balance 20,530 2,500 250 = 180 expenses
23,100
j. -750 -750
Drawings,
Ashwin
Balance 19,780 2,500 250 180 22,350
182 w ANSWERS
12. (a) Seri Consultation Services

Income Statement
For the year ended 31 December 2000
RM RM
Service Revenue 78,750
(-) Expenses:
Tax expenses 4,200
Utility expenses 7,350
Sundry expenses 1,265 (51,515)
Net income 27,235
(b) Seri Consultation Services

Statement of Changes in OwnerÊs Equity
For the year ended 31 December 2000
RM
Capital, Seri Dewi < 1 Jan 22,200
(+) Net income 27,235
49,435
(-) Drawings (6,000)
Capital, Seri Dewi < 31 Dec 43,435
(c) Seri Consultation Services

Balance Sheet
As at 31 December 2000
RM
ASSETS
Cash (23,300 < 6,000) 17,300
Supplies 8,480
TOTAL ASSETS 44,635
LIABILITIES
Accounts Payable 1,200
OWNERÊS EQUITY
Capital, Seri Dewi 43,435
TOTAL LIABILITIES AND O.EQUITY 44,635
ANSWERS v 183
TOPIC 2: RECORDING PROCESS
Exercise 2.1
1. (a) It is not a transaction and must not be recorded. This is because it will
not affect the entityÊs financial position (will not affect the asset,
liability or owner equity) and cannot be measured in currency unit.
(b) It is a transaction and must be recorded. This will affect the entityÊs
financial position (increase asset and ownerÊs equity) and can be
measured in currency unit.
Exercise 2.2
1. Account is a specific and separate accounting record for each item in the
financial statement. All transactions that affect the items will be recorded in
the accounts. Ledger is a group of accounts for a business entity. Chart of
accounts is the list of accounts in the ledger.
2. T-Account and three column account. T-account is easier but the three
column account enables us to know the last balance after each transaction.
3. Drawings are made by the owner for personal use while expenses are
incurred by the entity for the purpose of generating income. Drawings are
not considered in the calculation of net profit or loss, but are deducted
directly from ownerÊs equity. Expenses will be matched against income. The
difference between income and expenses will be either net profit or net loss.
This difference will be added or deducted from ownerÊs equity.
4. C
5. C
6. (a) Asset
(b) Expense
(c) Asset
(d) Income
(e) Liability
(f) Asset
(g) Expense
(h) Asset
184 w ANSWERS
7. (a)
Apr 2001
a. Cash 5,000
Capital, Cindy 5,000
(Cash investment by Cindy)
b. Supplies 275
Accounts payable 275
(Purchase of supplies on credit)
c. Cash 3,250
(Cash received for services
provided)
d. Rental expenses 750
Cash 750
(Payment of rental by cash)
e. Accounts payable 125
Cash 125
f. Accounts receivable 1,875
Service revenue 1875
( Customer has not paid for services
provided)
g. Utility expenses 390
Sundry expenses 187
Cash 577
(Payment for expenses by cash)
h. Salary expenses 1,250
Cash 1,250
(Payment for salary by cash)
i. Supplies expenses 162
Supplies 162
(Usage of supplies)
j. Drawings 550
Cash 500
Supplies 50
(Cash and supplies drawings by
owner)
ANSWERS v 185
(b) Post to ledger
Cash Account
Apr 2001 Capital, Cindy 5,000 5,000
Service revenue 3,250 8,250
Rental expenses 750 7,500
Accounts payable 125 7,375
Utility expenses 390 6,985
Sundry expenses 187 6,798
Salary expenses 1,250 5,548
Drawings, Cindy 500 5,048
Account Receivable
Apr 2001 Service revenue 1,875 1,875
Supplies Account
Apr 2001 Accounts payable 275 275
Supplies expenses 162 113
Drawings, Cindy 50 63
Accounts Payable
Apr 2001 Supplies 275 275
Cash 125 150
Capital Account, Cindy

