The 17,000-Dinar 'Profit' That a Bank Will Not Lend Against
Al-Noor Trading is a small wholesale supplier whose owner prepares monthly financial statements from a cash-basis summary. For December 2024 the summary shows cash sales and collections of 48,000 dinars and cash payments of 31,000 dinars, giving a 'profit' of 17,000 dinars. Four items were never recorded: (a) a 3,600-dinar annual insurance premium paid on 1 October 2024 covering twelve months from that date; (b) December electricity of 1,250 dinars, billed on 5 January 2025; (c) a 6,000-dinar advance received in December from a customer for goods to be delivered in February 2025; (d) monthly depreciation of 900 dinars on delivery equipment, never recorded since purchase. The owner wants to submit these statements to a bank for a 20,000-dinar loan and argues that adjusting entries are 'accounting formalities' that do not change real cash. The bank requires statements prepared on an accrual basis.
1. Compute the accrual-basis profit for December 2024 and state the effect and balance-sheet treatment of each of the four items.
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Start from the cash figure and correct it item by item.
- (a) Insurance: 3,600 covers 12 months from 1 October, so 300 per month. December's expense is 300. At 31 December, three months (Oct–Nov–Dec) are consumed, i.e. 900, so the remaining prepaid insurance asset is 2,700. The cash payment was made in October, so it is not even inside December's 31,000 of payments - the cash summary both understates the asset and understates the expense.
- (b) Electricity: consumed in December, invoiced in January → accrued expense 1,250 (current liability). Matching principle: the cost belongs to the period that used the power.
- (c) Customer advance: cash received before the earning process is complete. If the 6,000 is inside the 48,000 collections (normal for a cash-basis summary), it must be removed from revenue and shown as unearned revenue, a current liability of 6,000. If it was banked separately and excluded from the 48,000, no revenue adjustment is needed - the owner must confirm this, because the whole answer shifts by 6,000.
- (d) Depreciation: expense 900, accumulated depreciation 900 (contra-asset). Non-cash, but it allocates the equipment's cost to the periods that benefit.
Accrual profit = 17,000 − 300 − 1,250 − 6,000 − 900 = 8,550 dinars.
So the cash summary overstates profit by 8,450 dinars - roughly half the reported figure.
2. The owner says adjusting entries do not change real cash. Explain why the bank still cares, and identify which single adjustment most threatens the loan application.
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Why the bank cares. The bank is not lending against cash already received; it is lending against the borrower's capacity to generate future cash. A cash summary cannot show that, because it mixes operating activity with financing-type inflows and ignores obligations already incurred.
- Profit of 8,550 versus 17,000 changes the apparent debt-service capacity by half. A 20,000-dinar loan repaid over, say, 24 months needs roughly 900+ dinars a month; the corrected December profit supports about 8,550 a month before drawings, not 17,000.
- The unearned revenue is the real danger. The 6,000 was cash in, but it creates an obligation to deliver goods in February: inventory and labour go out with no matching cash inflow. Cash flow in February will be 6,000 lower than the sales figure suggests.
- Depreciation is non-cash, so it does not reduce cash, but it tells the banker that the delivery fleet is being consumed and will need replacing - a future cash need.
- Prepaid insurance of 2,700 is a genuine asset (a claim on future cover), so it strengthens the balance sheet even though it lowers profit.
Judgement: the unearned revenue is the item to defend. The owner should bring a February delivery schedule, an order backlog and a simple 13-week cash forecast showing the goods can be supplied from existing stock, and should not present the cash summary as 'profit' at all.
3. The owner wants to book the 6,000 advance as December sales 'because the customer has already paid'. Give the accounting and business-ethics reasoning against this, and one legitimate way to present the same cash position to the bank.
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Accounting reasoning. Revenue is recognised when the performance obligation is satisfied, not when cash moves. In December, Al-Noor has transferred no goods to that customer, so no revenue has been earned; the entity owes either goods or a refund. Recording it as sales would:
- overstate revenue and profit by 6,000;
- understate liabilities by 6,000, so the balance sheet would not balance honestly;
- break the accrual basis the bank has explicitly required, making the statements misleading as to a specific, material item.
Ethics reasoning. Presenting the figure as sales is not a 'presentation choice' - it is knowingly misrepresenting the statements to obtain credit. That is a misstatement to a lender, exposes the owner personally (loan covenants, possible fraud), and would make the entity's other figures untrustworthy. The owner's own argument - 'the cash is real' - is true but irrelevant: the cash is real and it is a liability.
Legitimate presentation. Show the 6,000 as cash and as unearned revenue, then attach a note: 'Advance received for a confirmed February order; goods already in stock; gross margin on the order X dinars.' The banker sees the same 6,000 of liquidity with an honest label, plus evidence of customer demand - usually a stronger credit story than an inflated sales line.