2

TUTORIAL
Principles of
Accounting

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TUTORIAL 2 OUTLINE

2.1 Shareholders’ Equity

2.2 Financial Statements

2.3 Income Statement

2.4 Statement of Cash Flow

2.5 Revised Net Income

2.6 Accounting Ratios

2.7 Depreciation Methods

2.8 Depreciation Book Values

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Professor R. Jassim Engineering Economy

2.1 SHAREHOLDERS’ EQUITY

LOM Inc. has 200 000 common shares outstanding, valued at $25/unit on the market.
DEF wishes to acquire all of LOM's stock and believes that it can do so by making an
offer to LOM shareholders midway between the market price and LOM's book value
per share. Current Assets (CA) $6 200 000
LOM's balance sheet contains the Net Fixed Assets (NFA) $4 100 000
entries shown here, in which the Other Assets (OA) $300 000
Capital Stock (CS) account has
Current Liabilities (CL) $3 150 000
been omitted.
Long-term Liabilities (LTL) $1 150 000
What should be DEF's bid to
LOM shareholders? Accumulated Retained Earnings (ARE) $2 300 000

LOM’s book value must be determined... ASSETS (‘000 $)

CA 6 200
Total Liabilities + SE = Total Assets = 10 600 000 NFA 4 100
OA 300
SE: 10 600 000 - 4 300 000 = 6 300 000 TOTAL ASSETS 10 600
CS: 6 300 000 - 2 300 000 = 4 000 000 LIABILITIES (‘000 $)
CL 3 150
LOM’s book value: Total SE = 6 300 000 LTL 1 150
Book value per share: 6 300 000 = 31.50 TOTAL LIABILITIES 4 300
SHAREHOLDERS’ EQUITY
200 000
CS 4 000

 DEF’s offer: 25.00 + 31.50 = $28.25 per share ARE 2 300

TOTAL SHAR. EQUITY 6 300
2
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2.2 FINANCIAL STATEMENTS

Minnie Mechanic purchased a small engine shop. Accordingly, she invested $8000 of
her personal savings ($1000 cash, $3000 inventory, $4000 equipment).

Over the first month of operation, sales and expenses for the shop were as follows:

Sales $13 500

Inventory purchases $7 000
Salaries $3 000
Advertising Expenses $250
Rental Expenses $600
Utility Expenses $400

In addition, the following information is available:

 Of the inventory purchases, an amount of $6000 was paid cash, while the rest is
still owed (i.e. $1000).
 The inventory now holds $2600 of merchandise.
i) Prepare a balance sheet on opening day.
ii) Prepare an income statement for the period (ignore any depreciation
expense).
iii) If by the end of the period, the shareholder's equity account has a balance of
$9850, determine the balance in the cash account.
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 Professor R. Jassim Engineering Economy

2.2 FINANCIAL STATEMENTS

Minnie Mechanic Engine Shop
Balance Sheet as of DD/MM/YY
Current Assets Current Liabilities 0
Cash 1000 Long-term Liabilities 0
Inventory 3000 Total Liabilities 0
Total 4000
Shareholders' Equity
Fixed Assets Capital stock 8000
Equipment 4000 Total Shareholders' Equity 8000

TOTAL ASSETS 8000 TOTAL LIABILITIES & S.E. 8000

Minnie Mechanic Engine Shop

Income Statement for the month ended DD/MM/YY
Sales 13 500

Less expenses:
Cost of inventory 7400
Salaries 3000
Advertising 250
Starting balance 3000 Rental 600
+ Purchases 7000 Utility 400 No information
 Ending balance 2600 11 650 given on taxes,
= Amount used 7400 so ignored.
Net Income 1 850
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Professor R. Jassim Engineering Economy

2.2 FINANCIAL STATEMENTS

Balance in Cash Account
Net Income, because no
withdrawals were made.
Assets = Cash + Inventory + Equipment
= Cash + 2600 + 4000

Liabilities + SE = Accounts payable + Capital Stock + Retained Earnings

= 1000 + 8000 + 1850 = 10 850

Cash: 10 850 - 2600 - 4000 = $4250

Alternate solution
Change in cash = net income + incr. in accounts payable + decr. in inventory
= 1850 + 1000 + 400 = 3250
Cash (end) = Cash (beginning) + Change in cash = 1000 + 3250 = $4250