Apr 2001 Cash 5,000 5,000
Drawings Account, Cindy

Apr 2001 Cash 500 500
Supplies 50 550
186 w ANSWERS
Service Revenue Account

Apr 2001 Cash 3,250 3,250
Accounts 1,875 5,125
receivable
Rental Expenses Account

Apr 2001 Cash 750 750
Utility Expenses Account

Apr 2001 Cash 350 350
Sundry Expenses Account

Apr 2001 Cash 187 187
Salary Expenses Account

Apr 2001 Cash 1,250 1,250
Supplies Expenses Account

Apr 2001 Cash 162 162
ANSWERS v 187
(c) Trial Balance
Cindy Insurance Agency

Trial Balance
as at 30 April 2001
Credit
Accounts Debit (RM)
(RM)
Cash 5,048
Supplies 63
Accounts payable 150
Capital, Cindy 5,000
Drawings, Cindy 550
Salary expenses 750
Rental expenses 390
Sundry expenses 162
TOTAL 10,275 10,275
8. (a) GENERAL JOURNAL

Feb 1 Supplies L104 274
Cash L101 274
(Purchased supplies by cash)
2 Drawings, Edlin L302 2,000
Cash L101 2,000
5 Cash L101 2,740
(Received cash from customer
for payment of accounts
receivable)
9 Office equipment L108 3,850
(Purchased office equipment
on credit)
15 Accounts payable L201 1,200
Cash L101 1,200
(Payment to accounts
payable)
188 w ANSWERS
18 Cash L101 580

Service revenue L401 580
(Received for services
provided)
25 Advertisement expenses L502 420
Cash L101 420
(Payment for advertisement)
28 Utility expenses L503 215
Cash L101 215
(Payment for businessÊs
telephone and electricity bill)
28 Drawings, Edlin L302 117
Cash L101 117
(Payment for telephone and
electricity bill of ownerÊs
house by cash from the
business)
28 Rental expenses L501 1,200
Cash L101 1,200
(Payment for rental of
business premises)
28 Sundry expenses L509 220
Cash
(Repair of office equipment L101 220
by cash)
(b) Post of entries to ledger
Cash Account No: 101

Feb 1 Cash 15,238
1 Supplies J1 274 14,964
2 Drawings, Edlin J1 2,000 12,964
5 Accounts J1 2,740 15,704
receivable
18 Service revenue J1 580 15,084
25 Advertisement J1 420 14,664
expenses
28 Utility expenses J1 215 14,449
28 Drawings, Edlin J1 117 14,332
28 Rental expenses J1 1,200 13,132
28 Sundry expenses J1 220 12,912
ANSWERS v 189

Feb 1 Balance 4,575
5 Cash J1 2,740 1,835

Feb 1 Balance 427
1 Cash J1 274 701

Feb 1 Balance 8,400
9 Account payable J1 3,850 12,250
Accounts Payable No: 201

Feb 1 Balance 1,730
9 Office equipment J1 3,850 5,580
15 Cash J1 1,200 4,380
Capital Account, Edlin No: 301

Feb 1 Balance 26,910
Drawings Account, Edlin No: 302

Feb 2 Cash J1 2,000 2,000
28 Cash J1 117 2,117
Service Revenue Account No: 401

Feb 18 Cash J1 580 580
Rental Expenses Account No: 501

Feb 28 Cash J1 1,200 1,200
190 w ANSWERS
Advertisement Expenses Account No: 502

Feb 25 Cash J1 420 420
Utility Expenses Account No: 503

Feb 28 Cash J1 215 215

Feb 28 Cash J1 220 220
(c) Trial Balance
Edlin Enterprise
Trial Balance
as at 28 February 2001
Account Debit Credit

