Rahman's Workshop: Turning a Draft Profit into a Defensible One
Encik Rahman runs a motor repair workshop as a sole proprietor and has drafted his statement of profit or loss for the year ended 31 December 20X5. It shows a net profit of RM48,600 before any of the following matters are dealt with. He is applying for a bank loan and wants the highest profit figure that can be defended.
The matters outstanding are: insurance of RM4,800 was paid on 1 April 20X5 for twelve months; wages of RM1,350 for December 20X5 are unpaid; rent received of RM9,000 was banked, of which RM1,500 relates to January 20X6; receivables of RM38,300 include a debt of RM2,300 now considered irrecoverable, and the provision for doubtful debts is to be 5% of the remaining receivables (the existing provision is RM2,050); and no depreciation has yet been charged on the workshop van, which cost RM90,000, has accumulated depreciation of RM36,000 and has always been depreciated at 20% per year on cost. Rahman proposes to switch to the reducing-balance method this year because he believes it 'shows the van is worth more'.
1. Prepare a schedule adjusting the draft net profit, with a working for each item.
Read the worked answer
| Item | Working | RM |
|---|---|---|
| Draft net profit | 48,600 | |
| Prepaid insurance | RM4,800 x 3/12 (Jan–Mar 20X6) | +1,200 |
| Wages accrued | December 20X5 unpaid | (1,350) |
| Rent received in advance | RM1,500 relating to 20X6 | (1,500) |
| Bad debts written off | debt now irrecoverable | (2,300) |
| Provision for doubtful debts | required 5% x (38,300 − 2,300) = RM1,800; existing RM2,050, so decrease of RM250 | +250 |
| Depreciation - van | 20% x RM90,000 cost (straight line, consistent with prior years) | (18,000) |
| Adjusted net profit | 26,900 |
Reasoning behind the two tricky lines:
- The provision decreases from RM2,050 to RM1,800, so the RM250 is income (a credit to profit or loss), not an expense. Students often add the RM1,800 as an expense instead.
- The bad debt is deducted first and then the 5% applied to the net receivables. Applying 5% to RM38,300 first would double-count the RM2,300.
2. Evaluate Rahman's proposal to change the depreciation method this year, quantifying the effect.
Read the worked answer
Under reducing balance: 20% x (RM90,000 − RM36,000) = RM10,800, so profit would rise to RM34,100 - a RM7,200 improvement created purely by an accounting policy change.
The proposal should be refused on these grounds:
- Consistency. The same method must be applied from period to period so that the two years can be compared. A change is allowed only if the new method reflects the pattern of consumption of the asset's benefits more faithfully. 'It shows the van is worth more' is not such a reason.
- Depreciation is an allocation, not a valuation. Neither method states what the van is worth; both simply spread its cost. Choosing a method to move profit is window dressing.
- Materiality and disclosure. A RM7,200 swing is 27% of the adjusted profit. If a genuine change were made, it would have to be disclosed with the reason and the effect quantified - which would immediately reveal the motive to the bank.
- No cash effect. Neither figure affects cash, so it cannot improve Rahman's ability to service the loan.
If a change were genuinely justified, it would be applied prospectively (opening net book value depreciated under the new method) with disclosure.
3. Rahman asks whether he can simply submit the RM48,600 draft figure because 'the bank only looks at the bottom line'. Advise him, and explain how a banker would actually read the two figures.
Read the worked answer
He must not submit the draft. Knowingly presenting figures he knows to be wrong to obtain credit is misrepresentation, and it breaches the fundamental principle of integrity. The statements must be adjusted and, ideally, accompanied by a short note explaining the adjustments.
A banker would read the two figures as follows:
- Profitability: RM26,900, not RM48,600 - a 45% reduction. Covering the loan interest out of RM26,900 is a very different proposition.
- Add back depreciation: RM26,900 + RM18,000 = RM44,900 of cash generated from operations before working capital movements, which is the figure a lender actually cares about for repayment capacity. This is a legitimate, defensible presentation - unlike inflating profit.
- Trend and stability: a proprietor who presents consistent, adjusted figures with notes is a lower credit risk than one whose figures are later restated.
Best advice: present the adjusted RM26,900, attach the add-back of depreciation as a cash-flow indicator, and include a short statement of the loan purpose and repayment plan. That is a stronger application than a figure the bank may query and discount anyway.