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2.3 INCOME STATEMENT

Old Henry MacDonald purchased a farm for $75 000. He paid $25 000
cash and financed the balance with a ten-year mortgage carrying an
annual interest of 9 percent due once per year. He then purchased cattle
with a cash payment of $3000, and issued a promissory note of $5000
carrying an annual interest rate of 8 percent for the balance. Revenues
and expenses during the first year of operation of the farm were as follows:
Sale of Calves $8 500
Sale of Hay $1 200
Salaries $1 500
Rental of machinery $2 000
Veterinarian fees $175
50 000 (0.09) + 5000 (0.08)
Fertilizer $200
Property taxes $450
Repairs $375
Interest on debt $4 900
Miscellaneous expenses $125
Depreciation $1 500
Prepare an income statement for the year, providing for income taxes at a
rate of 40 percent.
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2.3 INCOME STATEMENT

Old Macdonald Farms
Income Statement for the year ending DD/MM/YY
Sales: Total Income
Calves 8500
Hay 1200
9700
Less expenses:
Salaries 1500
Rental of machinery 2000
Veterinarian fees 175
Total Expenses
Fertilizer 200 (excluding interest
Repairs 375 on debt)
Miscelaneous expenses 125
Property taxes 450
Depreciation 1500
6325
Income before interest and taxes 3375
Interest on debt 4900
Income before taxes (1525)
Taxes 0
Net Income (Loss) (1525)

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2.4 STATEMENT OF CASH FLOW

When considering a statement of cash flow, categorize the following
transactions, by the following:
i) Operating/Financing/Investing Cash Flow or None
ii) Source/Use

a) Decrease in Accounts Receivable

b) Decrease in Inventory
c) Increase in Accounts Payable
d) Increase in Note Payable
e) Decrease in Total Fixed Assets
f) Decrease in Long Term Debt
g) Increase in Common Stock
h) Decrease in Retained Earnings
i) Revenue
j) Expenses
k) Depreciation
l) Interest
m) Net income (assume positive)
n) Dividends Paid

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2.4 STATEMENT OF CASH FLOW

Transaction Cash Flow Source/Use
Decrease in Accounts Receivable Operating Source
Increase in Inventory Operating Use
Decrease in Accounts Payable Operating Use
Increase in Note Payable Financing Source
Decrease in Total Fixed Assets Investing Source
Decrease in Long Term Debt Financing Use
Increase in Common Stock Financing Source
Decrease in Retained Earnings None
Revenue None
Expenses None
Depreciation Operating Source
Investing Use
Interest None
Net Income (assume positive) Operating Source
Dividends Paid Financing Use
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2.5 REVISED NET INCOME

Eddy Electric's income statement reports a net income of $150 000.
However, Eddy omitted a depreciation expense of $30 000. Given that the
tax rate is 40 percent, determine the revised net income.
Income before taxes
- Taxes @ 40%
= Net income (i.e. Income before taxes [1 - tax rate])
Income before-taxes: 150 000 / (1 - 0.4) = 250 000

Revised income before-taxes = 250 000 - 30 000 = 220 000

Revised net income = 220 000 (1 - 0.4) = $132 000

After-tax effect
Alternate Solution

Revised Net income = 150 000 - 30 000 (1 - 0.4)

= 150 000 - 18 000
= $132 000

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2.6 ACCOUNTING RATIOS

Jack Mechanic Inc.’s Balance Sheet for the year ending 31 December,
1990 is shown below.
JACK MECHANIC INCORPORATED
Balance Sheet as at 31 December, 1990
ASSETS LIABILITIES
Current Current
Cash 10 000 Accounts payable 35 000
Accounts receivable 25 000 Taxes payable 15 000
Inventory 15 000
Prepaid expenses 5 000 Long-term
Mortgage 45 000
Fixed TOTAL LIABILITIES 95 000
Equipment at cost 195 000
Accumulated depreciation 25 000 SHAREHOLDERS' EQUITY
Net 170 000 Capital Stock 115 000
Retained Earnings 30 000
Goodwill 15 000 TOTAL S.E. 145 000
TOTAL ASSETS $240 000 TOTAL LIAB. & S.E. $240 000

i) Determine the firm's quick ratio.

ii) Determine the firm's equity ratio.
iii) Determine the firm's debt to equity ratio.
iv) Determine the firm's book value.
v) Comment on the firm's short-term liquidity position as well as on its degree of leverage.
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2.6 ACCOUNTING RATIOS