Accounts
Number (RM) (RM)
101 Cash 12,912
102 Accounts receivable 1,835
104 Utilities 701
108 Office equipment 12,250
301 Capital, Edlin 26,910
302 Drawings, Edlin 2,117
401 Service revenue 580
501 Rental expenses 1,200
502 Advertisement expenses 420
503 Utility expenses 215
509 Sundry expenses 220
TOTAL 31,870 31,870
ANSWERS v 191
TOPIC 3: FINANCIAL STATEMENTS
Exercise 3.1
1. (b) False
2. (b) False
3. (a) True
4. (b) False
5. C
6.
(1) (2)
Account
Statement Type of Account
Account payable BS CL
Account receivable BS CA
Accruals BS CL
Building BS FA
General expenses IS E
Interest expenses IS E
Sales expenses IS E
Operating expenses IS E
Administrative expenses IS E
Tax IS E
Preference shares' dividends IS E
Sales revenue IS R
Long term loans BS LTL
Inventory BS CA
Cost of goods sold IS E
Paid up capital above par BS EQ
Notes payable BS CL or LTL
Retained earnings BS EQ
Equipment BS FA
Ordinary shares BS EQ
Preference shares BS EQ
Marketable securities BS CA
Depreciation IS E
Accumulated depreciation BS FA (contra account)
Land BS FA
Cash BS CA
192 w ANSWERS
7.
Company PC
Income Statement
Sales RM5,250,000
Less: Cost of goods sold 2,850,000
Gross profit RM2,400,000
Less Operating expenditure
Sales expenses RM350,000
Administrative and general expenses 600,000
Depreciation expenses 550,000
Total operating costs RM1,500,000
Profit before interest and tax RM 900,000
Interest expenses 250,000
Profit before tax RM 650,000
Tax (30%) 195,000
Profit after tax RM 455,000
Less: Preference sharesÊ dividend 100,000
Net profit (or profit available for
ordinary shareholders) RM 355,000
Earnings per share RM 0.17
8. Company ODC
Balance Sheet
as at 31 December 2001
Assets
Current assets
Cash RM2,150,000
Marketable securities 750,000
Account receivable 4,500,000
Inventory 3,750,000
Total current assets RM11,150,000
Fixed assets
Land RM2,000,000
Building RM2,250,000
Machines 4,200,000
Equipments 2,350,000
Total fixed assets RM10,800,000
Less: Accumulated depreciation 2,650,000
Fixed assets, net
8,150,000
RM19,300,000
Total Assets
ANSWERS v 193

Current liabilities RM2,200,000
Account payable 4,750,000
Accruals RM7,500,000
Total current liabilities 4,200,000
Long-term loans RM11,700,000
Total liabilities
Equities RM1,000,000
Ordinary shares 3,600,000
Paid up capital 2,100,000
Retained earnings
RM7,600,000
Total equities
RM19,300,000
Total liabilities and equities
Exercise 3.2
1. (b) False
2. (b) False
3. (a) True
4. (b) False
5. C
6. D
7. (a)
Hugo Enterprise
Statement of Retained Earnings
for the year ended 31 December 2000
Retained Earnings, 1 January 2000 RM 92,800
+ Net Profit (throughout year 2000) 37,000
- Dividends paid (throughout year 2000)
Preference shares RM 4,700
Ordinary shares 21,000 25,700
Retained Earnings, 31 December 2000 RM104,800
194 w ANSWERS
(b) Earnings per share
RM37,700 < RM4,700

= = RM2.36
14,000
RM21,000
(c) Dividends per share = = RM2.36
14,000
8. Dividends paid = RM736,000 + RM186,000 < RM812,000

= RM110,000
9.
Changes
Items Cash Flow
(RM)
Cash + 1,000 U
Account payable -10,000 U
Notes payable + 5,000 R
Long-term loans -20,000 U
Inventory +20,000 U
Fixed assets + 4,000 U
Account receivable - 7,000 R
Net profit + 6,000 R
Depreciation + 1,000 R
Share buyback + 6,000 U
Cash dividend + 8,000 U
Sales of Share + 10,000 R
ANSWERS v 195
10.
Suresh Corporation
Changes in balance sheet items
between 31 December 2001 and 31 December 2002
2001 2002 Changes Resource Usage
Assets
Cash 15,000 10,000 +5,000 5,000
Marketable securities 18,000 12,000 +6,000 6,000
Account receivable 20,000 18,000 +2,000 2,000
Inventory 29,000 28,000 +1,000 1,000
Total fixed assets 295,000 281,000 +14,000 14,000
Less: Accumulated 147,000 131,000 (16,000) 16,000
depreciation
Liabilities
Account payable 16,000 15,000 +1,000 1,000
Notes payable 28,000 22,000 +6,000 6,000
Wages accrual 2,000 3,000 - 1,000 1,000
Long term loans 50,000 50,000 0
Equities
Preference shares 100,000 100,000 0
Retained earnings 14,000 28,000 +6,000 6,000
TOTAL RM29,000 RM29,000
196 w ANSWERS
Suresh Corporation
Cash Flow Statement
For the Year Ended 31 December 2002

Net Profit RM14,000
Depreciation 16,000
Increase in account receivable (2,000)
Increase in inventory (1,000)
Increase in account payable 1,000
Decrease in accrual (1,000)
Cash flow from operating activities RM27,000
Cash Flow from Investing Activities (14,000)

Increase in total fixed assets
Cash flow from investing activities (14,000)
Cash Flow from Financing Activities RM6,000

Decrease in short term notes payable (8,000)
Dividends paid
Cash flow from financing activities (2,000)
Net increase in cash and marketable RM11,000
securities
Exercise 3.3
1. Fazrul Company
1999 1998
(a) Net working capital RM180,000 RM150,000
(b) Current ratio 2.5 times 2.07 times
(c) Quick ratio 1.17 times 1 time
ANSWERS v 197
Exercise 3.4
1. Fazrul Company
1999 1998
(a) Account receivable turnover 9.14 times 9.03 times
(b) Average collection period 39.9 days 40.4 days
(c) Inventory turnover 2.54 times 39.87 times
(d) Average inventory sales period 14.4 days 14.2 days
(e) Fixed asset turnover 142.3 times 140.01 times
(f) Total asset turnover 1.07 times 1.02 times
Exercise 3.5
1. Adiy Corporation
(a) Debt ratio = 50%

(b) Interest coverage ratio = 3 times
(c) Return on asset = 36%
(d) Average collection period = 27 days
(e) Total asset turnover = 2 times
Exercise 3.6
1. liquidity
2. current asset; current liability
3. inventory
4. cost of goods sold; inventory
5. total asset
6. net profit; ownersÊ equity
7. share price; earnings
8.
X-Cell N-Hance
(a) Return on asset 12.67% 11.25%
(b) Return on equity 31.67% 28.13%
(c) Net profit margin 10.27% 9.57%
(d) Total asset turnover 1.23 times 1.18 times
(e) Debt ratio 60% 60%
(f) Equity multiplier 2.5 times 2.5 times
(g) Interest coverage ratio 7.89 times 8.37 times
(h) Price/earnings ratio 6.25 12.62
(i) Dividend yield ratio 6.86% 1.89%
198 w ANSWERS
Exercise 3.7
1. (a) True
2. (b) False
3. D
4. C
5. Net profit = RM6,000
6. Return on equity = 4.0%
7. Fima Corporation
(a) Current ratio increased.
(b) Return on equity decreased.
(c) Debt ratio increased.
(d) Dividend yield increased.
(e) Account receivables turnover decreased.
(f) Return on asset decreased.
8. Lily Company
(a) Current ratio = 0.91 times
(b) Quick ratio = 0.63 times
(c) Average collection period = 32.5 days
(d) Inventory turnover = 20 times
(e) Fixed asset turnover = 4.60 times
(f) Total asset turnover = 2.8 times
(g) Debt ratio = 55%
(h) Interest coverage ratio = 4.0 times
(i) Gross profit margin = 13%
(j) Operating profit margin = 2%
(k) Net profit margin = 1.08%
(l) Return on asset = 3%
(m) Return on equity = 6.7%
9. Amri Company
Marketable securities = RM16,000
Account receivable = RM62,000
Inventory = RM73,560
Total fixed asset = RM146,663
Net fixed asset = RM96,663
Total asset = RM256,228
Notes payable = RM20,300
Total current liability = RM67,900
Long-term liability = RM58,677
Total liability = RM126,577
Total equity = RM129,651
Total liability and equity = RM256,228
ANSWERS v 199
TOPIC 4: FINANCIAL STATEMENT ANALYSIS