JACK MECHANIC INCORPORATED
Balance Sheet as at 31 December, 1990
ASSETS LIABILITIES
Current Current
Cash 10 000 Accounts payable 35 000
Accounts receivable 25 000 Taxes payable 15 000
Inventory 15 000
Prepaid expenses 5 000 Long-term
Mortgage 45 000
Fixed TOTAL LIABILITIES 95 000
Equipment at cost 195 000
Accumulated depreciation 25 000 SHAREHOLDERS' EQUITY
Net 170 000 Capital Stock 115 000
Retained Earnings 30 000
Goodwill 15 000 TOTAL S.E. 145 000
TOTAL ASSETS $240 000 TOTAL LIAB. & S.E. $240 000

i) Quick ratio: (10 000 + 25 000) / (35 000 + 15 000) = 0.70

ii) Equity ratio: (115 000 + 30 000) / 240 000 = 0.60
iii) Debt to equity ratio: 45 000 / (115 000 + 30 000) = 0.31
iv) Book value: 115 000 + 30 000 = $145 000
v) Liquidity problems; leverage within acceptable limits.
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2.7 DEPRECIATION METHODS

A company purchased an asset costing $55 000 and having an estimated
salvage value of $5000 at the end of a period of use of 5 years.
i) Using declining-balance depreciation, determine the depreciation
charge for accounting purposes in the third year of use of the asset.
ii) Using straight-line depreciation, determine the depreciation charge for
tax purposes in the third year of use of the asset.
iii) Given that the asset's rate of use decreases by 10 percent per year
over its useful life, and using unit-of-production depreciation,
determine its book value for accounting purposes at the end of its
fourth year of use.
i) When no depreciation rate is given, we find the rate which will yield the
correct salvage value. If the rate is given, we use it and ignore the
salvage value. For this question, we must solve for the rate to yield
desired salvage value.
r = 1 - (5000 / 55 000)0.2 = 0.380956 or 38.1%

DC3 = 55 000 (1 - 0.381)2 (0.381) = $8029

ii) DC3 = 55 000 / 5 = $11 000 (salvage value is ignored for tax purposes)

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2.7 DEPRECIATION METHODS

iii) No production values given…Therefore, base depreciation on
RELATIVE production values. Say production in year 1 is 1 unit.

Total production: 1 + 0.9 + 0.81 + 0.729 + 0.6561 = 4.0951

r1 + r2 + r3 + r4 = (1 + 0.9 + 0.81 + 0.729) / 4.0951 = 0.8398

BV4 = 55 000 - 0.8398 (55 000 - 5000) = $13 010

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2.8 DEPRECIATION BOOK VALUES

You have an asset worth $178 000 that will last 5 years and has an
estimated book value of $15 000. Using depreciation for accounting
purposes, determine the book value of every year for each of the four
depreciation methods described below.
i) Straight-line depreciation
ii) Declining-balance depreciation
iii) Sum-of-the-years depreciation
iv) Unit of production depreciation (40%, 25%, 20%, 10%, 5%)

i) Depreciation charge every year: (178 000 – 15 000)/5 = 32 600

BV1: $145 400

BV2: $112 800
BV3: $ 80 200
BV4: $ 47 600
BV5: $ 15 000

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2.8 DEPRECIATION BOOK VALUES

ii) Have to find rate to yield desired salvage value (since rate was not given in
question).

$178 000(1-r)5 = $15 000……r = 39%

BV1: $108 531

BV2: $ 66 174
BV3: $ 40 348
BV4: $ 24 601
BV5: $ 15 000
iii) Total depreciation after 1 year: 5/(1+2+3+4+5) = 0.333
Total depreciation after 2 years: (5+4)/(1+2+3+4+5) = 0.6
Total depreciation after 3 years: (5+4+3)/(1+2+3+4+5) = 0.8
Total depreciation after 4 years: (5+4+3+2)/(1+2+3+4+5) = 0.933
Depreciable amount: $178 000 - $15 000 = $163 000

BV1: $178 000 – 0.333*$163 000 = $123 667

BV2: $178 000 – 0.600*$163 000 = $ 80 200
BV3: $178 000 – 0.800*$163 000 = $ 47 600
BV4: $178 000 – 0.933*$163 000 = $ 25 867
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2.8 DEPRECIATION BOOK VALUES

iv) Total depreciation after 1 year: 40%

Total depreciation after 2 years: 40% + 25% = 65%
Total depreciation after 3 years: 40% + 25% + 20% = 85%
Total depreciation after 4 years: 40% + 25% + 20% +10% = 95%
Depreciable amount: $178 000 - $15 000 = $163 000

BV1: $178 000 – 0.40*$163 000 = $112 800

BV2: $178 000 – 0.65*$163 000 = $ 72 050
BV3: $178 000 – 0.85*$163 000 = $ 39 450
BV4: $178 000 – 0.95*$163 000 = $ 23 150
BV5: $178 000 – 1.00*$163 000 = $ 15 000

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