Exercise 4.1
1. Fazrul Company
1999 1998
(a) Net working capital RM180,000 RM150,000
(b) Current ratio 2.5 times 2.07 times
(c) Quick ratio 1.17 times 1 time
Exercise 4.2
1. Fazrul Company
1999 1998
(a) Account receivable turnover 9.14 times 9.03 times
(b) Average collection period 39.9 days 40.4 days
(c) Inventory turnover 2.54 times 39.87 times
(d) Average inventory sales period 14.4 days 14.2 days
(e) Fixed asset turnover 142.3 times 140.01 times
(f) Total asset turnover 1.07 times 1.02 times
Exercise 4.3
1. Adiy Corporation
(a) Debt ratio = 50%
(b) Interest coverage ratio = 3 times
(c) Return on asset = 36%
(d) Average collection period = 27 days
(e) Total asset turnover = 2 times
200 w ANSWERS
Exercise 4.4
1. liquidity
2. current asset; current liability
3. inventory
4. cost of goods sold; inventory
5. total asset
6. net profit; ownersÊ equity
7. share price; earnings
8.
X-Cell N-Hance
(a) Return on asset 12.67% 11.25%
(b) Return on equity 31.67% 28.13%
(c) Net profit margin 10.27% 9.57%
(d) Total asset turnover 1.23 times 1.18 times
(e) Debt ratio 60% 60%
(f) Equity multiplier 2.5 times 2.5 times
(g) Interest coverage ratio 7.89 times 8.37 times
(h) Price/earnings ratio 6.25 12.62
(i) Dividend yield ratio 6.86% 1.89%
Exercise 4.5
1. True
2. False
3. D
4. C
5. Net profit = RM6,000
6. Return on equity = 4.0%
7. Fima Corporation
(a) Current ratio increased.
(b) Return on equity decreased.
(c) Debt ratio increased.
(d) Dividend yield increased.
(e) Account receivables turnover decreased.
(f) Return on asset decreased.
8. Lily Company
(a) Current ratio = 0.91 times
(b) Quick ratio = 0.63 times
(c) Average collection period = 32.5 days
(d) Inventory turnover = 20 times
ANSWERS v 201
(e) Fixed asset turnover = 4.60 times

(f) Total asset turnover = 2.8 times
(g) Debt ratio = 55%
(h) Interest coverage ratio = 4.0 times
(i) Gross profit margin = 13%
(j) Operating profit margin = 2%
(k) Net profit margin = 1.08%
(l) Return on asset = 3%
(m) Return on equity = 6.7%
9. Amri Company
Marketable securities = RM16,000

Account receivable = RM62,000
Inventory = RM73,560
Total fixed asset = RM146,663
Net fixed asset = RM96,663
Total asset = RM256,228
Notes payable = RM20,300
Total current liability = RM67,900
Long-term liability = RM58,677
Total liability = RM126,577
Total equity = RM129,651
Total liability and equity = RM256,228
202 w ANSWERS
TOPIC 5: TIME VALUE OF MONEY
Exercise 5.1
1. RM127.63
2. RM6,050
Exercise 5.2
1. RM11,171.10
2. RM4,974.55
Exercise 5.3
1. RM1,000
2. RM2,268.43
Exercise 5.4
1. RM100.06
2. RM3,522.77
Exercise 5.5
1. RM330.96
2. RM61,050
Exercise 5.6
1. RM272.30
Exercise 5.7
1. RM1,000
ANSWERS v 203
Exercise 5.8
1. RM346.06
2. RM149.4
3. FVOA = RM3,000 (FVIFA 8%,15)
= RM3,000 (27.1521)
= RM81,456.30
FVAD = RM3,000 (FVIFA 8%,15) (1.08)
= RM3,000 (29.32)
= RM87,972.80
The difference: RM6,516.50
4. PV1 = RM4,000 (PVIF 18%,1) = RM3,390.00

PV2 = RM5,000 (PVIF 18%,2) = RM3,591.00
PV3 = RM5,000 (PVIF 18%,3) = RM3,043.00
PV4 = RM6,000 (PVIF 18%,4) = RM3,094.80
PV5 = RM8,000 (PVIF 18%,5) = RM3,496.80
Total PV = RM16,615.60
RM16,615.60 – RM30,000 = –RM13,384.40
Therefore, Mas Joko Company should not continue with its investment.
5. (a) RM180/5% = RM3,600

(b) RM180/10% = RM1,800
6. PVOA = RM12,000 (PVIFA 6%,10)

= RM12,000 (7.3601)
= RM88,321.20
The second choice should be chosen (RM88,321.20) as the present value is

more compared to the first choice (RM60,000).
7. PMTA = PVA / (PVIFA 10%,4)

= RM6,000 / 3.170
= RM1,892.74
8. PV = RM400 (2.72) –(0.10) (7)

= RM198.55

Accounting Book Very Essential

Uploaded by

Copyright:

Available Formats

Accounting Book Very Essential

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Accounting Book Very Essential

Uploaded by

Copyright:

Available Formats

What are the main topics covered in the document?

What are the main topics covered in the document?

What are the steps involved in the recording process?

What are the steps involved in the recording process?

BQOE III

Module Writers: Noor Asma Jamaludin

Moderators: Assoc Prof. Dr. Arfah Salleh

Azlina Abdul Aziz

Translated & Edited: Pearson (M) Sdn. Bhd.

Compiled by: Lilian Kek Siew Yick

Desktop Publishing: Centre for Instructional Design and Technology

Printed by: Meteor Doc. Sdn. Bhd.

First Printing, January 2009

Version January 2009

Topic 1 Accounting Environment 1

Topic 2 Recording Process 34

Topic 3 Financial Statements 79

Topic 4 Financial Statement Analysis 105

4.6 Market Value Ratio 128

Topic 5 Time Value of Money 144

This course provides learners with fundamental knowledge in the area of

Topic 3 discusses on the different types of financial statements used in business

Lasher, W.R. (2005). Practical Financial Management, (4th ed.). South-Western

Warren C.S., Reeve J. M. and Fess P. E. (2004), Accounting (21st ed.),

Warren et. Al (2001), Accounting: Customized by School Of Accountancy UUM

We might assume that accounting is only important to businessmen or

1.1 INTRODUCTION TO ACCOUNTING

1.1.1 Definition of Accounting

A process to identify, measure, record and present the economic information

Economic information are information related to economic activities; whereas an

1.1.2 Users of Accounting Information

Table 1.1: Differences between Internal Users and External Users

Internal Users External Users

1.1.3 Branches of Accounting

Table 1.2: Differences between Financial Accounting and Management Accounting

Financial Accounting Management Accounting

1.1.4 Professional Accounting Bodies in Malaysia

(a) Malaysian Institute of Accountants (MIA)

(b) The Malaysian Institute of Certified Public Accountants (MICPA)

(i) to advance the accounting theories and practices in all aspects;

(c) Malaysian Accounting Standards Board (MASB)

(d) Financial Reporting Foundation (FRF)

1.2 FUNDAMENTAL ACCOUNTING CONCEPTS

What are the important qualitative characteristics of accounting

1.2.1 Qualitative Characteristics of Accounting

The primary qualities of accounting information are relevant and reliability,

Figure 1.1 shows the summary for qualitative characteristics of accounting

Figure 1.1: Qualitative characteristics of accounting information

difference in arriving at a decision. In other words, something is said to be

The extent to which information is considered relevant depends on its

Figure 1.2 shows an example of performance information of a company in

Figure 1.2: Performance information of a company to assist investor in decision making.

(i) Feedback Value

Reliable information must have the following characteristics:

This example might help you to understand comparability. Let us assume

Figure 1.3: Profitability comparison

In your opinion, what will happen to a business entity if it only presents

1.2.2 Accounting Assumptions

(a) Assumption of Separate Entity

Segregation would enable you to evaluate the financial status of the